National Australia Bank: Wrong revals are not an option


Lee Oliver
Published on:

Demands for compensation from two currency option brokers over the rogue trading scandal of January 2004, presents the market with another act in one of the most entertaining financial farces for years.

Much has been written about the events leading up to the currency options debacle that cost National Australia Bank A$360 million ($263 million) in January 2004. It might have been expected that, after the widespread condemnation of NAB following the scandal, the bank would have moved quietly away from the spotlight and got on with rebuilding its reputation and business.

The bank’s decision to seek “exemplary damages” in excess of A$539 million against Icap and another broker it has declined to name, but which is known to be Cantor Fitzgerald, might, in its own mind, be part of that strategy. However, the move has sparked further incredulity in the FX options community.

Option traders

NAB seems to be pinning its hopes of a “rebate” on the discovery that the two broking companies routinely passed on wrong revaluation (reval) rates to the bank. These rates were meant to be independent, but investigations from PricewaterhouseCoopers and the Australian Prudential Regulation Authority highlighted the fact that they frequently originated from NAB’s own four-strong option team. The reports stated that some of the bank’s option traders routinely sent the brokers the rates, which were then e-mailed back unaltered.

This was not only a serious failing in NAB’s risk management but also a sad indictment of the professionalism of certain individuals at the two brokers. However, it seems extremely far-fetched to attribute the bank’s spectacular loss to these incorrect reval rates.

It was an open secret in the market that NAB’s option team actively traded what are known as the wings of the options market. These are the points where the market prices of options deviate the most from the theoretical Black-Scholes value. Black-Scholes might be fine for revaluing at-the-money options; but it is entirely inadequate for revaluing the out-of-the-money options found at the wings. The implied volatility of these options is normally higher than the at-the-money levels.

NAB’s traders were notorious for selling these options and then booking fictitious profits. When other participants in the market sounded warnings to NAB about its activities on this and other issues, the external whistle-blowers were basically told to mind their own business.

Both PWC’s and Apra’s reports highlighted the aggressive way in which NAB conducted its FX options business. NAB’s chief option dealer, Luke Duffy, currently serving a minimum 16-month prison sentence for his part in the fraud, had a reputation for being a bully. Sources say that he regularly told brokers they were either “with us, or against us”. In return for their compliance, he paid a lot of commission.

The legal outcome of NAB’s action is uncertain, especially as lawyers will be getting increasingly involved. But claiming such punitive damages from the two broking companies seems disingenuous. Although incorrect revals might have been passed to NAB by brokers for as long as five years before the scandal was exposed, both PWC’s and Apra’s reports made it clear that the amounts involved in this deceit were minimal.

The real damage was done by NAB’s options team incorrectly recording genuine trades in their systems, and worse, by inputting completely fictitious trades. PWC said it found a total of 467 false spot trades and 78 fake one-sided option trades in 2003.

Reval rates

Both reports also make it abundantly clear that the vast majority of NAB’s A$360 million loss occurred in the final quarter of 2003. And the cause was mainly that NAB’s dealers read the market incorrectly. The losses they racked up were then hidden by fictitious and incorrectly entered option and spot deals, not through dodgy reval rates.

As Apra stated in its report published in March 2004: “The losses ultimately incurred by NAB... were caused by four traders, possessed of an abundance of self-confidence, who positioned the NAB’s foreign currency options portfolio in the expectation that the falls in the US dollar that occurred mid last year would reverse and volatility would stabilize. Rather than closing their positions as the market moved against them, the traders chose to conceal their true positions... That this was possible was, first and foremost, due to the collusive behaviour of the traders themselves. However, it can also be attributable to an operating environment characterized by lax and unquestioning oversight by line management; poor adherence to risk management systems and controls; and weaknesses in internal governance procedures.”

One veteran options trader in London does not believe NAB has any real chance of receiving compensation from either Icap or Cantor. “The lawyers don’t care, they’ll get paid anyway,” he scoffs. “The main fault with NAB’s argument is that everyone in the market knew these guys were dodgy. How could it have taken NAB so long to work it out? You didn’t need to be a rocket scientist to know what they were up to. If the management couldn’t see what was going on, they must have had shit for brains.”

He also believes that it will be virtually impossible for NAB to prove that the reval rates were massively off market. “If a broker passed a 10.2% vol, when the real level is 9.8% what’s to stop him saying ‘our price was wide at the time and the rate we used was just the market mid [point of the quote]?’ This action is a joke.”

But Icap is not yet laughing and is taking the threat seriously. In a statement issued on November 9, it announced it did not accept any responsibility for the trading losses and that it intended to “vigorously contest any claim which may be made”. Icap’s statement also highlighted the fact that the operation NAB was threatening action against was actually a joint venture called TFS-Icap, which it runs with Swiss-listed broker Compagnie Financière Tradition. The office concerned is TFS-Icap’s Singapore branch.

A NAB spokesman denied that its failure to mention the joint TFS-Icap venture was because it did not really know who it had dealt with, which is certainly what it looks like from afar.

“My understanding is that Icap plc is the appropriate company to deal with. We didn’t name Icap – we haven’t at any stage sought to identify the parties,” he said.