What went wrong and how can this be avoided?
On 20th September, Mitsubishi reported an extraordinary loss of US$ 320 million at its Petro Diamond subsidiary in Singapore. According to Mitsubishi, the cause of the loss was the result of unauthorised trading activity on crude oil futures by a rogue trader.
What Happened at Petro Diamond Singapore?
According to the press release of Mitsubishi, a trader “ was discovered to have been repeatedly engaging in unauthorized derivatives transactions and disguising them to look like hedge* transactions since January of this year” Furthermore, “because the employee was manipulating data in PDS’s risk-management system, the derivatives transactions appeared to be associated with actual transactions with PDS’s customers”
*A hedge is a transaction where the derivative position on the futures market is intended to create an equal and opposite position to neutralise any exposure to market movements of the companies underlying business.
What appears to have happened, is that the trader was long crude oil futures in a falling market. In order to disguise his loses he fabricated physical fixed price sales to customers and had those entered into the system — The apparent profits on his physical sales were off-setting the losses on the futures. In this case, the derivatives transactions (disguised as hedges) were in fact fully exposed to market movements which the company was unaware of.
Should this have been noticed earlier and how?
Fraud by its nature is hard to detect — After all, the perpetrator is doing his best to cover his tracks. In the case of Petro Diamond, there would have been tell-tale signs to alert suspicion.
Some examples are;
· Abnormal trading patterns — was it usual to have such large positions on crude oil?
· Large exposures to customers — do the customers normally buy on fixed price and what was the marked-to-market on these positions?
· The futures losses reached +US$300 million — were abnormal cash margins calls being made to brokers?
· Erratic behavior of the trader — long holidays and sick leave or, no holidays and refusal to work in a team?
What could have been done to prevent this?
Various controls can be put in place to try to prevent such an event happening in the future. But in most cases these controls will pick up the problem after the event. Therefore, these measures can limit the damage, but it is very hard to prevent them from happening in the first place.
The key issue in the Petro Diamond case was the trader’s ability to fabricate the physical sales contracts — This is what he used to hide his losses.
What is the solution?
The fundamental problem stems from the commodities industry’s reliance upon paper-based systems; including contracts. These paper documents are all open to manipulation of one kind or another.
At TradeCloud our goal was to build a communications platform specifically designed for the commodities industry. Having contracts digitally recorded on the TradeCloud system was one of our top priorities.
Once a customer has accepted the terms of a deal on TradeCloud, a contract is issued immediately. This means there is no doubt that the transaction took place. In Petro Diamond’s case (if using TradeCloud) they would have known that the customer had not confirmed the alleged trades and raised a “red flag” immediately.
On TradeCloud we record;
1.) The time and date of the contract is made
2.) Which person agreed the terms of the deal
3.) Digital signatures by buyer and seller
4.) All of the agreed terms and conditions, including the GTC’s
The TradeCloud environment is a closed system, making it far less susceptible to fraud. Furthermore, we believe we have the most advanced contracting system in the industry — This allows for critical information such as analysis, diagrams, safety data info, and pictures to be added to the contracts.
The TradeCloud contracting system is just one feature amongst many we have created for a more secure and compliant environment for the commodities industry of the future. If you would like to learn more about how we are going about this, please feel to contact us via firstname.lastname@example.org
Author: Simon Collins — CEO & Co Founder of TradeCloud Services Pte Ltd.