FSLA UPDATE
The Financial Services Lawyers Association provides a forum for the open exchange of views and the
dissemination of knowledge and ideas in financial services law and regulation. Members include solicitors,
barristers, academics, judges, students and non-lawyers working in the industry. FSLA hosts a variety of events
throughout the year. To find out more about individual and corporate membership go to www.fsla.org.uk.
Author Michael Gomulka
Will UBS mark the end of rogue trading
or the beginning of regulatory collapse?
This article argues how hidden and high-speed transacting in
complex, uncertain and unstable products intensifies the risk
of rogue trading and that it appears unlikely that regulatory
supervision will catch-up with innovation.
“Rogue (n)
1. A vagrant; an idle, sturdy beggar; a vagabond; a tramp.
2. A deliberately dishonest person; a knave; a cheat.
3. One who is pleasantly mischievous or frolicsome; hence, often
used as a term of endearment.”1
A week is a long time, not just in politics. Take the seven days that
began with 7 December 2011.
On that day Hector Sants, the CEO of the Financial Services
Authority (FSA), met the leaders of Occupy London in a Bedouin tent
in the City of London and discussed, among other matters, the failures
of “light touch” regulation, the credit crunch, its aftermath and how the
FSA would approach its oversight responsibilities going forward.
Two days later, on 9 December, Prime Minister Cameron vetoed
a new European Union treaty that had the support of the remaining
26 member states and was designed to bring in measures that would
ensure the future of the euro, bring greater fiscal discipline to the
eurozone and thereby reassure sceptical markets. The primary reason
given for the veto was the protection of the City of London in the form
of exemptions from a perceived plethora of financial regulations.
Finally, on 13 December the FSA released its report into the
failure of RBS in 2008 and the consequential injection of £25.5bn of
state funds required to resurrect the bank.
Regulation of the financial sector, once a technocratic beast
that occasionally roamed into public view from the wings, is now
centre-stage. It must be strong enough to reassure a dazed and
confused public that there will be no repeat of recent crises, while
not strangling the recent historic mainstay of the UK economy at
a time when neither the government nor the private sector appear
overburdened with better alternatives.
UBS all seems so long ago. On 15 September 2011, we first
learned of the arrest of Kweku Adoboli, the man who cost his
employers at UBS $2.3bn by hiding his real trading exposure. Within
minutes of the story breaking “rogue” and “trader” became the
permanent precursors to his name and have stayed attached since.
Adoboli takes his place somewhere towards the top of the league of
recent rogues whose exposure has been met with a combination of
disbelief, incomprehension and, lately, anger. Yet there is ever a sense
that all this is sprinkled with a touch of admiration, to the extent that
in October he was running fifth in a Best Dressed Banker poll 2.
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While it might be argued that rogues are an inevitable function
of trading, and their infrequent discovery is evidence of both the
small problem they present and a testament to regulatory oversight,
this is not persuasive because it bears only a passing resemblance
to current market realities. With increasing velocity and opacity,
current trading structures, platforms and incentives appear
designed to deny discovery and external disciplines. Hidden and
high-speed transacting in complex, uncertain and unstable products
intensifies the rogue risk, and we can anticipate increases in their
occurrence and size.
Perhaps more importantly it is worth asking whether it is
the system that is out of control? Do exotic products, traded in
nanoseconds in the dark, run counter to efficient market theory that
depends so much on transparency and open access to information?
Seen in that way might UBS and other recent events point not to the
success of regulation, but rather to its inevitable impotence when set
against the ever-increasing intricacies of post-modern trading?
WHO AND WHAT ARE THE ROGUES?
“A rogue trader is a market professional who engages in
purchases or sales of securities, commodities or derivatives,
often unauthorized for a financial institution’s proprietary
trading account.”3
A casual observer might be forgiven for thinking that rogue
traders come along about twice a decade, but any closer inspection
reveals that, in recent times at least, their irregularities have been a
far more frequent feature of the markets than that.
The modern-day archetype of the rogue trader is Nick Leeson.
In 1995 he lost some £800m in hidden trades that took down the
blue-blooded Barings Bank. Leeson had moved from back office
to front office, controlled his own reporting, and thus was able to
hide his trading losses in the infamous five eights account. Neither
Leeson nor Barings revealed to the authorities in Singapore that he
had been refused a broker license in the UK due to the discovery
of a fraudulent statement on his application. His trading, although
unauthorised, went on for three years and brought with it significant
and declared profits for the bank, which appear to have asked very
few questions as to the source of their Far Eastern windfalls.
In the same year that Leeson’s losses came to light, bond trader
Toshihide Iguchi wrote a letter to his bosses at Daiwa Bank in Japan
informing them that he had been hiding losses that, by that point,
ran at $1.1bn. He had been trading without restriction or reporting
for 11 years. "We really believed in him," Akira Fujita, Daiwa's
Butterworths Journal of International Banking and Financial Law
president, said at a news conference at the bank's headquarters in
Osaka. “He created a system where he was in charge of everything.”4
Just a year later, in 1996, Yasua Hamanaka, a trader at Sumitomo
Corp, lost £1.3bn after illicit copper trading spanning a decade.
Quite how he was able to conduct unauthorised trading over such an
extensive period remains unknown.
In 2002 John Rusnak at Allfirst Financial lost $691m trading
the Japanese yen. His secret losses had begun five years before at a
comparatively paltry $29m.
In 2005 the Chinese government found itself short of 200,000
tonnes of copper following a bet on the metal’s price by a trader
named Liu Qibing. The trader disappeared, his very existence denied
by China, despite a number of market counterparties having traded
with him daily. The losses generated were $200m–$1bn.
Qibing is not the only public employee to have gone rogue. Before
Leeson, in September 1994, Robert Citron, Treasurer of Orange
County California, forced his employers to file for bankruptcy after
the leveraged positions he had taken in the interest rate swaps market
went sour and cost the county $1.6bn.
In 2007 rogue trading hit a new nadir with the case of Jerome
Kerviel, who lost £3.7bn of Société Générale’s money. Kerviel spent
five years in the bank’s middle office auditing its trading positions
before taking his chance on the trading floor. It is not fully known
quite how Kerviel managed to submerge his positions, which some
estimates have placed as high as €50bn, however, it appears certain
that had Christian Noyer, the Governor of the Bank of France at
the time, not allowed SocGen to trade out their positions without
informing the rest of the market, the bank may well have gone the
way of Barings 12 years before.
Finally, in September 2011, Kweku Adoboli was alleged to have
created losses of some £1.3bn at UBS by hiding his trading book’s
exposure. He is thought to have used the fact that Exchange Traded
Funds (ETFs) do not require the issue of trade confirmations until
after settlement, which itself can be a date far beyond that of usual
market instruments.
These are just a few of the largest unauthorised traders from the
past 17 years, all of whom have been responsible for losses at or over
$1bn. When one lowers the entry bar one finds the rogues’ gallery is
more densely populated.
In 2009 Toronto Dominion lost £56m in the summer after a
senior trader mismarked his book valuations month after month. The
bank was fined £7m in December for failing to put right systems and
controls it had been warned about two years before. May 2010 saw
Jonathan Bunn plead guilty to four counts of false accounting after
he took an unauthorised short position in HSBC shares at broker
Lewis Charles Securities, a trade that crystallised into a loss of
£2.67m. In June 2010 Steven Perkins was fined £72,000 and banned
from trading by the FSA following his purchase of seven million
barrels of oil during an “alcohol induced blackout”, a trade that
created a loss of £6m.
In the past three years Nomura, Morgan Stanley, UBS and a
host of other finance houses large and small have been fined by the
This is not a view that found favour with Nick Leeson when he
spoke to Jeremy Paxman exactly one week after Lord Turner’s speech:
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February 2011
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FLSA Update
FSA for lax systems and poor controls. And of course these are
the rogues who are caught and declared. They are those who have
lost money. But in many cases one finds that the activity has been
ongoing for a significant period and has generated profits before the
losses.
However hard one looks it is hard to find the exposure or
sanction of a money-making rogue trader. Of course the explanation
might be that those who take unauthorised positions are bound
to fail, are somehow less talented, and so have to try and cheat the
system to stay in the game. If not it would suggest that questions
are not asked of, or that heads are turned away from, such cases. If
regulation is efficacious shouldn’t profitable rogues be being revealed
at approximately the same rate as losers?
ROGUE REGULATION
“… a cost-benefit analysis reveals that the continued existence
of rogue trading in the face of pervasive legal rules providing
incentives for firms to curb such behavior indicates that financial
institution management has made a conscious decision to foster
an institutional culture that encourages at least some rogue
trading.”5
These incidents of rogue trading identify financial regulation’s
weaknesses rather than its strengths. In almost every case both
internal systems and external checks were overcome or circumvented.
The authorities appear to rely upon the discovery of losses and selfreporting which might seem too little too late.
Since 2008 the FSA has been keen to demonstrate its fullthroated commitment to a more muscular regulatory approach.
“Intensive supervision”, “more intrusive and more systemic” was how
Adair Turner, the FSA’s Chairman, put it in his 2009 review, “A
Regulatory Response to the Global Banking Crisis”. Margaret Cole,
former head of the FSA’s Financial Crime and Enforcement Division
and currently the interim MD of the Conduct Business Unit, has
repeatedly emphasised the need for regulation, supervision and
enforcement that creates “credible deterrence”.
Lord Turner may have appeared a tad too sanguine to some when
he addressed the City on the Financial Conduct Authority [FCA], the
regulatory successor to the FSA’s market supervisory and enforcement
roles expected to come into being in 2013. Lord Turner was speaking at
the City Banquet in October 2011, just weeks after the new UBS losses
were announced:
“The FCA will regulate wholesale and retail financial services.
On the wholesale side, continually evolving markets will create
new regulatory challenges, but many aspects of past regulatory
approach and market practice have worked well and do not need
radical change.”6
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“The regulators are always behind the curve. The innovation,
the creativity, happens with such speed and complexity that
they are always trying to catch up. You look back 50 years,
they were behind the curve then. You look back 16 years ago,
which was the time of Barings, they were even further behind
the curve and unfortunately, if you look to the future, they are
going to be even further behind. For me it’s not the quantity
of regulation…the quality has to improve…less people [at the
FSA] more output.”7
Leeson continued that he thought regulators had to be paid more,
maybe as much as the bankers they oversaw, because the “industry is
cannibalistic” and would take talent away otherwise.
This was one of the central criticisms of Charles Ferguson’s
documentary on the credit crunch8. Whether in Iceland, where a third
of regulators went to work for the banks shortly prior to the collapse
of the country’s financial sector, or the US, where the Federal Reserve
Chairman during the run-up to the 2008 crisis, Hank Paulson,
was the former CEO and Chairman of Goldman Sachs, Ferguson
identified the overly cosy relationships between finance houses and
their charges as a key conflict that allowed the rise of complex financial
products and the inflation of credit which he suggested lay at the root
of the crisis.
Certainly it seems that Paulson didn’t recognise the seriousness
of the situation until it was too late. Christine Lagarde, then French
Finance Minister and now head of the IMF, was astounded by
Paulson’s confidence that all would be well provided a few tweaks and
adjustments were made here and there, when she and Paulson met at
a G7 summit in February 2008. She told him “we are watching this
tsunami coming and you’re wondering which swimming costume we
should wear”9.
It may be that those public choice economists who argue that
the vested interests of global finance have subverted regulation
to suit their own ends, so-called regulatory capture, overstate the
case. It is inevitable that effective regulation requires a high degree
of co-operation from market participants, and that arms-length
relationships between them and those charged with their oversight
may contribute to better rules and principles coming into operation.
However, regulator-to-regulated relationships may have either
actually crossed ethical boundaries, or that the perception that they
have critically undermines public trust in the system. Any grist given
to the mill of suspicion that rogue regulators abound, damages the
integrity of market supervision.
Whatever the reason, Paulson, both during his time at
Goldmans and subsequently as Chairman of the Fed, was part
of a banking system that had begun to design ever more complex
financial products, sell them to institutional and retail clients, and
simultaneously take proprietary positions against the same products
calculating they would fall in value; all the time not recognising the
existence of any conflicts of interest. Such practices might be termed
rogue banking and if that is what was happening they appear to have
been armed with rogue weapons.
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HYBRIDS, HYDRAS AND HYPERSPEEDS: ROGUE
FINANCIAL INSTRUMENTS AND HOW TO TRADE THEM
“The derivatives genie is now well out of the bottle, and these
instruments will almost certainly multiply in variety and number
until some event makes their toxicity clear. Central banks and
governments have so far found no effective way to control, or
even monitor, the risks posed by these contracts. In my view,
derivatives are financial weapons of mass destruction, carrying
dangers that, while now latent, are potentially lethal.” 10
Credit default swaps, collateralised debt obligations, exchange
traded funds; the list goes on. The past decade has seen an explosion
in the number, complexity and variation of financial instruments over
and above the options, swaps and futures already widely in use. The
innocent pitfalls are obvious: potential for mispricing, mis-selling and
mis-marking, not out of greed or chicanery, but due to misunderstanding
of the nature of the product and its associated risk profile. In the hands of
a determined rogue trader the opportunities are exponentially increased
beyond those of plain vanilla shares, commodities, currencies and bonds.
Added to the heady mix of exotic products are two additional
factors. First, the increasing use of hidden or off-exchange trading
systems – dark pools of liquidity as they have been termed. Secondly,
the increasing use of high frequency trading platforms (HTFs) run by
computers using algorithms and executing tens of thousands of trades
where previously there would be one or two. It is precisely this type of
trading that appears to have been responsible, in part at least, for the
Flash Crash of 6 May 2010.
On that day the Dow Jones Industrial Average dropped 1,000
points in intra-day trading, which, at the lowest point, represented
a paper loss of $1trn from that day’s opening level11. Dramatic as
events seen over the trading day might appear, the speed and ferocity
of modern markets are thrown into much sharper relief when one
examines not the hours but the crucial minutes:
“On Thursday May 6, the stock markets had spent much of the
morning and early afternoon in moderately negative territory,
with the Dow Jones Industrial Average (DJIA) declining
161 points, or approximately 1.5 percent, by 2:00 p.m. (ET).
Concerns over the financial situation in Greece, uncertainty
concerning elections in the United Kingdom, and an upcoming
jobs report, among other things, hung over the market. Shortly
after 2:30 p.m., however, the market decline began to steepen
and, by 2:42 p.m., the DJIA was at 10,445.84, representing a
decline of approximately 3.9 percent. The DJIA then suddenly
dropped an additional 573.27 points, representing an additional
5.49 percent decline, in just the next five minutes of trading,
hitting 9,872.57 at 2:47 p.m., for a total drop of 9.16 percent from
the previous day’s close.”12
The trading in individual stocks also went haywire with
Proctor & Gamble and Accenture trading down to 1 cent and up
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at $100,000. The dramatic decline appears to have been arrested
by a five second pause on the Chicago Mercantile Exchange where
E-Mini S&P Futures Contracts were furiously being traded back
and forth by HFTs using algorithms that were driving equity prices
down artificially. These trading programs can result in more than one
million trades in a day by a single firm13. They may include trading
strategies that deliberately mislead others as to whether there is real
demand for, or pressure on, a given stock by feeding in false orders,
never intended to be filled.
The Chairman of the SEC began the conclusion of her initial
response to the flash crash with the following: “one of the challenges
we face in recreating the events of last Thursday is the reality that the
technologies used for market oversight and surveillance have not kept
pace with the technology and trading patterns of the rapidly evolving
and expanding securities markets.”14
The increased role of HFTs in markets creates a further headache
for institutional funds when trying to determine an efficient trading
strategy. Inevitably one option is to turn themselves to algorithm
trading; products such as Pragma’s Ghost being developed specifically
with such traditional market participants in mind.15
In February 2011 sugar nosedived 6% in one second. On 1 March
Cocoa futures dropped 13% in less than a minute. On 16 March the
dollar fell against the yen by 5% in minutes. As automated trading
becomes the dominant method of execution, so the susceptibility of
markets to flash crashes increases.
The challenges for regulators do not stop at nascent trading
technologies, but also extend to innovative and secretive trading
venues. For several years now there has been a steady increase in offexchange trading or Alternative Trading Systems (ATSs). These dark
pools of liquidity provide those who use them with anonymity and,
vitally, keep the size of orders and the price of trades hidden from
the market. In addition, ATSs have significantly reduced the costs of
transacting from five cents per share down to $0.005 excluding broker
fees16. Generally the technology utilised by newly founded dark pools
is more capable of facilitating HFT strategies where shares may be
held for mere seconds and any one participant can trade up to a million
times in a day. Some estimates put the US market share of HFTs in
black pools as high as 85%,17 while the SEC estimated that dark pools
accounted for 7.2% of all US trading on all exchanges in Q2 200918.
The advantages to those using dark pools are clear and require
little illumination. ATSs provide those who use them with cheaper
and faster execution of trades and the anonymity means large orders
are less likely to move prices before they are done. However, as the
SEC noted in 2009, they possess a “lack of transparency [that]
detracts from the public’s ability to assess the sources of liquidity in a
stock and dark pool activity in general,” and “dark pool participants
are able to have their orders filled, while those on publicly displayed
markets go unfilled, even though dark pools use the information from
publicly displayed markets to price the dark pool transactions. When
dark pools share information about their trading interest with other
dark pools, they can function like private networks that exclude the
public investor.”19
The market is also raising concerns over dark pools as evidenced
by a recent BNY Mellon “Global Trends in Investor Relations
Survey” of 650 companies across 53 countries that found a third of
respondents believed dark pools “negatively impact global trading
markets and that more oversight is necessary”. The same survey
reported that 52% of North American respondents believed that dark
pools were having a negative effect on equity trading 20.
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FSLA Update
CONCLUSION – POLITICS, PRAGMATISM AND PESSIMISM
“I too have been a close observer of the doings of the Bank of the
United States. I have had men watching you for a long time and
I am convinced you have used the funds of the Bank to speculate
in the breadstuffs of the country. When you won, you divided
the profits amongst you, and when you lost, you charged it to the
Bank. You tell me that if I take the deposits from the bank and
anul its charter I shall ruin ten thousand families. That may be
true, gentlemen, but that is your sin! Should I let you go on, you
will ruin fifty thousand families, and that would be my sin! You
are a den of vipers and thieves. I have determined to route you
out, and by the Eternal, (bringing his fist down on the table) I will
route you out.”21
The battle for transparent markets cannot be seen in isolation,
but rather against the backdrop of political and fiscal realities. In
2009 the financial services sector contributed some 10% or £124bn
to British GDP and £53bn in tax revenues while employing 1.6m
people22. Small wonder that David Cameron was prepared to deploy
the UK’s veto to prevent unwelcome regulation interfering with the
golden goose of the British economy. This standpoint found favour
with a potential rival to Cameron within the Conservative Party, Boris
Johnson. The Mayor of London told Andrew Marr that there was a
danger in overregulation and agreed the “goose may need to be plucked
but please don’t kill it”23.
On the other hand, people across the developed world are seething
as public purses are empty having paid out vast sums to save the global
banking system from itself.
This tension is playing out not just on the streets of our major cities,
but also in the dealing rooms of financial houses where the balance has
shifted significantly against transparency, against simplicity, against
effective regulation. Whether or not regulatory capture has occurred, it
appears unlikely that supervision will catch-up with innovation.
Kweku Adoboli’s alleged trading deficiencies took place on a Delta
One desk where, because the delta or volatility of the derivative being
traded is designed to be closely matched to the underlying asset, the
proprietary risk is theoretically low. As some may recall this was also
the position at the outset of hedge funds – they were meant to be
hedged, but now hedgies are a byword for excessive risk-taking and
Delta One appears to be heading down the same route.
It is not ETFs, HFTs, CDOs or dark pools in and of themselves
that create the challenges to regulators, it is that they are the
manifestations of a financial trading system that has morphed from
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Biog box
Michael Gomulka is a practising barrister at 25 Bedford Row,
London. Email: [email protected]
a marketplace for investment with speculative fringes into a global
playground for nanosecond computer gamers seeking any miniscule
advantage. With obstinate resistance to pan-European, let alone global,
regulation equipped to deliver real-time oversight, it seems likely that
regulators will continue to lose touch and be left to write the histories
of market failures rather than affect present practices or shape future
developments. If this is right, those who trade illicitly to the detriment
of the public, shareholders and counterparties will continue to flourish.
The world has gone rogue. n
1 Websters 1913 Dictionary online.
2 Cad & The Dandy in a “competition open to anyone working in
London’s financial service industry, whether it be a bank, hedge fund,
asset manager or City boiler room”.
10 Warren Buffet, Berkshire Hathaway Annual Report 2002, published in 2003.
11 Special Report: Globally the flash crash is no flash in the pan,
Johnathan Spicer, Reuters, 15 October 2010.
12 Testimony Concerning the Severe Market Disruption on 6 May
2010 by Mary L Schapiro, Chairman US Securities and Exchange
Commission, before the Subcommittee on Capital Markets, Insurance
and Government Sponsored Enterprises of the United States House of
Representatives Committee on Financial Services, 11 May 2010.
13 I bid.
14 I bid.
15 Institutional Investors Explore Smart Algorithms, Financial Times, 16
September 2011.
16 Dark Pools and High Frequency Trading to the Fore, DR Advisor
Insights, August 2011, JP Morgan.
3 Krawiec, Ki'mberly D, Accounting for Greed: Unraveling the Rogue
Trader Mystery. Oregon Law Review, Vol 79. Available at SSRN: http://
ssrn.com/abstract=258282 or doi:10.2139/ssrn.258282
4 From the New York Times, 27 September 1995.
5 Krawiec, Ki'mberly D, Accounting for Greed: Unraveling the Rogue
Trader Mystery. Oregon Law Review, Vol 79. Available at SSRN: http://
ssrn.com/abstract=258282 or doi:10.2139/ssrn.258282
6 Lord Turner’s Mansion House speech to the City Banquet on 20
October 2011.
7 Nick Leeson interviewed by Jeremy Paxman, Newsnight, BBC2, 27
October 2011.
8 Storyville, “Inside Job”, BBC2, 7 December 2011.
9 Ibid.
17 Ibid.
18 Financial Markets Regulation: The Tipping Point, Venkatachalam
Shunmuguam, VOX, 18 May 2010.
19 SEC Fact Sheet, 21 October 2009, http://www.sec.gov/news/
press/2009/2009-223-fs.htm
20 Tide Turns Against Dark Pools, Shanny Basar and Giles Turner,
Financial News, 25 October 2011.
21 A ndrew Jackson, President of the United States, from the minutes of
his meeting with the Philadelphia committee of citizens, February,
1834, from the Foreward of Henkels, Andrew Jackson and the Bank of
the United States, 1928
22 Page 10–11, The Times, 12 December 2011.
23 Andrew Marr Show, 18 December 2011, BBC1.
February 2011
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