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On Monday October 17, 2011, 4:29 pm EDT
With the recent scandal in which trader Kweku Adoboli lost 1.3 billion pounds for his employer, the Swiss investment bank UBS, rogue traders have been in the news. A rogue trader is a trader who takes unauthorized investing risks to attempt massive gains, but makes reckless choices in the process. These professionals may work as fund managers, at trading desks or in other capacities where they can invest large amounts of other people's money.
Playing by Their Own Rules
What makes these traders "rogue" is their unethical behavior. They may act without the authorization of their companies or supervisors, or exceed the limits they are given. Their investment styles might be more accurately described as speculating, betting or gambling. They may use enormous amounts of leverage or take high-risk positions in derivatives or currencies. Rogue traders often seek huge profits for themselves, but these individuals' professional positions and trading behavior, not their motivations, are what define them as rogue traders.
Rogue traders are usually willing to circumvent government regulations and company rules. These traders might initially be successful and emboldened by their results. They may take larger and larger risks to maintain or improve their track records. Ultimately, their risky bets can cause major losses for the companies they work for and bring criminal charges for fraud, collusion, breach of trust and more. These charges can bring jail time and fines to rogue traders.
Rogue Traders In Recent History
Over the last 20 years, we've seen a handful of major rogue trading scandals. In 1992, Harshad Mehta and other brokers colluded to manipulate the Bombay Stock Exchange. In 1995, Nick Leeson incurred a $1.4-billion loss for Barings bank that brought down the centuries-old institution. Trader Jerome Kerviel incurred a $7-billion loss for French bank Societe Generale, the largest uncovered thus far. Other rogue traders have been caught in Japan, the United States, Australia and the United Kingdom. There may be more rogue traders than we know about. Those who have been successful or who have avoided getting caught in unauthorized or illegal trading activities might be considered investment superstars or be quietly going about their business.
Some rogue traders are infamous not just for their scandalous trading behavior, but for their personal behavior. Stockbroker Jordan Belfort, the "Wolf of Wall Street," was convicted of money laundering and fraud in a relatively small pump-and-dump scheme that lost $200 million, but he is also known for reckless and outlandish acts, including organizing a trading floor midget-throwing contest, using massive quantities of illegal drugs and destroying a yacht and other vehicles.
A Rogue Trader's Downfall
A sudden, major loss usually triggers a rogue trader's demise. Complex trading strategies can go bad when something unexpected happens in the markets. In Leeson's case, nature intervened. A short straddle he placed on the Nikkei became a huge loss after an earthquake in Kobe.
Rogue traders might also be caught if a co-worker reports their behavior or if regulatory authorities catch on, as happened with Peter Young and an SEC investigation. An exchange may notice a particular trader's behavior or be tipped off, which occurred in the case of Jerome Kerviel and the Eurex derivatives exchange. Adoboli tried to hide his massive losses, but got caught falsifying accounting records.
The Fallout of Rogue Trading
A single rogue trader can bring down an entire company, no matter how well established it is or how successful it has been in the past. A rogue trader's influence can easily extend outside of his or her company. When a rogue trading scandal comes to light, it can cause a major drop in the share price of the bank or investment company associated with the scandal, which happened in September with UBS. Furthermore, a company with a tarnished name may have trouble retaining existing clients and attracting new ones. Top executives can also be forced out of the company for their failure to catch the problem before it exploded, or as part of a company's attempt to regain the public's trust.
The Bottom Line
Losses from rogue trading can be far reaching and extend worldwide. In the aftermath, victims and fearful onlookers may call out for increased government regulation, such as the recent suggestion to ban ETFs, in an attempt to prevent the next fraud. Regulations cannot put a stop to human ingenuity or fallibility. It will only be a matter of time before the next rogue trading scandal emerges.
