Rogues of Wall Street. Waxman Andrew

financed an expensive lifestyle. He was living the dream. Looking at Adoboli's profile in retrospect, one may wonder why he didn't stand out more from his colleagues. In reality, however, many of Adoboli's colleagues likely shared several aspects of this profile: his age, sex, lifestyle, and the aggressive, hard‐charging trading and work ethic. Slightly more unusual was his educational and work background in operations. However, it is the content of what Adoboli did at work, of course, that truly distinguished him from his colleagues. This is where any detective work should have come in. The fact that he was able to succeed in his deception for so long – some three years – highlights the difficulties involved in identifying such illicit activities.

      The Crime of Rogue Trading

      So what exactly is the Rogue Trader's sin? Traders are clearly paid by their employers to take risks. What exactly is wrong with the risks that the Rogue Trader takes?

      Simply put, trading floors require traders to be supervised. Rogue Traders do everything they can to evade supervision. Rogue Traders tend to operate on trading desks responsible for facilitating client trades and, as such, are generally barred from taking risks with their own trades. Their clients tend to include institutions such as asset managers that buy and sell stock in bulk. A client may, for example, want to sell $1 billion worth of stock in a certain company. The job of the trader is to achieve the best price for his client. This requires speed and secrecy to prevent buyers from bidding the price down once they become aware of the seller. Clients pay their bankers large fees to make sure this happens. As a result, at a large investment bank, trading books of some of the traders working in institutional equities can be in the billions of dollars buying and selling the stocks in which they make a market for their customers. For such traders, there are huge levels of potential risk unless their positions are hedged – that is, matching of long positions (loss in market value hurts them) with short positions (loss in market value helps them) in equal amounts. Profit comes, then, not from changes in market values – they should be market neutral – but from the commissions and financing fees from the large trades they execute. Such traders are not supposed to make a lot of money in betting on the direction of a particular stock or group of stocks. There is too much risk involved for that.

      In addition, in a typical investment bank, traders are generally limited to trading securities strictly within the scope of their “trading mandate.” An equity trader's mandate should be generally restricted to trading equities, a fixed income trader to certain fixed income products, and so on. A broad mandate is then defined down to a specific set of limits that a trader should trade within in order to restrict the potential losses that can be suffered from his book on any given day. This is called his VaR (value‐at‐risk) limit.23

      Without limit management, given the number of traders and the size of their trading books in a large investment bank, banks potentially face catastrophic losses on any given day. Limits tend to be defined based on the level of experience and seniority of the trader and act to limit the potential size of a trader's profit for a day, a week, or a year, as well as his potential loss. Any trader who wishes to increase his profit opportunity can theoretically do so by increasing or exceeding his trading limits. While a Genius Trader may prevail upon management to assent to a temporary or permanent limit increase because he or she is a genius (discussed further in Chapter 3), no such privileges are likely to be extended to ordinary folk, the ranks of which are populated by the potential Rogue Trader. Such a trader will only be able to exceed his trade limits by deception – in other words, without authorization. He does this by various illegal methods of falsification and wrongful concealment of his tracks and activities. One can now see why this is such a serious offense and why it is labeled rogue trading. No trading operation can survive without defining such limits and requiring traders to stay within them unless otherwise authorized to do so. Trading without authorization is the source of the Rogue Trader's crime and is punishable with jail time, depending on the extent of the losses he causes to his employer. These can be very large when things go badly wrong because he is trading unsupervised as well as unauthorized.

      Tools of the Rogue Trader's Trade

      A trader seeking larger profit opportunities has to exceed his limits without seeming to – that is, through various means of deception. The basic objective is always to make sure that the trading book does not cause any unusual questions to be asked by supervisors, controllers, and limit checkers. In general this means making it appear that the trader's positions and risk levels are reasonably well hedged in line with expectations and prescribed limits. There are many tricks that may be employed in order to do this. Here are just a few that have been identified.

Intraday Trading

      One opportunity traders on occasion take advantage of is the fact that their trading limits are generally set for the end of the trading day rather than intraday. The reason for this is simple: At the end of day, traders' positions are closed and static and therefore easily measurable. During the day, however, positions are constantly being updated and changed to reflect active trades and other transaction data. As a result, traders may execute trades in excess of their end‐of‐day limit during the trading day, either intentionally or unintentionally. As long as traders are able to bring their positions back down by day‐end, any intraday position excesses are normally unexamined. A deliberate strategy to trade beyond a trader's end‐of‐day limits by a considerable amount intraday is not necessarily easy to catch for the reasons just discussed. Furthermore, it is arguable, and has been argued by risk managers, that since the limit is an end‐of‐day limit, trading beyond it during the day is neither illegal nor unauthorized. While difficult to catch and prove, the extent of any loss is limited to those that can accumulate in a single day, which of course can be in the millions.

Phantom Trades

      Another strategy a trader may employ is to modify the trading book prior to the supervisory and controller review at the end of the trading day (supervisors are expected generally to review trader activity at the end of the day). This can be done by creating nonexistent trades to balance out the real trades. Subsequent to the reviews, the trader cancels out the nonexistent trades and repeats such activities on a nightly basis.

Fake Counterparties

      Another strategy has been to create fake counterparties to trade with, thereby allowing fictitious trades with that counterparty to be entered into his trading book to balance out the real trades. In all these cases, the trader creates an illusion of a hedged book. In reality, the book is anything but hedged.

Slush Fund

      In order to allow such a strategy to work over a period of time, the trader needs to keep undue attention away from himself. He is thus likely to use a secret account that enables smoothing of profits over time so neither profits nor losses are overly excessive. Excess profits may be transferred to the secret “slush fund” account on good days and transferred back to the trading account on bad days. The creation and use of such accounts was a key point discussed at the trial of Kweku Adoboli. Such accounts normally can be created fairly easily though it may require controllers' help (knowingly or unknowingly) to evade their detection.

      Developing expertise in or gaining access to back‐office systems in order to evade them then is a core part of the Rogue Trader's skill set. However, as we saw with the Rochdale case, a trader can sometimes do untold harm with one trade that gets through the system, which is well beyond the limits that can be borne by the firm. A small firm can have zero tolerance for such fatal trades whereas a large investment bank or hedge fund has most to fear from the type of rogue trading that took place at UBS.

      How Rogue Traders Succeed

With gatekeepers at every step in the process of trade execution – supervisors, controllers, operations, counterparty operations – one might think that to elude them all is some sort of magic feat. While there is certainly some skill involved, it is not magic but a couple of crucial factors that enable some Rogue Traders to escape detection for so long (see Table 2‐1).

Table 2‐1 Infamous Rogue Traders

      First is

23

VaR (value at risk) is the term given to risk‐management modeling methodologies developed in investment banks. The models developed under this methodology are intended to indicate the amount of value that would be lost in a day under given trading scenarios. The scenarios are normally developed on the basis of historical precedent.