Stock Ideas 
Investing Ideas France's Rogue Trader: A Portrait
Investing Ideas France's Rogue Trader: A Portrait 
Market Watch
| What happened (and what is still happening) is simply leverage in reverse, or what people used to call a "run on the bank." But... I think a great more detail would be helpful for you to understand. Please excuse the intricacies: None of this stuff is very easy to understand the first time you think about it. I'll try to avoid using any jargon… | |
| More... |
Most Popular
Login Form
| France's Rogue Trader: A Portrait |
| Tuesday, 29 January 2008 | ||||||||
|
The headlines in Friday's Financial Times said it all: "Rogue Trader Costs Société Général $7 billion." The story of French trader Jérôme Kerviel has all of the elements of classic financial drama: massive trading losses that push one of Europe's leading investment banks to the brink of bankruptcy; subsequent turmoil unleashed in global markets due to the unwinding of the bank's breathtakingly large positions; and rumors that the actions of a single, mid-level trader panicked the world's most powerful central bank -- the Fed -- into a 75 basis point rate cut to avert a market meltdown. France's Rogue Trader: A PortraitThe term "rogue trader" entered the financial vocabulary when former back office employee turned trader and British "barrow boy" Nick Leeson brought down Barings Bank in 1995, after a $1.5 billion losing bet in the Asian futures markets.France's Jérôme Kerviel is a particularly unlikely figure in the gallery of rogue traders. The 31-year-old trader, who brought France's second-largest bank to its knees, was a heartbroken workaholic who was prone to doze off at the copy machine. Downtrodden after the death of his father last year and the recent breakup of his two-year marriage, Kerviel was described by co-workers as little more than "an introverted office fixture." Needless to say, no one suspected him of fraud. Yet in other ways, Jérôme Kerviel seems to fit the classic pattern of a rogue trader. Contrary to popular perception, rogue traders are neither motivated by greed nor are weavers of elaborate schemes to defraud investors or banks. Instead, they are generally lone wolves trying to build a reputation as star traders. They start with a small trading position and a few losses, which then rapidly grow out of control. They then carry on with the deception in the constant hope that the market will prove them right. Rogue traders are also usually inexperienced. Kerviel had previously worked in the back office and had only been a trader for two years. Nor did our hero appear to be the sharpest tool in the shed. Senior SocGen officials who interrogated him noted that Kerviel knew he was taking huge positions, but that he did not understand the implications. Even after his fraudulent activities surfaced, Kerviel boasted that he had discovered "a new trading technique which was performing very well." Ironically, the one thing that traders with back office experience like Kerviel are genuinely good at is concealing their tracks. France's Rogue Trader: Risk Management Gone Awry
Even with Kerviel's skills in concealing his trades, it is also hard to imagine that SocGen's risk management systems and financial controls were up to snuff. By Jan. 18, the day he was finally caught, Kerviel had positions worth €30 billion on the Euro Stoxx, an index of Europe's biggest companies, €18billion on Germany's Dax and €2billion on the UK's FTSE. So the question arises: how was a single, mid-ranking trader able to run up an exposure of €50 billion -- more than SocGen's entire market capitalization? Here is my guess. Yes, Kerviel did conceal some directional bets during a time when the market went against him. But the real problem is more systemic. Like almost every sophisticated investment bank, SocGen assesses its traders' risks on a net basis. That means that even a junior trader can buy €50 billion of equity derivatives, as long as he also takes offsetting short positions. As long as he was able to convince his superiors that the position was fully hedged, Kerviel could essentially buy all the derivatives he wanted. That's the theory. But in practice, even fully hedged bets involve risks that are massively understated by traditional risk management models. Because they are based on historical data, these models are next to worthless in volatile markets like the ones in January -- to say nothing of extremely rare "Black Swan" events. I have traded derivatives similar to the index derivatives that Kerviel traded. I also fully hedged my exposure according to a standard derivative model (called "delta neutrality"). But it only took about a month of trading this way for me to realize that while hedging was better than nothing, a single volatile day -- say a 2% move in the market -- would throw your entire hedging strategy off kilter. (In technical terms, it's virtually impossible to hedge "gamma" and "vega.") And on a day like Jan. 21, when the German Dax fell 7% and the U.K. FTSE 5.5%, it's easy to see how even "fully hedged positions" would have caused massive losses. Yet that was the very day that Soc Gen unwound Kerviel's positions, turning what would have been a €1.5 billion loss into a loss more than triple that amount. France's Rogue Trader: A Whipping Boy That's why it seems that SocGen has spun the story so that Kerviel is taking the fall for sins he did not commit. It is not unreasonable to argue that most of the losses in the $7 billion headline figure -- were not Kerviel's fault. His trades were down "only" about €1.5 billion when SocGen discovered them 10 days ago. SocGen's management lost an additional €3.4 billion from abruptly unwinding those positions on the day of the biggest drops in European stock markets since 9/11. Had SocGen just held on until Friday -- or just simply unwound its position more slowly -- its losses would have been a fraction what they turned out to be. The hullabaloo surrounding Kerviel also had the benefit of shifting attention away from embarrassing subprime-related losses -- including write-downs of €2.05 billion related to "unhedged super senior CDO [collateralised debt obligation] tranches" and other subprime-related derivatives. None of this justified Kerviel's actions. But it does point out that sophisticated risk management systems are not nearly as robust as the arcane mathematics behind them would indicate. And no formula -- no matter how complex -- can defend against the determination of a wily rogue trader. Sincerely, Nicholas A. Vardy Editor, The Global Guru P.S. Today more than ever, you can profit from investing in the market, no matter which direction it is going. Global Bull Market Alert
|
||||||||
| < Prev | Next > |
|---|