Mismarking

Last updated

Mismarking in securities valuation takes place when the value that is assigned to securities does not reflect what the securities are actually worth, due to intentional fraudulent mispricing. [1] [2] Mismarking misleads investors and fund executives about how much the securities in a securities portfolio managed by a trader are worth (the securities' net asset value, or NAV), and thus misrepresents performance. [3] [4] When a trader engages in mismarking, it allows him to obtain a higher bonus from the financial firm for which he works, where his bonus is calculated by the performance of the securities portfolio that he is managing. [3]

Contents

Mismarking is an element of operational risk. [5] The trader engaging in mismarking is sometimes referred to as a "rogue trader." [6]

During market downturns, determining the value of illiquid securities held in portfolios becomes especially challenging, in part because of the amount of debt associated with these securities and in part because of fewer mechanisms for price discovery. [2] As a result, during such periods illiquid securities are especially susceptible to fraudulent mismarking. [2]

Notable cases

In 2007, two Credit Suisse traders pleaded guilty to mismarking their securities positions to overvalue them by $3 billion, avoid losses, and increase their year-end bonuses. [7] [8] [9] Federal prosecutors and the Securities and Exchange Commission charged that the traders' goal was to obtain lavish year-end bonuses that the mismarking would lead to. [10] [11] The traders engaged in what The New York Times called "a brazen scheme to artificially increase the price of bonds on their books to create fictitious profits." [7] A team of traders, facing an inquiry from Credit Suisse's internal controls Price Testing group, justified their bond portfolio's inflated value by obtaining "independent" marks from other banks' trading desks. [7] [12] The traders secured sham "independent" marks for illiquid securities that they held position in from friends who worked at other financial firms. [11] [7] [12] Their friends generated prices that valued a number of bonds at the prices that the traders requested, which the traders then recorded as the true value of the bonds. [7] [12] The false profits allowed the head of the group to secure a cash bonus of more than $1.7 million and a stock award of more than $5.2 million. [7] The bank was not charged in the case. [7] Credit Suisse's outside auditor discovered the mismarkings during an audit. [13] Credit Suisse took a $2.65 billion write-down after discovering their traders' mismarking. [11]

Also in 2007, the Royal Bank of Canada, Canada's biggest bank, fired several traders in its corporate bond business, after another trader accused them of mismarking bonds the bank held by overpricing them, and marked down the values of the bonds and recognized $13 million of trading losses relating to the bonds. [14] The bank said it investigated the accusations, and took remedial action. [14] The Globe and Mail noted: "traders might have an incentive to boost [the bonds'] prices because it could have an impact on their bonuses." [14]

In 2008, a Bank of Montreal trader pleaded guilty to intentionally mismarking his trading book in order to increase his bonus from the bank. [15] [16]

In 2010, a Merrill Lynch trader in London who mispriced positions he had on behalf of the bank by $100 million to cover up his losses was banned by the United Kingdom's Financial Services Authority (FSA) from working in the securities industry in the UK for at least five years. [17] [18] [19] [20]

Also in 2010, a trader at Toronto Dominion Bank in the UK was fined £750,000 ($1.16 million) by the FSA for intentionally mismarking his trading positions. [21]

In 2016, Citigroup fired a trader for mismarking his portfolio. [22]

Also in 2016, a trader at a company authorized by the Dubai Financial Services Authority (DFSA) was banned for six years from performing any functions in connection with the provision of financial services in the Dubai International Financial Centre after he mismarked his trading book. [23]

In 2019, SEC announced settled charges against a former Citigroup Global Markets Inc. (CGMI) trader for mismarking a book of illiquid credit derivatives while sustaining losses from unauthorized trading in U.S. Treasury securities (USTs). [24]

In 2022, SEC charged James Velissaris, former Chief Investment Officer and founder of Infinity Q Capital Management, with overvaluing assets by more than $1 billion while pocketing tens of millions of dollars in fees. [25]

Regulatory action

United States

To address mismarking, in 2020 in the United States the Securities and Exchange Commission proposed a new rule, entitled "Good Faith Determinations of Fair Value," intended to address valuation practices and the role of a fund's board of directors with respect to the fair value of securities investments. [26] [27]

See also

Related Research Articles

In economics and finance, arbitrage is the practice of taking advantage of a difference in prices in two or more markets – striking a combination of matching deals to capitalise on the difference, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the possibility to instantaneously buy something for a low price and sell it for a higher price.

Long-Term Capital Management L.P. (LTCM) was a highly leveraged hedge fund. In 1998, it received a $3.6 billion bailout from a group of 14 banks, in a deal brokered and put together by the Federal Reserve Bank of New York.

<span class="mw-page-title-main">Valuation (finance)</span> Process of estimating what something is worth, used in the finance industry

In finance, valuation is the process of determining the value of a (potential) investment, asset, or security. Generally, there are three approaches taken, namely discounted cashflow valuation, relative valuation, and contingent claim valuation.

Rational pricing is the assumption in financial economics that asset prices – and hence asset pricing models – will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.

<span class="mw-page-title-main">Credit Suisse</span> Swiss multinational bank

Credit Suisse Group AG was a global investment bank and financial services firm founded and based in Switzerland. Headquartered in Zürich, it maintains offices in all major financial centers around the world and provides services in investment banking, private banking, asset management, and shared services. It is known for strict bank–client confidentiality and banking secrecy. The Financial Stability Board considers it to be a global systemically important bank. Credit Suisse is also a primary dealer and Forex counterparty of the Federal Reserve in the United States.

Net asset value (NAV) is the value of an entity's assets minus the value of its liabilities, often in relation to open-end, mutual funds, hedge funds, and venture capital funds. Shares of such funds registered with the U.S. Securities and Exchange Commission are usually bought and redeemed at their net asset value. It is also a key figure with regard to hedge funds and venture capital funds when calculating the value of the underlying investments in these funds by investors. This may also be the same as the book value or the equity value of a business. Net asset value may represent the value of the total equity, or it may be divided by the number of shares outstanding held by investors, thereby representing the net asset value per share.

Fixed-income arbitrage is a group of market-neutral-investment strategies that are designed to take advantage of differences in interest rates between varying fixed-income securities or contracts. Arbitrage in terms of investment strategy, involves buying securities on one market for immediate resale on another market in order to profit from a price discrepancy.

The bond market is a financial market in which participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, but it may include notes, bills, and so on for public and private expenditures. The bond market has largely been dominated by the United States, which accounts for about 39% of the market. As of 2021, the size of the bond market is estimated to be at $119 trillion worldwide and $46 trillion for the US market, according to the Securities Industry and Financial Markets Association (SIFMA).

Style investing is an investment approach in which securities are grouped into categories, and portfolio allocation is based on selection among "styles" rather than among individual securities.

The following outline is provided as an overview of and topical guide to finance:

Orlando Joseph Jett is an American former securities trader, known for his role in the Kidder Peabody trading loss in 1994. At the time of the loss it was the largest trading fraud in history.

In financial trading, a rogue trader is an employee authorized to make trades on behalf of their employer who makes unauthorized trades. It can also involve mismarking of securities. The perpetrator is a legitimate employee of a company, but enters into transactions on behalf of their employer, or mismarks securities held by their employer, without their employer's permission.

Product Control is a control and support function, responsible for ensuring accurate financial reporting for trading, lending and treasury desks. The function is typically located within investment banking, corporate treasuries, hedge funds and more recently, crypto trading firms. See Middle office and Financial risk management § Banking. Given the responsibility for the financials, outlined below, Product Control is most commonly located within the Finance function, reporting into the CFO. The controllers are then assigned to a particular asset class, for example the Credit, Rates or FX desks

In economics and finance, the price discovery process is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers.

Fixed-Income Relative-Value Investing (FI-RV) is a hedge fund investment strategy made popular by the failed hedge fund Long-Term Capital Management. FI-RV Investors most commonly exploit interest-rate anomalies in the large, liquid markets of North America, Europe and the Pacific Rim. The financial instruments traded include government bonds, interest rate swaps and futures contracts.

Merrill, previously branded Merrill Lynch, is an American investment management and wealth management division of Bank of America. Along with BofA Securities, the investment banking arm, both firms engage in prime brokerage and broker-dealer activities. The firm is headquartered in New York City, and once occupied the entire 34 stories of 250 Vesey Street, part of the Brookfield Place complex in Manhattan. Merrill employs over 14,000 financial advisors and manages $2.8 trillion in client assets. The company also operates Merrill Edge, a division for investment and related services, including call center counsultancy.

International Investment Group (IIG) is an American financial institution that specializes in short-term trade finance and commercial finance with a focus on emerging markets. Through its affiliate IIG Capital it provides financing to small and medium-sized merchants, traders and processors with a need for supply chain financing.

Kareem Serageldin is a former executive at Credit Suisse. He is notable for being the only banker in the United States to be sentenced to jail time as a result of the financial crisis of 2007–2008, a conviction resulting from mismarking bond prices to hide losses.

Sung Kook Hwang, also known as Bill Hwang, is a Korean-born American investor and trader. He ran Archegos Capital Management, whose default on March 26, 2021 caused major losses to several notable investment banks. In April 2021, The Wall Street Journal reported that Hwang had lost US$20 billion over 10 days in late March, imposing large losses on his bankers Nomura and Credit Suisse. On April 27, 2022, he was indicted on federal charges of fraud and racketeering. The default of Archegos contributed to the eventual collapse of Credit Suisse.

References

  1. ↑ "1QIS 2 - Operational Risk Loss Data – 4 May 2001," Bank of International Settlements.
  2. 1 2 3 Eugene Ingoglia; Todd Fishman, Mark Daniels (April 22, 2020). "Amid falling markets, valuation challenges and mis-marking fraud risks rise". Investigations Insight.
  3. 1 2 George J. Benston (July–August 2006). "Fair-value accounting: A cautionary tale from Enron". Journal of Accounting and Public Policy. 25 (4): 465–484. doi:10.1016/j.jaccpubpol.2006.05.003.
  4. ↑ Kent Oz (2009). "Independent Fund Administrators As A Solution for Hedge Fund Fraud," Fordham Journal of Corporate & Financial Law.
  5. ↑ "Liontrust Asset Management: Annual Report & Financial Statements 2020". MarketScreener. July 21, 2020.
  6. ↑ Peter Nash (2017). Effective Product Control; Controlling for Trading Desks, Wiley.
  7. 1 2 3 4 5 6 7 Peter Lattman and Peter Eavis (February 2, 2012). "3 Former Traders at Credit Suisse Charged With Bond Fraud". DealBook.
  8. ↑ Lattman, Peter (April 12, 2013). "Former Credit Suisse Executive Pleads Guilty to Inflating the Value of Mortgage Bonds". DealBook.
  9. ↑ Jacob Gaffney (February 1, 2012). "SEC charges four Credit Suisse bankers in subprime bond fraud". Housing Wire.
  10. ↑ "SEC Charges Former Credit Suisse Investment Bankers in Subprime Bond Pricing Scheme During Credit Crisis". SEC.gov. February 1, 2012.
  11. 1 2 3 "Former Credit Suisse traders charged with fraud; US prosecutors charged three former Credit Suisse traders with inflating the value of mortgage bonds in 2007 as the housing market deteriorated, saying they used the scheme to boost their year-end bonuses". Australian Financial Review. February 2, 2012.
  12. 1 2 3 Joe McGrath (2020). "Why Do Good People Do Bad Things? A Multi-Level Analysis of Individual, Organizational, and Structural Causes of White-Collar Crime," Seattle University Law Review.
  13. ↑ Andrew Hurst (February 19, 2008). "Credit Suisse reveals $2.85 billion write-downs". Reuters.
  14. 1 2 3 Tara Perkins (October 26, 2007). "Trader alleges RBC undervalued bonds". The Globe and Mail.
  15. ↑ Rita Trichur (November 19, 2008). "Rogue gas trader admits to fraud". The Star.
  16. ↑ Tara Perkins (November 18, 2008). "Former trader pleads guilty in fraud that cost BMO $850-million". The Globe and Mail.
  17. ↑ Ridley, Clara Ferreira-Marques, Kirstin (March 17, 2010). "FSA bans former Merrill Lynch trader". Reuters.{{cite web}}: CS1 maint: multiple names: authors list (link)
  18. ↑ Ian King (March 16, 2010). "Merrill trader banned by FSA for mismarking". The Times.
  19. ↑ Alexis Stenfors (2017). Barometer of Fear: An Insiders Account of Rogue Trading and the Greatest Banking Scandal in History. Zed Books.
  20. ↑ Enrich, David (April 29, 2016). "A Disgraced Trader's Struggle for Redemption" . The Wall Street Journal .
  21. ↑ Muñoz, David Enrich, Cassell Bryan-Low and Sara Schaefer (September 22, 2011). "U.K. Sets Its Sights on 'Rogue' Traders". The Wall Street Journal.{{cite web}}: CS1 maint: multiple names: authors list (link)
  22. ↑ Dakin Campbell (July 26, 2016). "Citi Fired Mortgage Trader in March for Mismarking Portfolio". Bloomberg.
  23. ↑ "Former Dubai trader banned for $11m 'mismarking' scandal", Arabian Business, May 11, 2016.
  24. ↑ "SEC Charges Former Citi Trader with Mismarking and Unauthorized Trading", SEC.gov, Sep 26, 2019.
  25. ↑ "SEC Actions: Fund Investment "Mispricing" & "Mismarking" Cases 2022". www.houlihancapital.com. 4 April 2022. Retrieved 20 September 2022.
  26. ↑ "Good Faith Determinations of Fair Value; Proposed Rule," SEC 17 CFR Parts 210 and 270, Release No. IC-33845; File No. S7-07-20, April 21, 2020.
  27. ↑ Terrence O. Davis (May 28, 2020). "SEC Issues Fair Value Proposal". The National Law Review.
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.