Late last month, JérÃ´me Kerviel, a trader at French investment bank, Société Générale, was found to have made an unhedged 50 billion euro bet on the upward direction of European equity indices. As equity markets plummeted, in the wake of renewed financial turbulence resulting from the credit crunch, Kerviel lost his bet.
Before long, the 31-year-old trader was being questioned by the French authorities, and it was soon revealed that Société Générale had lost a massive 4.9 billion euros (around £3.7 billion) - the biggest loss in banking history. SocGen is now subject to takeover interest from its rival banks BNP Paribas and Credit Agricole, and Kerviel has been under 24-hour police supervision, after a special request for protection was put in by the French Finance Ministry.
Over 12 years ago, another rogue trader, Nick Leeson, was betting on the direction of the Singaporean stock market. And in 1995, although his actions triggered losses a mere quarter of the size of Kerviel's, they still caused the collapse of the venerable British investment bank, Barings. So what happened? What did he and Kerviel do wrong?
JérÃ´me Kerviel was an index arbitrage trader at Société Générale - a bank with both a retail arm (serving the public) and a wholesale/investment banking arm (serving companies, investors and itself). If you walked down a French high street, you could pay in money to your SocGen current account. Or if you ran a business, you could go to your local branch to ask for a loan. In other words, the usual, run-of-the-mill banking activities. But Kerviel's world was different to this one. He worked on the bank's trading floor.
His job was to exploit differences between the price of individual shares and that of whole indexes of shares, like the FTSE 100 - the basket of the 100 largest companies, measured by market capitalisation on the London Stock Exchange.
Like the other investment banks, who made money offering market making in financial securities (i.e. trading) services to their clients, SocGen had the idea of making a little extra money for themselves. They employed traders on proprietary desks to trade, not for clients, but for Société Générale itself. They gave them capital (or cash) to trade with and agreed with them a strategy and set of parameters within which they could apply trading techniques. In this case the technique was index arbitrage and Kerviel was betting on the direction of the German stock market - the DAX.
Arbitrage means buying something in one market and selling it in another. Let's take an everyday example - crisps. Imagine a packet of Walkers crisps on sale for 30p in Tesco. Also, imagine a six-pack of the same crisps costs £1.20. Do you see a way to make a profit here?
Tesco would probably get very cross, call the police and have you immediately escorted from the premises, but just imagine you could start a small retail outlet next to the crisp aisle, selling individual packets to everyone who wanted them. You would buy six packs of crisps at £1.20, or 20p per bag, and then sell them to crisp-buyers at the prevailing single-bag market price of 30p each - making a profit of 10p per bag.
To use the language of traders, you would go long in six-packs (i.e. you would buy them) and go short in single packets (i.e. you would sell them). Your outlay in one commodity would be matched by your income in the other. You would be hedged. This is described as arbitrage and in carrying it out it, you would become an arbitrageur.
Essentially, this is where you are buying fungible (or indistinguishable) products in the wholesale market (at a discounted price) and then capitalising on the imbalance in prices, by selling them on for a higher price in the retail market.
If trading in this way was legal and Tesco could do nothing to stop you, eventually one of two things would happen. Either the price of the six-packs would rise, or the price of the individual packs of crisps would fall. For, as long as there is a spread between them, more and more traders like you would enter the market to exploit it. Over time, the 'spread' would converge. Eventually, there would be very little difference between the price of crisps bought wholesale versus retail.
And now back to Kerviel. He would compare the price of equity indexes all day long against the aggregate prices of the individual shares they comprised. Wherever there was a difference, be bought the index and sold the individual shares, or vice versa, because he knew that the prices would converge over time.
Whenever he made this trade, he was hedged - as his long position in the index was always matched by his short position in the underlying securities - or vice versa. Or at least, that was what was meant to happen. But what he actually did was a different matter. What he ended up doing was betting, plain and simple. He bought the index, hoping it would go up, without buying the underlying shares. In effect, he was unhedged - or in trader parlance - naked. And his vast knowledge of control procedures at the bank, gained in a previous position with the company, enabled him to conceal his actions.
When the share prices plummeted, his fraudulent actions led to a loss of billions, and Société Générale's lax controls were exposed, seriously damaging their credit rating, and reputation, in the process.
So what now? It can be very difficult to convict somebody of fraud, and possibly even more so in Kerviel's case, since there has been no evidence to suggest that he was doing this to line his own pockets - he has always insisted that he was just trying to increase the bank's profits. Instead he has been charged with breach of trust. And if Kerviel is found guilty of this, he could face up to three years in prison and a fine of 370,000 euros (£186,500).
The language of trading
Long - buying securities in the hope their price will rise. You buy low and sell high.
Short - selling securities that you do not own, borrowing them to fulfil the sale contract from a stock lender and waiting for their price to fall so you can buy them back in the market, repay your lender and make a profit from the falling price. You still buy low and sell high - just the other way around. The technique is used to make a profit from falling stock prices.
Arbitrage - buying something in one market and selling it in another to exploit the price differentials between them - like buying a cheap
iPod in America and selling to your friend in the UK for the prevailing retail price - and pocketing the difference.
Index - a basket of securities - like the FTSE 100 - the hundred largest shares, measured by market capitalisation listed on the London Stock Exchange.
Hedged - a position that is balanced by another compensating position.
Naked - an unhedged position - a gamble.
Possible job interview questions
Explain to me how a short sale works.
How would you value a company?
What is the difference between fundamental analysis and technical analysis?
What is the current level of the FTSE 100?
Do you follow any stocks? Which ones and why?
If you had £1000 to invest in the market right now, what would you do with it?
Five to work for
Well, we would have said Société Générale...
"¢ Goldman Sachs
"¢ Morgan Stanley
"¢ Credit Suisse
"¢ Merrill Lynch
"¢ BNP Paribas
Jobs in the world of trading
Salesperson - builds relationships with clients and brings in business for their trader. They make money from commissions charged on sales or purchases.
Trader - buys and sells financial instruments, like securities (e.g. stocks and bonds), to make a profit. The money is made from the difference or 'spread' between the buy and sell prices.
Researcher - develops an understanding of, and forms an opinion on, an underlying company, security, commodity, index, market space or sector. They then write a report on it to encourage clients to buy or sell, using their sales team and trading facility.
Structurer - designs bespoke securities to meet the investment needs of customers, that cannot be met by pre-existing products. In effect, a financial 'engineer'.
Quantitative Analyst or Quant - builds computer (spreadsheet) models that anticipate future movements in securities or markets. These can be used by traders as a facility to trade, either to make a profit or hedge against risk.
"¢ Market Wizards - Interviews with Top Traders by Jack Schwager
"¢ Vault Guide to Sales and Trading by Gabriel Kim
"¢ Options, Futures and Other Derivatives by John C. Hull
"¢ Rogue Trader by Nick Leeson
"¢ All that Glitters: The Fall of Barings by John Gapper and Nick Denton