Before I get to the meat of my article, I want to pose a question: What’s the one thing that all rogue traders have in common?
We’ve all heard of Nick Leeson of Baring Brothers; he lost £600 million in 1995 and was subsequently made famous by his book: Rogue Trader, which was made into a movie. Many people have also heard of Jerome Kerviel — he’s the guy who lost $7.2 billion in 2008 at Société Générale Bank. I read there’s going to be a movie about him and it’s scheduled to come out next year. Jon Corzine has also been in the news recently, he certainly qualifies as a rogue trader.
I define a rogue trader as someone who’s taken unauthorized trading positions or risks. Someone who’s manipulated a market, hidden a loss or partaken in some kind of illegal activity. Quite often, the trader’s original intention was not about “going rogue.” Most incidents begin with a trader taking a loss (or more precisely, not taking a loss), then trying to make that loss back and losing more money. At that point, they’ve arrived at a fork in the road with two possible paths. One path is to come clean and tell their boss or someone at their company about the loss. The second path is to hide the loss and continue to try to make the money back. Naturally, the traders who took the first path never end up in a book called Rogue Traders. These are the traders who took the wrong road, the ones that “went rogue.”
You might think rogue traders should be confined to certain financial markets that are not regulated. An obvious conclusion is to assume that rogue traders are operating in unregulated markets. But that’s not the case. There have been rogue trading events in mortgage-backed securities, U.S. Treasuries, futures, natural gas, stock indexes, metals, energy and even in the LIBOR. You can find rogue traders throughout history and in all of the new financial instruments of the past 30 years.
Joe Jett: 36, American
Firm/title: Kidder Peabody, Head STRIPS trader
Date of rogue trading loss: 1994
Years with firm prior to incident: Four
Market or trading vehicle: U.S. Treasury STRIPS
Amount of loss incurred: $350 million
Trigger/event: GE (Kidder Peabody’s parent company) orders Kidder to reduce their balance sheet for quarter-end. Jett takes off his trades and the company loses money.
Fatal flaw: Assumed he could exploit a flaw in Kidder’s accounting system indefinitely.
Action by company: Fired
Legal or regulatory action: NASD (National Association of Securities Dealers) found Jett not guilty of fraud. SEC found Jett guilty of intent to defraud and fined $8.4 million.
Where is he now: CEO of Jett Capital Management
How is it possible that we’ve seen so many rogue traders over the years? One reason is that there’s always a flaw.
Last winter I went skiing with my family. I prepared for the bitter cold, especially that chairlift ride to the top of the mountain. I had my snow pants, layer upon layer of clothing underneath, goggles, hat, glove linings and, of course, ski gloves. In a way, the preparation to guard against the severe cold is like a personal risk management. But no matter how much you cover up, there’s always going to be a spot that you missed. It could be the crack between the hat and goggles; something you never know is exposed until the chairlift is close to the top of the mountain. That’s where it’s the coldest and the windiest. The cold creeps into the cracks that you didn’t know existed. Think of the same risk preparation, except at a financial institution.
One thing many (but not all) rogue traders have in common is an in-depth knowledge of a financial market. That knowledge allows them to spot a flaw in that market or in their firm’s trade processing or risk management system. However, knowledge of a flaw is not enough to entice a generally honest trader into taking the wrong path. It’s the combination of a trading loss with the knowledge of a flaw which often pushes them over the edge.
During the past 30 years, banks, hedge funds and investment banks have all had flaws exposed in their risk management systems. Goldman Sachs, JP Morgan, Sumitomo, Daiwa Bank, RBS, UBS, Merrill Lynch, Credit Suisse and Kidder Peabody all had rogue traders. These traders became more knowledgeable about their market and the risk management system than the people managing them. The trader knew more than the recent college grad assigned to monitor them and, too often, was more knowledgeable than their boss.
Jerome Kerviel knew the risk reports were run at 5:00 p.m. every day. He knew how to input “pending” trades before 5:00 p.m., which would not be confirmed by the settlements group, and then delete them after 5:00 p.m.
Nick Leeson was in charge of both the back office and the front office at Barings’ Singapore office. Clearly that’s not allowed anymore. Joe Jett found a flaw in Kidder Peabody’s accounting system that allowed him to book profits upfront on trades that didn’t settle for months. Howie Rubin not only kept his “risk management system” for mortgage-backed securities on his own LOTUS spreadsheet, but he was also able to hide paper trade tickets in his desk drawer; a relic of the time before computerized trade entry.
So we know that rogue trading events often occur when a trader takes a loss and knows how to exploit a flaw in the system that monitors his trading. But there’s also a third element: the willingness to exploit the flaw and cover up the loss. This is when the criminal element steps in.
Nick Leeson: 28, British
Firm/title: Baring Securities, Head trader, Head of Operations
Date of rogue trading loss: 1995
Years with firm prior to incident: Six
Market or trading vehicle: Nikkei stock index futures traded on the Singapore Monetary Exchange (SIMEX)
Amount of loss incurred: £600 million
Trigger/event: Kobe earthquake, Jan. 17, 1995
Fatal flaw: Married to a losing long Nikkei trade, position was too large to get out.
Action by company: Fired
Legal or regulatory action: Served 4½ years in a Singapore prison.
Where is he now: Conference speaker and works at a debt-restructuring firm in Ireland.
Punishments have varied considerably for rogue traders. First, keep in mind that there’s sometimes a fine line between being accused of being a rogue trader and actually being prosecuted for it. Both Howard Rubin and Brian Hunter were accused of rogue trading, but no charges were ever filed against them. David Heuwetter, Nick Leeson, Yasuo Hamanaka, Robert Citron, Toshihide Iguchi and Evan Dooley all spent time in prison. More recently, legal action is still pending for the LIBOR scandal, Jon Corzine and The London Whale. Of course, these are just a few examples; there are still many others out there.
It’s that criminal element that has allowed rogue traders to lose approximately $66.3 billion at financial institutions over the past 30 years.
Granted, it’s not accurate to call a Wall Street trader that’s suffered an enormous loss a rogue trder. But if you look at the 45 largest trading losses of all time, at least 40 can be attributed to a rogue trader.
Clearly, there were very few rogue trading losses before the 1980s. In fact, there was only one in 1974 that was large enough to show up in the history books. That’s the $180 million loss at Herstatt Bank in Germany on foreign exchange trading that led to its collapse. In the 1980s, there were $1.6 billion in losses, that’s when they started to register. In the 1990s, rogue trading losses were up to $18.6 billion and since the beginning of the 2000s, the number has grown to a startling $45.9 billion. There’s got to be a reason for this.
Demutualization & consolidation
Prior to the 1960s, Wall Street banks were all set up as private partnerships. Because the partners had unlimited personal liability, they took conservative risks. Everybody who was taking risk had their money tied up at the firm. There was a head trader, a long-time veteran of the markets, watching over everyone on the trading floor. It was a system that had unlimited downside for all of those involved. Imagine how risk-taking is different when your own retirement money is tied up at your employer.
In the 1950s and 1960s, Wall Street firms began to incorporate. As partnerships grew in size, the partners wanted to limit their personal liability. Merrill Lynch incorporated in 1952 and Paine Webber in 1969. It solved the problem of unlimited personal liability, but people still had their money tied up at the company. The conservative risk-taking incentive system was still in place.
But in the 1970s and 1980s, that’s when things really began to change. They all became public companies. Merrill Lynch went public in 1971, Salomon Brothers in 1978, Bache was sold to Prudential Insurance in 1981, Kidder Peabody was sold to General Electric in 1986, and Morgan Stanley went public in 1986. The partnership structure that had incentivized the employee-owners to take conservative risks was disappearing. Risks were being taken by low-level employees at investment banks with thousands of employees, and traders who lost huge amounts of money merely lost their jobs. Fallen traders often received second, third, and even fourth chances, because now they were known as big market movers. According to John Gutfreund, the CEO of Salomon Brothers, “The world changed in some fundamental ways, and most of us were not on top of it. We were almost dragged into the modern world.”
The system became even worse in the 1990s, because most of those investment banks were absorbed by global commercial banks. They had huge global trading operations, which were next to impossible to manage. The old conservative nature of the business was now entirely gone. It was a new era, populated by young and aggressive traders; traders who were eager to make large sums of money. The whole system was upside down. There was a flaw in the compensation system — the downside was limited and the upside was unlimited.
Brian Hunter: 32, Canadian
Firm/title: Amaranth Partners, Head trader
Date of rogue trading loss: 2006
Years with firm prior to incident: Four
Market or trading vehicle: Natural gas futures and swaps
Amount of loss incurred: $6.6 billion
Trigger, event: Good weather. Hunter was betting on another bad hurricane season in 2006 following the devastating hurricanes of Katrina and Rita in 2005 and an active 2004 season.
Fatal flaw: Assumed large trading positions could push around the market and generate profits indefinitely, but when his position got too big, he was unable to get out.
Action by company: Fired
Legal or regulatory action: Accused of violating FERC (Federal Energy Regulatory Commission) and CFTC rules, but was never personally prosecuted. Amaranth paid a $7.5 million fine on a related trading manipulation event.
Where is he now: Lives with his family in Calgary, Canada. Serves as an advisor in the natural gas market.
What have we learned?
One of the most important things we can learn from rogue traders is to learn from their mistakes. We can learn what went wrong, how losses were covered up and how markets were manipulated. In essence, what caused billions of dollars in losses.
In 1905 philosopher George Santayana coined an oft repeated phrase: “Those who cannot remember the past are condemned to repeat it,” in his book Reason In Common Sense. That quote was answered by the famous author Kurt Vonnegut years later with, “I’ve got news for Mr. Santayana: We’re doomed to repeat the past no matter what. That’s what it is to be alive.”
However, just because some people don’t learn from the mistakes of the past, doesn’t mean you shouldn’t.
When I first became a junior trader back in the early 1990s, I was given my own trading account at the bank where I worked. My boss gave me some very interesting advice. He told me the first thing I’d learn was “what not to do.”
Imagine that, he was basically telling me that I was going to make mistakes. And he expected it. He expected that I’d take losses — granted, only for a short period. Things like not putting a stop-loss on a trade, letting losses ride and grow larger. Trades which appeared to make easy money up front, but had hidden risks in the back-end. Not taking profits. All the Trading 101 words of wisdom written in all of the books that people so often ignore. In one way, learning from rogue traders is about learning “what not to do.”
Yasuo Hamanaka: 46, Japanese
Firm/title: Sumitomo Corporation, Head copper trader
Date of rogue trading loss: 1996
Years with firm prior to incident: 26
Market or trading vehicle: Copper
Amount of loss incurred: $2.6 billion
Trigger/event: After successfully cornering the copper market in 1995, the CFTC began investigating copper pricing abnormalities.
Fatal flaw: Tried for 10 years to make back a $50 million initial loss.
Action by company: Fired
Legal or regulatory action: Sentenced to 8 years of hard labor in Japan.
Where is he now: Works with his son providing consulting services in the scrap copper market in Japan.
Will new sheriff change the tide?
There’s a lot of new regulation out there in the markets today. The Dodd-Frank Act was passed in 2010. So, hopefully, going forward rogue trader losses are much less likely to occur. The risk management systems at banks are more robust. Many of the new financial instruments of the past 30 years are not so new anymore, so managers and risk managers at banks understand those risks better. But on a more cynical note, there seems to be a direct opposite correlation between regulation and losses. The markets are more regulated now than ever, but still rogue trading losses continue to grow. Remember, the London Whale rogue trading event occurred in 2012, two years after Dodd-Frank was passed.
So, what’s the best way to prevent the next rogue trading event from happening? What is apparent from a study of rogue traders is that when risk-takers have “skin in the game” they tend to act more responsibly than someone with a lot of upside and very little downside. In my experience, the best system to promote responsible risk-taking is with long-term incentives. That’s the system that worked so well for so many years before investment banks went public and commercial banks became too big to manage.
Now, to answer the question about what all rogue traders have in common. They’re all men. There’s never been a woman rogue trader. I can’t answer the question of why — that’s just always been the case.
Jerome Kerviel: 30, French
Firm/title: Société Générale, Equity trader
Date of rogue trading loss: 2008
Years with firm prior to incident: Eight
Market or trading vehicle: European equity index futures
Amount of loss incurred: €4.9 billion ($7.2 billion)
Trigger/event: “Black Tuesday” (Jan. 15, 2008) stock market sell-off.
Fatal flaw: Assumed no one at Société Générale back-office would properly confirm his rogue trades.
Action by company: Fired
Legal or regulatory action: Sentenced to 3 years in prison, ordered to pay back SocGen €4.9 billion.
Where is he now: In prison serving his sentence.
Scott E.D. Skyrm is author of the book Rogues Traders and is working on a sequal. Previously he was a global business head in fixed-income, securities finance, and securities clearing and settlement for Newedge and managed the repo desk at ING Barings.