Whereas the Rogue Trader operates behind the scenes and needs must remain hidden, the Genius Trader upends things while operating in plain view. When the Genius Trader strikes, it is not, strictly speaking, a case of trader malfeasance but of trader overreach spurred on by ego, enthusiastic management support, and, as a result, a lack of tight controls.

Characteristics of the Genius Trader

The Genius Trader is not as well known to the general public as his cousin the Rogue Trader, but the threat he poses to investment banks, their employees, and their shareholders is just as real. Who exactly is he? Well, he is a genius, of course. Furthermore, he is head over heels in love with his own genius, and so is everyone around him. He does not need to work behind the scenes like the Rogue Trader to gain access to large amounts of capital to trade with. Instead he works in the open with the full support of management.

Aside from being unusually smart and intellectually confident, what else distinguishes a Genius Trader? After all, being super smart and intellectually confident describes many traders at investment banks or hedge funds. In addition, then, Genius Traders have acquired during their tenure, or come to the bank with, an almost unimpeachable reputation for trading success. That success more often than not has resulted from exotic and obscure trades that netted significant profits for the firm. Even better if such profits were won in a trading cycle that was tough to do well in, and were achieved by taking positions contra to the general market sentiment. Such a label applies, for example, to a John Paulson¹ or a Steve Eisman,² each of whom made huge profits on bets contrary to the housing bubble in 2007. Such success is often associated with genius and the perceived rare ability to succeed in any market circumstances. While there is no guarantee that such insight will lead to repeat success in the future, such results are often hailed as if they do and lead those around the “genius” to loosen the grip of controls that would normally be exercised.

Another feature of a Genius Trader and the environment he operates in are frequent overrides of standards and procedures that are applied to all others. Two of those areas are worth dwelling on a little: trading limits and valuation policies. Generally speaking, one important aspect of trading risk management is to ensure that the exposure to any one particular product, region, trader, or counterparty is limited to a certain level of potential losses. This is done by applying a fixed limit to the size of positions that can be taken with respect to any single product, geographic region, trader and trading desk, and trading counterparty. By setting such limits, the bank can contain the losses from a trading strategy that finds itself on the wrong side of the market. While typically such limits are applied in a consistent way to every trader, according to his or her level and experience, one finds that Genius Traders are on occasion given greater latitude. They may, for instance, request a temporary increase in the limit in the size of position they can take because of a specific opportunity that only they know about or that their trading desk is uniquely positioned to take advantage of.

In terms of valuations, such traders are often engaged in trading securities that are hard to value, and as a result can be given latitude to value such positions themselves or to employ different valuation models than are employed elsewhere in the bank. This can give rise to gray and ambiguous positions with the potential opportunity to hide losses without straying outside of any legal boundary. The danger to the bank is that such losses can build on large positions without being brought to the attention of management if the valuation basis is modified to reduce the impact of the losses.

In all of these cases, we should note that the Genius Trader abrogates to himself, by intellectual authority rather than by dissembling, rights and privileges not available to others. This is the key difference with the Rogue Trader. It is also the case that such a Genius Trader sometimes occupies positions in the highest level of their bank or firm and is given honor and respect of the most senior members of the firm.

Genius Trader risk is also distinguished by the fact that people appear to be generally prepared to overlook missteps. A well‐known example of genius, perhaps the classic example, is John Meriwether,³ the trader who left Salomon Brothers to establish the hedge fund Long Term Capital. After the infamous losses and then the closure of Long Term Capital, Meriwether succeeded in growing a second fund, JWM Partners, until on July 7, 2009, it was announced that the fund would close after suffering losses. A third fund was then started in 2010 with some large losses announced as early as the following year. Such second and third chances are in strong contrast to Rogue Traders, clearly, whose next occupation is generally that of prison inmate.

A caveat to all of this is that a sharp intellect and high level of proficiency with quantitative techniques and advanced mathematics are prerequisites for good traders. Creativity is also a very important asset in a trader to ensure that they are constantly adapting their trading strategies based on their analysis of changing events in the markets in ways that help to maximize opportunities for themselves and their clients. What sets the Genius Trader apart are these other factors related to a dangerous kind of arrogance that makes him a potential danger to a firm and broader sets of actors.

It is interesting to review the list of the biggest trading losses incurred by individual traders, with the largest losses from Rogue Traders unauthorized by management, and therefore illegal, and the second set from Genius Traders legally made with the apparent full knowledge of management and the risk right in front of them. The losses in the latter group, shown in Table 3‐1, are distinguished from the first group, primarily in terms of the size of the losses. Table 3‐1 shows that four out of the five largest recorded losses by a single trader were incurred by “Genius Trader Risk,” the term I have used to describe the type of risk this second category represents. This is in some ways counterintuitive. Most of the focus around unexpected trading losses has tended to be on Rogue Traders, but the largest losses have come from the risk right in front of you, traders operating with the full support of management. Table 3‐1 shows five separate incidents with losses of over $5 billion where only one was perpetrated by a Rogue Trader. After the loss incurred by Jerome Kerviel, the next largest loss from a Rogue Trader event was that by Kweku Adoboli at UBS in 2011, which saw a loss of some $2.3 billion.

One reason for the disparity in size between losses that have resulted from genius trading risk versus rogue trading risk is because it is not so easy for a Rogue Trader to hide large positions from management. Losses tend to mount in an unhedged position so that at some point, these losses become apparent to someone, a controller for instance or a trading supervisor. Most investment banks have a certain number of small rogue trading incidents each year—incidents that are too small to become the subject of media coverage or regulatory concern. On the other hand, Genius Traders tend to be given latitude to trade, meaning large amounts of capital to trade with, and so the losses correspondingly will be higher when the market moves against them. There are also a large number of losses made by Genius Traders each year, too. However, it is rare that they are labeled as operational risk incidents—in other words, incidents caused by an operational failure.⁴ Maybe they will be called market risk incidents—the market simply went against the trader's position. Whether or not they are labeled as operational failures, of course, does not matter. What does matter is that there are indicators of this risk that can be tracked the way the diagram in Figure 3-1 shows.

The key indicators and controls against Genius Traders are:

• Exception processing—the trader requires exceptions to be made for the way his books are valued, perhaps not by the standard models.
• Supervision—the supervisor has difficulties understanding the trades executed and the strategy behind them.
• Trade limit breaches—trade limit breaches by the trader are frequent, and exceptions are granted on a regular basis.
• Stature within the firm—the trader's stature within the firm is such that he is untouchable.
• Trades in complex and hard‐to‐value securities—the trader plies his trade in securities that are obscure to the firm and hard to value. Generally used valuation processes tend to be replaced by custom spreadsheets managed by the trader's team, leading potentially to suspension of separation of duties between the independent valuation team and the trading team.

How to Manage Genius Risk

So now that we know how to identify genius risk, how can banks do a better job managing it?

First, senior management must regard “genius” with a critical eye and in the context of the “best interests of the team.” An example from soccer can be instructive here. Sir Alex Ferguson, ex‐coach of Manchester United, over the years showed the door to top stars like Carlos Tevez, Christian Ronaldo, and David Beckham when their egos threatened the team's overall stability. Such stars demand privilege and latitude that may result in negative consequences for the overall health of the team.⁵ As that example nicely illustrates, a manager and an institution's culture can be more successful when it is stronger and more confident than its biggest egos. Managers should have very limited tolerance for exceptions and individuals not willing to play as part of a team.

Second, banks can use data to expose the objective reality of different traders' performance. Another example from sports is useful here. Coaches in baseball, memorably portrayed in Michael Lewis's book and the film made of it, Moneyball,⁶ have mined data to expose when long‐held views about the value of certain types of players do not coincide with the reality. Mining financial trade data could be done to challenge similarly held views about the value and consistency of different traders. It is possible that a trader's reputation for brilliance on the back of several risky and very successful trades would not be borne out on the basis of longer‐run statistical analysis. To counter such perception with objective data might help to reverse decisions to extend more latitude to such traders, the sort of latitude that led to the sorts of disasters we have just discussed.

Third, it may well be worthwhile employing such people provided management does not allow them the latitude they might seek. While it is always useful to have bright people round, management needs to keep them in the team and playing by team rules. If management is not strong enough to enforce such rules or the trader does not or cannot comply, then such traders have to be shown the door.

Fourth, objective data analysis should also be used to identify certain patterns of behavior that might be suggestive of greater risk taking by certain traders if left unchallenged. Such type of analysis to catch a Genius Trader might include, for example, failures to document trade activities per requirements; routine requests to exceed trading limits temporarily; and changes in core valuation methodologies⁷ because they no longer represent market realities. The analysis of such exceptions in an analytical framework might support the targeting of such traders more effectively.

Fifth, there is potential here to leverage machine‐learning applications to identify when such indicators are present in the trading environment. Systematic surveillance of traders to identify norms of activity vis‐à‐vis these indicators should be helpful in identifying correlation of anomalous activities, and whether or not they present true exceptions and potentially risky behavior. We will explore these types of trade surveillance activities in Chapter 21.

Finally, if you are ever presented with an opportunity to invest with or take on a Genius Trader who has suffered a misstep, don't take it. The chances are that she or he will blow up again.