How to Manage "Genius Trader Risk"

Sometimes the biggest risk is the one right in front of you. If one looks at the list of the biggest trading losses incurred by individual traders, one set are those from rogue or trades unauthorized by management; the second are those from trades made with the apparent full knowledge of management- the risk right in front of you. The losses in the latter group, are distinguished from the first group in several other ways: first, very large losses associated with them appear to occur with greater frequency; second, there is no common term to describe their activities such as "rogue trader" or "ponzi schemer"; third, these folks generally get a second chance; and fourth, accountability appears to occupy something of a grey area. The table below shows that four out of the five largest recorded losses by a single trader were incurred by "genius trader risk", the term I have used to describe the type of risk this second category represents.

So what exactly is genius trader risk? Genius traders occupy positions in the highest level of their bank or firm. They have built an almost unimpeachable reputation for trading success over an extended period and command a level of respect within the firm equal or superior to its most senior officers. Their managers are unable or unwilling to challenge them intellectually and their valuations, hedges and strategies may not be fully transparent to others. The genius trader abrogates to himself, by authority rather than by dissembling, rights and privileges not available to others. Example of such rights might be, for example, to use a different valuation methodology, a unique hedging strategy, or an increase in the trading limit allowed for his product or strategy. This is the type of thing where, when the hedge goes wrong or the valuation is far off the mark, all throw their hands up to say, "how was this missed".

Genius risk is also identified by the fact that people appear to be generally prepared to overlook missteps. After the losses and then the closure of Long Term Capital, for example, John Meriwether succeeded in growing a second fund, JWM Partners until on July 7, 2009 it was announced that the fund would be closed after suffering losses. A third fund was started in 2010 with some large losses announced as early as the following year. This availability of second and third chances is in strong contrast to rogue traders, none of whom seem to get a second chance in capital markets after first spending a substantial amount of jail time.

And genius risk losses keep coming. 2012 of course saw the well-publicized losses at JP Morgan incurred by its CIO office and the "London Whale" Bruno Iksil. This case included all the key attributes of this type of risk: traders that were unusually well compensated, trading and hedging strategies that were apparently poorly understood by management, alleged issues with risk management modeling and procedures. As this case illustrates, however, it appears to be better to be the CEO of a firm that suffers a large genius risk loss than a rogue trader loss. While Jamie Dimon remains in place at JP Morgan, Oswald Grübel at UBS and Daniel Bouton at Societe General both stepped down in the wake of the Kerviel and Adoboli losses. In fact accountability for genius risk in general seems a little unclear in part because without a name for it, no one can own it. Furthermore, since the risk contains elements of market and operational risk, it seems to fall into a gap in between. Should such incidents be included for example in the calculations that help firms to determine how much capital to set aside for future operational risk losses?

While it may be true that genius risk occupies something of a grey area between risk disciplines, there can be no doubt that risk managers of whatever stripe, need to be held accountable for managing the risk. So what can be done to combat this risk?

First, the risk should be recognized more clearly for what it is and what it represents. Second, senior management must regard "genius" with a critical eye. An example from soccer can be instructive here. Sir Alex Ferguson, coach of Manchester United, has over the years shown the door to stars like Carlos Tevez, Christian Ronaldo and David Beckham when their egos threatened the team's overall stability. As that example nicely illustrates, a manager and institution's culture can be more successful when it is stronger and more confident than its biggest egos. Goldman Sachs is a great example of this. Risk managers there have the mandate to push out star traders, and do so, despite success, when they identify issues for concern.

[Check out the Ten Most Significant Operational Risks of 2012.]

Third, investors and other firms, presented with an opportunity to invest with or take on a genius that has suffered a misstep should be highly circumspect in doing so. Such a misstep may actually belie a repeating pattern of behavior that can be ill-afforded. Additional investigation and due diligence is required and managers should put the interests of the team before those of an individual as brilliant as he may be.

Fourth, supervisors and risk managers need to understand all traders' positions, the nature of the products they are trading etc. Managers must be senior enough to challenge the intellectual basis of established positions and valuations. Good risk managers must do much more than review the VAR limits but take an active part in understanding the trading strategy and apply independent judgment.

Fifth, management should not tolerate exceptions: a product priced differently than the standard methodology; traders who significantly exceed trading limits whether intra-day or end of day; new products traded without going through the approval process; products booked using non-standard systems or booking processes. Management must put in place ways to check and monitor such activities and demonstrate that they do not tolerate such behavior as routine.

By the very fact that it does not enjoy a name or a risk category of its own, we know that "genius" risk is relatively under-managed and understood. At the end of the day, however, a "genius" can "blow up the bank" just as much as a "rogue" can. In that case it behooves risk managers across all disciplines to spend as much time and effort on identifying and addressing the risk of the genius as that of the rogue.