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INSIGHT – Rogue traders beware – the middle men are here

After a brief spell on the run, Nick Leeson was arrested three years ago this month for his role in the rogue dealing scandal that led to the collapse of one of the world’s leading banks, Barings.

Poor risk management controls at Barings’ Singapore offices had allowed Leeson to run up losses of over #750m on the local derivatives exchange and hide the fact from his superiors. The affair stunned the banking world.

The problem for Barings was that Leeson was in an overlapping position that enabled him to do trades and then process some of the associated paperwork. The resulting disaster underlined the dangers of banks failing to adequately isolate their front-office trading from their back-office paperwork.

But the scandal also underlined the benefit of having an independent team reporting to senior management. The risk management concept of the “middle office” has been gaining currency since the late 1980s – Barings taught the financial world that this was one new idea it should take notice of.

The middle office is a means of risk control and risk management set up by financial institutions, especially security houses and banks, to act as a check on the activities of front-office traders and to provide an independent report to senior managers on the potential risks created by the organisation’s position in the market.

A clear lesson from the Barings fiasco was that effective reporting systems needed to be independent from traders if gambles taken with company money were to be unearthed. But Barings also broadcast the message that increasingly sophisticated trading procedures and market positions would require equally sharp controls.

Before the introduction of the middle office, responsibility for monitoring trading activities was left to the back office, which was generally staffed by bookkeeping, compliance and admin people. As trades became more complex, a greater need for technical expertise was apparent.

Stuart Barnett, partner in charge of the banking sector with Deloitte & Touche, confirmed this need for in-depth expertise. “Greater technical expertise is needed as the work of middle-office staff is based on complex financial models and evaluation systems and so they need the capability to understand these. Middle-office staff need both accounting and mathematical expertise,” he says.

As a result, he explains, a modern middle office will often encompass both accountants and mathematicians who can analyse the technical data.

The middle office is also likely to include former front-room traders who can give an experienced angle on dealing operations, so that the technical expertise can be successfully applied.

The success of a middle office will depend on how up-to-date its financial models and evaluation methods are and how the data collected from these tools is applied in practice. The data must be made to fit the trading circumstances of the company and middle-office staff should have the practical and technical know-how to achieve this.

That is why the middle office represents more than a simple duplication of the role performed by the internal audit function. Middle office staff use their specialist expertise to provide on the spot reports on the day-to-day trading activities and so provide a constant vigilance of traders and their actions.

But this does not mean that the world of banking has seen the end of the rogue deal. Last year NatWest Markets suffered a surprise #90m derivatives loss in its interest rate options division. The reverberations from that shock saw the departure of chief executive Martin Owen, global head of options Neil Dodgson, and four others, including trader Kyriacos Papouis.

The NatWest loss followed similar incidents at Morgan Grenfell, the asset management arm of Deutsche Bank, and industrial group Sumitomo Corporation, and begged the question as to whether middle offices were actually effective in practice.

Questions were asked as to whether relatively low-paid middle-office staff could realistically be expected to curb the exploits of highly-paid traders.

There is little doubt of the need for the risk management check that a middle office provides. And as the middle office function becomes increasingly common, its role is developing to cope with higher control expectations and more complicated markets.

The risk management tools used are also continuously upgraded to provide a more in-depth analysis of the trading activities. At the same time, pay rates for middle-office staff in general have improved.

But three years on, the financial community is still learning the lessons from the Barings collapse. One point the bankers seem to have taken on board is that, to avoid a similar disaster, every organisation must have a well-staffed, highly-resourced independent team that knows exactly what trades the dealers are making and what risks they are taking. The question is, why didn’t they realise that sooner?

Joanna Gant is a freelance journalist.

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