Trading Room - Anatomy of The Biggest Failures

Anatomy of The Biggest Failures

Whether as an actor or as a simple witness, the trading room is the place that experiences any failure serious enough to put the company's existence at stake.

In the case of Northern Rock, Bear Stearns or Lehman Brothers, all three wiped out by the subprime crisis, in 2008, if the trading room finally could not find counterparts on the money market to refinance itself, and therefore had to face a liquidity crisis, each of those defaults is due to the company's business model, not to a dysfunction of its trading room.

On the contrary, in the examples shown below, if the failure has always been precipitated by market adverse conditions, it also has an operational cause :

These operational causes, in the above columns, are due to organisational or IT flaws :

• A fictitious trade gets possible whenever the system allows to post a trade to either a fictitious counterparty, or to a real counterparty, but for which the system sends neither a confirmation to that counterparty nor an automated message to the back-office, for settlement and accounting;
• Hidden position, which are fraudulent, and excess over authorized positions, which is not, are also made possible by the absence of a mechanism of limits control with transmission of a warning to the Risk Department, or by the absence of reaction by the recipient of such a warning;
• Some insider trading cases can be explained by the proximity, inside the trading room, of desks with conflicting interests, such as the one that arranges equity issues with that invests on behalf of customers.
• Price manipulation is also possible if no control is made on the share of an instrument that is held in relation to the total outstanding on the market, whether this outstanding is the total number of stocks of a given corporate issuer, or is the open position of a listed derivative instrument;
• Risk can be miscalculated, because it depends on parameters whose quality cannot be assessed, or because excessive confidence is put in the mathematical model that is used;
• An erroneous valuation may stem from a fraudulent handling of reference prices, or because the lack of fresh quotations on an instrument, and the failure to consider an alternative, model-based, valuation, have led to the use of obsolete prices;
• The lack of trader's control can be assessed by the weakness of the reporting required from him, or by the lack of expertise or critique by the recipients of this reporting;
• A user entitlement may prove inadequate, either because it is granted by the hierarchy in contradiction with the industry's best practices, or because, though not granted, it is still enforced either because the system cannot manage it or because, by neglect, it has not been properly set up in that system;
• Finally, a capture error may arise in a system with weak plausibility controls, such as that on a trade size, or with no « four eyes principle » mechanism, whereby a manifest anomaly would have been detected and stopped by a second person.