Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Drunken trading and risk limits

The Financial Services Authority of the UK put out an order last month regarding a drunken broker (Steven Perkins) who bought $520 million of crude oil futures sitting at home at night with his laptop (hat tip Finance Professor).

I find it amazing that somebody sitting at home with a laptop between 1:00 am and 4:00 am can execute over 2,000 buy trades worth over half a billion dollars when his broking firm is essentially an execution only oil brokerage, and Perkins himself (and almost all other brokers in the firm) were barred from doing proprietary trading.

What does it say about the risk management and control systems at the brokerage firm (PVM)? The FSA explicity says that it “makes no criticism of PVM”:

Mr Perkins’ behaviour was contrary to PVM’s policies and procedures and the FSA makes no criticism of PVM in this notice. Mr Perkins was immediately suspended by PVM on 30 June 2009 and his employment later terminated.

I would however think that there are issues of risk management that cannot be wished away. The Telegraph reports that the transaction caused a loss to PVM of $9.8 million and resulted in the brokerage reporting a loss of $7.6 million for the year. The implication is that the normal profits of the firm were $2.2 million. A drunken broker supposed to execute only client transactions lost in a single night an amount which was more than four times the normal annual profits of the entire brokerage firm!

I think that financial firms need better risk management systems and need to think carefully about operational risk. When Perkins lied to his company that the trade was for a client, he did not claim that it was for large oil company, he said that it was for a “local trader” which is how independent oil traders are referred to. There should have been some counterparty risk controls kicking in when a half a billion dollar trade is made at the dead of night for a client who is a small time local trader. Some alerts should have been trigerred when the purchases by a single broker during the three hour window was more than 17 times the average daily volume of the entire market for this period of the night.

Interestingly, PVM is owned by senior brokers themselves and the poor risk management cannot be attributed to corporate governance issues. I think it reflects the failure of systems and processes at many financial firms to adjust to the modern reality of round-the-clock high-speed electronic trading.

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