MF Global, SocGen, And "Rogue" Traders – Don’t Fall For The Simple AnswersBy Francine • Mar 3rd, 2008 • Category: MF Global, PricewaterhouseCoopers, Societe Generale
The company’s shares fell 28 percent, the biggest drop since their July debut, after the firm said broker Evan Dooley made “unauthorized” trades in wheat futures yesterday morning. The Hamilton, Bermuda-based company said it was obligated to settle the trades. MF Global… is at least the second firm this year to attribute trading losses to the illicit activities of a single employee…“All it takes is somebody with enough understanding of how these trading, settlement and risk-management systems fit together and where the gaps are to create a problem,” said Adam Honore, an analyst at Boston-based financial services consulting firm Aite Group LLC. “SocGen was another example, and this is not going to be the last.”
***************************************************MF Global has incurred a $141.5m loss (via Futures and Options Week, subscription required, free trial available) after a failure in its retail order entry system allowed a retail trader to establish significant positions in his own account which were liquidated later that morning. The trader, named as Evan Dooley was trading on CME Group’s wheat futures. MF Global said that it was undergoing a third-party risk technology review of all of its relevant order entry systems (Blogger Note: by FTI Consulting).
Company CEO Kevin Davis said that the broker uses a combination of legacy Refco systems and third party technology. As MF Global was the individual’s clearer, the company is responsible to settle the debt with the clearinghouse (Blogger Note: The Clearinghouse is the Chicago Mercantile Exchange’s clearing firm), the company explained. The company stressed that no client funds had been impacted and said that the individual in question had been removed with immediate effect. Davis described the event as “truly awful” but he believed all problems now to be fixed.
The situations are very, very different. However, they will have a significant impact in two areas:
-The controversy raging in the financial futures industry over the model that is appropriate for the clearinghouses in order to maintain competition in and controls over markets, and
-The role of risk management and controls in sophisticated financial markets and the firms that make money in them.
There were several possible controls that MF Global should have had in place to mitigate the risk that such a situation, in an electronic trading environment, could occur. However, all of them are the type that “slows” things down for traders, especially in fast, volatile markets.
With today’s computerized systems, where every millisecond provides an edge for the aggressive speculator, trading firms have no choice but to provide speed. And speed in the wrong hands can swiftly translate into trouble.
“Obviously, one of the big advantages of electronic trading is how fast it can go. One disadvantage is how fast it can go,” noted Jim McGurk, a Chicago commodity attorney. “The issue is how to control access. Once the bullet has been fired, you can’t get the bullet back.”
Any or all of the controls described below are the kinds of controls that MF Global may have turned off in order to keep traders from complaining about slow systems.
1) Click controls – These are controls which limit the size of trading lots that can be executed in one click of the mouse button. They are intended to prevent “fat finger” syndrome, a mistake made by sloppy data entry. They also prevent a trader from losing touch with the reality of the risks they are entering into. Requirements to click multiple times should serve as a “reality check” for the trader, who has to re-confirm with each click. They also cause a trader who wants to trade 1000 contracts, but who has “click” limits of 100 contracts, to have to click ten times to accomplish his goal. In a fast moving market this means he may miss the pricing he needs.
2) Position limits – These are similar to click limits in that the system is programmed for a particular trader to limit his overall potential position. The dollar limits are established for his account and when the positions he has committed to reach that limit, some kind of authorization, whether manual or automated, must be obtained from firm management before entering any new trades. These may also slow down a trader who has to stop and get that authorization before proceeding. He may have an overall position which exceeds a system imposed “limit” but is a result of combining the positions of several customers who are each still within their individual limits. This additional complexity may not be built into the program.
3) P&L Limits – With automated Profit and Loss statements, the firm can calculate, either real-time or at least often during the day, the actual profit and loss position of the trades that are on, marking to market. This calculation may be off, depending on the time of day and whether a particular market is open and pricing is transparent. However, with automated P&L controls, when a trader exceeds their loss limit at any point in time, the firm can actually shut their computer down, preventing any further trades or preventing the trader from entering any other trades other than ones that unwind positions.
4) All of the controls in place in an automated system can be bypassed if a trader calls the MF Global trading desk, available 24 hours a day, seven days a week. With only an account number to identify him, a trader can place a trade that still has to be entered into a system and may not be checked or controlled on a timely basis in the same way that trades entered into an electronic trading platform can be controlled. That trade may even go to someone on the floor to execute, adding several human points of vulnerability to the equation.
In the case of the MF Global trader, rumors on the floor of the Chicago Mercantile Exchange are that this trader was probably trying to get out of an error, not bet the farm and cheat his firm. At some point he had made a mistake and was trying to trade out of it. Even if he had gotten back to zero or had made any money on the trades, he still would have been fired for exploiting the trust that the firm had placed in him in agreeing to be his clearing firm and allowing him to have a personal trading account. He clearly did not have his own money to back up these positions, or we would have not been talking about this at all. He either would have taken the loss or taken the profit himself.
Someone in this type of position, in a tenuous position with his firm, few clients with no significant activity, can still have the full faith and trust of the firm behind him. Whether he won or lost, he breached the trust placed in him if he went beyond the limits of his trading agreement with the firm. He was essentially a broker who had to step into trader mode, and he got very lost. Even if he had made US$10 million on the trades, the firm would not have allowed him to keep the money.
And therein lies the similarity between SocGen’s Kerviel and MF Global’s Mr. Dooley. From what I can see, neither one is any kind of “rogue,” thief, or sinister character. These are poor schmucks; albeit smart schmucks who understood the holes and vulnerabilities that could allow them to solve their problems. Mr. Kerviel’s problem was not having his colleagues respect him and not having the bonuses that went with that respect. Those were bonuses he planned to earn, within the SocGen lax control structure, for a job “well done.”
Mr. Dooley of MF Global seems like a guy who was hustling to keep up with the success he had enjoyed intermittently but, maybe, not lately. When he ended up on the wrong side of something the other night, he tried to fix it the only way he knew how – trading out of it. In neither case were these two guys trying to steal or run away with anyone else’s money. The firms they worked for allowed them, through a cowboy culture, lax controls and, perhaps, too much trust, to get caught in the vortex. Now those same firms are calling them “unauthorized rogue traders.” That is too simple and too simpleminded of an explanation for such a sophisticated environment.
The clearing firm is the first line of defense for a brokerage firm against unauthorized trading or exposures outside of risk limits. What’s comical is that the Department of Justice, via its letter to the Treasury regarding “vertical clearing house models” wants the US to implement a model for clearing firms like Europe’s, or the one that did not have enough weight or skin in the game to stop Kerviel and SocGen from racking up such big losses. The DOJ is saying that the Chicago Mercantile Exchange’s clearing operation and its relationships and tight straight-through processing model are a problem even though that model was able to put the brakes on the problem at MF Global in less than twelve hours.
I think the Department of Justice is wrong.
Finally, let’s ask ourselves, as we always do on this blog:
Where were the auditors?
MF Global has not been independent and publicly listed for very long, has not issued an audited annual report yet, and does not yet have an obligation to comply with Sarbanes-Oxley. They have issued quarterly financial reports to the SEC, carved out of the Man Group plc reports, but that are unaudited so far. Their CEO and CFO, however have made Sec. 302 certifications to the SEC regarding the firm’s internal controls.
From MF Global’s July 2007 prospectus:
We will be required by Section 404 of the Sarbanes-Oxley Act to evaluate the effectiveness of our internal controls by the end of fiscal 2009 and we cannot predict the outcome of that effort. As a U.S.-listed public company, we will be required to comply with Section 404 of the Sarbanes-Oxley Act by March 31, 2009. Section 404 will require that we evaluate our internal control over financial reporting to enable management to report on, and our independent auditors to audit, the effectiveness of those controls. While we have begun the lengthy process of evaluating our internal controls, we are in the early phases of our review and will not complete our review until well after this offering is completed.
Can’t wait to see how that works out…