Often times when news of a fraud occurs be it an outlandish Ponzi scheme, a rogue trader or some other lower level fraud, there is often at first a big media splash. The investing public then begins to learn the intimate details of the fraudulent scheme including details about its perpetrator. The problem is that the media, as do many investors, tend to have short memories (i.e. – does anyone talk about Bayou anymore?).

A few days or certainly months after the fraud, it seems as if there is virtual radio silence. After a long enough period of time it may begin to seem as if the fraud never happened at all. Then all of a sudden the perpetrator of the fraud is back in the news. Perhaps a trial date, revelations by a bankruptcy trustee uncovering further losses or even a tell all book by the fraudster themselves.

Such seems to be the case with many of the so-called “rogue trader” cases of late undertaken by the likes of Nick Lesson at Barings Bank and more recently Jérôme Kerviel at Société Générale and perhaps even the recent MF Global scandal which involved custody and re-hypothecation issues. Another notable recent example of alleged rogue is Kweku Adoboli at UBS.

Mr. Adoboli, a director of the bank’s Global Synthetic Equities Trading team in London, is alleged to have been a key player in the firm’s over $2 billion in losses through unauthorized trading. Initially it was reported that just like Bernard Madoff, the bank was unaware of the losses until Mr. Adoboli turned himself in. Details later emerged that UBS did indeed receive an automated warning from its computer system regarding Mr. Adoboli’s suspicious trading activities but ignored them.

When news of Mr. Adoboli’s alleged losses first came to light there was a huge media splash and then a whole lot of nothing. That is until recently when, after changing legal counsel, he entered a not guilty plea. He didn’t give a reason for his plea and he wasn’t required to. His Facebook posts such as “I need a miracle” perhaps are self-incriminating enough.

With what seems to be very late fat-tailed chunky losses every few years from either large bank trading desks or hedge funds (remember Amaranth anyone?) due to the purportedly single handed actions of these rogues in traders clothing, one question worth considering is exactly whose responsibility is monitoring such risks?

Said another way, where does the risk for monitoring rogue trader risk lie – within investment due diligence, operational due diligence, or both?

Certainly the most logically responsible individual responsible for such supervision would be the traders boss, perhaps followed by a close second of the firm’s risk manager(s). Beyond that of course the blame could be placed on regulators, but such blind sole reliance on governmental agencies ranges from the naive to the un-diligent. Ultimately it is up to investors to perform their own due diligence and protect their own investments from the actions of rogue traders. The first line of defense in this on-going risk oversight war is due diligence.

Before returning to our original question regarding where the primary responsibility for monitoring rogue trader risk lies, let us first consider the likely answer – that the monitoring for rogue trader risk should be the responsibility of both the investment and operational due diligence analyst. Many investors however, may be tempted to cover such trading risks solely during the investment due diligence and ongoing monitoring processes. This is a mistake.

Perhaps  a brief listing of the some of the potential key considerations when evaluating a firm’s susceptibility towards rogue trader risk would help clarify this issue. There are a number of important items investors should consider during the operational due diligence process to determine if a hedge fund, private equity fund or traditional fund has an appropriate internal trade oversight system to prevent such risks. These issues factor into areas of a firm’s internal policies and procedures across both operations, risk management, compliance, information technology and of course trade operations. Some key considerations investors may want to consider in this regard include:

• Who has authority to execute trades?
• How exactly are trades executed?
• Can traders trade from outside the office?
• Is the authority to trade universal or is different permission in place to buy and sell positions?
• Are dollar or volume limits in place for trading authority?
• Are other parts of the firm such as compliance and risk management involved in monitoring fund trade activity including any fund level restrictions which may be in place?
• Are those with the authority to execute trades located in multiple offices? If so who monitors their activity? How is this monitored?
• Can the firm’s risk management department unwind trades if necessary?
• Are trading guidelines and trading restrictions logged an monitored in a centralized trading system?
• Who has the ability to open trading accounts on behalf of the firm?

As with most things in the field of operational due diligence, operational failures typically result not in only in the loss of operational efficiencies but also in direct investment losses. Rogue trader risk is a good example of a blended risk factor which straddles the fence between the often blurry line between investment and operational due diligence.

Investors may be unfamiliar with the myriad of historical techniques employed by rogue traders in perpetrating such frauds and may be further ill equipped to fully ferret out such latent rogue risks. These investors may benefit from engaging a third-party specialty operational due diligence consultant such as Corgentum to ensure such risks are properly reviewed and monitored so that they are not entangled in the next rogue trader scandal.