Rogue Trading Cases: Barings, Societe Generale and Others

Reports written after a rogue trading case is found are read by staff in trade confirmation and reconciliation, risk management, and internal audit, who check whether their own controls have the same gaps.

Four cases at a glance

Rogue trading is when a trader enters into trades beyond the authority or limits given to them and hides the resulting positions or profits and losses with fictitious trades or false records. While the trades stayed hidden, the losses grew, and by the time they were found they had reached the large amounts shown in the table. Reports by the authorities and announcements by the companies document the course of events in four main cases, shown below.

All of these are cases in which operational risk materialized. The definition, the types of loss events, and how capital is held are covered in Operational Risk in Derivatives. Losses from misreading the market or from failed hedges involve no fraud, so they are not included among the cases here.

Barings (1995)

Late on the night of February 26, 1995, the Bank of England announced that the British bank Barings could not continue trading and was applying for administration¹. The cause was losses from unauthorized trading by a trader at its Singapore subsidiary (Barings Futures Singapore). The trading spanned contracts on exchanges in Singapore, Osaka and Tokyo, and after the collapse on February 26 the losses grew to GBP 827 million².

The trader's assigned job was arbitrage between the Singapore International Monetary Exchange (SIMEX) and the Japanese exchanges. He was supposed to hold the same Nikkei 225 futures contract as a sale on one exchange and a purchase on the other. Each trade earned little but also carried little risk of loss³. In practice, the trader did not hold the offsetting trades. He built up a large long position in Nikkei 225 futures and a short position in 10-year JGB futures. He also sold Nikkei 225 options in the form of straddles⁴. A straddle is a call and a put with the same strike price.

He hid this through an account numbered "88888," opened in July 1992. In the internal systems, it was registered as an account for handling trading errors. The trader had the system changed so that this account was left out of the reports on market trading⁵. Some information on the account did reach London, but no one analyzed it⁶. The trader also recorded trades that did not exist, to make his daily positions and the margin owed to the exchange look smaller⁵.

The Board of Banking Supervision's report concluded that the losses came from unauthorized, concealed trading at the Singapore subsidiary, and that serious failures of control and management confusion within Barings kept them from being noticed sooner. Funds were sent from London to Singapore without checking what they were for. Management in London treated these funds as loans to clients. They did not question lending more than GBP 300 million against only about GBP 31 million of collateral taken from clients⁶. Nor did anyone suspect the unusually high profits coming from arbitrage that was supposed to carry little risk.

The trader ran not only the front office (sales and trading) but also the back office (processing and settlement), which handles the trade paperwork. A 1994 internal audit recommended changing this, but the recommendation was not carried out⁶. After the collapse, ING acquired the Barings group⁸.

Daiwa Bank New York branch (1995)

On October 2, 1995, the US Federal Reserve Board (FRB) and the New York State Banking Department issued orders to Daiwa Bank and its New York branch. In the orders, the bank and the branch acknowledged that unauthorized trading in US Treasury securities had caused the branch losses of about USD 1.1 billion⁹.

The course of the losses is set out in the Notice of Charges that the FRB issued the same day. According to it, a senior officer at the branch had confessed, in a letter to Daiwa Bank's president, to trading and losses over 11 years, from 1984 to mid-1995. This officer was in charge of both trading in US Treasury securities and the custody department, which held securities for clients and for the bank itself. He sold Daiwa Bank's own securities and clients' securities held in custody to cover the losses, falsified the branch's records, and lied to auditors and examiners¹⁰.

In November 1992 and November 1993, the Federal Reserve Bank of New York and the New York State Banking Department pointed out weaknesses in the branch's internal controls, and they were told that the two roles had been separated. The FRB states that in fact they had not been¹¹. Daiwa Bank knew of the losses by July 1995 at the latest, but it did not notify the authorities until September 1995. The FRB also stated that this delay broke the rules¹². On November 2, 1995, the FRB and state authorities issued consent orders requiring Daiwa Bank to end its US operations by February 2, 1996¹³.

Societe Generale (2008)

On January 24, 2008, Societe Generale disclosed fraud by a trader in its equity derivatives division and announced that the loss was EUR 4.9 billion. The same day, it also announced that it had secured a capital increase to cover the loss¹⁴.

The trader's unit did arbitrage, aiming at small price differences between similar products, and positions that bet on the market going up or down (directional positions) were allowed only in small amounts for short periods. The trader went beyond this and took large directional positions in equity index futures and other products. He made them look offset by fictitious trades in the opposite direction¹⁵. The fictitious trades included purchases and sales of securities and warrants with a deferred start date¹⁵. Others were futures trades with the counterparty left as "pending" and forward contracts with a company inside the group as the counterparty¹⁵. The trader's eight-person team had a limit of EUR 125 million that it was not to exceed at the end of each day¹⁶.

Figure description

According to the Special Committee's report, the positions went undiscovered for some time, partly because staff in the control function did not check beyond the procedures. The figure generalizes the response to alerts before the positions were found; how they came to light is in the table below¹⁵¹⁷.

The positions found were those built up in January 2008 as shown in the table, and by the company's account they totaled about EUR 50 billion¹⁹. Because they exceeded the bank's total capital, the bank decided to unwind them at once¹⁴. The EUR 4.9 billion is the loss from unwinding in January 2008 minus the hidden profit from 2007¹⁹. The unwinding took three days, keeping trading within 10% of market volume¹⁹.

The bank's internal inspection department found that the control procedures had generally been carried out as required, but were not enough to detect the fraud. It gave two reasons: the concealment was skillful and used many different methods, and staff in the control functions did not dig deeper than the procedures required. There were no controls checking canceled or amended trades, trades with a deferred start date, trades with technical counterparties that were not real trading counterparties, or positions with a large notional amount¹⁷. When alerts came up before he was found out, the trader responded with false explanations and false emails (seven of them)¹⁷²⁰. The French Banking Commission imposed sanctions on Societe Generale for insufficient internal controls²¹.

UBS (2011)

On September 14, 2011, UBS discovered large-scale unauthorized trading on the exchange-traded fund (ETF) desk of its London branch. When the positions were closed out, the losses came to USD 2.3 billion²². Most of the losses came from positions in exchange-traded equity index futures²³. The desk's limits were USD 50 million of delta (the size of a position's exposure to price moves) overnight and USD 100 million intraday²⁴.

The trader manipulated profit and loss by booking futures trades he had actually made with outside parties late into the front office risk management system. He also recorded internal trades with no specified counterparty and fictitious ETF trades with deferred settlement, making the loss-making positions look offset by profitable trades²⁵. The desk's revenue was USD 9 million for the whole of 2010, but it rose to USD 21 million in January to March 2011 and USD 52 million in April to June. The desk supervisor did not ask how the revenue had grown²⁶.

In its Final Notice of November 25, 2012, the UK Financial Services Authority (FSA) imposed a financial penalty of GBP 29.7 million on UBS. Before the discount for settling at an early stage, the amount was GBP 42.4 million²⁷. On November 20, 2012, the trader was convicted of fraud and sentenced to seven years' imprisonment²⁸.

The FSA pointed out that even when limit breaches were reported to supervisors, they were not properly dealt with. Mismatches (breaks) found in the operations division's reconciliations were also cleared by junior staff, who accepted the trader's explanations without enough challenge. The finance function could suspend profit and loss to reflect booking errors or timing differences in bookings, and the suspensions were usually communicated by the trader. In August 2011, the trader requested suspensions totaling USD 1.6 billion, but the junior finance staff did not adequately challenge them²⁹.

Common control failures

The reports by the authorities and the companies identified three common failures in the four cases. Trading and record keeping were not assigned to different people, fictitious trades slipped through reconciliation, and warning signs went unchallenged. On the first, at Barings the trader also ran the back office⁶. At Daiwa Bank, according to the FRB's Notice of Charges, the head of trading also ran the custody department¹¹. In its 1998 principles on internal control, the Basel Committee on Banking Supervision gives the example of one person supervising both the front and back offices of trading³⁰. It then asks banks to split duties with conflicting interests among different people as far as possible, because giving them to one person makes it possible to falsify financial records and hide losses³¹.

The second is that fictitious trades and late bookings slipped past reconciliation with trading counterparties. At Societe Generale, the trader used trades with a deferred start date, which delayed the exchange of trade confirmations. He also used trades with internal counterparties, for which no confirmations were exchanged¹⁷. The front office risk management system at UBS allowed internal futures trades to be booked with the counterparty recorded only as "internal." It also did not require an offsetting trade (a mirror trade) to be created automatically on the other desk's side. Internal trades with no matching trade could therefore be recorded²⁵. How booking errors and confirmation matching work is covered in Booking Errors and Confirmation Mismatches.

The third is that warning signs such as limit breaches, reconciliation mismatches, and unusual profits appeared but were not questioned. The Basel Committee on Banking Supervision points out that many of the units that later caused large losses had at first reported profits far larger than their apparent risk would suggest. It also says senior management should have been concerned about those profits³². The high profits from Barings' supposedly riskless arbitrage and the sudden jump in the UBS desk's revenue are examples of this⁶²⁶.

What changed afterward

The authorities reviewed their principles for internal control and how they share information with one another. In September 1998, the Basel Committee on Banking Supervision published a framework for internal control systems in banking organizations that set out 13 principles. One of them is splitting duties with conflicting interests among different people (segregation of duties), discussed in the previous section. The Committee explained that the principles drew on lessons from cases at banks that had run into problems³⁴. In 1996, the Bank of England's Executive Director for Supervision said that if the authorities had pooled information from the exchanges where Barings traded, the problem would have come to light sooner. Referring to the Daiwa Bank case, he also noted that information held by the home country authorities had not reached the US authorities promptly, and said that the exchange of information among authorities was being reviewed³⁵.

On March 11, 2008, after the Societe Generale case, the UK FSA set out the points to check in controls against rogue trading: front office culture and governance, trading authorities and limits, the control functions' willingness to challenge, and risk management and limits³⁶. Societe Generale itself added monitoring of notional amounts, of trade cancellations, and of whether staff took their vacations, and set up a new unit to monitor activity across departments²¹.

UBS divided its controls against rogue trading into three parts following the three lines model (called the three lines of defence in the FSA's Final Notice). The first line was desk supervision in the front office together with trade confirmation and settlement by the operations division. The second was the finance, risk management and compliance functions, and the third was group internal audit. The FSA's Final Notice identifies where controls failed in each line³⁷.

Notes

1. "Barings (Hansard, 27 February 1995)," HC Deb 27 February 1995 vol 255 c693 (the opening of the Chancellor of the Exchequer's statement: the inability to continue trading, the application for administration, and contracts on three exchanges) and c694 (the request for an investigation). ↩ ↩² ↩³

2. "Barings (Hansard, 18 July 1995)," HC Deb 18 July 1995 vol 263 c1454. The Chancellor of the Exchequer's summary of the report's main conclusions, the course of cumulative losses, and the date of publication. ↩ ↩² ↩³ ↩⁴ ↩⁵ ↩⁶

3. Stephen J. Brown and Onno W. Steenbeek, "Doubling: Nick Leeson's trading strategy" (pre-publication version), Section 1 (page 2) and Section 2.1 (page 4). ↩

4. Brown and Steenbeek, Sections 2.2 (page 7) and 2.3 (page 7). The long position in Nikkei 225 futures, the short position in government bond futures (over 28,000 contracts), and the sale of Nikkei 225 option straddles from January 1994. ↩

5. Brown and Steenbeek, Section 2.2 (pages 5–6). That the account was registered as an error account, that the trader had the system changed to leave it out of reports, and that fictitious trades made the positions and the SIMEX margin look smaller. ↩ ↩²

6. "Barings (Hansard, 18 July 1995)," c1455. That funds from London were sent without checking, that collateral was about GBP 31 million against lending of over GBP 300 million, that the unusual profits were not questioned, and that the 1994 internal audit's recommendation was not carried out. ↩ ↩² ↩³ ↩⁴ ↩⁵

7. Brown and Steenbeek, page 8 (the losses on the option positions and the margin on February 23) and the table of periods in Section 4 (the date of the earthquake). ↩ ↩²

8. "Barings (Hansard, 18 July 1995)," c1456 ("the takeover by ING has stabilised the group"). ↩

9. Board of Governors of the Federal Reserve System, release of October 2, 1995 (page 1 of the PDF), and the order of the same day (page 2 of the PDF; that the branch acknowledged losses of about USD 1.1 billion). ↩

10. Board of Governors of the Federal Reserve System, "Notice of Charges and of Hearing" (attached to the October 2, 1995 release, pages 16–17 of the PDF), paragraphs 3–5 (the "ALLEGATIONS" section). The losses and how they were hidden are described as based on the officer's written confession. ↩

11. Board of Governors of the Federal Reserve System, "Notice of Charges and of Hearing," paragraph 6 (page 18 of the PDF) and paragraph 8 (page 19 of the PDF; that the trading function and back-room operations had not been separated). ↩ ↩²

12. Board of Governors of the Federal Reserve System, "Notice of Charges and of Hearing," paragraphs 7 (page 18 of the PDF) and 9 (pages 19–20 of the PDF), and the preamble (page 3 of the PDF) and paragraph 9 (page 9 of the PDF) of the order of the same day. ↩

13. Texas Department of Banking, release of November 3, 1995, first paragraph. ↩

14. Société Générale, "10 points to better understand the Jérôme Kerviel affair" (June 2016), point 1 (page 1). ↩ ↩² ↩³ ↩⁴

15. Special Committee of the Board of Directors of Société Générale, "Progress report of the Special Committee" (February 20, 2008), paragraphs 6–8 (pages 1–2). ↩ ↩² ↩³ ↩⁴

16. Société Générale, "10 points to better understand the Jérôme Kerviel affair," point 4 (page 2). ↩

17. The inspection department's interim summary (English translation) attached to the Special Committee of the Board of Directors of Société Générale's report, Section 2 (page 6 of the PDF) and Section 4 (page 7 of the PDF). That the counterparties were companies inside the group is in paragraph 8 of the report (page 2) and Exhibit no. 3 of the summary (page 11 of the PDF). ↩ ↩² ↩³ ↩⁴ ↩⁵

18. The interim summary by the inspection department (English translation) attached to the Special Committee of the Board of Directors of Société Générale's "Progress report of the Special Committee" (February 20, 2008), Section 1 (page 5 of the PDF), and paragraph 9 of the Special Committee's report (page 2). What prompted the investigation is in point 1 of "10 points." ↩ ↩² ↩³ ↩⁴ ↩⁵

19. Société Générale, "10 points to better understand the Jérôme Kerviel affair," point 3 (page 2). The inspection department's interim summary (Section 1, page 5 of the PDF) gives a different breakdown, but the net figure is the same. ↩ ↩² ↩³

20. Société Générale, "10 points to better understand the Jérôme Kerviel affair," point 8 (page 3). ↩

21. Société Générale, "10 points to better understand the Jérôme Kerviel affair," point 9 (page 3) and its continuation (page 4; the "Fighting Back" plan and the monitoring unit SAFE). ↩ ↩²

22. Financial Services Authority, "Final Notice" (UBS AG, November 25, 2012), paragraph 23. ↩

23. The FSA's Final Notice (UBS AG), paragraph 6. ↩

24. The FSA's Final Notice (UBS AG), paragraph 22 (the desk's limits). ↩

25. The FSA's Final Notice (UBS AG), paragraph 25 (the booking of internal trades and the lack of a mirror trade requirement). ↩ ↩²

26. The FSA's Final Notice (UBS AG), paragraph 31. ↩ ↩²

27. The FSA's Final Notice (UBS AG), paragraphs 1–2. ↩

28. The FSA's Final Notice (UBS AG), paragraph 5. The trader was convicted on two counts of "fraud by abuse of position." ↩

29. The FSA's Final Notice (UBS AG), paragraphs 27, 32, 40, 41 and 42. ↩

30. Basel Committee on Banking Supervision, "銀行組織における内部管理体制のフレームワーク" (A framework for internal control systems in banking organizations; provisional translation by the Financial Services Agency), September 1998, "補論 II" (Appendix II), paragraph 6 (in Japanese). ↩

31. Basel Committee on Banking Supervision, "銀行組織における内部管理体制のフレームワーク" (provisional translation by the Financial Services Agency), Principle 6 and paragraph 27 of the main text (in Japanese). ↩

32. Basel Committee on Banking Supervision, "銀行組織における内部管理体制のフレームワーク" (provisional translation by the Financial Services Agency), "補論 II" (Appendix II), paragraph 8 (in Japanese). ↩

33. The inspection department's interim summary (English translation) attached to the Special Committee of the Board of Directors of Société Générale's report, Exhibit no. 3 (page 11 of the PDF; that no confirmations are exchanged for internal trades) and Exhibit no. 4 (page 13 of the PDF; that forwards with internal counterparties did not appear in the daily reports). ↩

34. Bank of Japan, "銀行組織における内部管理体制のフレームワーク（日本銀行仮訳）" (A framework for internal control systems in banking organizations, provisional translation by the Bank of Japan), September 22, 1998, "プレス・ステートメント" (Press statement) (in Japanese). ↩

35. Bank of England, "International regulatory co-operation post-Barings" (Quarterly Bulletin, 1996, page 221). A summary of a speech given on March 7, 1996. ↩

36. The FSA's Final Notice (UBS AG), paragraph 15 (issue 25 of Market Watch, March 11, 2008). ↩

37. The FSA's Final Notice (UBS AG), paragraphs 26–28, and the sections for each of the three lines (paragraph 29 onward; the third line from paragraph 50 onward). ↩