A month before he was caught, the trader Jerome Kerviel worried that his supervisors at Societe Generale would uncover a secret profit of one and a half billion euros which he had made in fraudulent trades. For years he had used the French bank’s money to gamble on hunches that various stock markets would move in a particular direction. In mid-2005, for example, he guessed that European stocks were about to fall. When suicide bombers struck the London transport system early in July, Kerviel made 500,000 euros from the resulting downturn in the markets. His wagers were doubly lucrative because he chose not to hedge – to place an insurance bet in case the markets moved the wrong way – a measure most stockbrokers use to manage their exposure to risk.
At first Kerviel gambled with relatively modest amounts, but his early success seems to have created an addiction to risk. When he realised that he could hide his losses by entering non-existent trades in the bank’s computer system (so that his investments looked hedged) he became much bolder. Last spring he concluded that the subprime crisis was going to have a much larger impact on the markets than early analyses suggested. When this didn’t seem to be the case, Kerviel chalked up a loss of more than 2 billion euros (and exposed the bank to a potential loss of 30 billion euros). But, as the credit crisis deepened, his strategy began to pay off. By the end of the year the rising tide of mortgage defaults had dragged so many banks into the crisis that Kerviel’s gamble had earned a large profit-one he hid from his bosses lest they ask for an explanation.
A few weeks later the profits had gone, leaving the bank with trading positions that eventually cost more than seven billion euros to ‘unwind’. The settlement of these positions appears to have been one of the major reasons for the sudden drop in the US stock market in late January, an event which caused the US Federal Reserve to make one of the largest interest rate cuts in recent history.
Remarkable though it seems, Societe Generale’s sudden collapse follows a familiar pattern for financial institutions that have overlooked or misunderstood their true exposure to risk. In 1995 the British merchant bank Barings Brothers was brought down by a single trader who lost US$1.3 billion in fraudulent derivative trading in Singapore and Japan. Shortly afterwards, Japan’s Daiwa bank discovered that one of its traders had concealed losses of US$1.1 billion in unauthorized trades in the US bond market. A year later, Sumitomo – another Japanese bank – declared losses of US$2.6 billion incurred by a single employee who had engaged in illicit copper trading. In 2002 a currency trader defrauded US$750 million from Allied Irish Banks. These are only the most egregious examples, a comprehensive list would run to several pages.
Each new scandal brings forth regulatory promises of new safeguards: rules and technologies that will make it that much more difficult for the next rogue trader. Yet there always seems to be another loophole, some new way of gaming the system and hiding one’s tracks. This is an important point, for the ability to beat the new system always seems to embolden rogue traders. At Barings, Daiwa and Societe Generale, the first fraudulent trades were all for relatively minor amounts. It was only when the traders realised that their scams had gone undetected that they began to take larger gambles.. (Nick Leeson, the Barings trader, survived two full audits before he was caught; the Daiwa Bank trader incurred his losses over 11 years.)
The business culture in many successful financial institutions is another problem. After the major deregulation of stock markets in the mid-eighties, particularly in departments that handle the complex, high-risk financial instruments associated with options and derivatives trading, mid-level employees often handle vast sums of money with little or no sense of its true value. Traders who toss millions of dollars around the markets each day often make a fraction of that annually. Even so, traders are driven by a profit-obsessed culture which ranks its members almost entirely according to the money they produce. They are therefore understandably reluctant to own up to costly errors, especially when they have managed to retrieve or disguise earlier losses without being noticed.
Yet another problem is that high-speed electronic trading has now become so complex that it is difficult for an overworked accountant – is there any other? – to isolate a single fraudulent trade, or even a series of carefully disguised false trades, within the hundreds of thousands that many brokerages carry out each year. Furthermore, many brokerage supervisors do not understand the intricacies of the trades which their employees execute each day. Given that, it seems almost inevitable that occasional rogue traders will exploit vulnerable systems.
Rogue traders are unavoidable, the clever ones tend to be caught only by extremely vigilant managers who are willing to chase down every hint of suspicious activity with singleminded determination. In large companies this is extremely impractical if not downright impossible. So, bad as this latest example of ruinous fraudulent trading may seem, there will probably be another in the near future. Fear and greed, and traders fuelled by these emotions, have always driven the world of high finance; until we learn how to make large profits without taking risks, they always will.
