Saturday, January 26, 2008

Rogue Trader in France

A rogue trader working for a bank has managed to lose a record $7 billion making unauthorized trades. The trader, Jérôme Kerviel, worked at the bank Société Générale in France. He lost the money trading in the European stock index futures market.

Stock index futures are essentially side bets between two parties on whether the stock market will go up or down. This rogue trader made about $40 billion in bets that the stock market would go up, and as we have seen over the last week, those bets didn’t work out very well. When the bank discovered the huge bets, they sold them off quickly and ultimately lost $7 billion in the process.

There have been many stories about rogue traders over the years. One thing all the stories have in common is huge losses. Don’t these rogue traders ever get lucky and make money?

My guess is that many of them do make money, at least for a while. What would bank management do if they discovered a rogue trader who risked billions, but had made a billion dollars for the bank? Would they fire the guy or promote him? Either way, I’m guessing that the story wouldn’t make it to the press. So, we only hear about enormous losses.

It’s hard to understand how a bank’s control procedures could be so weak that one person (or even a few people) could put all of the bank’s assets at risk. Even if all the risk is held in customer accounts (some of which may be bogus), automated tools should be able to detect a suspicious huge net risk across all customer accounts.

A rogue employee at a car company might be able to create fake orders for a hundred or even a thousand cars. But, the scale of this rogue trader’s fraud is like tricking General Motors into making a million extra cars based on false customer orders. You’d think that General Motors might figure it out before building too many new car manufacturing plants.

A bank’s management should be responsible for knowing the risk level of its investments. It is unacceptable to simply blame a rogue trader. If a trader is able to put the bank’s entire asset base at risk, then the blame goes straight to the top.

Investors often choose to invest in banks because of the perceived safety and regular dividend stream. These investors deserve to be told how much risk the bank is taking with its assets. Whatever rules exist for this type of disclosure, risk information is either not known or is not conveyed to individual investors in a way that they can understand.

2 comments:

  1. But who ends up paying for this? I don't have $7B hanging around, so who is on the hook for all of these losses? Are the trades nullified? Is an insurance oompany going down because of it?

    --C8j

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  2. Big Cajun Man:

    The bank lost the money. The bank is big enough that it can absorb this loss without going under. The trades weren't nullified; the bank just sold off the positions. This means that the bank sold the futures for less than the rogue trader originally paid for them.

    Ultimately it is the bank's shareholders who lose money. The bank's profits for the year are $7 billion lower than expected.

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