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Corporate Culture Is Key Element in Fighting Rogue Trading

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Every financial institution is acutely aware that rogue traders can cause tremendous damage to the balance sheets and reputations of the firms for whom they work.  Detecting and preventing rogue trading activity, however, is not easy.  Large financial institutions have made significant investments in sophisticated systems to identify unauthorized activity, but the ability of individuals to avoid detection and make unauthorized trades remains a concern for the risk management and executive teams in many leading organizations.

Margins in the industry have been squeezed from multiple forces and the financial marketplace has become more competitive than ever, putting ever increasing pressure on trading organizations to generate revenues.  This pressure can also contribute to a rogue or “cowboy” mentality that blurs the line between acceptable and unacceptable behavior.  Traders, after all, are rarely penalized for making successful yet unauthorized trades.  Typically it is only the trades that go bad which gain the attention and challenge of management.

It has become increasingly clear that technology and information systems cannot be relied upon exclusively to track or catch rogue traders.  Such traders are often trusted insiders with intimate knowledge of the systems in place; moreover, they may be acting with what they believe to be the best interests of the organization in mind.  Informed, capable employees adapt readily to changing environments and increased complexity, but systems do not.   One of the best ways to deter rogue trading, therefore, is to concentrate on organizational culture and behavior.

It is almost impossible to change an organization’s culture without strong leadership and clear messages from the top.   The board and senior management should seek to develop, not only an awareness of risk, but a mindset that helps protect the company from the dangers of rogue trading.  This depends not only on communication but on putting proper mechanisms in place for monitoring and oversight, along with more effective incentives and performance management structures.

Risk-taking is an essential part of the financial services industry, particularly in the capital markets business.   Capital markets firms often experience difficulties among front, middle and back offices.  The way traders’ books are marked, particularly during a down period, can limit a trader’s access to capital, affecting his or her ability to execute trading strategies and causing friction between the trading desks and risk management functions.  These differences can become entrenched, and the resulting antagonism can prevent the kind of cooperation needed to foil a rogue trader.

Our survey of the risk management practices of nearly 400 global companies shows that some companies – we call them “risk masters” – have developed specific, effective practices that help better protect their organizations from the dangers of rogue trading.  For example, risk masters more often have risk-based compensation structures in place that reward employees using a risk-adjusted return metric.  This structure rewards traders based on the amount of risk taken to achieve their returns; traders who risk less for the same level of return as a peer are more highly compensated as a result.  Comprehensive, well-communicated ethics and compliance programs can also lessen the risks of rogue trading.  Employees need to know how to report misconduct and should be able to do so without fear of retaliation.

Firms should regularly review and align their formal written policies with what goes on informally at the trading desks.  If there is a large gap between policy and practice, more employees will disregard formal rules in favor of what they see taking place in the “real world” trading environment.   One of the most famous rogue traders, Barings’ Nick Leeson, had a back office background and was allowed to settle his own trades, in contravention of stated company policy.

Organizations involved in trading activities will never be completely impervious to the risks posed by rogue traders.   We believe, however, that clear communication of a company’s risk appetite and tolerances, its ethical policies and reporting standards can not only deter rogue trading but can encourage potential “rogues” to consider working elsewhere.   Corporate culture can in fact be an important first line of defense in protecting organizations against such activity.