No Surprises Combating Rogue Trading

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No Surprises Combating Rogue Trading

• Geoff Kates
• Managing Director Lepus

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Overview

• Introduction
• Gallery of Rogue Traders
• Why does it still happen?
• Why have lessons still not be learnt?
• What should be done?

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Gallery of Rogue Traders

• Drexel Burnham Lambert 650M - 1990
• Allied Lyons 150M - 1991
• Bombay Stock Exchange - 1.3B 1992
• Metalgesellschaft - 2.2B rescue 1993
• Chile Copper Group - 175M 1994
• Barings Bank - 1.3B 1995
• Daiwa - 1.1B 1995
• NatWest - 90.5M 1995
• Common Fund of the United States - 128M 1995

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Gallery of Rogue Traders

• Sumitomo - 1.8B 1996
• Deutsche Morgan Grenfell - 400M 1996
• Credit Suisse - 10M 1997
• Griffin - 10M 1998
• Chase Manhattan - 60M 1999
• Transcanada Pipeline - 49M 2000
• Muirpace - 32M 2000
• AIB - 750M - 2002

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Why does this still happen?

• Increased Complexity of Financial Firms Traded
  Instruments
• Insufficient risk management and internal
  controls
• Inefficient risk management and internal controls
• Collusion
• Agency Problem

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Increased Complexity

• Global Institutions
• High Volume, many counterparties
• Complex chain of events
• Exotic Products

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Insufficient Risk Management Internal Controls

• Pressures of Cost Efficiency
• Insufficient controls for remote offices
• Bureaucratic rather than genuine controls

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Inefficient Risk Management Internal Controls

• Not enough Collaboration between parties involved
• Not many banks have one individual for
  Operational Risk
• Information is not integrated

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Collusion

• Front and Back Office working together
• Senior Managers covering up their juniors

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Agency Problem

• Traders do not have the concept of ownership
• Accountability
• Hedge Funds have clear ownership

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Why have lessons not been learnt?

• Lessons have been learnt but to a different
  extent
• Lessons have been learnt but loopholes still
  appear

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Lessons have been learnt but to a different extent

• Large banks have been spending money on it
• Larger budgets
• More sophisticated Risk Management Systems
• Tighter internal controls
• Problem in smaller banks is lack of resources

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Lessons have been learnt but loopholes still
appear

• Changes have occurred
• Better Capitalisation
• Segregation of Front and Back Office
• Complexity of controls make them easier to
  overcome

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Could regulators have done more?

• Introduce minimum risk management standards for
  all banks
• Ensure integrity of the system
• Reduce high leverage of some 1st Tier Investment
  Banks

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What should be done?

• Reassign Responsibilities
• Improve basic risk management standards
• Reassess Internal Controls
• Holistic Risk Management Approach
• Escalate Processes
• Reassess remuneration policies
• Listen to regulators
• Protect against insolvency
• Outsourcing of Trading
• Psychology

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1. Reassign Responsibilities

• Shared amongst all parties involved
• Supervisors
• Traders
• Proactively driven from the top
• All levels of employees should be empowered to
  prevent Fraud
• Clear lines of responsibility and accountability
  should be established
• Senior management should be role models for all
  employees

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2. Improve basic risk management standards

• Unresolved Issue for smaller (overseas) branches
• Head Office quite often does not fully understand
  what overseas branches are doing
• Risk still seen as extra expense of doing
  business
• Information flow key to doing business
• View moving to seeing Risk Management as a
  revenue enhancing tool

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3. Reassess Internal Controls

• Checks and Controls that should be in place
• How Meticulous should checks be?
• How often should the checks be carried out?
• Who should supervise and carry out the checks?
• What are the supervisory tools?

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What Checks and Controls should be in place?

• Supervisory
• Trades against confirmations
• Credit and Trading Limit
• Cash Flow
• Anti-Collusion
• Counterparty
• Cash Trades vs. paper gains

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Supervisory Controls

• All Trading Supervisors should have separate
  clearing and operational duties
• Separating Front from Back Office
• Trading sheets should be checked and signed off
  daily

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Checks of Trades against Confirmations

• Checks of individual trades against counterparty
  confirmations is essential
• Risk Managers should be notified on discrepancies
• Cannot cut corners on this
• How to check ask a trader how many unresolved
  confirmations they have each day and how old the
  latest confirmation is.

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Credit and Trading Limit Controls

• Issued and monitored with due attention
• Watch for (excessive) breaches of these limits
• Match the PL with the credit limits of every
  trader

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Cash Flow control

• Ultimate test of whether rogue trades are taking
  place
• Much harder to conceal cash that has to be paid
  to a counterparty
• Look for unusual cash requests from traders
• May not be a good measure some of the time due to
  volume of individual trading

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Anti-Collusion Controls

• Various measures have been tried
• Traditional Whistleblowers
• Supervisor scorecards
• Independent supervisors reporting to the board
• Operational, Financial, Risk and Legal all have
  representation on the board

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Counterparty Controls

• Counterparties often see evidence of rogue
  trading before the banks with the problems do
• Many examples of this
• Barings (whole market)
• AIB (Goldman Sachs)
• Encourage a culture of communicating this

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Checking cash trades offset with paper gains

• Reconciliation of such areas is crucial to
  spotting rogue trading

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How meticulous should the checks be?

• If it looks too good to be true it probably is
• No trader makes money 100 of the time
• Check your profits as closely as your losses
• Detailed checks of Balance Sheets

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How often should the checks be carried out?

• Small banks batch based overnight
• Larger banks intra-day
• Ideal deal by deal

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Who should supervise and carry out checks?

• Supervisors
• Risk Managers
• Traders
• Counterparties
• Internal Auditors
• External Auditors

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Supervisors

• Need to have long and relevant experience
• Understand the peculiarities of the front office
• Should have a multi-layered hierarchy of
  Supervisors

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Risk Managers

• Number of banks feel they should be on the floor
  in direct contact with traders
• Should not interfere with traders if within
  prescribed limits
• Should concentrate on where limits have been
  broken and how supervisors allowed this

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Traders

• Traders not making money if other traders
  breaking rules
• Longer Term view should be that if a rogue trader
  exists, will affect the bonuses of them all
• Joint responsibility/scorecard approach may be
  way forward

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Counterparties

• Part of their role should be responsibilities
  over their peers
• Often the first to recognise a rogue trader
• Consistent betting against a trend
• Volumes rise dramatically
• Need to inform more the rest of the banking
  community

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Internal Auditors

• Need to co-ordinate closely with Risk Managers to
  spot inconsistencies
• Need to raise level of expertise to spot what is
  happening

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External Auditors

• Proved to be the weakest link in the chain of
  controls
• Fail to carry out comprehensive audits due to
  lack of specialised knowledge
• Need to raise standards of performance

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What are the supervisory tools?

• Best tool is fully qualified staff with extensive
  experience and knowledge
• Technology being used more to support supervision
• Tools such as Autonomy and Searchspace starting
  to be used

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4. Consider Holistic Risk Management Approach

• Risk and Finance Managers need to work with each
  other
• The REAL approach (Risk Enterprise and
  Accounting Logic)
• Based on Accounting consistent with Economic
  Evaluation of Business
• Needs to be a Power Relationship with
  discrepancies being investigated

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5. Escalate Processes

• All procedures in Front, Middle and Back Offices
  need to be managed efficiently
• Contracts need to be completed and put in place
  quickly
• Hard to spot rogue complex trades otherwise
• Need to escalate and make sure processes are
  consistent and efficient

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6. Reassess remuneration policies

• Large Part of Traders performance related bonus
  needs to be deferred
• Bonus related to performance of bank (by issuing
  shares as bonus)
• Look at how much traders make over a period of
  time rather than just a single year
• Reduce discrepancy of trading and non trading
  compensation
• Make sure risk and back office staff are paid the
  right amount to get the right quality of people

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7. Listen to Regulators

• Seen as assisting, not as adversary
• Good at spotting and disseminating best practices
• Used as a resource and sounding board

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8. Protect yourself against Insolvency

• Operational Risk Capital Allocation
• Rogue Trader Insurance

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Operational Risk Capital Allocation

• Big controversy about this area
• How effective is it
• Lot of debate
• Some banks already allocating capital against
  business units based upon results of internal
  audit

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Rogue Trader Insurance

• Number of players in this market
• SVB 30 Banks have taken out their Insurance
• Swiss Re broader coverage, higher minimum loss

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9. Outsourcing

• Isolation of proprietary trading areas
• Internal Hedge Funds
• Limit legally the capital exposure
• Reaction to concerns of rating agencies

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10. Psychology

• Need to understand the psychology of traders
• Look at 3 areas
• Disposition
• Learning Experiences
• Trading Environment

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Conclusions

• Never become complacent about internal controls
• Continuously reassess and improve Risk Management
  Systems
• Look closely at the 10 areas detailed above
• If it looks too good to be true it probably is