18 January 2012

Geneva Association: Insurance companies' highly controlled use of derivatives has also resulted in protection from “rogue trader” problem

In recent discussions on financial stability in insurance, the issue of insurers' use of derivatives has become the object of some considerable focus. The NAIC examines why "rogue trading" has not been an issue for an insurer to date.

Unauthorised trading scandals — commonly referred to as “rogue trading” — have been occurring periodically in financial markets in recent years. While the institutions that have been the victims of these schemes claim to have devoted considerable resources in an attempt to avoid this problem, these schemes have continued to occur with a disturbing regularity. The most recent scandal, involving Kweku Adoboli at UBS, cost UBS US$2.3 billion in losses that were incurred on unauthorised trades. There is a line of similar scandals that have occurred over the years, at least one of which resulted in the failure of a major financial firm.

The question of why these scandals keep occurring despite the efforts to avoid them remains an interesting one. Firms have primarily attempted to limit these occurrences by improving compliance controls through better systems and staff. Examples of improvements that can be made are post-trade functions of valuations and collateral management, which can benefit from operational and technological improvements. One of the most important improvements is a robust and transparent valuation process, especially for over-the-counter derivatives that are hard to value since there are no published daily exchange prices. The valuation of derivatives is always a challenge, especially for those that are out of the mainstream or have unusual or complex terms. Banking rules recommend that trading and other bank staff take a consecutive two-week mandatory vacation. The idea is that, over that time period, other individuals in the organisation will have an opportunity to come across any unauthorised trades in the normal course of business.

Full paper

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