Rogue Rage

"Ex-Daiwa Rogue Trader Says Most Unauthorized Trades Hidden"

    This short Bloomberg article is thought provoking.  If we remember correctly, the Daiwa trader (Toshihide Iguchi) never took a vacation during his 12 years of illicit activity.  His colleagues all thought he was hardworking.  In reality, he had to be in the office to prevent discovery of his fraud.  As one consequence, banks began enforcing a "two weeks away from the office rule" as a low-cost fraud mitigation tactic.

    As a long-time risk manager, we find some of Iguchi's comments in the article to be insightful and relevant while others are off the mark.  As an example of the latter, Iguchi explains his view that rogue traders are not motivated by greed by saying such people "engage in unauthorized trades in attempts to recover initial losses and protect their careers."  Well, this is greed - perhaps one could call it "defensive greed."  The choice is between honesty, with possible loss of job, versus dishonesty, with retention of job, salary, bonuses, and social standing.  Valuing money and ego over integrity is absolutely a character failing of some kind - the word "greed" is just as good as any other.

    We agree with Iguchi when he says "all traders ... lose money at some point" after which he adds that traders' natural instinct is to hide their losses.  He cites "corporate culture" as the "core problem" because the culture "is focused on profitability."  Aside from the sad spectacle of watching an adult blame somebody else for his own unethical choices, we agree that corporate culture is a core problem.  But the problem is not the desire to be profitable.  Rather, it's the false expectation and understanding of what a "trader" is and how he/she makes profits and losses.

    The folklore that WAY TOO MANY PEOPLE BELIEVE is that "good traders" reliably make money with little risk simply because they know "when to buy" and "when to sell."  The real-life situation bears little resemblance to this caricature.  Many prop traders, for example, are effectively dealers.  They're willing to accumulate long and short "inventory" and show bids and offers to the market.  This market-maker role is a valuable service which does merit a net positive return.  But there's risk and an honest calculation of capital to hold against the risk will show that a good prop trader can earn a good return on capital.  But this return on capital is not much different from a normal,  long-term investor's return on capital.

    Other explanations for "trader profits" run the good-to-bad gamut of "add true value to the market" to "misleading" to "dubious" to "illegal."  Quick examples are:

ADD TRUE VALUE:  Swap trader provides customized exchange of cash flows for a corporate Treasury department's hedging of interest rate and foreign exchange risk.

MISLEADING:          Bond trader keeps her book net long and counts bond coupons as trading profit.

DUBIOUS:                  Derivative trader finds simple pair trades that produce positive carry with no risk capital assignment due to his firm's (or a regulator's) flawed model for the trades.

ILLEGAL:                  Equity trader actively cultivates contacts in or near target companies to gain non-public information.