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No Surprises – Combating Rogue Trading

No Surprises – Combating Rogue Trading. Geoff Kates Managing Director Lepus. Overview. Introduction Gallery of Rogue Traders Why does it still happen? Why have lessons still not be learnt? What should be done?. Gallery of Rogue Traders. Drexel Burnham Lambert – $650M - 1990

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No Surprises – Combating Rogue Trading

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  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? www.lepus.co.uk

  3. Gallery of Rogue Traders • Drexel Burnham Lambert – $650M - 1990 • Allied Lyons – £150M - 1991 • 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 www.lepus.co.uk

  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 - 2002 www.lepus.co.uk

  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 www.lepus.co.uk

  6. Increased Complexity • Global Institutions • High Volume, many counterparties • Complex chain of events • Exotic Products www.lepus.co.uk

  7. Insufficient Risk Management & Internal Controls • Pressures of Cost Efficiency • Insufficient controls for remote offices • Bureaucratic rather than genuine controls www.lepus.co.uk

  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 www.lepus.co.uk

  9. Collusion • Front and Back Office working together • Senior Managers covering up their juniors www.lepus.co.uk

  10. Agency Problem • Traders do not have the concept of ownership • Accountability • Hedge Funds have clear ownership www.lepus.co.uk

  11. Why have lessons not been learnt? • Lessons have been learnt but to a different extent • Lessons have been learnt but loopholes still appear www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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? www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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. www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  26. Checking cash trades offset with paper gains • Reconciliation of such areas is crucial to spotting rogue trading www.lepus.co.uk

  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 www.lepus.co.uk

  28. How often should the checks be carried out? • Small banks – batch based overnight • Larger banks – intra-day • Ideal – deal by deal www.lepus.co.uk

  29. Who should supervise and carry out checks? • Supervisors • Risk Managers • Traders • Counterparties • Internal Auditors • External Auditors www.lepus.co.uk

  30. Supervisors • Need to have long and relevant experience • Understand the peculiarities of the front office • Should have a multi-layered hierarchy of Supervisors www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

  41. 8. Protect yourself against Insolvency • Operational Risk Capital Allocation • Rogue Trader Insurance www.lepus.co.uk

  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 www.lepus.co.uk

  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 www.lepus.co.uk

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

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

  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” www.lepus.co.uk

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