Case 2: Derivative Scandals

Case 2: Derivative Scandals

1. In 1993, Allfirst Bank hired a currency trader to shift the bank's forex (FX) operations from a merely hedging endeavor to one that would yield profits and boost the bank's bottom line.

   • John Rusnak was bullish on the yen. He believed the yen had taken all the damage it could following the bursting of the Japanese bubble. Further, Rusnak believed the yen would appreciate consistently against the dollar
     • Under these conditions, a trader normally would buy forward contracts to get yen for cheaper than market value, while hedging the position with a combination of put and call options.
       • he neglected to hedge his forward contracts. His luck held, however, until a series of policy changes in Asia culminated in crisis on the Asian market and prompted a long slide in the value of the yen and other Asian currencies.
         • With his unhedged positions facing losses, Rusnak panicked. He entered false options into the system that made it look like his positions were hedged.
           • Prime brokerage accounts generally are given to hedge funds and high profile traders with a lot of capital to play with. However, Rusnak was granted the account despite the fact that, unbeknownst to his superiors, he already was working in the red.
             • With his new account, Rusnak increased the size of his trades and kept his losses hidden by using options and a higher level forex contract called a historical rate rollover. This allowed him to hold off realizing his losses, while still betting more on the yen. It also meant that the total value of the forex operations at Allfirst was increasing
               • When the bank demanded that Rusnak release some of the capital to ease its balance sheet of the heavy skew towards the forex market, the house of cards came tumbling down.
                 • Rusnak's positions revealed a staggering loss of $691 million.
                   • Rusnak's transparency with the FBI hurt Allfirst because it had no one to blame but its own permissive policies.
   • ALLIED IRISH BANK - JOHN RUSNAK

2. From 1992, Leeson made unauthorised speculative trades that at first made large profits for Barings: £10 million, which accounted for 10% of Barings' annual profit. He earned a bonus of £130,000 on his salary of £50,000 for that year.

   • he used one of Barings' error accounts (accounts used to correct mistakes made in trading) to hide his losses. Leeson claims that this account was first used to hide an error made by one of his colleagues; rather than buy 20 contracts as the customer had ordered, she had sold them, costing Barings £20,000.
     • Management at Barings Bank also allowed Leeson to remain chief trader while also being responsible for settling his trades, jobs usually done by two different people.
       • By the end of 1992, the account's losses exceeded £2 million, which ballooned to £208 million by the end of 1994.
         • The beginning of the end occurred on 16 January 1995, when Leeson placed a short straddle in the Singapore and Tokyo stock exchanges, essentially betting that the Japanese stock market would not move significantly overnight. However, the Kobe earthquake hit early in the morning on 17 January, sending Asian markets, and Leeson's trading positions, into a tailspin.
           • Losses eventually reached £827 million (US$1.4 billion), twice the bank's available trading capital. After a failed bailout attempt, Barings was declared insolvent on 26 February.
   • BARINGS BANK – NICK LEESON

3. The bank states that Kerviel was assigned to arbitrage discrepancies between equity derivatives and cash equity prices, and "began creating the fictitious trades in late 2006 and early 2007, but that these transactions were relatively small. The fake trading increased in frequency, and in size".

   • Bank officials claim that throughout 2007, Kerviel had been trading profitably in anticipation of falling market prices; however, they have accused him of exceeding his authority to engage in unauthorized trades totaling as much as €49.9 billion, a figure far higher than the bank's total market capitalization.
     • Bank officials claim that Kerviel tried to conceal the activity by creating losing trades intentionally so as to offset his early gains.
       • Some analysts suggest that unauthorised trading of this scale may have gone unnoticed initially due to the high volume in low-risk trades normally conducted by his department.
         • The bank said that whenever the fake trades were questioned, Kerviel would describe it as a mistake then cancel the trade, after which he would replace that trade with another transaction using a different instrument to avoid detection.
           • Managers for Société Générale have described some of the means Kerviel employed to avoid the bank's internal controls and escape detection.
   • SOCIETE GENERALE – JEROME KERVIEL