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I always meant to blog about the wider theme of “beta” but due to the wide proliferation and exposure of exchange traded funds, the other big beta instrument, derivatives, was kept to the side. Truthfully, my past was always more focused on the use of derivatives but when I blogged about it, I had limited feedback. Very different with ETFs … when I wrote something about a unique ETF about to come to market, the Wall Street Journal called me up. You now know why I focus so much on ETFs.

But once in a while, another story pops up on the derivative side that’s too big to dismiss. I wish it were some new exposure (like carbon credits) but unfortunately, like hedge funds, the derivatives markets provides a spectacular blowup/debacle once in a while and like a collision on the freeway, everyone pauses to take a look. This time, it’s SocGen’s (Société Générale SA (OTCPK:SCGLY)) turn. Facetious as that may sound, this graph from the WSJ gives a quick snapshot of past blowups back to the days of Nick Leeson and slightly beyond.

It seems that in time, we often see the latest blowup being outdone again and again.

For anyone who has taken a risk management course, these “rogue traders” and their blowup events are part of the curriculum. But are they truly rogue? To me, that implies that they were on their own. That may not fit the definition of “rogue” but my point is that in all cases, the focus is so finely tuned towards the individual and not the environment he was in (hey, who no female rogue traders?!)

Out there are people studying for their FRM or PRM designations (from GARP and PRMIA respectively) and I wonder what they’re thinking when they read today’s news. Same old story. Somehow, this guy knew how the back office worked. Somehow, despite all the debacles of the past, they’re still able to circumvent the safeguards that are in place. Just how “safe” these “guards” are … that might just be the key question. You simply have to wonder if this SocGen incident will make a difference in the way such institutions monitor and manage operational risks. Here’s an article from GARP that discusses this topic. Somehow, I feel like there will be minimal change in the way things operate at financial institutions.

My previous post discussed risk from the point of view of the financial advisor who services the individual investor. Here I want to think about risk from a more micro point of view. This “micro” view would apply to the internals of a bank, hedge fund or any big pile of money. Just as in my previous post, I think that the more things become complex (adding hedge funds to a portfolio, for example) the more things are susceptible to trouble. The derivatives markets are relatively complex and the mechanisms in the back office operations of seemingly sophisticated institutions allow for an individual with the right technical skill set to determine where is the weakest link and, if given the opportunity, take advantage of that knowledge should it be required. Clearly, to take away the ability for an individual to exploit an opportunity is the objective of this exercise.

This is not a call to tell financial advisors to stay away from hedge funds. My argument there has always been for financial advisors to realize that the resources required to adequately determine which (if any) hedge funds belong in client portfolios is quite onerous. Nor is this posting meant to be a purely negative assessment of the derivatives industry. In fact, my point in this blog is that derivatives are not bad themselves but, as everyone knows, are like dynamite … things can get out of hand quite quickly. I believe we can’t simply ask why the banks and hedge funds haven’t tightened up their operations so that such blowups can’t happen or are at least minimized in terms of magnitude via some set of protocols. Surely, the risk managers, the top officers and board of directors would want and have placed such risk policies and procedures in place. Shouldn’t they have? The question is simply implementation.

Perhaps it’s just not possible to make a fool-proof security system. I’m thinking of a cornered cat. It’ll come out fighting if required. Now think of Nick Leeson or this new guy Jerome Kerviel. You’ve been allowed to trade, things might be going well (you’ve had that feeling at the craps tables in Vegas, right?) and you’re on top of the world. Nothing different there. Nothing wrong. That’s just human nature. But nothing goes up forever and sometimes things go bad. Hey, crap happens but every so often things really get out of hand. Sometimes, we hold onto losses no matter how bad they get. Normally, one would eventually accept the situation and simply exit the position.

For some, that might simply mean taking a big loss. For some, that might mean shutting down their hedge fund and starting up a new one under a new name. But for some, there’s something else that’s entirely sinister. A common theme in the financial blowup is the hiding of losses. In some cases (I’m thinking of some hedge fund blowups but not Amaranth as far as I know) the trader tries to siphon some money away. I think the idea is “Damn, I’ve lost a ton of money. My career is over. If I’m going to go run and hide, I better take some cash with me.” I don’t think that was the case with Leeson and now Kerviel. There’s was simply trading gone bad and a futile attempt to hide the losses. In both situations, the inevitable story is one of a world slowly closing in around them with the noose tightening ever so slightly until the eventual day when they’re on the front page/screen of every media outlet on the planet. I suppose that’s the ultimate risk of any institution (note how I’ve just flipped this to not focus on the individual - they’re not thinking about this risk because no one everplans to participate in a blowup). Congrats SocGen, you’ve just gained a new perspective on risk. Welcome to the world of “front page risk”. That’s a toughy to measure and is not like VaR and standard deviation covered in most textbooks.

The perception of risk is really not that difficult a subject. I think it’s amazing how a significant event like this can crystallize what risk management is all about. I think it’s less about risk management and more about thinking of all the steps in the process and what can go wrong at each step. Like many things in life, I suppose it all comes down to the details.

Source: SocGen and the Perception of Risk