Wednesday, November 17, 2010

Jerome Kerviel Talks More About His Rogue Trades

As a former trader, I'm somewhat fascinated by the story of SocGen's rogue trader, Jerome Kerviel.  What confuses me most is how the bank could have been so flat out unquestionably incompetent as to let this happen.  Kerviel basically asserts that they weren't in the dark about it - that many people knew what he was doing, but that they didn't complain until things went bad.

I am by no means attempting to abdicate Kerviel of responsibility, but I'm flummoxed by how SocGen could have missed the reality of this situation.  Their lack of risk management is, in a word, remarkable.   Lets talk about some details.

I'll talk in the first person, although I never in my life booked a fake trade to my system. When I trade, there is a counterparty to all of my trades - someone on the other side - which is to say that I buy FROM someone, and I sell TO someone.  Most of it is booked electronically now, although back in the day we did lots of stuff via phone and wrote manual tickets:  Bot 250,000 IBM @ 108.25 MSCO  4c.  This is pretty self explanatory:  it means I bought 250k shares of IBM @ $108.25 from Morgan Stanley and paid them 4c a share.  I'd probably then type that trade into my electronic order management system, and at the end of the day all of the trades would flow through to an electronic booking system which would send an electronic file of all of my trades to ADP for processing.   Morgan Stanley does the same thing on their side.

The next morning, the first thing that happens is that my operations guys come over and tell me if there are any "breaks."  A break would occur, for example, if Morgan Stanley's version of the trade didn't match up with mine.  Maybe I accidentally put in $109.25 for the price - or maybe they thought it was supposed to be 6c a share commission, or maybe I made the trade up entirely and there was no real trade at all - in any case, there are lots of people whose job it is to figure this out.  There's an entire settlement system designed to figure this out. 

Additionally, there are internal risk management groups and PnL monitoring groups that watch trader positions and keep a very close eye on the difference in the positions in the trader's position management system and those that have actually "settled."

If the operations guys were all on vacation, and everyone decided to ignore the break, there would be another notification at settlement, which is T+3 for stock trades.  If I buy 250k IBM from Morgan Stanley on Monday, the trade settles Thursday - that's when I actually deliver them the money and they deliver me the shares (electronically, almost all the time).  If I made up a fake trade, it might take MSCO a few days to figure out why I was trying to send them money to pay for IBM that they didn't sell me, but it shouldn't take my bank long at all to figure out that MSCO didn't give us the IBM we were paying for.  This is yet another check and balance in the system.  It's probably very hard to book a fake trade in common equities.

Now, I think that Kerviel was trading futures - likely DAX (German index) futures (and CAC - French index futures).  I don't know the intricacies of settlement in European futures markets, but if they are anything like US markets, I cannot fathom how it's possible for him to "fool" the bank's systems simply by entering fake "offsetting" trades, unless, of course, the systems were completely inadequate.  My former colleagues suggest that he could have booked fake over-the-counter swaps that don't have exchange settlement, but again, that's the point of all the other links in the chain of command within the banks:  the PnL monitoring group, the risk management group - we are talking about $50 BILLION in trades here - that's not the kind of thing that gets ignored or written off with an "oh, ok - no problem."  Additionally, the bank would send and receive margin flows for the real positions on a nightly basis.  Someone should absolutely realize that there are not offsetting margin maintenance flows coming from the fictitious trades (cause they're fake, of course) even though there would be money flows if the trades were real.  This would be yet another red flag.  At the end of the day, the actual daily flow of money from bank to bank is pretty hard to fake from the trading desk - traders have nothing to do with that process.

If there are any European ops experts in my audience, feel free to weigh in.  The basic question is this:  Was SocGen grossly incompetent in operations and risk management?  Or did Kerviel take advantage of some flaw in the European settlement process that I don't know about?  Either way, again, I'm not trying to absolve Kerviel of responsibility here, but it's important to hold SocGen accountable as well, as they appear to be complicit in the outsized risk positions (or incompetent in their inability to detect them).  A complicit (or incompetent) bank is just as dangerous to the system as a rogue trader.  It seems clear to me that one cannot pull off this type of fraud alone at a bank with any sort of capable oversight - he'd need at least 2 other key people  in other divisions helping him.  But to clarify again, I'm not alleging that this is a deeper conspiracy, rather, I'm alleging that SocGen's risk oversight procedures are/were completely unacceptable.

I am confident that I could not have done this at my bank.  Are there traders out there who think that their bank's risk management procedures are so craptastic that they could pull of this kind of fraud without anyone noticing?  I'd love to hear about it.


Mark S said...

Not that this has anything to do with trading but as far as a bank's internal controls system goes, I would not be too confident.

Canadian Imperial Bank of Commerce. An assistant branch manager with a lending limit of $25,0000 at a branch with a branch lending limit of $100,000, managed to steal over 11 MILLION dollars in less then two years by writing phony loans. Of course the money was all pissed away at Las Vegas and Atlantic City. All this despite the fact that the bank was audited by CIBC headquarters while all this was going on.

So no, when it comes to the breakdown of an internal control system, I cannot be surprised. Shocked, but not surprised.

Kid Dynamite said...

Mark - right - there are always people who find a way to beat their system. but there's a monstrous difference between $11mm and $5 BILLION.

D said...

If anything its probably a lot easier to steal money as a branch manager than a trader. All the branch manager has to do is use the proceeds from the fake loan to continue to make interest payments until the fraud is discovered. Its a rather simple ponzi scheme, which is part of why the lending limits are set so low, and there are supposed to be lots of other people checking up on the loans (to verify that there are actual borrowers making real payments).

Duff Samoa said...

I agree with you, there is no way I can see how he could have pulled this off without people at least turning a blind eye to what he was doing.

I think there is a lot more to this story than what people have been told.

Unknown said...

hey kd

after reading your blog for more than a year, i can finally contribute something. thx for the great work your doing here, i appreciate it a lot!

after all we know (which is not that much, as the mainstream media is not really into the details in this case) kerviel traded mostly futures and options on the dax on the eurex exchange.
on eurex trades are settled t+1, and margins are debitted and creditted on a daily basis. further you have one counterparty, the eurex clearing company.
so there is no way kerviel could hide his positions so long. as within days somebody should have recognised the massive additonal margin bookings on the margin account with the ccp.

as it is possible to deposit securities with the ccp as insurance for your margin account, it could have been possible that socgen had some cushion, i.e. that the ccp did not have to call for additional margin for some time.

however, the information available to us and the final actions taken by socgen (eliminate the position in a fire-sale, who would do that anyway if they did not have to??) let us conclude, that the position was indeed to huge for socgen and they had to sell in the end.

i don't think kerviel was able to work this sceme out alone, lots of people must have known what was going on...

don't get me wrong, kerviel was a fool to put off something like this, but now they use him as an easy scapegoat.

ketzerisch said...

I'm in European trading too and I agree with Michael. There is NO way that these trades remain undetected for any period larger than a day or two. Certainly not for the prolonged period that must have been needed to actually build up the position that large.

The swings in the variation margin must have been so large that anyone not completely dull must see immedeately that something was wrong.

I once read that repeatingly Kerviel updated trade statements to hide his positions. Any Back Office guy should raise his eye brow immideately if a single trader is doing that.

Anonymous said...

I'll have to stay anonymous on this, but I used to be a credit risk trader for a US bank. We have a rather odd trade with a French bank, which was not complex, but was definitely non standard. The French bank was required to post margin in the trade, and this was calculated manually by a guy on our side. Turned out, our guy didn't understand the deal and was overstating the mark to market by about $250mm, but the French bank had posted this amount without arguing for about 6 months. We thought they might be angry when we told them, but they did not seem to be too bothered.

I suspect most of these banks have huge volumes of manual overrides, and when you see a really massive number, you assume there is a manifest error, but the French banks seem to have especially arrogant traders who refuse the explain things to their middle office guys and just shout that it is wrong. The irony is, the best way for a middle office guy to make the step up to front office is to have the balls to stand up to a trader.

Anonymous said...

Just to join this discussion:
Eurex started to officially inquire at SocGen about the those trades back in October of the previous year - first bey calling and later on in writing. Only to be told by a SocGen official that they (SocGen) know what they are doing at that it was none of Eurex' business.

Yangabanga said...

Anon @ 3:49 is on the money. Kid you know when this first came out I said there was no way this could've happened without a conspiracy because it wasn't OTC. I'm revising my opinion. Incompetence coupled with extreme institutional arrogance coupled with garbage systems could do the same.

I think your experience in the US is not at all the same as the experience outside of it or London. There is an ingrained culture of don't question your superiors in France and don't do anything to rock the boat so you keep your job and your pension. The incentives are aligned completely AGAINST whistleblowers who get shat on for having ruined things for everyone (?!). Most of the people in the chain, no matter how senior, just need a plausible reason to cover their own ass and any fiction will do.

I'm going to draw a parallel to the Korean Air debacles that happened decades ago. The copilots would rather HE CRASH THE PLANE than speak up against their superior, the pilot. They had to fix the culture to fix that.

I don't know this was a fact in this case but I can see how it could happen.

Kid Dynamite said...

Great feedback from everyone in the comments. I want to clarify one thing, Yangabanga - the futures trades were not OTC - BUT the fake trades that he booked to offset COULD have been OTC. that still doesn't mean it's just rubber stamped and "ok'd"

interesting analogy with the Korean Air "don't talk back to your superiors" culture

Greycap said...

I haven't followed this story lately, but earlier reports were that the "offsetting" trades were indeed OTC. Perhaps it was the old nostro account trick - but then how did Kerviel get a multi-bn credit line for the account?

Like you, I was puzzled by the margin problem. Obviously, the fictional OTC counterparty would not have cooperated in posting collateral, so there should have been enormous cash/collateral consequences visible in top-of-the-house numbers. Even positing some co-conspirators, this makes one wonder.

Mezrich said...

I used to be an exotics trader at a UK bank, and given that experience I have to say that I agree with all of the comments posted so far. It is beyond understanding how this was not discovered by anyone from (middle office guys, to risks, or anyone basically). When booking a trade, if for whatever reasons something was slightly wrong, we would have the guys in the back-office on our back in no time, and that would escalate rapidly if it was not taken care of.

I would like to mention a few other things that should have been huge ringing bells to anyone :
- When Kerviel was buying futures, SocGen was charged with brokers fee of some kind. I assume the that the amount of brokerage fees must have grown to very important amounts. Our trading boss was on our back when brokerage fees were becoming too important (most likely, when they were above our budgeted amount for the year I imagine).
- Also, it seems Kerviel got a 1 bn € loean from treasury at SocGen. How come no one realized something was up?

At last, I would like to say that talking to other colleagues with french banks, my impression with French banks is that they hire ops guys with very low salaries. The end result is that they clearly do not give a f*ck.

At last do not be surprised with SocGen not being blamed during the trial and all the blame being put on Kerviel. Unlike in the UK or US laws, in France the concept (case law) of "constructive knowledge" does not exist. The boss should have known that something was wrong given that they are boss, they are experienced, etc...

Additionally, did not apply the obligation to mitigate your loss

scharfy said...


The gist of this is that whole division was doing directional bets, disguised as arb - that's correct I think, right?

But the awesome size is mind boggling.

According to his testimony, at his 'peak' he was doing DAX trades 30 billion Euros notional

30 billion Euro notional on the DAX is like 150,000 contracts net short or long - is that even possible?

Holy shit. Thats retarded.

Mark S said...

Hey, I just thought of another one. What about that guy who traded for Barings Bank, one of the oldest financial institutions in Britain.

Nick Leeson! Yes, he was a futures trader and managed to lose 1.3 billion. WITH A B!

He put Barings out of business. So much for internal controls.

The grisly details are here:

Anonymous said...

It seems highly likely the offsetting trades were OTC and not marginned, this would have made it (a little) easier. In this scenario, SocGen posts margin with the exchange and agrees with the exchange feed on the position, but thinks that it is market risk flat thanks to the OTC. Now all the perp needs to do is to keep the OTC away from the trade verification process. Perhaps he keeps cancelling and reentering the OTC trades so that they always look a day away from being confirmed for instance. Or if SocGen only reconciled their OTC positions once a month, perhaps he only has to hide it for a day or two over month end: with multiple legal entities where the checks happen at different times he might even be able to switch it between them and thus avoid both checks...

Anonymous said...

completely right

i used to be a whistle blower in France :
The one who shows the shit is the one that made it.
Furthermore, you are expected to clean it, and management considers you as the trouble maker.

Yangabanga said...

@Mezrich Wow I didn't know that constructive knowledge bit but that explains a lot. Imagine, legal incentive to be ignorant!

Anonymous said...

The big difference with Nick Leeson and Kerviel is when Leeson was trading, he was functioning in two roles. He traded and was responsible for back-office settlements. This understandably allowed him to hide his trades in an error account that was reported to be a client account. His scheme blew up when the market continued to hammer his positions, and Barings couldn't afford to put up any more variation margin on the trades. Once the trades were fully known, they didn't unwind them immediately. It also didn't help that in Leeson's time positions weren't marked-to-market as quickly as they are today.

My 'gut feel' on Kerviel's actions is this - he had authorization to trade a certain amount, got greedy and knew how to 'game' the system to leverage up his position. When the errors were discovered, he was given the full blame because of the culture. SocGen couldn't take the fall because it would hurt their image.

Anyway, great comments and a good blog post Mr. Dynamite.

Anonymous said...

I worked at 2 places where shananigans occured . Nothing happened to anyone , until the losses started to mount .

Make $$$$$ - - - - no one cares

Kid Dynamite said...

I think Anon @ 2:42am has really nailed this... it doesn't change the point - that SocGen's risk management is inadequate - but I think it's the most likely explanation.

JayTrader said...

I don’t know who to believe in this. If that is the case, both have blood on their hands. This sounds to me that SocGen has a crappy, out of date, and grossly inadequate computer system and Kerviel manipulated it. This is no different than Joseph Jett was able to do at Kidder back in the 90’s. SocGen paid the price by almost going out of business later on during the year and Kerviel’s life has been ruined because he will be working for 10 lifetimes paying back the loot he lost. At the end of the day, it’s preposterous to think that his superiors at SocGen were completely clueless to what he was doing. They knew just like Kidder knew, but his defense that just because his superiors knew what was going gives him a free pass to put in fictitious trades basically is par for the course in global finance these days.
Net Net... You cant fight city hall when City Hall runs the machine.

Kid Dynamite said...

JayTrader - I think you bring up an important point: I don't think Kerviel is saying that he should get a free pass just because others knew - I think he's just saying that he's being singled out as a scapegoat for the gross incompetence and greed of all of his superiors.

make sure you read the Der Spiegel article I put in the main body of the post as a late edit today.