“I wanted it to be a surprise for you.”

So said Jérȏme Kerviel to the senior management of French bank Societe Generale when they asked him what he expected to do with a hidden €1.4 billion ($2.1 billion) trading profit at the end of last year.

Not for nothing was Kerviel chosen for the “nicest trader award” last year by the back office at Societe Generale. Kerviel is going down in financial history not only as the person who engineered the largest trading loss ever (€4.9 billion), but as the humblest rogue trader yet. Even French financial authorities are impressed – they dropped fraud charges against him when they discovered he did not benefit from his activity by one cent.

Usually rogue traders are nice guys who turn nasty in a toxic and lax environment. Societe Generale certainly provided the environment. Employees describe the trading situation there as ultra-high pressure. All traders were judged first and foremost on how much “prop trading” profit they made for the bank (from proprietary trading for the bank’s own account). The French union responsible for back office employees in the trading division has asked for a formal investigation of three employee suicides there in recent years, all of which took place in the Societe Generale offices at the La Défense business complex. In the most recent case, a back office manager, told he was being investigated for “work irregulaties” in his department, promptly cleaned out his desk and jumped to his death from the top of his building.

Kerviel grew up in this environment. He was one of the rare back office workers to graduate to a trading desk, though his position at the “Delta One” trading desk involved only the most basic and lowest risk arbitrage duties. He was quiet, unassuming, intelligent, diligent, hard-working, friendly – these are not the qualities of the typical rogue trader, who is usually arrogant and rude to lesser individuals. Perhaps Kerviel would have gotten there eventually, if anyone had ever known he was contributing a gargantuan amount of profit to the trading desk.

Who knew what, of course, is a matter of contention. Kerviel is asserting that his management knew about his profit, and that all the traders routinely violated their limits to meet the increasing pressure for prop trading revenue. The senior executive responsible for trading – Jean-Pierre Mustien – who is ultimately responsible for the profit-obsessed trading culture at Societe Generale, says he didn’t know. He did, however, sack six levels of management above Kerviel, including Kerviel’s manager at the Delta One trading desk, who had protected Kerviel last year when outside regulators were probing excessive trading volumes.

Management is also backing away from their earlier assertions that Kerviel acted alone. Now they say they are investigating over 1,000 cell phone calls Kerviel made in recent months. And no one is repeating the allegation made last month when the scandal broke that Kerviel was a “computer genius.” Just because he remembered trader passwords when he worked in the back office doesn’t make him some kind of master computer hacker.

While we may never know exactly how Kerviel perpetrated his scheme – the French are not as prone as the British to expose all in these sorts of scandals – we know a bit more from an 11 page report released by the Finance Minister, Christine Lagarde, and which excoriates Societe Generale for its trading environment and lax risk controls.

Kerviel’s trading job was to take long or short positions on the equity markets and immediately hedge them, locking in a small gain or loss. If he was successful, over time he would have more gains than losses, and at no time would there be large open positions.

More precisely, say he bought 100 contracts on the DAX 30 index, a futures contract that blends the performance of the top 30 German stocks on the Eurex exchange. The contracts would expire anywhere up to 3 months from the date of purchase. If Kerviel held on to these and did nothing more, he would have an open position subject to market risk. If the 30 stocks on average went up in price, he would make money, and lose if they went down in price.

This is precisely what Kerviel was not supposed to do. He was to immediately sell 100 similar contracts on the same exchange, or sell them “over-the-counter” to any bank that quoted him a synthetic, or derivative, contract that mimicked exactly what the Eurex contracts would do. In this way, Kerviel would lock in a small gain or loss. Once he had done this, if his original position went up in value, the over-the-counter position would go down for the same amount, and vice versa until everything matured three months later. This is typical arbitrage business.

To do this over and over and generate enough small profits to pay the bills, Kerviel would need to build up a lot of bought and sold contracts – often huge volume is expected in the arbitrage business. The first question that comes to mind, though, is why no one at Societe Generale questioned the fact that by the end of 2007 Kerviel had amassed 140,000 DAX 30 contracts, worth €50 billion.

The compliance officers at the Eurex exchange certainly wondered. They sent several requests to the Societe Generale trading management throughout 2007 asking them to explain the growing volume in the DAX 30 contract. Societe Generale’s compliance officers, and eventually Kerviel’s manager, wrote back saying everything was in order.

The reason they thought so was that Kerviel was entering phony trades to the system that made it look like he was perfectly hedged – for every DAX 30 contract he purchased, Kerviel would create a similar contract that he sold, only it would be fake. He did this because he knew how to access the back office booking system having worked there. He also knew various traders’ passwords so he could enter the phony trades from a proper dealer’s computer. He knew when the compliance officers would periodically check these trades, so he would hide them or remove them on those occasions and replace them later. As his volume expanded he would need to “roll over” his maturing phony contracts into the next 3 month cycle, so he would create thousands of “amendments” and “cancellations” of his trades to accomplish this.

All of this kept Kerviel a very busy man. He worked long hours every night, well after everyone else went home. He never took a vacation in two years. He told people it was because his father had recently died and he was too upset to take a vacation. He was very believable in this; for a year after his father’s death Kerviel only wore black business suits to work.

By the end of last year, this pleasant but intense 31 year old had amassed a position on the futures exchange worth €50 billion. The entire capital of the bank was only €35 billion. At year end, this position was worth a profit of €1.4 billion – not too unusual as a percentage of the overall position, but extraordinary considering that only the largest and baddest hedge fund managers in 2007 approached a profit of anything like this.

Except – according to the Societe Generale management – no one knew about it other than Kerviel. Everyone else at the bank assumed they were perfectly hedged, which meant that Kerviel’s phony hedges were allowing this profit to be hidden, as well as the gargantuan €50 billion position. It was the position that was the real problem. A ten percent price change the other way would expose the bank to a €5 billion loss. This, in fact, is precisely what happened. By January 21st of this year, the market had begun to sink and the profit evaporated, turning into a €1.0 billion loss.

Kerviel said he panicked. He had realized that the compliance officers at his bank were starting to sniff around too carefully at his phony hedges. Perhaps he also realized how naïve he was being in assuming he would be considered a hero when he revealed his wonderful secret profit to bank management. So early this year, he actually tried to deliberately lose money to reduce the profit. The market gave him an unexpected boost by crashing throughout the month of January.

The compliance officers finally caught up to him on January 21 when they began a three day investigation that revealed the full extent of the open position. At this point, Kerviel retreated to his brother’s home outside of Paris and took a few calls from Jean-Pierre Mustien, admitting his phony hedges. After this, he “lawyered up” and reserved all comments for the government inspectors.

Kerviel insists that at this point, if the bank management had even half the skill he had displayed as a trader, they would not have sold their position and turned a €1.0 billion paper loss into an ultimate €4.9 billion real loss. Kerviel is right about this, from a trading perspective. The market bottomed the day Societe Generale finished closing out the €50 billion position, and had they waited they would have had a much smaller loss later in January or early this month.

But this is why Kerviel was a trader and not a manager. From the perspective of the bank management, there was no choice but to close the position immediately. The position was many times larger than the limit for the Delta One trading desk, which was only €100 million. It was larger than the maximum position the bank imposed on itself overall, and that had been identified in legal documents to the government regulators, to its auditors, to its shareholders in equity offerings, and to the public in its annual reports. Holding on to such a position, fradulently created, would have been a far greater breach of legal and public trust than taking a large loss.

Still, there is plenty of embarrassment to be had by Societe Generale management, not the least of which are the 8 risk management deficiencies that Christine Lagarde identified in her report. They include the things we’ve cited here – poor password protection, insufficient security over trader and back office systems, inability to properly respond to Eurex exchange queries, blind acceptance of thousands of trade cancellations and amendments by a single trader, inexistent firewalls between the trading desk and the back office, and refusal to impose a forced vacation policy as most banks do for their employees in sensitive positions.

But the chief deficiency – the one that is most perplexing – is the inadequacy of the confirmation process. When any bank does a trade with a registered exchange such as Eurex, there is a same-day confirmation of that transaction and all of its details. Societe Generale had to know by the end of every day exactly what its position was with the exchange, and as it began to lose money, they would have seen hundreds of millions of euros in margin collateral going out the door to be posted at the exchange.

What, then, about the hedges? Presumably Kerviel was making up phony hedges for over-the-counter banks like Citibank, Barclays, JP Morgan, etc. Where were the same-day confirmations that would have shown immediately that no such trades existed?

While it is possible Kerviel was able to create phony confirmations of his phony trades, the bank has not asserted this to be the case. In fact, the bank has suggested that everyone in the over-the-counter market is many months behind in confirming the details of these equity derivatives. This makes sense, because the central bank supervisors have been complaining for years about the dilatory practices of the banks when it comes to confirming their derivative transactions.

More than likely, Kerviel took advantage of these weaknesses, and when it looked like the back office was finally going to get around to confirming one of his phony trades, he replaced it with a whole new one. Maybe this is where his thousands of cell phone calls were heading – to back office friends who would inform him innocently of where they stood with their confirmation work load (it would be easy for him also to get printed reports on this work as well). Without this weakness, Kerviel’s scheme would have fallen apart instantly.

Kerviel’s motivation seemed to be to prove to himself and management that he belonged in the big leagues as a trader – something not so easy in the French business system where attending a second class college like Kerviel did makes it almost impossible to break into top positions. As usually happens in these rogue trader episodes, he got in too deep. His trading skill turned out to be more luck than perspicacity.

While he may be unique as the most pleasant and well-meaning of rogue traders – he may even get away without a prison sentence – much of what Kerviel did is depressingly familiar. Like his predecessor Nick Leeson at Barings Bank, Kerviel started out as an arbitrage trader who secretly morphed into a massive position taker. Like almost all other rogue traders, he circumvented back office controls and exploited risk management weaknesses. He entered phony transactions to the system and even wrote phony letters purporting to be from outside parties. Almost everything Kerviel did is to be found in all of the classic rogue trader post mortems, from Barings Bank to Allied Irish Bank to Daiwa Bank to Kidder Peabody and on and on.

What Societe Generale management has shown, at the very least, is that it did not read the reports from these previous frauds, or forgot the lessons if it did so. Certainly, it had phalanxes and cohorts of risk managers, compliance officers, oversight personnel, and auditors hired to prevent exactly what happened. It may have had wonderful risk management policies, talented staff, and all the surface bells and whistles. It just didn’t have the discipline imposed by top management to make the risk management system work.

Contrast this with the approach at Goldman Sachs, where risk managers are said to be like gods in their powers and the respect given them. All senior trading managers are required to serve part of their career in risk management. But even the mighty Goldman Sachs, which has so far shown itself adept at maneuvering around the treacherous reefs and shoals that constitute today’s markets, trades at only a modest P/E ratio in the stock market. In fact, no large financial institution anywhere trades at a P/E ratio of a growth or high value stock such as an energy company or technology firm.

This is because the stock market doesn’t trust the earnings at these financial companies. Societe Generale has affirmed once again why no one should, not when a major trading firm can lose almost 20% of its capital overnight. That’s the type of devastating equity collapse that drives a company into the hands of its competitors, and Societe Generale is going to be very lucky to escape from this disaster with its independence.

What we are seeing is the utter fruitlessness of relying on risk management to protect shareholders of large financial companies. What is increasingly coming into question is whether the churn and frenzy of modern bank trading is ultimately worth it for the banks involved. There are already serious questions being asked about whether this activity benefits the global economy at all, but if we can’t even find a silver lining for the practitioners, it is time to ask whether the entire trading and derivatives market serves any purpose whatever.