Friday, January 25, 2008

SocGen – where were the controls?

(Chase Cooper) Societe Generale yesterday announced an exceptional loss of €4.9 bn due to unauthorised directional trading in 2007 and 2008 by one staff member, Jerome Kerviel.

The trader’s role was supposed to be limited to using the futures markets for plain vanilla hedging of the bank’s European cash equity portfolio with index futures. SocGen is clear that he fraudulently acted ‘beyond his limited authority’. They state that the trader had formerly been employed in a back-/middle-office function, and his in-depth knowledge of the bank’s control procedures contributed to his concealing the true positions ‘through a scheme of elaborate fictitious transactions”.

Kerviel and his supervisors have been fired.

Obvious comparisons are being made with Nick Leeson, but there are some very significant differences.

  • Leeson was supposedly operating both a client sales and trading operation and a proprietary exchange arbitrage strategy. He was able to justify the ever-increasing margin calls for his own positions as arising from clients’ positions (e.g. the so-called “Spear, Leeds & Kellogg receivable”). Kerviel was operating a plain vanilla index hedging book.
  • Leeson was operating in a small office on the other side of the world from Barings Head Office in London, with his line manager in either Tokyo or London. Kerviel was operating in SocGen’s Paris office with his line managers and other traders close to him.
  • Leeson only managed to lose £800-900mn on closure of the positions. Kerviel has lost four times that much.
  • Leeson was able to carry out the fraud as he was in charge of both trading and settlement, so hid his own trades and dealt with the margin calls. Kerviel was not settling his own business, albeit he was familiar with the systems.
  • There was no effective independent risk management covering Baring Futures Singapore’s activities. SocGen has an active risk management division.
  • The ‘senior chaps’ in the line above Leeson did not understand how the switching trading operation between Tokyo/Osaka and Singapore worked and generated such large apparent profits, which Leeson obfuscated. Directional trading of European index futures is not remotely complicated, particularly for the winner of so many Equity Derivatives House of the Year awards in the last five years.
  • Leeson’s Singapore operation had been audited once. Global banks in this space are forever auditing their derivatives operations.

Very limited information is currently available, but some obvious questions arise – not just for SocGen itself.

From a SocGen perspective, however cunning, and well-informed in respect of existing control processes the rogue trader was, €4.9bn is a staggering amount of mark-to-market loss for him to be able to disguise: obviously a part of that loss will have been crystallised and exacerbated by the sheer scale of the positions that SocGen has liquidated or re-hedged over 3 days, but even so the question has to be asked – however well-acquainted he was with internal controls, where were the red flags?

This is not just about market and counterparty risk. Questions for SocGen to ask themselves include:

  • Was he behaving unusually erratically or secretively, whilst sitting on a loss as it increased towards the stupendous close-out number?
  • He must have been making an enormous number of cancels and rebooks and/or book entry transfers – SocGen has implied he was moving positions around just before each risk control was due to be exercised: how come no-one noticed or thought it odd?
  • As he was apparently concealing the notional size of his position, why didn’t they pick up on the ever increasing variation margin calls?
  • SocGen has said that the trigger for discovery was a red flag on counterparty risk – but he was running a plain vanilla directional hedging book, which should mean exchange traded index instruments settled directly with the clearing house, with variation margins paid or received daily – so where was the counterparty risk limit breach?
  • If, as seems likely, he was creating fictitious OTC index trades in the names of other market participants or corporate clients, why wasn’t he challenged for dealing off-exchange in breach of his authority?
  • It is also said he created fictitious companies to book phantom trades to, which calls into question SocGen’s new client take-on processes and ongoing monitoring if there was a high volume of high value trades with a counterparty no-one had ever heard of.
  • He has been described as a computer whizz-kid who hacked a system as impenetrable as the US Government’s Department of Defence. Can SocGen be sure that they removed his user account privileges for the back office systems when he transferred to the front office?

We are sure that Euronext and any other European derivatives exchanges involved, and the Clearing House(s), will also be reviewing their own procedures for interrogating large positions for Members, even when margin calls are being made and routinely met.

Finally, whilst SocGen took action to close these huge positions in a falling market with no announcement of their intentions, is there an echo here of the Citibank “Dr Evil” case, at least in terms of the impact of the action on the European equity markets – or was this the right thing to do – with Banque de France approval – to avoid the chance of systemic impact on the banking system?

This story has many months to run, and many more facts are yet to come out…

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