Investments  

Rogue trading cases reveal systemic flaws

    CPD
    Approx.30min

    The criminal trial of Kweku Adoboli – the rogue trader of last year’s scandal at UBS – has come to a close. Adoboli begins a seven-year prison sentence for the fraud of gambling away the bank’s money.

    He has been found not guilty of false accounting, as the jury were not sure he booked the fictitious trades predominantly to make a financial gain for himself.

    In 1995, when Nick Leeson’s £830m loss brought down Barings Bank, we all thought there must have been a secret bank account where he had hidden his profits. Otherwise why would he have done it? But no, these rogue traders do not earn directly on their fraudulent dealings, they only earn a higher bonus, indirectly.

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    Throughout the trial, Mr Adoboli’s defence lawyer claimed that the culture of the Swiss bank made traders feel they could ignore risk limits, as long as they were making profit for the bank.

    Adoboli’s rogue trading, however, is not about openly breaching the risk limits. He built up secret positions risking billions of pounds of the bank’s money. On paper, he did not exceed the limits. On paper, the positions of the bank were all hedged.

    Jerome Kerviel, the rogue trader of Societe Generale, got caught in the storm of the credit crunch in 2008. He lost €4.9bn (£3.4bn) for his bank. Mr Adoboli’s trades emerged in the wildly fluctuating market of 2011. He caused a loss of $2.3bn (£1.4bn).

    Somehow, it is always when a bank faces losses that the fraudulent positions surface. Till then, no-one questions the unreasonably high profitability of a relatively low risk activity. When the market circumstances change unfavourably, however, the skeletons are falling from the closet.

    Would they have been caught for breaching the risk limits, if they had produced extra profits?

    The two high profile cases raise suspicion about the rules of the game: if you make a profit, your bonus is bigger, and you are a genius. In case of usual losses, your liability is limited. This practically guarantees disproportionate risk-taking. However, if you lose a lot, that is unauthorised trading.

    Rogue trading often starts when traders want to hide, temporarily, a smaller loss. To rebalance, they gamble on a “sure” bet. When, however, that sure deal fails, they cannot accept and cut the losses by withdrawing from the risky position, but double up.

    The spiral of doubling is the typical weakness of gamblers. The financial crisis marked the investment banks as casino banks, for trading with risky financial products. Extending this analogy, the trading floor is the Gamblers Anonymous fellowship.

    The verdict serves as a deterrent. Commander Steve Head from City of London Police said in front of the court building: “Others who tread a similar path, can expect the same fate.”

    To reform the financial system, the US accepted the Dodd-Frank Act in 2010. An important element of the law is the Volcker rule, limiting the risky trading activity of deposit collector banks. It is about limiting excessive risk taking funded with insured deposits.