Rogue Trader
Candlefocus EditorAt its core, a rogue trader is an employee of a financial institution who, without authorisation, takes high-risk and often highly leveraged positions with the potential to generate large gains - and correspondingly large losses. Rogue traders typically target stocks, bonds, commodities, or other financial instruments and often take out a high degree of leverage, i.e. borrowing on margin or with other leverage instruments, to increase the size of their positions and potential gains. However, when their bets go wrong, the losses can be equally magnified, often resulting in losses for their employers too.
The incentive for rogue traders typically comes from the allure of potentially huge rewards if their trades turn out to be successfull. In the eyes of rogue traders, it makes sense to take calculated risks in an effort to achieve outsized rewards, since they traditionally do not face any of the direct costs if their trades fail.
Unfortunately, many rogue traders are prone to under-estimate the risks of their trades. This can lead to a situation where a trader may be in denial of the amount of loss that their trades may incur, or must be unable to accurately calculate the amount of potential loss. Combined, these factors can result in catastrophic losses for both the financial institution and the trader.
Famous examples of rogue traders exist, some of which have caused entire banks and brokerages to collapse as a result of their activities. Nick Leeson, the trader whose actions famously caused the collapse of Barings Bank, is one of the most high profile rogue traders. Leeson was able to hide his losses by secretly setting up an offshore account, which seemed to cushion some of the losses. In the end, his bluffed bets on the markets cost the bank $1.4 billion.
In an effort to minimize the risk of these types of situations, financial institutions have implemented a variety of risk controls, such as limits to position size or daily loss levels, and close monitoring of traders' activities. These procedures are typically aimed at curtailing rogue trading, which may be defined as any unauthorized trading of financial instruments without proper risk management or process controls in place to manage the risk.
In conclusion, rogue trading remains a major threat to financial institutions. By taking part in unauthorized and highly profitable trades, rogue traders can cause an irreparable loss in the form of liquidity and excess leverage. Moreover, it has caused notable financial institutions to fail, leaving innocent investors with huge losses. Institutions need to ensure that proper risk management procedures are in place in order to limit the losses that rogue traders can incur.