BUSINESS

Exploding the myth of the ‘rogue trader’

STEVE MAICH May 19 2008
BUSINESS

Exploding the myth of the ‘rogue trader’

STEVE MAICH May 19 2008

Exploding the myth of the ‘rogue trader’

BUSINESS

STEVE MAICH

Things were already falling apart for Nick Leeson by Jan. 16,1995. He was then a 28-year-old derivatives trader, working in Singapore for Britain’s venerable Barings Bank, and widely considered a star. What his bosses didn’t

know was that for three years he’d been hiding mounting trading losses in a numbered brokerage account, and those losses had ballooned into the tens of millions of dollars.

That night, Leeson entered an innocuous “straddle trade” on the Singapore and Tokyo stock markets. It was a bet that not much would happen to Asian stocks overnight. But in the wee hours of Jan. 17 the Kobe earthquake hit, Japan’s market plunged and Leeson went into a death spiral. Like a poker player who makes increasingly desperate bets on ice-cold cards, Leeson’s losses just kept compounding. On Feb. 26, with his losses totalling US$1.4 billion, he left a note on his desk that read “I’m sorry” and hopped on a plane for Malaysia. The deception was quickly uncovered and within a few days Barings collapsed and Leeson was arrested.

For the next 4V2 years Leeson sat in a Singapore prison, convicted of fraud and forgery. Inside, he was served divorce papers, was diagnosed with colon cancer, and wrote a book called Rogue Trader. He survived the cancer, was released from prison and eventually achieved something like redemption.

This week, Leeson will be in Toronto to speak to the alumni association of the University of Western Ontario’s Richard Ivey School of Business about risk management and the psychology of a cheater. “As individuals and leaders, it is imperative that we learn how to recognize and correct the fatal flaws that may be lurking within our own organizations,” Ivey says in its press release.

That’s an appealing idea. We’d like to believe that Leeson can offer more than a voyeuristic glimpse into the dark side of high finance. We’d like to think he can provide a blueprint for the mind of a fraudster, and hand us the key to preventing these kinds of disasters.

But he can’t do any of that. And, truth be told, you don’t even have to press him very hard before he admits as much. “I’m afraid I don’t have the answer,” Leeson said over the phone last week from his home in western Ireland. “The lessons are not learned. The pursuit of profit still overpowers everything

else that happens in the financial industry.”

Sure, he has a few ideas for dealing with financial miscreants—tougher prison sentences; more aggressive and sophisticated internal controls; personality testing for traders. But he’s quick to acknowledge that none of it stands a chance when stacked up against the massive rewards heaped upon the boldest players in the financial world.

Financial frauds happen for the same reason that race cars crash. The car owner hires a driver whose job is to drive as fast as humanly possible without crashing. But both driver and owner know that there’s no prize for

driving safely around the track and being a courteous competitor. Winning is everything, and the same holds true in the financial business. The incentives are all geared toward the maximization of profit, period. And the magnitude of profit is a direct function of the risk you are willing and able to take.

Financial institutions have internal controls, but they were no match for Nick Leeson in 1995As he points out, “internal audit departments and compliance departments just don’t attract the same calibre of people as the trading desks. They totally lacked the ability to intelligently question what was going on.”

Nothing has changed in that regard. If anything the gulf between the auditors and the traders has only widened along with the growing complexity of financial alchemy.

That’s why, more than a decade after Barings’ collapse, Société Générale lost close to $5 billion last year, allegedly due to unauthorized speculation by a trader named Jérôme Kerviel. Despite the high-profile disasters, there is no incentive for bankers to address that imbalance because internal auditors don’t make money, traders do. And no CEO ever earned a bonus for reining in the money-makers.

In that sense, there is really no such thing as a “rogue trader.” In 2006, University of Manchester business professor Ian Greener published a paper examining the Barings collapse and exploding the rogue myth. “Whenever significant financial trading fraud occurs, the central protagonist is always portrayed in a similar way to Leeson, as acting alone and subverting the system,” Greener wrote. “But malfeasance doesn’t work like this... For significant fraud to occur, the fraudster must be trusted and even protected by those around him or her.” Traders like Leeson, he says, create socio-technical networks—managers and colleagues who rely on him for their own success.

Leeson kept asking for more and more capital to trade with—tens of millions of dollars at a time, day after day—all in hopes of digging his way out and covering his tracks. It made no sense that a mid-level trader, who was supposed to be making low-risk arbitrage swaps, would need that much cash, but nobody asked questions until Barings’ own lenders refused to advance any more credit. Management “had to know that something was wrong,” Leeson says. “It just defies common sense. I can only think they were trying to hold on until the end of February when bonuses were paid.”

It was only when that socio-technical network finally crumbled that his boldness was revealed to be recklessness and deceit. Nick Leeson knows what he did was wrong, and he never misses an opportunity to remind you of that. But he’s no monster, and he was never a rogue. He was a guy desperate for success in a game that venerates risk and ridicules caution. And now he’s a guy who makes a decent living confessing his sins over and over, offering warnings but not solutions. In the end, the only certainty in his story is that it will be repeated. M

steve.maichamacleans.rogers.com