Why rogue traders will never disappear
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John Gapper’s new e-book, How To Be a Rogue Trader, is really good. Gapper’s been covering such things ever since he wrote a 1997 book about Nick Leeson which itself has just been reissued in Kindle form. And you might be surprised how many rogue-trading scandals there have been between then and now. Leeson was roughly contemporaneous with Joseph Jett, at Kidder Peabody; since then we’ve had Toshihide Iguchi at Daiwa, Yasuo Hamanaka at Sumitomo, John Rusnak at AIB, a team (!) of four rogue traderes at National Australia Bank, Jerome Kerviel at SocGen, and of course Kweku Adoboli at UBS.
Gapper’s book looks at the common pathologies here, and finds quite a few. The first is a trait common not only to rogue traders, but rather to all animals — it’s been seen in birds quite vividly. It’s the entirely rational decision which you see in any movie where somebody utters the line “it’s the only chance we’ve got” — no matter how improbable your chances of success, if the alternative is failure, then you take the gamble.
Some people are more likely to take those risks than others, of course — and those people are exactly the ones who end up getting hired on trading desks. As Gapper recalls, Christopher Heath, the former CEO of Barings, would ask potential recruits if they were “hungry” — much as Ace Greenberg and Jimmy Cayne did at Bear Stearns. And “hungry” is exactly the state that you need to put birds in before they start taking stupid risks.
Investment banks don’t just hire the kind of people who are more likely to go rogue, they also encourage exactly the kind of trading that rogue traders excel in. Risk-management operations are designed to reduce risk, rather than detect fraud. And rogue traders, if you believe their numbers, tend to be running extremely low levels of risk.
There’s an almost infinite number of strategies, on Wall Street, which work until they don’t. Many involve shorting volatility in one form or another, maybe by selling out-of-the-money options. That brings in lots of cash, and you can do it for a long time until you blow up. More desperate strategies involve doubling down in an attempt to make up bad bets — a strategy which Andrew Weisman has demonstrated is likely to work for more than seven years of outperformance until the inevitable conflagration. Or you can simply mark your illiquid assets to “market” rates which get further and further away from reality. If a rogue trader does this, says Gapper, he “appears to be doing everything right”.
And he’s also likely to be supported, at least implicitly, by the most senior executives at the bank. “There has never been a case of a rogue trader carrying on his fraud for months or years without the executives in charge having noticed at least some signs of trouble, and often having been bluntly advised to investigate,” writes Gapper. “They often react by ignoring what they see, and telling the whistleblowers to shut up.”
Of course we have no data on how many times executives are asked to investigate something suspicious and they say yes. But this kind of gut denial that anything could be amiss is far too common in executive ranks, especially in banks where the first job of every executive is always to manage risk.
Gapper does find one thing which the executives, as opposed to the rogue traders themselves, have in common: they, too, have excessive amounts of hunger. The banks worst hit by rogue trading, Gapper writes, are not generally found in Wall Street’s bulge bracket. Instead,
they are striving to get there… they are outsiders that are eager to make their mark and are willing to take short cuts. They tend to be retail and commercial banks seeking to transform themselves into investment banks. They have a case of what became known before the 2008 crisis as “Goldman envy”.
Just as rogue traders want to be successful traders, rogue banks want to be Goldman. These kind of blow-ups, in other words, are a natural byproduct of precisely the ambition which is so highly valued on Wall Street. And as a result, they’ll never go away.
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A slightly different take here. Commercial bank executive coveted Goldman’s bonus payouts, and Goldman executive coveted the pile of money at commerical banks.
They both got what they wanted and then proceeded to blow the whole arrangment sky high.
There’s another reason rogue traders will never disappear: it’s really, really easy for management to pin one of their own screw-ups on a “rogue trader.” The trader has every incentive to shut up: he gets severenced away, management saves face, and the trader goes to work somewhere else, because everyone on the Street knows what really happened.
The exception, of course, is when the trader has to do criminal time. Then he has every incentive to talk. But there have been “rogue traders” as long as there have been traders. Usually they are bright, aggressive individuals who explore a new twist on the market, usually on their own, without much guidance because the twist is totally new. And management knows all about it.
Michael Lewis’s first (and best) book outlined a couple of rogue trading incidents that were really cover-ups for the suits. How many have there been? Who knows! But I *know* that there has been at least one more than have been publicized.
“Just as rogue traders want to be successful traders, rogue banks want to be Goldman.” Especially if they are run by a former head of Goldman.
In terms of the complicity of management, has there ever been a reported case of unauthorized trading making a ton money?
So, basically, what you’re saying is that really, there are no “rogue” traders. There are traders who get caught doing shady/fraudulent/illegal things because they lost a ton of money and got proverbially hung out to dry. But if they are hired for certain personality traits and management tacitly approves of what they do, then it’s part of the business plan of the management. There’s nothing really “rogue” about it.
http://acynicalcrank.wordpress.com
Unfortunately main street assumes the greatest risks when a rogue trader reduces the value of their fund.
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There are no doubt other situations brewing as I type. Agreed with one message here; that the trading environment attracts personality types with the potential to “going rogue”. Effective detection and control measures are therefore the minimum we should expect, but if these are the only weapons, they can never be enough. We know that not everyone walking in to a pub becomes an alcoholic; not everyone walking into a store is compelled to steal. We need to look more to values, principles and culture and not just within the hot-house of a trading room.
All too often corporations have grandiose mission statements and stated values, with little if any practical measures to make them real.
Rogue traders will disappear the day claw-backs becomes the rule for banks and investment firms principals and executives.
Or even better, subject principals to unlimited liability in case of bankruptcy, regardless of the actual form of incorporation of the failed investment concern. The industry will restructure itself almost instantly between ultra-safe plain vanilla commercial banks on one hand and, on the other hand, tightly managed partnerships like IBs used to be in the olden days.
Frwip, yes because commercial banks are ultra-safe. Just look at Countrywide, Northern Rock, the S&Ls in the 80s, the commercial banks lending to the 3rd world in the 70s, citibank in 1990. No danger there at all. Just like the partnerships never ever caused any trouble, just ask investors in 1929 or Goldmans in 1994.
Yet another sign of how non-stop fabrication by finanical “journalists” has distorted the actual facts.
@Danny Black,
Do you think principals in S&Ls would have let the type of operations that sunk their outfits if they had carried personal liability for the losses?
Reckless finance is entirely a problem of asymmetric incentives, principals keeping their wages and bonuses even when the transactions that created the “earnings” that justified the bonuses in the first place go bust a few years later. Take the money back and I guarantee you you won’t see a lot of “rogue” finance.
Frwip, we know that partnerships did go bankrupt. We know banks where the majority of the principal’s wealth was in the bank equity didn’t stop them taking risks – for instance BSC and LEH – nor did having their bonuses paid over years make a difference. So empirically what you are saying is false.
@Danny Black,
The point is not to get rid of failures. There will always be failures. It’s part of capitalism.
The point is to make sure that failure isn’t a business plan. Failure must look like what used to happen to the Lloyd’s Names when they failed to pay out.
And don’t worry for the principals at Bear Stearns and Lehman Brothers. They did very well. They “lost” a lot of paper money (that wasn’t there to start with) but they are OK. They still have the 8 or 9 figures bank accounts, the 6,000 sqft duplex over Central Park, the mansions in the Hamptons, the crash-pad in The Bahamas, the villas in France, and a 30% time share on a Gulfstream G550 to zip along between those in proper fashion (or it may a be a Bombardier Global Express, pretty cool too). I would really, really enjoy being ‘bankrupt’ like that.
Anyway, just read Bill (William K) Black about control fraud, and may be you’ll get what the whole point is about.
As someone who has spent a long time in the market, controlling risks – the reasons WHY are quite well known – and even recounted in Satyajit Das’ Traders Guns.. et al . There is the Power equation – in favour of Trading – where Trading aggressively lies through its teeth, esp to Risk management b ut also to General Management, goes to General Management and gets their support to do precisely what is risky. General Management is generally clueless – &/or hasn’t the time or inclination to really check it out – and anyway figures the situations as – We’re here to make money..what are these guys saying ? .. (and) – Its either Money or getting screwed – so let it go thru. When we’re screwed its ‘curtains !! Or the Blame & Denial Game – Deny you knew anything or authorised or approved anything. AND Blame the Risk guys – and demand to know WHY WE’RE IN THIS GODAWFUL MESS !!! And so the game goes.
Till Sr / General Management & Traders are called to account, given no wiggle room on their excuses, and blasted for their lies, CYAs and denials – and hauled into the clink – kicking & screaming.. as should happen to the effing traders who got into positions which they should never have been in – in the first place ! – till then this merry game will continue.
Remember – we’re talking about a sector that is like cancer !! One that has grown way out of control & size ! Without any linkage to the real economy – and what is really needed – as regards Investment Products. When such a percentage of a Nation’s GDP is predicated on and comes from the Finance sector (Financialisation – being the New Buzz Word !!) – and when you have legions of young guys hired and told to ‘produce’ !! And I don’t care HOW !!- The Blue Sky approach – THAT, my friends is a recipe for disaster.
That – and overwhelming Greed in a get-rich-quick culture – with the US underlying disastrous state of Debt & Finances – leads ultimately all the way to what Janet Tavakoli has called “Fraud as a Business model “. Regulators are corrupted, Congressmen are paid off. And there are NO REMAINING CHECKS & BALANCES left.
Why should it matter? (ie Traders & Rogue Traders). In such an environment Traders are just the trigger-happy,hired hands – their quick Guns …blasting away, whatever they are allowed to get away with!!
Frwip, all you need to do is run a world-class investment bank successfully for a couple of decades and you too can have all those things.
Also, surely Lloyds names is a COUNTER-example to what you are claiming, ie that unlimited liability will somehow stop people being over optimistic.
@Danny Black,
You mean a “successful world-class investment bank” like Lehman Brothers or Bear Stearns ?
You’re funny :-)
for 20 years…. Should be easy for you no?