InvestmentsNov 28 2012

Rogue trading cases reveal systemic flaws

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      CPD
      Approx.30min
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      CPD
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      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.

      The Vickers committee – set up to develop a similar regulation for the UK – was about to finalise its recommendations when the UBS scandal erupted. Their plan to ring-fence the retail bank from the investment bank gained support from the trader’s gambling. The immediate reactions welcomed the case as the perfect illustration of the riskiness of proprietary trading.

      Mr Adoboli’s desk, however, was only supposed to execute client orders. When a customer wanted to bet on the future value of a market index, like the S&P500 or the Dax, UBS structured an ETF mimicking the index, so the client did not have to buy all the shares included in the basket of the index. According to the rise and fall of the indices, the bank paid the profit (or loss) the clients made. The bank was supposed to close the positions against its clients, by hedging them.

      Mr Adoboli, however, thought he knew the market better than the client. When he judged the client was going to lose on the position, he left the bank’s position open. The bank’s internal policies do not allow this risk taking, therefore he recorded fictive counter positions. As all trades were seemingly hedged, he did not breach the risk limits.

      This “market making” – when the bank facilitates the trade of a client – is exempt from the Volcker rule. The UBS incident drew the attention to this grey area, but the regulation is only meant to limit risk-taking, not to stop the criminal activity of fraudsters.

      A common feature in the rogue trading cases of Societe Generale in 2008 and the one of UBS in 2011 is that both fraudsters started working in the back office, where they have become familiar with the control checks when processing the trades. Later, when they moved to the front office, where the trades are contracted, they were able to exploit the weaknesses of the controls.

      Whenever a bank suffers huge losses because of unauthorised trading, the internal auditors of the peer banks rush to answer the question at hand: “Could it happen to us?”

      They test the control points that failed to spot the fake trades.

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