UPDATE: Question answered, by my Friend Who Does This Stuff For A Living
Treason doth never proper. What’s the reason?
Why, if it prosper, none dare call it “treason.”
Does it strike you as strange that no big bank ever announces that it has made $2.3 billion in unauthorized trading? Somehow, “rogue” traders always wind up losing tons of money; they never seem to win.
This should be statistically impossible. Since risks are symmetric and transactions costs tiny, if there were really trading strategies that could reliably lose billions of dollars, you could make huge sums just by making the opposite bets.
This suggests to me that big banks only classify trading activity as “unauthorized” when it loses huge amounts of cash. Otherwise, they’re happy to quietly pocket the money. I’m curious how much of their reported earnings come from activity that would have resulted in the traders’ being marched off in handcuffs had the market gone the other way.
Tags: rogue trading, UBS, unauthorized trading
“I’m curious how much of their reported earnings come from activity that would have resulted in the traders’ being marched off in handcuffs had the market gone the other way.”
Obliquely, America’s Finest Newspaper got there first:
Visa Exposed As Massive Credit Card Scam
http://www.theonion.com/articles/visa-exposed-as-massive-credit-card-scam,21136/
When a “rouge trader” is winning they call him “genius.” Remember when Enron was “The smartest guys in the room?”
This suggests to me that big banks only classify trading activity as “unauthorized” when it loses huge amounts of cash.
That’s pretty close to accurate, but I don’t think it’s sinister. Generally, traders’ authorization is to commit up to a certain amount-if they are ahead, they can close winning positions and keep trading. It’s the same ruleset as I use when playing poker-I’ll buy in for $5, and play until it’s gone; as long as I’m ahead, I’m “authorized” to keep playing.
Good point. In addition to self-selection bias, there may be fiscal incentives as well: losses from rouge traders can be decuted from tax bill or credited against future tax liabilities
I think SamChevre raises an important point, in that most of these “rogue trader” stories involve someone who, like a stereotypical bad gambler, has suffered a bad initial loss and then has made the situation exponentially worse by, in essence, repeatedly going “double-or-nothing” on the debt they’ve incurred. The gamble that failed and resulted in their initial loss might have been well within their authorized investing range (not that their career would survive the bad bet if not made good); their eventual losses make the headlines. If their initial bet had instead paid off, they might well have been rewarded, but even if it paid off big the amount risked would not have been of such an epic scale, and so the amount gained likely would similarly not be terribly notable on the scale of the whole bank.
There are exceptions, of course. I seem to recall a notorious episode in which a “rogue trader” attempted to corner the world copper market. The attempt required enormous amounts of capital if it were to stand a chance, and stood to reap an absolute fortune if successful. In the event, the scheme failed, incurring huge losses - losses of capital that had all been risked as part of the one undertaking rather than having been wagered in a series of escalating gambles intended to make good an initial loss.
“Since risks are symmetric”? Next you’re going to tell us they’re normally distributed.
Matt Taibbi recently ran a post in the same direction.
It is a must read too because it digs to the core of the problem:
Of course since all three branches are now owned by Wall Street, FDR’s Glass-Steagall Act will not be coming back…
Which reminds me of a recent post by Krugman:
I’d also like to suggest that the end state is not a liberal democracy. But rather, an oligarchy controlled democracy in which adult children are kept passive, not by Huxley’s soma, but by gadget-candy. Who would have thought human monkeys could be so enchanted with hand held screens pumping out social media bling? All the billionaires have to do is just make sure everyone has a cell-toy with an all you can eat media plan. If the oligarchs do that, you can expect little protest when the top 1% own 90% of everything…
http://www.rollingstone.com/politics/blogs/taibblog/the-2-billion-ubs-incident-rogue-trader-my-ass-20110915?print=true
http://krugman.blogs.nytimes.com/2011/09/20/doom/?pagewanted=all
By the way… The John Judis article Krugman links to is absolutely must read. Highly recommended.
When I worked in finance, one of the operational risk officers I worked with maintained that most rogue trading scenarios start out with hiding a substantial loss that was *within* sanctioned trading limits.
The end result resembles a martingale betting strategy with a losing first toss. Transaction costs make it less fair than a coin toss, especially as implicit costs (mostly market impact) increase with the purse size for each round. Disaster and hilarity ensue.
I seem to recall that one bright spot for Enron was a gas trader made a huge Natural Gas hedge (short position) and made bundles for the bankrupt company and its creditors when prices fell (probably the Enron-caused bubble bursting). I seem to recall that the size of the windfall seemed large (and wondered if this bet was outside the bounds of the trading limits) for one trader to make a bear bet in a rising market. I bet no one investigated since the creditors were helped.
Although it’s fun to imagine banks rewarding successful rogue traders, the comments above about trading limits are closer to the mark. Trading strategies would be allocated less internal capital if they are losing, even if the institution expects them to come back. The rogue trader instead finds a supervision lapse to try double or nothing to re-establish his profitability.
Speaking of symmetry, who do rogue traders lose money TO?
I can’t see how a “trader”, “rogue” or otherwise, “loses” a billion dollars the way I might lose my car keys. The billion dollars leaves HIS account by going into some other trader’s account. In the absolute simplest case — rogue trader buys 10 billion dollars’ worth of XYZ stock today and XYZ drops 10% tomorrow — the billion dollars he “lost” is money the trader(s) who sold him the stock “won”. The billion dollars is right there, in their accounts; that’s why it’s no longer in his. The “financial market” is a zero-sum game within itself.
When “authorized” traders “make money”, the money comes from the accounts of other traders, “rogue” or not.
-TP
Correction.
I wrote: If the oligarchs do that, you can expect little protest when the top 1% own 90% of everything…
My bad. I meant 99% of everything…
Here’s Nicholas D. Kristof in an op-ed:
http://www.nytimes.com/2011/06/05/opinion/05kristof.html?_r=1&pagewanted=all
There’s something to this, but I doubt it tells the whole story. My own suspicion is that there are more than a few traders who exceed their limits and that management looks the other way as long as there are profits. When too much is risked and the bet goes sour the swashbuckling king of the trading room turns overnight into a “rogue trader.”
In fact, investment bankers by nature have huge appetites for risk, and most of them take pride in being able to sleep at night even when their bets are going the wrong way. If you’re not a person who can doze through a two-hour foot massage while your client (which might be your own bank) is losing ten thousand dollars a minute on some exotic trade you’ve cooked up, then you won’t make it on today’s Wall Street.
koreyel, what this means as much as anything is that Matt Taibbi doesn’t understand what investment banking is. Or, possibly more likely given other places I’ve caught him playing extremely loosely with the facts, he is pretending that he doesn’t understand what it is in order to produce an entertaining rant.
What he’s describing is prop trading. Investment banking can sometimes slide into prop trading, but not only are they not the same thing, when they do become mixed it’s just as much a perversion of investment banking as it is of commercial banking. Probably moreso. So long as it’s kept separate from prop trading, investment bankers actually have *less* appetite for risk than commercial bankers do. The latter make loans which might default. The former are involved in providing financing for other people to make deals with, and have their exit strategy in place before the deal ever goes down.
There is nothing exciting about investment banking. It involves ridiculously long hours for relatively small margins. (Small at least when compared to the kinds of operations you’re discussing; a firm using an IB to float its IPO is usually justified in thinking that the margins are outrageous.)
There are lots of good reasons why regulations should be written to keep prop trading away from both commercial and investment banking. Keep in mind that the biggest fault lines in the 2008 meltdown weren’t commercial banks at all. Lehman was a pure investment bank. Bear was an investment bank and a clearinghouse. AIG is an insurance company. Having the investment bank industry go belly up is as damaging as having the commercial banks do the same.
On the other hand, I remain deeply skeptical that the repeal of Glass-Steagall, properly speaking, played much of a role at all. There are actually some decent reasons why commercial banks and investment banks should be able to work together. I think that the repeal of Glass-Steagall became something that people could actually point to as being the problem without really understanding what it was. The result is that a lot of people are spending a lot of energy fuming about something that isn’t very important instead of focusing on things that do, like actually separating both types of banking from prop trading.
That, and it allows Matt Taibbi to get his kicks by ranting and raving, no matter how much he has to mislead his readership to do so. I don’t have the time to find it right now, but about six months ago, I went through a post about one of his pieces on financial regulation at Balloon Juice and found six egregious problems, which ranged from gross errors of representation to a couple that involved flat out falsehoods about the timing of events.
I can’t put it any more simply than this: Do not trust Taibbi. He has zero commitment to the truth, only what gets him publicity.
Excellent and amusing post. I’m sure you are basically right. However, the assumption that returns are symmetric is invalid. The reason is that traders don’t just place one bet. The known rogue traders lose some money, not billions but enough to be fired, then bet double or nothing. The incentives for traders imply that a large loss is very costly, but a twice as large loss is not more costly. In your model, there is a line of rogue trading losses such that the trader is fired (otherwise the bank pockets the money or maybe even a very small loss) and another level such that the bank calls the cops. Once one’s book is below the lower line, it becomes rational to make huge bets (including huge bets with negative expected returns).
I would guess that there ar lots of lucky rogues but that they don’t make billions for their banks. If markets were really efficient (which they aren’t) one would expect average trading profits of rogues and not rogues to be zero. Under that assumption the huge numbers of lucky rogues who make small profits would balance the small number of persistently unlucky rogues who lose billions. A lucky rogue can lose, bet double or nothing, win that bet and then nobody has to know about the initial loss (or lose, lose the double or nothing bet, then win the next or so ad till they catch him).
But wait if markets were perfectly efficient, there wouldn’t be any traders. The fact is that investment banks make huge amounts of real authentic not cooked books profits. I think it is clear that they do this mostly not with research (which helps sure) but by offering gamblers negative expected value bets, just like casinos but on a much larger scale. In any case, there are systematic profits and losses and the efficient markets hypothesis has the same scientific standing as the flat earth hypothesis.
For another thing, traders elsewhere can sometimes spot an unusually fooling rogue and profit off of his roguishness and folly. There was this guy in Chile trading copper futures who mixed up the buy and sell buttons (and the profit and loss records). Someone who is eager to buy at a very high price and sell at a very low price will not have symmetric returns for long. The other traders figured out what was happening and Chile was much poorer not from bad luck (except in hiring the trader).
J. Michael Neal,
This is a good suggestion.
One thing we’ve learned is that banks seem to be unable to put in the controls needed to keep the occasional trader from blowing them up. So isolating the disaster is important.
Would such a separation reduce the capital available to trading operations?
J. Michael Neal: that horse left the barn decades ago. To the extent that when the latest loss made the news UBS sent out a letter of reassurance telling people that the $2.3B had been lost entirely on the proprietary trading side, with no unauthorized losses in customer accounts. Proprietary trading is a huge part of what people who call themselves investment bankers do.
Meanwhile, conversations among IT people suggest that yeah, this is pretty deliberate. You could put back-office controls into place if you were serious about keeping people from trading over their limits, but that would require giving the computer people authority equal to that of traders, hence not going to happen.
I think that the repeal of Glass-Steagall became something that people could actually point to as being the problem without really understanding what it was.
That’s right. Likewise Fannie and Freddie. Their structure and incentives were bad, but that’s not what caused the crisis.
That’s funny, I remember you being very supportive of the big banks before. In fact, you staunchly debated and argued in favor of bailing out the banks. If you think that traders ought to be held accountable for their actions, why don’t you hold the institutions that enable them accountable?
I recall a New Yorker cartoon of two fat cats in the back seat of a limo, and one of them says “Just once I want to hear about a lucrative drug deal gone terribly right”
There are no rogue traders, there are only rogue banks
Posted By Barry Ritholtz On October 2, 2011 @ 7:41 am In Apprenticed Investor,Bailouts | 15 Comments
This is my Sunday Washington Post [1] column from last weekend:
There are no rogue traders, there are only rogue banks
In 1995, derivatives broker Nick Leeson of Barings Bank engaged in “unauthorized” speculative trading. The massive losses — 827 million pounds — led to the collapse of Barings, the oldest investment house in Britain.
In 1996, another rogue, Sumitomo Bank copper trader Yasuo Hamanaka, lost at least $1.8 billion. Some reports put the true losses at $4 billion.
Then, in 2008, Jerome Kerviel of Societe Generale lost 4.9 billion euros — about $6.8 billion.
And just last week, UBS suffered a $2.3 billion hit connected to an alleged rogue trader.
As history teaches us, there are no rogue traders; there are only rogue banks.
Here’s a news flash: If you issue credit, your working assumption must be that there are unqualified people who will try to borrow money from you. It is the job of every lending facility each and every day to separate the qualified borrower who has the capacity to service that debt from the unqualified borrowers who do not. This is why there is no such thing as a predatory borrower — banks must assume that all borrowers are predatory and protect themselves. This is why lenders — at least before 2002 – inquire about income, employment history, credit scores, other debt, etc., before making a mortgage loan.
Similarly, if your business involves the use of leveraged capital for speculation by your employees, then it is your job to know which, if any, of your people are not competent. It’s a simple mathematical fact that some of your traders will take losses; in some cases, enormous but manageable losses. Your job is to identify these people and move them to other professions.
There will be a small number who will try to hide their inabilities. Your job is to separate the qualified from the unqualified, to watch over the full lot of traders and speculators in your employ. Toward that end, you will establish trading limitations, leverage constraints, risk parameters. Traders must stay within the limitations you impose on them: money lines, maximum drawdowns, loss limits.
Thus firms that highly leverage their capital to put it into the hands of a few thousand employee speculators have a crucial job: They must ensure that capital is being precisely and properly managed. They must make sure that risk levels are tolerable, that proper controls are in place, that their IT systems and internal technology can track what is happening, in as near to real time as possible.
This is not easy. It is a complex set of processes that requires constant vigilance. It must be reflected in the corporate culture from the top down. And it becomes more and more complex as the size of the organization grows. The assumption must be that every employee is a potential rogue trader.
Banks are supposed to have expertise in preserving capital and managing risk. If they cannot discharge those simple duties, then perhaps they should not be in the business of finance. Most of all, they should not be engaging in behavior that puts taxpayer money at risk.
Anyone who runs a shop that has a proprietary trading desk is obligated to do everything in his power to prevent that single employee from bringing down the company. It’s not too hard to see that anyone who earns a bonus by risking the firm’s capital is a potential disaster.
With this backdrop, how is it that we seem to have a major rogue trader pop up every year or so? The simple answer is, a rogue trader who nets massive losses is a complete and utter failure by the bank’s management. UBS was unable to track its capital on a timely basis, as its London trader hid losses for more than three years. So much for real-time supervisory tracking.
The arrest of a rogue trader is a red flag. The discovery of the fraud is a company admission of being poorly managed. The board of directors should be holding senior management just as responsible as the trader for the losses. They may not have committed the same legal fraud — hiding the trades — but they should be sacked for gross dereliction of duty.
Understand what this means within the broader context of our financial sector’s not so innocent foibles: Any firm that hires “robo-signers” is just as bad as a firm that has rogue traders. Both actions are an indictment, an admission of failure and of managerial incompetence. Each illegal act represents a crucial failure of risk management, of legal compliance, of the ability to do jobs safely and within the law.
In an era of bailouts on the backs of the taxpayer, it points to a simple reality: Firms must decide whether they are going to sacrifice profit in pursuit of safety, or sacrifice safety in pursuit of profit. Whatever they decide, it is not the responsibility or obligation of taxpayers to backstop these choices.
Consider the choices made by management: The collapse of firms such as AIG, Bear Stearns and Lehman Brothers were caused by the same sort of poor judgment as UBS’s $2 billion in losses — only the rogues gallery there included the senior-most managers of the firms. Alan Greenberg exhorting his staff to focus on reusing paper clips, while the mortgage syndication division lost billions of dollars. Dick Fuld surrounding himself with yes men while the firm’s leverage and risk exposure went through the roof. Tom Savage, president of AIG’s Financial Products, calling derivative underwriting free money.
Paul Volcker, arguably the greatest central banker in history, has persuasively argued that proprietary trading should not be part of the insured depository banking sector. I utterly agree with Fed governor Thomas Hoenig, who has described the banking sector as “more akin to public utilities” than independent entities. Want to be independent to pursue proprietary trading? Let’s drop their FDIC insurance and see how far their reputations carry them.
The next crisis — the one after the present one in Europe — is where I expect to see the ultimate damage wreaked by rogue bankers.
The bailouts have created a moral hazard, where leveraged speculators and rogue bankers know that the state will bail them out. This is unacceptable. There is no reason that taxpayers should be responsible for any rogues, traders or bankers.
Perhaps UBS’s failure [2] to prevent this did us a favor. It points out that Volcker is right: Any firm that can blow itself up should not qualify for taxpayer guarantees. Lenders, underwriters and mortgage originators are in the business of using their capital to earn a fair return safely. That government-backed insurance should be available only to depository banks, not firms associated with speculative traders.
~~~
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation [3]” and runs a finance blog, The Big Picture [4].
Article printed from The Big Picture: http://www.ritholtz.com/blog
URL to article: http://www.ritholtz.com/blog/2011/10/there-are-no-rogue-traders-there-are-only-rogue-banks/
URLs in this post:
[1] Washington Post: http://www.washingtonpost.com/business/there-are-no-rogue-traders-there-are-only-rogue-banks/2011/09/20/gIQA3sCxtK_story.html
[2] UBS’s failure: http://www.bloomberg.com/news/2011-09-24/gruebel-quits-as-ubs-chief-ermotti-interim-successor-bank-to-reduce-risk.html
[3] Bailout Nation: http://www.amazon.com/gp/product/0470596325?ie=UTF8&tag=washingtonpost-20&linkCode=xm2&camp=1789&creativeASIN=0470596325
[4] The Big Picture: http://www.ritholtz.com/blog../
There are no rogue traders, there are only rogue banks
Posted By Barry Ritholtz On October 2, 2011 @ 7:41 am In Apprenticed Investor,Bailouts | 15 Comments
This is my Sunday Washington Post [1] column from last weekend:
There are no rogue traders, there are only rogue banks
In 1995, derivatives broker Nick Leeson of Barings Bank engaged in “unauthorized” speculative trading. The massive losses — 827 million pounds — led to the collapse of Barings, the oldest investment house in Britain.
In 1996, another rogue, Sumitomo Bank copper trader Yasuo Hamanaka, lost at least $1.8 billion. Some reports put the true losses at $4 billion.
Then, in 2008, Jerome Kerviel of Societe Generale lost 4.9 billion euros — about $6.8 billion.
And just last week, UBS suffered a $2.3 billion hit connected to an alleged rogue trader.
As history teaches us, there are no rogue traders; there are only rogue banks.
Here’s a news flash: If you issue credit, your working assumption must be that there are unqualified people who will try to borrow money from you. It is the job of every lending facility each and every day to separate the qualified borrower who has the capacity to service that debt from the unqualified borrowers who do not. This is why there is no such thing as a predatory borrower — banks must assume that all borrowers are predatory and protect themselves. This is why lenders — at least before 2002 – inquire about income, employment history, credit scores, other debt, etc., before making a mortgage loan.
Similarly, if your business involves the use of leveraged capital for speculation by your employees, then it is your job to know which, if any, of your people are not competent. It’s a simple mathematical fact that some of your traders will take losses; in some cases, enormous but manageable losses. Your job is to identify these people and move them to other professions.
There will be a small number who will try to hide their inabilities. Your job is to separate the qualified from the unqualified, to watch over the full lot of traders and speculators in your employ. Toward that end, you will establish trading limitations, leverage constraints, risk parameters. Traders must stay within the limitations you impose on them: money lines, maximum drawdowns, loss limits.
Thus firms that highly leverage their capital to put it into the hands of a few thousand employee speculators have a crucial job: They must ensure that capital is being precisely and properly managed. They must make sure that risk levels are tolerable, that proper controls are in place, that their IT systems and internal technology can track what is happening, in as near to real time as possible.
This is not easy. It is a complex set of processes that requires constant vigilance. It must be reflected in the corporate culture from the top down. And it becomes more and more complex as the size of the organization grows. The assumption must be that every employee is a potential rogue trader.
Banks are supposed to have expertise in preserving capital and managing risk. If they cannot discharge those simple duties, then perhaps they should not be in the business of finance. Most of all, they should not be engaging in behavior that puts taxpayer money at risk.
Anyone who runs a shop that has a proprietary trading desk is obligated to do everything in his power to prevent that single employee from bringing down the company. It’s not too hard to see that anyone who earns a bonus by risking the firm’s capital is a potential disaster.
With this backdrop, how is it that we seem to have a major rogue trader pop up every year or so? The simple answer is, a rogue trader who nets massive losses is a complete and utter failure by the bank’s management. UBS was unable to track its capital on a timely basis, as its London trader hid losses for more than three years. So much for real-time supervisory tracking.
The arrest of a rogue trader is a red flag. The discovery of the fraud is a company admission of being poorly managed. The board of directors should be holding senior management just as responsible as the trader for the losses. They may not have committed the same legal fraud — hiding the trades — but they should be sacked for gross dereliction of duty.
Understand what this means within the broader context of our financial sector’s not so innocent foibles: Any firm that hires “robo-signers” is just as bad as a firm that has rogue traders. Both actions are an indictment, an admission of failure and of managerial incompetence. Each illegal act represents a crucial failure of risk management, of legal compliance, of the ability to do jobs safely and within the law.
In an era of bailouts on the backs of the taxpayer, it points to a simple reality: Firms must decide whether they are going to sacrifice profit in pursuit of safety, or sacrifice safety in pursuit of profit. Whatever they decide, it is not the responsibility or obligation of taxpayers to backstop these choices.
Consider the choices made by management: The collapse of firms such as AIG, Bear Stearns and Lehman Brothers were caused by the same sort of poor judgment as UBS’s $2 billion in losses — only the rogues gallery there included the senior-most managers of the firms. Alan Greenberg exhorting his staff to focus on reusing paper clips, while the mortgage syndication division lost billions of dollars. Dick Fuld surrounding himself with yes men while the firm’s leverage and risk exposure went through the roof. Tom Savage, president of AIG’s Financial Products, calling derivative underwriting free money.
Paul Volcker, arguably the greatest central banker in history, has persuasively argued that proprietary trading should not be part of the insured depository banking sector. I utterly agree with Fed governor Thomas Hoenig, who has described the banking sector as “more akin to public utilities” than independent entities. Want to be independent to pursue proprietary trading? Let’s drop their FDIC insurance and see how far their reputations carry them.
The next crisis — the one after the present one in Europe — is where I expect to see the ultimate damage wreaked by rogue bankers.
The bailouts have created a moral hazard, where leveraged speculators and rogue bankers know that the state will bail them out. This is unacceptable. There is no reason that taxpayers should be responsible for any rogues, traders or bankers.
Perhaps UBS’s failure [2] to prevent this did us a favor. It points out that Volcker is right: Any firm that can blow itself up should not qualify for taxpayer guarantees. Lenders, underwriters and mortgage originators are in the business of using their capital to earn a fair return safely. That government-backed insurance should be available only to depository banks, not firms associated with speculative traders.