Currency Exchange Trading and
Rogue Trader John Rusnak
Sharon Burke
Department of Mathematical Sciences
Villanova University
Edited by Klaus Volpert
Introduction
In 1993, a foreign currency trader, John Rusnak, was hired
by Allfirst bank in Maryland. Hiring Mr.
Rusnak was the start of an idea that was forming in the mind of Allfirst’s
Treasurer Dan Cronin. The idea was to
have a foreign exchange trading center at Allfirst. John Rusnak was hired to bring profits to
Allfirst via proprietary foreign exchange trading. Prior to Rusnak’s arrival, foreign exchange
trading at the bank was limited to assisting bank customers in hedging against
currency risk. Allfirst performed this
service for companies that were dealing with overseas trades.
This decision would eventually incur a $691 million loss
for Allied Irish Bank, the owner of Allfirst bank. The story of this loss involves foreign
exchange trading, bank organization, organizational politics, human dynamics, work
ethic, inadequate accounting controls and more.
This analysis will include a review of foreign currency trading
concepts, the strategies that Rusnak employed to trade and to cover his losses,
the findings of the Ludwig report and analysis of how this transpired.
Currency Markets
The currency market includes the Foreign Currency Market
and the Eurocurrency Market. The Foreign
Currency Market is virtual. That is,
there is no one central physical location that is the foreign currency
market. It exists in the dealing rooms
of various Central banks, large international banks, and some large
corporations. The dealing rooms are
connected via telephone and computer and FAX.
Some countries co-locate their dealing rooms in one center. The Eurocurrency Market is where borrowing
and lending of currency takes place.
Interest rates for the various currencies are set in this market. [1]
Trading on the Foreign Exchange Market (FOREX) establishes
rates of exchange for currency. Exchange
rates are constantly fluctuating on the FOREX market. As demand rises and falls for particular
currencies, their exchange rates adjust accordingly. Instantaneous rate quotes are available from
a service provided by Reuters. A rate of
exchange for currencies is the ratio at which one currency is exchanged for
another.[2]
The following are examples of
currency rates from the Wall Street Journal on April 16, 2003:[3]
|
FX Summary
|
Prior US Close
|
6:45 ET
|
|
USD/JPY
|
120.16
|
120.29
|
|
EUR/USD
|
1.0815
|
1.0843
|
|
USD/CAD
|
1.4485
|
1.4474
|
This table shows the closing
exchange rates from the Foreign Exchange market. For example, the USD/JPY value is the
exchange rate for dollars to yen, that is, 120.16 yen per one dollar. The dollar is the base currency in this case,
as it is one unit of a dollar per an amount of yen.
The foreign exchange market has no regulation, no
restrictions or overseeing board. Should
there be a world monetary crisis in this market; there is no mechanism to stop
trading.[4] The Federal Reserve Bank of New York publishes
guidelines for Foreign Exchange trading.
In their “Guidelines for Foreign Exchange Trading”, they outline 50 best
practices for trading on the FOREX market.[5] This document is not legally binding or
regulatory in nature.
Exchange
Contracts
The actual exchange of currencies is governed by contracts
between the buyer and seller of the currencies.
There are a variety of contract options available to investors. Mr. Rusnak focused on Spot and Forward
contracts in his trading.
Spot Exchange
The spot exchange is the simplest contract. A spot exchange contract identifies two
parties, the currency they are buying or selling and the currency they expect
to receive in exchange. The currencies
are exchanged at the prevailing spot rate at the time of the contract. The spot rate is constantly fluctuating. When a spot exchange is agreed upon, the
contract is defined to be executed immediately.
In reality, a series of confirmations occurs between the two
parties. Documentation is sent and
received from both parties detailing the exchange rate agreed upon and the
amounts of currency involved. The funds
actually move between banks two days after the spot transaction is agreed upon.[6]
Forward Exchange
The forward exchange contract is similar to the spot exchange;
however, the time period of the contract is significantly longer. These contracts use a forward exchange rate
that differs from the spot rate. The
difference between the forward rate and the spot rate reflects the difference
in interest rates between the two currencies. This prevents an opportunity for
arbitrage. If the rates did not differ,
there would be a profit difference in the currencies. That is, investing in one currency for a year
and then selling it should be the same profit or loss as setting up a forward
contract at the forward rate one year in the future. Investing in one currency would be more
profitable than investing in the other.
Thus there would exist an opportunity for arbitrage.[7] Forward exchange contracts are settled at a specified
date in the future. The parties exchange
funds at this date. Forward contracts
are typically custom written between the party needing currency and the bank,
or between banks.
Currency Futures and Swap Transactions
Currency futures are standardized forward contracts. The amounts of currency, time to expiry, and
exchange rates are standardized. The
standardized expiry times are specific dates in March, June, September, and
December. These futures are traded on
the Chicago Mercantile Exchange (CME).
Futures give the buyer an option of setting up a contract to exchange
currency in the future. This contract
can be purchased on an exchange, rather than custom negotiated with a bank like
a forward contract.[8]
A currency swap is an agreement to two exchanges in
currency, one a spot and one a forward.
An immediate spot exchange is executed, followed later by a reverse
exchange. The two exchanges occur at
different exchange rates. It is the
difference in the two exchange rates that determines the swap price. [9] There is also something called a currency
swap. This is a method to exchange an
income stream of one currency for another.[10]
Options
A currency option gives the
holder the right, but not the obligation, either to buy (call) from the option
writer, or to sell (put) to the option writer, a stated quantity of one
currency in exchange for another at a fixed rate of exchange, called the strike
price. The options can be American,
which allows an option to be exercised until a fixed day, called the day of
expiry, or European, which allows exercise only on the day of expiry, not
before. The option holder pays a premium
to the option writer for the option. The
option differs from other currency contracts in that the holder has a choice,
or option, of whether they will exercise it or not. If exchange rates are more favorable than the
rate guaranteed by the option when the holder needs to exchange currency, they
can choose to exchange the currency on the spot exchange rather than use the
option. They lose only the option
premium. Options allow holders to limit
their risk of exposure to adverse changes in the exchange rates.
Currency Hedging
It is common for currency options to be used to hedge cash
positions. For example, if Company A is
buying stereos from Japan, they will make an agreement to pay Company B for the
stereo equipment in yen. The spot rate
at the time of the deal is 119Y to the dollar. Suppose that the stereos are
selling for $100.00 each or ¥11,900 a piece.
The company is purchasing 100 stereos.
They need to provide ¥1,190,000 to the seller. If the stereos were purchased today, they
would cost the company $10000. The
company would exchange $10,000 for ¥1,190,000.
This deal will be transacted in three months. In three months, currency rates will
change. If the dollar falls against the
yen, for example, the spot rate for yen in exchange for dollars may be ¥100 to
the dollar. In that case, in order to
provide ¥1,190,000 to the seller of the stereos, the company must exchange
$11,900. The deal costs an extra
$1,900. However, if the yen falls
against the dollar, the spot rate might become ¥130 per dollar. In that case, the ¥1,190,000 needed to close
the deal will cost $9154.00. The company
has saved $846.00.
Companies are not typically in the business of gambling
with their profits on deals. It is in
the company’s best interest to lock in an exchange rate they can count on. They are motivated to insure that their
profits are as expected. Two ways they
might do this are to enter forward contracts or to buy options. Company A could choose to enter into a
forward contract with a bank. They would
settle on a forward rate that was acceptable to both parties. The contract would settle in three months
when the delivery was due. The forward
contract is a binding contract and they must make the exchange.
The company could assess the
interest rates available in the U.S and in the Eurocurrency market. They could either invest $10,000 in the US
for 3 months, or exchange $10,000 into yen and invest the ¥1,190,000 for 3
months.
Company A could also use options to reduce their exposure
to currency fluctuation. The company
will need yen to pay for the stereos.
They could purchase a call option to exchange ¥1,190,000 with an expiry
date of 3 months or more if it is an American option. They would select an exchange rate that would
be acceptable but not too expensive.
They might choose to buy a slightly out-of-the-money call option to
cover them if the currency exchange rate falls.
If it stays the same or rises, they will exchange at the spot exchange
rate at the time the payment is due.
Trading Strategy of John Rusnak
The foreign currency market is the market that John Rusnak
gambled and lost in. He used spot transactions, forward transactions and
options to amass losses of $691 million.
Mr. Rusnak had been employed in foreign currency trading beginning in
1986 at Fidelity Bank in Philadelphia. He worked at Chemical Bank in New York
from 1988 to 1993. In 1993, he was
looking for a less stressful position than what he had at Chemical Bank.
Coincidently, David Cronin, the Treasurer of AllFirst Bank in Maryland was
looking for a new foreign currency trader.
Mr. Cronin was originally from Ireland.
He had come to the U.S. to represent the interests of Allied Irish Bank
when they had purchased Allfirst.
Allfirst was formerly known as First National Bank of Maryland.
Mr. Cronin was impressed with John Rusnak when he met him
in 1993. Mr. Rusnak proposed a trading
strategy that sounded new and inventive.
He told David Cronin, “…he could consistently make more money by running
a large option book hedged in the cash markets, buying options when they were
cheap and selling them when they were expensive.” [11] The Ludwig report, a report commissioned by
AIB to determine the extent of John Rusnak’s fraud, states that “Mr. Rusnak
promoted himself as a trader who used options to engage in a form of arbitrage,
attempting to take advantage of price discrepancies between currency options
and currency forwards.” In order to
execute this strategy, John Rusnak would have had to buy options “…when they
were cheap relative to cash (when the implied volatility of the option was
lower than its normal range) and sell them when they were expensive (when the
implied volatility is higher than normal.”
In his trading, John Rusnak did not achieve these lofty
goals. Mr. Rusnak executed simple
directional trades on the spot and forward markets. He mostly traded in yen and euro. Occasionally, he would use complex options. [12]
Mr. Rusnak placed large sum one-way bets that the yen would increase in value
against the dollar. Specifically, he bought yen for future delivery, probably
with forward contracts. As the yen
declined, he could not go back on the forward contracts as they are binding,
and was forced to take his losses. He did not hedge these bets with options
contracts.
Mr. Rusnak’s core trading belief was that the yen was going
to rise against the dollar. His strategy
throughout all his trading was to place bets in this direction. It is interesting to note what was happening
with the yen during the time period Mr. Rusnak was trading. From 1990 – 1995, the yen appreciated. From mid-1995 to 1997, the yen was
depreciating against the dollar. In
April of 1997, exchange rates were around 125 yen to the dollar. The Asian market crisis followed soon after
causing further problems for the yen. [13] From 1993 to 1997 at Allfirst, John Rusnak
appeared to be doing well. Information
on his trading practices prior to 1997 is not available. One may speculate that from 1990 – 1995, he
was able to do well with his market view.
However, as the yen depreciated, John Rusnak eventually began to have
great problems with his one-sided trading.
[14]
Concealment
of Losses
At
the end of 1997, John Rusnak had lost $29.1 million by his wrong bets in
trading. The jargon of gambling suits
his activities well. After his losing
bets and heavy losses, John Rusnak embarked on a path to cover up those
losses. Instead of taking responsibility
and reporting his losses immediately, he decided to hide them, buy himself some
time and see if he could win back the money he had lost. Like those with a gambling addiction, John
Rusnak thought if he could just place one more bet, place the right bet, he
could win it all back. He used many
complicated schemes to hide his losses.
They included falsification of documents, misuse of office technology,
fraudulent entries in accounting systems and intimidation of office personnel.
Bogus Options
The first technique John Rusnak used to hide his losses was
to enter bogus options in the banking system.
The purpose of these fake options was two-fold. The options appeared to hedge his directional
trades. They also gave him a way to hide
the losses with a bogus asset. At the
end of his trading day, when Mr. Rusnak was entering his daily trades in the
bank system, he would enter two false trades.
He would enter two options that would offset each other. The options had the same premium in identical
currencies. They were for the same
amounts of currencies and used the same strike price. The expiry dates on the options were
different.
For example, Mr. Rusnak would enter a put option “sold” by
Allfirst to a party in Tokyo. The option
would allow the Japanese bank to sell yen at a certain strike price. This option would expire on the day it was
written. He would also enter a call
option written by the Japanese bank to buy yen at the same strike price as the
other option. This option would expire
months in the future. The put option
would disappear off the books the next day, removing that liability from the
banks records. The call option would
stay on the books as a valuable asset that covered his losses.[15]
It was important to have the premiums of the two options
exactly cancel each other out. If the
options had not canceled out to zero, there would have been a payment due to
either Allfirst or to the counterparty in Tokyo. All payments were required to go through the
Allfirst’s Treasury Departments back office.
Since these options were false, Mr. Rusnak did not want the back office
involved. Keeping the premiums the same
meant there was no net payment and thus no requirement for the back office to
be involved in payment. Anyone who
really looked at the options would have questioned the fact that the two
options had different expiry dates but the same premium. That did not make sense. Also, the put option was a deep-in-the-money
option. The holder of the option would
make a profit by exercising it. The
option went off the books in one day unexercised. That was unusual and did not make sense. [16] It is probable that the call option was also
deep-in-the-money.[17] There were several of these options that the
bank had “paid” high premiums for. The
high premium indicates they were probably deep-in-the-money options. Their high value was necessary to cover the
high losses that Mr. Rusnak was incurring.
The fake option trades were written in the opposite direction of the
losing bets he placed. This made it
appear to Allfirst that he had offset his losses.[18]
With forward positions in
yen, the deep-in-the-money calls would have created a payoff diagram that
looked similar to:
Falsified
documents
The bogus options solved one problem, covering the losses;
however, they created another problem.
The Treasury back office was responsible for confirming all trades. The foreign exchange operation at Allfirst
was operating on a shoe-string compared to what a large bank would have in
place. Typically a true foreign exchange operation had research departments,
dealing rooms, computer programs that automatically confirmed trades and a more
sophisticated set-up. Allfirst was using
telephone and fax to execute and confirm trades.
John Rusnak knew that the Treasury back office was going to
need to confirm his trades. He used his
PC to create false trade confirmation documentation. His PC was discovered to have a directory
called “fake docs”. This directory
contained logos and stationary from various banks in Tokyo and Singapore. Mr. Rusnak used these files to construct fake
confirmation documents on his computer.
He was able to convince the treasury back office to accept these
documents from him, rather than confirming the trades themselves as required.[19] Eventually, Rusnak was able to convince the
back office to not confirm the trades at all.
He was able to argue that since the trades netted to zero, they did not
need to be confirmed. This argument was
probably acceptable given confirming Asian trades with their system would have
required night-time phone calls. There is also evidence of John Rusnak having a
forceful personality that intimidated others. Some in the company say that it
was a senior management decision to not confirm Asian counter party trades that
netted to zero. The Ludwig report
indicates that no evidence of this management decision could be found.[20]
Prime Brokerage
accounts
In 1999, with $41.5
million lost, John Rusnak turned to prime brokerage accounts. He needed to increase the size of his trades
so he could catch up on his losses.
Prime brokerage accounts are typically used by high profile
traders. They are very often used by
hedge funds.[21] The prime brokerage accounts provided John
Rusnak with net settlements. Daily spot
transactions were rolled into one forward transaction to be settled at a future
date with the prime broker. This
accomplished several things for Mr. Rusnak.
Having all the daily spot transactions rolled into one net settlement
meant that the Treasury back office could not track his daily trades as
effectively. It was a means of obscuring
what he was really doing.
Mr.
Rusnak was able to expand the scale and scope of his trading to large volume
high value currency trades.[22] He needed to be able to do this to win back
the large amounts of money that he was losing.
Mr. Rusnak was able to convince David Cronin, the Allfirst Treasurer,
that the prime brokerage accounts were a sound idea. He sold them as a way of growing Allfirst’s
foreign exchange operation. He also said
that using the prime brokerage accounts would relieve the back office of the
extra work they needed to do on his behalf.
His false concern for the back office is quite interesting in light of
how often he was at odds with that department over his trading practices. He told the banks setting up the prime
brokerage accounts that he could increase his bonus by reducing his demand for
the back office staff. John Rusnak used
the prime brokerage accounts as another opportunity to enter fictitious
trades. He could enter fictitious trades
with the brokerage banks to further manipulate the bank’s records. He would reverse these transactions by month
end before the monthly settlement was done.[23]
The
prime brokerage accounts allowed John Rusnak to use a type of foreign exchange
contract called a historical rate rollover.
This type of contract was invented to assist companies in handling
delayed shipments from foreign companies.
It is a method to extend a currency contract in the event that a
settlement of the contract would create a loss for the contract holder. For a purchaser of goods, when the goods are
delayed, it can be convenient to extend a contract and wait to exchange funds
until payment is required.
However,
for a trader, these types of contracts allow losses to be rolled forward. If the trader’s contract is due to be
settled, and settlement would not be in his favor, he can delay settlement and
keep the original rate of the contract.
The New York Times reports “The rollover buys time for a trader who
hopes that the currency rates will change in his favor in the future. The risk, of course, is that the losses will
deepen…”[24] For John Rusnak, this was certainly the
case. The historical rate rollover is
warned against in the Federal Reserve Bank of NY standard of conduct:
“Accommodation of customer
requests for off-market transactions (OMTs) or historical rate rollovers (HRROs)
should be selective, restricted, and well documented, and should not be allowed
if the sole intent is to hide a loss or extend a profit or loss position. Counterparties should also show that a
requested HRRO is matched by a real commercial flow.”[25]
The Federal Reserve had been
warning against the HRROs since 1991.
The use of historical rate rollovers by Mr. Rusnak should have alerted
his trading partners that something was suspicious.[26] No one reported him and no one questioned
him.
Value at Risk calculations
John Rusnak avoided detection by manipulating the bank’s
Value at Risk (VaR) calculations. Value
at Risk is calculated using the Monte Carlo simulation technique. One thousand hypothetical exchange rate
fluctuations are generated. Those rate
fluctuations are applied to the trader’s portfolio. The tenth worst outcome produced is the
bank’s Value at Risk.
The VaR is the main check used on traders to make sure they
are not losing more than the bank can afford to lose. The VaR is the largest amount of money the
bank can afford to lose if there are adverse trading conditions. For John Rusnak, the VaR was $1.5
million. As of the end of 1999, Rusnak
had lost $90 million. He had clearly
found a way around this check.
A trader is responsible for calculating and monitoring
their own VaR. The VaR is also
independently calculated by Treasury risk control as a check on the
trader. The bogus options discussed
earlier made John Rusnak’s open forward positions look as if they were
hedged. This improved his VaR as it made
his portfolio seem less risky. The
fictitious prime brokerage account transactions he was entering also obscured
his true VaR. He was able to convince the
risk control group to accept a spreadsheet of his open currency positions from
him with no confirmation. He altered the
values in this spreadsheet to make his open positions seem less than they
were. And since the risk control group
did not confirm these values, he got away with this technique.
John Rusnak was able to take advantage of technology and
cost cutting measures to obscure his stop-loss limit. The stop-loss limit was
an amount of loss, after which, Rusnak’s trading would have been shut down for
the month. Mr. Rusnak could not afford
to lose any time in trying to win his losses back. He had to find a way around the stop-loss
limit because he was regularly exceeding it.
Mr. Rusnak found that he could manipulate the currency exchange rates used
by the bank to force calculations that made it look like he had not exceeded
his stop-loss limits. Again, he was able
to provide his own spreadsheet with the exchange rate values. These exchange rates were supposed to be
independently confirmed by the risk management office of the Allfirst Treasury.
[27]
Mr. Rusnak had convinced the computer operations department
to download exchange rate data from Reuters onto his PC. He claimed he needed to have these rates
downloaded to his system so he could monitor his VaR. From his PC, a spreadsheet was then forwarded
to the systems in the treasury front and back offices. All of the bank’s foreign exchange rates were
passing through John Rusnak’s hand before being fed into the computer
system. This was a serious breach of the
integrity of the bank’s systems. One of
the reasons this happened was that the bank did not want to pay $10,000 for an
additional feed from Reuters for the treasury back office.[28] This additional feed would have enabled the
back office to independently confirm exchange rates and check John Rusnak’s
calculations.
Sale of options
By the end of 2000, Mr. Rusnak had lost $300 million. He was getting pressure from his superiors to
reduce his use of the company’s balance sheet.
The balance sheet of a company lists their assets, liabilities and stock
holder’s equity at a given time. It
shows the resources the company has available to it for operating activities
and investment. [29] David Cronin, head of treasury, was taking
notice of the large amount of the balance sheet John Rusnak was using. Foreign exchange trading revenue was $13.6
million. The net trading income,
however, was only $1.1 million. Mr.
Rusnak was using more of the balance sheet but getting less in return. Cronin asked John Rusnak to reduce his use of
the balance sheet.
John Rusnak needed large amounts of cash to continue his
gamble to win back the money he had lost.
Having his balance sheet usage restricted was somewhat of a blow. To get around this restriction and continue
his quest to win back his losses, he came up with a plan. He would sell deep-in-the-money options at
high premiums to finance his trading.
The options he sold had deep-in-the-money strike prices. The strike prices were so deep, it was
extremely likely that the options would be exercised. They were European options that expired in a
year and a day. They were essentially
loans from the counterparties to Allfirst, to John Rusnak. He received millions of dollars in premiums
for the options. He would “pay back” the
money when the option was exercised in a year.
As an example, in February 2001, Rusnak made an agreement
with Citibank. For a premium of $125
million, Rusnak wrote a put that gave
Citibank the right to sell yen at a strike rate of 77.37 yen to the
dollar. The exchange rate at the time
was 116 yen to the dollar. The dollar
would have to fall 35% for the option to go unexercised. The option was effectively a high interest
loan. The loan payment would come due as
a lump sum with interest when Rusnak had to buy yen that Citibank wanted to
sell in one year’s time. Rusnak had
found another way to buy time. However,
it created a liability that was sitting on Allfirst’s books. Rusnak entered a bogus deal with Citibank
that made it appear that Allfirst had repurchased the option. [30] Rusnak repeated this process with Bank of
America, Deutsche Bank, Bank of New York and Merrill Lynch.[31] The options he sold totaled over $300 million
raising his total losses to $691 million, when the yen depreciated further.
Losses Revealed
John Rusnak avoided an amazing number of situations where
he could have been caught. He avoided
detection over a period of five years.
In my research I found 12 separate occasions where his activities were
questioned by the Allfirst treasury back office, risk management department at
Allfirst, the SEC, and the CEO of Allied Irish Bank. John Rusnak was able to avoid detection on
all occasions.
A particularly involved scheme occurred during the one
audit conducted at Allfirst during the five year time period of the fraud. Mr. Rusnak was asked to confirm an Asian
trade that was bogus. He set up a FAX
account at Mailboxes etc. in Manhattan under the name David Russell. He gave the FAX id code of that account to
the auditors. The auditors faxed a
confirmation request to that FAX id.
John Rusnak then called the Mailbox etc. store, posed as David Russell
and had them FAX a return confirmation.
This worked.
At one point, the bank gave Mr. Rusnak Travel Bloomberg
software so that he could trade from home and while on vacation. This was a direct violation of U.S. law. U. S. law requires that traders take 10
consecutive days off from trading every year.[32] This is specifically so someone else takes
over their duties and fraud can be discovered.
Finally in December of 2001, John Rusnak’s luck began to run
out. A treasury back office supervisor
happened to look over the shoulder of one of their employees and saw that there
were two trade documents from Asian trades that Mr. Rusnak executed that did
not have attached confirmations as required.[33] The supervisor discussed with the employee
that all trades had to have confirmations.
The employee believed that any Asian trades that netted to zero did not
need to be confirmed. The supervisor
requested that the employee get the trades confirmed. In late January, the supervisor again found
that Asian trades that netted to zero were still not being confirmed. The back office had become lax and given up
after years of losing battles over concerns with Mr. Rusnak’s trading. Unfortunately, they were not getting the
backing they needed to do their job. The
back office employee did not bother to seek confirmations.
Around this time, David Cronin, the Allfirst treasurer,
noticed that Mr. Rusnak’s use of the balance sheet had spiked up to $200
million in January. Mr. Cronin had
directed that it stay under $150 million.
Also, David Cronin discovered that the foreign exchange trading volume
for the bank had been at $25 billion for the month of December. He decided to shut down John Rusnak’s trading
positions for a month. Meanwhile, the
back office requested Mr. Rusnak’s help in obtaining confirmations for the
Asian trades. John Rusnak was able to
stall for time and offer to get the confirmations himself. He resurrected his fake documents file and
created false trade confirmations on his computer. When the trade confirmations were shown to
his supervisor, the supervisor noticed that they looked suspicious.[34]
For the next week, John Rusnak stalled. There was a day or two where the bank thought
that he had disappeared. It later turned
out that he had been conferring with his family, a lawyer and finally the
FBI. He essentially turned himself in
and cooperated. His most important task
at that time was convincing the FBI that he had not embezzled the money, that he
did not have it hidden anywhere. It had
all been lost on the foreign exchange market.
Executives at AIB and Allfirst were staunch in believing that Mr. Rusnak
had not acted alone. Whether or not he
acted alone reflected on the bank. If he
had not acted alone, the bank could position itself as a victim. If he had acted alone, the bank would have
shoulder the blame of not catching the fraud.
Mr. Rusnak had acted alone. He
was charged with seven counts of bank fraud and entering false entries in bank
records.[35] He plead guilty and was sentenced to 7 ½
years in prison and a $1 million fine.[36]
He will not profit from any book or movie deals. He maintains that he will not write a book or
sell rights to a movie for the sake of his family.
The Ludwig Report
Shortly after Mr. Rusnak’s fraud was discovered, the Allied
Irish Bank (AIB) Board of Director’s authorized an investigation by Eugene
Ludwig of Promontory Financial Group LLC of Washington DC. Mr. Ludwig had been Comptroller of the
Currency from 1993 to 1998 under President Bill Clinton.[37] He had a strong background in bank
regulation. The Board of Director’s
needed to bring in an impartial party to investigate. They needed to restore the confidence of
their shareholders.
When the news of John Rusnak’s fraud was reported, shares
of AIB fell from €13.62 to €11.36 on the first day. AIB had been the largest
capitalized company on the Dublin Stock Exchange at a capitalization of €12
billion.[38] In one day they fell to €10 billion, losing
€2 billion in capitalization. AIB
employed 30,000 people in Ireland. There
was a fear in the market that AIB would collapse like Barings Bank. That was not the case. AIB had been about to announce a profit of
€1.4 billion ($1 billion) for 2001. The discovery of John Rusnak’s fraud
reduced this to €612 million ($426 million). [39] There were rumblings at the time, “Was this
another Barings Bank?” There were
interviews with Nick Leeson, the trader whose losses had caused the fall of
Barings Bank. Although there were many
similarities to the two stories, AIB was able to absorb the loss.
Early in the discovery of the fraud, executives at Allfirst
and AIB believed that Rusnak had coconspirators. Finding that there was collusion to achieve
the fraud would absolve the bank of blame.
If he had not had people helping him that meant the bank’s self-
regulating and monitoring procedures had failed miserably.
Eugene Ludwig’s team investigated Allfirst and John
Rusnak’s fraud beginning on February 8, 2002.
They published their report on March 12, 2002. The Ludwig team discovered what John Rusnak
had done to conceal his losses. They
determined that he had worked alone.
They identified the following failings in control at Allfirst and AIB
that taken altogether, allowed Rusnak to commit fraud[40]:
· “The failure of the back
office to attempt to confirm bogus options with Asian counterparties”
· “The failure of the middle
and back offices to obtain foreign exchange rates from an independent source.”
· “In 1999, an internal
audit of treasury operations took no samples of Rusnak’s transactions to see if
they had been properly confirmed.”
· “In 2000, the internal
audit sampled only one trade of Mr. Rusnak’s to check if it was properly
confirmed.”
In addition to these failures
of control, the bank missed opportunities by ignoring problems raised by the
treasury back office. Employees in the
back office raised issues ranging from problems confirming trades, problems
with Mr. Rusnak’s personality to warnings that there was a possibility that Mr.
Rusnak could be manipulating foreign exchange rates. John Rusnak was showing a yearly profit for 5
years straight. He became untouchable in
organizational politics because he appeared to be so good. The back office staff eventually gave up
raising flags on his trading practices as they were continually shot down by
management.[41] With executive backing, the treasury back
office could have performed a very valuable function and assisted with
detecting John Rusnak’s fraud.
John Rusnak’s supervisors were not
experienced in foreign exchange trading.
They did not adequately supervise his activities. A knowledgeable supervisor would have seen
that the deep-in-the-money bogus options expiring on the same day they were
purchased was odd. The sheer size of
Rusnak’s positions warranted closer scrutiny.
No one was monitoring John Rusnak’s daily profit and loss (P&L)
figures. They were not reconciled
against the general ledger.[42] If this step had been taken, questions would
have arisen as to why his daily P&L swung so widely from profit to loss and
back.
There were many who had an opportunity
to be aware of the size of Rusnak’s positions.
In 1999, a risk assessment auditor questioned the size of Rusnak’s over
limits. Citibank contacted AIB’s Group
Treasurer to confirm that AIB could cover a net settlement of $1 billion on
John Rusnak’s Prime brokerage account. The SEC 10k filings of Allfirst showed
the size of Mr. Rusnak’s positions.
Credit limits were exceeded by Rusnak.
In May 2001, AIB’s CEO was contacted by a market source and questioned
about the size of John Rusnak’s positions.
There was a trader that worked with Rusnak who could have noticed the
size of his positions and questioned it but didn’t.[43] The traders at the prime brokerage accounts
also knew his positions. All traders
should be aware of the Foreign Exchange trading guidelines. These guidelines outline suspicious trading
activity. For example, the use of
historical rate rollovers (HRRO) expressly states that HRROs should not be used
to cover losses. [44] The two banks providing prime brokerage
accounts for John Rusnak should not have provided this service and could have
taken the step to pursue his conduct with his superiors. Those who were watching the forex market came
to recognize Rusnak’s trades.[45] There were many who knew or could have
guessed the size of his positions and raised an alarm.
Following are some highlights of the
Ludwig report findings on what contributed to the fraud:
·
“The architecture of Allfirst’s
trading activity was flawed.” They had
one lone trader trying to essentially implement a hedge fund. He had none of the “specialized knowledge,
scale, diversification and specialized expertise” that his competitor’s had.
·
Senior management in Baltimore and
Dublin did not focus sufficient attention on the Allfirst trading operation.
·
Mr. Rusnak was unusually clever
and devious. He knew the banking systems
well from his experience at Chemical Bank so he was able to circumvent their
controls. However, given that the
controls were weak; this did not take so much cleverness as it did desperation.
·
Mr. Rusnak’s activities may have
been facilitated by individuals at other firms.
Investigation after the report has not found this to be true.
·
Treasury management weaknesses at
Allfirst also contributed to the environment that allowed Mr. Rusnak’s fraud to
occur. The Allfirst treasurer had a
dual reporting structure. David Cronin
reported into Allfirst through a variety of different managers. He also reported into AIB. The CEO of Allfirst thought AIB was managing
Cronin and vice versa. Therefore, the
treasury operation was not managed as thoroughly as it should have been.
·
Senior management at both
Allfirst and AIB thought their control structures, auditing, etc. were more
robust than they actually were. The risk
reporting processes needed to be more robust.
The risk management team needed to be more proactive in finding problems
rather than dealing with what was presented to them.[46]
Analysis
The
Ludwig Report provides great detail into what happened at Allfirst and the
various areas of laxity, weakness and fault that contributed to John Rusnak’s
ability to pull off this fraud. This
story shows the darker side of corporate operations, what can go wrong. The most significant were the failures in
technology, the disorganization and politics, the auditing and monitoring
failures and John Rusnak’s addictive style of trading.
Technology
As the Ludwig report highlights, Allfirst was running a
foreign exchange trading operation without the full backup needed to sustain
the levels of trading John Rusnak was involved in. Banks that trade in the volume Mr. Rusnak was
trading in typically have a large support staff. There are individuals backing up the trader
by doing market research. Traders are
working in groups where it is more difficult to commit fraud. In particular, larger trading organizations
use the Crossmar Matching System to confirm trades. This system can confirm trades in effect
instantaneously. Traders enter their
trades in to Crossmar Matching System.
The system automatically confirms the trades for both parties. Instead of using this state of the art
computing system, Allfirst was using a system of telephone and fax
communication. At the time John Rusnak
was trading, FAX and telephone confirmations were behind the times for large
trading organizations. John Rusnak used
the loopholes present in the out of date system.
The system suited a small state bank that traded
occasionally to assist its clients when they needed a currency hedge. It was inadequate for the volume and size of
the positions Mr. Rusnak was taking. The inadequate system left openings for
John Rusnak to fake FAX communications and create fake confirmation
letters. It is of interest to note that
Allfirst felt the Crossmar matching system was too expensive to implement for
only two foreign exchange traders.[47] This was seen as a sound business decision
given the faith that was placed in the VaR monitoring system and the faith
placed in the head of Treasury. [48] However, it had a long term cost in the
losses that John Rusnak incurred that would have been much harder to conceal
with such a system.
A glaring technology and design lapse was the use of John
Rusnak’s spreadsheet to feed exchange rates from Reuters to the bank’s
system. The Treasury Operations
department allowed Mr. Rusnak to have the only feed from Reuters for exchange
rates. The operations department
designed an information system that included an employee’s personal computer. This is a serious breach of good system
design practices. It was a security hole.
John Rusnak was able to insert himself into the bank’s information
system and change data. Once this
problem was identified, it took one year before the problem was rectified. Allfirst had been unwilling to spend an
additional $10,000 to install a second feed from Reuters to confirm exchange
rates. That $10,000 feed would have
secured their system.
John Rusnak was given Travel Bloomberg Software for his
laptop. This software enabled him to
trade at home and while on vacation.
U.S. Law requires that traders take 10 consecutive trading days off per
calendar year.[49] The technology providers in a bank system
should be cognizant of the regulations on the use of its systems. Although this is not a traditional role for
such a department, there is an opportunity for advanced operations in
partnering with risk management and auditing departments in banks to strengthen
control. There would have been value in
this case in particular in someone in computer operations saying, “No. We can’t
give you that software. It’s
illegal.” Integration of regulations and
good business practices is essential in all departments of any corporation.
Organizational
Politics
The Ludwig report has several examples of organizational
politics contributing to the environment that permitted the fraud. In particular, David Cronin, the Treasurer,
had a dual reporting structure with Allfirst and AIB. It was unclear who was really monitoring his
activities. Unfortunately, the CEO of
Allfirst and executives at AIB did not communicate well. Susan Keating the CEO of Allfirst, was not in
the loop on the Treasurer’s activities.
She should have been as the CEO.
However, her knowledge of Treasury was weak. She wanted to make organizational changes to
place David Cronin, the head of treasury under the CFO, however, her perception
was that AIB would not approve.[50] When the AIB CEO was alerted to some problems
with Rusnak’s trading, he went to his old colleague David Cronin for
explanation. He did not involve Susan
Keating. There was a pattern of
miscommunication, this being one example.
There was a sense of Allfirst wanting to run itself, be
independent. This led to unclear
demarcation of responsibilities. When it
is unclear who are responsible, chances are no one will be.
The politics between the front, middle and back offices of
the treasury caused problems. The back
office personnel were often discounted in favor of John Rusnak. They came to find that in a disagreement,
upper management would support Mr. Rusnak.
John Rusnak was permitted to bully the back office. He had a reputation for being difficult to
work with. The discounting of the back
office personnel in favor of the trader, Rusnak’s bullying and his management’s
condoning his behavior took the power of control from the back and middle
office and moved it to the front office.
The back and middle offices should have been the check on John Rusnak’s
trading. They were hampered in their work
by favoritism shown to Mr. Rusnak. Also,
the three branches of the treasury reported into David Cronin. It is customary in banks to separate the
reporting of these branches as the back and middle offices are to be a check on
the front office. Having the three
branches report into David Cronin created a conflict in that he had goals to
achieve with trading in the front office and he was supposed to monitor the
activities of that office as well.
Accounting
Practices
The
lack of audits and inadequacy of audits, the failure to review profits and
loss, the practices of not confirming trades, not independently confirming
exchange rates, not checking VaR independently with independent data allowed
Rusnak to get away with fraud. Many of
the techniques that Rusnak used were in direct violation of the Guidelines for
Foreign Exchange trading. In particular,
trades are expressly recommended to be confirmed as soon as possible.[51] The practices that John Rusnak used would not
have been effective if regular audits were conducted, if data used for
calculations was independently verified, if trade confirmations were made. Also, if the risk management departments had
strong executive backing, they could have been much more effective.
Addictive
Behavior
John
Rusnak’s story has many parallels to gambling addiction. He loses money and continues to repeatedly
lose money. He thinks that if he just
has more time, he can win it back. He
exhibits wishful thinking and arrogance.
He deludes himself as the losses rise in to the hundreds of
millions. His choice to cover up his
actions rather than come forward and face the consequences leads him into a
downward spiral. All his actions are focused
on not being found out. He began having
drinking problems and was obsessively trading after hours to try to win back
the money.[52] He was bullying other employees, using anger
to drive people away and hide his activities.
The Guidelines for Foreign Exchange trading activities warns against
substance abuse and gambling in traders.[53] Human resources and managers that were better
educated in the warning signs of addictions may have been able to recognize
that Mr. Rusnak was having a problem.
Greater awareness of addictive behavior would behoove trading
institutions.
Conclusion
John
Rusnak did perpetrate this fraud alone.
He had no direct accomplices.
However, there were many indirect accomplices. All those mentioned who did not report what
they saw, allowed him to talk them out of doing their jobs, and trusted the
status quo rather than ask questions to get to the truth assisted John Rusnak.
Allfirst experienced problems that many corporations have. They had organizational political conditions
influencing decisions. The fact that Allfirst was owned by a foreign company
introduced some additional complexity in politics. Decision making in corporations can be based
on budget and money at the expense of other important considerations. Some decisions are made by looking at short
term cost, rather than long term.
Employees don’t always follow the standards set by the company. And supervisors are can be too busy to
enforce the standards. How a corporation
and the people in it address these challenges is the differentiator between
failure and long term success and satisfaction.
Albert Einstein is quoted as saying “Insanity is
doing the same thing and expecting different results.” John Rusnak was a person who got himself in
trouble and then kept using the same methods to get himself out of trouble. He kept placing the same types of bets hoping
for the same outcome: that the dollar would fall against the yen. John Rusnak created a crazy situation that
resulted in loss of family stability, position, self-respect and the respect of
his community. He has full responsibility for his actions. The corporation has responsibility also. AIB and Allfirst allowed an environment where
he could commit his fraudulent actions.
In the case of AIB and Allfirst, the suggestions of the
Ludwig report were implemented. The
company hopefully learned quite a bit from the analysis and suggestions in the
report. Corporations are ultimately made
up of people. People have foibles and
imperfections. However, when you bring
people together, their strengths can be combined and they can help each other
with their weaknesses. They can achieve
more together than they might have alone.
This is the highest goal of business, a goal it is important not to
forget in light of stories like this one.
Epilogue
John Rusnak pled guilty to the charge of bank fraud in
October 2002. He was facing a sentence
of up to 30 years in prison and a $1 million fine. Through the plea bargain process, in January
2003, it was negotiated that Mr. Rusnak would serve a seven and a half year
sentence in Federal prison at Fort Dix, N.J.
He was ordered to repay the $691 million he lost for the bank. Mr. Rusnak will repay $1000.00 per month
through his five year probation period after the sentence is served for a total
of $60,000. Details for payment plan
after probation have not been determined.
David Irwin, lawyer for John Rusnak, requested that his client be able
to enter drug and alcohol rehabilitation program while in prison. The judge has ordered that Mr. Rusnak enter
substance abuse and gambling recovery programs while he is on probation. He is also ordered that he cannot work for a
bank for the rest of his life without obtaining permission from the federal
government.[54]
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