Kerviel: The SocGen Rogue Trader And What Is Surprising About 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.

http://en.wikipedia.org/wiki/List_of_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.

http://news.yahoo.com/s/nm/20100608/ts_nm/us_socgen_kerviel

“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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BP Stock Is A Buy After Deepwater Horizon

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This has gone beyond sensible levels, with BP now being asked to pay theoretical costs like those relating to people not visiting Florida beaches which are clean because they might not have been and also the wages of oil workers at other companies who have been laid off because of the moratorium on deepwater drilling. The shares are off 16% overnight, prompting an RNS announcement by the company that it believes the share price move is unjustified by the financial state of the company. RNS stands for Regulatory News Service and is the stock market channel for officially mandated announcements, like this one (dramatic unjustified price action) or other reasons (e.g. someone buys 5% of the company).

This is worse: BN 8:50 *BP 5-YEAR DEFAULT SWAPS SOAR 208 BASIS POINTS TO 594, CMA
SAYS

The CDS (Credit Default Swap) price represents the price of insurance against insolvency of the company. This means the market thinks there is 6% of that now. Unfortunately I am forced to agree. The trade is no longer ‘will the reasonable costs of the cleanup be less than the share price decline?’ – that continues to be true with the latter number now around £49bn. But it is clear that costs way beyond ‘reasonable’ will be imposed because, remarkably, Obama is suffering on approval rating on this more than Bush did with Katrina.

Now I chose to take this risk, I can take the loss and that’s what markets are about. So if I get screwed, it’s no one else’s problem. I am also still confident that if the company survives, it will be worth 650p again in three years. But look at this:

barack-obama-s-attacks-on-bp-hurting-british-pensioners

Of course, the political asymmetry is that none of those people vote in the US. But maybe we need an ad campaign featuring suffering grannies. And maybe this gets diplomatic now. After all, it is hard to see what BP have done wrong here. We are still at the level of punishment being exacted on a no fault basis: if it is proved that BP were negligent in some way, this will kick off. But right now, as far as we know, they were engaged in a legal operation, they conducted it in accordance with regulatory standards, they have worked hard at fixing the problem by various means, it is admitted on all sides that what they are trying to do is unprecedentedly hard and they have paid a lot of compensation claims. What else do the Americans want?

See Also:

What Is “Theory Of Mind?”

John #McDonnell’s Characterisation Of #Finance Is Misconceived

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

83% of Millennials Regret How They Handle Their Finances: Why?

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Where To Cut UK Government Spending: An Alternative Approach

Thanks to Dave H. for pointing me at this IFS document:

The public finances: 1997 to 2010

Now there are two unperceptive ways to come at this document, depending on your political stance. You can claim it proves that Labour spent all the money and the Tories will sort it out. But that forgets that RPI was 18% in the first year of the Thatcher administration – the tired claim then would be to blame Big Jim. Or alternatively, you can say that the recovery is fragile, and severe cuts now endanger it. That ignores the fact that £156bn is not a feasible amount of borrowing every year for five years nor can it be justified, as I previously argued.

Neither of these approaches are useful of course, and this document is more balanced than that. My views are post-political. I have one objective and one only: balance the books. Beyond that, I don’t care who is in Downing Street. Governments of both stripes will fail to tackle the structural deficit while doing other annoying and pointless things. Labour will fail to tackle it while recruiting an unproductive army into the public sector in a version of the payroll vote writ large. The Conservatives will fail to tackle it while being antagonistic in Europe – our largest trading partners. Or maybe this time it’s different…?

People assume I am right wing because I keep wanting to cut social security. But my primary motivation for that is just that we need to cut the deficit and it is the largest slice of the pie, by some distance. So you need a smarter response than just to suggest cutting traditional right wing shibboleth items like defence instead. Because I don’t care. I think probably it would be good to help people in Afghanistan and Iraq, and maybe we do have a security threat emanating from those place, but we probably have to take that risk because we haven’t got enough money for two new aircraft carriers and a Trident replacement.

The second reason for cutting social security is derives from the question: ‘what is it good for?’ I know what I get from the NHS and the Education spend. Both are public sector monoliths which probably waste 1/3 of the money put into them, and we should fix that. But that doesn’t mean that you don’t get a benefit from every pound you put in. In education, you could double the spend and still get results. The law of diminishing returns would only bite seriously when you got to to gold plating levels. But we are a million miles away from that. You could give every child in the country 13 years of one-to-one tuition with a specialist graduate teacher paid £60k plus a £10k bonus per A-grade and you would see immense benefits from that. Likewise with the NHS – put money in, and people will live longer and better. What do I get from social security apart from bribing people who can’t be bothered to feed themselves not to chuck a brick through my window? Why isn’t it a protection racket?

So what does the document say?


“Both parties inherited large structural deficits from their predecessors: 4.8% of national income in 1978–79 and 2.8% of national income in 1996–97.”

“By year 11 of their terms in office, both governments were recording exactly the same structural deficits: 2.6% of national income in both 1989–90 and 2007–08.”

Here’s the problem:

Now the standard left response here is to say that the way this gets completely out of hand after year 11 of the Labour administration is because the bankers are responsible for a global financial crisis. In which case I desire you to point me to the section of the pie charts in
cuts which show bank bailout spending, and also why it isn’t true that the first sign of the crisis was a crash in subprime mortgages in the US. Some bankers may be to blame for that, but not I-banks, and it has more to do with excess saving by the Chinese than anything else. But there is plenty of material in the document for you to use against me if you disagree. I think it’s wrong though, primarily because the situation had got out of hand before the crisis and all of that money will come back and may even make a profit.

“On the eve of the financial crisis, the UK had one of the largest structural budget deficits among either the G7 or the OECD countries and a higher level of public sector debt than most other OECD countries, though lower than most other G7 countries. Most OECD governments did more to reduce their structural deficit during the period from 1997 to 2007 than Labour did. This fiscal position formed the backdrop to the financial crisis.”

That wraps it up for me. So what’s the answer? Slay an equal number of sacred cows on both sides. Cut defence, though it’s only £38bn so it won’t help much. Cut the NHS – even though that will do damage, it is better than cutting education in terms of being economically adverse. Do not cut £1bn out of science spending – it is futile and about the most disadvantageous choice available – the leverage multiple on that will be higher than elsewhere. Leave education spending alone. Which again, only leaves social security as the major source of cuts.

See Also:

What Is “Theory Of Mind?”

John #McDonnell’s Characterisation Of #Finance Is Misconceived

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

The Forthcoming #Bitcoin Crash Will Kill The #Trump Demographic

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The Existence Of The Global Poor Does Not Mean We Can Address No Other Issues

There are arguments based on the fact that many people in the world are poor that says we should do nothing else other than help them. This would have extreme consequences and would be undesirable; all human life would become unbearable

Peter Singer argues that we harm the global poor. By ‘we’, he means those of us living in the developed world, and by ‘harm’ he means actively damage. He is writing in November 1971 at a time of famine in East Bengal. He observes that if I am walking past a drowning baby in a pond, I have a duty to assist even if I might get my expensive suit dirty. He is careful to specify that it is a shallow pond: I am not being required to endanger myself. He compares the aid spend of the Heath administration at that time (£14.75m) with the projected cost of Concorde (£440m, with the out-turn being £1,400m). [You can scale all those numbers up by around 10x if you want to use RPI as an inflator.]

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Thomas Pogge goes further. Everyone in the West is culpable as a result of the industrial revolution being founded on uncompensated asset transfers in colonial times. We must now assist much more than we are currently doing.

Now I don’t agree with the premises but the argument seems valid. Singer says there is no difference between helping the baby and helping someone in sub-Saharan Africa under famine conditions. I think there is a disanalogy in that as Pogge points out, it isn’t just one baby in the pond – there have been 270m deaths from famine in the 15 year period starting in 1990. You can’t save that number of babies from drowning. The 270m number is more than died in combat in the whole of the last century.

I don’t think there is any case for Jobseekers’ Allowance to be paid in this country, at least while there are any job vacancies. You will doubtless disagree with me and saying I am being too harsh, and that people have a human right to work. I also disagree with that, but it doesn’t matter. Because the question for you is how to deal with the Singer and Pogge argument if you think there is a human right to work or to subsistence at the expense of others. Then:

Why is it OK to spend money on people in Bolton to keep them alive but not in Africa?

Singer wants us to spend maybe 25% to 40% of GDP on aid. He doesn’t want to use all of it because he admits that that would be counterproductive – it would be better to retain a strong economy than overtax it. But then in a variant of the above question, which is phrased for physicists since that was whom I was in the JB with last night, is:

Why is it OK to spend £5.6bn on the LHC when people are starving?

I have given my response to this. If you want to deny my exit is conscionable, then you will need a different answer. Maybe you want to say something like ‘ we should look after the people who are already here first’. But do you really want to say that? Why does conscience end at the borders, if it exists and produces duties? Why should people fortunate enough to be born here get looked after? Aren’t you dangerously close to saying ‘we should look after the people who look like me’? Or are you saying ‘I can see that homeless person so I should help him’ while people you can see only on television who are much worse off can be safely ignored…?

So I would announce the end of Jobseekers’ Allowance in three months with a three month transition period after that. I don’t mind weakening it if you don’t think I have a right to insist that people move – the phase out can occur only to the extent that there are no jobs locally available if you like. Note that this is not Incapacity Benefit – paid to those who medically cannot work – or Carers’ Allowance – paid to those looking after someone. I have said nothing about those benefits.

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I think if we must spend this money, it is morally better spent in Africa and even the economics say so. It is mathematically the case that almost 3 of those 270m people were the smartest person in 100m. I don’t know of any reason why people with the capacities of an Einstein wouldn’t be born anywhere in the world. Shouldn’t we be finding those people and helping them? You can be as smart as Einstein and also incredibly diligent; it won’t help you or us if you don’t make it to three months old.

See Also:

What Is “Theory Of Mind?”

Jacob Rees Mogg Is Wrong To Say That Loss of Passporting Will Not Be A Problem For The City

#Norway Is Still A Safe Investment Option

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

UK Government Spending: Where It Needs To Be Cut And Why

This is a pair of pie charts showing the UK Government’s income and expenditure from a couple of months ago. This will doubtless be revised after the emergency budget on 22 June. You can see the size of the problem here. The difference between cash in and cash out is made up by borrowing. At the time these graphs were were produced, the gap was £704bn – £541bn = £163bn.

These numbers are generally expressed as a proportion of GDP. The limit under the Maastricht criteria was 3%. The UK is not in the Eurozone, but reports these numbers anyway. The situation improved somewhat recently to around £156bn p.a., but that is still bad at 11.6% of GDP.

UK borrowing below forecast, still worst since WWII

The questions are these.

Justification

Why is it OK for some people to spend other people’s money? If we continued on the previous path without cutting public spending, we would borrow maybe an additional £1,000bn over the course of a parliament. It would take probably 40 or 50 years to pay that back at best. We are spending it now, but will not hang around to pay it back. Why should people graduating with me this year have to pick up that tab?

Do we need cuts?

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There are still people who want to borrow more and spend more. “Now is not the time to be making severe cuts to the economy. Cuts too deep and too soon risk the economy falling back into recession,” said Brendan Barber, TUC general secretary, which has warned that the plans could increase unemployment and the benefits bill. Well, that’s true – but what is the alternative?

Where to cut?

If you want to solve a cashflow problem, you have to reduce spending and increase income (or taxes). The government has decided this split will be 80/20. If you want to do something serious about this problem, you have to look at the largest item, which is by far social security spending at £231bn p.a. on the above pie charts.

To put that in perspective, the LHC, which is the most expensive scientific experiment ever built, cost £5.6bn.

http://en.wikipedia.org/wiki/Large_Hadron_Collider#Cost. What would the UK economy be like if we built 41 LHC’s in Leeds every year?

See Also:

What Is “Theory Of Mind?”

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

Where To Cut UK Government Spending: An Alternative Approach

Where To Cut UK Government Spending: An Alternative Approach

Problems With Quantitative Easing

So the G20 has worked out we need to stop pumping money in and start repairing the fiscal balances of governments. A good move. Even Strauss Kahn, who has been frankly a bit overly French on this, is on board with the change. Surprisingly, it seems to have been the Americans who have been dragging their feet the most.

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Still waiting for the Hungarian shoe to drop properly. Maybe that is containable since they are not in the Eurozone, but when the spokesman for the Premier says that talk of sovereign default is ‘not exaggerated’ you know things are serious.

The G20 also dropped the idea of a global bank levy, saying rather disingenuously that it would be up to individual countries to take their own steps. That’s disingenuous because the whole point is that you can’t do something like that unilaterally because it won’t be effective and it will be counterproductive.

Merkel’s ban on naked shorts (should be policy also for German holidaymakers) was a brilliant move if you were seriously interested in relocating three desks worth of traders from Frankfurt to London for a short period. If that wasn’t high on your policy agenda, then…not sure what you get.

Populist driven economic policy is generally even worse than the democratic outcomes elsewhere because people are actually actively bad at economics as opposed to merely being poorly informed and generally uninterested as in other spheres.

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So what does this mean? Markets seem to have been spooked more by poor NFP numbers out of the US than anything else yesterday, but in any case not enough may have been known during opening hours – the G20 communique is reported as of lunch time today. So we’ll see on Monday. And also whether this top cap thing in the Gulf is going to work.

See Also:

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

UK Government Spending: Where It Needs To Be Cut And Why

Where To Cut UK Government Spending: An Alternative Approach

John #McDonnell’s Characterisation Of #Finance Is Misconceived

#Norway Is Still A Safe Investment Option

Norway and NOK: yes

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So the next question is where can I avoid getting killed since the whole world is blowing up? People keep asking me this. Also there is some kind of idea that because not all currencies can go down together (true) it doesn’t matter where you are (false).

In the US and the UK, there are totally unsustainable borrowing profiles which are politically extremely hard to shift in a democracy. Much of the US budget is entitlement spending; an operational leverage effect that results from that means that any serious cuts have disproportionate effects on the remaining programmes. I still like the US in general because it has the world’s most dynamic economy and the politicians may be smarter than the population and understand that cutting back on immigration is rather bad demographic economics. But you can’t really park there.

In the UK, we have bizarrely just lost the Chief Secretary of the Treasury to a rental payment scandal in which one cannot be sure that his treatment would have been identical had he been heterosexual. He was looking very credible at cutting sufficiently to retain the Aaa rating – which is essential if this borrowing profile of a rather insane £156bn p.a. can come off with some kind of glide path down rather than a hard stop – but we now have the former Press Officer for the Cairngorms who will presumably be just as effective at putting The Fear into Work and Pensions and their £230bn annual spend.

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So no GBP and no USD. EUR? Well, there’s Greece. And Spain. And now Hungary. So forget it. It might make holidays cheaper again, but that’s the only benefit.

All three of these problems have a long way to go before being resolved.

So nothing is left, right? No – there is Norway. Seriously. Why?

No debt

They have no government debt and so they do not pay interest on it – cf. UK annual debt service £43bn.

Big surplus

Even more amazingly, they have saved their oil revenue in a big pension fund worth about $443bn. They own about 2% of equity in Europe.

Own currency

The NOK has a number of great things going for it, including the huge pension pot, but also: it isn’t the EUR, the GBP or the USD.

So what should you do? Well, you could just buy the NOK and sit still waiting for the rest of the world to crater. You would probably make out in local CCY terms. But there are proper companies there doing serious things you could look at. These two have NYSE listings:

NYSE Global Listings

NYSE Technologies Global Market Data | as of 17:08 ET 03 Jun 2010 | Market data delayed
Name Symbol Listing Last Trade Date/Time Volume Change % Change
Seadrill Limited SDRL NYSE $ 21.20 03Jun10 16:48 ET 1,262,094 $ 0.41 1.97
Statoil ASA STO NYSE $ 20.96 03Jun10 16:02 ET 2,038,401 $ 0.35 1.69

You can guess what they do.

So you could even sit there and gain from any NOKUSD strength without lifting a finger or going to Oslo.

See Also:

What Is “Theory Of Mind?”

The Existence Of The Global Poor Does Not Mean We Can Address No Other Issues

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

How To Profit From Thorium