Bloomberg reports today that Morgan Stanley London has suspended a credit trader and made a $120 million "negative adjustment"related to "erroneous values of his positions."
This comes, of course, after Merrill London identified a $20 million loss due to deliberate mismarking by a trader on the equity derivatives desk (see our earlier post.)
We shouldn't pick on Merill and Morgan, mind you: their misfortunes fall into insignificance compared to Credit Suisse's stunning $2.65 billion write down related to a trading group that mispriced CDO's (also, see our earlier post.) Lehman has also had some difficulties, let alone the Bank of Montreal which had a near $500 million loss due to two natural gas traders providing bogus prices to their head office.
We continue to believe that pay structures dominated by incentive compensation (be it a hedge fund's "20%" in 2 and 20, or the "eat what you kill" model of prop desk compensation) create an unavoidable conflict of interest (incidentally, hedge funds which have 2 and 20 and then pay their staff on individual P&L is probably the most toxic combination of all).
As such, best pratice must always be for the security pricing process to be owned by the back office, independent of the traders. Yes, we may give up some market color and "accuracy" if we put the back office in charge, but we gain independence. We have yet to find the investor who is not prepared to accept a few basis points of difference between front and back office marks across the aggregate book in return for removing the risk of a 5,000 basis point loss in the event of a hedge fund pricing fraud.
Clearly, if a global, regulated institution like CS, Morgan, Merrill and Lehman can have a pricing problem, then so can a hedge fund. So how can investors respond?
The recent best practice papers from the President's Working Group, the hedge fund working group, AIMA etc. have all emphasized the need for segregation of duties, although with varying degrees of "weasel words" which let the PM's get involved on the hard to price positions. It's time to get rid of these exceptions and make sure that the hedge fund industry adopts a clear and consistent back office pricing regime.
In other words, it's time to walk the walk, not just talk the talk.