A number of high-profile financial institutions have hit the headlines in recent years for losses incurred through fraudulent or “rogue” trading, or through poorly executed or monitored trading strategies. Yet most occurrences of fraudulent trading do not reach the front pages.
On any given day there may be instances of traders operating beyond the established rules of their organisation, breaching policies or exceeding risk limits, mis-booking trades or otherwise manipulating the trading profit and loss.
Such behaviour is not confined to the financial services sector. UK and European gas and power utilities have large optimisation and trading businesses, buying and selling billions of financial and physical contracts across a range of commodities and territories. They are inherently exposed to fraud and rogue trader risk.
While incentives for risk-taking are higher in financial institutions, in times of volatility and uncertainty in markets and the wider economy the pressures and opportunities for fraudulent trading or trading outside authorised limits in utilities are significantly increased.
Exposure to direct financial loss is the most obvious repercussion. However, the consequences of fraudulent trading can persist long after the event. Reputational damage to the company can be extensive and increasingly, given the evolution of the European regulatory regime in which commodity traders operate, fines and increased scrutiny are much more likely, which can be both costly and time consuming.
PwC’s analysis of incidents of recent trading frauds reveals a number of recurring themes that the utility sector can learn from:
· most frauds occur over a long period in companies where large positions are carried in the ordinary course of business;
· frauds are committed by front office individuals with a knowledge of and access to middle and back office systems and processes, typically from having worked their way up to the front office;
· while collusion is rare, it is possible that organisations may turn a blind eye to unauthorised activity by virtue of lax monitoring of process compliance, for example, particularly when it is profitable;
· monitoring controls are ineffective or bypassed. Red flags such as operational, profit and loss, and risk management irregularities, including high levels of cancelled trades, are dismissed, ignored and undetected. Amber flags and other suspicions are too often not aggregated due to companies not effectively collating individual indicators across front, middle and back office functions;
· lack of segregation of duties across key functions or within the IT element of the trading system and other aspects of the control environment are common. Plus, a culture of openness and challenge is often found wanting.
There are consequently a number of areas where utilities should focus their efforts.
Tone at the top. It is critical that a strong tone from the top is established that places emphasis on “doing the right thing”. This must flow throughout the organisation and be reinforced by heads of desks, book leads and across the key functions. Breaches of limits and incidences or attempts of fraud should be dealt with quickly and robustly.
Effective challenge is critical. An important aspect of the tone at the top is having people across middle office, back office and control functions such as internal audit who feel empowered to challenge inappropriate behaviour and escalate suspicious activity. This is particularly the case where utility companies are making increasing use of complex, non-standard contracts as part of optimisation and trading strategies. All too often we see middle and back office functions playing catch up, creating a window of opportunity where controls or understanding are one step behind the front office.
The importance of strong preventive and detective controls. While preventive controls based on segregation of duties, system access and integrity – and other aspects such as a balanced remuneration policy – are paramount, where these fail, it falls on detective controls to be the organisation’s last line of defence. All too often frauds tend to be uncovered by accident. Detective controls clearly need to be more effective.
In light of this, it is encouraging to see an increasing number of UK and European utilities bring fraud and rogue trader risk up the corporate agenda. We are seeing greater focus on the following key courses of action:
· systems: assessment of access and change management, real-time reporting and risk alerts, use of spreadsheets or other manual workarounds;
· end-to-end controls reviews: assessing whether controls are designed effectively and whether they are actually operating, plus the extent to which control owners know what “unusual” looks like;
· risk dashboards: assessing whether current reporting and key metrics are fit for purpose, including the tracking of red and amber flags;
· trade surveillance: proactively using data mining and analysis to uncover unusual trading patterns;
· human behaviour: assessing human and organisational factors such as culture, performance management and personality (see box, pages 22-23 ).
The inherent risk of fraud within most commodity trading operations remains high and given increasing regulatory oversight of commodity traders, it is important that fraud and rogue trader risk are kept high on the agenda throughout the organisation. Utilities, just as much as banks, need to be alert to the warning signs.
Richard French is a partner at PwC London’s energy & utilities assurance practice. Jonathan Rose is a senior manager, specialising in providing assurance services to commodity trading clients in the UK and overseas
Culture shock: detecting rogue traders is about human nature as well as risk control
Traditional attempts to control rogue trading focus on risk and control systems. A more holistic approach would also take account of human and organisational factors such as culture and leadership, human behaviour and decision making.
Human and organisational factors are now critical considerations in industries where there is a risk to human life. Factoring them in has dramatically improved aviation safety records over the past 50 years, for example, while the likes of worker fatigue and stress are taken into account in high-risk heavy industries like mining, even with the best technologies and systems.
While the direct risk to human life is thankfully missing, rogue trading can still lead to significant financial and reputational loss. That incidents are still occurring even when sophisticated control systems are in place to prevent them suggests that parts of the puzzle are not being addressed.
As discussed in the main feature, organisational culture and an emphasis on doing the right thing are some of the most significant aspects of a utility’s governance and control framework. Some questions companies should ask about their own culture are:
· are traders king and do they act independently of support functions?
· do support functions think and act like they have the authority to challenge traders?
· is there enough investment in support functions (people and systems)?
· is there a perception that management is only interested in profit and doesn’t pay enough attention to the risks taken or methods used to make that profit?
The first three questions relate to a “them and us” culture, likely to be borne of an uneven balance of power between traders and support functions. Research has shown that those considered to have “expert power” (are experts in their field) or those who have “coercive power” (appear threatening and instil fear in others) are unlikely to be challenged. This could be a reason why the front office is rarely challenged in some environments. For a culture of doing the right thing to exist, effective challenge of the front office is critical.
Changing culture is never a quick fix, because it is made up of many factors. It is fruitless to try to change too many things at once. Understanding the current culture is the first priority, followed by prioitising a handful of things which, if improved or removed, would have the biggest, sometimes even disproporationately big, impact on the business and therefore its culture.
A separate issue is that organisations gaining a better awareness of decision making can support their traders in making more rational decisions, helping to reduce the risk of rogue trading. Decision making can be influenced by information and patterns that we are not aware of, which can lead us to make poorer decisions. For instance, working long hours, stress and high consumption of alcohol and drugs can be commonplace in trading environments.
Many organisations now incorporate personality profiling in their recruitment of key roles. Utilities could consider using such profiling when recruiting traders to look for certain traits which provide a buffer against the effects of stress. The most important of these is resilience.
Chris Frost is a partner at PwC’s consulting performance improvement practice and Sonia Cochet is a senior manager with a background in organisational psychology, specialising in leadership and culture change for utilities
This article first appeared in Utility Week’s print edition of 2nd November 2012.
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