Well, Mr. Adoboli isn't quite as good as Mr. Kerviel when it comes to rogue trading, but the financial impact of his unauthorized trades has now increased from the initial estimate of $2 billion to $2.3 billion. Still a strong effort from the 31 year old, who pushes Nick Leeson of Barings fame down to #3 in the rogue trading hall of fame.
Back in January 2008, we commented on the Soc Gen debacle (the post also contains a potted history of just some of the multitude of rogue traders in the investment banking industry). The title of our comment at the time - do we really want hedge funds to aspire to be institutions?
Our point then - which this week's events at UBS support once more - is that most hedge funds have a number of significant, structural advantages over large investment banks when it comes to rogue trading.
At their core, the trading desks of investment banks are self administered - there is no independent oversight over trade capture, reconciliation, valuation and P&L reporting. This is a huge weakness in the investment banking model: ultimately, can you trust the trader paid directly on his or her investment performance without a third party, independent arbiter to check that all is bona fide?
Moreover, as we all know, the back offices of investment banks are very much the junior partner in any discussion with the trading desks - they are a cost centre, while the stars of the trading desk drive profits. There is an obvious chasm between the compensation levels of the back office professionals and the front office traders: you do not need to be an astute observer of behavioural dynamics to predict that a discussion between someone on a $50k bonus as compared to $5m will be an uneven affair.
It is also striking that both Kerviel and Adoboli share the same profile: more modest employees, without family name or Ivy League / Oxbridge credentials, who started in the back office before getting a chance to step onto the lowest rung of the trading desk - the Delta 1, equity index business. Both appear to have used their knowledge of back office procedures to faciliate their frauds. Both also had a first fingertip on the trading desk hierarchy and could see the potential for truly colossal compensation in the far distance, with all the lifestyle benefits that come from multi million bonuses.
How does this impact hedge funds? Thinking of the contrast between alternative asset managers and investment banks, we can identify five factors which impact the potential risk of undetected rogue trading.
1) Organization size
Investment banks are massive organizations. With a reported 15,000 staff on the UBS investment banking payroll (itself just part of the bank's' total 65,000 person headcount), the law of averages creates the risk that there could be at least one outlier employee: someone who could become sufficiently envious, stressed or misguided to start to conceal trades. The organization is then so big, its systems so complex, the number of trades so high - finding a way to exploit some weakness in how data is monitored becomes more conceivable.
A hedge fund, however, is generally a much smaller and far more cohesive entity. While there are a handful of funds with several hundred employees (and less than 5 with more than 1,000) the vast majority of firms have fewer than 50 staff. In reality, it would be hard not to pick up strange behaviour in a hedge fund when there is only a small group of investment professionals, all clustered around the same desk in their daily fight with the markets.
Conversely, risk would seem to rise when funds get larger: once a fund has tens or even hundreds of risk takers, even a hedge fund begins to lose the automatic protection of everyone sitting together and watching each other's behaviour. Risk also increases when traders are spread out amongst multiple locations, especially when the traders are isolated in a preferred location separate from the back office.
Many hedge funds, in house, use a central accounting system such as Advent Geneva. Investment banks, by contrast, rely on a hodge podge of systems, some current, some ancient - with a lot of Excel as a Band Aid. A single, centralized platform for all data is a critical component which underpins any strong control environment, giving many hedge funds a strong controls advantage.
For funds, therefore, best practice is to see a robust, single platform supporting trade capture, reconciliation and accounting. Equally, more complex funds with a mosaic of different systems for different asset types increase the risk that a motivated employee could exploit weaknesses in the systems infrastructure.
3) Authority of the back office
In an effective hedge fund, the CFO and COO are senior members of a firm's management team, with genuine authority to hire, fire and build a robust control environment. Indeed, in our view, the quality of the CFO is likely the single most important control factor in a hedge fund: a capable CFO will have the technical knowledge and experience to get the job done right, but - even more importantly - he or she will have the authority and stature in the organization to set a "tone at the top" which focuses on controls and oversight.
We have completed due diligence on many hedge funds where the CFO and / or COO are exceptional professionals, with genuine governance over their organizations. By contast, investment banks may not be as strong as their facade would suggest - as just one example, we have recently read a number of books about the 2008 financial crisis, all of whom have various stories of how risk management and back office professionals were readily marginalized during the sub prime profit frenzy.
4) External oversight
As we have stated above, investment banks are self administered. The post Madoff, now mandatory appointment of an independent, third party administrator creates a significant control benefit in favor of hedge funds.
We do have some words of caution, however. Firstly - as we have frequently noted in Risk Without Reward - not all administration servicing is created equal. To provide the best protection against rogue trading, an administrator should complete daily accounting, taking trade records from the manager (not the PB) and then completing a daily reconciliation to each prime broker, custodian and counterparty. Weekly or monthly accounting cycles do not provide the same degree of external oversight.
Secondly, the most effective control comes from a parallel system, where the manager's in house back office and the external administrator both complete full accounting and reconciliation procedures daily. We do see risk in the trend to completely outsource accounting and reconciliation: in this model, there is no in house accounting, and the administrator becomes an outsourced back office, moving away from the model of independent watchdog. Both managers and investors should remember than administrators will, for cost reasons, often hire staff a more deeply resourced hedge fund wouldn't: best practice controls, therefore, always balance in house expertise with external independence.
Finally, one of the key risk factors in any asset management organization is how investment professionals get paid. Investment banks, by and large, operate on the Darwinian principle of "eat what you kill". This compensation model obviously creates an "every man for themselves" culture: it motivates risk taking to boost income, and equally scares poorer performers facing their stop loss limits to find desparate ways to stay in the game. Either - and especially the latter - can drive rogue trading.
Within a hedge fund, it is more common to see a model of discretionary compensation, or at least a hybrid where elements of formulaic, performance based compensation are balanced with discrectionary bonuses or payment based on firm wide performance rather than just individual trading P&L. Hedge funds have also proved flexible to implement a range of effective comp deferral schemes which further mitigates the incentive to rogue trade.
Unfortunately, we do have to remind investors that hedge funds cannot be immune from the risks of rogue trading. As with all types of fraud, a clever trader likely can fool all of the people - at least some of the time. However, on balance, the smaller, more cohesive nature of hedge funds, their more tightly controlled systems, stronger CFOs and better independent oversight materially reduces risk. Most hedge funds are not like investment banks, and that's a good thing, at least when thinking about rogue trading.
Hedge Fund Operational Risk Due Diligence
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