SocGen had one of the best risk management systems. Yet there was such a major failure of controls. No one knows how he was able to pick the locks. He had a perverse understanding of the "complex" control systems because of his experience in the middle office.
That is really hogwash. The Middle office teaches you how to book trades and how to calculate P&L. The Middle office does not teach you anything about the control system, as the controls are mostly in the Back-Office.
This is how derivative trades are actually controlled. Trader does a trade, presses a button and the system books it and sends it through to the Back-Office. Back-office calls the counterparty and confirms the details of the trade. At settlement, Back-office moves cash with the counter-party's Back-office. Trader estimates his Profit or loss, Middle-office confirms his profit or loss, and Back-office counts the cash. Its all very simple really, when you are counting just one widget.
In reality it works this way. Trader does a million trades. Sytem processes everything"STP' - straight through processing. Trader has no way to track the beans, so he relies on the system to calculate his Profit or loss. Very rough estimates are made based on the "risk". But as the complexity and volume increases, these estimates become less and less reliable. Middle Office has the same problem. Middle Office uses the very same systems to re-estiamte the P&L, and generally would like to agree with the Trader. Back-Office pays out the cash. All the outsourcing has resulted in the Back-office being in India, Buffalo, Singapore or some other unreachable place. Most of the time they are just paying out the cash as fast as the orders come in to settle. If something is missing they might track it, or they might let it go, depending on their situation. So cash is no longer counted, one major control does not really work.
The other control is the confirmation with the counterparty. Again, this is a Back-office function that has systematically been reduced to bare bones. Most places are back-logged on confirmations for atleast a few months. There are millions of trades with internal counterparties that are not tracked at all. There are old portfolis that no-one looks at, new ones that were opened without everyone knowing about it, dummy portfolio that should not have live trades and so on.
The point here is that we are not manufacturing cars, or making small loans out of the local credit Union. There the beans are generally counted and Accounted for at a higher level of accuracy. The derivative business is a lot of smoke and mirrors, filled with charlatans.
The kid fresh out of Ivy league schoool with a few sound bytes about how the market "thinks" gets to play with millions of dollars as a Trader. The CEO does not know the Trader's positions, the head of the desk may not know the extent of all the Trader's positions, the middle office person that does his P&L does not know a whole lto more, and the Back-office processor that pays out on these transactions does not know either. The truth is that no-one really knows or asks questions. As long as the numbers are positive, everyone gets paid. "Them that ask no questions, are'nt told no lies- so watch the wall my darling, as the gentlemen go by" - Smuggler's song. So it is really surprising that there are so few of these blow-ups.
