Financial Risk, MVE 220 Chalmers University of Technology

Jrme Kerviel
The poorest man on earth
Daniel Werner 880908-2012 Karl Lawenius 901213-0093 [2010-11-24]

The authors have written this report together, no part belongs to one more than the other.

Contents
Introduction ......................................................................................................................................... 3 Trading ................................................................................................................................................ 3 Timeline .............................................................................................................................................. 4 Banking system ................................................................................................................................... 5 Risk control ......................................................................................................................................... 6 Kerviels story ..................................................................................................................................... 7 Conclusions ......................................................................................................................................... 8 Further reading .................................................................................................................................... 9 References ......................................................................................................................................... 10

Introduction On October 5th 2010 Jerome Kerviel became the poorest man on earth. He was fined 4.9 billion and sentenced to five years in prison. A couple of years earlier he was an ordinary trader at the French bank Socit Gnrale, SocGen, but grew tired of the day to day trading. He started betting more and more money, eventually resulting in the biggest loss a single man has caused a bank - a loss of 4.9 billion. How could this happen with todays technology? How can a single man manage to lose so much money and jeopardize the future of one of Frances oldest and most renowned banks? Trading The job of a trader in a bank is to use the banks funds to make bets on the market and earn money according a certain risk level. There are many different kinds of products to bet on; stocks, options, futures, currencies and derivatives. To understand how Kerviel lost the money, it is important to understand how the trading works and how they minimize their risk. The traders at a bank work in different teams, grouped together in areas of expertise. Some work with derivatives, other with stocks or currencies. They work together analyzing the market and trading for maximum revenue. Because every trade with a small risk generates a small sum, the big money is made by making a lot of trades. The traders therefore sit by their computers and trade as fast and as much as possible. Banks often have a bonus system for their traders, the more money made for the bank, the higher bonus. (BBC, 2008) In order to minimize risk, traders use the hedging technique. Derivatives are the financial instruments most often used to do so. A derivative is a security that is derived from underlying assets, such as stocks. The best way to understand hedging is to think of it as insurance. There are many different ways to hedge a position. To hedge by location means to buy equities on one market and at the same time sell them in another, at a better price. To hedge by timing is to secure a high sell price in the future. A third way to hedge is to go long on one kind of product you believe in and simultaneously bet the opposite, go short, on another product with a negative correlation to the first. If you bet correctly, you will earn money on the long bet. If the bet was false, you lose money. However, since you bought your insurance you earn some money on that bet, and altogether you lose much less. The goal of hedging is never to earn more money, but to protect from losses. (Investopedia, 2010)

Timeline Kerviel was hired by SocGen in 2000 as an employee in the middle office (see banking system) after graduating with a master of finance from the University Lumire Lyon 2. (The Telegraph, 2008) He started his career at the bank with a dream of becoming a Delta One trader, where they mainly deal with trading of stock portfolios, index, exchange-traded funds and quantitative trading (mathematical and statistical models). He reached this goal in 2005 when he was promoted to a junior position in the Delta One department Kerviels job was within the area arbitrage; he bought and sold portfolios of stock market index futures. (NY Times, 2008) After getting settled at the Delta One office Kerviel wanted to make more money faster and started to bet on the outcome of the whole market instead of betting in a hedged way as he was supposed to do. "His job was to make bets on small price differences between contracts, not to trade on the markets' direction," (Jean-Pierre Mustier SocGen's CEO, 2008) His first unauthorized trade is believed to be late 2005 when he shortened stocks in the German insurance company Allianz, and therefore bet on a downturn for the market. This bet turned out to be a successive one and the bank made a winning of 500 000. Although this trade was not hedged and also exceeded Kerviels credit limit, SocGen did not give Kerviel a warning, but accepted the win. (CIOZone, 2008) Strengthened by this success Kerviel continued betting on the outcome of markets instead of dealing with arbitrage, as he was supposed to. From this point on he chose not to hedge his bets, to earn more money and get a greater bonus. To hide this unauthorized trade he started making up fictive trades. The key part of this fictive operation was that by the end of the day all trades had to have a counterpart. That is all bets had to look hedged, so that it did not look like he had exceeded his credit risk. By faking a hedge Kerviel risked more money than it looked like in the computer system, with a chance of winning more. For example by going long with 25 million without a hedge he risked it all, but with the fictive hedge it only looked like he was risking 1 million. Playing this way Kerviel was able to trade with 400 billion in securities during two years and by the end of 2007 it is said that he had a positive gain of 1.4 billion euros. (BBC, 2008, Der Spiegel, 2010).
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As the year 2008 began the European stock market suffered great losses and its index fell. At the same time Kerviel made big investments betting that the market would turn back up. This was not the case and Kerviel started to lose a great amount of money. During this period Kerviel made his investments according a technique often used in roulette, a martingale every time you lose money, you double your bet. Casinos have limits of how much you can bet, banks and stock markets do not. (CIOZone, 2008) SocGen had a security system that recorded losses and not trades, so it was not until Kerviel started to lose money that SocGen discovered what he was up to. When they found out about Kerviels activities he had been able to put positions of about 50 billion on the market. When SocGen found out about this amount of money they panicked and started to sell off all the investments on the weak market. When doing so they lost 4.9 billion, the largest loss ever caused by a single trader. (NY Times, 2010) Kerviel was suspended from the delta one unit on the 20th of January 2008. On January 28th he was taken in to custody by the French Police and remained there for 38 days. The trial against him started on the 8th of June 2010 and ended about for months later on the 5th of October. The outcome was that Kerviel was guilty of breach of trust, forgery and unauthorized use of computer systems and thereby sentenced to 5 years in prison, with two years suspended. He was also committed to pay a fine of 4.9 billion to SocGen and banned for life from working with financial service. Kerviel is not forced to sit off his penalty until after an appeal is made and is now working as a computer consultant, making 2 300 a month. With this salary it will take Kerviel about 177 500 years to pay of his debt. (Der Spiegel, 2010) Banking system The banking system consists of three different types of offices; the front, the middle and the back office. The front office is the place where the bank handles the dealing with clients, the marketing, the service and sales. This is where the money is made. The back office and middle office, also known as operation, are places never seen by customers. The back office is where all the administrative work is done. It is where they handle the position keeping and see to the verification and settlement of all transactions the front office has done. The marketing, the IT and HR department are also often a part of the back office. In the middle office, people work with analysis and management risk. They analyze the market and credit risk from trades from the front office, and set limits of the amount allowed to trade with. This to ensure no bad
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trades would jeopardize the overall revenue. The middle office is also responsible for detecting fraud. The middle offices finance department is responsible for the banks assets management and is the main advisor to the board of directors. (BBC, 2008) Risk control According a report written by Frances finance minister, Christine Lagarde, there were three areas in which SocGen failed to control their risk. The first neglected area was that an employee from the operations could be reassigned to the front desk, just what happened with Kerviel. This, according the report, is due to the fact that the employee then knows what means are used to detect fraud, and perhaps could use this information. The other area was the security with the internal computer system which was substandard. The last was the lack of warning system to alert management about an individual trader taking on too much risk. France's Banking Commission fined SocGen 4 million on account of the scandal. (BBC, 2008) Another report from an internal investigation states that Kerviels direct bosses were unqualified for their jobs. The direct supervisor lacked experience in trading and did not get enough support in his role as a supervisor. If they would have had better knowledge and control over the market activities, and reacted on the warning signals earlier, the loss may have been prevented. According the report Kerviel knew how to be convincing in order to fool his entourage. (NY Times, 2008) SocGen had a warning system. In 2003 they created a database where all losses would be stored. This database would then be used to analyze the losses and see in what kind of situation and how they became losses, both in France and abroad. However, this database only saved all losses, not all transactions. Since Kerviels bet of 50 billion euro was not yet a loss, the system did not react. The amount was still pending when he was caught. The system also failed to see that there were several fake hedges that did not minimize the risk of positions. (CIOZone, 2008) After the incident SocGen said they would spend up to 100 million to improve its risk management. They have since then created two different groups working with the monitoring of trades and supervision of operational security. They have investigated in a new IT Security system and also trained 7800 of their employees in fraud awareness. (Societe Generale, 2010)

Kerviels story The questions about who did what, and more important who knew what, are two very important questions in the Jerome Kerviel case. This following section explains what Kerviel has to say about his role as a contrast to what SocGen has to say. Kerviel claims that SocGen knew about his activities since it all started with the first bet on Allianz. He states in an interview that his boss pointed out that a trader of his experience was not allowed to take on such high risks, but afterwards increased both his limit and his freedom of trade. (Der Spiegel, 2010) In the risk control section we mentioned that SocGen had a computer system that discovered losses and not transactions and thereby SocGen had no knowledge about what was going on. Kerviel however claims that he in March 2007 predicted that there would be a crash as a result of the American subprime loans. He therefore started to invest, little by little, money in a market crash. Between March and July he took out positions worth 30 billion, but the market never collapsed. This exposed him to losses of up to 2 billion, but Kerviel claims that the bank covered his losses every time, without saying a word. Several times during 2007 the German-Swiss derivatives exchange, Eurex, complained to SocGen about Kerviels trading activities. He had invested too much money and had in this way affected the entire market. According Kerviel these reports were ignored by the bank, and are proof that they knew about his activities.

Conclusions It is very hard with our knowledge and the information we have to decide who to believe, Jerome Kerviel or SocGen. Their stories have similarities but differ on some very important points. According Kerviel people at the bank knew what he was doing, and that it was common practice. According SocGen, Kerviel managed to manipulate the computer system and worked alone without the banks knowledge. A fact to consider is that Kerviel stands alone facing the second largest bank in France with almost unlimited resources. A verdict against Kerviel will be forgotten in 10 years, a verdict against SocGen would shake the entire banking world. If what Kerviel says is true, it is the people working at the bank who are responsible for the loss. The banking people have a strong will of earning money, and thereby making bigger bonuses, and take on too much risk since the money involved is not their own. We think the solution for this is a strong leadership with high morals, who tell their employees to make money at a low risk and not as much as possible. If SocGen is right and Kerviel was a lone rogue trader manipulating the system, the safety in the bank has to be looked over. Not only SocGen should then look over their security systems and see if something is lacking, all banks should. With todays technology it is very important banks securities work. Trades happen within seconds, and money transfer faster than ever before losing its value and become ones and zeros. Whoever is right, one person should not be able to trade with money equivalent to one sixth of the GDP of Sweden. To invest 150 million, it only takes a second. For 1 billion, you need four seconds. Things go so quickly with computers that you lose any sense of the amounts involved. Jerome Kerviel, 2010

Further reading The articles of NY Times and BBC have been a primary source of information. The article written by CIOZone is also recommended. For readers further interested in the story from Jerome Kerviels point of view we highly recommend reading his interview with the German magazine Der Spiegel (see the list of references). For those skilled with the French language, we recommend reading Kerviels own book; L'engrenage: Mmoires dun Trader (The Spiral: Memoires of a Trader, not yet published in English).

References CIOZone (2008) A five part study of how to minimize risk. http://www.ciozone.com/index.php/Case-Studies/5-Measures-To-Minimize-Risk.html accessed 2010-11-23 Christoph Pauly, translated from German by Josh Ward. (2010) I Was Merely a Small Cog in the Machine. Der Spiegel 16/11. http://www.spiegel.de/ accessed 2010-11-23 Investopedia (2010) http://www.investopedia.com/ accessed 2010-11-23 Martin, B., Allen, N., Allen P. and Samuel, H. (2008) Jerome Kerviel was 'honest, working class'. The Telegraph. http://www.telegraph.co.uk/ accessed 2010-11-23 Jean-Pierre Mustier, SocGen's CEO, January 27, 2008, press conference Societe Generale (2010) http://www.societegenerale.com/en?_force=1 2010-11-23 Various authors. (2008-2010) Various articles. BBC. http://www.bbc.com/ Search word: Jerome Kerviel accessed 2010-11-23 Various authors. (2008-2010) Various articles. New York Times. http://www.nytimes.com/ Search word: Jerome Kerviel accessed 2010-11-23

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