Friday, September 23, 2011

Ruminations on Rogue Trading

We are in the midst of a "rogue trading" scandal and the media loves it. It started with this report in the Wall Street Journal about an unnamed trader who had lost $ 2 billion for the Swiss banking giant, UBS. The trader was quickly identified and named as Kewku Abodoli, a director at the UBS Delta One desk (more on that later). Today's story has more details, with a comment from Abodoli's lawyer about how much he regrets his actions (or at least getting caught). If you have a sense of deja vu, it is because you have seen this story play out before. Just to refresh your memory, here are some memorable rogue traders from times past, with one being famous enough (Nick Leeson) that he had a movie (and not a very good one) made about him.

What is rogue trading?
Rogue trading is trading by an individual, that violates his or her employer's norms and rules on investing and risk taking, exposing the entity to catastrophic risk. Note that rogue trading does not require "losses" to qualify. A rogue trader can take "catastrophic risks" and make millions or lose millions. Only the latter join the gallery of rogue traders, tarred and feathered by the media, and forced to do the perp walk. What about the rogue traders who make money? They are richly rewarded, celebrated as master traders and generally leave to start their own hedge funds. Enough said!

Why is there rogue trading?
So, why is there rogue trading? The answers are surprisingly simple and universal:
  1. Trading is addictive: Anyone who has traded knows that the process can be addictive, where trades lead to more trades, and at least for some people, there is no stopping the trading. 
  2. The search for the "big" payoff: It is human nature to aspire for the pot of gold at the end of the rainbow, the mega million dollar prize on the lottery and the trifecta  at the race track. In trading, that big payoff is (or at least seems) closer than in any other profession and many rogue traders start down their chosen path hoping to make the "big trade"...
  3. House money and Breakeven effects: In an earlier post on Jerome Kerviel, I noted that two well documented tendencies in behavioral finance: the tendency to take more risk than you should with other people's or house money and the proclivity to reckless risk taking, once you start losing money, to get back to break even. As you look across the rogue trading episodes, they all share this characteristic. These traders all started with small losses, which they tried to recover from with bigger bets, and the process kept escalating until you get to hundreds of millions of dollars. 
How do rogue traders generate these losses and how do they get away with it?
When we read about the magnitude of the losses that are generated by rogue traders, we are faced with two questions: How do you lose hundreds of millions of dollars? How is it possible to do so undetected?

Let's start with the first question. For a trader to lose hundreds of millions, he or she has to "lever" up and there are at least three ways this can be accomplished:
  1. Buy on borrowed money: You can borrow immense amounts of money on a small capital base, especially if you work at a large bank, and invest the amount in risky assets. You increase the upside on your equity investment, if you are right, but you magnify the downside, if you are wrong.
  2. Derivatives: You can make bets on derivatives that have potentially unlimited losses: this is the case when you buy or sell a futures contract on a commodity or a currency or when you sell options (either calls or puts).
  3. Long-short strategies: You can sell short on some risky assets, collect the proceeds and buy other risky assets, i.e., the hedge fund strategy. If the asset prices move in the right direction (your short sold assets have to drop in value while your long assets have to increase in value), you can make dramatic returns on small investments. However, if asset prices move in the wrong direction, your losses can be many times your equity investment.
Coming back to Kewku Abodoli, the rogue trader of the moment, it is worth noting that he traded on the "Delta One" desk. On the surface, Delta One desks are relatively placid and profitable places, where traders trade derivatives and exchange traded funds (ETFs) to take advantage of movements in the underlying assets (the delta in the desk name references the option delta, i.e., the percentage change in the option value for a unit change in the stock price). However, access to derivatives and ETFs can be a double edged sword, allowing a rogue trader to take very large risk exposures.

As for how rogue traders evade being caught, there are at least three possible explanations:
  1. Time lags in risk measurement/management systems: Given how quickly prices move in financial markets, there can be time lags in marking investments to market and learning about risk exposures. These problems are exacerbated with ETFs, since they are themselves often portfolios of traded assets which have to be marked to market. 
  2. Systematic measurement error in risk management systems: All risk management systems are based upon risk measures that are estimates. Thus, Value at Risk (VAR), a widely used risk measure at banks, has measurement error on many of its inputs, and some of these errors are systematic. For instance, a VAR that is based upon the assumption that asset prices move in a normal distribution will understate the risks of assets whose prices are discontinuous and tend to jump. Traders that learn about these systematic errors can then exploit them to hide real risks in their portfolios.
  3. Avoidance and Denial: It is possible that those who monitor the rogue trader get a sense that something is wrong much earlier than the final denouement. However, in a very human response, the first response is to deny that a problem exists and avoid it, until it blows up.
How can you stop rogue trading?
So, how can you stop the next rogue trader from bringing an institution down? As an institution, you can reduce the chance that you will be the next victim by doing the following:
  1. Hire the right traders: In my post on Jerome Kerviel, I pointed to the folly of entrusting trading to young men, a group that tends to take bigger and more reckless risks than any other subgroup of the population. I also suggested, only half in jest, that investment banks hire a few traders' mothers to trade alongside the traders, since older women are the perfect counterweight to young men in risk taking. I am sure that Mr. Abodoli would have been more cautious in his risk taking, if his mother had been sitting at the next desk.
  2. Real time and dynamic risk measurement systems: Risk management systems should track prices in real time and capture bad risk exposures early. 
  3. Restrict trading in illiquid assets: Even the most sophisticated risk management investments have trouble dealing with assets that are illiquid, where the prices are appraised values and not transaction values. As investing choices widen from traded stocks and corporate bonds to ETFs, derivatives and mortgage backed securities, risk management systems have come under more strain.
  4. Simple and focused risk management systems: Since inputs into risk measurement and management systems have systematic measurement error that traders exploit, simpler risk management systems that have fewer bells and whistles are more difficult to game. In addition, investment banks can borrow a technique that El Al, the Israeli airline, has used for years to keep terrorists off their planes. Rather than spreading their resources wide and check every passenger, they profile passengers and focus on those most likely to create problems. Banks can adopt a similar practice: rather than have risk management systems that track every trade in the bank, they can identify those areas, where rules are most likely to be broken and focus attention on them.
  5. Stress testing: Every risk management system will fail. It is a question of when, not whether. The key to good risk management is how you respond to failures in the system, not successes. Rather than assume that everyone is playing by the rules and measuring the consequences, it makes more sense to assume that some will not play by the rules and prepare for the consequences.
  6. Look at outcome and process, not just outcome: I started this post by noting that rogue traders who make millions are feted and celebrated. As long as we continue to do that, we will incite traders to take unconscionable risks. The best way to bring home the point that you will not put up with rogue trading is to fire a rogue trader who makes millions and to deny him his bonus.
Here is the bottom line. The breast beating that happens after every rogue trading episode will subside. Banks will revamp their risk management systems and tell you that these new systems are now rogue-trader proof. I am a cynic, and I am sure that a few months or years from now, no matter what is done now, there will be another rogue trader at another bank. Consequently, I think it behooves all of us to be proactive about rogue trading:

  1. Top managers at banks: The six suggestions that I have above are all directed at management, but they will reduce, not eliminate, the likelihood of rogue trading. Top managers at banks have to consider rogue trading to be one of the risks that comes with proprietary trading. When allocating capital to different businesses (corporate banking, investment banking, proprietary trading) should incorporate this risk. (Proprietary trading will have to make a higher return on the equity invested in it to break even than commercial banking...)
  2. Investors in these banks: By the same token, investors in banks have to be cognizant of the risks that come with proprietary trading. A bank that generates a higher proportion of its profits from proprietary trading is riskier, other things held equal, than a bank that generates its revenues from traditional banking. If these banks trade at the same multiple of earnings, I would pick the latter over the former. In practical terms, I am suggesting that when screening for bargains among banks, we look at the percentage of profits from proprietary trading as a risk measure.
  3. Regulatory authorities: If rogue trading is part and parcel of proprietary trading, then it follows that institutions where the government provides a backstop should not be allowed to indulge in it. This is the basis for the Volcker rule in the US and the new banking rules that are being discussed in the UK, both of which would bar commercial banks from proprietary trading. I agree.


Anonymous said...

Kweku Adoboli

Subu said...

Well said Professor ...well said "...A rogue trader can take "catastrophic risks" and make millions or lose millions. Only the latter join the gallery of rogue traders, tarred and feathered by the media, and forced to do the perp walk.

What about the rogue traders who make money? They are richly rewarded, celebrated as master traders and generally leave to start their own hedge funds.

Enough said! ...."

Uncontrolled desire leads to uncontrolled greed and ultimately leads to loss of balance , crazy actions ..and so on ...

Add this flow to an industry where white collar criminals either get rewarded or just a mild slap on the wrist (compared to some one who shoplifts a corner store), there is NO controlling the greed .. crime ... stupidity.... loss

Result : You see what happens to public money , investor money , bank's balance sheet etc

However, what's surprising me is this :

- Greed is universal

- It's not just bankers who want to make a quick buck

- Businesses know that greed is universal

- So businesses have brought in control not just today, over decades

- Electronic Stores, supermarkets, warehouses, manufacturing companies, hotels and myriad other businesses have devised controls over the years to mitigate risk.

- Security systems, beepers, Balance of power, two signatories / approvals beyond a limit ... security cards, frisking while leaving the store, metal detectors blah ..blah ..blah are in place to mitigate risk

- We hardly hear about a store manager who manipulated the system and sold all TVs at a loss or a shop floor manager or car showroom manager who drove away with a fleet of cars ... or dumped them in the river

- When that is the case, how do these well paid bankers who run businesses across continents end up with middle or low level employees defrauding them (banks and ultimately shareholders) of BILLIONS .. [yeah millions aren't big enough to be reported internationally !!]

I am left with only one answer.

Most of these dudes (now called crooks) start with some sort of an approval of the banks or their bosses ... wink wink ...go on ... let us see what happens ... and when the "tide retreats, we know who is swimming naked" to roughly quote Warren Buffett

So it isn't a lack of awareness, rather it is lack of willingness

It isn't lack of oversight, it happens in plain sight

As you said professor "... Enough Said.."

Aswath Damodaran said...

Thank you.. Even rogue traders deserve to have their names spelled right. My bad..

Ashwin Malshe said...

Here is an ex-trader Kid Dynamite's take on the whole rogue trader episode. He points out that there are far too many checks to avoid precisely this same huge loss.

Thomaschrishan said...

In my post of Jerome Kerviel, I pointed out the folly of trading trust young people, a group that tends to take more risks and reckless than any other subpopulation.

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