You Can Beat The System, But You Can’t Beat The House

Answers to the familiar of SocGen’s scandal sound. The usual remedies – new guidelines for derivatives trading, tighter trading controls and higher bonuses – have been trotted out after each breakup by Enron. Unfortunately, they will be more successful this time than last, because everyone is mistaken for a systematic managerial failure.

The truth is that current risk management and regulatory systems are designed to retrospectively identify at what point a thief has stolen your money, not to warn you when he is actually stealing it. Asking an investment banking group to investigate a fraud perpetrated against the systems designed by the investment bank is unlikely to create a new approach. Rather than saying it won’t happen here (as French did after Parmalat), or it won’t happen again (after Enron, WorldCom et al), we should ask: are there lessons to be learned from other industries?

The game known as trading looks with austere disapproval on known trading Root Casino UAE like playing, wrote Ambrose Bierce in the Devil’s dictionary. Gambling is highly regulated, but does not rely on regulation to manage its internal risk; takes that from you.

With risk as its basic product, gambling works on the assumption that, given the chance, everyone wants to take money from it – customers and staff. It also assumes that most of the thefts are internal work. Therefore, he concludes, the organization should be looking at people with working knowledge of systems – such as Jérôme Kerviel and Nick Leeson, who were familiar with their back-office setups – and not the systems themselves.

Casino surveillance cameras are trained on the croupiers as well as the users. Watching the croupiers is the dig bosses, who are also watching. Everyone is monitored for behavioral changes and unusual patterns, whether winning or losing. When a change is seen, managers investigate until they are satisfied with the explanation. Some large insurance companies are doing something similar, using stress-detector technology to screen claims. Only claimants whose rumor models exhibit anomalies are investigated.

When Kerviel’s behavioral abnormalities were reported, he was apparently able to shrug them off with minimal explanation, like Leeson had at Barings. Management control of: those in charge were either player-managers most responsible for their own performance, or so far on the chain as to they are disconnected from the game.

Perhaps cursing the comment in the Barings affair was that of a very senior official who saw no reason for concern because Leeson’s business showed nothing extraordinary. Actually, his findings were so contrary to both his own previous findings and that of his peers that he warranted immediate research. The Senior Manager had no idea that his results were unusual – he just saw them as good. The same was true of John Rusnak, the currency trader who lost £ 354m to the Irish ally, Kerviel and no doubt many others.

According to research by France’s central bank governor, Christian Noyer, SocGen’s commands were appropriately not continued. In other words, there were no floor walkers or pit bosses. Even though the surveillance systems were effective, management’s actions were not.

This is a direct consequence of the leveling of organizational structures. What has generally been flattened is the monitoring function traditionally performed by central-managers of long-service with elephant-like corporate memories that could intuitively spot the contradictions of behavior.

Psychologist Gary Klein calls this decisions triggered recognition: you might know them as an experience. The gaming industry relies on this control function to support its technical systems and to ensure its internal risk management. It is the manager who activates the deep search, not the system.

The game has another invaluable lesson for financial markets: the simplicity of its terminology. For example, it has only one term for all the activities it covers – betting. A government supposedly dedicated to educating the public in the intricacies of financial services would do well to copy this appproach. If you invest in a construction company, derivatives, credit derivatives, options or futures, you are betting that the return will outweigh the risk. In casino, everyone understands that there is no such thing as zero risk and no such thing as guaranteed returns.

Perhaps the sharpest lesson from the game is that if someone is playing with my money, I especially watch them carefully. I was once asked to follow a colleague at the small bookies where I worked and report on his movements. It turned out that it was the runner who dismissed; big bets. When the shop took a bet it couldn’t cover if the horse won, it transferred the risk to other bookies by betting a proportion of the punter’s money on the same horse with them. If the horse lost, all the bookies make money; if he won, the losses were spread and so manageable. Call it hedging.

My boss suspected the runner dismissing money with other bookies – he was playing that the horse would lose and could pocket the money. If they won, of course, my boss would be exposed and probably out of business. Thus business-critical activity was therefore carefully monitored.

Kerviel has decided not to protect his bets. Markets have turned and his stock could finally mean the sale of SocGen. Some years ago I wrote that the financial market was the largest casino in the world. It appears that we are traducing the casinos; they seem to be better regulated and better managed.