Prof. Laurent Jacque knows risk. The director of Fletcher’s International Business Relations Program and Walter B. Wriston Chair of International Business Relations has advised companies, conducted academic researched and written extensively managing business risk. Jacque, who also holds a joint appointment at the HEC School of Management in France, his alma mater, has won five teaching awards throughout his career. Jacque’s latest book deals with the hot topic of the day: Debacles in the global derivative markets. The book, titled Global Derivative Debacles: From Theory to Malpractice, analyzes a half-century’s worth of derivative meltdowns and makes a case for companies engaged in the derivatives business to make a serious investment in internal oversight.
Q: Tell us in a nutshell what the book is all about.
This book analyzes in depth all major derivatives debacles of the last half century including the multi-billion losses and/or bankruptcy of Metallgesellschaft (1994), Barings Bank (1995), Long Term Capital Management (1998), Amaranth (2006), Société Générale (2008) and AIG (2008). It unlocks the secrets of derivatives by telling the stories of institutions which played in the derivative market and lost big. For some of these unfortunate organizations it was daring but flawed financial engineering which brought them havoc. For others it was unbridled speculation perpetrated by rogue traders whose unchecked fraud brought their house down.
Should derivatives be feared “as financial weapons of mass destruction” or hailed as financial innovations which through efficient risk transfer are truly adding to the Wealth of Nations? By presenting a factual analysis of how the malpractice of derivatives played havoc with derivative end-user and dealer institutions, a case is made for vigilance not only to market and counter-party risk but also operational risk in their use for risk management and proprietary trading. Clear and recurring lessons across the different stories call not only for tighter but also “smarter’ control system of derivatives trading and should be of immediate interest to financial managers, bankers, traders, auditors and regulators who are directly or indirectly exposed to financial derivatives.
Q: Was this book prompted by the recent derivative debacles, or is it just a happy (or unhappy) coincidence that it came out as the topic is so fresh on our minds?
This book really grew of my long-standing interest in foreign exchange risk management. At first glance the book may appear as closely related to the sub-prime crisis but in fact derivative debacles are as old as financial derivatives themselves and the book spans a half-century starting with an early debacle (1964) which engulfed the Belgium branch of Citibank where a rogue trader had been speculating – against bank’s policies – with an elaborate portfolio of mismatching sterling/dollar forward contracts that the pound sterling would not devalue.
Q: Who is the target audience for this book?
The book will be of obvious interest to financial executives, derivative traders as well as managers and directors who oversee treasuries and trading desks. Importantly though the book was purposefully written in a non-technical fashion to reach a broad college-educated readership with an interest in world financial affairs. Indeed the book is self-contained and introduces necessary financial concepts as each story unfolds. The arcane world of derivatives may be intimidating, but derivatives cannot be avoided nor ignored (abstinence is not an option). They permeate many of the key goods and services which are at the core of modern life: for example, the price of energy is largely influenced by oil and natural gas derivatives and the cost of securitized consumer finance (variable rate home mortgages and automobile loans) embodies interest rate derivatives and credit default swaps.
Q: One of your key conclusions regards the perils of transforming Treasury Departments into profit centers. What advice would you give to companies that are moving in this direction?
Treasury departments may be set up as profit centers provided that guidelines and rules of engagement are clearly set up by the board of directors and enforced vigilantly. In such cases treasury operations should be closely monitored by the firm’s comptroller/back office and direct reporting to the board is strongly recommended. Last but not least, the comptroller and back office should be independent from the treasury operations.
Q: How is it that trading rooms have so easily circumscribed trading limits? What do you recommend to prevent this?
Monitoring of derivative trading desks as in the case of Barings or Societé Générale broke down when the front office (which does the actual trading of derivatives) is able to deceive the back office responsible for recording, reconciling and settling trading operations. This will happen when traders started their professional career in the back office as in the case of Nick Leeson (at Barings) and Jerôme Kerviel (at Societé Générale). Both had been promoted to the front office after working for lengthy period of time in the back office. They knew in details the modus operandi of the back office including sensitive computer passwords and were thus able to fool the back office through elaborate and fraudulent schemes. The other important consideration is the one of resources: if the volume of activities by the front office rapidly outgrow the resources made available to the back office (measured by headcounts of accountants, programmers, auditors etc…but also computer systems) the monitoring of trading breaks down. In a way that was the problem with Barings and Société Générale among others. Trading is very lucrative for banks and there should be plenty of money available to keep the back office well staffed and equipped. Also it is critical to keep “agency trading” (on behalf of the bank’s clients) strictly separate from “proprietary trading” – that is trading with the bank’s capital.
Q: You describe failure to report derivative positions as one problem that affects many big organizations. Is this something that you think organizations can fix themselves or is this a place for government intervention?
These are really issues for the firm’s management to work out by themselves. I see no reason to involve the government in the micro-management of private sector institutions. Municipal finance is the exception to this rule and should be subjected to closer governmental scrutiny. In my view, the best approach would be to encourage companies’ boards to tighten up their reporting/monitoring guidelines and to conduct systematic “variance analysis” of Treasury and trading operations. The other key principle is to keep back office staff separate and independent of front office traders. As noted previously two of the worst debacles – Barings and Société Générale – involved traders who had started their professional career as back office clerks and who were “promoted” to front office trading positions. Another cardinal rule is to require traders to take vacations – actually a requirement in the US financial service industry. By “passing” their trading books to someone else when traders go on vacations, any covert speculative trading activities would be uncovered. The Allied Irish Bank currency trader insisted on having his laptop equipped with a direct Bloomberg feed and connected to the bank trading room while on vacation. Jerôme Kerviel at Société Générale – in direct violation of French cultural norms – never took a vacation from his trading desk!
Q: Another failing you outline is a failure of systematic audits by accountants who understand the full complexity of derivatives. Do you have any rules or advice on accounting that you would give to firms involved with derivatives?
We need more and better-trained accountants/auditors who are well versed in the arcane world of derivative products trading and core principles of financial engineering. Certified Public Accountants should also be certified in financial engineering as it applies to derivative trading. This is the price to pay to make effective monitoring possible and reliable and avoid major debacles where losses are measured in billions whereas the cost of competent back office staff is measured in thousands. This is an area where banks and multinationals have been penny wise and pound foolish. Continuing education of your back office staff to keep up with ongoing financial innovations would go a long way in preventing major debacles caused by fraudulent activities in the front office. More basic is the fact that back office tend to be understaffed and therefore unable to keep up with derivative trading activities which are continuously growing in both volume and complexity.
Q: When it comes to risk management, you note the risks of relying on past trends to predict future outcomes. That’s something I believe we saw in predictions about mortgage default rates. Do you have any rules or advice on this?
History doesn’t necessarily repeat itself. Many of these daring speculative schemes were predicated on extrapolating into the future past trends. Humans have a tendency to project into the future what they have experienced in the past – at their own peril. For example many of Long Term Capital Management convergence trades were predicated on stable historical trends: bond spreads and stock index volatilities which may have temporarily wandered out of established ranges would inexorably revert back to normalcy. In the words of Victor Haghani – LTCM London-based star trader and strategist – “what we did is rely on experience. And all science is based on experience. And if you are not willing to draw any conclusions from experience, you might as well sit on your hands and do nothing.” Except for the once-in-a-hundred-year flood, linear extrapolation is a reasonable approach to modeling the future. Unfortunately financial history is populated – albeit sparsely – by “Black Swans,” or unlikely but catastrophic events which devastate the global economy. In the same vein LTCM put great faith in the Value-at-Risk metric as the all-encompassing gauge of the fund risk exposure. In August 1998 LTCM estimated its one-day Value-at-Risk to be $35 million with a 99% probability: on September 21, 1998 the fund lost $ 550 million. Value-at-risk is a very useful gauge of risk exposure as long as close attention is paid to the time frame over which its key parameters are estimated. LTCM seemed to have relied on relatively recent history as the relevant time period to build its models and failed to make allowance for “Black Swans.”
Q: You prescribe day to day marking-to-market as a solution to prevent trading schemes from spinning beyond control. We’ve heard loud complaints from bankers about the impact of being forced to use mark-to-market on their income statement. What do you think of this debate?
These are two different issues – both very important. When dealing with derivatives you can trade them through organized exchanges such as the Chicago Mercantile Exchange where you will be forced to daily marking-to-market. You will also be required to post a margin – a form of collateral which insures that should the contract be losing money its holder has money in the bank to fund the loss; in other words there is no counterparty risk to worry about. When trading over-the-counter there is no such mechanism and every market participant is responsible for assessing counter-party risk: indeed there are significant risks of counterparty defaulting and these defaults may very quickly mushroom into systemic risk. This is what happened with Long term Capital Management in 1998 and again in 2008 with Lehman and AIG where the bulk of derivative portfolio were over-the-counter and unlike the collapse of Amaranth where all natural gas derivative contracts were with NYMEX and marked to market daily.
Bank being forced to mark-to-market loans and mortgage-backed securities is an entirely different question. In times of crisis, the secondary market for loans or fixed income securities becomes very illiquid and the few transactions recorded may grossly undervalue loans portfolio thereby exacerbating the crisis and making banks look a lot worse than they are actually. Hence, the reluctance by the industry to subject itself to such a requirement. We have good pricing algorithms which can be used as reliable pricing models and they should be used.
Q: Could you give your assessment of the recent financial reform legislation? Is there anything else you would want to do if you were writing the laws?
It is a very, very long document and I would not pretend to know what it really entail in any details. In my own view legislation is not necessarily the answer to preventing future derivative debacles. The Volcker rule forcing banks (especially commercial banks which rely on FDIC insured household deposits) to divest themselves from their proprietary trading operations is certainly a step in the right direction.
Q: If you were a mere investor who wanted to keep away from firms veering towards debacle, what would you be on the lookout for?
The use of financial derivatives is a necessity in the 21st century of globalized commerce and finance. Investors should not avoid firms known to be actively involved in derivative trading. What an investor would want to ascertain is the risk management system and control guidelines implemented by the institution – admittedly easier said than done.
Lauren Dorgan, F11