eFinancialCareers

This week has seen the discovery of one more rogue trader – this time at Merrill Lynch. Following hot on the footsteps of Jérôme Kerviel and the contingent at Credit Suisse, Merrill’s rogue is far from the first. And nor will he be the last.

Rogue trading is but a symptom of a cancerous system created and nurtured on the founding principle of ‘Maximum gain for the minimum number of people in the minimum amount of time.’

The hypocrisy is so overt that many firms have stopped paying lip service to the concept of client first, long termism, business building, honesty and a sense of fair play.

Institutions are built on criminally negligent and deceitful premises – researchers are pressured to view companies and deals favourably where it is in the selfish best interests of the institution; salesmen are judged on their ability to offset losing positions and dump unwanted garbage onto unsuspecting clients and counterparties; and traders are expected to make money consistently – for failure means exile to the lower rungs of the pyramid, or termination.

Within this system, the individual trader has an incentive to overstate his or her profits in order to lay claim to the maximum possible bonus at the end of each year. The potential rewards are infinite; the only risk is the loss of a job.

The menace of mark to model

Under the historical system of mark to model pricing, traders were effectively given scope to influence the size of their own bonuses. By pricing illiquid funds with no market value according to model and then basing bonuses on the assumption that this ‘mis-mark’ represented fair value, the system invited corruption. Unsurprisingly, some rogues appear to have fallen for precisely this temptation.

Since January, things have changed. The Financial Accounting Standards Board (FASB) has mandated that companies value their illiquid assets at fair market value instead of historic value. This in turn has forced banks to value their illiquid securities at the lower market value instead of the mark to model value, and has led to billions in additional writeoffs.

Now however, the Institute of International Finance (IIF), the leading international banking lobby (led by Deutsche Bank chairman Josef Ackermann), is fed up with the painful consequences resulting from mark to market pricing. The IIF has proposed changing the rules, allowing banks to use historical and not market prices to value illiquid assets.

The audacity of the IIF’s suggestion is stunning – if adopted it will officially sanction wholesale abuse where all losing positions will be warehoused as ‘marked to maturity’. This will lead to even larger crises where defaults will create a step function drop in banks' capital.

Not all banks are in favour. Goldman has threatened to quit the lobby, calling the proposed changes “Alice-in-Wonderland accounting”; Morgan Stanley has also objected to the proposal.

A return to historical accounting would only exacerbate the culture of corruption suggested by the recent crop of rogue traders.

Marked to market has an inherently built-in concept of ‘probability of default’, the very basis of valuing any asset. Removing this on the hopeful premise that all will be well in the future is to adopt the Japanese principles of the 1990s, to invite manipulation, and to open the door to opportunistic rogues.