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OPERATIONAL RIKS- CASE STUDY

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Tutorial: Operational Risk - Case Study

Topic: The AIB Fraud

Rusnak's Trading Strategy

John Rusnak was a proprietary foreign exchange (FX) options trader at Allfirst. He engaged in arbitrage between FX options and the spot and forward FX markets.

In theory, this should be a form of low risk trading as it involves hedging FX options positions in the cash (spot and forward) FX markets. A successful arbitrage strategy would involve buying options when they are cheap relative to cash and selling them when they are expensive. Exploiting temporary price discrepancies that may exist within or between the markets can produce profits.

In practice, however, Rusnak was actually adopting a directional trading strategy. This is a speculative strategy that involves taking a view on the direction of movement in the price of a currency (Japanese yen in this case). Most of Rusnak's positions were simple forward FX deals.

Trading Losses

Bogus Options

How did Rusnak hide his losses? Why did his superiors not realize quickly what was going on?

To conceal his losses and give the impression that the real positions were hedged, Rusnak created bogus options positions. He would simultaneously enter two bogus trades into the Allfirst trading system. These two trades would involve the same currency and the same strike price, and would be neutral from a cash viewpoint (the first would involve the receipt of a large option premium, while the second would involve the payment of an identical premium).

For example, one trade might imply that Rusnak had sold a deep in-the-money put option on Japanese yen to a counterparty in Tokyo or Singapore, while the other trade would suggest he had purchased an offsetting option from the same counterparty.

Bogus Options

The key difference between the two bogus trades was that the first option would expire on the same day it was written, while the other option would not expire for several weeks. At the end of the day, the one-day option that had (apparently) been sold (a liability to Allfirst) would not appear on the bank's books as the option would have expired. The offsetting option that Rusnak had supposedly bought (an asset to Allfirst) would appear on the books, and this would conceal the real losses from the spot and forward market trades.

As each bogus option expired, Rusnak would roll it over into new bogus options in order to keep this seemingly valuable asset on the bank's books.

Responsibilities in the Bank

Which bank function do you think should have been responsible for confirming and settling Rusnak's trades?

The front-office

The middle-office

The back-office

Prime Brokerage Accounts

Rusnak continued to lose money on his spot and forward market trading, apart from a few months in late 1999. Much of this trading activity was carried out under net settlement agreements and, subsequently, prime brokerage accounts (PBAs) that Rusnak had established with other financial institutions (Citibank, Bank of America and Merrill Lynch).

These arrangements allowed him to enter into foreign exchange spot transactions with third parties (in the prime brokers' names), but without having to confirm and settle each transaction (functions that were performed by the relevant prime broker).

The PBAs enabled Rusnak to increase significantly his real trading at Allfirst. The bank and each of the prime brokers typically had one net settlement of all of the prime brokerage account transactions at a fixed date each month. Rusnak would enter fictitious prime brokerage transactions into Allfirst's books and then amend, cancel or reverse these transactions before the monthly net settlement with the prime broker. He convinced his superiors that these PBAs made sense for Allfirst as they eliminated the need for extensive back-office operations.

Real Deep In-the-Money Options

As Rusnak's trading activity grew, the losses and the bogus options positions did likewise. In 2000, Allfirst began looking more closely at the amount of the balance sheet used to generate trading income. Because his use of the balance sheet was unwarranted relative to the size of his profits, Rusnak was ordered to scale back his balance sheet activity in early 2001, which left him needing a new source of funds.

His solution was to sell year-long, deep in-the-money options. These, however, were not bogus options, but real options. Rusnak sold five Japanese yen/US dollar put options with strike prices that were extremely attractive to buyers, thus making them willing to pay large premiums (totaling USD 300 million) for the options (see table). These payments generated a large amount of cash that was used to fund the monthly settlement of Rusnak's forward FX positions.

The problem, however, was that these real options created massive potential liabilities on Allfirst's books. To conceal this, Rusnak used yet more bogus options to give the impression that the original options had been repurchased. The end result was that Allfirst was saddled with huge, unrecorded liabilities in late 2001.

Manipulation of VAR Measure

Value at risk (VAR) is a statistical measure of a bank's exposure to market risk. It estimates the maximum expected loss of a portfolio over a given time horizon and at a given confidence level.

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