You know you’re walking in a minefield if you have a trading position that’s nearly five times the total economic output of Cambodia… or 1.5 times the market capitalisation of the big global bank you’re working for. And it’s even more risky if the bank you’re working for has no idea what you’re doing.
Jerome Kerviel was a junior level derivatives trader earning US$66,000 per year at Societe Generale (SocGen), one of Europe’s largest banks. We probably wouldn’t be talking about him now – except that as of January 9, 2008, he had amassed a stock index futures position of US$73 billion. The way he did so ended up costing Societe Generale US$7.2 billion – or about six times what Nick Leeson lost for Barings.
Here’s what happened
Kerviel had dug himself a hole by buying EUR 30 billion worth of Eurostoxx pan-European stock index futures contracts, EUR 18 billion of Germany’s DAX futures and EUR 2 billion of London’s FTSE futures. These contracts expired over the following one to three months.
(Futures are derivatives used to essentially bet on the future price of a stock index. Kerviel bought them in the hope these markets would go up over the following months. And derivatives are investment instruments that derive their value from an underlying asset, like a stock, a market index, the price of oil and so forth.)
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Kerviel’s objective was to profit when two securities that should converge to the same price, temporarily aren’t the same price – which is called arbitrage. The idea is to buy the cheaper security, sell the more expensive one, and then wait for their prices to come together.
For example, if the stock price for Coca-Cola is trading at US$45 on the New York Stock Exchange, but is trading at the equivalent of US$44.90 on the London Stock Exchange, an arbitrage trader could go short Coca-Cola in New York (to profit when the price goes down), and buy the shares, or go long, in London (to profit when the price rises). Then when the two prices converge, with one going higher, the other lower, he makes money.
Kerviel bought Euro stock market futures hoping they would go up. Normally, he would have offset these bets by, for instance, shorting U.S. stock index futures (to profit if markets go down). In this way, if European stocks suddenly fell, the short U.S. stock futures – which tend to move in the same direction as European stock futures – would make money, offsetting the loss.
Because the price difference between similar securities may be small (in the Coca-Cola example, the 10-cent difference is an enormous spread for arbitrage traders), it’s normal for arbitrage traders to take huge positions, and use leverage, or borrowed money, to make them even larger. That way they can make big profits even if the difference in price is tiny.
However, in the months leading up to January 2008, Kerviel had learned how to hack SocGen’s risk surveillance system – and was only doing one half of the arbitrage trade. In other words, Kerviel had been taking, say, long positions and offsetting them with short positions that didn’t exist.
By manipulating the bank’s software, he was making risky one-sided bets – while his firm thought he was making lower-risk arbitrage trades. Kerviel reportedly made nearly US$2 billion in profits in 2007 by making these kinds of unauthorised trades.
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Astoundingly, it was later discovered by SocGen that the massive trade Kerviel entered in early January 2008 was actually an attempt by Kerviel to lose money. (It worked extremely well.) He believed the previous year’s US$2 billion in unauthorised bank profits was about to be discovered. He feared he might lose his job, and was trying to generate losses to mask his fraud.
This may explain why Kerviel was betting on markets going higher, despite the fact that the subprime mortgage crisis was just beginning. Global markets were looking wobbly and astute traders were going short, or betting on markets going down – the opposite of what Kerviel was doing.
The first indication that something was wrong
On the afternoon of Friday, January 18, 2008 a compliance officer discovered that a trade had exceeded the bank’s risk threshold. When he checked with the brokerage that had supposedly executed an offsetting trade, he learned that no such trade existed.
In the last hour of trading on January 18, the price of SocGen stock plunged 8 percent. News sources reported that speculation of impending huge write-downs at the bank was the cause of the decline. Apparently, word of Kerviel’s huge bet had leaked out.
As the extent of the fraud became apparent to banking officials over the weekend, Kerviel was fired. However, bank executives still had to deal with the US$73 billion worth of long futures, which at that point had already lost the bank US$1.4 billion.
Indications were that markets on Monday were probably going to go down – no doubt made worse by rumours that SocGen was in trouble. Bank executives were faced with a choice: Let the unauthorised trades run their course and hope the stock market would eventually rally, or close the positions immediately to avoid losing even more money – and potentially endangering the survival of the bank.
After a difficult debate, with the future of the bank possibly at stake, bank officials decided to sell the positions as quickly as possible. From January 21 to 23, SocGen “unwound” the futures contracts purchased by Kerviel, selling them into the market. Selling US$73 billion worth of futures in that short period of time drove prices of the futures even lower – making the bank’s losses worse.
When the last of the unauthorised positions was sold, and the dust had settled, Jerome Kerviel had lost SocGen US$7.2 billion, making him the worst rogue trader in history, at least in terms of money lost.
The big question
In the months and years that followed, the question was asked over and over again: How could a junior trader, with human supervision, not to mention computer surveillance, hide such massive trades?
Part of the answer lies in Kerviel’s knowledge of the bank’s back office operations. Like Nick Leeson, he used his deep knowledge of his employer’s risk monitoring systems to hide his unauthorised trades.
Kerviel was able to circumvent the firm’s computerised fraud detection system, and create a web of fake trading accounts – right under the noses of his supervisors. Years after the fraud, it was discovered that managers missed more than 1,000 fraudulent trades by Kerviel.
Like Leeson and Liu Qibing, Kerviel had also earned a reputation as a hotshot money-maker. On several instances, including the 9/11 terrorist attacks and the London bombings in 2005, Kerviel had earned SocGen colossal gains. His reputation as a rising star among the 100 or so traders on the bank’s trading floor was well known.
Kerviel said that his superiors had ignored the growing size of his trading positions, and would come to him and say: “Hey, cash machine, how much did you earn today?” SocGen was inclined to let their star trader break the rules, as long as the profits were flowing.
In short, like most rogue traders in the years before their blow-ups, both Kerviel and his supervisors had become overconfident of the trader’s abilities. And this overconfidence led to disaster when the traders’ “genius” was exposed as anything but.
And there was something else: Failed by supervisors more concerned with profits than traders’ mental health, Kerviel had become a trading addict. As we’ve written previously, the brain activity of successful traders is similar to that of someone high on alcohol, cocaine or heroin. A chemical called dopamine floods the brains of winning traders making them euphoric, just like drug users. But when profits turn to losses, the trader is like a junkie in need of a fix – he needs another successful trade to get a dopamine “high”.
Years later, Kerviel admitted to becoming obsessed with winning, as if he was “playing a computer game.” He was quoted as saying that he had experienced pleasure in making “astronomic” bets. Addicted to the markets, he would stay at his desk in front of a quote screen for 16 hours at a time, only answering workmates with a robotic “yes” or “no”.
In short, Kerviel became obsessed with stock prices and this caused him to make catastrophic investment decisions.
Kerviel was eventually convicted for breach of trust, forgery and unauthorised use of SocGen’s computers. He was given a three-year jail term in 2010, and ordered to pay back SocGen US$6.3 billion, a sum the bank acknowledges that it will never collect.
After spending less than five months behind bars, Kerviel was given a conditional release in 2014. He continues to fight his sentence. (In September 2018, France’s highest court of appeal rejected his latest appeal.)
In addition to defrauding his employer, Kerviel made all the worst mistakes an investor can make: he was overconfident, used too much leverage, did not have a stop-loss strategy, and he became emotional and obsessive.
The person who lost more money than any other trader ever made the same mistakes we’re all prone to make. So we all need to be alert to avoid repeating them, whether we’re trading hundreds, thousands or billions of dollars.
Publisher, Stansberry Pacific Research