The Toronto-Dominion Centre Working

2:30pm – 3:30pm, 30th March 2014

Toronto-Dominion Centre and Bay St financial district, Toronto, Canada


Preparation material: Francis James Chan’s The Prop Trader’s Chronicles: Short-Term Proprietary Trading Strategies for Both Bull and Bear Markets (Hoboken, NJ: John Wiley & Sons, 2013).




(i) Understand the geography of Toronto’s financial district.

(ii) Make a psychological connection to Toronto’s bank prop traders.




Chan’s book on intraday trading at a Toronto-based proprietary trading firm alludes to inter-firm competition amongst Bay St trading firms. On arrival in Bay St it became clear that Canada’s five major banks — Bank of Montreal, Scotiabank, the Canadian Imperial Bank of Commerce, the Toronto-Dominion Bank, and the Royal Bank of Canada — dominate the area.


The dominance of bank proprietary trading desks explains several aspects that Chan had omitted from his description of intraday trading strategies. Chan and others relied on contracts for difference without overnight holdings. They attempted to understand the order flow of market microstructure using Level II quotes from the NYSE and NASDAQ exchanges rather than technical analysis charts. In game theory terms this was Chan’s attempt to use the best available dominated strategies in a predator-prey ecosystem that the banks dominated.


The Toronto-Dominion Centre evokes this institutional banking power in Ludwig van der Rohe’s modernist, international architecture. The TD Bank Pavilion, TD North, and TD West buildings impose themselves on the surrounding area. Their tenants include banking, financial services, investment banking, investment brokerage, and private equity firms.


On 11th October 2011, I had visited the Tokyo Stock Exchange and formally began a personal research program “to develop a private, low-key, personal vehicle for long-term self-sufficiency.” The Toronto Stock Exchange was closed so I was unable to repeat the experience. Instead, I stood in the TD Bank Pavilion and grasped the essence of institutional banking power evoked in Adam Smith’s satirical book The Money Game (London: Michael Joseph, 1968).


Later that afternoon I visited the Toronto Eaton Centre and the Indigo Books & Music store. Indigo’s business and investment book section was a mix of inspirational biographies; retail investor primers; and technical analysis books. Much of this is outdated information from an institutional banking perspective which relies on non-public trade secrets. I bought a paperback copy of Nassim Nicholas Taleb’s Antifragile: Things That Gain From Disorder (New York: Penguin, 2012) as a reminder of the tacit knowledge that a trader may create through personal experience, research, and reflection.


The next day I read the new Michael Lewis book Flash Boys: A Wall Street Revolt (New York: W.W. Norton & Co., 2014) which features former Royal Bank of Canada trader Brad Katsuyama – founder of the IEX Group dark pool – and critic of high-frequency trading. Lewis describes RBC as a sleepy backwater compared to Wall Street but this wasn’t my sense when walking past the RBC Centre in Wellington Street West, Toronto.


Several days later I learned of a new University of Toronto study (PDF) on how retail traders and high-frequency traders interacted on the Toronto Stock Exchange in 2012. The study felt like a research counterpoint to the Lewis book. The study found that retail investors largely benefited from the market microstructure of high-frequency trading firms.


I resolved to do two things over the next five years:


1. To develop a greater awareness of how bank proprietary trading desks affect market microstructure using dominant trading strategies in a predator-prey ecosystem.


2. To continue to develop a personal knowledge base and decision heuristics akin to Nassim Nicholas Taleb’s published work.

15th September 2012: What I’m Reading

What I’m reading this weekend:


Evgeny Morozov on The Naked and the TED (The New Republic). The Khannas’ use of Technik comes from Oswald Spengler’s Man & Technics (1931) which I read as an undergraduate. Morozov is scathing about populist futures consulting and writing in a way that resonates with strategic foresight colleagues and that recalls Mark Dery’s writings for 21C and other publications. I read Alvin Toffler’s Future Shock (1970) in the office of Newcastle’s This Is Not Art festival.


Situational Awareness (Ritholtz). Money manager Barry Ritholtz makes some excellent points about how to prioritise daily work and to cut through the noise and unimportant/non-urgent tasks.


Anatomy of a Campus Coup (New York Times). Andrew Rice’s profile of the University of Virginia crisis involving president Teresa Sullivan is a glimpse of the Machiavellian politics and patronage systems that university administrators work in, daily. The role of trader Paul Tudor Jones and disruptive innovation proponent Clayton Christensen are a harbinger of what is to come in higher education. The “high-finance mentality” of private equity and hedge funds is reshaping university boards and driving cost reduction initiatives.


How Michael Jackson Made Bad (The Atlantic Monthly). Joseph Vogel analyses the media backlash and record industry politics that led Jackson to experiment with technological innovation. “Study the greats, and become greater.”


Who Wants To Be A Billionaire? (Vanity Fair). The inside track to the startup incubator Y-Combinator and its opportunity evaluation and venture capital screening processes.


Obama’s Way (Vanity Fair). Michael Lewis’s profile combines his interviewing and narrative gifts with some shrewd insights worthy of Richard Neustadt about the decision-making challenges and processes of the executive branch.


Your Brain on Pseudo-Science (New Statesman). Coauthor Ben Eltham alerted me to Steven Poole critique of “junk enlightenment of the popular brain industry” including popularisers like Malcolm Gladwell and Jonah Lehrer. Poole’s targets include popular writers and publishing marketing. Poole is on the mark about how to write a genre bestseller. There’s actually a deeper history here about what happens when pseudo-scientific methods diffuse from their original context into sales, marketing, and self-improvement arenas. For instance, neurolinguistic programming (NLP) was originally developed by Richard Bandler and John Grinder as a methodology to model human excellence: “embedded commands” came from their study of Milton H. Erickson’s clinical hypnotherapy. Go back to the original research and run your own experiments.

31st December 2011: Trading Books

Market Wizards: Interviews With Top Traders by Jack D. Schwager (Columbia, MD: Marketplace Books, 2006). (TS-3). Schwager’s interviews are frequently at the top of professional traders’ recommended reading lists for their insights into the personalities, backgrounds, decisions and different strategies of traders. Schwager’s follow-up books The New Market Wizards (Columbia, MD: Marketplace Books, 2008) and Stock Market Wizards (Columbia, MD: Marketplace Books, 2008) feature further informative interviews with different groups of traders. Useful for comparison with Brandt, Einhorn, Lewis, and Mallaby below.


The Big Short: Inside the Doomsday Machine by Michael Lewis (New York: Penguin Books, 2010). (TS-3). Lewis (Liars’ Poker, Moneyball) profiles the Wall Street analysts and hedge fund traders who foresaw the 2007-09 global financial crisis: Steve Eisman, Mike Burry, Greg Lippman, Charlie Ledley, Ben Hocket, John Paulson and others. The Big Short how credit default swaps and other synthetics of financial engineering were created. Lewis exemplifies how ‘contrarian’ traders think and make trading decisions about financial markets: there is enough journalistic reportage in this book to actually model the trading strategies. For details of J.P. Morgan’s creation of collateralised debt obligations see Gillian Tett’s Fool’s Gold (Little, Brown, New York, 2009). For details of John Paulson’s ‘Soros trade’ see Gregory Zuckerman’s The Greatest Trade Ever (Penguin Books, London, 2009). For the best account of the negotiations behind the 2007-09 global financial crisis, see Andrew Ross Sorkin’s Too Big To Fail (Viking, New York, 2009). For further analysis of the business cycle implications, see Nouriel Roubini and Stephen Mihm’s Crisis Economics (The Penguin Press, New York, 2010).


More Money Than God: Hedge Funds and the Making of a New Elite by Sebastian Mallaby (London: Bloomsbury PLC, 2010). (TS-3). Mallaby’s history of hedge funds – financial vehicles that enable pooled investors to speculate on stock-markets – has interviews and historical details which are unavailable elsewhere. More Money Than God explores how hedge funds have evolved over the past four decades, from journalist Alfred Winslow to philanthropy. There are interviews with George Soros, Julian Robertson, Bruce Kovner, Paul Tudor Jones, John Paulson, and details of David E. Shaw’s firm D.E. Shaw and James Simons’ Renaissance Technologies: two ultra-secretive quantitative hedge funds. As with Jack D. Schwager’s series on traders, this is an invaluable book for understanding how hedge funds actually work and the motivations of their founders. For some of the best academic research (and influenced by Isaac Asimov’s Foundation series) see Andrew Lo’s Hedge Funds: An Analytic Perspective (Princeton University Press, Princeton, 2010). For a comparison with ratings agencies, see Timothy J. Sinclair’s The New Masters of Capital (Cornell University Press, Ithaca NY, 2008).


Fooling Some of the People All of the Time: A Long Short (And Now Complete) Story by David Einhorn (Hoboken, NJ: John Wiley & Sons, 2011). (TS-4). In 2002, hedge fund manager David Einhorn gave a speech advising investors to ‘short’ Allied Capital. Einhorn’s talk triggered a criminal investigation and maneuvers between Einhorn and Allied Capital. This book can be read as an investigation of corporate governance issues that foreshadowed the 2007-09 global financial crisis. Its primary value lies in revealing the research methods and decisions that a successful value-oriented fund manager uses; the accounting tricks that firms use; and how Kahneman’s biases and heuristics can influence hostile situations. If you want to understand the basics of corporate finance, valuation and fundamental analysis then see the McKinsey model in Tim Koller, Richard Dobbs, and Bill Huyett’s Value: The Four Cornerstones of Corporate Finance (John Wiley & Sons, Hoboken NJ, 2010).


Diary of a Professional Commodity Trader: Lessons from 21 Weeks of Real Trading by Peter L. Brandt (Hoboken, NJ: John Wiley & Sons, 2011). (TS-4). Most trading books feature post facto selections of trade examples and market timing. Brandt’s diaries and technical analysis charts convey how difficult trading actually is; the importance of risk and money management; and the struggles to deal with Kahneman’s biases and heuristics. This book dispels the myths of day-trading success and much of the publishing books that Wiley Finance, McGraw-Hill and other publishers release.


Thinking, Fast and Slow by Daniel Kahneman (New York: Farrar, Straus & Giroux, 2011). (TS-1). Kahneman (awarded the 2002 Nobel Prize in Economics) and his late colleague Amos Tversky pioneered the study of psychological biases and decision heuristics. Kahneman distinguishes between System 1 (fast, emotional) and System 2 (slower, methodical, logical), and how these different cognitive systems affect us. An excellent primer on how to think, reason, and decide more effectively, which makes accessible over four decades of Nobel Prize-winning research. Effective trading is about making reasoned decisions in a fast, volatile environment. For an example of how event risk and volatility can affect decision-making and financial models, see Roger Lowenstein’s When Genius Failed (Fourth Estate, London, 2002) on the 1998 collapse of the hedge fund Long-Term Capital Management.


Unconventional Success: A Fundamental Approach to Personal Investment by David Swensen (New York: The Free Press, 2005). (TS-3). Swensen is the successful investment manager with Yale University’s endowment fund. Unconventional Success distills his insights on the investment process; how to develop an investment portfolio; the different asset classes; and the role of asset allocation over market timing (trading). Swensen — like John C. Bogle (founder of The Vanguard Group), Burton G. Malkiel (A Random Walk Down Wall Street), and others — recommends that you put most of your money into a low-cost index fund like Vanguard or Dimensional Fund Advisers. Swensen’s companion book Pioneering Portfolio Management (The Free Press, New York, 2009) deals with active managers in an institutional funds context. If you want to understand the institutional money management approach, see Richard C. Grinold and Ronald N. Kahn’s Active Portfolio Management (McGraw-Hill, New York, 1999) for quantitative and risk management processes, and Antii Ilmanen’s Expected Returns (John Wiley & Sons, Hoboken NJ, 2011) for asset allocation decisions.


The Predators’ Ball by Connie Bruck (New York: Penguin USA, 1989). (TS-3). In the 1980s high-yield or junk bonds led to a mergers and acquisitions bubble. Bruck profiles junk bonds trader and market creator Michael Milken (now a philanthropist) and the major deals that his firm Drexel Burnham Lambert financially engineered. The Predators’ Ball has substantive insights and journalistic reportage on Milken’s thinking and strategies, similar to Lewis (The Big Short) and Mallaby (More Money Than God). This period is also covered in the Adam Curtis documentary The Mayfair Set (1999). This is a cautionary tale of ethics and power: Milken essentially created and monopolized the junk bond market but acted unethically and was involved in the Ivan Boesky scandal. The epochal RJR Nabisco deal is covered in Bryan Burrough and John Helyar’s influential Barbarians At The Gate (Collins Business, London, 2008). For a comparison of Drexel Burnham Lambert with the private equity firm Kohlberg Kravis Roberts see George P. Baker and George David Smith’s The New Financial Capitalists (Cambridge University Press, New York, 1998).


Inside Job (Sony Classics, 2010). (TS-3). Charles Ferguson’s Academy Award-winning documentary dissects the 2007-09 global financial crisis and its roots in a housing speculative bubble, the failure to regulate derivatives markets, and a ‘winner takes all’ trading culture. Features interviews with George Soros, Nouriel Roubini, Raj Rajaratnam, and others that summarise complex issues.


Million Dollar Traders (BBC2, 2009). (TS-3). European hedge fund manager Lex Van Dam and ex-trader Anton Kreil supervise 8 novices who run a hedge fund in London’s Cass Business School for two months. Several weeks into the project, the 2007-09 global financial crisis begins, and each trader reacts in different ways. Interesting for its use of simulation learning, event arbitrage and how the various personalities deal (or don’t) with stressful situations and uncertain decision-making. In one sequence, the cameras reveal that Kreil is having instant chat messages with outsiders using a producer’s account: Van Dam may actually be trading against the novices.


The Mayfair Set (BBC, 1999). (TS-3). Adam Curtis (The Century of the Self, The Power of Nightmares, The Trap, All Watched Over By Machines of Loving Grace) profiles a group of entrepreneurs associated with London’s Clermont Club, including Jim Slater, James Goldsmith and Tiny Rowland. The Mayfair Set documents their stock-market deals and internecine fighting from the late 1950s to the 1980s mergers and acquisitions bubble in the United States. Curtis links together fears about national sovereignty, business cycles, financial innovation, media battles, and luck. Jim Slater’s Return To Go: My Autobiography (Weidenfeld & Nicolson, London, 1977) recounts the Slater Walker years whilst Geoffrey Wansell’s Tycoon: The Life of James Goldsmith (Grafton, London, 1987) is an insightful, semi-authorised account of how Goldsmith pioneered mergers and acquisitions raids and asset management techniques.

25th October 2011: ACSPRI

• ACSPRI has a Summer Program 2012 in Canberra, Australia, on statistics and research methods.

Who Killed The Electric Car? (2006) explored the market failure of early hybrids and electric cars. Now there’s a sequel: Revenge of the Electric Car (NY Times video clip).

The New Yorker‘s John Cassidy on the macroeconomist John Maynard Keynes.

Vanity Fair‘s Michael Lewis on Californian local politics.

31st May 2011: Dropped

For the past several years, in a developmental editing role, I have worked with academics on their grant applications and publication track records. The Australian Research Council’s Excellence for Research in Australia (ERA) initiative has been one external driver of this work. Minister Kim Carr’s announcement on 30th May that he is ending ERA’s journal ranking system has renewed debate, from incisive critics like Anna Poletti and Josh Gans.

The ARC originally conceived ERA’s 2010 journal rankings to bring evidence-based metrics and greater transparency to the higher education sector. Its Excel spreadsheet of 19,000 ranked journals was a controversial but useful tool to discuss with academics their ‘target’ journals and in-progress work. The team that built the Excel spreadsheet benchmarked the project against similar exercises in the United Kingdom, Europe and New Zealand. Whilst there was confusion about the final rankings of some journals, ERA 2010 was a move in the direction of Google’s analytics and ‘chaordic’ projects.

Minister Carr gave the following reason for ending the journal rankings:

“There is clear and consistent evidence that the rankings were being deployed inappropriately within some quarters of the sector, in ways that could produce harmful outcomes, and based on a poor understanding of the actual role of the rankings.

“One common example was the setting of targets for publication in A and A* journals by institutional research managers.”

Consider a more well-known ranking alternative to ERA: Hollywood’s Academy Awards. Studios invest hundreds of thousands of dollars in lavish marketing campaigns for their films. The nominees gain visibility and negotiation bargaining power in the film industry and for ancillary marketing deals. The winners gain substantive, long-term career and financial benefits, and not just a guest appearance on the television series Entourage. Success goes to the resilient. A similar dynamic to ERA 2010 plays out in the quarterly rankings of mutual fund managers, and in subcultures like the 1978-84 post-punk or ‘new wave’ music movement which ushered in MTV’s dominance.

ERA’s developers appear to have made three mistakes. First, there were inconsistencies between the draft and final rankings which remain unexplained, and that galvanised public criticism from academics. Second, its developers may not have considered the ‘unintended’ yet ‘real-world’ decisions that institutional research managers would make using ERA data: poaching high-performance researchers from competitors, closing low-ranked journals, reengineering departments, and evaluating the research components of promotions applications. If this sounds scary, you probably haven’t worked on post-merger integration or consortia bids. Third, the choice of letter codes – A*, A, B, C and unranked – rather than a different descriptive measure, introduced subtle anchoring, framing and representativeness biases into the ERA 2010 journal rankings.

Academics often knew what ERA sought to explicitly codify yet this tacit knowledge could be fragile. For instance, Richard Slaughter spent significant time during a Swinburne Masters in strategic foresight distinguishing between the field’s flagship journal (Elsevier’s Futures), the savvy new entrant (Emerald’s Foresight), and the critical vanguard (Tamkang University’s Journal of Futures Studies). Each journal had its own history, editorial preferences, preferred methodologies, and delimits. You ‘targeted’ each journal accordingly, and sometimes several at once if an article was controversial. ERA’s draft rankings reflected this disciplinary understanding but the 2010 final rankings did not. Likewise, to get into the A*-ranked International Security journal or to get a stellar publisher for international politics – Cambridge, Princeton, Yale, MIT – can take several years of drafting, re-drafting, editing, seminars and consulting with colleagues and professional networks. An influential book from one of these imprints can take up to five to seven years, from ideation to first journal reviews. The “quality is free” in the final manuscript.

This presented a challenge to institutional research managers and to university workload models. This developmental time can inform teaching, seminars, conference panels with exemplars, and peer networking. But it doesn’t necessarily show up quickly as a line-item that can be monitored by managers or evaluated by promotions committees. Instead, it can look like ‘dead time’ or high-reward gambits which have not paid off. Thus, the delays can be potentially detrimental and could affect institutional perceptions on academic performance. Institutional research managers also may not have the scope to develop the above tacit knowledge outside their disciplinary training and professional expertise.

So, like Hollywood producers, the institutional research managers possibly resorted to the A* and A journal codes as visible, high-impact, high-reward rankings. It was a valuable, time-saving short-cut through complex, messy territory. An academic with 15 A* and A level publications looked more convincing on paper than academic with 30 B and C level papers over the same period. A research team with A* and A level publications would be well positioned for ARC Discovery and Linkage grants. Australian Government funds from the annual research data collection had halo effects and financial benefits to institutions, like the Academy Award nominees have for film studios. It can be easier to buy-in expertise like professors and ambitious young researchers than to try and develop would-be writers. Rather than a “poor understanding”, I suggest the institutional research managers had different, perhaps less altruistic goals.

This was clearly a different role to what Carr and the ERA developers had intended, and conveyed to me at a university roadshow meeting. It was a spirited and valuable discussion: I pointed out to the ARC that a focus largely on A* and A level articles meant that 80% of research outputs were de-prioritised, including many B-ranked sub-field journals. However, there were alternatives to scrapping the system outright (or shifting to Field of Research codes and strengthened peer review): Carr might have made the inclusion and selection criterion for journals more public; could have addressed open publishing, and new and online journals; changed the ranking system from letter codes to another structure; and accepted some of the “harmful outcomes” as Machiavellian, power-based realpolitik which occurs in universities: what the sociologist Diane Vaughan calls “institutional deviance”. This may still happen whatever solution Carr and the ERA developers end up devising.

Perhaps if Carr had read two management books he would have foreseen the game that institutional research managers played with the ERA 2010 journal rankings. Jim Collins’ Good To Great (HarperCollins, New York, 2001) counselled managers to “get the right people on the bus”: A* and A level publishing academic stars. Michael Lewis’ Moneyball (W.W. Norton & Co, New York, 2003) examined how Oakland A’s general manager Billy Beane used sabermetrics – performance-based sports statistics – to build a competitive team, improve his negotiation stance with other teams, and maximise his training budget. Beane had to methodologically innovate: he didn’t have the multi-million dollar budgets of other teams. Likewise, institutional research managers appear to have used ERA 2010 like sabermetrics in order to devise optimal outcomes based on university research performance and other criteria. In their eyes, not all academics have an equal performance or scholarly contribution, although each can have a creative potential.

To me, the ERA 2010 journal rankings are still useful, depending on the appropriate context. They can inform discussions about ‘target’ journals and the most effective avenues for publications. They can be eye-opening in providing a filter to evaluate the quantity versus high-impact quality trade-offs in some publication track records. They have introduced me to journals in other disciplines that I wasn’t aware of, thus broadening the ‘journal universe’ being considered. They can be a well-delivered Platonic shock to an academic to expand their horizons and time-frames. The debate unleashed by Carr’s decision will be a distraction for some who will, instead, focus on the daily goals and flywheel tasks which best leverage their expertise and build their plausible, preferred, and personal futures.

21st March 2010: Bloomberg on Michael Lewis and The Big Short

Wrote two pages for PhD draft on Alastair Johnston‘s generational model of strategic culture analysts in security studies and international relations theory.

Cover of

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Michael Lewis on Bloomberg‘s ‘For the Record’ to promote his new book The Big Short: Inside the Doomsday Machine (New York: W.W. Norton & Company, 2010). Amazon’s #1 book although the reviews are affected by end-user problems with the Kindle  version. Lewis clearly has had extensive media training.

Major points that Lewis makes:

The five main people that Lewis profiles are outsiders — stockmarket analysts rather than bond market specialists — who had to learn about the subprime mortgage market in order to track stocks that they were interested in, and who then decided to short the market.

Financial innovation should be regarded with some skepticism – we can see examples that led to greater inefficiencies rather than more efficient markets, so some innovation can have a downside, and this may be clear only in retrospect. Lewis believes collateralised debt obligations should be more transparent, i.e. traded on exchanges and clearinghouses, so that all parties can manage their counterparty risk.

Financial service firms are now more professional than what Lewis saw at Salomon Brothers during the late 1980s. Yet Wall Street is now far more cynical: bonuses, incentives and hypercompetition have eroded the partnership ethic that keeps these firms stable.

Reviews of The Big Short: The Big Money, Washington Post.

A 20th anniversary piece on David Lynch’s Twin Peaks has a couple of interesting anecdotes on how Lynch dealt on-set with his actors.

Roger Lowenstein asks: Who needs Wall Street?

John Kay on oblique decisions.

Decision Sciences For The Masses

Malcolm Gladwell‘s new book Outliers: The Science of Success (New York: Little, Brown & Co., 2008) appears to be the publishing event of the week.

Gladwell (The Tipping Point, Blink) spearheads a group of writers who are masterful at using anecdotes about insights from statistics, system dynamics and the decision sciences that will interest a broad readership.  This group also in  Chris Anderson (The Long Tail), James Surowiecki (The Wisdom of Crowds), Nassim Nicholas Taleb (Fooled by Randomness, The Black Swan), Tim Harford (The Undercover Economist), Steven Levitt and Stephen Dubner (Freakonomics), and Michael Lewis (Liar’s Poker, The New New ThingMoneyball) also belong to this group.  Apart from outliers and tipping points these books explore intuitive decisions, long tail distributions, the Law of the Many, chance, low probabilty high-impact events, martingales, and data-driven decisions.  Each author has a different background: Taleb is an epistemologist and former trader, Anderson is a technology pundit, and Lewis, Gladwell and Surowiecki are essayists and journalists.

For me, six observations emerge from these authors.  First, they have a writing style that appeals to a broad audience.  Second , they provide an introduction to quantitative elements of decision-making and judgments.  Third, their publishers have created a niche market in airport reading and popular science paperbacks.  Fourth, they differ in their approach to theory building: Anderson, Gladwell and Surowiecki take an insight, interview people, and promote it; Taleb, Harford and Lewis draw on their domain experience; and Levitt and Dunbar illustrate how a subject matter expert can collaborate with a journalist to reach a broader audience.  Fifth, their books have seeded a range of Web 2.0 strategies, which vary in rigour, validity, generalisability and applicability to real-world analysis.

Finally, their publishers have used their marketing appeal to build an audience during turnarounds and post-acquisition integrations: Gladwell and Surowiecki helped revive The New Yorker, Levitt and Dunbar’s blog gained The New York Times an Internet readership, and Anderson revamped Wired after Conde Nast‘s acquisition.

Investors’ Regret: Société Générale v Jérôme Kerviel

On 4th July 2008, The Banking Commission of France (BCF) fined Société Générale €403 million euros for the bank’s lack of internal controls in a €4.9 billion trading loss in January 2008.  SocGen blames ‘rogue trader’ Jérôme Kerviel for the loss after it discovered his trading positions on 18th January.  SocGen’s chairman Daniel Bouton also blamed Kerviel for the stockmarket’s 6% fall on 21st January 2008.

Kerviel counter-blames SocGen for its loss, fired his lawyers, and adopted an aggressive stance with a new legal team during a court hearing in France on 23rd July. SocGen had already suffered fallout from the revelations about Kerviel’s losses: Bouton made changes to senior management, and the French bank had to raise €5.5 billion euros to recapitalise, and prevent SocGen from becoming an M&A takeover target.SocGen’s ‘rogue trader’ claim against Kerviel recalls the fate of trader Nick Leeson whose speculation on derivatives and options markets led to the collapse of Baring’s Bank in 1995.  Leeson attempted to trade himself out of bad decisions through his knowledge of exotic options, his control of the settlements role, and his tactical deception using spreadsheet models and accounts with whited-out text that was invisible to others.  SocGen claims Kerviel used complex program trades with exchange traded funds and swaps for a similar tactical deception.  Leeson’s losses made Baring’s illiquid and in 1995 the English merchant bank was sold to ING for £1.

On the surface Leeson and Kerviel share enough similarities as a pair to warrant the ‘rogue trader’ label.  Both had knowledge of sophisticated financial instruments and markets.  Both used this knowledge to make substantial profits for their respective firms.  Both were in teams which faced rapid revenue growth but also with a lack of internal controls: Singapore for Leeson and Delta One for Kerviel.  Both used tactical deception in attempts to escape from adverse trade situations, caused by the misuse of financial instruments, dynamic disequilibriua in the markets, and cascade events.  In Leeson’s case, Japan’s Kobe earthquake on 17th January 1992 was also a Black Swan event.  Both Leeson and Kerviel have made counter-accusations that the banks’ senior management were scapegoating them for larger institutional losses.

One central difference between Leeson and Kerviel is that all game-players are now more aware of ‘rogue trader’ as a media narrative and symbol of financial villains.  Bloggers posted Kerviel’s resume online and registered his name as a website address.  Bouton quickly singled Kerviel out for blame before French authorities also charged Kerviel’s manager. Kerviel countered this with claims that SocGen’s senior management was happy with his trading and that the bank had broader problems with its risk management system.  Independent sites such as also discussed Kerviel’s case.

SocGen appointed a Special Committee to investigate Kerviel’s trades and to evaluate its corporate governance and risk management systems.  The Special Committee and General Inspection reports found problems with Kerviel which echo post-mortems on Leeson: no supervisor, an inexperienced new manager, problems with intraday positions and high-correlative markets, ignored red flags, and a lack of transparency between middle office and back office functions.  The bank also derisked its internal review by hiring PricewaterhouseCoopers to evaluate SocGen’s risk management systems.  The audit firm then derisked itself by de-scoping its report which PwC claims was based on SocGen’s internal documents and industry best practices.

Was this an exercise in ‘plausible deniability’?  Perhaps.  Did it interest book publishers? Yes, the entrepreneurial small press turned Kerviel’s case into several ‘quick books’ for micro audiences.  Did Kerviel create a new market?  Definately: at a university career fair in May 2008 a Gen Y consultant pitched to me that her Big 4 accounting firm could prevent future Leesons and Kerviels through the automatic control of access rights to critical IT systems.  I countered that whilst this solution would provide audit trails, it might not deal with the ‘human factors’ that allow failures such as Leeson and Kerviel to (re)occur.

CF’s fine signals some deeper problems in SocGen’s corporate governance and risk management systems.  Traders can use knowledge of complex derivatives, options and trading systems for tactical deception.  They may also perceive risk management as a separate function rather than an integral process, although this is changing after the 2007 subprime crisis.  Senior managers who keep changing their stories in a crisis may be stonewalling.  The pressure to make profits can mean that outcomes-based systems are manipulatable according to the outcomes demanded.  In Kerviel’s case managers ignored ‘red flags’ from the Eurex derivatives exchange.  Could Eurex have the independent power to bar traders who reach a high level of ‘red alerts’ in a given period?  What if Eurex took a solution from nuclear detente and have a ‘red phone’ line direct to SocGen’s internal auditors and external regulatory agencies?

Leeson and Kerviel are proof that traders always face the possibility of large losses from consistent market trades.  Fans of Oliver Stone’s film Wall Street (1987) and Michael Lewis’s memoir Liar’s Poker (W.W. Norton & Co., New York, 1989), which is mandatory reading in many MBA corporate finance classes, can overlook this market reality.

But equally overlooked is a more troubling problem: the differences in promotion pathways and work culture between compliance/legal/risk staff and traders who must live by their next deal regardless if the client blows up.  Gordon Gekko (Michael Douglas) recruits Bud Fox (Charlie Sheen) in Wall Street because Fox is ambitious, risk aware, and his working class roots give him a gritty edge.  Lewis suggests in Liar’s Poker that Salomon Brothers traders share a similar outlook.  SocGen’s managers promoted Kerviel to junior trader from a compliance role and SocGen’s lawyers now believes this risk management knowledge aided Kerviel’s tactical deception.  Described by friends as ‘honest, working class’ Kerviel might be Bud Fox without the ‘remorse of conscience’.