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Derivatives

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On May 4, 1864, the French financial firm Société Générale was created. It was one of

Europe's largest banks, with customers in over 70 countries, and it was also featured in the

Fortune 500, ranking 67 in 2006. It primarily provided retail banking and financial services, as

well as worldwide investment management and services and corporate and investment banking.

Jerome Kerviel was born on January 11, 1977, in Pont L'Abby, Brittany, France, and

grew up there. Kerviel earned a bachelor's degree in 1999 from the University of Nantes and a

master's degree in finance in 2000 from the University of Lyon. At the age of 23, he joined

Société Générale in the summer of 2000. His first employment at the corporation complied, but

in 2005 he was promoted to a junior trader role working with derivatives, earning over $60,000

per year. Kerviel's job was to profit from pricing differences between equity derivatives and the

market price of the underlying equities. Derivatives are financial products that draw their value

from a fundamental asset, such as a stock, a stock price, or the oil market's price. Derivatives that

track the underlying asset in multiple ways include futures, options, forwards, and swaps.

Kerviel's responsibility was to benefit when two securities that should have the same

price at the same time do not - a practice known as arbitrage. The strategy is to buy the less

expensive security, sell the more expensive security, and wait for their prices to converge. A long

derivative position is typically offset by a matching short position to mitigate risk in derivative

trading. For example, if a trader buys Euro stock market futures hoping the market will rise, this

bet is typically offset by shorting US stock futures to profit if markets fall, as European and US

stocks tend to move similarly. Kerviel initially made only one side of these bets. Kerviel put

himself in an undesirable position by investing 30 billion euros in Eurostoxx pan-European stock

index futures contracts, 18 billion euros in DAX futures in Germany, and 2 billion euros in FTSE

futures in London. These contracts were set to expire within the following one to three months.
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Futures are derivatives that are used to bet on the price of a stock index in the future. Kerviel

bought them with the expectation that the markets would climb in the next months.

By January, 2008, he had amassed a $73 billion holding in stock index futures. The method he

used cost Société Générale more than $7 billion.

Although Kerviel's efforts helped to establish Société Générale not only as a corporation

but also as a brand, he was sentenced to five years in prison on October 5, 2010. (With two years

of the sentence suspended for time already served). He was also ordered to repay the amount lost

by his former company. In 2014, when Jerome filed for an appeal, it was decided that he did not

have to pay for the damages due to the lax internal controls in place at the time. This brings to

light the voluntary slackening of the rules with a view toward a short-term gain in the company.

Furthermore, Société Générale was facing paying back about 2.2 billion Euros tax deduction it

won when the losses were announced back in 2008.

The lengthy court cases between 2010 and 2014, show evidence of poor controls which

resulted in the bank paying a 4 million Euros fine. Société Générale was also ordered to pay

Kerviel 450,000 Euros in compensation for unfair dismissal after a Paris employment tribunal

said that he was fired without real and serious cause. Jérôme Kerviel was tried and convicted of

forgery and falsification of papers, breach of trust, and fraudulent data entry into an autonomous

processing system. The Bank, according to these rulings, was the victim of fraudulent activity

committed without its awareness since the transactions were disguised, obscured, and

rationalized by fabrication.

While Kerviel conveyed many attributes with other unauthorized traders, he was distinct

in one way: his motivation was not greed to become wealthy, but rather to have his trading
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profits launch his career and cash in on the bonus provided to traders who demonstrate the type

of profitability he established for the bank. Red flags were raised; however communications to

his superiors about his trading activity were overlooked due to the company's overall prosperity.

Despite five levels of improved security designed to prohibit traders from taking positions larger

than a set amount and a group compliance division in charge of overseeing trader activity,

Kerviel was able to evade internal controls for more than two years.

Société Générale stated that Kerviel had previously worked in the IT department and

thus had a thorough understanding of its systems and procedures. Staff mainly followed those

processes, but they were insufficient to uncover the fraud, partly due to Kerviel's efforts to

escape detection and partly due to staff failing to perform in-depth investigations when warning

flags were raised. Société Générale’s lack of risk management drew the attention of France's

finance minister, only to show that Kerviel's acts were not difficult to uncover and management

was not following the procedure correctly with routine checks. That's how Kerviel got away with

his schemes for 5 years before being arrested.

Using the back office and control systems, Kerviel was able to enter into fraudulent

hedging contracts to appear to be taking minimum risks. He then canceled the fraudulent

contracts before they were resolved by logging into the system under different names and

replacing them with new ones. However, His ability to elude detection for years points to several

serious flaws in the bank’s controls. Most importantly, when the bank compared its trading

statements with the bank's cash position, Kerviel's dishonesty should have been clear. However,

the bank consistently ignored the disparity between Kerviel's actual position and the bogus trades

he placed into the system. At times, the difference reached several billion euros.
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Since the incident was discovered, internal controls have been tightened to ensure that it

does not occur again. Société Générale announced the creation of an independent committee to

evaluate present monitoring methods and assess what steps should be taken to avoid this from

happening again. Kerviel's extended period of lawlessness was only feasible owing to a lack of

information exchange between the various components of Société Générale's internal control

system, as well as a failure to report any irregularities identified to the bank's leadership. The fact

that it took the bank's top management so long to identify the trader's fraudulent activity once

again shines a focus on internal control flaws.

The involvement of the bank's Board of Directors during the Kerviel issue was inadequate

in terms of the job that it was intended to accomplish as the bank's primary control body. The

Board Members' lack of expertise in market operations was also a major contributor to this

notable absence. Efforts have to be taken at the Board level and throughout the bank to enhance

Board Member recruitment and training.

Like previous big crises that highly mediatized huge corporations have had to endure, it

sparked intellectual effervescence in business circles and among governance specialists, resulting

in the creation of reform ideas. Among the various approaches to contemplate are merchant

recruiting and internal controller training. Given that Société Générale's first error was ceding

front-office operational responsibilities to an employee who was deeply familiar with a bank's

intricate system of back and middle offices, there is little reason to suspect that major market

banks will inhibit any back-office staff member (and, more likely, any middle office employee)

from trading in the future. As a result, further improvement in human resource management is

required.
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Some of the technological changes include monitoring nominal commitments, tracking

treasury movements, conducting in-depth analyses of external information demands, and

removing the partitions that still separate the front and middle offices. It is also important to

mention that at this time, it was up to organizations and institutions to carry out the job of

regulators working outside of market players and investment banks. After all, Kerviel's

transactions took place on exchange-traded markets that required margin payments and variation

margins.

The solutions that governance may provide to improve the control function necessitate,

first and principally, a strengthening of the Board's privileges, institutions, and techniques. This

may start with a promise of better information coming from outlets other than Top Management.

The Board of Directors should be elevated to the status of an equal and exclusive body to which

a company's internal investigators must report. The establishment of specialist committees

should also increase the organization's operational efficiency. Furthermore, this more codified

organization may be supplemented by changes in the composition of the Board, with members

who are not only self - reliant but also appropriately educated in risk prediction. Finally, it is

likely that within a few years, significant multinational banks will see a requirement for financial

market professionals who understand sound governance standards and the specialized

approaches used by international financiers.

References

Iskyan, K. (2016), “Here’s the story of how a guy making $66,000 a year lost $7.2 billion for one

ofEurope’s largest banks”, Business Insider, May 8, 2016.

https://www.businessinsider.com/how-jerome-kerviel-lost-72-billion-2016 5?

r=US&IR=T

Societe Generale report on the Kerviel case.

https://www.societegenerale.com/en/news/newsroom/kerviel-case

The demand for farming system intensification, and potential demand for mechanization,

started rising in Kenya in a few pockets of areas favorable for intensification. It has been argued

that an increasing population and greater food demand motivate an increase in effective

mechanization, in particular with regard to draft animals in areas where tractors are not

appropriate or have failed (O’Neill and Kemp 1989). Migration to more favorable areas leads to

more intensive production with a shorter fallow period. An example is Nyanza province,

described as early as the 1940s (Humphrey 1947). Similarly, immigration occurred into the high

altitudes, which had historically enjoyed a better climate and lower incidence of disease , such as

the North Kavirondo district (Wagner 1949) and the Kikuyu highlands (Humphrey 1945).

Mechanization was more substantially stimulated by such farming intensification than by other

factors. For example, the spread of the plow from settlers to smallholders had been a relatively
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minor channel of diffusion, because such transfers had often been inhibited by a number of

discriminatory practices (Pingali, Bigot, and Binswanger 1987). Infrastructure development also

led to farming system intensification and increased use of more modern mechanization methods.

Intensive production of maize in more fertile parts of Kenya was directly induced by the railways

built by the colonial government, and commercial production of maize along the railways has

been concentrated in the areas with high potential for production (Pingali, Bigot, and Binswanger

1987). Favorable areas with a good railway network, such as Nyanza province, started seeing the

use of animal-drawn moldboard plows as early as the 1920s and the 1930s, for the production of

maize and cotton (Pingali, Bigot, and Binswanger 1987). By the mid-1980s, the use of

mechanization had spread gradually for various transport operations in areas including most of

the highlands, Embu and Machakos districts, and areas around Nairobi; it had also spread,

though to a lesser extent, for plowing activities in areas including Embu and Machakos districts

(Pingali, Bigot, and Binswanger 1987). In these areas, the use of animal-drawn plows had also

started spreading by the mid-1980s. Also by that time, private-sector contract-hire operations

with tractors had also been observed in various locations within Kenya, including Nakuru and

Narok districts (Pingali, Bigot, and Binswanger 1987). Animal power has the potential to

enhance a farmer’s ability to adopt and use renewable practices such as animal manure, crop

rotation, and ridging. It allows the cultivation of larger areas, increases household production and

food security, and enhances the likelihood of a marketable surplus (BishopSambrook 2005). In

the late 1990s, it was estimated that 65 percent of the cultivated area in Africa south of the

Sahara (SSA) was prepared by hand, 25 percent by draft animals, and 10 percent by tractors

(FAO and UNIDO 2008). In Kenya, the main draft animals are oxen and donkeys, which are

well distributed throughout the country. The use of animal traction had also benefited from the
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breeding of larger cattle with greater tractive power. Kenya was one of the successful examples

of such activities, where the use of breeding activities originally aimed at producing suitable beef

and dairy cattle had been applied to breeding cattle for tractive purposes (Jaetzold and Schmidt

1982). Tractors were introduced in Kenya shortly after World War II, and in the two decades

following the nation’s 1963 independence, the government promoted motorized mechanization

to smallholders through state-sponsored tractor hiring and tractor credit schemes, with the aim of

increasing the production of crops (Guthiga, Karugia, and Nyikal 2007). The adoption of tractors

in SSA went through various phases between 1945 and 1981, each phase being significant in

increasing the number of tractors in use (Pingali 2007). Kenya was among the first generation of

tractor users in SSA, with the introduction of a substantial number of tractors in 1945–1955, and

adoption spread from settler farmers to farms owned by native Africans. In early years, tractors

were used in public irrigation schemes such as the Mwea Irrigation Settlement Scheme, where

tractor hiring through leasing companies started in 1960 (Pingali, Bigot, and Binswanger 1987).

In 1966/67, government tractor hiring service was initiated in Kenya when 50 tractors were

introduced to provide cultivation services, primarily for areas under the Masai Wheat Scheme

(Pingali, Bigot, and Binswanger 1987). Although these 50 tractors achieved about 770

productive hours per machine in 1967/68, and remained relatively productive in early years, once

the total number of tractors increased to 150 in 1980, the number of productive hours per tractor

decreased substantially, to 167 a year in 1980 (Pingali, Bigot, and Binswanger 1987), which was

considerably lower than the rate of about 1,000 hours recorded in the private sector in Kenya in

1981 (Seager and Fieldson 1984). Whereas such low performance of public-sector hiring

services was similar to the experience of other African countries, in the case of Kenya, the

public-sector hiring service operations were also restricted to their respective jurisdictions and
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not allowed to operate outside them. Similar to many other SSA countries, Kenya saw a decline

in mechanization in the 1980s, especially in the use of tractors and tractor hiring services for

farming (Pingali 2007). In Kenya, similar to other SSA countries, most farmers could not

individually afford tractors, and the organization of cooperatives or farmer groups to access

credit and obtain tractors was rare (Lamidi and Akande 2013). Large-scale farming, in contrast to

small-scale farming, has seen higher levels of mechanization at all stages of production. For

example, irrigation schemes for sugarcane production in Kenya, similar to those in Sudan and

Tanzania, have been highly mechanized. The major mechanized operations include land

preparation, cane loading, and cane transport to the factory (Kienzle, Ashburner, and Sims 2013).

Another example is large-scale wheat farming in Kenya, which uses tractors for cultivation and

planting, spraying equipment, and combine harvesters; most of this machinery is owned rather

than hired (Longmire and Lugogo 1989). However, these types of farmers have remained small

in terms of share in Kenya. After the collapse of tractor projects, attention was given to draft

animal power as a more sustainable option. In Kenya, a program to support draft animal power

was established in 1970, covering the selection and training of draft animals, the development of

the collar harnesses and oxen yokes, farmer training, and development of specialized equipment

(Onyango 1988). These efforts have produced mixed results. For maize production, the

promotion of mechanization projects saw a relative success in Kenya, but to a limited extent

compared with other countries in East Africa, such as Tanzania (Anthony 1988).