Can high levels of volatility make traders go rogue?

New research sheds light on how risk blindness can develop

When we hear about a rogue trader who has lost millions or sometimes billions of dollars, our reaction is usually the same: How could they take such huge risks?

We assume the rogue trader knew the risks he (and they are always men) was taking and decided to ignore them. This accords with the most common explanation about the role of risk in rogue trading, namely an exacerbated risk appetite, fuelled by management oversights and regulatory pitfalls.

But new research suggests that rogue traders may have been blind to the risks in the first place.

In a joint project, researchers in neurofinance at UNSW Australia, the University of Geneva and the University of Sydney have discovered that a person's perception of risk can be altered by how much volatility they have been exposed to.

This is important, because at times financial markets can be subject to a large amount of volatility, where the value of a security or the level of a financial index fluctuates rapidly.

The researchers conjectured there would be an after-effect of volatility, which would make people who had been exposed to high levels of volatility underestimate volatility in future.

They tested this by showing 56 participants the movements of a graph on a screen that were similar to those a stock trader would see on their computer terminal when prices were moving. Some participants were shown a graph with high volatility, while others saw graphs with low volatility. Next, the participants were shown a graph with medium volatility, and their reactions measured.

In their paper, Variance After-Effects Distort Risk Perception in Humans, the researchers explained their findings thus: "After looking at a risky stock, a medium-risk stock looks safer, whereas after looking at a safe bond, the same medium-risk stock seems riskier."

'We say it's not a risk preference issue. The problem is specifically with the perception of risk' 

ELISE PAYZAN-LE NESTOUR

Changing the environment

The real world implication of this observation is that if a financial market trader has been working in very volatile markets, then they will be less able to perceive volatility because of the after-effect.

"If you apply the after-effect to the phenomenon of rogue trading, what is happening with most rogue traders is that those guys have been exposed to chronically high levels of risk and so they are just blind to risk subsequently," says Elise Payzan-Le Nestour, one of the paper's authors and a senior lecturer in the school of banking & finance at UNSW Business School.

"That explanation really departs from the standard explanation for the phenomenon of rogue trading, which is that rogue traders have an exacerbated risk appetite – that is, they are just risk seekers.

"We say it's not a risk preference issue. The problem is specifically with the perception of risk. It's a completely new explanation."

Payzan-Le Nestour says it may be fairly simple to alter the behaviour of rogue traders. "If you change their environment and you ensure they are not exposed to high levels of risk all the time, then it should be effective at stopping the behaviour," she says.

"Until now we thought rogue trading had to do with an exaggerated risk appetite, so we did not see the point in changing the traders' environment in this vein."

Racking up losses

Rogue traders typically work in investment banks and are authorised to trade shares, bonds or currency with the bank's or clients' money. They become rogue traders when they start making unauthorised trades, perhaps larger than they are allowed to do or in investments they are not allowed to hold.

Their rogue trading usually comes to light after they have made a catastrophic loss for their employer.

Nick Leeson is perhaps the best known of all rogue traders. More than two decades ago, he was working as a derivatives trader in Singapore for the English investment bank, Barings. He started by making some unauthorised speculative trades that netted a £10 million profit for Barings.

But his luck soon turned and he started hiding his losses in one of Barings' error accounts, which banks use to hold money so they can later correct administrative errors. As his losses mounted, Leeson made increasingly risky trades to try to recoup the lost money.

He fled in 1995 after racking up losses of £827 million, which caused the collapse of the 200-year-old investment bank.

The notoriety of the case and the six and a half years Leeson spent in prison have not deterred rogue traders since then. In 2011, London-based equities trader Kweku Adoboli cost his employer US$2 billion in unauthorised equities trades. He was found guilty of fraud and sentenced to seven years in prison.

'If our perception of variance is biased by after-effects this means that o?ur assessment of financial risk is distorted'

ELISE PAYZAN-LE NESTOUR

Situational drivers

Doug Hirschhorn is a former trader with a doctorate in sports psychology who coaches traders at major hedge funds. He says it makes sense that traders would have after-effects from working in a volatile environment, but he is not sure to what extent the findings apply to the creation of rogue trading.

According to Hirschhorn, rogue trading is very rare and is created by a 'perfect storm' of factors that on their own would be manageable.

These are situational drivers, including their own performance expectations and those of their managers; financial pressures or the need to maintain a lavish lifestyle; the fear of missing out on market moves; and poor or insufficient risk monitoring.

Another factor is a previous history of being rewarded or even seeing someone else being rewarded for holding on to losing positions too long that eventually turned around and became winners.

"Rewarding this behaviour causes it to be positively reinforced so it is likely to be done again," says New York-based Hirschhorn.

The so-called fat finger errors, where traders mistakenly key in the wrong number for a trade and make a huge loss as a result can be another situational driver. Sometimes traders elect to hide their error and try to trade their way out of it, which becomes rogue trading.

There are also personality traits and characteristics, including a strong competitive drive and a win-at-all-cost mentality in sport; high levels of internal confidence; low levels of openness; little respect for authority; and a low desire to follow rules and a weak moral compass.

Hirschhorn says that some rogue traders are aware of the risks they are taking, while other traders who have low emotional intelligence are less affected by them.

"If the market is moving up or down they are not as affected emotionally by the movement in the market," he says.

This isn't always a negative – it can help some of those people stay more objective and focused – but conversely it can make others capable of taking risks that might scare off someone else.

Risk metrics

The research has implications beyond the financial markets.

Payzan-Le Nestour says it's an important result because many professional investors and investment companies use indications of volatility as part of their risk modelling, which is what in theory allows them to manage the risks involved in investments.

"If our perception of variance is biased by after-effects this means that our assessment of financial risk is distorted," she says.

"It's an important discovery for the financial community for that reason, because almost all of our risk metrics use variance so it is a little bit problematic."

But wider than that, a chief executive, for example, will weigh up risks before committing cash and effort to a new strategy and Payzan-Le Nestour says their perception of risk could be altered if they have been working in an environment of high volatility.

"Our risk metrics are potentially contaminated by after-effects," she says.