23 Nov 2011
In mid-September Swiss giant UBS was doing well. It was recovering rapidly from a cumulative write-off of over $50bn in losses from its involvement in toxic sub-prime debt during the financial crisis. Its boss Oswald Grübel, hired to resurrect the 157-year-old institution’s reputation and finances, was judged to be doing an outstanding job in what was confidently expected to be a fitting swansong to a brilliant career.
Then, on September 15, he got a phone call from UBS’s London subsidiary. There was a problem in Delta One, the division that trades everything from currencies to shares, and it was Grübel’s worst nightmare. An employee of whom he had doubtless never heard, Ghanaian-born Kweku Adoboli, had lost the bank €1.49bn in rogue trades. Hitherto considered to be a model staff member, 31-year-old Adoboli had admitted responsibility to his managers and been arrested on suspicion of fraud.
It would quickly emerge that Adoboli had been cracking under the strain of his deception and had posted the despairing line on Twitter: “I need a miracle”. But there was no miracle, certainly not for Adoboli and not for Grübel and UBS. By early October Grübel was gone, replaced by Italian-born UBS veteran Sergio Ermotti after having accepted responsibility for the disaster or, more likely, having been forced to leave by a stunned board of directors. Before he left though, Grübel had sacked at least two of Adoboli’s managers. Meanwhile, UBS’s patched-up reputation » was once again in tatters and European banking was reeling from yet another demonstration of how vulnerable a giant institution can be to one man with an inside knowledge of computer trading systems.
Thus Adoboli joins a growing and surprisingly long parade of rogue traders who have caused severe reputational and financial damage to a systemically important bank. The penultimate and still most spectacular example is France’s Jerome Kerviel, convicted last year for illegal trades within Société Générale, totalling nearly €4.9bn. Six years earlier, Allied Irish Bank’s John Rusnak cost it $700m in its US operations. And seven years before that, Nick Leeson infamously brought down centuries-old British bank Barings, once the personal bank to the Queen, with $1.4bn in illegal trades. And that’s just the tip of the iceberg. If rogue – or merely unauthorised – trading in Asia and America is taken into account, billion dollar-plus losses have been clocked up in roughly every second year since the early nineties.
Although all of the above offenders came from different countries and backgrounds, they share remarkably common characteristics in terms of personality and motivation. Rogue traders tend to be intelligent, ambitious, hard-working, in their thirties, and computer-literate. They also hail from relatively humble backgrounds, and they are all male. Consider Briton Nick Leeson, the only rogue trader to bring down a bank. Having started working life as a humble clerk with the private bank Coutts, he ended up running Baring’s futures markets in Singapore, a new business for the institution he managed to ruin.
As for Kerviel, a black belt in judo, he started with Société Générale in the back office known as “the mine” and took years to become a full-fledged trader, albeit starting on low limits. A graduate of a minor university in Brittany, he sat alongside traders hired from the elite schools and consequently felt a need to prove himself. “I was held in lower regard than the others because of my educational and professional background,” he would later tell prosecutors.
Adoboli was of the same mould. Head boy at a Quaker-run school in his adopted country, he graduated in computer science and management from the University of Nottingham and had been hired on the strength of high grades and aptitude. When he was arrested, his shocked father, a former UN official, reportedly said: “Fraud is not our way of family life.”
Working the system
The startling aspect of rogue, or merely unauthorised trading, is how easy it is for a skilled operator to cover his tracks. And this is despite the widespread reforms undertaken by regulators and the overhaul of internal systems by the banks themselves in the wake of repeated breaches of limits. Kerviel told prosecutors that traders at Société Générale almost routinely exceeded guidelines while managers looked the other way. Provided, that is, the traders’ bets kept on coming up the right way.
It didn’t take Adoboli long to master the system. According to a preliminary statement from UBS, he was dealing in exchanged traded funds, a hugely popular method of investing based on indexes rather than on individual shares or instruments. His trading was fully in line with the bank’s guidelines, or so it thought. In fact, Adoboli was using what are known as “forward settling” cash positions to disguise breaches of the UBS rulebook. This allowed him to register payments before they had actually been settled, thus leveraging that artificial gain into the next trade. This way, he was claiming profits he hadn’t made.
In fact, Adoboli was exploiting a financial-markets convention known as “fails-to-deliver” trades. They are booked before the securities concerned have been delivered and the money actually changes hands. According to a survey by CNN at the time, the value of fails-to-deliver trades were running at $200bn a day. Indeed, some institutions use the convention as a way of smoothing cash flows in between accounting cycles.
In one of the most disturbing revelations, Adoboli was able to run up these massive losses in only three months. According to UBS, he’d been trading EuroStoxx, DAX and S&P 500 indexes. “The positions taken were within the normal business flow of a large global equity trading house as part of a properly hedged portfolio,” UBS said in a statement. “However, the true magnitude of the risk » exposure was distorted because the positions had been offset in our systems with fictitious, forward-settling, cash ETF positions, allegedly executed by the trader.”
Dealing on Delta
Most rogue traders, including Adoboli, worked on Delta One, the dealing desk that buys and sells financial derivatives. These aren’t actual assets but instruments that mirror the assets, in Adoboli’s case the exchange-traded funds. By dealing in derivatives that leverage the underlying value of the asset, whatever it may be, the gains (and losses) are massively magnified. As Protiviti, international consultants in risk management and internal audits, points out, Delta One trading can become a “manic money-go-round.” In an investigation in September, financial writer Ian Mathiason pointed out: “Bankers love Delta One because it incentivises traders to take more risks, and as a result potentially make spectacular gains.”
Delta One offers plenty of opportunities for a determined operator. As Protiviti explains: “Rogue trading activities may manifest themselves in a variety of ways, but the most common drivers are attempts to manipulate incentive compensation plan results or to hide an error.” And sometimes they’re done purely for the trader’s pocket. In off-market transactions, one of several ploys, a trader works with a counter party from another organisation to execute transactions at mutually agreed prices. Any profits above the market price are split between the two parties. In front-running, a form of insider trading, a dealer in the know will execute a transaction before the institution does and deposit the gains in a personal account.
No red lights
Rogue traders sometimes have inside help. This is especially true now because of the highly sophisticated warning mechanisms that did not exist in Leeson’s day. Typically, trading desk software flashes signals to senior managers when somebody exceeds individual limits. At UBS these signals were seemingly not picked up, but they were at Société Générale, as Kerviel insisted throughout his trial. In his initial interrogation he told the investigating judge: “I cannot believe that my superiors did not realise the amount I was risking. It is impossible to generate such profit with small positions. That’s what leads me to say that while I was [in the black], my supervisors closed their eyes on the methods I was using and the volumes I was trading.”
In fact, this is a highly credible explanation. His defence produced many emails purporting to show that Kerviel’s superiors were not only well aware of his illegal trading, mainly on German stock prices, but secretly raised his limits because he was making so much money for the bank. In one year alone Kerviel produced €1.5bn in profits. That’s why, he claimed, his limits were eventually raised 1,700 percent and the system of alerts on his software was deactivated by managers.
Indeed they once summoned him back from holiday to execute even more of these profitable trades. This kind of subterfuge was not unusual. “We presented the court with evidence that many traders had been doing things in a way similar to how I did them and that my bosses knew what was going on,” Kerviel told Der Spiegel magazine after his conviction.
At no stage, incidentally, did Kerviel attempt to profit on his own account from his trades. Eventually he was caught out by the markets, as rogue traders are. At one stage Kerviel had taken out positions worth €30bn, exposing Société Générale to potential losses of up to €2bn. But why did he do it? “I didn’t feel like I had delusions of grandeur. With the support of my bosses, I was caught up in a spiral of always making more and more,” he insists.
177,000 yearly payments
Compared to sentences for common burglary, rogue traders get off relatively lightly. Leeson served four years of an admittedly tough six and a half year sentence in Singapore, where he was treated for cancer of the colon, but has since bounced back. He received substantial royalties for his autobiography, Back from the Brink, and was the subject of the movie Rogue Trader. And, having taken a degree in psychology, he gives after-dinner speeches and lectures companies on risk management in a symbolically rich example of poacher turned gamekeeper. At least Leeson wasn’t expected to pay the money back. As well as being handed a five-year jail sentence with a two-year suspension, Kerviel has been ordered to repay the full €4.9bn, a restitution that will take him 177,000 years. He has rejected film offers and is preparing for another round of litigation in the appeals courts.
But where does the Adoboli affair leave UBS now? Unlike in the Barings case, even a loss of €1.49bn does not deal a mortal blow to a global giant like UBS. In fact, it represents just 0.4 percent of total assets. As Grübel quite correctly told staff in a memo: “While the news is distressing, it will not change the fundamental strength of our firm.” It will however, knock a big hole in third-quarter profits and will probably, say analysts, lead to something much more far-reaching – the sale of UBS’s investment bank business. As respected Swiss newspaper Tagesanzeiger pointed out, investment banking has become too dangerous: “In this branch of the business, in the nine years after the dotcom bust, UBS has suffered a cumulative loss of around CHF 30bn [from investment banking].”
And what can banks do to prevent similarly disastrous incidents? UBS has told staff it would not rest until it had built a system “which protects us effectively against every possible likelihood of attack.” Every episode of rogue trading has triggered a similar response, but history suggests future attacks are not only possible, but likely, unless banks’ Delta One undergoes a complete overhaul, not of practices, but of ethics.
Kerviel will never work in a bank again, but he surely knows as much as anybody about what goes on and his warnings may prove prophetic. “Nobody knows everything that’s hidden in the balance sheets of banks. In fact, they are completely impenetrable,” he told Der Spiegel. “To invest €150m, it only takes a second. For €1bn, you need four seconds. Things go so quickly with computers that you lose any sense of the amounts involved. The international market is so big that it absorbs all orders in just a matter of seconds. The wheel continues to spin faster and faster. It’s insane.” That may yet be the best explanation of what is wrong with today’s banking system.