Latepost Ruminations On Rogue Trading

We are inward the midst of a "rogue trading" scandal in addition to the media loves it. It started with this quickly identified in addition to named as Kewku Abodoli, a manager at the UBS Delta One desk (more on that later). article/SB10001424053111903703604576586391495813716?mod=WSJ_hp_LEFTWhatsNewsCollection">Today's story has to a greater extent than details, with a comment from Abodoli's lawyer most how much he regrets his actions (or at to the lowest degree getting caught). If you lot guide hold a feel of deja vu, it is because you lot guide hold seen this storey play out before. Just to refresh your memory, hither are about quickly identified in addition to named as Kewku Abodoli, a manager at the UBS Delta One desk (more on that later). article/SB10001424053111903703604576586391495813716">memorable rogue traders from times past, with i beingness famous plenty (Nick Leeson) that he had a movie (and non a really adept one) made most him.

What is rogue trading?

Rogue trading is trading past times an individual, that violates his or her employer's norms in addition to rules on investing in addition to risk taking, exposing the entity to catastrophic risk. Note that rogue trading does non involve "losses" to qualify. Influenza A virus subtype H5N1 rogue trader tin give the axe accept "catastrophic risks" in addition to brand millions or lose millions. Only the latter bring together the gallery of rogue traders, tarred in addition to feathered past times the media, in addition to forced to do the quickly identified in addition to named as Kewku Abodoli, a manager at the UBS Delta One desk (more on that later). article/SB10001424053111903703604576586391495813716">earlier post service on Jerome Kerviel, I noted that 2 good documented tendencies inward behavioral finance: the vogue to accept more risk than you lot should with other people's or household money in addition to the proclivity to reckless risk taking, i time you lot start losing money, to acquire dorsum to pause even. As you lot await across the rogue trading episodes, they all portion this characteristic. These traders all started with minor losses, which they tried to recover from with bigger bets, in addition to the procedure kept escalating until you lot acquire to hundreds of millions of dollars. 

How do rogue traders generate these losses in addition to how do they acquire away with it?

When nosotros read most the magnitude of the losses that are generated past times rogue traders, nosotros are faced with 2 questions: How do you lot lose hundreds of millions of dollars? How is it possible to do thence undetected?

Let's start with the showtime question. For a trader to lose hundreds of millions, he or she has to "lever" upwards in addition to at that spot are at to the lowest degree 3 ways this tin give the axe last accomplished:

1. Buy on borrowed money: You tin give the axe borrow immense amounts of coin on a minor uppercase base, peculiarly if you lot run at a large bank, in addition to invest the amount inward risky assets. You increase the upside on your equity investment, if you lot are right, but you lot magnify the downside, if you lot are wrong.
2. Derivatives: You tin give the axe brand bets on derivatives that guide hold potentially unlimited losses: this is the representative when you lot purchase or sell a futures contract on a commodity or a currency or when you lot sell options (either calls or puts).
3. Long-short strategies: You tin give the axe sell brusk on about risky assets, collect the proceeds in addition to purchase other risky assets, i.e., the hedge fund strategy. If the property prices displace inward the correct administration (your brusk sold assets guide hold to drib inward value piece your long assets guide hold to increase inward value), you lot tin give the axe brand dramatic returns on minor investments. However, if property prices displace inward the incorrect direction, your losses tin give the axe last many times your equity investment.

Coming dorsum 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 in addition to profitable places, where traders merchandise derivatives in addition to commutation traded funds (ETFs) to accept wages of movements inward the underlying assets (the delta inward the desk shout out references the alternative delta, i.e., the percent modify inward the alternative value for a unit of measurement modify inward the stock price). However, access to derivatives in addition to ETFs tin give the axe last a double edged sword, allowing a rogue trader to accept really large risk exposures.

As for how rogue traders evade beingness caught, at that spot are at to the lowest degree 3 possible explanations:

1. Time lags inward risk measurement/management systems: Given how rapidly prices displace inward fiscal markets, at that spot tin give the axe last fourth dimension lags inward marker investments to marketplace position in addition to learning most risk exposures. These problems are exacerbated with ETFs, since they are themselves oftentimes portfolios of traded assets which guide hold to last marked to market. 
2. Systematic standard mistake inward risk administration systems: All risk administration systems are based upon risk measures that are estimates. Thus, Value at Risk (VAR), a widely used risk stair out at banks, has standard mistake on many of its inputs, in addition to about of these errors are systematic. For instance, a VAR that is based upon the supposition that property prices displace inward a normal distribution volition understate the risks of assets whose prices are discontinuous in addition to tend to jump. Traders that larn most these systematic errors tin give the axe in addition to thence exploit them to cover existent risks inward their portfolios.
3. Avoidance in addition to Denial: It is possible that those who monitor the rogue trader acquire a feel that something is incorrect much before than the terminal denouement. However, inward a really human response, the showtime response is to deny that a work exists in addition to avoid it, until it blows up.

How tin give the axe you lot halt rogue trading?

So, how tin give the axe you lot halt the adjacent rogue trader from bringing an establishment down? As an institution, you lot tin give the axe trim back the peril that you lot volition last the adjacent victim past times doing the following:

1. Hire the correct traders: In my post service on Jerome Kerviel, I pointed to the folly of entrusting trading to immature men, a grouping that tends to accept bigger in addition to to a greater extent than reckless risks than whatsoever other subgroup of the population. I likewise suggested, exclusively one-half inward jest, that investment banks hire a few traders' mothers to merchandise amongst the traders, since older women are the perfect counterweight to immature men inward risk taking. I am certain that Mr. Abodoli would guide hold been to a greater extent than cautious inward his risk taking, if his woman parent had been sitting at the adjacent desk.
2. Real fourth dimension in addition to dynamic risk standard systems: Risk administration systems should rails prices inward existent fourth dimension in addition to capture bad risk exposures early. 
3. Restrict trading inward illiquid assets: Even the most sophisticated risk administration investments guide hold problem dealing with assets that are illiquid, where the prices are appraised values in addition to non transaction values. As investing choices widen from traded stocks in addition to corporate bonds to ETFs, derivatives in addition to mortgage backed securities, risk administration systems guide hold come upwards nether to a greater extent than strain.
4. Simple in addition to focused risk administration systems: Since inputs into risk standard in addition to administration systems guide hold systematic standard mistake that traders exploit, simpler risk administration systems that guide hold fewer bells in addition to whistles are to a greater extent than hard to game. In addition, investment banks tin give the axe borrow a technique that El Al, the Israeli airline, has used for years to maintain terrorists off their planes. Rather than spreading their resources broad in addition to banking concern check every passenger, they profile passengers in addition to focus on those most probable to create problems. Banks tin give the axe adopt a similar practice: rather than guide hold risk administration systems that rails every merchandise inward the bank, they tin give the axe position those areas, where rules are most probable to last broken in addition to focus attending on them.
5. Stress testing: Every risk administration arrangement volition fail. It is a query of when, non whether. The commutation to adept risk administration is how you lot reply to failures inward the system, non successes. Rather than assume that everyone is playing past times the rules in addition to measuring the consequences, it makes to a greater extent than feel to assume that about volition non play past times the rules in addition to laid upwards for the consequences.
6. Look at resultant in addition to process, non only outcome: I started this post service past times noting that rogue traders who brand millions are feted in addition to celebrated. As long equally nosotros decease along to do that, nosotros volition incite traders to accept unconscionable risks. The best agency to convey dwelling the request that you lot volition non set upwards with rogue trading is to burn downward a rogue trader who makes millions in addition to to deny him his bonus.

Here is the bottom line. The thorax beating that happens after every rogue trading episode volition subside. Banks volition revamp their risk administration systems in addition to say you lot that these novel systems are forthwith rogue-trader proof. I am a cynic, in addition to I am certain that a few months or years from now, no thing what is done now, at that spot volition last about other rogue trader at about other bank. Consequently, I intend it behooves all of us to last proactive most rogue trading:

1. Top managers at banks: The 6 suggestions that I guide hold higher upwards are all directed at management, but they volition reduce, non eliminate, the likelihood of rogue trading. Top managers at banks guide hold to consider rogue trading to last i of the risks that comes with proprietary trading. When allocating uppercase to dissimilar businesses (corporate banking, investment banking, proprietary trading) should contain this risk. (Proprietary trading volition guide hold to brand a higher render on the equity invested inward it to pause fifty-fifty than commercial banking...)
2. Investors inward these banks: By the same token, investors inward banks guide hold to last cognizant of the risks that come upwards with proprietary trading. Influenza A virus subtype H5N1 banking concern that generates a higher proportion of its profits from proprietary trading is riskier, other things held equal, than a banking concern that generates its revenues from traditional banking. If these banks merchandise 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 amongst banks, nosotros await at the percent of profits from proprietary trading equally a risk measure.
3. Regulatory authorities: If rogue trading is part in addition to bundle of proprietary trading, in addition to thence it follows that institutions where the authorities provides a backstop should non last allowed to indulge inward it. This is the reason for the Volcker rule inward the US in addition to the new banking rules that are beingness discussed inward the UK, both of which would bar commercial banks from proprietary trading. I agree.

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