How to stop rogue-trading losses

I'm now better informed than I was about how Kweku Adoboli managed to lose so much money for UBS.  I needn't reveal any confidences: this is a fair outline of what I have been told went on.

Whenever losses like this are uncovered, the bank concerned is censured, and rightly so, for whatever lax practices allowed the risk management system to be fooled.  But there is one simple procedure that would have caught each of the notorious rogue traders - Nick Leeson at Barings, Jérôme Kerviel at SocGen, or Kweku Adoboli at UBS.  And that is to check positions giving rise to any funding requirement out of proportion to the risk being reported.

All three traders were supposed to be carrying out low-risk trading, in which equity futures hedged the risk on other, quite simple instruments.  For Leeson, it was similar futures on another exchange.   For Kerviel it was a basket of shares or warrants, and for Adoboli it was ETFs.  Because the positions were supposed to be low risk, they were authorized to trade in very large size.  But in each case, the offsetting trades were faked so the actual risk was enormous, as were the losses when markets turned sharply against the positions.

When you hold an equity futures position, you pay or receive daily "variation margin" as market prices move. In each of these rogue-trading cases, the banks will have paid out most of the losses in variation margin even before the losses were discovered (the balance of the losses being due to market moves caused by trading out of such large positions after their discovery).  Barings ought to have been receiving offsetting variation margin on the offsetting futures trades, but weren't.  In the other two cases the purported offsetting trades would not have been expected to generate margin.  But large profits were being reported on the offsetting trades, slightly greater than the large real losses.  It would have taken only a brief investigation to discover that many of the offsetting trades had been neither confirmed nor settled by their counterparties.  At which point a thorough investigation would have been instigated.

I'm not saying that this sort of check would catch all rogue traders.  But it would detect sizeable losses from rogue trading before they become huge losses.

This sort of investigation might well pay for itself even if there were no rogue traders.  This is because arbitrage businesses exploiting small margins should be accounting carefully for funding costs (which have become much larger since the 2008 crisis) and for credit risk.  Investigation might show that the apparent profits may not really exist in businesses that seek to exploit narrow arbitrage opportunities by trading in high volume.

Another thing that should be monitored is an explosion of trading volume in any one instrument - in Adoboli's case that would be forward-settled ETFs.  The trading desk concerned should have to demonstrate that the market demand is there and that it's genuinely profitable to satisfy it.

There's one more thing that banks might consider doing: appoint a senior banker with a small team whose sole remit is to prevent large trading losses, whether by rogue trading or by concentration of risk in illiquid instruments.  This team should be paid mostly in salary: any bonuses should be paid in cash (not shares) deferred for three years and forfeited if major trading losses are uncovered during the deferral period.  Team members should not be allowed to transfer to trading jobs.