Rogue trader blows sox off control systems

The apparent ease with which a former software developer turned rogue trader was able to sink France's second-biggest bank into a €4.9bn ($7.2bn) hole has sparked questions about the effectiveness of risk analysis systems.

Jerome Kerviel, 31, a junior trader at Société Générale Paris headquarters, caused five times the damage as notorious rogue trader Nick Leeson, who ran up losses of £800m ($1.58bn) that resulted in the collapse of his employer Barings Bank in 1995. Kerviel created fictitious accounts to take risky positions in the derivatives market that resulted in huge losses as stock markets across Europe fell.

The losses, reckoned to represent the largest ever fraud by a single trader, have shaken a banking system already struggling from the effects of the US sub-prime lending crisis. The City of London is buzzing with rumours that it was the unravelling of Kerviel's risky position after SocGen discovered them last weekend led to a drop in share prices across Europe, as market bears responded to a influx of sell orders by pushing markets further down.

SocGen maintains it will be able to weather the storm, with plans to raise €5.5bn ($8.01bn) in order to maintain liquidity. The bank continues to anticipate posting €800m ($1.176nn) profits for 2007.

Kerviel, described in reports as both intelligent and a troubled Walter Mitty-style fantasist, appears to have acted alone and without any personal financial benefit. He apparently joined the bank as a developer working on the middle office systems that control how much a trader can risk. The systems limit how much a trader or group of traders can risk.

"The total potential trades are just summed up, and matched against the limit for an individual/trading desk/company," an IT director at a leading investment bank told El Reg. "I say 'potential' since much may be offers to buy/sell rather than actual transfers. There's also some complex risk analysis processing, though I doubt that's relevant to SocGen."

The role gave Kerviel the knowledge of how to manipulate the system when he became a junior trader in 2005. His role as a hedger involved covering the bank's exposure to large losses by taking positions opposite to those taken out by more senior traders. Trading limits in the order of tens of millions of dollars ought to have been applied.

In December Kerviel removed limits on his personal trading positions and created fictitious customer accounts to balance the books, The Guardian reports. In December he took out a series of short positions, essentially betting that the market would fall. Not much happened. In January, Kerviel went the opposite way and gambled that the markets would rise, with disastrous results. He traded in futures contracts on three major stock markets in France, Germany and the Eurozone that involved highly-leveraged bets on the stock price of market-listed firms.

Kerviel seemed to believe that he had come up with a trading approach that would rake in huge gains for the bank and a fat bonus for himself. In reality he was acting like a woefully misguided gambler. His actions only came to light when one of his trading positions was flagged up on SocGen's internal system as going over his trading limit. After confessing responsibility when interviewed by senior executives last weekend, Kerviel has since gone AWOL amid expectation that SocGen will initiate legal proceedings against him.

Bank officials are puzzling over his motives.

Philippe Collas, from SocGen's global investment management division, said: "In December things were going very well for him, then he panicked, he gambled against the market, he started deliberately losing to try and hide it, to reduce the possibility he'd be caught. He made no money out of this, not a cent, this wasn't done to get rich. What was his motive? I don't know, maybe he wanted to prove himself. It's difficult to get money out of a bank, as soon as you try you will leave a trace."

SocGen is keen ro describe the losses as "isolated and exceptional" but that's done little to subdue questions about why the fraud was not detected earlier. Société Générale is based in France but trades in Europe and in other parts of the world, including the US, where its shares are traded as ADRs. That presumably leaves its subject to controls applied by the Sarbannes-Oxley Act. In case you forgot, that is the regulatory regime introduced in the US in response to accounting scandals at WorldCom and Enron, among others.®