Jim Spoon was the interest-rate options dealer at International Eastern Bank (IEB). He had been in the market for only three years but had established himself as one of the most profitable traders in IEB's global derivatives group. At the Bishopsgate branch of that well known chain of City hostelries, Rob Royce, Jim was meeting one of his main brokers, Jack Sprat, who worked at Yurigeller Brokers Ltd.
"How're you doing Jim?" the plummy tones of Jack Sprat rang around Rob Royce's. A few heads looked up and Jim cringed. Jack already had an open bottle of Bollinger in an ice bucket by his table. Jack was a 1980s' throwback. Despite record bonuses most traders and brokers today espoused the more austere moresof the 1990s. It didn't make sense to draw attention to yourself in these days of continuous reorganization at the City's large banks.
"That was a good deal you did today," said Jack as Jim took his seat, casting furtive glances around the room to check who was there. Jim noticed the crew from Derivatives Advisory Group (DAG), the consultants hired by IEB to run their slide rules over its derivatives operation. Jim blanched.
"I'll just have a Perrier. I've got some work to do this evening. Yes, it was a fair deal but one of the DAG guys was asking me about it."
"What's his interest?" asked Jack waving his arm at the waiter to order a large bottle of Perrier for Jim.
"He seemed curious about the profit I made on it."
"I assume you told him that's why you're one of the best-paid derivative traders on the street?"
"Well not exactly in those terms," said Jim. "But I did explain how a lot of houses overestimated the volatility on out-of-the-money options."
"That's the trouble with these academics. They don't understand how we make money in these markets."
"He's not exactly an academic. He was in the market for 10 years before helping to set up DAG with the other guys."
"Can't have been much cop if he has to resort to running a rule over other people's books. Anyhow I guess you satisfied him."
"I guess so," said Jim. "But he's checking the valuations right now."
"You've nothing to worry about there. I had your risk management guy onto me today asking for vol levels and I gave him the right ones."
"Good. I suppose they should be satisfied." Jim seemed to relax a little and the colour returned to his face.
"Before I forget. I've got the tickets for the ski weekend." Jack reached for his inside pocket, extracting a travel agent's wallet which he handed to Jim, who furtively slipped it into his own. "I'm going on ahead but there'll be a few of the lads on the same flight as you."
Jim was not sure how his firm, the SFA and the Bank of England viewed these junkets but he was consoled by the fact that all the brokers seemed to be doing it now. Most of the traders from the bigger houses and a few from the smaller ones were expected to be there. The Yurigeller ski weekend was becoming one of the established events of the market and the other brokers were all now trying to compete. The fact that neither the Bank nor the SFA seemed to remark on this new trend in broker entertainment seemed to confirm that the Bank's previously puritan attitude to this kind of hospitality had relaxed. It was probably because the UK brokers needed to compete with their continental brethren, who had been doing it for years.
The DAG trio across the room began to break up. One of them left first and made his way to the Bank of England. The other two left a few seconds later and returned to the offices of IEB.
"I guess you're right," said Veronica Hayes to her business partner Anthony Bostock. They were two of the three partners of DAG. The third and senior partner Chris Young was on his way to the Bank of England to see his old friend Jill Swire, who worked in the Bank's supervision division.
"It's as clear as a pikestaff," said Bostock. "Spoon writes all these out-of-the-money options at market rates but inputs an exaggerated smile on his volatilities, giving himself a thumping great profit."
"How come their risk management department don't pick it up?"
"It's simple. They ring Yurigeller to get their volatility levels and you've just seen the man who tells them. He's the same one who brokes the deals."
"But all the same I can't understand why they don't pick up the enormous open position in out-of-the-money options." Veronica had a PhD in theoretical physics from Imperial College.
"Simple," said Bostock. "The risk managers tend to look just at the one VaR (value-at-risk) number and because Spoon is putting in such low volatilities it doesn't show up on the radar screen."
"As I mentioned I reckon they're overvaluing the book by about £100 million, plus-or-minus 15%," said Veronica. "It will take me a while to nail down the precise figure. Where do we go from here?"
"We're going right up to see Melbach [the CEO]. It won't take the Bank and the SFA long to start calling once Chris has briefed them, and I think he'd like to get his calls in to the governor and the head of the SFA first. I just wanted to check my suspicions before we went public. That loudmouth Sprat has told us just about everything." They entered IEB Tower and took the elevator.
"I can't believe it's that simple," said Veronica. "When we were trading I don't remember this sort of thing happening."
"You missed a lot then. Remember how American Farmers Bank ran all their accounting on an accrual basis and found a $100 million hole. Then there was the guy who wrote options with his own company and kept his machine locked up so no-one else could get in. Look, we were all a different breed in those days. Not many of us came from trading backgrounds and in any case we'd been brought up differently. We didn't have to fiddle the valuations to make money. It was there on a plate because the markets were so inefficient. Then bonuses got so large that a whole new breed were attracted in. In some ways they were good for the market: they were sharper and meaner and the market is better priced now. But they carry the seeds of their own destruction. Because the market's so efficient they have to work harder for their money. They invent more and more exotic products to sell to their clients. Most of these products have no use other than to hide what the treasurer is doing from his board and the shareholders, but some have a genuine function, for example allowing retail customers to do things they couldn't have done before. If anything, this Spoon thing is a bit of an old-fashioned fiddle." They had reached the 26th floor, the CEO's suite. Melbach greeted them a little coldly. DAG's interim report lay open on his desk. The visit to Royce's had only served to confirm what they had already deduced from listening to the tapes.
"Are you sure there's nothing wrong in the exotics book?" Melbach asked.
"Nothing that stands out," replied Anthony.
"Thank God. In any case we're bringing in Cost & Firebrand to look after this from now on. We'll need them to handle the shareholders and regulators. I'm sure they'll contact you if they need further information. Let accounts have your invoice. And now if you'll excuse me I have some calls to make."
Meanwhile, Spoon was having a problem getting back into the office. His entry card didn't seem to be working. He was complaining to the night security guard when the lift door opened and out stepped the CFO and the head of security to have a quiet word.