SocGen allegedly failed to act on Kerviel warnings

Marin's statement yesterday indicated that the problem had been identified three months ago. But each time that Eurex or the bank's internal auditors raised questions, Kerviel was able to produce documents showing that there was no risk associated with the trades. Marin described those documents as "fake" and said that Kerviel has admitted producing false documents and making unauthorised changes in the bank's computer systems - going back as far as 2005.

On 27th January, the bank issued a carefully worded statement in which it explained how arbitrage works - and how risks in one portfolio offset risks in another. In short, it explained hedging.

For the first time, the bank was unequivocal about describing Kerviel's actions as "fraud."

And the bank is explicit about the mechanisms they have discovered.

Statement: 27 January 2008

It is not the role of Société Générale's Equities businesses to take directional positions on the equity markets (i.e. to speculate on rises or falls). The division where the trader worked is assigned to arbitrate financial instruments on European stock markets. This is a proprietary trading business which is completely independent of the Equities activity's client businesses.

For example, this arbitrage business involves purchasing a portfolio of financial instruments A and selling at the same time a portfolio of financial instruments B with extremely similar characteristics, but with a slightly different value. The arbitrage business generates its profits or losses from these differences in value.

Because these differences are both small and temporary, the arbitrage activities rely on a very large amount of operations involving very high total nominal amounts.

The fact that portfolios A and B have very similar characteristics and that they offset each other, means that these activities generate very little market risk.

However, these risks do exist and, as part of the development of its arbitrage activities, Societe Generale has put in place a large number of controls designed to monitor the risks involved: control of operations and control of market risk linked to the changes in the prices of portfolios of financial instruments.

The exceptional fraud which we have suffered consisted of avoiding these controls or making them inoperable: the trader inserted fictitious operations into portfolio B in order to give the impression that this portfolio genuinely offset portfolio A which he had purchased, when this was not the case.

These fictitious operations, were registered in Société Générale's systems but did not actually correspond to any economic reality.

2. The method behind the fraud

- The trader involved had been employed at the Group since 2000. He first spent five years working in different middle-offices (one of the departments which controls traders). Consequently, he had a very good understanding of all of Société Générale's processing and control procedures. In 2005 he became a trader in the arbitrage department.

In the course of his arbitrage activity, the trader developed an initial portfolio A comprising genuine operations using financial instruments (futures) which reproduced changes in the main European stock market indices (Eurostoxx, the Dax, the FTSE, etc.).

The financial instruments in the portfolio, which were genuine and consistent with the volumes traded by a large investment bank, were subject to daily controls and in particular margin calls with the main clearing houses. Insofar as these instruments were actually purchased and considered as such by Société Générale, the margin calls were checked and settled by or paid to the bank.

- The risks generated from commitments made by the bank are managed and controlled on a daily basis. With regard to this fraud, the financial instruments in portfolio A were in appearance offset by the fictitious operations housed in portfolio B, which meant that the only visible risk was very low residual risk.

As a result, the trader was able to hide a very sizeable speculative position, which was neither consistent with nor related to his normal business activity for the bank.

In order to ensure that these fictitious operations were not immediately identified, the trader used his years of experience in processing and controlling market operations to successively circumvent all the controls which allow the bank to check the characteristics of the operations carried out by its traders, and consequently their real existence.

- first, he ensured that the characteristics of the fictitious operations limited the chances of a control: for example he chose very specific operations with no cash movements or margin call and which did not require immediate confirmation;

- he misappropriated the IT access codes belonging to operators in order to cancel certain operations;

- he falsified documents allowing him to justify the entry of fictitious operations.

- he ensured that the fictitious operations involved a different financial instrument to the one he had just cancelled, in order to increase his chances of not being controlled.