Rogue Traders and Wild Hearts-VRK100-17Sep2011

Rogue Traders and Wild Hearts

Rama Krishna Vadlamudi, Hyderabad. 17 September 2011.

We humans have a speculative-cum-creative urge in our minds and hearts. The wild streak constantly encourages us to explore new worlds and unfamiliar territories. Great discoveries have been made for centuries as a result of our innovative thinking. But when greed overtakes our emotions, it makes us overconfident and in the end we stumble flat on our face many a time. Imagination knows no bounds in financial markets.

Derivates are famously described as ‘financial weapons of mass destruction’ by Warren Buffett, the legendary US investor (his company Berkshire Hathaway too trades heavily in the derivatives market is a different issue). Everybody knows what role they played in bringing down the financial world to a near collapse in 2007/2008. As the saying goes, “Guns don’t kill people, people kill people.” It’s the slipshod supervision and regulation that is responsible for the massive losses caused by derivatives traders. 

On 15 September 2011, UBS had reported that unauthorized trades by its trader caused losses to the Investment Bank amounting to $ 2 billion. UBS is a Swiss-based bank. Now, we have come to know the name of the trader is Kweku Adoboli and the 31-year old has since been arrested by London Police and charged with fraud and false accounting.   

Nick Leeson, who is nicknamed as Rogue Trader, was responsible for the collapse of the 233-year old Barings Bank in 1995. As a derivatives trader for the bank in Singapore Exchange, he speculated and lost a cool $ 1.3 billion for the bank. He put his bets on Nikkei, the Japanese stock market index, which crashed after the Kobe earthquake. The money was so huge that the bank had no choice but to close down permanently.

Jerome Kerviel was working as a trader for Societe Generale’s derivatives desk in Paris. He too had tried to make huge bets on financial markets. In the process, he lost $ 7.2 billion of depositors’ money in 2008.

Yasuo Hamanaka was well known as ‘Mr Five Per Cent’ or ‘Mr Copper.’ He was working as a copper trader for Sumitomo Corporation, Japan. He was doing copper trades for his company on the London Metal Exchange and had bought huge positions by keeping the physical copper ingots in US warehouses. He wanted to corner the entire copper market of the world. But in the end he stumbled and the total losses for his company were about $ 2.6 billion in 1996.

What is the Common Thread?

Amusingly, in all these cases the banks/companies claim they were kept in the dark by these erratic traders and their trades were unauthorized. Yasuo Hamanaka had been speculating in the copper market for 10 years. One fails to understand how Sumitomo Corporation could claim the trades were unauthorized. It’s very clear that banks’ and companies’ risk management and supervisory practices were very poor, to say the least.

We claim we have built up massive communications systems that are very fast and modern so that we can communicate with one another in split second. If one looks at these cases, there is clearly a big communication failure.

Regulators also cannot escape their share of blame. Take the case of Sumitomo Corporation. The company is headquartered in Japan, the trades were done on London Metal Exchange and the copper warehouses were located in the US. It is very curious to know that Hamanaka’s trades had escaped the attention of all the regulators in Japan, London and the US – that too for ten long years.

The familiar pattern is that we are confident of our predictive power. Everyday we predict that market will go this way or that way. We start with small bets. Initially we make profits over a period of time and we come to the conclusion that we have found a creative and unique formula for success in the financial markets. We suddenly become greedy and increase our stakes and we would be helped in the process by bull markets. More profits are made. We are acclaimed and rewarded with hefty pay packets by our pay masters. One day the music stops and the markets move violently against our bets.

Initially, we get the impression, the downside is temporary and we are tempted to increase our positions. To cover up our mistakes, we try to average down and the process goes on for some time. Suddenly one day we realize that the game cannot be continued further into infinity as there are big holes which cannot be filled or covered up. And we blame the markets for our speculative orgies. Finally, the disastrous story is out.

Once the story is out, the regulators will make some noises and make pledges to tighten the regulation, supervision and risk management. After the initial excitement dies down, boredom sets in. This continues until the next scandal breaks out of the blue. Till that time let us hope that our money with these banks and companies is safe and we will get back our principal and interest.

Interestingly, all these losses are usually revealed during bear markets. If it is our own money, the pain is restricted to our immediate family. But, if we are resorting to these speculative urges with public money, then the ache is ‘diversified’ into lot of depositors and investors.

The recent violent moves in Indian rupee against the US dollar may expose some chinks in the balance sheets of several Indian companies when they declare their quarterly results next October. During 2007 and 2008, India Inc has lost more than Rs 20,000 crore by purchasing wrong hedging instruments from banks’ derivatives desks.

Where is the end to such superhuman activities? In the last three or four centuries, fortunes have been made and evaporated by market men in futures markets. I suspect that we continue to hear such stories as long as mankind exists.

I suppose all the banks’ derivatives trading desks should be moved to the large casinos in Las Vegas, so that people who deal with them will come to know of the dangers of derivatives before they place their bets.

As you know, we go to casinos to lose our hard-earned money!