There's an unending parade of proposed systems to prevent the kinds of bank fraud that attack customer accounts—every size and shape, from new companies with another way to cut the data, all the way to the ultra-expensive EMV.
But when you read about a big bank brought low by fraud—such as UBS or Societe Generale—it's not because of the kind of fraud these up-to-the-minute solutions target, i.e. fraud in customer accounts. The big damage, enough to threaten to wipe out a large bank, is from fraud in proprietary accounts.
Kweku Adoboli, former UBS trader, is now on trial for a $2.3 billion fraud, in London. "Rogue traders" used to be spectacular—remember Nick Leeson, whose fraud bankrupted Barings Bank in the 1990's? Now it's commonplace. No one's interested in Adoboli.
Yet this is grotesque, bizarre. It doesn't happen to Microsoft or Walmart, it doesn't happen in 5100 Chase branches. Multibillion dollar frauds (like multibillion dollar risk management failures without fraud) typically stem from proprietary trading, particularly in derivatives. Nobody's proposing preventatives for this kind of fraud. That would be too simple, too untechnological, too humdrum.
Sure, it's possible for a trader such as Chase's "London whale" to cause billions in damage even without fraud, because of inadequate risk management. But trader fraud should be much easier to eliminate than losses from misguided risk judgment about transactions that are promptly, clearly and accurately accounted for.
Improved process can snuff it. Trader fraud occurs only because we do not require immediate trade confirmation posted infallibly to the institution's books, plus marking of positions that is uninfluenced by traders. Instead, the trader is allowed to wave a magic wand to create false transactions and false values and hide real ones.
Why don't we see multibillion dollar trader fraud on the NYSE, or NASDAQ, or bond markets? It mostly depends on derivatives, those miraculous engines of "risk reduction." It is facilitated by resurrecting antique, late 19th century methods of trading and settlement: the telephone, maybe a keyboard, and no real-time verification, no clearing. This flight back to the distant past is necessary to avoid transparency and exposure of orders to competing market makers—hence to maintain unlimited spreads. To participants in this narrowly self-serving system, the fraud risk is a small price to pay for big bonuses, especially since fraud "can't happen here," and counterparties assume they are protected by collateral.
This would be impossible without non-regulation, enacted into law in the waning days of the Clinton administration, over the incisive and farsighted objections of Brooksley Born, who then chaired the CFTC. "Greenspan didn't believe that fraud" prevention "was something that needed to be enforced."
Fraud also couldn't happen without government kowtowing to the industry's demand that we not only compete in laxity with even more supine foreign jurisdictions, but promote unregulated access by our own institutions to wild West trading arrangements, for instance in London. And it probably couldn't happen without repeated Republican slashing of the regulatory budgets.
But we're not going to get much more clearing. Nor transparency, nor reasonably efficient markets. We won't have U.S. standards applied to all trading controlled by U.S. institutions.
We're also not going to implement the more straightforward remedy of eliminating proprietary trading by banks altogether.
Even so, we can prevent most proprietary fraud.
Instead of having the trading records checked and values assigned to positions by a pitiful on-site flunky whose dream is to get the trader to recommend him for a low-level trading job, how about this:
Record all trader phone and data line traffic. Prohibit trading not done through these monitored lines. Have all the recordings checked within 24 hours (preferably within eight) by a remote compliance or accounting person. The recording would identify the counterparty electronically, and the verification agent would compare each trade against whatever record the trader transmitted. All discrepancies would be immediately resolved by telephone inquiry to the counterparty. Exclude traders from the position valuation process. Trust, but verify.
Verification and valuations agent would be shifted from day to day between at least 10 traders and would be prohibited from telephone communication with them. Automatically fire any trader with repeated discrepancies.
Otherwise, what happens when, two or 10 fraudsters get together. They may all work for the same institution, or, worse, they could be working for different institutions. The resultant losses could total $10 billion – or $100 billion.
A LIBOR-size crime that directly hits banks' books. If this isn't systemic risk, what is?
Andrew Kahr is a principal in Credit Builders LLC, a financial product development company, and was the founding chief executive of First Deposit, later known as Providian.