Case Study: How to Lose 2 Billion Dollars Raoul Demers was a junior level trader on the derivatives desk in the London branch of a global Swiss bank. Previously, he had worked as a trade compliance analyst in the Geneva office. Raoul’s duties were to engage in routine hedging of certain client accounts, typically using vanilla futures and/or options on standard equity indices. A common situation was where the bank was serving as a “transition manager” for a custodial client who was moving between external managers for a specific mandate. For instance, client X may have become dissatisfied with the performance of a European Value Equity manager and has fired them and is moving management of that mandate to a new investment firm. The bank, Raoul’s employer, as custodian will provide the transition services as they already have the client’s assets in custody. They will receive a “model” portfolio form the new manager, one that reflects the new manager’s approach to managing European Value Equity. Over a period of two weeks or more, the bank will buy and sell assets for the client account to transition it from the old manager’s approach to that of the new manager. Meanwhile, they will hedge the overall portfolio against market movements – in this case by taking short derivative positions against the relevant index future (in this case MSCI European Value Equity Index Futures). Another situation would arise where a client was invested primarily to generate income – either equity via dividends or fixed income via coupon payments – but wanted to be insulated against market movements. The London branch denominated most of its trading in Pounds Sterling, no matter what the underlying currencies of the clients’ accounts. Hedging of currency risk was assigned to another desk than the one Raoul worked on. Raoul would be assigned the notional asset amounts he was to hedge and his task would be to establish and maintain suitable futures positions. His first 12 months in this position were successful, but Raoul chafed at the much greater salary and bonuses being earned by other traders working on more sophisticated accounts. Raoul was a bit of an amateur statistician and experimented with trying to find patterns in market data. Over time, he felt he had worked out a reliable system for predicting short term moves (1 to 3 months) in the equity indices which were the underlyings for the derivatives he employed for hedging client accounts. Based on his experience as a compliance analyst in Geneva, he knew that there was really only one key compliance metric: this was the difference between the current market value of the assets hedged and the equivalent economic exposure of the hedge positions. Managers were also expected to set limits on the magnitude of the assets to be hedged based upon the skill and experience of the traders they supervised. Because of his junior position and relative lack of experience, Raoul’s manager had set his level of responsibility for assets fairly low. Raoul’s manager religiously reviewed the daily summary compliance report which depicted for each trader a single number: the net equivalent economic exposure of the hedges and net market values of all the hedged accounts. One day in a routine one-on-one meeting with his manager, Raoul remarked on a list taped to the edge of the manager’s computer screen. The list consisted of the names of all the traders and a figure in pounds sterling. “Oh that’”, the manager replied, “That is my cheat sheet for reviewing the compliance summary. If the net market value difference on the daily report exceeds that amount I go to the details. It annoys me greatly to half to do so, so mind your positions accordingly.” In the course of his training and conversations with colleagues, Raoul learned about Forward Settling Exchange Traded Fund (ETF) trades. These were trades which did not settle until up to three months after the trade date. Filling in one day for a trader on a different desk who was sick, Raoul was asked to execute a Forward Settling ETF trade with a broker in Frankfort. Approaching the end of day in London, he became concerned that he had not received an affirmation of the trade from the broker or that his bank’s compliance team had not raised a flag about the trade. He was worried that the lack of an affirmation corresponding to the trade he entered into the system would trigger a compliance error for which he would be blamed. Fearing that he had somehow missed something, Raoul called the broker to see what the issue was. The broker in Frankfort explained that his firm did not send affirmations for these sort of trades until a few days before actual settlement and that this was a pretty common practice among European brokers and market participants for Forward Settling ETFs. Felling a little embarrassed for his ignorance, Raoul began to think: the only evidence for the existence of this sort of ETF trade was what the trader entered into the system. There is no paper trail until a few days before settlement which might be months down the road. He immediately began to strategize a scheme that would allow him to put on major derivative bets on the movement of market indices based on his statistical system and disguise them from the compliance folks and his manager. A few big scores could propel him into major bonuses and promotion.

1. Putting yourself into Raoul’s shoes – outline how you would engineer such a scheme.

2. What weakness in the compliance control program would he be exploiting?

3. What would be the most likely scenario that would cause the scheme to unravel?

4. If there is one or more weaknesses in the compliance system – what additional controls could mitigate them?