Rogue Trader Intrigue: Why Do They Continue to Gamble?

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Gapper explained that this "loss aversion" behavior was also observed among yellow-eyed junco birds during an experiment. The sparrows, after having been deprived of food for four hours, would fly directly to a feed dish that only sometimes had an abundance of food, versus a dish that always had two seeds. Gapper wrote, "To know what goes on in the mind of a Nick Leeson or a Jérôme Kerviel — and that of every reckless gambler — it helps to be a bird-watcher." 

Researchers and psychologists Daniel Kahneman and Amos Tversky, in their experiments with students and faculty at the University of Stockholm and the University of Michigan and with Israeli subjects, concluded that "… a person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise." Their findings, which were published in the March 1979 issue of Econometrica as "Prospect Theory: An Analysis of Decision Under Risk," reaffirmed "the well-known observation that the tendency to bet on long shots increases in the course of the betting day."  

This seminal article and others written by Kahneman in the field of behavioral economics lead to him winning the Nobel Prize in economics in 1992. In 1979, Kahneman and Tversky asked their subjects questions like: Which of the following would you prefer: a) 50 percent chance to win $2,000 or b) a guaranteed $1,000? Given this choice, a majority of people (80 percent) in the study would take option b.

Kahneman and Tversky's research revealed that when a person had already lost $2,000 and was faced with a choice of the sure gain of $1,000 or an even chance of winning $2,000 or nothing at all, that person tended to take the even chance of winning $2,000 or nothing at all thus avoiding the sure gain of $1,000. Kahneman and Tversky concluded those individuals still hadn't yet adapted to the existing loss. In other words, that person flies toward feed dish No. 2 and becomes a sparrow or rogue trader.

CHARACTERISTICS OF A ROGUE TRADER

What are the characteristics of a rogue trader? Chase Cooper, an international risk management and compliance solution company, published a long list of similar characteristics between Adobli and Kerviel. The first paragraph of the newsletter, "Chase Cooper Metric: Rogue Trading Special Edition," reads like an FBI or Interpol profiler's report on rogue traders:

Within your Delta 1 Equity Derivatives group, do you employ a likeable 28 year old male index derivative trader who has been promoted to the trading floor, initially as a trader's assistant, from a middle office trade support or product control function? Does he have a very good understanding of your back- and middle-office systems and processes, including where the weaknesses are? Does he have a decent finance- or business-related degree from a good (but not top-end) university? Was joining the bank his first permanent employment after graduating?

If so, please take a closer look at what he's doing, Chase writes in his newsletter. Based on the experience of Société Générale, and now UBS, it's entirely possible that he has started (or is about to start) to take small directional bets on particular index or stock futures, he writes. Chances are likely that he's pretending to hedge by using fictitious trades, and — if his actions are successful and undiscovered — he may increase his bonuses fractionally, Chase writes. Left alone to his own devices, in three years' time you could discover an unrealized trading loss of about $2 billion, as well as significant additional losses that unwind as the investigation continues, Chase posits. Your perpetrator hopefully would be arrested, tried and convicted. What is certain is that your company would be pilloried by shareholders, regulators and the press alike, he writes.

Much can be learned from the actions of real-life rogue traders as well.

LESSONS FROM LEESON

In 1995, Leeson broke the bank when he accumulated £800 million in losses, while working as a trader for Barings Bank in Singapore. Those losses were almost the entire amount of Barings' assets.

In 1993, after being in Singapore for only a year, Leeson had made £10 million for the bank — almost 10 percent of Barings' earnings for that year. His performance certainly earned him some leeway, because, in 1994, after he lost £208 million while trading, Leeson was granted extra funds to engage in additional trading.   

To add insult to the demise of Barings Bank, the institution, which was founded in 1762, was sold to ING for only £1 in 1995. This is compared to Leeson's trading jacket, which was sold in 2007 for £12,000.

EVIL KERVIEL

Nicola Clark reported in the Oct. 5, 2010, article in The New York Times, "Rogue Trader at Société Générale Gets 3 Years," that Kerviel, a former trader for the French bank Société Générale, was convicted for, among other things, unauthorized use of the bank's computer system for rogue bets. Kerviel claimed he had been trading beyond his trading limits for more than two years. In the fourth quarter of 2007, the former back-office worker had generated a €1.4 billion profit in unauthorized trades. 

Scheherazade Daneshkhu reported in the June 21, 2010, article in The Financial Times, "Kerviel team ‘frequently' broke the limits," that Kerviel's immediate supervisor, Eric Cordelle, admitted at trial that the trading desk on which Kerviel worked "fairly frequently exceeded" trading limits. 

At one point, the trading limit was €125 million, and Kerviel made eight trades that exposed the bank to €50 billion in potential losses. Cordelle told the court when asked about anomalies in trading patterns that "Jérôme was always able to come up with reasons, convincing explanations." On Oct. 5, 2010, Kerviel was sentenced to three years in prison and ordered to pay the bank €4.9 billion in restitution.

ADOBOLI'S ATROCITIES

In September 2011, Adoboli, another back-office employee turned equity derivatives trader, was accused of fraud for allegedly hiding £1.3 billion of rogue trading losses at the UBS London office. A memo from UBS interim CEO Sergio Ermotti to his employees — and released to the press — provides another glimpse into a failure to respond adequately to warning signs. In the memo, Ermotti said the bank was aware that its IT systems had detected the rogue activity but he wrote that "this was not sufficiently investigated nor was appropriate action taken to ensure existing controls were enforced." We have to wonder what good is having an effective detection system in place if a company doesn't take appropriate remedial reaction or enforcement action.

Incidentally, UBS has a history in rogue trading. In 1988, the bank's entire senior management was forced out following its involvement in the collapse of Long-Term Capital Management, the U.S. arbitrage hedge fund, located in Greenwich, Conn.

All three of these rogue traders have one trait in common: their employers unintentionally made it possible for them to commit fraud. As Gabber wrote in his Dec. 2, 2011, article, "What makes a rogue trader?", "Rogue trading, it is now clear, is not an aberration, but integral to the banking system. Like the cycles of financial speculation and crashes that have occurred throughout history, rogue traders are always with us."

Richard Hurley, Ph.D., J.D., CFE, CPA, is a professor at the University of Connecticut (Stamford) School of Business.

Tim Harvey, CFE, JP, is director of the ACFE's UK Operations and a member of Transparency International and the British Society of Criminology. 

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