Sunday, February 3, 2008

The Societe Generale Scandal: Are There American Jerome Kerviels?

With the recent publicity of a $7.2 billion loss to Societe Generale at the hands of a junior trader, the management and directors of all major banks, brokerage firms and even general business corporations should be asking whether their company has the same problem. All banks and brokerage firms, and virtually all business corporations of any significance, transact in derivatives contracts. These instruments are firmly embedded in modern corporate finance, and may be found in surprising places, like a company's short term investments of its excess cash. The costs of unexpected derivatives risk have been in the limelight since last summer, and the subprime mess illustrates the problems created when you don't understand the risks of the investments you hold. The SocGen scandal, the other hand, exemplifies the dangers of not knowing what your people are up to.

One of the most salient points to emerge from the SocGen scandal is that questions about Kerviel's trading were raised by a third party. As reported by the Wall Street Journal in its February 2-3, 2008 edition (p. A7), Eurex, a European exchange that served as the market for some of the futures contracts Kerviel traded, inquired about his high volume of trades in early November 2007. SocGen's back office supposedly forwarded the inquiry to Kerviel for his response. This, if true, was a crucial mistake. If you ask a potential crook whether or not he's a crook, what kind of response do you think you'll get? (Exhibit A in this respect is the late Richard Nixon.)

When questions are raised about a derivatives employee's trading, other corporate personnel or an outside law firm should do an internal investigation and then respond to the third party. Asking the potential culprit to respond is unlikely to uncover any wrongdoing that might have occurred. Indeed, forwarding the Eurex inquiry to Kerviel for response only fuels suspicions that other personnel at SocGen knew what he was up to, but wanted him to reply so that their involvement would remain obscure.

In endeavoring to confirm an employee's derivatives trading, it is important to go to third parties for information. Don't rely solely on internal sources of information. Computerized surveillance systems are the products of the human mind, and therefore will be imperfect. A computer savvy 31-year old can often outwit the computer-challenged 50-year olds supervising him. If there is a financial institution that served as the counterparty, contact that organization for confirmation (or not) of the trades. If the derivatives contracts were traded on an exchange, documentation either from the clearing agent for the contracts or the broker that supposedly handled the trades, should be sought. Without third party confirmation, you don't know anything for sure.

Another item to look at is cash. Reportedly, Kerviel controlled upwards of 30 billion Euros of contracts that were long the European stock markets (i.e., he thought European stocks would go up). He didn't offset the long position with a short position (which would have been a bet that European stocks would drop). Assuming that a big bank like SocGen can trade these things with 1% down (or 99% margin), Kerviel would have required about 300 million Euros (or close to $500 million) in cash to support his actual long position. Even at a big bank like SocGen, $500 million or so moving to the clearing firm at the behest of one trader, or even one trading desk, is a large enough item that you'd think someone might notice. Perhaps someone did. Perhaps someone knew what he was doing. If SocGen's surveillance systems didn't pick up this kind of cash movement, if Kerviel was able to conceal the movement of this much cash, or if someone was in cahoots with him, then SocGen has some serious improving to do.

Of course, there's the point that Kerviel himself reportedly made. SocGen didn't force him to take much vacation time. It's been long understood within the banking industry that all persons handling cash or other assets should be made to take significant vacations, like two weeks at a stretch. Scams tend to fall apart if no one is around long enough to keep all the necessary balls in the air.

The Jerome Kerviels of the world tend to become emboldened the longer they remain undetected. Banks and other companies must be ever vigilant. However painful these scandals may be, failure to act will only make things worse.

Crime News: a food fight doesn't pay.

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