Jérôme Kerviel is a former arbitrage trader at Société Générale who went rogue and landed himself in massive debt. His scheme could make millions by executing $73 billion in unauthorized trades but when he fell, he fell hard. Now 6.3 billion is the number he will carry for the rest of his life. That’s how much money going rogue in 2007 and 2008 cost Société Générale, and how much he will have pay when he gets out of prison in 2015.
Arbitrage is supposed to take the risk out of trading. The practice involves taking advantage of price discrepancies between things that should cost the same. If you buy the cheaper and sell the more expensive it’s risk-less money making until the prices converge. The markets can go either direction, so long as there is a discrepancy, there is a profit. Essentially arbitrage is the “possibility of a risk-free profit at zero cost.” But Kerviel didn’t play by the rules—hence the whole “rogue trader” designation. He disregarded the need to balance in hope of a better pay off. Essentially he would take a long position, and then use computer hacking to make up a fictitious short position to balance it. Société Générale only looked at the net, not gross, difference between the positions and so they only saw small variations. (Say Kerviel went long with 1000 dollars and short with 950. The net between the two is only a 50 dollar difference which looks good on paper, but when the 950 short to balance things out doesn’t exist, problems arise.) Because arbitrage takes advantage of very small price differences, the volume of the trades has to be massive in order for any money to be made and that’s why Kerviel took such a big hit.
The Atlantic talked with Frank Partnoy, a former investment banker and current law professor at the University of San Diego, to figure out what such a massive debt means for Kerviel and how the banks deal with rogue trading. The Airspace breaks down the key points.
The fine is mostly a fictitious one
“He’s obviously not going to be able to pay the fine. What happened to Kerviel is the financial equivalent of sentencing someone to life plus 100 years…. There’s the fine, and then there will be a structured settlement. They’ll likely reach some kind of agreement where a significant percentage of any money he makes for the rest of his life will be paid into a fund to cover the fine. He’ll be like Sisyphus pushing the boulder up the hill every day for the rest of his life.”
Banks are aware of rogue trading. It’s a consequence of how they operate
“[Senior bank managers] set up the risk management systems in a way that makes at least some rogue trading expected and almost inevitable. The idea is they give their traders leeway. As a manager, you don’t want your traders to be risk-averse. You want your traders to be risk-seeking. If you really constrain your traders, you keep an eye on them, and you check all of their trading marks in detail so you understand every single trading position—if you do that, in the aggregate, your traders aren’t going to make as much money. It’s an argument about the entrepreneurial spirit. You want to free up your employees to take risk. Inevitably, when you free them up, traders will start to aggressively mark their positions and take risks they maybe shouldn’t—like Kerviel. He had this arbitrage strategy, which is supposed to be neutral, but how do you really monitor neutrality? Well, somebody takes a little risk here, have a slightly mismatched option position that makes some money, they lose some money so they mismark to hide that loss, but then it works out in the end, because they make money on some other trade. If you have 100 traders you might make more money even if one of those 100 rips you off—the 99 of them will make so much more money than they otherwise would. If you look at the history of the past two decades, there’s some truth to that. Bank trading operations are massively profitable. The way traders make money are often dubious, sometimes illegal, and we see these repeated instances of rogue trading.”
Bringing back Glass-Steagall probably wouldn’t do much
“It’s a mistake to take these incidents as one-offs. They reflect deep risk within the banks. But I do think trading will keep showing up. Even if you brought back Glass-Steagall, there would be pressure to create exceptions, like with Bankers Trust back in the 80s and 90s. It’s kind of like a piece of Swiss cheese, where there’s pressure for the holes to get bigger and bigger. There’s just too much profit in trading for banks to agree to forgo all those profits. If you implemented Glass-Steagall, the commercial banks would want to keep as much of this as they could, and they would do it by labeling it “hedging” or something else.”