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Rusnak lost $691 million for Allied Irish Bank

Introduction
o $691 million lost in the foreign exchange market o $1 billion profit at AIB for 2001 reduced to $426 million o 5 years of fraud and undiscovered losses o 7 years in prison with $1 million fine o How did this happen?

Agenda
o Foreign Exchange Concepts o Trading Strategies o The Losses and the Cover-up o Near Misses o Lessons Learned o Summary

Foreign Exchange Markets


o Currency bought and sold at exchange rates determined by supply and demand o No central location dealing rooms in banks and companies o Most foreign exchange trading between banks o London, New York , Tokyo have largest markets o Eurocurrency Market Borrowing and lending foreign currency

Types of Exchange Contracts


o Spot Exchange - binding contract to buy or sell a currency for another immediately o Exchange rate is the current spot rate from Reuters o Exchange of monies occurs two days later

Types of Exchange Contracts


o Forward Exchange binding contract to buy or sell a currency for another at a future date o Exchange rate is the forward rate o Forward exchange rate differs from spot rate to reflect interest rate differentials between the two currencies prevents arbitrage o Monies are exchanged at an agreed upon date

Types of Exchange Contracts

o Future Standardized Forward Contract amounts and exercise dates are standard March, June, September, December

o Swap Exchange of currency income streams

Currency Options
o Gives the holder the right, but not the obligation, either to buy from the option writer, or to sell to the option writer, a stated quantity of one currency in exchange for another o Strike price is a fixed rate of exchange o On a particular date (European) or up to a particular date (American) o Option holder (buyer) pays a premium to the option writer (seller) when the option is written o An option gives the holder the choice to exercise it. o Calls and Puts are available.

Background
o Allied Irish Bank acquired First National Bank of Maryland (First Maryland) in 1989 o Treasury Department run by David Cronin o Front Office Trading and investment o Middle Office Asset and Liability Management and Risk Control o Back Office operations and verification of Front Office trading o Small foreign exchange operation with trading to hedge for clients at Allfirst

Rusnaks Hedge Strategy


o 1993 Allfirst looking to expand into proprietary foreign exchange trading o Create a niche player in forex to impress AIB o Rusnak promised o to swell profits by trading in options o Consistently make more money by running a large options book hedged in the cash market o Buy options when they were cheap and sell them when they were expensive.

Actual Investment Strategy


o Directional Trades on the spot and forward markets, mostly on yen and euro. o Occasional use of complex options o 1997 Currency forwards in favor of the yen increasing in value against the dollar. o Large sum one-way bets were not hedged with reverse option contracts. o Lost money as the yen began depreciating in 1995 and the Asian crisis unfolded.

$29.1 million down

The Cover-Up
o Bogus options o 'Fake docs' o Prime Brokerage Accounts o Value At Risk o Options for Sale

Bogus Transactions
o Fictitious trades entered in the banks accounting systems appeared to hedge the directional trades. o Bogus trades were entered in pairs that offset each other o Options looked like they had identical premiums in the same currency

Example Bogus Trade


o Put option is sold by Allfirst to a Tokyo bank allowing that bank to sell yen at a specified price expires on day written o Allfirst purchases a Call option from the same Tokyo bank to buy yen at a specified price in the future has a future expiry date o Rusnak is short a Put, long a Call and long a forward contract. o Payoff diagram is a straight line with positive slope

Pay-OFF DIAGRAM

Bogus Transactions (continued)


o The put option that was "sold" expired on the same day written. The liability of it went off the books immediately. o The call option that was "purchased" stayed on the books as an asset of the bank. The value of the option covered the losses. o Two options were necessary so the received premium and the paid premium canceled out.

Bogus Transactions (continued)


o The treasury back office was responsible for the net settlement and would take notice if the options did not net out. o Different expiration dates result in different option prices. o Deep-in-the-money Put option would have been exercised. o When a Call option reached its expiry date, it was rolled into another bogus option.

Fake Docs
o Every trade at the bank was required to be independently confirmed by the Treasury back office. o Rusnak used his PC to create false trade confirmation documentation. He called the file on his computer "fake docs". o Mail Box Etc. to fake Fax confirmation o Rusnak bullied the back office into not confirming Asian trades that netted to zero.

Fake Docs (continued)


o Allfirst's trade confirmation practices were outdated - phone and fax. o Back office staff did not relish coming in at night to confirm Asian trades. o Large banks with foreign trade departments used Crossmar Matching System which confirms trades in minutes. o Allfirst did not feel Crossmar was worth the investment given they had only two traders in foreign exchange.

$41.5 Million Down

Prime Brokerage Accounts


o High profile trading accounts typically used by hedge funds. o Daily spot transactions are rolled into one forward transaction to be settled at a future date with the prime broker. o Expand the scale and scope of trading to large volume high value currency trades. o Relieve the back office of work. o Make Rusnaks bonus bigger.

Prime Brokerage Accounts


o Fictitious Prime Brokerage transactions in the Devon accounting system o Entries were reversed before month end reconciliation to hide losses o High risk 'historical rate rollovers" used o Gains or losses rolled over into a new contract at the historical rate of exchange o Warned against by Federal Reserve Bank of NY foreign Exchange Committee

$90 Million Down

Value at Risk
o Main method used by banks to monitor traders activities o Largest loss the bank anticipates given adverse trading conditions o Calculated using the 'Monte Carlo' simulation technique to generate 1000 hypothetical rate fluctuations and the resulting profit or loss o The Value at Risk (VaR) is the 10th worst outcome for the portfolio o Rusnak's limit was $1.5 million

Value at Risk Manipulation


o Bogus options appeared to hedge his real positions o Entered forward transactions in Devon but reversed them before monthly settlement o Hid his large open currency positions by supplying his own values in a spreadsheet

Value at Risk Manipulation (continued)


o Manipulated currency rates to make it look like he had not exceeded his monthly $200,000 stop-loss limit o Exchange rate data from Reuters was fed directly to Rusnak's PC o Rates were then fed from a spreadsheet on Rusnak's computer to the bank's database.

Value at Risk Manipulation (continued)


o Treasury back office was supposed to independently confirm the exchange rates. o "...the bank would not pay $10,000 for a data feed from Reuters to the back office due to the bank's cost cutting drive." o Up until April 2001, Rusnak manipulated rates using this system.

$300 Million Down

Balance sheet usage


o Balance sheet usage was coming under scrutiny in January 2001 o Foreign exchange trading revenue was $13.6 million while net trading income was $1.1 million o Management wanted use of the balance sheet, use of cash, reduced o Rusnak's solution was to sell deep in the money options to raise money

Options for Sale


o Options were sold with deep-in-the-money strike prices o Rusnak received large cash payments in the millions of dollars for these options o Strike prices were extremely unlikely to be reached so Rusnak would most likely owe o Yen puts against the dollar o European option that expired in a year to give Rusnak time to win the money back

Citibank's Deal
o $125 million in cash for a strike rate of 77.37 yen to the dollar in return for an option that would expire in a year and a day o Yen at the time was 116 to a dollar o Dollar would have to fall 35% or more for the option not to be exercised o Option was effectively a high interest loan

$674 Million Down

Near Misses
o 1999 - Risk Assessment auditor questions Rusnak's over limits o March, 2000 - Citibank questions Allfirst's ability to settle a $1 billion prime account o March 2000 - Rusnak gets Travel Bloomberg software to trade at home and on vacations despite this being a violation of US law.

Near Misses (continued)


o August, 2000 - An internal audit of treasury checked trading confirmations. They checked one out of 60+ trades and by chance picked a valid one. 30+ were fake. o August, 2000 - Rusnak exceeds a $1 million credit limit by $86 million. Investigation reveals "trader error".

Near Misses (continued)


o January, 2001 - When asked to confirm a bogus option by auditors, Rusnak sets up a fake mailbox in Manhattan and has fake confirmations faxed to the office. o April 2001 - Foreign Exchange rate spreadsheet is found to be corrupt.

Near Misses (continued)


o June 2001 - AIB CEO questions size of foreign exchange operation. o October 2001 - SEC questions size of Allfirst's cash flow in regards to foreign exchange. o December 2001 - Treasury Back Office supervisor realizes Asian trades are not being confirmed. o January 2002 - Annual report shows $100 million in open positions. Rusnak calls this a mistake.

Lessons Learned
o Some of the lessons are strikingly similar to those of other rogue trader cases, such as Barings: o Lack of clear reporting lines, inadequate supervision of employees and failure to control fully the business that an overseas office was engaged in.

Lessons Learned
o Proprietary trading is a high-risk activity and it is not just a question of market risk. A relatively small outfit without access to the information, expertise and economies of scale of much larger financial institutions may find it difficult to manage and control a proprietary trading business effectively. The potential operational risks may outweigh the potential market returns, perhaps greatly.

Lessons Learned
o The relationship between parent company and overseas units needs to be clear From the o Ludwig Report: We think it is enormously important that there is unambiguous accountability. In some areas, it was not clear who was accountable to whom, and the reporting lines within Allfirst and between Allfirst and AIB were blurred.

Summary
o Rusnak lost money and covered the loss in hopes he could win it back. o Technology lapses in the bank were optimized to hide losses o Regular internal audits did not take place o Back Office monitoring of trades was ineffectual o Politics between AIB and Allfirst interfered with monitoring Rusnaks activities

Resources
o Report to the Borad of Directors of Allied Irish Banks, P.L.C., Allfist Financial INC.,and Allfirst Bank Concerning Currency Trading Losses Submitted by Promontory Financial Group and Wachtell, Lipton, Rosen & Katz March 12, 2002 o Panic at the Bank by Siobhan Creaton and Conor OClery o www.aib.ie o Foreign Exchange Markets Brian Coyle o Currency Options Brian Coyle o Trading in Currency Options William Sutton o New York Times o Financial Times www.ft.com