Psychology of Risk, Speculation and Fraud by Linda Davies Will the European single currency defeat financial speculators or will the Euro itself become a victim of speculation like the pound sterling, when it was forced to leave the exchange rate mechanism, and more recently the currencies of the Asian Tigers? Although the Euro now exists as a tradable currency Europe is still in a process of transition to full monetary union and hazards could still lie in wait. A novelist who is a former banker puts herself in the place of the speculators and outlines a possible scenario. In addition she explores the motivations that turn some people into lawful speculators and others into financial criminals, leading to financial scandals such as Barings, BCCI, and Bre-X. This is the text of a speech at the Financial Panel 1997 of the European Research Center, Amsterdam, 11 June.

After lunch or dinner speakers must tread a fine line between giving their audience indigestion or sending them to sleep. I will endeavour to fight physics. I'm going to talk, not just about EMU, but also about the psychology of risk, speculation and fraud. Indulge me as I digress from EMU for a short while. I thought after a morning of EMU, you might appreciate a mental stretch of the legs as we stroll away onto the wider plains of financial risk upon which we all live. Among my subjects will be one sector of society which I might call sworn enemies of EMU - the foreign exchange speculators. I will tell you a little bit about how I came to write my first book, Nest of Vipers, and then I shall read a passage where fraud and FX speculation combine. I hope this will give an insight into the mindset of the type of people whose objectives are to exploit instability, people who will attack ferociously the weaker or borderline currencies in the lead up to the implementation of EMU. Finally, I shall use my novelist's imagination and describe a plot against EMU. Perhaps this will be where imagination and reality meet. The philosophy of EMU, one of promoting stability and accordingly diminishing risks, is a powerful one, but I'd like to set it in a context of human desire and history. In the financial world, risk, reward and catastrophe are cycles repeated by every generation. Greed, hubris and systemic fluctuations have given us the South Sea Bubble, Barings, Bre-X, Tulip Mania, to name just a few of the thousands of ready examples. Those of you who buy Dutch bulbs, perhaps you will pick some up at the airport, might flinch from the highest price ever paid for a bulb at the height of Tulip Mania in the autumn of 1636. In today's prices, a single bulb was sold for over thirty five thousand dollars. Speculation can degenerate into craze. Love might be blind, but greed is deaf. In March this year, Bre-X, the Canadian exploration company, touted its gold find in Indonesia as the world's biggest potential gold mine. Geological reports appeared to confirm the hype. Bre-X rose in value to over four point four billion Canadian dollars. Then the geologist apparently "JUMPED" out of a helicopter, and Bre-X shares became virtually worthless overnight. The stuff of novels, you might say...... Why is this relevant to you? It's relevant because it forms part of the typically unquantified risk arena in which you all operate. No one is immune from the speculators, from the risk of fraud, from the all too human motivations of greed, and ego. Human nature hasn't changed, but the scope for financial destruction had increased dramatically with technology led interdependence of financial markets, increasing transaction size, and the advent of the derivatives markets.

Now, I'm not a criminal by nature, nor indeed by education, although some might argue that my seven years in the City of London were an excellent training ground. But, to write about financial crime, I need to be able to think like a criminal. While most of you probably spend a lot of time trying to minimise the risks inherent in the financial and business world, I spend most of my time trying to exploit those risks. While you probably do not like to dwell on what might go wrong, I spend years pondering it. While you look at colleagues and wonder how much they make for you, I am asking myself how much they take from you. While you look at a financial system and recognise the forces tending toward stability, I search for the latent and systemic instabilities, and for those who seek to inflame them. I am not a Cassandra, always prophesying doom, but I get paid to think the unthinkable, and then write about it. It all started one hot day in July 1991. The markets languished, and I was day dreaming. I sat at my trading desk at my investment bank, where I sold junk bonds, stared at my flickering computer screens, and wondered just how much damage I could do. I had multiple trading counterparties, recorded phone lines, and I operated on the age old City axiom: My Word is My Bond. My telephone trades could commit me to hundreds of millions of dollars of exposure. But, in my fantasy incarnation, I decided I didn't really want to bring down a bank, I just wanted to make some money. Say, a few hundred million dollars. By the time I left for the evening, I'd worked out how. I imagined that I was a proprietary foreign exchange trader, trading on the back of my bank's own capital. I had an ally, a finance minister in G7, or a central banker. I was blackmailing him into revealing in advance, G7's currency support interventions, and interest rate changes. It would be like knowing the winner of the Arc de Triomphe in advance, and having hundreds of millions of dollars to bet with. I could trade on behalf of my bank, and benefit by way of seven figure bonuses. I could also trade on personal account, using the elixir of leverage, and make myself a fortune. George Soros made a billion dollars legally from breaking the pound on Black Wednesday. Imagine how much money someone could make illegally! And so I wrote Nest of Vipers. In the excerpt I am about to read, I try to show the mentality of some of the predators who stalk the trading floors of investment banks, the temptations they face, and the ease with which a massive crime can be committed. These people could be your colleagues, your counterparts, your bankers, your neighbours. They are part of a tiny elite that comprises the biggest market in the world; the foreign exchange markets. Their collective decisions can destroy political aspirations and economic policy. The repercussions of their actions filter down to everyone who is either a borrower, or a lender, or has commerce with either. Perhaps only a hermit who shuns the cash society can remain unaffected by their actions. To most FX traders, theirs is a thrilling game, fought with necessary unsentimentality about the world beyond the trading floor. They are financial mercenaries. Their job is to make a killing. At this point in her speech Linda Davies read an extract from Nest of Vipers

Sarah heard her name shouted from across the trading floor as she returned from lunch, an hour late, her cheeks glowing from the champagne. 'Line two,' announced Simon Wilson, as she hurried to the desk. 'Some Kraut.' Sarah glanced at him and hit line two. It was Manfred Arbingen. He came straight to the point. 'Did you know there was a G7 meeting today?' he asked smugly. Sarah laughed. 'No, I didn't. That's peculiar, the next one was supposed to be in two weeks.' 'Very peculiar. Unscheduled, unannounced. I only know because I went to the Bundesbank to pick up a friend for lunch. I had my car, we were going for a drive into the country. Anyway, as I was driving in, I almost got mowed down by a cavalcade of limos, six of them, tinted windows, big aerials, you know. I wasn't sure who it was, so I asked the guards, and they whispered that it was the finance ministers and central bankers. G7.' 'What do you think they were up to?' Arbingen laughed. 'What do you think?'

'Well, it couldn't have been policy. That would keep until the next scheduled meeting. It must be some sort of intervention.' She paused, weighing things up. 'But that hardly warrants a special meeting. They could have worked that out on the telephone, unless it was something really big, controversial, and I don't think that's likely. None of the currencies are that out of line.' 'They're not,' agreed Arbingen. 'The same goes for interest rates. I can't see them making any dramatic gestures there either.' 'I can't make any sense of it, that's for sure. I suppose we'll all have to wait and see. We'll find out something sooner or later.' Sarah thanked Arbingen for his news, cut the line and replaced the receiver slowly on the desk. Sooner or later wasn't good enough in the markets. You had to find out now, before the next man, anticipate the market's conclusions and reactions, position yourself accordingly. Sarah's mind began to race. She got up and walked over to the coffee machine, hidden in a little alcove on the edge of the trading floor, next to the atrium. It was light and secluded, and you went there for a seemingly casual gossip, or, like now, if you wished to think unobserved. Curiosity is endemic on a trading floor, and traders are adept at perceiving secrets fermenting in a colleague's mind, then relentlessly ferreting them out. Sarah had no intention of revealing to her colleagues what was on her mind, but she could do without the grilling and the scrutiny. It was impossible to think straight when at least two pairs of beady eyes followed your every move. She stared at the coffee machine, taking extra time to ponder the buttons, before finally punching out 146: coffee white, frothy, medium strength, one sugar. The coffee machine burped and spluttered, a plastic cup dropped into position, and with a noisy squirt steaming liquid rose to the brim. Sarah sipped carefully, mulling things over, gazing out at the pot plants dotted around the floor of the atrium. Last Thursday Scarpirato decides to buy one-week sterling/dollar futures, selling the dollar, buying sterling: a plausible, but highly speculative position. Four days on, one event, which might make that position pay off, takes place, secretly. And now, no doubt sterling would start to rise. Some coincidence, thought Sarah. Insider trading was one of the fastest ways of making money known to the City. It could explain the spectacular profits made by Scarpirato. It was also one of the most difficult forms of fraud to detect and prove. Tracking the flow of information was like trying to catch quicksilver. Sarah reached for a cigarette from the packet in her shirt pocket. She struck a match and inhaled deeply. If Scarpirato were trading on inside information of G7's currency intervention activities, then he must have a very senior mole. G7's currency policy is one of its most closely guarded secrets. Because of the danger of leaks, it is rarely consigned to paper. It is discussed and agreed by the ministers, the central bankers and the prime ministers of the member countries, and put into effect by the central banks. It is executed by the trading departments of the central banks, but Sarah thought it unlikely that any leaks would come from there. The traders would be told at the last minute. They would have far less time to pass on their inside information than would their superiors, the ministers and the bank governors. And the traders would be more exposed. All their calls were taped. Any transgressions would be all too obvious. Sarah felt sure that if there was a leak, it would come from the mist-shrouded upper echelons. Sarah puffed furiously on her cigarette. If her theory was correct, a top politician or central banker was at the centre of a billion-pound conspiracy. The possibility was almost too large to grasp. To a foreign exchange trader with access to large sums of money, and the cover of regular dealings in the market, having a mole in G7 was like having the key to the central vaults at Fort Knox. The implications hit Sarah like a fist in the face. If there was such a conspiracy, the participants would not give up high office and big money without a fight. Abruptly, Sarah dropped her cigarette into her coffee and placed the cup into the waste bin. She turned and walked towards the ladies room. Locking herself into a cubicle, she dropped the cover over the lavatory, and sat down. She leaned forward pensively, her chin cupped in her hands. She sat for ten minutes, till the cold marble floor chilled her feet through the soles of her thin leather shoes and the violent air conditioning raised goosepimples on her arms. Her nerves gnawed at her stomach.

She knew that she had already made her decision, even as her rational mind paraded alternatives before her as if she had a choice. She stood up and briskly rubbed her arms. It might just be that her imagination had run out of control. It wouldn't be the first time. But she would pursue her suspicions until they were exhausted, or confirmed. She would worry about the repercussions when they came. As she walked back to her desk, she was surprised to feel, not trepidation, but a sense of reckless exhilaration. It made her think of Alex. He had used those words when trying to describe the feelings that swept over him as he ascended a sheer rock face, with thousands of feet of empty space hanging below him. He said that his courage increased when faced with a particularly hazardous cliff. Sarah laughed at herself Alex, in his gentle way, would have ridiculed the comparison. Each time he inched up a rock face, clinging on by fingers and toes, he risked his life. Sitting at a desk in central London was about as safe as you could get. Sarah walked back to her desk. 'I think I'll join this little punt.' Arnott sat up out of his slouch. Wilson grinned as if it were a huge joke. Sarah smiled grimly. She could do with the money; she could ill afford the risk, but then, she was sure, that there was very little risk involved. It was what they called on the floor, a no-brainer. She decided to go into the market and take a spot position. She had capital of two hundred thousand pounds in cash. That enabled her to trade a maximum of three million pounds. The difference would be made up of borrowed money. If her position started to lose money, she could run it until the losses reached two hundred thousand pounds. Then she would be forced to cut the position and the two hundred thousand pounds would be raked out of her account to cover the losses. But Sarah felt confident there would be no losses.- her capital would be safe. She called Johnny McDermott. Normally someone like McDermott, who dealt with the orders of big institutions, wouldn't take personal account (p.a.) trades as well, but he made an exception with Sarah. McDermott had started his career executing p.a. trades and Sarah had been one of his early clients. When McDermott changed banks and began to execute institutional trades, he dropped most of his p.a. clients, but Sarah remained. The compliance departments in their respective banks didn't exactly love the relationship: it could look a bit incestuous; but they lived with it. They accepted the argument that Sarah and Johnny put forward. They just liked to trade together, it amused them, brightened their day, and, more importantly, both Sarah and Johnny were 'big hitters', making huge profits for their employers. They earned a little leeway. They would sometimes spend hours a day on the telephone, talking, joking, amusing themselves if the markets were quiet, but they could be equally brusque. 'Johnny, where do you have spot Cable?' '1.4560, 70.' 'I'll take three sterling at seventy, p.a..' 'That's done. But you're cutting it a bit tight, aren't you?' 'Don't worry Johnny. I know what I'm doing.' 'I hope so.' It was the biggest personal account trade Sarah had ever done. She had traded over a hundred times that amount many times at Finlays, but other people's money, referred to as OPM, or opium, on the floor, always felt different. It was just a commodity, a series of numbers that moved one way or the other. There was excitement, pain when positions didn't work out, but never the direct, searing hit of emotion in the bloodstream. Other people's money just slid off the surface. Sarah wrote out her trade ticket, stamped it, dropped it in the settlements tray and lit up a cigarette. She felt the delicious double edge of the gambler's thrill. If the trade went wrong, her capital would be wiped out, and with it much of her security. But if it went right, she could make tens of thousands of dollars. And see her hunch confirmed. It wouldn't prove that Scarpirato was insider trading, but it would substantiate her suspicions. She leaned back in her chair, face raised to the ceiling and exhaled loudly. Arnott watched every move, and looked at her strangely. Minutes after Sarah had completed her trade, the central banks of G7 entered the markets simultaneously and started buying sterling and selling the dollar. The word spread like wildfire around the trading houses across the globe: somebody, somewhere, was buying sterling, in size.

First the big banks and currency funds started buying for their own account, then smaller buyers jumped on the bandwagon. At two fifteen p.m. London time, ten minutes after Sarah had taken her position, sterling began to rise. Sarah watched the green flickering figures, dancing more than usual after her liquid lunch. She screwed up her eyes, and felt the first tremors of excitement. Sterling was rising in little hops, minute by minute. She watched the procession, her mind a well of concentration, ruthlessly shutting out all other thoughts, watching the market, talking to the market, feeling the market rise. For every tick - one hundredth of a cent - sterling rose, her paper profit grew by three hundred dollars. And the desk's by around fifty thousand dollars. The proprietary traders watched and waited. Dante Scarpirato left his sanctuary, took his trading seat next to Arnott, and peered at the screens. A controlled excitement gripped the muscles of his face as sterling ticked up. By three o'clock, it was up three quarters of a cent against the dollar, and the desk was sitting on a profit of over four million dollars. Enmities forgotten, they huddled together in excitement. They all agreed it was too early to cut the position and take their profits. The trend was accelerating, with sterling rising in bigger jumps each minute. By twenty past three, the pound was up a full cent against the dollar. No one they spoke to in the market knew why. No new figures were out, but someone somewhere was buying, and in massive amounts. The word was buy sterling; the rumours were rife. Sarah listened only to one: the central banks, led by the Bundesbank, were buying sterling. It was just as she expected. She turned sideways in her seat, and caught Arnott and Scarpirato in profile. They looked triumphant. Clearly she was not the only one who was not surprised. As her suspicions were borne out by the figures on the screens in front of her, she felt a mixture of fear and excitement. At three thirty, sterling had risen one and a quarter cents against the dollar. Sarah's profit was $37,500; large by personal trading standards, but dwarfed by the desk's profit. Sarah did a quick calculation in her head: nearly seven million dollars. Sarah closed her ears to noise around her and sat in a vacuum of concentration. She held on. Scarpirato sat, cigar smoke rising like vapour, as he stared, transfixed at the screens. It was almost as if he were willing the market up. Wilson and Arnott united against him, urging him to cut the position. He quashed them with a raised hand; King Canute holding back a wave of entreaties. Sarah watched, saying nothing. At four o'clock she decided it was time to sell. She rang McDermott. 'Johnny where d'you have Cable?' 'Ninety-five figure five.' (Shorthand for 1.4695, 1.4705) She sold, nearly forty thousand dollars richer in a couple of hours. Her first taste of dirty money. She examined the sensation: a certain stickiness, unreality. She felt that she was leaving herself behind. Another rubicon had been crossed. She deadened herself. It was, she told herself, crime in the name of the law. Fragmentary memories came unbidden. She banished them. Scarpirato watched her cut her position. Then he relented. He turned to Arnott, Wilson and Jensen and told them to sell, both the futures and the spot position. They hit their phones like rattlesnakes. In two minutes, they had sold out. The position was cut, the profit taken: $6,800,000. They wrote the tickets and sat back exhausted, euphoric, grinning at each other. Sarah let their mood consume her. The sensation was almost sexual. They felt dizzy, triumphant. They switched off their screens and went to Corney & Barrow on Old Broad Street to celebrate.

Those are the kinds of people who could be playing with your money! And attacking your currency. Bankers who hire money hungry geniuses should not always express surprise and amazement when some of them turn around with brilliant, creative, and illegal means of making money. Moving back to EMU, and the risks that I perceive from a novelist's perspective. I'd like to take as my starting point, the sterling crisis of Black Wednesday, 16th September 1992. Black Wednesday reminded us of two things; one the size and power of the Foreign exchange markets, and two, the amounts of money that can be made by well capitalised, well informed, and pro risk traders. I say this as a cautionary warning to countries in the pre currency lock convergence period.

So let's see things from a novelist's perspective. Let's pretend, let's give vent to imagination, not political goals, or economic theses. Let's pretend I am a super-speculator. I am male, post thirty. Good degree, but not necessarily. I could be like Joe Lewis, the secretive British FX billionaire, reputed to have made over a billion dollars in one year from FX trading from his Bermuda base, incidentally, reversing the charges every time he rang his London brokers. I have a war chest of a hundred million dollars. That will enable me to go into the FX markets and take positions of a few billion. I'm the kind of person liberal editorial writers loathe, politicians too. For I, and others like me, will exploit ruthlessly any divergence between political aspirations and economic reality. I hate the idea of EMU. I love instability. I'm a financial warrior. I laugh at the image of Norman Lamont, the former British finance minister, standing outside the Treasury raising interest rates every half hour, and drowning in the sea of speculative money that sank the pound. I am the predator, circling the herd, waiting and watching for the weakest member. I, and the community of foreign exchange speculators contribute ninety five per cent to the daily FX turnover of three trillion dollars. That's three thousand billion dollars every day. That compares to the latest EU central bank reserves of three hundred and eleven billion dollars. So, my speculator is part of a supremely powerful gang. He loathes EMU, but he will follow its progress as closely as any politician, perhaps more closely. For him, and his tribe of stateless warriors, there are billions of dollars at stake. That is the flag to which they bow, not nationalism, not politics, not dogma. He shall be a hyena waiting for the corpses of the countries that do not make EMU. Can you imagine the lead up to currency lock? Politicians trying to knock their countries and currencies into shape. Let me tell you the dream scenario of my speculator, let's call him Mr FX. One of the key countries to EMU is having trouble with convergence. Its politicians are determined it will meet the criteria, they're doing what politicians of course will be unable to do once a part of EMU, they are using their unindependent central bank to manipulate monetary policy to a short term goal. Amongst the political community, it is unthinkable that this currency will not join EMU. But I, and Mr FX make a living from thinking the unthinkable. He thinks this country will not join EMU. He could buy a supremely cheap out of the money put option on this currency, because most people, even the markets, think even if the country doesn't quite meet the criteria, it will be fudged into EMU. The odds, if you like, on his bet, are fantastic. A rank outsider. And then the unthinkable happens, the country doesn't join EMU. Mr FX and his co-warriors punish it ruthlessly, short selling its currency, driving the exchange rate down with their trillion dollar war chest. Perhaps the countries of the EU try to support the beleaguered currency, going into the markets. Norman Lamont could tell us all about how successful that will be. Ten billion dollars later, Mr FX and his gang retire to count their profits. But don't worry, they'll be back. Luxembourg is apparently trying to devise a war plan to head off speculative attack by FX predators. My advice is; get ready! And if you think the speculators can't get at the countries within EMU, think again. It won't be long before our derivatives geniuses dream up a new synthetic currency. Where there is motive, there will always be opportunity.