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Kerviel: How He Got Away With It

Jerome Kerviel, accused of being a rogue trader, is now on trial. SocGen lost $7bn in the incident which heads the list of major trading losses.

How did he do it?

This is actually a very similar situation to Nick Leeson at Barings – number 11 in the top list. They were both involved in forms of arbitrage, which exploits tiny differences in price which ‘shouldn’t’ really be there. In fact, pricing theory fairly obviously requires that there can’t be a price difference between two identical items. If that were false – say if one loaf of bread had a different price to an identical one – then I could make a risk free profit by buying at the low price and selling at the high price. And there can’t be a risk free profit because everyone would pile in. You can see that what would happen would be that the prices would equalise.

Now this is what the arbitrageurs exploit. It all hinges on what ‘identical’ means. Not quite identical introduces some risk. Leeson was buying one product in Osaka and selling the same product in Singapore. Clearly if the product is the same, exactly, there is no risk. You might ask what might cause a price difference – there might be transient local factors such as someone big in Osaka decides to buy something. And then there could be a delay before Singapore catches up. And that catch-up process is exactly what the arbs do.

Kerviel was involved in arbing equity index futures and underlying equities. Equities are stocks, indices are groups of stocks like the FTSE-100 and equity index futures is just a bet on where the FTSE-100 will be in six months from now. Clearly you can do that on a risk free basis if you, say, sell the index and buy all the stocks in it. [Incidentally, if you want to be an insider trader but don’t want to go to prison, maybe you could buy an index in which the stock you can’t trade figures and then sell everything in the index except the one you aren’t allowed to trade…but I don’t recommend it…]

Why is it dangerous?

There are two common factors between this case and Leeson. In both, the alleged misdeeds were possible because the trader and the back office person were effectively the same person. Leeson actually did his own monitoring, an extraordinary failure which rightly cost the jobs of many at Barings. I could go further and say it was so remarkable that everyone involved in the company deserved to lose all their cash, but I know there were lots of Barings debentures held by grannies and I suspect we can’t expect them to have known what they were doing. While Kerviel came from back office himself and knew the control systems and would have known how to defeat them. I also will claim that back office types are rather easy for front office traders to browbeat and this history will have played a part in Kerviel’s psychology and the desire to get somewhere fast.

Secondly, because you are exploiting tiny price differences, you need to trade in vast amounts. And all the time. The control problem comes when you do not have offsetting equal and opposite trades but wind up taking huge uncovered positions. Leeson sorted this out with a fax purportedly evidencing a large receivable from a hedge fund. Towards the end, he was drawing in funding from all over Asia, which should have alerted someone.

What is odd about this case?

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You can’t make large amounts of money from arbitrage. You just can’t, because risk and reward are closely linked. You can see from the loaf of bread example that that has to be true. So if you are a manager in an I-bank, you need to get very concerned if your arbitrage desk is making large profits.

Now this leads to the strange consequence that Kerviel must have been concealing large profits. And this is what you see.

“During the largely procedural first day of the trial, Kerviel’s lawyer said Societe Generale would have been clearly able to see data showing Kerviel’s extraordinary profits of 1.4 billion euros at the end of 2007”

Note that this is profit not revenue, and that SocGen as a whole might typically make a net profit around EUR600m in a quarter. Do you think you could spot Kerviel in there?

“Seated on a plastic chair in front of rows of lawyers in black garb, the ex-trader said his annual salary at Societe Generale was 48,000 euros in 2006 with an annual bonus of 60,000 euros”

Now that is not a lot of money for traders. They might typically expect to make 5% to 10% of what they produce, or more in some cases where they are reliably producing large returns. Apparently Kerviel was expecting to make EUR300,000 for 08, on a declared profit of EUR60m. That’s a 0.5% return. You can see that this is not enough. Someone with that type of track record could just set up on their own, use the track record to raise funds, and trade themselves for maybe 50%. There is another type of arb there.

The GBPEUR exchange rate in 07 was 0.67, so we are talking about someone earning a salary of £32k. This is not far north of what we used to pay graduate trainees in London. So what we have here is someone being paid back office amounts, a French I-bank culture in which you shouldn’t really pay very much or have high quality people, and back office resentment of the flash and the furious.

“Lawyers also read a transcript of a conversation between Kerviel and SocGen’s ex-investment bank chief Jean-Pierre Mustier when the scandal broke, in which Mustier reportedly said: “If you won 1.4 billion euros, that means you’re very good. What you did was a pain, but it’s not a big deal.”

If Kerviel can make that out, then Mustier has failed in a stunning way to understand what arbitrage is. It is a French word, after all. It may be difficult to see how Kerviel can avoid jail, but he cannot have been on his own in this one.

See Also:

What Is “Theory Of Mind?”

The Late Evaluation Effect And Financial Markets

The Psychology of Successful Trading: see clip below of me explaining my new book!

The RMT Is Right, Just This Once

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By Tim Short

I am a former investment banking and securitisation specialist, having spent nearly a decade on the trading floor of several international investment banks. Throughout my career, I worked closely with syndicate/traders in order to establish the types of paper which would trade well and gained significant and broad experience in financial markets.
Many people have trading experience similar to the above. What marks me out is what I did next. I decided to pursue my interest in philosophy at Doctoral level, specialising in the psychology of how we predict and explain the behaviour of others, and in particular, the errors or biases we are prone to in that process. I have used my experience to write The Psychology of Successful Trading. In this book, I combine the above experience and knowledge to show how biases can lead to inaccurate predictions of the behaviour of other market participants, and how remedying those biases can lead to better predictions and major profits. Learn more on the About Me page.

8 replies on “Kerviel: How He Got Away With It”

In fact, here are some graduate numbers from 04. Naturally this predates the crisis. You can index them up for a couple of years to compare with Kerviel’s £32k.

“However, for European analysts at least, the bad news is that base pay will be almost the same in 2005 as 2004, at £35,000. Sign-on bonuses and year-end bonuses may take this to around £40,000 to £45,000; summer interns can expect around £450 per week. ‘At the end of the day, base salaries in investment banking haven’t changed for a while,’ comments one recruiter.”

Note the disappointed tone both about the state of the market and the relatively higher US salaries. Why is Kerviel happy with less than graduates get in London?

Looks that way. Wikipedia says he had a BA in Finance and a Masters in back office finance management. His first job was with SocGen, where he joined the back office in 2000. In 2005, he became a trader and it looks like the world ended pretty much immediately…

Wikipedia incidentally has higher salary numbers for him than are mentioned in the court case. So either there is an error, or it is a different year. In any case, the amounts involved are relatively modest.

It does seem that he has not personally benefited in any significant way, beyond one or two bonuses which were not immense. Leeson also did not conduct fake trades directly to benefit himself, but did of course rack up some decent bonuses on the back of fake results. The Baring’s managers referred to him as a ‘turbo-arbitrageur’ which looks pretty hollow in the light of my previous remarks.


Worth noting that French banks are remarkably stingy with regards to pay (relatively speaking). Across the Street, for a FO position, entry level pay starts at around £40-45k base, with maybe another £10-15 in bonuses. Soc Gen and BNP are, as far as I know, offering around £27-28k base to their new recruits. If there is a disparity in pay between the US and Europe, there seems to be an even larger one between US banks and their European counterparts (exc. the Swiss- CS/UBS).

Good post. An interesting blog. Do please continue.


Hi –

Yes, that looks about right. The French numbers look a little low to me, but that could well be a reflection of the world changing in general and in particular, the Kerviel effect will not have acted to lift starting salaries at French banks though of course I would argue it should have done. CSFB of course believes it is equally US/European as it has an approximately equal business footprint in both geographies – which should be a USP – and maybe UBS are brought along with them. In general the advice to new starters at I-banks is to ignore the initial compensation levels because if you survive three years, you will then double it every year – but I think those French levels would indicate that there is no intention to match the street either to begin with or later and so it could only be recommended if there was significant extra job security or there were no other options available to the individual concerned.

In the long run, I can’t see how it is sustainable for them. Granted profits have been hit hard and they don’t have the same rep or market cap as say GS/MS/JPM, but they will see that continually depressing salaries is going to lead to a brain drain; as it has already at RBS. These sorts of tough measures cannot work if they are only imposed unilaterally. Looks for all intents and purposes to be about putting out the right image until the Daily Mail readers stop carding about IB salaries.

Out of interest, I see that you’re a Phil student. Do you do still do any active trading or are you now more of commentator?


The great thing about things that are unsustainable is that they do not continue! But yes, there is a very clear discontinuity between the public interest at RBS – maximise the value of the public shareholding but because of political sensitivities, bear down on bonuses. This is exactly the reason why public ownership is unhelpful.

The French are very good at derivatives in London – I don’t say that ironically because of Kerviel – and I think there is a difference between how things happen in Paris and London. I would not go so far as to say that Kerviel could not have happened in London, but there would be much more competition for a front office slot and thus higher quality people. I should be careful about using the word quality here. After all, if you had been Kerviel and known that your legitimate rewards would be maybe 0.5% of what you made, then doing what he did is actually the smart response. As far as I can see, the exceeding of limits is not the Leeson gradual build up – Leeson claims in his book, and I believe him, that the first use of the infamous 88888 error account was to cover for a junior who got on the wrong end of a client order for 20 contracts by accident. Kerviel seems to have joined up and immediately started ramping up orders of magnitude beyond his limits. Also Leeson was very unlucky with the Kobe earthquake. But anyway, the only way to solve all of this is to let the market decide what to pay people.

On whether I am active, yes and no. I still trade for income, but I decided about 14 months ago after a couple of very good Gilts trades that the right response to market dislocation was to park almost all my cash on deposit for two years. So the BP stuff is just for fun. So if you like I am active but currently voluntarily on the sidelines.

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