Rogue episodes appear to be growing

August 31, 2014 07:00 PM

Futures has new offices very close to the historic Chicago Board of Trade building. One of the benefits of being so close to the CBOT is the ability to stroll through its lobby and see some old friends and sources that can provide tips and inside information on issues going on in the industry. 

A few weeks ago I ran into trading and local sports legend Lee Stern in the CBOT lobby and he pointed out that he would be celebrating his 65th anniversary as a member of the CBOT this November. All I could think of was “Wow!” We had just gotten through looking back over 500 issues of Futures spanning 43 years covering the industry. That period encompassed numerous revolutionary changes for the industry—and Stern was there for all of it. He was a member for more than 22 years before the launch of Futures magazine. 

We talk to Stern—another legendary trader who started out as a runner—about his start in trading, and how he has evolved over the years (see “Lee Stern: Trading 65 years and going strong,”). Obviously our back page does not provide the space to adequately discuss a lifetime in the business, so look for expanded coverage of our interview with Stern online. 

It is coincidental that we speak with Stern in the issue where we focus on rogue traders because Stern was the victim of an infamous rogue trading episode. Darrell Zimmerman, a floor trader who had an account at Lee B. Stern & Co. , attempted to manipulate the bond market by placing size orders directly in the pit while his partner, Anthony Catalfo, bought options that benefited from Zimmerman’s actions. Both were caught and spent time in jail, but it cost Stern nearly $8 million and his clearing firm, and it all happened in a matter of minutes (about 30 feet from where I was standing at the time). 

The rogue traders that Scott Skyrm—author of the book Rogue Traders—highlights in “Inside the mind of a rogue trader,” were obviously more institutional, but shared some common traits. Scott does a nice job in describing the “fatal flaws” of the rogues he highlights. While all of their stories are unique, there are some similarities among the traders (perhaps the most common being the inability to take a loss). 

Ironically, JPMorgan’s Bruno Iksil—the trader dubbed “the London Whale,” (see “The London Whale: Rogue risk management,”)—was ready to take his medicine and get out with a large loss, but his superiors were not, insisting the team “protect the position.” 

This is where the London Whale story diverges from most rogue trading events and into something much worse. It is one thing for a young, aggressive trader driven by ego to refuse to take a loss and pile on to a losing trade pulling his firm down in the process; it is quite different—and more worrisome—when “higher ups” at a firm encourage this type of dangerous behavior. 

And remember, the purpose of JPMorgan’s Synthetic Credit Portfolio was to hedge the bank’s credit exposure. JPMorgan Chairman and CEO Jamie Dimon went before Congress and argued for the value of portfolio hedging. Yet from what Skyrm revealed in his research, there was no direction from the bank to Iksil that there was specific exposure that needed to be hedged. Everything we learned from this episode indicates that these were purely speculative positions. 

There were several other red flags. It is scary that when directed to reduce their risk-weighted assets, the chief investment office team switched the methodology of measuring the value-at-risk (VaR), enabling them to technically be compliant but actually increase exposure to risk. Seeking this type of loophole is an assault on logic as well as proper risk management, particularly for a group whose stated goal was to hedge risk. As they got deeper in the hole, all effort was made to hide the loss even as Iksil himself wanted to get out. 

Another red flag is the personal nature of the competition. Because these were unique instruments, the hedge funds on the other side of this huge position knew the seller. Most institutional traders will do everything they can to disguise their position. This can be done easily if you are trading something as liquid as major currencies, but not credit default swap indexes. 

Speaking of currencies, our markets story, “Forex: What happened to the volatility?”, talks about the frustration of a sector controlled by central bank activity. In the aftermath of the credit crisis of 2008, central banks have attempted to keep long-term interest rates as low as possible to spur growth. This has led to a distorted world where traders follow central bank activity above other fundamentals. 

This has led to a strange low-volatility period in a sector known for its major trends. One thing we know about markets is that trends don’t last forever, and eventually we will see a breakout. When that happens it will likely be dramatic, but “when” is always the key question. As the saying goes, markets can remain irrational longer that you can remain solvent. 

In our interview, Stern makes the point that markets are always changing and in order to survive, traders need to adapt and change with the times. This period of endless quantitative easing is due to end this fall and perhaps a new era of less interventionist central banks will begin. It probably won’t happen until the Federal Reserve and other central banks begin the process of moving interest rates higher, which isn’t likely until the second half of 2015. But it will happen—and when it does, traders will have to adjust.


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About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.