When getting answers isn't the end of the matter, only the beginning Tuesday, February 26, 2008

Below is an extract from the SocGen Internal Interim Report into Kerviel's activities

Intermediary conclusions of the internal audit mission

The conclusions of the internal audit mission confirm the main characteristics of the fraud, as explained on January 24th 2008 by Société Générale's management.

The author of the fraud departed from his normal arbitrage activities and established genuine "directional" positions in regulated markets, concealing them through fictitious transactions in the opposite direction. The various techniques used consisted primarily of:

• purchases or sales of securities or warrants with a deferred start date;
• futures transactions with a pending counterparty;
• forwards with an internal Group counterparty.

The author of the fraud began taking these unauthorised directional positions, in 2005 and 2006 for small amounts, and from March 2007 for large amounts. These positions were uncovered between January 18th and 20th 2008. The total loss resulting from these fraudulent positions has been identified and amounts to 4.9 billion euros, after their unwinding between January 21st and 23rd 2008.

The General Inspection department believes that, on the whole, the controls provided by the support and control functions were carried out in accordance with the procedures, but did not make it possible to identify the fraud before January 18th 2008. The failure to identify the fraud until that date can be attributed firstly to the efficiency and variety of the concealment techniques employed by the fraudster, secondly to the fact that operating staff did not systematically carry out more detailed checks, and finally to the absence of certain controls that were not provided for and which might have identified the fraud.

The Inspection General department has refrained from drawing any conclusions at this stage regarding the responsibility of the front office managers supervising the fraud's author, given the ongoing legal investigation which has not enabled it to interview all those concerned. At this stage of the investigations, there is no evidence of embezzlement or internal or external complicity (i.e. the existence of a third party who knowingly assisted the fraudster to conceal his positions).The investigations are continuing, in particular, to cover a wider area than the activities of the author of the fraud.

Separately FT Alphaville reports that the 75 alerts raised over the trading activities of Jérôme Kerviel at Société Générale were not unusual according to Daniel Bouton, chairman and CEO of SocGen. Hmmm, perhaps they weren't at SocGen and that was the problem!

He went onto say that "The role of the middle office is to ask questions, so it's not surprising he [Kerviel] was asked a lot of questions.'' Shame they didn't understand the answers since, according to the report, control procedures had been respected in many cases but "no initiative was taken to verify Mr Kerviel's assertions or to communicate the information to his superiors," even when his assertions lacked plausibility.

Hmmm. Perhaps the internal control manual failed to explicitly point out that having investigated and received answers to questions, you were supposed to apply a sense and reasonableness test to them.

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SocGen's Kerviel - "hang on, I'll just write an email" Friday, February 08, 2008

Highlights of recent snippets from the FT to emerge from the Soc Gen saga
Staggering but amazingly basic weaknesses in the control environment.

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SocGen - its gross how things fall through the net Monday, January 28, 2008

Ever told a little lie, but then found yourself in a spiral of more deceit as you seek to preserve or cover-up the initial one?

I find it hard to tell at this point whether the only person that was locked into such a spiral was SocGen "rogue" trader, Kerviel. This is a strong assertion, but each time a new pronoucement is made to add to the story, it becomes more incredulous. Yesterday, for instance, it was announced that:

Though he was only supposed to buy futures – bets on the direction of European markets – if they were covered by a hedge – a similar position limiting any loss – he used other people’s access codes and “falsified documents” to create fake hedges, leaving the bank exposed to the full downside.

SocGen said he had evaded detection for almost a year by only choosing “very specific operations with no cash movements or margin call and which did not require immediate confirmation” and by constantly switching between different types of instrument.

By January 18, when he was finally caught, he had positions worth €30bn on the Euro Stoxx, an index of Europe’s biggest companies, €18bn on Germany’s Dax and €2bn on the UK’s FTSE.

So the Bank is disclosing that Kerviel's job was to seek to make profits by carving out off-setting positions (hedge position) that limited the possible profit or loss that would arise from market movements. Such positions would be created from two assets that were assumed to be close, if not perfect, substitutes for each other. For example, one could buy futures to create a long exposure profiting from the market rising and buy put options that would allowing you to sell an equivalent exposure with a strike price below the current market price, termed "out of the money" options.

Such a structure might look like this
In risk terms, the Bank's maximum price exposure would be deemed to be the loss of 10 and it is this on which Kerviel might have been monitored. However, if the option contracts were fictitious then the Bank would be fully exposed to the market movements. The use of purchased options would be consistent with the assertion that no margin calls were involved, but it would normally involve payment of a premium and exchanging confirmations of the trade with a counterparty to independently verify the existence of the trade.

So, another instrument possibility might be a performance or total returns swap. These trades are stuck directly between two counterparties rather than on an exchange. They agree to pay each other the returns on nominated assets. For example a simple example is where one counterparty agrees to pay the interest on £5bn in exchange for receiving the "returns" on the market from the other. The respective payments on such swaps might only occur quarterly, with no initial outlay. More importantly, the confirmation of such trades can be flaky since they follow no standard process. This type of trade would certainly fit with the comments in the press reports.

Again, from a risk perspective, provided the notional value of the swap offset the futures positions, they might have considered Kerviel to have a "flat" position. That is not to say that other risk questions would have arisen such as the exposure to the counterparty and their credit worthiness.

Importantly, such deals are precisely the areas that SocGen excelled in and traders would have been encouraged to engineer both to satisfy client demand and create "risk free" trades that generate profit.

However, this doesn't overcome the challenge for Kerviel that every trade should be confirmed independently of the trader with the counterparty and controls should be in place to chase up outstanding confirmations. The reason for such controls is precisely to address the risk of incorrect or fraudulent transactions being booked. The absence of such confirmations will normally prompt investigations and reversal of uncollaborated transactions.

However, one important element often missing from risk environment is properly dealing with backdated or cancelled trades. Inside many firms, risk reports are produced daily reflecting what happened yesterday or positions at right now. As such, one possible vulnerability is that a trader cancels a historic trade booked 30 days ago and replaces it with another that is 10 days old. The risk team wouldn't care about this because their systems would be unlikely to flag up that this created a historic position, since the current position is fine thanks to the newer trade. However, a middle office function would be required to investigate a 30 day old trade that hadn't been confirmed would be investigated. But cancelling such a trade would almost certainly halt the investigation and the 10 day old trade wouldn't yet warrant attention until later. In such a scenario, everything hinges upon the controls over cancelling and rebooking trades. Unfortunately, human failings means booking errors can easily and regularly arise, leading to complacency, with the result that controls over rectification of such"errors" are usually the laxest.

Obviously, more pieces of the jigsaw will emerge over coming days and weeks that will improve our understanding of the complete picture, but as the last few posts may have illustrated, there are always weak spots in any impregnable fortress.

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SocGen - a sprinkle of hundreds and thousands Saturday, January 26, 2008

In the FT today,

Jean-Pierre Mustier, head of corporate and investment banking at SocGen, gave more details of the methods Mr Kerviel used to evade the banks’ controls.

“Every two or three days, he was changing his position. He would input a transaction that would trigger a control in three days and before that happened he would replace it with a different one,” said Mr Mustier.

He said the rogue trader was managing hundreds of thousands of concealed trades and an equal number of falsified hedges to give the appearance that any loss was offset.

Ok, so most banks are easily able to upload/import huge volumes of trades into the sales trading systems from spreadsheets and the like, simply because this is how most clients send in program trades. By keeping the value of each one relatively small, they may have kept below transaction limits. However, most traders have position limits that they have to keep within and his daily turnover would have been immense if he was rolling these positions every few days. If the control functions weren't alerted by his activity, I'm surprised a desk head wasn't chatting with a trader who was doing so much business.

From the reference to a "three day" control, it might be that SocGen operated a timetable such as
Here's where the "lone gunman" assertion looks very peculiar. It seems inconceivable that someone in one of the teams, particularly client services, had never sought to speak to the client especially one who never paid their margin calls. Whilst the trader would have been consulted, it would be highly irregular for these teams to accede to a request that all communications with a client were routed through a trader.

Kerviel would have also been sitting in a trading room surrounded by colleagues. Usually prop traders work in teams and so SocGen are effectively suggesting that Kerviel was conducting all these activities in full view of his colleagues. Admittedly a colleague sitting at a keyboard all day, playing with spreadsheets etc is completely normal behaviour for a trader.

In the Nick Leeson case, he was booking trades to an error/suspense account. Most banks have controls over opening accounts [documentation required, several internal authorisations] and classify accounts to which trades are booked as House, Exchange/Market and Client. One way round this is to make use of previously little used or dormant accounts. However, Suspense/Error accounts in each of these categories are normally closely inspected but even if they were only checked every few days, the volume of trades assigned by Kerviel to such accounts, if he was using this approach, would have been enormous. Moreover, the account balances would have been sizeable and warranted attention. I should acknowledge that, sadly, a consistent pattern of activity or balance can lull people into a comfort level that things are "normal", whereas eractic fluctuations or activity draw suspicion.

Again, all the above is conjecture on my part, but the story coming out currently is very flimsy and it's a risky PR strategy.

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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
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
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 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.

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