In the financial markets, recessions have a way of bringing out the worst in people. Or perhaps uncovering the bad that was already there.
Several cases of fraud involving derivatives – Bernard Madoff’s Ponzi scheme being by far the grandest – have come to light since the collapse of Lehman Brothers in September 2008.
It is very hard to quantify this while investigations are still continuing. It is harder still to tell whether frauds have been caused by the stressful market conditions of the credit crunch, or rather were there all along, and have been revealed by those conditions.
Certainly, in some cases, as investors have moved money out of the markets and firms have deleveraged, crimes have been exposed. Sometimes this has happened because tough conditions meant books were scrutinised more carefully.
At the same time, more frauds may be being committed, as traders strive to recoup big losses and meet targets in a high pressure recessionary environment.
The CFTC files
Here are some recent announcements from the CFTC about its enforcement actions – all from late 2009
October 30 Federal court freezes assets of Richmond Hamilton and the Chicago commodity pool he manages in a $1m pool anti-fraud case.
November 6 New York court gives $500,000 fine and ban to David Lee, former natural gas trader for Bank of Montreal, who settled charges of mismarking and misvaluing the bank’s natural gas options to exaggerate trading profitability.
November 10 Federal court freezes assets of David Owen, charged with a multi-million dollar commodity pool fraud. Owen, via Oasis Futures, charged with fraudulently soliciting at least $2.5m, misappropriation and concealing trading losses.
November 12 Federal court orders Dawn Musorofiti to pay $82,600. In 2003 and 2004, she solicited funds from customers in her neighbourhood to trade commodity futures by making false promises of large profits and no risk of loss. She pretended to be a Nymex broker, but sold illegal, off-exchange futures.
November 12 Michael Kourmolis banned from futures industry for fraudulently soliciting customers to open accounts at IFC to trade foreign currency futures. Kourmolis falsely told at least one customer that because of IFC’s “large fund and our banks and institutions overseas,” it could “maximise profit potential while also minimising capital risk.”
November 13 Hedge fund EMF Financial Products pays $4m to settle charges that it made false statements concerning its market positions to the Chicago Board of Trade.
November 23 New Jersey federal court orders Robert Sucarato to pay $2m in restitution and penalties for fraudulently soliciting investors and concealing trading losses with false account statements in hedge fund anti-fraud action.
November 24 Federal court freezes assets of Trevor Cook and Patrick Kiley and their Oxford and Universal companies, charged by the CFTC with defrauding investors of tens of millions of dollars in foreign currency scheme.
November 24 Louisiana federal court freezes assets of William Guidry, Matthew Pizzolato and Capital Funding Consultants, charged with operating a $2m commodity pool fraud.
November 25 Oklahoma City Chinese community targeted in multi-million dollar commodity futures Ponzi scheme operated by Kenneth Lee, Simon Yang and their companies. Prestige Ventures Corp, Federated Management Group and Lee charged with fraud and misappropriating funds, Yang with fraud and providing false information to the CFTC.
“Everyone expects fraud to be flushed out when the tide goes out,” says Ken Farrow, director of fraud services at Control Risks, the risk consultancy, in London. Farrow is a former head of the economic crime unit at City of London Police.
When times were good, he argues, market players often plunged in to transactions or even mergers, pressured by vigorous competition, without fully investigating their counterparties. Some of these deals have come back to haunt them.
James Doyle, a London-based partner at English law firm Lovells, agrees. “In markets which are more volatile, more of these things tend to come to light,” he says.
On the other hand, in such cash-strapped times, when companies’ trust for one another is low, the incentive for management to cover up fraud by their employees is also higher.
“I wonder if there’s a tendency to sweep things under the carpet,” Doyle says. At the moment, a company is more likely to go out of business if it is involved in a fraud scandal. “The emphasis is survival... One does wonder whether things will surface over time,” he says.
Big institutions may be even more at risk than smaller ones. “In larger organisations that are very busy, it’s easy to conceal because so much trading is going on,” Doyle believes.
Feeling the heat
Meanwhile, the pressure of the downturn may even now be goading derivatives professionals to commit fresh frauds.
Brian Dilley, partner in the forensic department at KPMG in London, says that some players are straining for higher returns as a way to make back money they have lost. Unfortunately, this enables fraudsters to take advantage of people’s desperation.
One of the main fraud-related problems is mismarking to market. “In any sort of trading environment, the incentive to manipulate numbers is higher when they’re going down,” says Dilley.
The constant pressure of trading creates a bigger incentive to do things wrong than in other areas of financial services, Dilley believes. “In a trading environment, people are making money daily on what they hold,” he says. “They’re not necessarily trying to take money themselves, they’re trying to stay employed.”
The beginning of the downturn, when markets were exceptionally volatile, may have been a prime time to commit fraud.
“In my experience, fraud thrives in volatile times,” Farrow says. “It’s only some time later that the horror comes out of the woodwork.”
As far as the overall health of the markets is concerned, the actual frequency of fraud may be less important than its perceived prevalence, as business decisions are influenced so much by sentiment.
There is a widespread perception of increased risk across the board, and derivatives are no exception.
Derivatives cases often attract a lot of attention from the media and gain a disproportionate amount of coverage, compared with the more mundane mortgage and insurance frauds. That, too, may have increased market participants’ awareness of fraud risks.
Farrow says that since the downturn began, Control Risks has had more interest from people investigating the possibility of fraud.
Protiviti, another risk and business consulting firm, has also noticed that clients are more cautious.
“During the last year, people have had to take stock of the value of their positions,” says John Cassey, an associate director at the company in London. “They lost a lot of money... therefore people are more cautious of valuations and carry them out more frequently.”
Mismarking in the UK
The UK Financial Services Authority has had three mismarking cases over the last two years, all at top investment banks.
Credit Suisse was fined £5.6m in 2008 for not acting in a timely way to stop mismarking and pricing errors in its structured credit portfolio, as bankers tried to hide losses on collateralised debt obligations of residential mortgage-backed securities.
Morgan Stanley received a £1.4m penalty in May 2009 when former proprietary trader Matthew Piper mismarked trades on the investment grade trading desk, which meant the firm had to make a negative adjustment to his marks of $120m. Piper had been trading credit default swap indices and options on them.
And then in November Nomura was docked £1.75m for control failures in its London-based international equity derivatives group, which allowed a trader in Hong Kong to mismark his positions.
The UK government is looking at giving the FSA the power to prosecute attempted market manipulation, but at the moment it is unable to prosecute unless the attempted manipulation has had a real impact on the market.
In June PVM Oil Futures lost $10m when it had to close out unauthorised large Brent Crude trades that one of its experienced traders, Steve Perkins, had allegedly made during the night. The trading was discovered the following morning.
Of course, the move to central clearing should bring more transparency, which is a deterrent to potential fraudsters. But it seems that as the downturn has shifted the power balance in favour of investors, they are probing deeper before trusting an individual or an institution with their money.
Raj Sitlani, global head of business development at Sucden Financial in London, believes that although investors have not been put off derivatives, they want full transparency.
He says that investors are now “insistent that they have a managed account structure and full visibility”.
Many market participants think investors are more wary of derivatives fraud now than they were before the downturn. They acknowledge that there has been a flight to safety, although they do not think this has been more prevalent in derivatives than in other sectors of the market. “There’s a flight to safety across the whole [financial services] industry,” Dilley points out.
No worse than elsewhere
Indeed, most market participants believe that fraud risk is no more pronounced in derivatives than in other areas. Gavin Benson, a director at Protiviti, says that: “There is fraud in all industries... when markets go down to the extent they did, it became very difficult to cover tracks.”
Anthony Belchambers, chief executive of the Futures and Options Association, says “fraud is always going to be on the increase at times of recession” but that it is no more significant in the derivatives industry than in other financial markets.
“This is not a product issue, it’s a people problem and a control problem,” he says. The main problem, he says, is that derivatives are leveraged products, so misbehaviour can exacerbate loss.
Many agree that OTC derivatives are more susceptible to fraud and manipulation than exchange-traded products. “If you offer trading on well-established exchanges, it’s as watertight as it can possibly be,” says Sitlani.
Transparent pricing, such as exchanges provide, has advantages when it comes to fighting fraud — many cases involve overvaluing, which is much harder to do with exchange-traded derivatives.
“The more exotic and harder to value [derivatives] are, the more prone they are to fraud,” says Dilley. “There’s a higher risk in any product that is harder to value... there’s more incentive to bluff your way through an investigation.”
Problems involving mismarking, such as Credit Suisse’s problems with structured credit and Morgan Stanley’s with CDS, are often linked to the less-transparent OTC markets. And even when the value of a trade appears to have been independently verified, it could be that the person verifying the trade is collaborating with the trader or broker.
What is a fraud?
According to the UK Financial Services Authority, there are seven types of market abuse:
- Insider dealing
- Improper disclosure (when inside information is disclosed improperly)
- Misuse of information
- Manipulating transactions
- Manipulating devices
- Dissemination (giving out false or misleading information about an investment or the issuer of an investment)
- Distortion and misleading behaviour
Insider dealing and market manipulation are criminal offences and can lead to a penalty of up to seven years in prison. Market abuse is not a criminal offence but the FSA can impose an unlimited fine.
The UK Fraud Act of 2006, introduced in November 2006, divides fraud into three main categories:
Abuse of position
“In many respects, the SocGen case demonstrated that it’s easier to cover your tracks in OTC than ETD,” says Belchambers, referring to the bank’s €4.9bn loss from the activities of alleged rogue trader Jérôme Kerviel in January 2008. Kerviel was found out, of course, but not before he’d made an alleged €49bn of unauthorised trades – hardly an encouraging record.
Regulation? No thanks
Fraud can be combatted by regulators, companies and investors. Most market participants concede that no matter how sophisticated a protection system is, some people will always find a way of bypassing it. Yet they do not believe more regulation would help.
“I think there’s enough regulation in place,” says Sitlani. “There’s always going to be an argument for tighter controls, but it’s a business decision as well.”
Many emphasise the role of supervision, rather than regulation. Belchambers suggests that “better people management within firms” and “better appreciation of people risk” are needed.
Farrow believes regulators should play a tougher role but that the emphasis should be on supervision and control measures rather than just regulation. “It’s got to come from internally — the investment has to be there,” he says.
When it comes to regulators, he thinks “we’ll never have adequate resources” and that “it comes down to vigilance by companies themselves”.
The problem with this is that often companies do not take extra measures to combat fraud until it is too late.
“I think that greater transparency may help in reducing the likelihood of fraud,” says Cassey. “The difficulty in a change of law is that it’s often cumbersome and doesn’t address the reason for fraud.” He believes that fraud is inevitable to a certain extent. “Fraudsters will always find a way of getting past regulations,” he says. “The best you can do is apply more common sense and questioning.”
Belchambers agrees that one is “bound to get people slipping through the net”. The question, he says, is whether it can be caught quickly enough.
Siân Williams +44 207 779 8370 firstname.lastname@example.org