Rogue trading, fixing Vix and pruning Libor

The week on, March 30-April 6, 2018

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The danger of ignoring trader behaviour in risk management

Quants show popular risk measures fail to limit risk-seeking behaviour among traders

Short-vol products pose new risk to investors, experts warn

Vix manipulation reports may be leading investors to pile back into risky short-volatility products

Libor administrator prepares to cut number of rates

Action aimed at keeping Libor going after 2021, says head of Ice Benchmark Administration


COMMENTARY: Human after all

Value-at-risk has come under steady criticism as a risk measure, for failing to register the true danger of tail risk events; expected shortfall (ES) has been praised as a replacement. But this week on both measures came under fire – specifically because they fail to model the true risk of rogue traders.

Academics Damiano Brigo and John Armstrong argue that, while humans are normally risk-averse – the loss of $100 harms them more than the gain of $100 would please them – this doesn’t always apply, in particular in two rather important cases: a shareholder in a limited-liability financial institution and a trader for that institution. In both cases, their potential losses are capped. Shareholders cannot lose more than their total investment in the company’s stock, and, Brigo and Armstrong point out, “no matter how badly their trade performs, once they have lost their job and their reputation, the size of the loss beyond that point will matter little”. Modelling this with an S-shaped utility curve shows VAR and ES limits should have little impact on the behaviour of a rogue trader.

Like so many good ideas, this seems simple. So why has it been missed? It comes down to a very common mistake: treating institutions as though they were people. VAR and ES would work very well to limit the risk-taking of (for example) Credit Suisse. But it’s easy to forget Credit Suisse itself has never taken a single risk decision; it’s a legal entity, not a sentient being. Decisions are taken by people, who can have very different preferences and incentives to the institutions for which they work. 

This change in perspective is showing up elsewhere; in the US, the Fed’s proposal to push risk management responsibility down to business heads rather than leaving it with the board has not been universally welcomed, but it could be the first step towards regulators, in the US and elsewhere, realising their job should not be to regulate the behaviour of institutions, but of people.



The cleared US dollar interest rate swaps market reached a cumulative volume of $21 trillion gross notional in Q1 2018, up 32% from $16 trillion in Q1 2017



“The manipulation story is probably more dangerous than anything else because everyone thinks ‘okay, well it wasn’t a down market, it was just manipulation’, and therefore we are back to the races” – Jerry Haworth, 36 South


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