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Second French rogue trader case sparks risky thinking

Can real-time controls prevent fraud?

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A trader suspected of losing his employer as much as €751m ($940m) in ill-judged derivatives trades has been placed under investigation. The case has sparked a fresh assessment of the adequacies of compliance systems and how they might be improved and stirred up a few unhappy memories.

Boris Picano-Nacci, of French mutual bank Caisse d'Epargne, has been placed under judicial supervision by an investigating magistrate following his arrest and questioning by financial police. The case represents further fallout from losses that emerged on 17 October and have already prompted the resignation of the bank's three top executives.

Prosecutors are considering whether there are grounds to bring a breach of trust case against Picano-Nacci, who may also face a civil lawsuit from his former employers.

French Finance Minister Christine Lagarde said last week that a preliminary investigation by France's banking commissioner had uncovered "holes" in the bank's controls, a finding echoed by early findings from an internal investigation, AP reports

The case invites comparison with the far larger losses at another French bank, Societe Generale, that emerged earlier this year. Former trader Jerome Kerviel made a series of high-risk gambles of the movement of derivatives that cost the bank $7.1bn to unravel.

Kerviel, who worked in the back-office of the bank prior to getting a job as a junior trader, allegedly used a variety of ruses to prevent the detection of his fraud. His tactics included creating two sets of accounts, with the fake accounts used to hedge against market movements in the real account.

The trader also allegedly stole access codes in order to cancel out trading operations before falsifying documents to cover up these cancelled trades. Kerviel also replaced cancelled orders with other financial instruments in order to hide his tracks.

A presentation at the RSA conference last week focused on the lessons learned from the Societe Generale, as well as wider questions how risk management technology could prevent fraud. Joseph Magee, chief technology officer at technology consultants Vigilant and Steven Zaki, a market analyst at Vigilant, explained that while there was no such thing as a "silver bullet" solution much can potentially be done to detect fraud before trading positions get out of hand.

in the Soc Gen case irregular trading patterns were either undetected or disregarded while while compliance rules and triggers were circumvented. The best defence - according to Vigilant - is controls that operate in real time.

Real-time risk monitoring systems could potentially detect problems at a much earlier stage, the duo told the conference. "Kerviel made massive spread bets on the futures market while concealing the true extent of the position and the bank's liability," Zaki said. "The positions were worth $73.3bn more than the market capitalisation of Soc Gen, which was around $52.6bn at the time."

Kerviel made millions for his employer in the early stages of his trading before the market took a turn and everything went titsup. Existing regulations - focused on historical reports - are now no longer adequate in regulation the financial markets if they ever were, Vigilant argues.

"Government reports - which cover policies, reports and separation of duties - do not require real-time monitoring. So-called adequate controls are not timely enough to detect and prevent fraud," Zaki said.

Vigilant's Security Information and Risk Management (SIEM) system triggers on actions such as a trade above a trader's limit or access to a trading systems from home on a day when a trader is supposed to be on holiday. The system doesn't prevent trades from being lodged, but it does prevent money leaving a firm before trades are made.

The system generates alerts of varying priority levels but is tuned so as not to generate a storm of notices that might easily be ignored. The technology - based on components from IBM, Novell and others - needs to be tuned to particular environments.

"Soc Gen followed guidelines on adequate controls but these controls are out of date," said Vigilant's Magee. "Real-time transactions require real-time monitoring."

Kerviel only gained a relatively small discretionary bonus in addition to his basic salary. Vigilant reckons he was motivated more by "making a name for himself" as an elite trader rather than possible financial gain.

Responding to questions after the presentation, Magee said that Kerviel made huge profits for the bank of as much as $1.4bn during previous quarters using the same tactics so that it could be that "managers were turning a blind eye" to Kerviel's trades. "The bosses at the bank were at fault," Magee said.

The factors leading up to the sub-prime crisis and credit crunch were somewhat different in that, as Magee considers, "banks got into these positions consciously over time". ®

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