We've commented more than a couple of times (here, here and here, for example) on the folly of putting portfolio managers and traders in charge of pricing their own books - and in recent months Credit Suisse, Morgan Stanley and Merrill Lynch have all learnt this lesson the expensive way.
Add Canada's Toronto Dominion Bank to the list.
According to a Bloomberg article, one of TD's London traders has just left the bank (i.e. been fired) as a result of "incorrectly priced credit derivatives, costing the bank around C$96 million ($94.3 million) in pre-tax earnings." The culprit is described as a "senior male trader".
Thinking about this, a number of comments come to mind.
Firstly, all the recent mispricing episodes seem to have occurred in London. This is despite the view that the FSA's gentlemanly guidance provides a more tightly controlled regulatory environment than SEC rule making. Whatever that means about the quality of the FSA's guidance, more generally we are of the view that if these problems can happen in London, they can certainly happen in NYC.
Secondly, these episodes - so far, at least - are not the work of disgruntled traders at the bottom of the totem pole, envious of their high flying peers (that's the Paris syndrome, of course.) These are senior traders, who have tenure, high compensation - and the knowledge and authority to find ways around control systems, at least for some period of time.
Thirdly, and very disappointingly for TD, this is not the first time their London trading team has landed the bank in hot water. Barely six months ago, in November 2007, the FSA fined TD GBP490,000 for "systems and control failings."
According to the FSA news release at the time,
"Mr. [Simon] Brignall was employed as a senior fixed income trader at the firm. On 9 March [2007], he resigned and revealed to TD Bank that he had been attributing false values to his trading positions for a period of almost two years. He had done this in order to hide significant losses on his trading book. He had also entered into a number of fictitious trades during the two weeks leading up to his resignation.
TD Bank did not identify, through its own systems and controls, either the extent of the mispricing of the trades or the fictitious trades. The FSA identified three main system and control failings in relation to Mr. Brignall's trading book.
These were:
- the absence of a system of independent price verification;
- a lack of effective trading supervision; and
- a failure to implement effective trade break escalation procedures.
The most important of these was the failure to have in place a system of independent price verification in relation to Mr. Brignall's trading book. This meant that there was no independent third party check on the valuations that Mr. Brignall had attributed to his own trading positions. The FSA regards this as a fundamental control."
The only good news for TD at the time was that, as a result of the FSA's "executive settlement procedures", they qualified for a 30% discount on their fine (we're not kidding.)
It's clearly a major ouch for TD that they have just let exactly the same thing happen again. More generally, this is (yet another!) example of why traders, compensated based on performance, should not be able to price their own books.
Given the frequency of these mispricing episodes, however, it also raises another question. Obviously, if a multitude of investment banks can lose many millions of dollars when they let their traders mark their own positions, the same could happen in a hedge fund which also puts the PM's in charge of marking their own book. So far, though, we have pretty few examples of deliberate mismarking (Lipper, Beacon Hill etc.) and not many of recent vintage, despite the valuation challenges of recent months.
Why is this? Is this because hedge funds have better controls, or because when the portfolio managers own their own hedge fund, there is no-one to blow the whistle on mispricing events?
That's something to think about.
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