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The Societe Generale Rogue Trade Debate
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Feb. 3rd, 2008 | 12:43 pm
The European Market seems to know no respite. After the Northern Rock scandal, it is the turn of the costly rogue trade at Societe Generale to cause a commotion. The French bank lost about 5 billion euros with an exposure of ten times that much - not withstanding an emergency cash call on shareholders. The bank blamed it on Jerome Kerviel, a junior trader working as part of its highly successful equities derivatives group.
What did Jerome’s accusers actually indict him for? Jerome allegedly used a slim arbitrage technique to create fake hedging contracts and rather surprisingly raked up massive losses as these contracts later got cancelled. In this technique that Jerome used - called Delta One - investors bet on share price movements but do not buy or sell the stocks in question. For instance: an investor wants to earn returns on a £10 million investment in a particular index – say the FTSE 100 index. He has to cough up an upfront fee (the margin) to the bank of say £1 million. If the index went up 5%, the client is paid half a million pounds. If the index went down 5%, half of his margin would be lost. The investment bank’s obligation to the investor moves in perfect correlation to the trade specified by the investor. Hence the name ‘Delta One’. The profit margin for the bank is low and hence there is an onus on volumes. Banks hedge out the risk they have assumed mostly by netting positions with another portfolio which offsets the first. This leaves one to wonder whether such a low risk business can actually explain the colossal rogue trade.
Financial analysts, forensic accounting experts, investors and rival banks are all making several accusations – most of which SocGen seems to have provided explanations for, satisfactory or not.
1. Given stringent internal controls in the equities derivatives business, how did the rogue trader pull this off?
SocGen: The trader inserted fictitious operations into portfolio B in order to give the impression that this portfolio genuinely offset portfolio A which he had purchased, when this was not the case. Hence the internal controls were ineffectual or inoperable as the operations did get registered in the systems but did not correspond to reality.
It is quite possible that the profit making equities derivatives business could have been granted some flexibility from many audit controls as it made up a third of the group’s profit. This could have only worked in favour of the trader. This speculation would only undermine the position of the Chairman of SocGen, Mr. Daniel Bouton who was a former adviser to the French government on Corporate Governance!
2. Margin calls should have served as a warning sign.
SocGen: The rogue trader chose very specific operations with no cash movements or margin call and which did not require immediate confirmation.
According to sources SocGen did pay up large margin calls as a result of the falling value of the futures position that Mr. Kerviel had assembled. A dwindling cash position should have sounded an alarm at the least – but was anyone listening?
3. Positions are commonly hedged using bespoke derivatives and the paper work takes weeks to complete.
SocGen: The trader falsified documents.
That was easy! However a couple of things to consider are that even if the trader did not falsify documents, there is definitely a period of exposure for the bank when the contracts are getting tossed hither and tither.
In spite of everything, what was Mr.Jerome Kerviel’s personal incentive in all this? Or was he simply made a scapegoat by the bank which was trying to save its face or conceal names of (maybe) some board members who could have been at fault? This is quite plausible considering that a rival bank even made a statement that Jerome was not entirely to blame as his futures trading had only accumulated a deficit of 1.5 bn euros. The rest was apparently lost by the board of SocGen.
Many questions and many more answers. There is no time to lose in crying over spilt milk. What remains to be done is to strengthen internal risk controls in all financial institutions.
Speaking about SocGen, Mr. Bouton would now be secretly praying to not score a hat trick after two major debacles - losing the bid for Paribas to BNP and the rogue trade in question.
What did Jerome’s accusers actually indict him for? Jerome allegedly used a slim arbitrage technique to create fake hedging contracts and rather surprisingly raked up massive losses as these contracts later got cancelled. In this technique that Jerome used - called Delta One - investors bet on share price movements but do not buy or sell the stocks in question. For instance: an investor wants to earn returns on a £10 million investment in a particular index – say the FTSE 100 index. He has to cough up an upfront fee (the margin) to the bank of say £1 million. If the index went up 5%, the client is paid half a million pounds. If the index went down 5%, half of his margin would be lost. The investment bank’s obligation to the investor moves in perfect correlation to the trade specified by the investor. Hence the name ‘Delta One’. The profit margin for the bank is low and hence there is an onus on volumes. Banks hedge out the risk they have assumed mostly by netting positions with another portfolio which offsets the first. This leaves one to wonder whether such a low risk business can actually explain the colossal rogue trade.
Financial analysts, forensic accounting experts, investors and rival banks are all making several accusations – most of which SocGen seems to have provided explanations for, satisfactory or not.
1. Given stringent internal controls in the equities derivatives business, how did the rogue trader pull this off?
SocGen: The trader inserted fictitious operations into portfolio B in order to give the impression that this portfolio genuinely offset portfolio A which he had purchased, when this was not the case. Hence the internal controls were ineffectual or inoperable as the operations did get registered in the systems but did not correspond to reality.
It is quite possible that the profit making equities derivatives business could have been granted some flexibility from many audit controls as it made up a third of the group’s profit. This could have only worked in favour of the trader. This speculation would only undermine the position of the Chairman of SocGen, Mr. Daniel Bouton who was a former adviser to the French government on Corporate Governance!
2. Margin calls should have served as a warning sign.
SocGen: The rogue trader chose very specific operations with no cash movements or margin call and which did not require immediate confirmation.
According to sources SocGen did pay up large margin calls as a result of the falling value of the futures position that Mr. Kerviel had assembled. A dwindling cash position should have sounded an alarm at the least – but was anyone listening?
3. Positions are commonly hedged using bespoke derivatives and the paper work takes weeks to complete.
SocGen: The trader falsified documents.
That was easy! However a couple of things to consider are that even if the trader did not falsify documents, there is definitely a period of exposure for the bank when the contracts are getting tossed hither and tither.
In spite of everything, what was Mr.Jerome Kerviel’s personal incentive in all this? Or was he simply made a scapegoat by the bank which was trying to save its face or conceal names of (maybe) some board members who could have been at fault? This is quite plausible considering that a rival bank even made a statement that Jerome was not entirely to blame as his futures trading had only accumulated a deficit of 1.5 bn euros. The rest was apparently lost by the board of SocGen.
Many questions and many more answers. There is no time to lose in crying over spilt milk. What remains to be done is to strengthen internal risk controls in all financial institutions.
Speaking about SocGen, Mr. Bouton would now be secretly praying to not score a hat trick after two major debacles - losing the bid for Paribas to BNP and the rogue trade in question.