As long as there have been financial markets, there have been serious financial losses. But the traders of today have shown a talent for blowing billions.
Now the attention of financial commentators and astounded public is on the management of the so-called “London Whale” trading losses – revolving around a trader in financial derivatives working at JP Morgan’s London office called Bruno Iksil. This time the loss is a whopping $6.2 billion.
In the past few days, the lid has been lifted on the inner workings of the world of trading by a legal case filed in New York. The London Whale himself has not been charged with any wrongdoing, and has co-operated with authorities throughout their investigation. Rather, the case has been brought against two of his managers – Javier Martin-Artajo and Julien Grout.
The papers allege these two individuals were responsible for hiding more than $660m in losses associated with the case. A careful reading of two 16-page documents reveals some of the dynamics that allowed the company to lose so much in such a short period of time, and not be picked up.
What went wrong
The first thing that struck me about this case is just how complicated the day jobs of the people involved were. They traded in credit default swaps. These are like an insurance policy on an underlying credit risk. Sounds complicated right? Well imagine trying to manage a huge institution full of people doing equally complicated activities.
Oversight is going to be difficult when the task to oversee is so baroque. This creates significant space for traders to hide mistakes and operate off the regulatory and even managerial radar. Research on knowledge workers - those who, like traders, “think for a living” - suggests that the technical complexity of their tasks often creates ambiguity: the right and wrong answers are unclear and difficult to understand. These workers can take advantage of ambiguity to buffer themselves from the prying eyes of would be managers and regulators. This can be good, as it creates autonomy and intellectually challenging work for the professional. But it can be bad insofar as there is a lack of monitoring which can stop potentially disastrous mistakes being made. Such conditions of complexity create the perfect conditions for rogue trading to flourish.
The next big insight to be found in this document is the fact that it was not just one individual engaged in the London Whale trade, but a group of people. The losses were quickly identified and there are several emails in which Iskill tells his superiors that the losses are escalating and he could no longer hide them. But because these things are complex and based on risk, there was hope the loss was recoverable – they just had to wait and the market would change.
According to the court documents, the more senior manager (Martin-Artajo) noted that he was under pressure from New York (the headquarters) to deliver good results. The more junior (Groute) recognised he certainly had some wriggle room in how he kept track of the results every day (the difference between bid and ask price on which the contracts were valued), and he used it to avoid having to report the losses. By doing this, both of the managers were able to look good to HQ, thereby preserving their own prospects and the prospects of their department.
If the prosecution’s version of events is true, why did the group not come clean when it was clear how much money they had lost? Research suggests that as soon as we commit to one minor misdemeanour, we are far more likely to commit to a larger related one. So for instance, if I say to my colleague I will go for a beer with them during work hours, then I am more likely to go on to drink many more beers (even though I know it is probably a bad idea). This is what we call escalating commitment. In the London Whale case, we see a perfect case of “escalating deception”, when small deceptions lead to ever-larger ones.
The final big insight from this report is there was little independent checking. The legal document notes that only one person was charged with independently checking the risk of decisions made by traders in this part of the organisation. And given the lack of capacity, this person did not tend to make independent judgements. Instead they relied on the expert of advice of the traders. The result is that the very people who were supposedly being monitored were providing expert advice to the person who was supposed to be checking on them.
Lessons for industry
Recent examples of traders making huge losses not only offer some important lessons about what can go wrong, but also what financial institutions may need to fix in the future.
First, it is quite clear that the complexity of the products many traders are dealing with created room for highly specialised experts to exploit the widespread ignorance about what they were up to. Dealing with this might mean cutting back on complex products. Where this is not possible, it might mean trying to contain complexity so failures cannot happen on such a grand scale.
Second, organisations must get over the bias towards reporting good news. To do this, financial institutions need to allow and indeed positively encourage employees to give bad news when they see it. The kind of no-fault reporting of safety issues found in the petro-chemical industry is an example of this. What this means is that if you are an employee and see a problem on an oil-rig and you report it, you will not be held at fault. This often liberates the identification of minor problems and an ethos of continued improvement.
Third, it’s clear rogue trading builds up over time. To stop this, circuit breakers and clear decision points are useful. These force people to periodically stand back and reflect on whether they are making wise choices. An example here is the treadmill which forces a runner to slow down every 30 minutes, thereby potentially saving them from an injury. It is also important to offer people easy ways out when they realise they have got themselves in too deep.
Finally, we saw that rogue trading is often missed because there is a lack of independence in oversight. To address this, it is vital that financial institutions build in better risk management roles that can take genuinely independent views. This has certainly already begun to happen in most large institutions. The really big challenge is to make these internal critics into a daily part of the trading floor who are not treated as impediment to doing business. Doing this involves bringing together a risk loving culture of the traders with a more risk averse culture of the compliance team. It may sound impossible, but it is a daily reality in many other sectors like resource exploration, the military, and emergency services.
And if organisations like JP Morgan don’t start building these measures into their workplace culture, groups of traders are going to keep losing them billions.