What is Rogue Trading?

Rogue trading is when an employee authorized to trade on behalf of their employer begins to trade outsize the parameters of their mandate. This article provides a deep dive into rogue trading. We’ll look at how it’s done, cover one of the wildest Wall Street rogue trading stories, and learn how firms are fighting to prevent potential billion dollar losses. This is one way not to start off your finance career, but you can certainly make a name for yourself (and earn some prison time in the process).

Rogue Trading Overview

Although not commonly talked about, rogue trading is a relatively common phenomenon. Traders frequently operate outside their specific risk parameters and trading criteria. Firms usually don’t catch these traders. Occasionally, banks will handsomely reward them if their unauthorized trades are successful.

In general, there are two primary reasons that traders go rogue. First, they have racked up significant losses that they are trying to cover up or make back. Second, they get caught up in a culture of intense competition and pressure to deliver results. It’s an incredibly stressful job and the stakes couldn’t be higher.

Trades can ‘go rogue’ in a few different ways:

• They could be different securities altogether. For example, a bond trader switches from AAA corporate bonds to risky junk bonds.
• They could be the same securities but with a different strategy, outsize quantities, or excessive leverage. The bond trader amasses a short position of $10B worth of AAA bonds when his book is supposed to max out at $100M and is long-only.
• It could be mismarking the value of securities. The bond trader is dabbling in complex, illiquid asset backed securities and inflates the value of his book by 10x versus what standard valuation methodologies would hold the position at.
• Or, it could also be hiding losses. The bond trader shifts a $100M loss to a different trading account and clear his own book.

Over the next 50 years we’ll probably see 50 new and different methods of rogue trading. Innovation in financial markets is constant, and with it come both opportunities and huge risks. Now, quantitative traders go rogue with an errant line of code in their algorithm.

A Classic Rogue Trading Tale: Barings’ Nick Leeson

In the early ’90s, British trader Nick Leeson made his way to Singapore form the UK. He was tasked with opening the futures and options trading desk for Barings Bank on the Singapore International Monetary Exchange. At his new office, he headed both front and back office operations (trading and support, as well as compliance). Some foreshadowing, turns out he moved to Singapore largely because he failed to receive a UK securities license after submitting a fraudulent application.

Initially, Leeson killed it. His first year he raked in a profit of £10 million, or 10% of earnings for the whole of Barings. Unfortunately, his luck quickly turned. Trades began to go south and Leeson used one of Barings’ error accounts (meant to correct small trading mistakes) to hide the losses.

With no apparent repercussions, Leeson and team continued to employ the error accounts to transfer trading losses off the normal books. Apparently, one of the traders on Leeson’s team had a habit of rolling into work every day horribly hungover and probably coked out — not a recipe for workplace success, this homie was an error account regular and racked up huge losses.

Starting small, the error accounts held approximately £2 million in losses by the end of 1992. Following their initial ‘success’ with the accounts, this amount grew to £23 million by 1993. But, by 1994, the group hit combined losses of £208 million.

Like any self-respecting WallStreetBets trader, Leeson followed a strategy of doubling down every time he lost a trade. Remarkably, this occasionally worked for him, earning himself the reputation of being a trading genius through his early Singapore years.

However, as with the best WSB traders, reality caught up to Leeson in spectacular fashion. In January 1995, Leeson placed a short straddle in the Singapore and Tokyo stock exchanges, essentially wagering that the Japanese exchange would not move significantly overnight. Too bad for our homie, the Great Hanshin earthquake hit early the next morning. No surprise, markets cratered and Leeson’s position was obliterated.

Don’t worry, even catastrophic losses from a once in a lifetime natural disaster couldn’t stop our boy Leeson. He doubled down, using a long future arbitrage strategy to bet that the Japanese market would rapidly recover.

Shockingly, this bet did not work either. You really hate to see it (especially if you were a Barings shareholder). On February 23rd, 1995, Leeson left a note saying simply “I’m sorry” and fled the country. Investigators uncovered total losses in the neighborhood of $1.4 billion, or twice Barings’ available capital. An ensuing bailout attempt failed, and Barings was declared insolvent on February 26th. Thus marked the end of the UK’s oldest merchant bank.

Eventually extradited, Singaporean courts sentenced Leeson to six and a half years in prison. Really not bad for him, especially considering he made it out in four with good behavior.

Like any true Wall Street crook, Leeson eventually scored a book deal from the debacle, publishing Rogue Trader. He’s now a regular on the corporate speaking circuit and promotes himself at nickleeson.com using the tagline ‘The Original Rogue Trader.’

How Do They Do It?

In post mortems, it’s often the case that rogue traders exploited multiple weaknesses in their firms’ procedures and trading systems. Investigations frequently show that multiple managers were aware of the supposed profits (which often turn out to be fictitious), and therefore knew that risks were being taken.

That means it’s not always a case of a trader sneaking behind everyone’s backs, devising ingenious methods for skirting risk controls. It could be as simple as a trader tripping the risk management system, but their manager ignoring the warning.

The same performance pressure that drives traders to go rogue also incentivizes managers to turn a blind eye. Foremost in their mind are potential bonuses and promotion opportunities (or fear of layoffs for underperformance). Likelihood of positive outcomes increases as profits increase (which, again, are likely to be fictitious profits in a rogue trading scenario). Unsurprisingly, prospects diminish if your group has to fire the most productive trader.

Putting an End to Rogue Trading

The key for firms is to reduce or eliminate the human element as much as possible. Top firms avoid giving any individual broad authority to both make trades and subsequent entries in firm systems. They also promote teamwork culture, with the goal of eliminating the ‘star trader’ role that is often the one responsible for these events. Selfishly, banks can offer lower compensation if employees believe profits resulted from collective effort rather than individual genius.

Simple checks like tracking trader profitability vs. expectations, and subsequent investigations of meaningful deviation, are often enough on their own. This, of course, requires consistent setting and enforcement of rules. Not the bending of rules when the profits start flowing.

Also important is the power and autonomy of a bank’s compliance function. If actual or perceived reporting structures place compliance under the purview of a trading group head, it’s pretty clear that compliance measures will not be as stringent (Nick Leeson case in point). If compliance is well regarded within the firm, has clear power above and beyond the traders, and is not thought of as a useless cost center, it is less likely there will be significant negative outcomes such as a rogue trading event.

These days firms also employ sophisticated risk management tools and analytics. These systems will automatically track trader activity vs. parameters, level of risk taken, irregular trading patterns, and any number of increasingly advanced real time analyses. Compliance teams are huge and are knowledgeable operators, something which hasn’t always been the case.

Unfortunately, these precautions too often foster complacency. The most important preventative measure is a deep-rooted institutional culture of honesty. Senior leadership must prioritize honesty and trustworthiness over performance goals and metrics, driving these cultural priorities throughout the organization.

Or don’t, because there’s nothing more fascinating than seeing some goon evaporate billions of dollars like a meme trader on steroids.