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  • 1.ROGUE TRADEREXECUTIVE SUMMARY August 2002

2. No Surprises IntroductionTimes of crisis or uncertainty often provide a fertile breeding ground for fraudulent trading.It is no secret that nervous traders can make mistakes and having incurred losses theysometimes take larger risks to try to recover these shortfalls - only to end up losing evenmore money. In this scenario, these traders then become fraudsters to cover their owntracks. If this sounds a little far-fetched and like a passage from a Hollywood script, thenyou'd be correct. Except these Hollywood films, such as "Rogue Trader", are based onreal life. This report is written in light of the rogue trader incident at Allied Irish Bank that wasannounced earlier last month. The aim is not so much to investigate the actual incidentbut to reflect the opinions of the banking community on the following issues: Why is this still happening? Why have the lessons not been learnt? Who is to blame? What can banks do to protect themselves against rogue traders in the future? Most importantly, this report offers a list of the top ten preventive measures that banksshould consider implementing in order to avert rogue traders within their institutions. Thislist was compiled on the basis of first-hand suggestions from a wide range of financialprofessionals, including risk managers, traders and independent consultants.Gallery of rogue tradersEver since the spring of 2001, when the "hi-tech boom" came to an end, the financialmarkets have demonstrated an alarming volatility. Losing money, it seems, keeps gettingeasier. In fact, some pessimists are already predicting that the investment bankingbubble will soon burst in the same manner as the dot.com bubble did a few years ago. This is an unsettled time and as one of the market analysts stated "there are rogue wavesin the worlds financial seas." So, what do banks expect from their risk managers and frontoffice supervisors during such times? An answer to this question arose in a casualdiscussion between Lepus and a risk manger, who laconically answered: No surprises.This shrewd remark gains added sarcastic connotations in the light of the most recentrogue trader incident in the Allied Irish Bank (AIB). We start this report by highlighting the three biggest occurrences of this kind in recenttimes and also outline the chronology of rogue traders over the last decade. The firstname on our list of Rogue Traders is the man behind the latest scandal. 12/05/10 2 3. John Rusnak AIBs US subsidiary, Allfirst Financial, is currently at the centre of an international fraudinvestigation, after it was revealed that John Rusnak defrauded the bank of $750m bygenerating fictitious foreign exchange transactions. Although the exact details of the fraud are yet to be released, it is believed that irregulartrading activities had been taking place in AIB for about a year and involved a very largeamount of trades. Rusnak executed a large number of transactions that involved buyingand selling Japanese Yen and US Dollars. He appeared to offset the risk involved in thesedeals by taking out options contracts. This is a standard practice amongst currencytraders and provides insurance in case markets move in a way not anticipated in theprevious FX transactions. Allegedly, Rusnak built up big bets that the Yen would strengthen against the Dollar.Instead, as the graph below shows, it has significantly weakened in the past 12 months.The losses were quite significant, but they would have been offset by profits from theoptions deals. However, as it was discovered by AIB deplorably late, the options werenever purchased. What happened was that the purchase orders were entered into thebanks system artificially. That is, it was made to appear as if options contracts had beenbought when, in fact, they had not. Although the general mechanism of the fraud is clear, the investigation still has to clarifythe precise sequence of events and discover whether there was any collusion, if anyindividuals personally profited from the fraud and why the internal controls failed. It hasalready been confirmed that AIB will not go bankrupt as a result of this fraud, as it is aretail bank with sufficient capital to cover the incurred losses. However, over the pastdecade there have been only two other cases that have caused losses on such a similargrand scale. Nick Leeson The most famous rogue trader to date is Nick Leeson who caused the collapse ofBarings Bank under debts totalling $1.3 billion in 1995. Leeson was involved inunauthorised futures and options trading on the Singapore International MonetaryExchange and the Osaka Securities Exchange. He used a special account, bearing thenumber 88888 to conceal his losses. This elaborate deception was made possible due to12/05/103 4. the fact that as a cost-cutting measure Leeson operated both as a front-office trader andas a back-office settlement manager. Suspicions were first aroused in 1994 when Baring's external auditors questioned thecredit from Spear, Leeds & Kellogg, a New York City-based securities trader, offsettingLeeson's losses. Leeson forged faxes from Spear Leeds & Kellogg, Citibank and one ofhis superiors in London reassured the auditors that the money was paid to Barings. Theforged proof was accepted. Leeson kept up the charade for more than two years while pulling in over $1 million inwages and bonuses. In 1993, he got an extra $195,000 for his exceptional performanceand was on track to be rewarded a further $689,000 for 1994. Underneath this generousremuneration, Leeson's losses were secretly escalating. He bet heavily on Tokyo's Nikkeistock index at the beginning of 1995. He bought and held on to Nikkei futures even afterthe January earthquake in Kobe. Over three months he bought more than 20,000 futurescontracts worth about $180,000 each in a vain attempt to move the market. Some threequarters of the $1.3 billion that Leeson lost resulted from these trades. When it becameimpossible to conceal his fraud anymore, Leeson fled. Once caught, he was sentenced tosix-and-half years in prison. Unable to cover the losses, Barings was sold to the Dutchbank ING - now called INGBarings. Yasuo Hamanaka Even greater than this was the 1.8bn loss that the Japanese Conglomerate Sumitomoincurred due to Yasuo Hamanaka's unauthorised trading over a 10-year period.Hamanaka was apparently known as Mr. Five Percent because he and his teamcontrolled at least that share of the world copper market. Hamanaka was given unusualautonomy within the Sumitomo organisation and this lack of oversight allegedly allowedhim to keep two sets of trading books, one reportedly showing big profits for Sumitomo inthe buying and selling of copper and copper futures and options, and a secret accountthat recorded a dismal tale of billion-dollar losses. Because Yasuo Hamanaka produced huge profits (at least on paper) he was not rotatedinto other jobs as most Sumitomo executives were. His books showed that his divisionhad cash reserves far greater than they actually were and no one dared to look tooclosely at his transactions. Finally, it was the pressure of an internal investigation that ledHamanaka to bow to the inevitable and confess. He revealed to his corporate bosses thathe had been conducting unauthorised trades for the past 10 years in a vain attempt tocover up snowballing losses. He was sentenced for 8 years. Other rogue traders Unsurprisingly, "rogue traders" attract an amount of media attention that is almost in directproportion to the amounts of money involved. This is why almost everyone is familiar withthe three infamous incidents outlined above. However, not everybody understands theextent and frequency of similar frauds, most of which lack publicity only due to smallersize of the incurred losses. In fact, if we look at the past decade, every year was markedby at least one or more "rogue trader" incidents. A chronology of trading frauds appears tobe almost uninterrupted until 2002. 1990 12/05/104 5. Michael Milken, the head of bond operations at US Drexel Burnham Lambert, wassentenced to 10 years for securities fraud. Drexel filed for bankruptcy after paying $650m(458m) in fines. 1991 Allied Lyons Plc (now called Allied Domecq Plc) lost 150m in FX dealing. 1992 Indian banks and brokers were accused of colluding to siphon $1.3bn from the inter-banksecurities market to fuel a boom on the Bombay stock exchange. 1993 German industrial group Metallgesellschaft suffered huge losses on derivatives, forcingcreditors to mount a $2.2bn rescue. 1994 Chile Copper Corp (Codelco), the world's largest copper producer, lost $175m throughone trader's unauthorised activities. Wall Street broker Kidder Peabody fired its government trading desk boss, Joseph Jett,after it uncovered a scheme that created phantom trades, resulting in a one-time chargeof $210m after tax. Orange County, California, was declared bankrupt after investment losses of $1.6bn fromits derivative-heavy investment portfolio. 1995 Barings Bank collapsed under debts totalling $1.3 billion as a result of Nick Leesonsunauthorised trading. Japan's fifth largest bank Daiwa suffered a $1.1bn loss from unauthorised bond trading byToshihide Iguchi, one of its US executives. Whenever he lost money as a governmentbond trader, he allegedly pulled and sold bonds from Daiwa's own accounts or those of itscustomers, and then forged documents to make trades appear as if they are authorised.During the period of 11 years Iguchi made astronomical 30,000 transactions while tryingto cover his losses. As a result, Daiwa US was closed and the trader was sentenced tofour years. NatWest incurred losses totalling to 90.5m after trader Kyriacos Papouis and his then-boss Neil Dodgson concealed trading losses by overhauling options positions held ontheir books. Common Fund of the United States, which oversees $20bn of funds for educationalinstitutions, said a rogue trader had caused it to lose about