Market Basics: Jerôme Kerviel

This weeks instalment will touch on a French trader who will be encrypted in modern history of finance. Namely, Jerôme Kerviel. You might have heard of him from globally renowned movie ‘’The Outsider’’.

Kerviel was active as a trader from 2005 to 2008 for French bank Société Générale, from offices located in Paris. After working for the back office, where he developed knowledge about the risk-tracking practices followed by the bank, the Lyon Lumière University graduate got promoted and subsequently joined the front office as a full-time trader. Having accepted the position towards the end of 2007, the French trader had accumulated as close as 50 billion EUR on futures and equity indexes by mid-2018.

Following this short run of success, Mr. Kerviel got sentenced to 3 years in federal prison, charged with fake documents and the manipulation of information technology systems. When the bank decided to close his positions, the losses incurred by the junior trader were approximated at a hefty 4.9 billion EUR. In a more fortunate turn of events, the French national court later announced in 2016 that the amount Société Générale was owed by the French Trader was cut from 4.9 billion to a mere 1 million EUR. This change in sentiment came after local law enforcement laid open a previously undisclosed transfer of 455k EUR from his former employer for unjustified lay-off, indicating their involvement in his actions.  

 What were Kerviel’s sectors?

When he joined Société Générale at the age of 23, he gained experience in the compliance department and turned trader just a few years later. Following this, he was assigned to locate arbitrage opportunities in the derivatives market. Arbitrage opportunities are market discrepancies which investors, traders and hedge funds can benefit from if they use the right mechanisms at the right time. In hindsight, it is clear that Jerôme leveraged his experience in compliance and arbitrage opportunities to learn from market imperfections, and benefit on the back of the common taxpayer from this.

But what were the positions Jerôme Kerviel took and how did they end up engendering such high losses?

The first unwarranted activity followed by the trader was so-called ‘Spiel’, which refers to a (specifically the playful nature in) games in German. This illegal market trick consists of tapping into the bank’s cash, and thus reducing its liquidity, while simultaneously taking extremely risky positions in the stock market. Specifically, uncovered positions lacking any form of hedging strategies are taken in mass, hence generating either significant wins or terrible losses. Looking back at the available data, it appears that the French trader was first incentivised to do so, after having accumulated a loss of 100.000 EUR from previous investment activity.

Coming in at second in the category “one should not but one still does it” is ‘The Carpet’. Every trader has an annual target that their respective employer expects them to reach. If, for instance a trader has gone through a very good year and thus exceeded set objectives, he can tap into the carpet. This deception method aims at “putting the gains under the carpet”, with the goal of extracting the cash in times of financial downturn. This way, the trader can still show solid trading figures to outsiders yet keeps the cash away from the firm, and thus federal tax collectors. A second trick behind this technique is to lower expectations of the employer as a trader. By putting cash directly in their own pocket, traders consistently avoid exceeding set targets or getting assigned to higher, more demanding corporate standards.

Finally, ‘The leverage’ entails tapping into debt in order to take on positions and thus intensifying fluctuations of the trader’s balance. Jerôme Kerviel did so in his March 2007 positions, which had accumulated to a worth of roughly 30 billion EUR, while being short on US subprimes. Jerôme’s underlying strategy here was to never close a position in loss, and in doing so, avoid being charged for a two billion loss if he closed his position. If the situation  then improves in later months, he earns a profit of half a billion and uses this to lever a gain of almost one billion one month later.