Regular readers of our Masters of Fraud series are familiar with rogue trading. Nick Leeson, Kweku Adoboli and Howard Hubler have all posted spectacular losses for their respective firms. While not as big a name as other rogue traders, Jerome Kerviel, a former trader at French bank Societe Generale, was back in the news this week. In 2009, his unauthorized bets saddled ‘SocGen’ with a stunning 4.9 billion euros ($5.5 billion), threatening the French bank’s very existence. Here is a recap of how it happened and some recurring themes that have led to increased regulatory scrutiny.
Jerome Kerviel’s story has resonated with many people who have followed his epic rise and fall. Kerviel was born in France in 1977. Like most, Kerviel didn’t enjoy the typical posh upbringing that accompanies many who land at white shoe firms like Societe Generale. After all, his father was a blacksmith and his mother a hairdresser.1
By all accounts, Kerviel did well in school; eventually earning a Master’s in Finance degree from University Lumiere Lyon 2.2 The program reportedly included a concentration in organization and control of the financial markets. This financial program was partly set up by the French government to facilitate students for middle and back-office positions, not client-facing, front office careers such as trader or financial advisor. As such, Kerviel began his career in 2000 in Societe Generale’s compliance department. After proving his mettle there, he landed on their Delta One trading desk to engage in arbitrage trading.3
If this all sounds familiar, it should. Our other Masters of Fraud profiles had eerily similar paths to their downfalls, namely Adoboli and Leeson. Young, male traders at large banks with experience in back-office operations continue to make the list.
While Leeson is considered the original Rogue Trader, it should be noted that Kerviel’s trading losses were six times greater than Leeson’s which brought down England’s Barings Bank in the mid 1990’s.
In 2006, Kerviel’s mandate on the trading desk was to capitalize on any arbitrage opportunities that arose throughout the course of a trading day. An arbitrage is a temporary mispricing of a security that can be bought or sold for profit until the market price comes back to the correct pricing.
For example, a stock listed on the New York Stock Exchange may be trading at $50 per share but is trading at $50.10 on the Frankfurt exchange. An arbitrageur could come in and buy the shares at $50 while simultaneously selling them on the Frankfurt at $50.10, realizing a 10 cent profit per share.
While 10 cents per share may not seem like a lot of money, since this opportunity is essentially riskless in its purest form, banks and hedge funds that find such pricing discrepancies use large amounts of leverage to capitalize on the trade. So while one share of this trade would produce a 10 cent profit, if a trader can borrow money (through derivatives) to arbitrage one million shares, it would produce a $100,000 profit, all done in an instant.
Derivatives are highly speculative investments and allow a trader to gain massive exposure through the use of leverage.
As algorithmic trading has gotten more prolific, high frequency traders have squeezed out the vast majority of arbitrage opportunities today. They still exist, but in the more illiquid markets such as the corporate bond or structured product arenas. But even just a decade ago, they were still prominent.
Jerome Kerviel was not a senior trader by the time of his debacle and was making less than 100,000 euros per year (salary and bonus) as a junior derivatives trader.4 Kerviel was supposed to be simply placing arbitraged, not directional bets, on markets. But Kerviel was apparently getting bored with this type of trading and wanted more action, and money.
Like Leeson, Kerviel soon stopped the hedging side of the trade and turned the bets into directional ‘long-only’ bets on the market. And the same outcome occurred. For Kerviel, the financial crisis of 2008 rocked global stock markets, causing his long derivatives trade to spectacularly blow up. For Leeson, it was the 1995 Kobe earthquake that decimated his Nikkei futures positions.5 Mr. Kerviel was sentenced to five years in jail for “breach of trust and fraud (with two years suspended).”6 He ended up serving less than five months’ time.7
Lack of Compliance Control
The obvious question was “How could this have happened?” Kerviel’s trades were finally discovered by a compliance officer when a position limit he was carrying exceeded an authorized amount, setting off an alert. The risk manager made a routine phone call to check on the counterparty and soon discovered that none existed. The trade, which had been entered as a hedge (a short sale transaction to offset an existing ownership position) did not actually exist. It was Kerviel’s experience having worked in compliance prior to being promoted to trading that gave him specialized knowledge to book fictitious trades that allowed him to get away with it for as long as he did.
The crux of this story is whether Kerviel truly acted alone as a rogue trader or was SocGen implicitly allowing the activity to continue. Obviously Societe Generale would prefer the former and wants to distance themselves from Kerviel as much as possible. They even went so far as to refer to Mr. Kerviel as a financial “terrorist”.8 It didn’t work.
The interesting thing about Mr. Kerviel is that he has become a bit of a rebellious, anti-establishment figure in the eyes of some compatriots, somewhat similar to Edward Snowden in the United States. Remember, France is not as staunchly capitalist as places such as the United States, so some actually consider him a hero. In fact, a French court has mandated that Societe Generale pay Kerviel over 400,000 euros for unfair dismissal.9 The award seems to be more of a statement that the bank knew about the fraud and did nothing to prevent it from spiraling out of control.
There is a scene in the 2016 French movie L’Outsider where Kerviel’s bosses coach him how to get around the relaxed internal controls at Societe Generale.10
It begins with Kerviel posting a large losing trade to the tune of 100,000 euros (the equivalent of approximately $112,202 today) after being hungover from a night of drinking and cavorting with exotic dancers. The film’s central theme is that Kerviel’s direct superiors showed him how to cover his tracks with bogus inputs and false trades.
Playing on this sentiment, Kerviel made an odd pilgrimage since the trading loss, hiking from Rome to Paris to publicize the evils of finance. He was invited to meet with the Pope along the way, a symbolic alliance with a pontiff that has rambled against the evils of capitalism.11 Kerviel then proceeded to complete his trek all the way to Paris (on a rather pious 30 euros per day). The stunt has appealed to the masses, already negative public perception of Wall Street and investment banking operations in general. It’s also apparently appealed to the judge’s perceptions.
Kerviel’s fine was reduced to one million euros (approximately $1.1 million) on September 23rd. While this may seem large to many, Kerviel was originally ordered to pay the entire trading loss back to SocGen, 4.9 billion euros. The judgement reflects the growing sentiment that Kerviel was simply a pawn in SocGen’s strategy who was a convenient scapegoat if the scheme was ever uncovered. Ironically, the reduced sentence could actually negate a $2.2 billion euro tax credit Societe Generale was allowed in 2008 as a result of Kerviel’s rogue actions, according to Bloomberg.12 We will keep readers posted on any further developments regarding that possibility.