The thing about useful stuff is: The SocGen fraud

The SocGen fraud - the real story.....perhaps Friday, January 25, 2008

Fraud –noun

1.	deceit, trickery, sharp practice, or breach of confidence, perpetrated for profit or to gain some unfair or dishonest advantage.

2.	a particular instance of such deceit or trickery: mail fraud; election frauds.

3.	any deception, trickery, or humbug: That diet book is a fraud and a waste of time.

4.	a person who makes deceitful pretenses; sham; poseur.

Source : Dictionary.com

As it stands, SocGen is maintaining that their rogue trader, Jérôme Kerviel, appeared to have acted alone and does not have appeared to have operated for personal financial gain, albeit his motives have not been determined.

The notional futures positions taken by Kerviel are reported as being as high as EUR60bn. For those less familiar with these instruments, it is worth explaining that when investing in exchange traded futures, one doesn't have to pay for the full notional value but instead one normally has to a) pay an initial deposit, commonly 5-10% of the notional value which is termed initial margin b) immediately pay to cover any losses but with the benefit you can also be paid any profits. The central function in the market (clearing house, which is like the central banker) collects these sums from the brokers that have positions in the market and the brokers in turn collect these sums from clients or their own funds.

So, SocGen would have had to pay the clearing house the initial margin on the positions or deposit collateral. In turn, the reported positions in client accounts should have been covered by say EUR6bn of initial margin, which would have been demanded in either cash or collateral (high quality assets such as treasury bonds). This sum might have been lower based upon

the accounts being set-up to demand lower initial margin i.e. say 5% instead of 10%
credit lines, similar to overdraft limits, which firms offer to "creditworthy" clients on which they can earn additional lending income.

To achieve this, Kerviel could have manipulated the account static data and, say, set high credit limits for the accounts he was using, thereby eliminating/reducing the calls for initial margin from the "client".

But assuming he couldn't eradicate all of the initial margin requirement and had to fund losses, some other wheezes, in order of ease, might have been

to post fictitious cash receipts purporting to be from the "client", knowing that their discovery on a bank reconciliation might take some time, especially if he knew there were problems in that function. However, to maintain this deceit, takes regular intervention.
to re-assign/claim real cash receipts from other clients for his accounts, knowing that uncovering and unwinding this might similarly take time.
to transfer positive cash balances from other client accounts to those he controlled (termed "teeming and lading" in the audit world]
to transfer unused collateral from other client accounts to those he controlled. This method would be preferred as people tend to check statement cash balances on an account more frequently and carefully than collateral balances.
to link his accounts to those of real clients and set up "family offsets", that would allow his deficits to be covered positive balances in cash or collateral held by other client accounts

I should mention at this point that my familiarity with these things stems from work I've historically undertaken designing and operating control systems to prevent such activities. Traders wouldn't be allowed access to the functions above, but the bank has already made clear that Kerviel had borrowed passwords from other people to pursue his activities. These could have been other traders, which could have enable him to process trades above his authority level or old colleagues in the middle office (control and processing function), giving him access to the above functions.

Of course, speculation on what happened is somewhat pointless. But it's fun isn't it? So, what might have prompted this behaviour? There are at least four possibilities:

the trader was running a "prop" book and taking positions for the bank's own account. He would have been rewarded for the profits he made. If he were doing badly, he may have wished to hide these losses by creating fictitious client accounts into which he could transfer the positions. This is what supposedly what happened with Nick Leeson and Barings, with the hope being you could trade your way out of the problem without being detected.
same scenario but, rather than hide losses, he was fictitiously creating profitable positions in his prop accounts to improve his standing in the firm either for prestige or to get a better bonus. In some firms, big windfalls made just ahead of bonuses being set will always help get one a better bonus (short term memories amongst management are a constant complaint in banks), reversing them thereafter.
the trader was speculating for personal financial gain and so took positions which he put into accounts he controlled, hoping to reap the profits and take cash out of the accounts. The bank currently insist this isn't the case but they would say that wouldn't they.
He was pressured by others into these actions, be they internal or external, under duress

The investigation will inevitably take some time [investigating accountants get paid by the hour, so why rush such an important assignment]. Seeking co-conspirators will inevitably be part of that work, as well as determining whether assets were extracted from the bank.

One thing is certain - other banks won't be smug. They all fear the rogue trader and pray that their control systems can withstand/prevent it from happening from them, but know that few systems are perfect especially if collusion between staff occurs or lapses in control procedures occur.

But one mystery remains - the size of the positions. Everything above makes sense in the context of a few tens of millions, even a few hundred million. But 60bn. That is a serious position to have to hide in the books and to cover up. All of the actions I described would have to be on a massive scale for no one anywhere in the Bank to spot increases in the basic financial ratios or absolute values. You just can't have such sizeable discrepancies on reconciliations without there being panic; Clients are going to notice such large amounts missing from their accounts; somebody on the funding and collateral management desk has to notice the significant shortfalls or changes in activity.

SocGen is a big player in the equity derivatives space. However, no "client" could carry such positions even across multiple accounts without some scrutiny on a daily basis. The commission generated from related trades would make the "client" worthy of senior management attention. And if these were House accounts, somebody in the risk department must have been tasked with inspecting them.

So something isn't right here.

An alternate scenario doing the rounds is that the bank made some big strategic bets that went horribly wrong. However, it would be hard to keep that secret and certainly after the event with everyone looking to disassociate themselves from the mess.

Regardless, there are some in the USA who are angry/anxious/nervous that the impact of SocGen unwinding such sizeable positions may well have exacerbated the market falls that kicked off in the Far East and thus bounced the Fed into a rate cut of 75bp. This ignores that the market had already priced in such a cut and so at worst it may have brought it forward a week. Nonetheless, this may cause some friction between the USA and France.

Labels: fraud, socgen