Prisoner’s Dilemma

Today, the last two of the four NAB rogue traders involved in the $360 million foreign exchange loss were sentenced by the Victorian County Court. The head of the desk Luke Duffy and Senior trader Gianni Gray had already pleaded guilty and been sentenced to 29 months, and 16 months jail respectively. David Bullen and Vince Ficarra chose to fight the charges with Bullen representing himself, and much like in the classic game theory problem, suffered the higher penalties for fighting. Bullen receiving a 44 month sentence, and Ficarra 28 months.

What possessed Ficarra and Bullen to fight the charges is beyond me. Ficarra being the junior, in his first job, working for a group noted for their bullying behaviour had ample mitigating circumstances. These might have, if he had pleaded guilty and shown contrition saved him a custodial sentence, or at the very least got a very much lighter sentence than what he received. Trying to fight the charges in the face of taped evidence of them discussing lying to back office seems the sheerest folly. He may have been junior but he clearly knew what he was doing was wrong. In the end Ficarra received one month less than the leader of the group, perhaps part of the all or nothing risk attitude that got them into trouble in the first place.

The other thing that gets me about this, is why did everyone else get off for free? Sure a number lost jobs, but that hardly reflects the fact that the negligence in every area of letting this go was so breathtakingly extreme as to be unbelievable. While the fake trades may not have been discovered until too late, lots of other behaviour was completely out of the bounds of any reasonable trading activity and was clearly a target for further investigation.

Bullen’s behaviour since the scandal broke has been bizarre as this collection from Crikey highlights. Choosing to represent himself in court, writing a book Fake, My life as a Rogue Trader, claiming to be a Buddhist and talking freely to the media with such quotes as, “The $180m is not ‘lost’. Someone else in the world has it, so the planet has not lost anything.” and “This might be the best thing that’s ever happened for the bank, myself, and the people involved”.

More telling though was his claim that “We were already over the limits for a number of months and the bank knew about it…It has been going on and off for a year and consistently every day since October. It was signed off every day by the risk-management people.”

The APRA report into the incident agreed with him stating:

Despite the currency options desk being in excess of market risk limits almost daily, there was no serious effort by Global Markets to either bring the business back within mandated risk parameters, or undertake any rigorous reassessment of the adequacy of the existing limit structures.

The PWC report (a much better read by the way!) is more detailed.

Although in some cases the true risk position was obscured by the false transactions which were structured by the Traders to achieve this goal, a large number of limit breaches were approved on a daily basis by Mr Dillon, and at various times reported to the General Manager Markets Division (Ron Erdos). A daily summary of limit breaches was sent for a period to Mr Erdos who then delegated the review to the Head of another desk in the Markets Division.

The VaR position records show that limits were persistently breached throughout 2003. The VaR position then escalated significantly in January 2004. Both these points are clearly illustrated in Figure 2.5 below.


The line along the bottom with the arrow pointing to is is supposed to be the maximum this measure is risk is meant to reach, but as can be seen risk was rarely below the line. In a properly functioning system, traders would have been required to reduce any breach of this limit the following day, and if it breaches persisted, it would result in their sacking.

Management at NAB claimed that they did not believe the numbers coming out of their system which may have explained the bumping along just above the limit, but certainly didn’t explain the explosion in risk which commenced in October 03. In addition VaR was not the only risk measure that showed the traders consistently and increasingly outside limits but despite this no attempt was made to investigate what was going on. Even without knowledge of the fraudulent deals, the length of time over which it significant breeches occurred and severity of them made the desk obvious targets for some close investigation which should have uncovered the fraud much earlier. Similarly the failure to pass this information up to board level stinks of more than negligence.

The whole affair is also one of how a system with supposedly many levels of checks, can be overidden by a few agressive bullys to whom no one was prepared to stand up to. In addition we are left with the question of should more people have been charged.


8 Responses to Prisoner’s Dilemma

  1. james says:

    Management didn’t believe the numbers ?
    But we kept trading anyway ?

    It sets a very poor precedent that this is an acceptable excuse – surely any trading room/desk manager can now use this excuse ? This has to be seen as negligence if regulation is to mean anything.

  2. james says:

    There has been a fair bit of discussion of ‘trader culture’ and while I agree for the most part that it is a blokey, boozey and aggressive environment which almost certainly attracts and to some extent encourages risk-seeking behaviour, I haven’t seen any explicit references to the role of the typical trading remuneration structure in producing risk-seeking behaviour. The simple fact is that while traders are rewarded with bonus payments on the basis of their trading *outcomes* – as opposed to their *expected* outcome – and have limited exposure to the downside of making bad trades they will seek to take risks. As an extreme example, consider a trader who has made no money all year and on the last day of the year takes a big 50-50 punt on some market result: if he wins, he gets his 6% (say) of the years earnings and gets paid a big bonus whereas if he loses, he just gets his salary. If his attempt at concealing from his manager the fact that there was no reason (edge) for taking the 50-50 bet is hopeless, he might even get fired. Its worth noting that even having an effective risk system won’t eliminate this behaviour but it should stop the size of the coin flip getting *too* big. Anyway, the point is that with or without effective risk control, this risk seeking behaviour is encouraged by what is ultimately a very common remuneration structure – although not having propert risk control makes this strategy even more attractive.

    Properly managing a trading desk/room/operation is not something the old boys who are ultimately in charge of Australian financial institutions are capable of doing.

  3. Rod Clarke says:

    Honest officer – my speedo did say 160kph but I didn’t beleive it!

  4. Steve says:

    Yes, bonus structure is effectively an option pay off, which encourages high volatility as it makes your option worth more.

    I’m interested though how you think you can measure either in advance or afterwards the expected return vs the actual outcome.

    Currently banks are moving towards risk adjusting returns to try to cut this sort of thing down.

  5. JC says:

    There is one hitch to the 50/50 idea. Jobs are not that easy to come by, especailly if you’ve lost money for the present bank. I think the permutation of trying to figure out the best fit is next to impossible.

    I once worked with risk adjusted returns. It is a good way of figuring out efficienct use of capital. A trader making a million dolls on a billion doll bet is not as efficient as a trader doing it witha 5 million bet.

  6. Steve says:

    JC, wasn’t my comment on the 50/50 thing, but yes there is job loss as a extra downside.

  7. james says:

    Steve, estimating/measuring/quantifying expectation in advance is obviously hard – especially in the context of human traders. But any trader who makes a trade should be able to justify why they have done so and this ‘story’ justifying their belief that they are getting the best of it needs to be assessed by someone capable of doing so. The captain of the first fifteen is probably not the right man. My employer makes a reasonable attempt at this in as much as the senior (even the very top) people are former traders, smart and technically minded. There have been traders who they believe are trading with edge but losing – sometimes over multiple consecutive years but these people still get paid well and receive bonusses. Its clearly pretty subjective but quite often the ‘story’ will be strong. With good management people who just punt will be uncovered.

    Assessing post-trade edge is a matter of forcing traders to record their pre-trade estimates of edge/return and risk. The trader and risk management should agree on the risk. Both these will ‘determine’ what the probability of a particular set of outcomes being observed by chance is. This lets you keep track of how unlucky a trader is and eventually someone appears to be so very very unlucky that its clear they’re actually crap.

    No trader that I have ever known or heard of would be dilligent enough to do this since they’re too busy making money right ?

    I was aware that risk management departments (and funds mngmt too) are interested in risk adj rtn but has anyone ever heard of a trader in an australian bank being given a bonus based on a risk adjusted PL ?

    and as for getting a new job …. this guy seems to be doing ok (!)

    and no, I didn’t know the last point in the ‘did you know’ section.

  8. […] In my opinion this sort of thing does not invalidate VAR, but more likely is a warning of its limitations. It is not the all encompassing measure of risk, and this is something that risk managers should be aware of. However, I’ve discussed before if the NAB had paid attention to it they could have avoided worst parts of the FX options debacle. VAR is a useful measure of risk, but its not everything. […]

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