Société Générale (SG) revealed on January 24 that an alleged rogue trader on its arbitrage desk had racked up EUR4.9 billion in losses by taking unauthorised directional trades on European equity indexes. The losses have raised questions about the firm's control processes, and analysts suggest it could make the bank a target for a takeover.
The trader, named as Jerome Kerviel, had built up exposures to the Dow Jones Eurostoxx 50, Dax and FTSE 100 indexes with a notional amount of EUR50 billion, hiding his positions by entering fictitious offsetting trades into the bank's systems. Having worked in the middle office between 2000 and 2005, the trader was able to exploit his knowledge of the bank's processing and control procedures to avoid detection, SG said.
"He was working before at the middle and back office and knew perfectly how to hide the positions with some fictitious transactions on forwards on indexes. In terms of the value-at-risk spread tests, the delta every night on the position was zero," explains Christophe Mianné, head of global equities and derivatives at Société Générale Corporate and Investment Banking, speaking exclusively to Risk on the day the losses were disclosed.
Unlike the index transactions (built up through the futures market), the fictitious trades did not require immediate confirmation or daily margin payments, and Kerviel was also able to hack into computer systems and falsify documents to justify the entry of the false trades, the bank claims. Another technique apparently involved rolling 30-day forward positions, which were unwound just before confirmation and replaced by forwards with different counterparties, Mianné adds. "He was very clever. But that's not an excuse, because we have to be cleverer."
The scheme only came to light after at least one of the fictional over-the-counter trades attracted back-office attention on Friday, January 18. It seems SG contacted a variety of counterparties, one of which was Deutsche Bank, to check the terms of the trade. However, the bank denied knowledge of the trade on January 19. "Then we spent hours, all night, evaluating the rogue trade, because the trader didn't want to tell the truth immediately, and discovered at the end of Sunday night what the futures position was," Mianné explains.
By January 20, the bank had discovered the full extent of the rogue trades and informed the Banque de France and the French financial market regulator, the AMF. The decision was then taken to close out the trades, starting Monday, January 21. "For reasons of market integrity, we had to settle the positions as fast as we could," the bank's chairman, Daniel Bouton, told a press conference on January 24. "We are not speculators. Our objective was to restore confidence in SG."
However, the close-out of positions coincided with a steep dive in equity markets around the world on January 21. Some analysts have suggested the unwind may have contributed to the sell-off, which saw the Dow Jones Eurostoxx 50 index drop by 7.3% in a single day. However, SG claims the close-out of positions, which took place over three days, never exceeded 8.1% of daily trading volumes.
"We estimate the impact we had on the market was approximately half a per cent," says Mianné. "We had nothing on the Asian markets, and when we arrived on Monday morning, the Asian and emerging markets were already falling. So the impact was minimal. The secrecy was well managed until the start of Wednesday afternoon (January 23), when rumours started to circulate."
The losses were disclosed on the morning of January 24, along with a write-down on subprime exposures of EUR2.05 billion in the fourth quarter of 2007. The bank also revealed it will launch a EUR5.5 billion capital increase, underwritten by JP Morgan and Morgan Stanley, which will take its tier-one ratio to 8%.
Moody's Investors Service downgraded the bank from Aa1 to Aa2 on the back of the news, while Fitch Ratings downgraded it from AA to AA-. "The extent to which the fraudulent positions taken were concealed raises questions about the effectiveness of the bank's processing systems and creates reputational risk for the group," Fitch said.
Indeed, the bank's reputation has come under further attack following reports that Frankfurt-based exchange Eurex alerted SG to a potential problem in November 2007. Despite this, the unauthorised trades remained undetected. Eurex would not comment, other than to say "the control mechanisms at the exchange functioned correctly at all levels". SG did not respond to requests for comment.
Top management at Société Générale has been reshuffled in the wake of the losses. Mianné, who had been promoted to head of global markets in December, was parachuted back in to head the global equities and derivatives division. His former co-head of global equities and derivatives, Luc Francois, who took sole charge of the division after Mianné's promotion, has left the bank, as has Marc Breillout, head of fixed income, currencies and commodities. Olivier Khayat, formerly co-head of capital raising and financing, succeeds Breillout, while the other co-head of capital raising and financing, Jean-Luc Parer, will now take sole charge of the division.
Analysts at Credit Suisse suggested the bank could become a takeover target following the losses - ironically, they said its best defence could be that potential buyers are wary of acquiring a group with such poor internal controls.
Nick Sawyer and Alexander Campbell.