30/10/2020 Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs REGULATORY IMPLICATIONS OF ROGUE TRADING Unfortunately, rogue trading is not a new phenomenon, but has a long and sordid history, claiming some of the most well respected firms as its victims. Rogue trading refers to traders engaging in fraudulent practices, while trading on behalf of their institutions with a view of deliberately violating an institution’s trading related rules / mandates, with the intention of deriving superior monetary benefits, for themselves. Analysis of its long history (refer to Table 1 for select events and their consequences) reveals typical attributes, with some exceptions, namely a) traders’ assuming sizeable, complex, sensitive, and speculative positions, b) track record of abnormal profits in many cases, as loss making positions are hidden, c) ‘doubling up’ of positions when market moved against the positions, with a view to continue to hide losses from coming to the surface, d) no collusion with other traders—frauds were committed by individual front office traders, with knowledge and access to middle and back office systems and / or processes, e) alerts raised did not evoke sufficient response—they were ignored in many cases and f) basic controls such as segregation of duties and oversight were found to be severely lacking. Table 1 - Select High-Profile Rogue Trading Events & Consequences itps:financeandriskblog accenture.com/regulatory-insightstegulatory-compancelreguatory-¢mplications-of roquestrading ane30/10/2020 2013 itps:tinanceandriskblog accenture.com/regulatory-insightstegulatoy-compancelreguatory-mplications-of roquestrading U.S. based brokerage firm Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs $52mn * Broker for investment funds and hedge funds dealing with mortgage- backed securities under Troubled Assets Relief Program. * Between 2009 and 2011 when the fraud was committed, fictitious customers were created that caused buyers of securities to pay more. Payment of $ 2.2 mn in March 2012 to resolve the matter with regulators, Fall in trading revenue, from $ 40 million profit in 2009 to $10 million loss in 2011. Overcharging of commissions to the tune of approximately $1 million according to the Securities and Exchange Commission. ane30/10/2020 2012 itps:tinanceandrskblog accenture.com/regulatory-insightstegulatoy-compancelreguatory-mplications-ofroguestrading us. investment bank Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs $6.2 bn + Build up an outsize position in an obscure corner of the credit markets. Ultimately, the position proved devastating for the bank. It was said that this practice started five years ago. + The group's risk controls did not keep up with its increasingly large bets. + Internal investigation by the bank, led by the bank’s former CFO, found that some traders might have improperly valued their Positions as losses mounted. * After revising the valuations, the bank had to restate its first-quarter earnings. + The bank closed out the position and moved the remainder of the credit derivative trade to the investment bank + The bank is now subject to rigorous regulatory audits by The Securities and Exchange Commission, the Office of the Comptroller of the Currency and the Federal Reserve. ane30/10/2020 2011 Switzerland based bank itps:tinanceandrskblog accenture.com/regulatory-insightstegulatoy-compancelreguatory-mplications-ofroguestrading Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs $2bn + Trader responsible for the loss is suspected to have used the fact that some ETF transactions in Europe are not issued confirmations until after settlement has taken place. The exploitation of this process allows a party ina transaction to receive payment for a trade before the transaction has been confirmed. + The Trader hid loss making positions by creating fictitious forward cash ETF trades which did not have immediate confirmation. * Prior to this, the trader moved from back office to equities trading desk. + The then CEO resigned to assume responsibility. + The UK's Financial Services ‘Authority fined the bank 29.7 million pounds (U.S. $476 million) for system and control failings. + The bank announced that it would cut back halt of the risk- weighted assets in its investment bank over the next five years, to reduce risk exposure in the wake of the trading scandal. ang30/10/2020 2010 2009 2008 itps:tinanceandrskblog accenture.com/regulatory-insightstegulatory-comp.ancelreguatory-¢mplications-ofroguestrading Global financial derivatives broker US. wealth & investment management firm French universal bank Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs $141 mn $456 mn $7.2 bn * Trader responsible for the loss was indicted on fraud and other charges after racking up $141 million in losses speculating in wheat futures contracts in February 2008. + The incident was disclosed in December 2009. + Trader responsible for the loss deliberately overvalued his trading positions to hide losses. + Fictitious trades were created with pending or fake counterparties to negate overall risk exposure. + Trades were booked with a deferred start and would be cancelled/ amended before confirmation process. This was done 947 times. + In addition, the trader booked 115 couples of symmetrical trades at different prices, for the same products. * Prior to this, the trader moved from back office to trading desk. ‘+ Worked in synthetic funds tracking Euro Indexes, + us. regulators slapped a $10 million fine on the firm for lax supervision. + Forced the U.S. bank to make a $456 million write down. + European Stock markets suffered heavy losses as the bank tried to close out positions built up. sig30/10/2020 2006 2002 1996 itps:tinanceandrskblog accenture.com/regulatory-insightstegulatoy-compancelreguatory-mplications-ofroguestrading Large Australian bank us subsidiary of Ireland bank Large trading company Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs $9187 mn $6$691 mn $2$2.6 bn + The two former foreign exchange options dealers at the bank were found guilty of making false trades to safeguard bonuses and hide losses. + The losses were a result of a failed speculative position where the traders falsified profits to trigger bonuses over a number of years. + Inorder to generate the reported profits, the traders speculated on the US dollar, betting that it would rise against the Australian dollar and other currencies. + The trader concealed positions in fictitious forward currency options. + Concealed losses after bad bets snowballed in one of the largest ever cases of bank fraud. + Large losses in copper trading accumulated over a period of more than 10 years went undetected. * Investigations by the Australian Prudential Regulation Authority (APRA) highlighted the need for cultural change. * Following the scandal, the Group sold its stake in the bank toa US. based bank. + Company's financial losses were over 2.6 billion dollars. ene30/10/2020 Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs + Nick Leeson hid positions by recording fake profits by selling options to himself. * Booked premiums on seven clearing accounts + Barings Bank and corresponding losses collapsed and on suspense accounts. was 1995 | Barings Bank | $184 + Prior to this, he was moved subsequently bn from back office to trading sold to Dutch desk with a significant Bank ING for increase in salary over 2 one pound. relatively short period of time. + His performance significantly outstripped peer group. Position within Risk Management Framework Under the Base! Committee's categorization of Operational Risk, rogue trader risk falls under the ‘People Risk’ category that accounts for errors and misdeeds of employees. In terms of Loss Event Types defined by the Basel Committee, unexpected losses due to rogue trading are categorized under ‘Internal Fraud’. Though rogue trader risk falls under Operational Risk, large losses due to rogue trading are often triggered by adverse movements in Market Risk factors (for example: interest rates, foreign exchange rates, commodity, and equity prices). In this typical interaction between Operational & Market Risk factors, severity of losses due to rogue trading is determined by Market Risk factors. In other words, unless accompanied by adverse movements in relevant Market Risk factors, rogue trading positions would result in relatively low losses as purely Operational Risk events. As an example, the penalty leveled by a regulator would most likely be less than an adverse market movement. Understanding of the risk interactions and their impacts, as depicted in Figure 1, are critical to devise necessary controls and monitoring of positions to effectively manage rogue trader risks. View full illustration itps:tinanceandrskblog accenture.com/regulatory-insightstegulatoy-compancelreguatory-mplications-ofroguestrading me30/10/2020 |rariten Brinn Rogue Weng & Wate Sle aston Lowes oH Aiko Toque Ting cr Figure Regulatory Requirements Please refer to appendix for a description of regulatory requirements. View full illustration rater Guanse en Prevention oF Rogie Tad ft oagene rte romans Fortier Fea ke sos Seana ies Pe ‘tewieeh 754 Cot tempat feeders htm , sua Set“one vente engin te betes ie desrtnen aes aieanseense! ass {fence ne Om forse ry ‘oy wa: ok us sec (oats negenest alte eng "eo toy Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs interaction between Rogue Trading & Market Risks: Impact on Losses Common and unique anti-rogue trading requirements of regulators are summarized in this section. The most prominent common requirements are around Risk & IT controls, segregation of duties, reviews by internal audit, strong policies and procedures and ownership by top management. Figure 2 - Summaries of Regulatory Requirements How Accenture Can Hel The risks of falling victim to a rogue trading event are, on the one hand, small. Yet the impact on the company can be catastrophic, as evidenced by recent events. Firms face negative impacts to their itps:tinanceandriskblog accenture.com/regulatory-insightstegulatoy-compancelreguatory-mplications-of roquestrading ane30/10/2020 Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs balance sheets, as well as their reputations which can even lead to bankruptcy. Regulators are also looking at further ways to protect shareholders, and provide greater transparency to the market. A strong risk management program can help provide the necessary assurance to shareholders, as well as help position the firm for compliance with potential upcoming regulations. Essential components of an effective risk management program are listed in Figure 3 and are detailed in the section. View full illustration Tj Conger manage GF RSG THER HE Bias Boreranee [teem foal ‘npc Peeing Seton cusiestan Sa Teng Figure 3 - Major components in management of Rogue Trader Risk Processes Risk masters focus on both quantitative and qualitative aspects of trading operations to prevent rogue trading. They implement more checkpoints and reviews as control measures to inhibit and prevent any individual or group from spinning out of control. These processes can differ in the particulars, but at a minimum, should provide coverage around: * Due diligence on trader backgrounds/profiles to ensure segregation of duties. + Review of trading aggregation structure and entitlements. + Review of user entitlements (within systems, etc...). + Mandatory vacation or “cool off” periods for traders. + Review of limit breaches. + Review of all amended and cancelled trades. Governance Risk masters generally utilize an independent risk committee to regularly assess positions— the Chief Risk Officer also reports directly to the Board of Directors, providing more independence in risk assessments. Appropriate oversight needs to be achieved at multiple levels of trading operations. This itps:tinanceandriskblog accenture.com/regulatory-insightstegulatoy-compancelreguatory-mplications-of roquestrading angsoro72020 Regulatory Impleatons of Rogue Trading - Accenture France & Rsk Blogs structure allows the risk organization to remain independent, and to experience less pressure from other parts of the organization to ignore risks. People Risk masters often have risk based compensation structures in place that reward employees using a risk adjusted return metric. This structure rewards traders based on the amount of risk taken to achieve their returns. Traders who risk less for the same level of return as a peer are more highly compensated because, if these trades had turned sour, the firm would not have suffered as great a loss. Risk masters also help confirm that their departments are staffed by highly knowledgeable personnel with a complete understanding of the complete trading portfolio. People are at the heart of any risk management program and can often prove to be the weak link, even in very sophisticated risk management programs, Analytics Risk Masters have a keen understanding of the key requirement that statistical, modeling and other analytical tools use, both historical and forward looking data to derive meaningful insights. Typically, where a technical software solution has been deployed, analytics are focused on the meaningful analysis of process controls, production of KPIs/Dashboards and the on-going optimization of technical software. Technology The next generation of risk management technologies will need to move beyond those that make post- mortems possible and find causes, to systems that are more proactive in identifying risky patterns in a way that can prevent disaster in the first place. Leading edge risk management requires more “preventative” systems to reduce or eliminate the risk of the negative behavior from occurring in the first place. Conelu To rise to the challenges of competitive and volatile markets, and protect against the potentially devastating losses that can result from rogue trading, the next generation of risk management capabilities must be integrated, comprehensive and holistic with strong capabilities in processes, governance, people, analytics and technologies. This kind of complete solution can establish better protection, while also providing competitive advantage to a trading organization by creating transparency and visibility, thus enabling it to react faster than its peers in an ever changing global landscape and the specific risks posed by rogue trading. References 1. Accenture Point Of View - Risks and Rewards — How Integrated and Holistic Risk Management Capabilities Can Mitigate the threats of Rogue Traders by Shelley Hurley, Fred Kim and Amit Gupta - Published 2012 itps:tinanceandriskblog accenture.com/regulatory-insightstegulatoy-compancelreguatory-mplications-of roquestrading sone30/10/2020 Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs 2. Accenture, Rogue Trading—Risk Management Town Hall Call, December 2011, presentation deck . Accenture, Fraud and Financial Crime Community of Practice discussion deck, November 2012 Reuters: Fact box - UBS trader joins rogues’ gallery of financial crime, September 15, 2011 3. 4 5. Geoff Kates, Lepus, No surprises—combating rogue trading 6. PricewaterhouseCoopers, Rogue trading, February, 2008 7. ”. US SEC: National Examination Risk Alert: Strengthening Practices for Preventing and Detecting Unauthorized Trading and Similar Activities, Volume II, Issue 2 , February 27,2012 8. ESMA: Guidelines on systems and controls in a highly automated trading environment for trading platforms, investment firms and competent authorities, ESMA/2011/224, July 20, 2011 9. EBA: Guidelines on the management of operational risks in market-related activities, October 12, 2010 10. FINRA: Unauthorized Proprietary Trading: Sound Practices for Preventing and Detecting Unauthorized Proprietary Trading, Regulatory Notice 08-18, April 2008 11. FSA: Market Watch Newsletter: Markets Division: Newsletter on Market Conduct and Transaction Reporting Issues, Issue No. 25, March 2008 For additional information on Rogue Trading, please contact: * Subramanian Venkataraman - Author * Loren M. Madden - Author * Vicki Wilson - Author + Samantha Regan ~ Key Contact * Chris Porsena - Key Contact Appendix - Detailed Regulatory Requirements. Regulator Regulation Publication e Summary Date and Impact us. Strengthening Feb 2012 Investment The SEC's Office of Securities Practices for advisors and | Compliance and Preventing broker inspections and Exchange and Detecting dealers Examinations has Commission | Unauthorized warned investment Trading and advisers and broker- Similar dealers to keep eye on Activities potential front-office rogues who know too much about back- office functions. Some insights from the Commission's National itps:tinanceandriskblog accenture.com/regulatory-insightstegulatory-compancelreguatory-mplications-ofroguestrading wnit9sor172020 Regulatory Impleatons of Rogue Trading - Accenture France & Rsk Blogs Examination Program to prevent unauthorized trading are as follows: 1. Establish Robust Front Office Supervision © Define independent and clear reporting lines © Develop knowledge of complex Securities/trading sttrategies by Traders © Discussions with direct and indirect reports © Structuring of incentives © Disaggregation of functions © Management “Open-door” policy © Trading and booking systems Reviews © Establish additional controls and scrutiny 2. Periodic transfer of other department personnel (e.g. Finance, Operations, Risk) into trading positions itpstinanceandriskblog accenture.com/regulatory-insightstegulatory-complancelreguatory-mplications-of roguestrading sanesor172020 Regulatory Impleatons of Rogue Trading - Accenture Fiance & Rsk Blogs 3. Monitor extended settlements/“rolling of positions 4, Emphasize need for trade confirmations 5. Enforce mandatory vacations 6. Independent trading reviews 7. Align silo systems 8. Perform periodic control testing 9. Set the right “Tone from the top” itps:tinanceandriskblog accenture.com/regulatory-insightstegulatoy-compancelreguatory-mplications-of roquestrading s3n930/10/2020 European Securities and Markets Authority Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs Guidelines on systems and controls ina highly automated trading environment for trading platforms, investment firms and competent authorities July 2011 Operators of regulated markets and multilateral trading facilities, investment firms executing orders on behalf of clients and/or dealing on own account This Consultation Paper sets out and explains the draft guidelines on organizational requirements for fair and orderly trading, and dealing with market abuse (in particular market manipulation). There are separate standards for trading platforms (regulated markets and multilateral trading facilities) and investment firms executing orders on behalf of clients and/or dealing on own account. Salient guidelines for investment firms include: 1. Provide compliance function authority to challenge trading staff suspicious of market abuse 2. Conduct market abuse training for traders 3. Audit and ongoing monitoring of alerts 4. Arrangements for the identification and reporting of suspicious transactions and orders 5. Maintain records of up to 5 years for any suspicious market abuse conducts itps:tinanceandriskblog accenture.com/regulatory-insightstegulatory-compancelreguatory-mplications-ofroguestrading sanes0/102020 European Banking Authority Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs Guidelines on the management of operational risks in market- related activities October 2010 All European Banking Institutions The guidelines aim to highlight supervisory expectations relating to specific arrangements, procedures, mechanisms and systems in trading areas that could prevent or mitigate operational risk events (including rogue trading) The subject is addressed from three different angles i.e. governance, internal controls and reporting through 17 key principles. Salient features of guidelines include: 1. Establish appropriate internal controls 2. Segregation of duties between front-office and control and support functions. 3. Promote a front office culture, designed to mitigate operational risks 4, Mandatory vacation for trade desks 5. Appoint control staffs with understanding, skill, authority and incentive to provide an effective challenge to traders’ activities itps:tinanceandriskblog accenture.com/regulatory-insightstegulatory-compancelreguatory-mplications-ofroguestrading 1811930/1072020 Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs 6. Proactive fraud management 7. Establish minimum standards for transactions by traders 8. Most trading to be done in trading room within trading hours 9. Maintain relevant documentation and audit trail 10. Emphasis on reconciliations 11. Appropriately designed and maintained IT systems 12. Warnings and Alert systems itps:tinanceandrskblog accenture.com/regulatory-insightstegulatoy-compancelreguatory-mplications-ofroguestrading sere30/10/2020 Regulatory impleatons of Rogue Trading - Accenture Finance & Risk Blogs FINRA issued this notice to highlight sound practices for firms to consider, as they develop procedures and processes to prevent rogue trading. Key highlights of FINRA’s guidance include: 1. Mandatory vacation Regulatory policies The Gotice 08-18 2. Heightened scrutiny Financial practices for of red flags Industry preventing April 2008 Member Regulatory | and detecting 3. Protection of Authority unauthorized systems and risk proprietary management trading information 4. Clear supervision and accountability 5. Establish controls for intercompany/ affiliate transactions, similar to 3rd party 6. Develop compliance culture with “tone at the top” The Market Watch: | March AIIUK Based The newsletter Financial Newsletteron | 2008 Banks highlights the types of Services unauthorized measures that firms Authority, trading at should consider when UK. Société reviewing the systems Générale and controls which protect them against, rogue trader risk. 1. Develop front office culture and itps:tinanceandriskblog accenture.com/regulatory-insightstegulatory-compancelreguatory-mplications-ofroguestrading smesor172020 Regulatory Impleatons of Rogue Trading - Accenture Fiance & Rsk Blogs governance suited to risk management 2. Establish trading mandates and limits 3. Establish control Functions —culture and authority to challenge traders 4. Sound risk management and Limit procedures 5. Management reports and red flags 6. Controls to flag and challenge off- market rates 7. Detail P&L analysis 8. Reconciliations between front- office, risk management and back-office systems 9. Emphasis on confirmation of trades 10. Reconciliation of margining, collateralization and cash management 11. Segregation of Duties and IT Security Copyright © 2013 Accenture. All rights reserved. Accenture, its logo, and High Performance Delivered are trademarks of Accenture. This document is produced by Accenture as general information on the itps:tinanceandrskblog accenture.com/regulatory-insightstegulatoy-compancelreguatory-mplications-ofroguestrading sanesoro72020 Regulatory Impleatons of Rogue Trading - Accenture France & Rsk Blogs subject. It is not intended to provide advice on your specific circumstances. [If you require advice or further details on any matters referred to, please contact your Accenture representative.] Risk Reporting Rogue Trading REGULATORY COMPLIANCE TEAM Accenture Regulatory Compliance Team, Finance & Risk Practice ‘VIEW PROFILE itps:tinanceandriskblog accenture.com/regulatory-insightstegulatoy-compancelreguatory-mplications-of roquestrading rene