Today's news that a thirty something trader at Societe Generale Paris (Soc Gen) managed to conceal rogue trades generating losses in excess of $7 billion is stunning. The trader, who according to Bloomberg made a salary and bonus combined of less than Euro100,000 a year, had apparently joined the trading floor from the firm's back office in 2006 and used that knowledge to manipulate Soc Gen's accounting systems to conceal his trades. Bloomberg reports that the trader apparently created a fictitious trade to offset every real transaction.
Rogue trading and misvaluation crop up with unnerving regularity in the institutional world. Only four months ago, Calyon, the investment banking arm of Soc Gen's competitor Credit Argricole, disclosed an "unauthorised proprietary trade" which generated a loss of $347 million. In April 2007, a two person trading team in New York used fake valuations to conceal a $400 million decline in value of their natural gas option book at the Bank of Montreal.
In 2006, the heads of a Citibank commodities trading desk pled guilty following a scheme designed to inflate the perceived profits generated by their desk. Back in 2002 and 2003, another Citi rogue trader ran up losses of $20 million trading gold and silver. In late 2005, a trader at Deutsche Bank London ran up a (British Pound) 30 million loss. In 2004, the National Australia Bank announced an (Australian dollar) 340 million loss due to rogue trading in currency options. Then, of course, there's John Rusack at Allied Irish Bank, Nick Leeson and Barings, the Kidder Peabody episode in the 1990's, Sumitomo's copper trading etc.
These losses occurred in the world's most sophisticated financial institutions. Such organisations are publicly traded and subject to the full weight of global regulatory oversight. Those quoted in the US have to endure every last check and verification imposed by Sarbanes Oxley. Each firm has multiple layers of risk management, compliance checks and internal audit.
Against this background, our first reaction is that the hedge fund industry is doing extraordinarily well not to have endured a significant case of rogue trading (we are only aware of two fairly small cases where there was unauthorised trading - Pheonix in Canada and Circle T Partners in the US.)
On the one hand, hedge funds enjoy some very significant structural advantages over institutions. Most funds are small - the vast majority of firms employ less than 50 staff, and only a tiny handful employ more than 500. It is very hard to conceal trading activity when a hedge fund is really just six people around a desk, with everyone knowing what everyone else is doing. Secondly, most hedge fund principals invest the vast majority of their own personal wealth in the strategy, so everyone at the desk has their own financial future tied up in the fund. This creates a very different dynamic compared to a rogue employee who flips and starts to defraud a faceless, global monolith.
On the other hand, it's self evident that all hedge funds, however big, have far fewer operational, accounting, risk and compliance resources than institutions. While there have been relatively few trading problems, perhaps that's more by good luck than management. There certainly have been numerous valuation failures - Lipper Convertibles, Lancer, Beacon Hill etc.. In this second, valuation "category", the Bank of Montreal case provides a salutory example.
The Soc Gen case comes only two days after the UK Hedge Fund Working Group published its best practice standards. While we are not fans of the standards (see our earlier post) the underlying intent to increase independence, segregation of duties and overall investor disclosure is obviously a move in the right direction. Thinking of today's Soc Gen news, we are drawn to a comment letter written by the US lobby group the Managed Funds Association in response to the Hedge Fund Working Group's draft best practice document which was issued in final form this week. The MFA, in particular, took exception with the UK view that hedge funds should appoint independent administrators or at least ensure that the valuation process is controlled by the back office, not the front office. The MFA commented:
"The Paper (i.e. the UK Hedge Fund Working Group draft best practice document) also contains a number of references to third party administrators. Though a number of U.S. based hedge funds retain third party administrators, many do not. Further, the services provided by third party administrators to U.S. based hedge funds can differ significantly from the services provided by administrators in other jurisdictions. Administrators to U.S. based funds, for example, will assist in calculating the fund’s net asset value, but the calculation is based on values reported by the hedge fund manager. U.S. based administrators do not typically conduct the actual valuation of the fund’s assets. A significant reason that many U.S. hedge funds do not retain third party administrators, and why administrators to U.S. funds provide different services than elsewhere, is that administrators in the U.S. often do not have the expertise to provide certain services relating to the more complex investments made by hedge funds. As a result, many U.S. based hedge funds have built up their internal infrastructure to acquire the necessary expertise to deal with these instruments. In light of the significant differences in the use of and services provided by third party administrators, MFA believes that recommendations regarding the role of third party administrators should not be included in a set of global recommendations. MFA also believes that background sections in the Paper should note that practices with respect to the use of third party administrators vary across jurisdictions."
In our view, one of the lessons of the Soc Gen case is to reinforce the need for hedge funds to appoint vigorous, capable external administrators. As we have noted above, even the largest self administered hedge funds are tiny compared to global financial institutions. The obvious conclusion to draw from Soc Gen's stunning loss is that if this can happen in a global institution, it can certainly happen in a hedge fund. And, in our view at least, the best way to reduce the risk of rogue trading (and equally "rogue valuation") is to make sure that someone other than the manager is keeping the books.