12/06/2011 04:46 pm ET Updated Feb 04, 2012

The Folie De Grandeur of Rogue Traders

Listen up! I have just finished reading the brilliant, fast-paced How To Be A Rogue Trader in global finance by the prize-winning Associate Editor of the Financial Times, John Gapper and hereby recommend it as required reading (ASAP) by the CEOs, risk officers, derivatives traders, boards of directors, accountants and Wall Street analysts of every publicly held financial institution here or abroad. The title I take to be the classic British irony on how mostly arrivistes from outside the establishment can seem to break the bank without anyone discovering their chicanery -- until it is too late. By the way, usually their supervisors are too stupid to understand what is happening; derivatives in currencies and complex securities based on arcane mathematical models are hard to grasp. A perfect vacuum in which to gamble with other people's money.

Gapper's work is an Internet published work (Penguin Special Short, $3.99) that can be read in two hours or so. It is part Le Carre novel, part financial history, part psychological personalty analysis, and is the first journalistic survey I've ever seen on the phenomenon of the Rogue Trader, the usually young knave who wants fame more than fortune and quickly -- and so in effect either destroys his bank like Nick Leeson at Barings; or causes unexpectedly humungous losses that are part scandal, part financial disaster. The process reminds Gapper of Orwell's "Shooting An Elephant" for the sheer out-of-control chaos such supposedly ambitious schemers can cause.

Just as insider trading is an integral part of the financial system, so is the rogue trader. Curiously -- and I'm not sure Gapper made enough of this point -- all the institutions impacted are international, not American. What a frightening lineup; Barings of the UK, UBS of Switzerland, UAB of Australia, Societe Generale of France, Daiwa of Japan, and Allied Irish Banks of Ireland.

What fascinates Gapper and should press you to grab the Short off the net, are the psychological ambiances of a rogue trader. He is driven by the inability to accept loss -- and so instead of fessing up to a bad trade, he secretly doubles up and doubles up and doubles up, hiding the transactions -- which Gapper points out is easy to do if you are both head of the trading desk and in charge of the back office.

Cleverly, Gapper borrows from the risk aversion studies of Kahneman and Tversky to explain that "the more trouble people are in the bigger the gamble they will take to get out of their hole." And they are aided and abetted by superiors who "ignore" and deny what is happening probably for fear of their own rocky position.

Or in the case of Swiss giant UBS, Gapper shows it to have been "a rogue bank" long before 31-year-old Ghanaian Kweku Adoboli, lost billions without ever being discovered. UBS, it seems, allowed Adoboli to make unauthorized trades in part because bank managers failed to adequately confirm some of his trades with counterparties outside the bank, according to the Wall Street Journal today. Adoboli is surely headed for jail, as have most of the rogue traders, because they committed fraud in falsifying bank records.

Risk control systems are obviously mediocre or non-existent in Europe. How else could Societe Generale trader Jerome Kerviel increase his 28 billion Euros position in 2006 to 49 billion euros. No wonder the French banks are rumored to be the most vulnerable to the debt contagion in Europe today -- and needed to be offered emergency financing by a passel of central banks last week.

Apparently, few institutions have emulated Goldman Sachs' highly expensive risk control system of 18,000 computers churning out daily reports on every trading desk, and sending alarms if any positions worldwide seem to be too risky in relation to the worst day's price action for that product.

I am waiting for Gapper to tell us soon just exactly how much of a rogue trader MF Global was in the weeks leading to its bankruptcy and the disappearance of at minimum $600 million in cash.