Exclusive Interview With NIck Leeson: An Inside Look at Rogue Trading
Nick Leeson, the infamous trader who in 1995 bankrupted Barings Bank in a rogue trading scandal, offers advice in the wake of the Societe Generale debacle on how firms can prevent rogue trading.
By Cristina McEachern
March 07, 2008
More than a decade has passed since Barings Bank, the oldest investment bank in the U.K., was bankrupted by a rogue trader who racked up an astounding $1.4 billion in trading losses. In those 13 years, one would think that Wall Street firms have learned a great deal about detecting rogue behavior, and that technology has come a long way to improve risk management, internal controls and oversight on the trading floor in order to prevent such fraud.
Think again. While firm after firm on Wall Street wrote down billions of dollars in subprime exposures in weathering the credit crisis, the financial industry was blindsided by Paris-based Societe Generale's January announcement that a single rogue trader topped the Barings debacle with record-setting losses of more than $7 billion. Jerome Kerviel, a 31-year-old junior trader, took his place in history as the perpetrator of the largest rogue trading losses ever recorded -- a dubious position previously held by Nick Leeson of Barings infamy.
As news of SocGen's trading scandal spread, theories emerged as to how this could have happened, why it went unnoticed and who should have caught Kerviel. In fact, the investigation into Kerviel's actions still is ongoing, and it has become obvious that it will take time to sort through his devious actions and SocGen's internal missteps.
But Nick Leeson, who has a first-hand perspective that few others can claim, has plenty to say about rogue trading. Leeson's trading losses at Barings Securities (Singapore) amounted to more than $1 billion back in 1995, and he has spent more than a decade paying the penalties -- both public and private -- for his crimes (see related sidebar, below). In an exclusive interview with Advanced Trading, Leeson candidly reflects on how he was able to get away with his misdeeds at Barings and his ultimate downfall, and he offers some essential strategies to help firms avoid rogue trading.
Success Leads to Failure
In many ways, rogue trading ultimately comes down to human frailty -- a person inextricably gets caught up in the drive to succeed and the highs that result from securing huge profits. While firms can build up internal controls and implement risk management systems and other management and technology solutions to prevent fraud, a rogue trader often is familiar with these tactics and, obviously, is highly motivated to not get caught.
"Certainly in my case, a success story builds up around you and builds up in the bank and in your private life, and to a certain degree you enjoy that," says Leeson. "It starts off very slowly, and then it gathers pace, and everybody around you fuels it." Seeing the huge profits he allegedly was generating, Leeson explains, people around him bought into the hype, ratcheting up expectations. "The management of the bank holds you up as an example of how they want things to be done," he relates.
One of the most "ludicrous" examples of this, according to Leeson, occurred during his last days at Barings in 1994. The CEO of Barings Worldwide at the time traveled to Singapore to sit down with Leeson to "discuss with me how we could set up similar operations around the world, particularly in Brazil where there was a futures and options market just opening up," Leeson recalls. "Everybody is buying into it and you get caught up," he adds.
"If you ask any trader what their biggest fear is, it would be fear of failure," Leeson continues. "And fessing up to what is going on is probably the biggest failure you could ever imagine." For three years, he notes, he believed that somehow he could work his way out of his trading mess.
So could it happen again? Of course, says Leeson -- it happens all the time, just not to the magnitude of the SocGen scandal. And usually it is caught sooner and dealt with quietly. "[Firms] absorb the losses and get rid of the employee, but it's all about the magnitude," he explains. "I believe it is happening more frequently than anyone is aware -- maybe not daily, but if you looked around the world, I would probably say weekly."
As for the SocGen losses, Leeson says he was completely surprised. "They were on the cutting edge and they were extremely profitable," he comments. "They seemed to know everything that was going on, and it came as a massive shock to me that something like this would occur at SocGen." Leeson adds that while there were many loopholes or inadequacies evident in the SocGen situation, a scandal of that magnitude comes down to a "complete breakdown of systems and controls on a number of levels over a number of years."
Avoiding Rogue Losses
So what can firms do to help stop traders from spiraling into rogue territory? Leeson points to a few key controls that should be reexamined.
First, Leeson says, while it sounds obvious, ensuring that trading positions are monitored and checked by management or auditors on a regular basis is critical. But, as with the SocGen and Barings cases, this simple step often is overlooked or isn't enforced as often as it should be.
Leeson advises checking and collating positions on a daily, if not intraday basis. "If you look at cases such as SocGen in France and myself in Singapore, we were both able to build up massive positions on exchange-traded products which defy common sense," he relates.
"When I worked for Barings in Singapore, we had two trading accounts -- one was a London account and one was a Tokyo account," Leeson explains. "If you had added the two together and compared it to SIMEX [the Singapore International Monetary Exchange], where the positions were held, there would have been massive differences, which would have been my illegal trading account."
In addition to compliance officers monitoring trades and e-mails, the settlements department also should have been monitoring the trading positions and checking that they agreed, Leeson adds. "A trader should trade and trade only," Leeson contends. "Perhaps somebody else should be inputting those positions into a risk management system." He stresses that traders should be somewhat isolated in terms of a reporting structure and they should never be allowed to look after their own positions or how they are settled.
Know Your Business
Beyond the trading floor and back office, Leeson advises, upper management must have a solid understanding of the business. Leeson knows just how dangerous it is for top executives to lack an understanding of each business and trading area within the firm. This understanding, he insists, has to go beyond the traders themselves, who live and breathe the products they trade.
"Understanding the business that you are in is fundamental and must start at the very top of the organization and work its way throughout," says Leeson. "I can speak first-hand that at Barings, management became very distracted from what was going on at the ground floor. They had no expertise in futures and options, and no understanding of how the markets worked."
Leeson points to a time at the end of 1994, just before Barings collapsed, when the SIMEX futures exchange in Singapore raised serious concerns about the level of margin that Barings was posting with the exchange. That amount, he recalls, was equal to several times the capital of the entire bank.
According to Leeson, SIMEX sent letters directly to the CEO at the time, who Leeson says knew very little about futures and options and how they were settled. So the CEO passed them along to the CFO, who also had no futures and options experience. Ultimately, the letters of concern landed back with Leeson, who answered them to his benefit and continued his cover up.
"If you have an information or knowledge deficit to someone who is more junior than you, you don't like to highlight it, so you're not asking the key questions and not asking how the business operates because you want it to appear as if you know everything that is going on," Leeson suggests.
To best avoid this type of knowledge deficit or prevent management from failing to understand certain business areas, Leeson says, internal audit teams should consist of people who have direct front-office experience in these trading areas. The perfect people to understand these types of things of course are ex-traders. "These are the people who have worked at the sharp end of the business, and when they're no longer needed there, they can be utilized elsewhere," he comments.
Leeson points to his experience while working at Morgan Stanley in the late 1980s as an example of effective audit teams. According to Leeson, his group included a trading desk and a settlement group, but a group of "controllers" sat between them. The controllers were accountants, but they also had first-hand knowledge of what goes on in both the trading and settlements areas. "They were accurately able to combine those two areas together and check that everything was working effectively," Leeson says.
Offering another example of effective internal checks, Leeson refers to a recent meeting he had with the CEO of the Hong Kong Shanghai Banking Corp.'s Middle East operations. At the firm, he says, 50 percent of the internal audit teams are audit professionals and 50 percent are people who have worked directly in the areas they oversee. "These are people who know how you can mismark trades, who know how you can circumvent the rules. They have been trained and have been decision makers and now are looking out for certain things," Leeson notes. "That blend of audit professionals and front-end business professionals is essential." Leeson adds that while it does become costly to employ these types of teams, it doesn't compare to allowing a rogue trader to run up $7 billion in losses.
Systems That Work
Again, it might sound like a given, but Leeson says it also is extrememly important for firms to invest in risk management systems that actually work as they are supposed to, as well as in the people who understand the technology. "If you look back over the recent episodes, some of the risk management modules -- whether they are correctly tested, whether they work in the manner that they are supposed to, is open to question," he points out. "Any trading operation is always heavily focused on the income side of the business, and sometimes the controls should get more focus."
Leeson says paying the people in these positions more, and making the jobs themselves more high-profile, would help attract talented employees. "From an individual business perspective, you must make sure that your internal controls are beyond reproach," notes Leeson.
"At Barings, it has been proven that the risk management systems just didn't work," Leeson claims. "In the SocGen case, the level of money involved -- one trader who is apparently betting 13 times the capital base of the bank -- that should be drawing some attention."
At the end of 1994, "I probably had 500 million pounds from the bank to fund the illegal positions that I had, and the capital base of the bank was only 250 million pounds," Leeson adds. "And the legal limit that you can lend to a subsidiary is only 20 percent of the bank's capital, so it was 10 times in breach of that limit."
In SocGen's case, if Kerviel was able to build up an exchange-traded position that exceeded the capital base of the bank by 13 times, that would suggest some very simple risk management functions were not being performed, Leeson continues. "They may have been checking some complex risk management algorithms but ignoring the most simple things," he suggests.
Leeson also points to disparate systems as an opening for his rogue trades, something that he says more-unified risk management could help avoid. "At Barings, different systems were looking after plain vanilla equities and something else was looking after futures and options and something else for the warrant products," he relates. "Only when those reports were actually brought together could you actually see what exposure the bank had and could you compare things. It enabled me to circumvent the accounting and risk management processes."
Having centralized risk managers can help, Leeson says. During his time at Barings, the firm reportedly was beginning to solidify its risk management functions and had appointed head executives in London, Tokyo and Hong Kong -- but not yet in Singapore. When it came down to it, there was no single manager overseeing Leeson or his activities from the risk management side.
Every trader knows that the big money is made when new products start up and only a few firms are getting in on the action. But this is when risk management controls often are slower to catch up with trading than the cash flows.
"A lot of focus is on moving on to the next product so that you can maximize your return," explains Leeson. "And if you do that with one hand and with the other hand you don't make sure that you're controlling it correctly with the people and systems that you have in place, that imbalance is always going to be very, very risky."
Leeson says that derivative products in general present more of an opportunity for rogue trading. "Because of the leverage that they have over the market, derivatives are always going to be the area that needs to be focused on," his asserts. "But anything that has a highly geared leverage against the actual commodity or the market that you're trading should be focused on." In particular, Leeson points to warrants, futures, and options and credit derivatives as presenting the biggest opportunity for rogue traders.
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