portfolio

le cas jerome kerviel

Sun, 25 May 2008 18:44:11 GMT

Rapport de synthèse du cas jerome kerviel.

L’Inspection générale (SEGL/INS) a été saisie par le Comité exécutif du Groupe le 24 janvier 2008 pour conduire une mission d’investigation sur la fraude opérée par Jérôme KERVIEL (JK), trader au sein de l’activité de dérivés actions sur le marché des warrants « turbo » (Cf. Focus n°1).
L’objet de la mission, validé par le Comité spécial du Conseil d’administration de la Société Générale, a consisté à (i) décrire le mécanisme de la fraude afin de vérifier que les montants de positions et de perte calculés par SG CIB étaient exacts, (ii) rechercher les motivations et éventuelles complicités de JK, (iii) identifier les dysfonctionnements des contrôles et les responsabilités à l’origine de la détection tardive de la fraude, (iv) vérifier que de telles fraudes n’existent pas sur d’autres périmètres de SG CIB.
S’agissant des dysfonctionnements et des responsabilités, notre étude ayant exclusivement porté sur le périmètre de la fraude, nos conclusions ne s’appliquent qu’à la table DELTA ONE, au sein de laquelle JK opérait, et son environnement immédiat. L’organisation de SG, notamment celle de DELTA ONE, est présentée en Focus n°2 (Présentation de l’organisation SG).
Le présent rapport dresse les conclusions de la mission au 20/05/2008, les travaux sur la fraude ayant été achevés à cette date (1).

(1) Nos travaux de rapprochement n’ont pas pu être menés à leur terme s’agissant des positions titres en raison de travaux de réconciliation transversale en cours chez OPER. Nos travaux n’ont pas non plus couvert de manière exhaustive l’étude des suspens cash, leur traitement n’étant pas différencié selon le centre opératoire. Enfin, nous avons concentré nos travaux d’écoute des bandes téléphoniques et de revue de boites e-mails sur les interlocuteurs et périodes clés mais n’avons pas couvert de manière exhaustive la période 2005 – 2008 pour l’ensemble des protagonistes.

Capital Market Line

Sun, 10 Feb 2008 06:43:16 GMT

How Leeson Broke Barings part 3

The BoBS report notes "In each instance, the entries in the Contac system reflected a number

of spurious contract amounts at prices different to those transacted on the floor,

reconciling to the total lot size originally traded. This had the effect of giving

the impression from a review of the reported trades in account '92000&' that these had taken place at different times during the day. This was necessary to deceive Barings Securities Japan into believing the reported profitability in account '92000' was a result of authorised arbitrage activity. The effect of this manipulation was to inflate reported profits in account '92000&' at the expense of account '88888', which was also incurring substantial losses from the unauthorised trading positions taken by Leeson. In addition to crossing trades on SIMEX between account '88888&' and the switching accounts, Leeson also entered fictitious trades between these accounts which were never crossed on the floor of the Exchange. The effect of these [off-market trades, which were not permitted by SIMEX], was again to credit the 'switching' accounts with profits whilst charging account '88888' with losses."

The bottom line of all these cross-trades was that Barings was counterparty to many of its own trades. Leeson bought from one hand and sold to the other, and in so doing did not lay off any of the firm's market risk. Barings was thus not arbitraging between SIMEX and the Japanese exchanges but taking open (and very substantial) positions, which were buried in account '88888'. It was the profit and loss statement of this account which correctly represented the revenue earned (or not earned) by Leeson. Details of this account were never transmitted to the treasury or risk control offices in London, an omission which ultimately had catastrophic consequences for Barings shareholders and bondholders.

Figure 10.3², below, shows the number of cross-trades executed by Leeson. It is the difference between the solid line which represents all the Nikkei trades of account '92000' not crossed into account '88888' and the broken line which reflects the position Leeson reported to Barings management. The figure graphically illustrates the chasm between reported and actual positions. For example, Barings management thought the firm had a 'short' position of 30,112 contracts on SIMEX on 24 February; in fact it was long 21,928 contracts after ignoring the trades crossed with account '88888'.

Figure 10.3 Graph to show the Nikkei Position of Account '92000'. Reproduced by permission from the Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings.

Footnotes:

1, 2) Report of the Banking Supervision Inquiry into the Circumstances of the Collapse of Barings, Ordered by the House of Commons, July 1995, Her Majesty's Stationery Office, London

The Security Market Line

Sat, 09 Feb 2008 06:52:53 GMT

How Leeson Broke Barings part 2

But Leeson's Osaka position, which was public knowledge since the OSE publishes weekly data, reflected only half of his sanctioned trades. If Leeson was long on the OSE, he had to be short twice the number of contracts on SIMEX. Why? Because Leeson's official trading strategy was to take advantage

of temporary price differences between the SIMEX and OSE Nikkei 225 contracts. This arbitrage, which Barings called 'switching', required Leeson to buy the cheaper contract and to sell simultaneously the more expensive one, reversing the trade when the price difference had narrowed or disappeared. This kind of arbitrage activity has little market risk because positions are always matched.

But Leeson was not short on SIMEX, infact he was long approximately the number of contracts he was supposed to be short. These were unauthorised trades which he hid in an account named Error

Account 88888. He also used this account to execute all his unauthorised trades in Japanese Government Bond and Euroyen futures and Nikkei 225 options: together these trades were so large that they ultimately broke Barings. Table 10.1 gives a snapshot of Leeson's unauthorised trades versus the trades that he reported.

For the rest of the chapter, contracts will be discussed or converted into SIMEX contract sizes.

Unreported positions (Fact)

The most striking point of Table 10.1 is the fact that Leeson sold 70,892 Nikkei 225 options worth about $7 billion without the knowledge of Barings London. His activity peaked in November and December

1994 when in those two months alone,

Futures
Table 10.1	Fantasy versus Fact: Leeson's Positions as at End February 1995.
	Number of contracts¹ nominal value in US$ amounts		Actual position in terms of open interest of relevant contract²
	Reported³	Actual⁴
Nikkei 225	30112 $2809 million	long 61039 $7000 million	49% of March 1995 contract and 24% of June 1995 contract.
JGB	15940 $8980 million	short 28034 $19650 million	85% of March 1995 contract and 88% of June 1995 contract.
Euroyen	601 $26.5 million	short 6845 $350 million	5% of June 1995 contract, 1% of September 1995 contract and 1% of December 1995 contract.
Options
Nikkei 225	Nil	37925 calls $3580 million 32967 puts $3100 million
1. Expressed in terms of SIMEX contract sizes which are half the size of those of the OSE and the TSE. For Euroyen, SIMEX and TIFFE contracts are of similar size. 2. Open interest figures for each contract month of each listed contract. For the Nikkei 225, JGB and Euroyen contracts, the contract months are March, June, September and December. 3. Leeson's reported futures positions were supposedly matched because they were part of Barings' switching activity, i.e. the number of contracts on either the Osaka Stock Exchange, the Singapore International Monetary Exchange or the Tokyo Stock Exchange. 4. The actual positions refer to those unauthorized trades held in error account '8888'. Source: The Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings, Ordered by the House of Commons, Her Majesty's Stationery Office, 1995

he sold 34, 400 options. In industry parlance, Leeson sold straddles. i.e. he sold put and

call options

with the same strikes and maturities. Leeson earned premium income from selling well over 37,000 straddles over a fourteen month period. Such trades are very profitable provided

the Nikkei 225 is

trading at the options' strike on expiry date since both the puts and calls would expire worthless. The seller then enjoys the full premium earned from selling the options. (see Fig 10.2 for a graphical presentation of the profit and loss profile of a straddle.) If the Nikkei is trading near the options' strike

on expiry, it could still be profitable because the earned premium more than offsets the small loss experienced on either the call (if the Tokyo market had risen) or the put (if the Nikkei had fallen.).

Figure 10.2 Payoff Profile of a Straddle.

covariance

Fri, 08 Feb 2008 07:15:40 GMT

How Leeson Broke Barings

The activities of Nick Leeson on the Japanese and Singapore futures exchanges, which led to the downfall of his employer, Barings, are well-documented. The main points are recounted here to serve as a backdrop to the main topic of this chapter - the policies, procedures and systems necessary for the prudent management of derivative activities.

Barings collapsed because it could not meet the enormous trading obligations, which Leeson established in the name of the bank. When it went into receivership on February 27, 1995, Barings, via Leeson, had outstanding notional futures positions on Japanese equities and interest rates of US$27 billion: US$7 billion on the Nikkei 225 equity contract and US$20 billion on Japanese government bond (JGB) and Euroyen contracts. Leeson also sold 70, 892 Nikkei put and call options with a nominal value of $6.68 billion. The nominal size of these positions is breathtaking; their enormity is all the more astounding when compared with the banks reported capital of about $615 million.

The size of the positions can also be underlined by the fact that in January and February 1995, Barings Tokyo and London transferred US$835 million to its Singapore office to enable the latter the meet its margin obligations on the Singapore International Monetary Exchange (SIMEX).

Reported activities (Fantasy)

The build-up of the Nikkei positions took off after the Kobe earthquake of January 17. This is reflected in Figure 10.1 - the chart shows that Lesson's positions went in the opposite direction to the Nikkei - as the Japanese stock market fell, Leeson's position increased. Before the Kobe earthquake, with the Nikkei trading in a range of 19,000 to 19,500, Leeson had long futures positions of approximately 3,000 contracts on the Osaka Stock Exchange. (The equivalent number of contracts on the Singapore International Monetary Exchange is 6000 because SIMEX contracts are half the size of the OSE.) A few days after the earthquake Leeson started an aggressive buying programme which culminated in a high of 19,094 contracts reached about a month later on February 17.

Figure 10.1 Baring's Long Positions against the Nikkei 225 Average.
Source: Datastream and Osaka Securities Exchanges

minimum-variance frontier

Thu, 07 Feb 2008 06:35:21 GMT

Lack of supervision

Theoretically Leeson had lots of supervisors; in reality none exercised any real control over him. Barings operated a 'matrix' management system, where managers who are based overseas

report to local administrators and to a product head (usually based at head office or the regional headquarters). Leeson's Singapore supervisors were James Bax, regional manager South Asia and a director of BFS, and Simon Jones, regional operations manager South Asia, also a

director of BFS and chief operating officer of Barings Securities Singapore. Jones and the heads of the support functions in Singapore also had reporting lines to the Group-wide support functions in London. Yet both Bax and Jones told the BoBS inquiry that they did not feel operationally responsible for Leeson. Bax felt Leeson reported directly to Baker or Walz on trading matters

and to Settlements/Treasury in London for backoffice matters. Jones felt his role in BFS was limited only to administrative matters and concentrated on the securities side of Barings' activities in South Asia.

Leeson's reporting lines for product profitability are not clear cut since his supervisors have disputed who was directly responsible for him from January 1, 1994. His ultimate boss was Ron Baker, head of the financial products group. But who had day-to-day control over him? Mary

Walz, global head of equity financial products, insists that she thought Fernando Gueler, head of equity derivatives proprietary trading in Tokyo was in charge of Leeson's intra-day activities since the latter's switching activities were booked in Tokyo. However, Gueler insists that in October 1994, Baker told him that Leeson would report to London and not Tokyo. He thus assumed that Walz would be in charge of Leeson. Walz herself still disputes this claim. Tapes of telephone conversations show that Leeson spoke frequently to both Gueler and Walz. (The bottom line however is that Gueler reported to Walz.)

Two important incidents vividly illustrate the cavalier attitude Barings had towards supervising Leeson. The first involves two letters to BFS from SIMEX. In a letter dated 11 January, 1995; SIMEX senior vice-president for audit and compliance Yu Chuan Soo, complained about a margin shortfall of about US$116 million in account '88888' and that Barings had appeared to break SIMEX rule 822 by previously financing the margin requirements of this account, (which appeared in SIMEX's system as a customer account.) SIMEX also noted that the initial margin requirement of this account was in excess of US$342 million. BFS was asked to provide a written explanation of the margin difference on account '88888' and of its inability to account for the problem in the absence of Leeson.

No warning lights went off in Singapore. No one investigated who this customer really was and why he was having difficulties in meeting margin payments or why he had such a huge position;

or the credit risk Barings faced if this 'customer' defaulted on the margins that Barings had paid on its behalf. A copy of the letter was not sent to operational heads in London. Simon Jones did not press Leeson for an explanation; indeed he dealt with the matter by allowing Leeson to draft Barings' response to SIMEX.

The second incident did come to the attention of London but again was dealt with unsatisfactorily, perhaps because Barings' personnel themselves are unsure about what really happened. At the beginning of February 1995, Coopers & Lybrand brought to the attention of London and Simon Jones the fact that US$83 million apparently due from Spear, Leeds & Kellogg, a US investment group, had not been received. No one is sure how this multi-million dollar receivable came about. One version of events is that BFS, through Leeson, had traded or broked an over-the-counter deal between Spear, Leeds & Kellogg, and BNP, Tokyo. The transaction involved 200 50,000 call options, resulting in a premium of 7.778 billion (US$83 million). The second version was that an 'operational error' had occurred; i.e. a payment had been made to a wrong third-party in December 1994.

Both versions had very serious control implications for Barings. If Leeson had sold or broked an OTC option, then he had engaged in an unauthorised activity. Yet he was not admonished for doing so; nor is there any record of Barings' management taking any steps to ensure that it did not happen again. If the SLK receivable was an operational error, Barings had to tighten up its back-office procedures.

isovariance

Wed, 06 Feb 2008 07:02:25 GMT

Market risk

Because Leeson controlled the back office and because Barings had no independent unit checking the accuracy of his reports, the market risk reports generated by Barings' risk management unit and passed on to ALCO were inaccurate. Leeson's futures positions showed no market risk because trades were supposedly offset by opposite transactions on another exchange. Peter Baring and Baring shareholders have learnt too painfully the meaning of 'garbage-in, garbage-out' because a system is only as good as the data it receives

Multistage Stochastic

Tue, 05 Feb 2008 07:09:03 GMT

Credit risk

The credit risk implication of the client advances represented by the 'top-up' balances was significant if the total funds remitted to Singapore was to meet genuine client margin calls. Yet the Credit risk department did not question why Barings was lending over US$500 million to its clients to trade on SIMEX, and collecting only 10% in return. It did not seem to have an idea of who these clients were, yet Barings' financial losses would have been significant if some of these clients defaulted.

The Credit Committee under George Maclean insists that it was Baring's policy to finance client margins until they could be collected. But no limit per client or on the total 'top-up' funds was set. Indeed clients who were advanced money this way appear not to have undergone any credit approval process.

The Credit Committee never formally considered the credit aspects of the 'top-up' balance although they could see the growth of these advances as recorded on the balance sheets. Plainly put, the credit risk controls of Barings Securities were shambolic.

Skewness

Mon, 04 Feb 2008 16:08:32 GMT

Poor control procedures

Funding

Barings' control procedures were sloppy. No where is this point better illustrated than in the way it funded BFS (or more accurately Leeson's unauthorised positions). Barings did not require Leeson, to distinguish between variation margin needed to cover proprietary and customer trades; neither did it have a system to reconcile the funds Leeson requested to his reported positions and/or that of its client positions. (The London office for example could have used the Standard Portfolio Analysis of Risk (SPAN) margining programme to calculate margins and would then have realised that the amount of money Leeson was requesting was significantly more than that called for under Simex's margining rules.) London simply, automatically, remitted to Leeson the sum of money he asked for, despite misgivings felt by many senior operational staff about the accuracy of his data.

The fact that no one even asked Leeson to justify his requests is all the more astounding given the size of his demands. At the end of Dec 1994, the cumulative funding of BFS by Barings London and Tokyo stood at US$354 million. In the first two months of 1995, this figure increased by US$835 million to US$1.2 billion.

The BoBS inquiry team notes, "We described...how [Tony] Railton [Futures and option settlements senior clerk] discovered in February 1995 that the breakdown of the total US Dollar request was meaningless, and that the BFS clerk knew the total funding requirement for that day and made up the individual figures in the breakdown to add up to the required total." From November 1994, BFS usually requested a round sum number split equally between US dollars for client accounts and proprietary positions. The BoBS team notes, "Tony Hawes [group treasurer] confirmed that he identified this feature of the requests: 'That was one of the main reasons why during February 1995 I paid two visits to Singapore.' If the US Dollar requests had been in relation to genuine positions taken by clients and house [Barings itself], on any one day we consider it unlikely for the margin requests for these two sets of positions to be identical; as for having the requests split 50:50 most days, this is in our view is beyond all possibility. Tony Hawes appears to agree with this view. He told us that: 'It was just one of the factors that made me distrust this information... It was quite too much of a coincidence. ...Throughout I put it down to poor book-keeping and sloppy treasury management in Barings Futures [BFS].

"David Hughes [Treasury Department manager] also told us that the 50:50 split: 'was a cause for concern...we said, this cannot be right.' He explained that: 'I do not think we could have house positions and client positions running totally in tandem.' [Brenda] Granger [manager, futures and options settlements] confirmed that she would have spoken to Hughes about the split. She added: 'We would joke about Singapore, -Why don't we send somebody's mother [anyone] out there to run the department since Nick is so busy now?".

Staff in London could not reconcile funds remitted to Singapore to both proprietary in-house and individual client positions. But no remedial action was taken. Their cavalier attitude to reconciliation is illustrated by Figure 10.4³ which shows total funds remitted to Singapore ostensibly to pay customer margins. place fig 10.4 here

The solid line in Figure 10.4 shows the total funds sent to BFS by Barings Securities London (BSL) - the entity to which all customer trades of London were booked; the broken line the amount of money funded by Barings Securities Group Treasury in London, this funding was known in the firm as the 'top-up' balance. The Group Treasury advanced this money, on behalf of clients, because it was not always possible for clients to transfer money to Barings in time to meet SIMEX intra-day margin calls. (The bank was expected to recover from clients these advances as quickly as possible.) Figure 10.4 shows that BSGT had to consistently advance a substantial portion of the funds earmarked for margins for client positions. The graph shows that from 1 January to 24 February 1995, the proportion of genuine client moneys which were transferred to BFS fell as a proportion of the total funding Indeed on 21 February 1995, BSGT had to advance all the client margins of some US$440 million. On 24 February, only US$50 million of the US$540 million sent to Singapore to cover client positions had been recovered from individual clients (i.e. the difference between the solid and broken lines). Barings control did not reconcile the top-up payments to individual client balances - if it did it would have discovered that it was sending out far too much money just to cover the margin calls of clients.

Figure 10.4 Top-up Funding from BSGT to BSL and Margin Balances from BFS from 1 January 1995. Reproduced be permission from the Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings

Linear regresion

Sun, 03 Feb 2008 06:46:35 GMT

Adequate capital

There are two aspects to this issue - an institution must have sufficient capital to withstand the impact of adverse market moves on its outstanding positions as well as enough money to keep these positions going. Barings management thought that Leeson's positions were market neutral and were thus quite happy to fund margin requirements till the contracts expired. In the end, these collateral calls from SIMEX and OSE proved too much to bear (as was pointed out earlier, they were larger than Barings' capital base) and the 200-year old institution was forced to call in the receivers. It was funding risk that seriously wounded Barings but the terminal shot came from the discovery that the enormous positions were unhedged.

Funding risk also nearly sank Metallgesellschaft, a German industrial company, in 1993. In that year alone, Metallgesellschaft's US subsidiary paid out $900 million in margins for its crude oil hedges on NYMEX. When the American subsidiary asked for a cash infusion to meet further margin obligations, the parent refused and closed out the NYMEX contracts at a loss. The latter only survived because a consortium of German banks quickly put together a rescue package of $2 billion.

Both the Barings and Metallgesellschaft stories highlight the need for institutions to pay more attention to the interim funding needs of hedged and semi-hedged positions. But the parallel ends here. Baring's senior managers continued to fund Leeson's activities because they thought they were paying margins on hedged positions (as well as those of their clients) whereas they were actually losing money on outright bets on the Tokyo stock market. Metallgesellschaft, on the other hand, refused to grant any more interim finance because they thought they were losing money on contracts which were infact bona fide hedges for the company's long-term obligations. Both incidents illustrate the need for senior managers to be more knowledgeable about hedged positions because the issues facing them are complex in many cases.

As it turned out Barings had significant market risk from its naked positions so even if it had managed to borrow enough money to cover its margin costs till the contracts expired, it would have been unable to withstand the substantial losses it would suffer on expiry. Agents appointed by Barings' administrators closed out the contracts at losses totalling US$1.4 billion, so Barings' inability to meet its margin obligations at the end of February just hastened its demise. Its fate had been sealed at the end of January when Leeson had an unauthorised Nikkei exposure of about 30,000 contracts.

Standard Deviation

Sat, 02 Feb 2008 06:58:26 GMT

Senior management involvement

The crux of the Barings' collapse lay in senior management's lackadaisical attitude to its derivative operations in Singapore. Every major report on managing derivative risks has stressed the need for senior management to understand the risks of the business; to help articulate the firm's risk appetite and draft strategies and control procedures needed to achieve these objectives.

Senior managers at Barings can be found wanting in all these areas. For example, while they were happy to enjoy the fruits of the success of the Singapore branch, they were not so keen on providing adequate resources to ensure a sound risk management system for a unit that alone ostensibly accounted for one-fifth of its 1993 profits and almost half of its 1994-profits. The senior management's response to the internal auditor's report for a suitably experienced person to run Singapore's back office was that there was not enough work for a full-time treasury and risk manager even if the role incorporated some compliance duties. No senior managers in London checked on whether key internal audit recommendations on the Singapore backoffice had been followed up.

Barings' senior management had a very superficial knowledge of derivatives and did not want to probe too deeply into an area that was bringing in the profits. Arbitraging the price differences between two futures contracts is a low-risk strategy. How could it then generate such high profits if the central axiom of modern finance theory is low risk-low return, high risk-high return? And if such a low-risk and relatively simple arbitrage could yield so much profits, why were Barings' better-capitalised rivals (all with much larger proprietary trading teams) not pursuing the same strategy?

The profitability of the business was marvelled at by all senior managers, but never analysed or properly assessed at Management Committee meetings. Senior managers did not even know the breakdown of Leeson's reported profits. They erroneously assumed that most of the switching profit came from Nikkei 225 arbitrage, which actually only generated profits of US$7.36 million for 1994, compared with US$37.5 million for JGB arbitrage. No wonder Peter Baring, ex-chairman of Barings, told the bobs that he found the earnings "pleasantly surprising" since he did not even know the breakdown. Andrew Tuckey, ex-deputy chairman, when asked whether there had ever been any discussion about the long term sustainability of the business, told the same investigation, "Yes...in very general terms. We seemed to be making money out of this business and if we can do it, can't somebody else do it? How can we protect our position?...." Senior management naively accepted that this business was a goldmine with little risk.

Of Ron Baker (head of the Financial Products Group) and Mary Walz (Global head of Equity Financial Products), two of Barings' most senior derivatives staff and Leeson's bosses, the BoBS report concluded, "Neither were familiar with the operations of the SIMEX floor. Both claim that they thought that the significant and large profits were possible from a competitive advantage that BFS had arising out of its good inter-office communications and its large client order flow. As the exchanges were open and competitive markets, this suggests a lack of understanding of the nature of the business and the risks (including compliance risks) inherent in combining agency and proprietary trading."

Given the huge amounts of cash that Barings had to borrow to meet the margin demands of SIMEX, senior managers were almost negligent in their duties when they did not press Leeson for more details of his positions or/and the Credit department for client details. Members of the Asset and Liability Committee (ALCO), which monitored the bank's market risk, expressed concern at the size of the position, but took comfort in the thought that the firm's exposure to directional moves in the Nikkei was negligible since they were arbitrage (and hedged) positions. This same misplaced belief led management to ignore market concerns about Barings' large positions, even when queries came from high level and reputable sources including a query on January 27 1995 from the Bank for International Settlements in Basle.

The bank was haemorrhaging cash and still London took no steps to investigate Singapore's requests for funds - partly because senior management assumed that a proportion of these funds represented advances to clients. Even then the complacency is still baffling. BFS had only one third-party client of its own - Banque Nationale de Paris in Tokyo. The rest were clients of the London and Tokyo offices. Either London or Tokyo's existing customers had suddenly become very active or Leeson had recently gone out and won some very lucrative accounts or Tokyo or London had a new supersalesman who had brought new business with him. Yet no enquiries were made on this front, which displays a blasé attitude about a potentially important source of revenue.