Wild West trading

Once again investment bank managers are scratching their heads, asking themselves what needs to be done to stop rogue traders from racking up losses behind their backs.

On Friday Kweku Adoboli, a 31-year-old trader at UBS, was arrested in London for allegedly circumventing the bank's risk management systems to conduct unauthorized trades that generated $2.3 billion (1.7 billion euros) in losses without anybody noticing.

The scandal has not only burned a deep hole in the bank's balance sheet; it has also given UBS, which stands for Union Bank of Switzerland, the dubious honor of being dubbed the "Unauthorized" Bank of Switzerland by cynics in the financial sector.

Indeed, the harm done to the bank's image could cost the bank much more than the billions Adoboli allegedly blew in the trading room.

Not the first time

The scandal at UBS is the latest incident in a sad history of unauthorized trading among the world's biggest investment banks. At the top of the list of rogue operators over the past two decades is Jerome Kerviel, responsible for a loss of $6.8 billion (4.9 billion euros) at Societe Generale in 2008.

Kerviel's undoing prompted sweeping changes in the investment industry, including the introduction of risk management departments and stricter compliance regulations.

Many banks also introduced real-time monitoring systems designed to set off alarm bells whenever traders breach volume limits or make suspicious changes to orders, while human resources managers red-flag traders who refuse to take any vacation over a long period of time.

Given all these checks and balances, some experts question how a trader can become a "rogue" for more than a few minutes, let alone days, weeks or even months.

"Rogue traders don't work in a vacuum," said Simon Morris, a partner at the UK law firm CMS Cameron McKenna. "Behind every rogue trader is a rogue manager who hasn't done his job."

Banks need to upgrade their monitoring systems and check their control algorithms not on a monthly or even weekly basis but daily, he added. They should also thoroughly test every new trading product before it is implemented.

"Rogue trading needs an environment of occasional complacency to succeed," Morris said.

Organized in 'silos'

Wolfgang Fabisch, CEO of the German compliance consulting firm b-next, points to another problem. "The units set up to prevent unauthorized trading are often organized in silos," he told Deutsche Welle. "They need to be interlinked."

Another problem, he said, is that compliance units are often established and run by lawyers responsible for taking legal action against those who break the rules. "But they aren't in charge of organizing the business processes and installing the 'circuit breakers' to curb operational risks," he said, urging these functions to be merged.

Stewart Hamilton, a professor of accounting and finance at Switzerland's IMD international school of management, remains generally unconvinced of banks' efforts to clamp down on Wild West traders.

"The reality is that everything banks claim they've done to improve the situation is insufficient," he said. "Compliance monitoring is still regarded in most organizations as a second-class operation."

Hamilton points to what he says is an entrenched attitude among banks that risk management and controls are nothing more than a cost and a pain.

"All this reminds me of my early days as an accountant when the senior partner used to greet the person who would be described today as the chief compliance officer with 'Good morning, Mr. Overhead,'" he said.

Excessive risks

Many experts agree that because investment banking is so focused on growth, the industry will always encourage ambitious staff members to take excessive risks to keep ahead of rivals, rewarding them with huge bonuses for their efforts. No big investment bank, they argue, has ever exposed a rogue trader who has boosted its profits with unauthorized trades.

"Traders, by nature, are gamblers and very short-term thinkers," Hamilton said. "Many of them are seduced by the ludicrous sums of money they can earn."

In its last annual report, UBS itself said that it had authorized "increased risk taking" for "incremental trading activity."

Derivatives – financial contracts whose value is derived from underlying assets – have proven to be an increasingly profitable area of trading for banks like UBS.

"Many of the problems that we've had with unauthorized trading in recent years have come from fairly complex derivative instruments that many people, including myself and even some traders, don't properly understand," Hamilton said. "And regulators have long been behind the ball in determining the risk levels of activities such as derivatives."

But if UBS is the latest big investment bank to trip over some unauthorized trading that has gone afoul, "it will hardly be the last," he said.

Author: John Blau
Editor: Sam Edmonds