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No Surprises – Combating Rogue Trading

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Presentation on theme: "No Surprises – Combating Rogue Trading"— Presentation transcript:

1 No Surprises – Combating Rogue Trading
Geoff Kates Managing Director Lepus

2 Overview Introduction Gallery of Rogue Traders
Why does it still happen? Why have lessons still not be learnt? What should be done?

3 Gallery of Rogue Traders
Drexel Burnham Lambert – $650M Allied Lyons – £150M Bombay Stock Exchange - $1.3B – 1992 Metalgesellschaft - $2.2B rescue – 1993 Chile Copper Group - $175M – 1994 Barings Bank - $1.3B – 1995 Daiwa - $1.1B – 1995 NatWest - £90.5M – 1995 Common Fund of the United States - $128M – 1995

4 Gallery of Rogue Traders
Sumitomo - $1.8B – 1996 Deutsche Morgan Grenfell - £400M – 1996 Credit Suisse - $10M – 1997 Griffin - $10M – 1998 Chase Manhattan - $60M – 1999 Transcanada Pipeline - $49M – 2000 Muirpace - £32M – 2000 AIB - $750M

5 Why does this still happen?
Increased Complexity of Financial Firms & Traded Instruments Insufficient risk management and internal controls Inefficient risk management and internal controls Collusion Agency Problem

6 Increased Complexity Global Institutions
High Volume, many counterparties Complex chain of events Exotic Products

7 Insufficient Risk Management & Internal Controls
Pressures of Cost Efficiency Insufficient controls for remote offices Bureaucratic rather than genuine controls

8 Inefficient Risk Management & Internal Controls
Not enough Collaboration between parties involved Not many banks have one individual for Operational Risk Information is not integrated

9 Collusion Front and Back Office working together
Senior Managers covering up their juniors

10 Agency Problem Traders do not have the concept of ownership
Accountability Hedge Funds have clear ownership

11 Why have lessons not been learnt?
Lessons have been learnt but to a different extent Lessons have been learnt but loopholes still appear

12 Lessons have been learnt but to a different extent
Large banks have been spending money on it Larger budgets More sophisticated Risk Management Systems Tighter internal controls Problem in smaller banks is lack of resources

13 Lessons have been learnt but loopholes still appear
Changes have occurred Better Capitalisation Segregation of Front and Back Office Complexity of controls make them easier to overcome

14 Could regulators have done more?
Introduce minimum risk management standards for all banks Ensure integrity of the system Reduce high leverage of some 1st Tier Investment Banks

15 What should be done? Reassign Responsibilities
Improve basic risk management standards Reassess Internal Controls Holistic Risk Management Approach Escalate Processes Reassess remuneration policies Listen to regulators Protect against insolvency Outsourcing of Trading Psychology

16 1. Reassign Responsibilities
Shared amongst all parties involved Supervisors Traders Proactively driven from the top All levels of employees should be empowered to prevent Fraud Clear lines of responsibility and accountability should be established Senior management should be role models for all employees

17 2. Improve basic risk management standards
Unresolved Issue for smaller (overseas) branches Head Office quite often does not fully understand what overseas branches are doing Risk still seen as extra expense of doing business Information flow key to doing business View moving to seeing Risk Management as a revenue enhancing tool

18 3. Reassess Internal Controls
Checks and Controls that should be in place How Meticulous should checks be? How often should the checks be carried out? Who should supervise and carry out the checks? What are the supervisory tools?

19 What Checks and Controls should be in place?
Supervisory Trades against confirmations Credit and Trading Limit Cash Flow Anti-Collusion Counterparty Cash Trades vs. paper gains

20 Supervisory Controls All Trading Supervisors should have separate clearing and operational duties Separating Front from Back Office Trading sheets should be checked and signed off daily

21 Checks of Trades against Confirmations
Checks of individual trades against counterparty confirmations is essential Risk Managers should be notified on discrepancies Cannot cut corners on this How to check – ask a trader how many unresolved confirmations they have each day and how old the latest confirmation is.

22 Credit and Trading Limit Controls
Issued and monitored with due attention Watch for (excessive) breaches of these limits Match the P&L with the credit limits of every trader

23 Cash Flow control Ultimate test of whether rogue trades are taking place Much harder to conceal cash that has to be paid to a counterparty Look for unusual cash requests from traders May not be a good measure some of the time due to volume of individual trading

24 Anti-Collusion Controls
Various measures have been tried Traditional Whistleblowers Supervisor scorecards Independent supervisors reporting to the board Operational, Financial, Risk and Legal all have representation on the board

25 Counterparty Controls
Counterparties often see evidence of rogue trading before the banks with the problems do Many examples of this Barings (whole market) AIB (Goldman Sachs) Encourage a culture of communicating this

26 Checking cash trades offset with paper gains
Reconciliation of such areas is crucial to spotting rogue trading

27 How meticulous should the checks be?
If it looks too good to be true it probably is No trader makes money 100% of the time “Check your profits as closely as your losses” Detailed checks of Balance Sheets

28 How often should the checks be carried out?
Small banks – batch based overnight Larger banks – intra-day Ideal – deal by deal

29 Who should supervise and carry out checks?
Supervisors Risk Managers Traders Counterparties Internal Auditors External Auditors

30 Supervisors Need to have long and relevant experience
Understand the peculiarities of the front office Should have a multi-layered hierarchy of Supervisors

31 Risk Managers Number of banks feel they should be on the floor in direct contact with traders Should not interfere with traders if within prescribed limits Should concentrate on where limits have been broken and how supervisors allowed this

32 Traders Traders not making money if other traders breaking rules
Longer Term view should be that if a rogue trader exists, will affect the bonuses of them all Joint responsibility/scorecard approach may be way forward

33 Counterparties Part of their role should be responsibilities over their peers Often the first to recognise a rogue trader Consistent betting against a trend Volumes rise dramatically Need to inform more the rest of the banking community

34 Internal Auditors Need to co-ordinate closely with Risk Managers to spot inconsistencies Need to raise level of expertise to spot what is happening

35 External Auditors Proved to be the weakest link in the chain of controls Fail to carry out comprehensive audits due to lack of specialised knowledge Need to raise standards of performance

36 What are the supervisory tools?
Best tool is fully qualified staff with extensive experience and knowledge Technology being used more to support supervision Tools such as Autonomy and Searchspace starting to be used

37 4. Consider Holistic Risk Management Approach
Risk and Finance Managers need to work with each other The ‘REAL’ approach (Risk Enterprise and Accounting Logic) Based on Accounting consistent with Economic Evaluation of Business Needs to be a ‘Power’ Relationship with discrepancies being investigated

38 5. Escalate Processes All procedures in Front, Middle and Back Offices need to be managed efficiently Contracts need to be completed and put in place quickly Hard to spot rogue ‘complex’ trades otherwise Need to escalate and make sure processes are consistent and efficient

39 6. Reassess remuneration policies
Large Part of Traders performance related bonus needs to be deferred Bonus related to performance of bank (by issuing shares as bonus) Look at how much traders make over a period of time rather than just a single year Reduce discrepancy of trading and non trading compensation Make sure risk and back office staff are paid the right amount to get the right quality of people

40 7. Listen to Regulators Seen as assisting, not as adversary
Good at spotting and disseminating best practices Used as a resource and sounding board

41 8. Protect yourself against Insolvency
Operational Risk Capital Allocation Rogue Trader Insurance

42 Operational Risk Capital Allocation
Big controversy about this area How effective is it Lot of debate Some banks already allocating capital against business units based upon results of internal audit

43 Rogue Trader Insurance
Number of players in this market SVB – 30 Banks have taken out their Insurance Swiss Re – broader coverage, higher minimum loss

44 9. Outsourcing Isolation of proprietary trading areas
‘Internal Hedge Funds’ Limit legally the capital exposure Reaction to concerns of rating agencies

45 10. Psychology Need to understand the psychology of traders
Look at 3 areas Disposition Learning Experiences Trading Environment

46 Conclusions Never become complacent about internal controls
Continuously reassess and improve Risk Management Systems Look closely at the 10 areas detailed above “If it looks too good to be true it probably is”

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