Allied Irish Banks and Allfirst, 2002

At a glance

What happened

A trader on Allfirst's small treasury desk in Baltimore lost about $691m over five years, mostly on bets that the yen would rise against the dollar. To hide the losses he booked pairs of fake options with Asian banks that appeared to hedge his real positions, and he persuaded the back office that those counterparties did not send confirmations. A back-office employee finally found confirmations that did not exist in early 2002. Allied Irish Banks announced the loss that February and later sold Allfirst.

Why it went wrong

Each pair of fake options was built so that one lapsed the same day while the other stayed on the books as an apparent asset offsetting his losses. Neither was real, and nobody chased the missing confirmations. The value-at-risk system took its exchange rates from a source the trader supplied himself, so his risk looked smaller than it was. Prime brokerage accounts that net-settled trades hid individual positions, and warnings from colleagues and auditors were not followed up.

What it teaches

Every trade must be confirmed with the counterparty, with no exceptions. Market data used for valuation and risk must come from an independent source, never from the desk being measured. Netting arrangements need position-level reconciliation. And a small desk in a subsidiary still needs the full set of controls, because size is not the same thing as risk.

Key terms

Trade confirmation

Agreement of a trade’s terms with the counterparty, the proof that the trade exists.

Independent price verification

Checking the rates and prices used to value a book against sources independent of the trading desk.

Prime brokerage

A service in which one bank clears, settles and finances a client’s trades executed with other dealers.

Net settlement

Settling many trades as one payment, which can hide individual positions if not reconciled trade by trade.

Deep in the money

An option whose strike is far from the current price in the holder’s favour, so it is worth almost its intrinsic value.

Value at risk

An estimate of the loss a portfolio should not exceed over a period at a given confidence level.

Where it sits in the course

Case studies like this one are used throughout risk management teaching, including FRM® preparation, as worked examples of operational risk: fictitious trades and unconfirmed deals. In OTC Learn the lesson runs in five steps: what happened, the position, why it broke, what it cost and what it teaches, followed by a worked example with the numbers. See the lesson outline.

Related case studies

• Société Générale, 2008Fictitious hedges, and a €4.9bn exit

The instruments behind it

OTC Learn lessons on the products this case turns on:

• FX OptionThe right to exchange currency at a strike
• FX ForwardLock in a future exchange rate