Trader's losses grew undetected for two years

To senior NatWest executives, the most alarming feature of the pounds 90m hole that has appeared in its interest rate options business is the fact that it remained undetected for more than two years.

It now emerges that losses had been building up in the book run by the young options trader Kyriacos Papouis since late 1994 and yet they were only uncovered in February this year, three days after the parent bank had announced profits of more than pounds 1.1bn.

In part that is due to the highly complex and esoteric nature of some of the financial instruments used in debt derivatives trading.

In part it is due to the failure of management systems to identify that something was going wrong and tackle the source of the problem.

In part it was due, it now appears, to conscious efforts to obscure the losses through the mis-pricing of options and the transfer of value between trading books, which made it more difficult to detect the mis- pricing.

The mis-pricing only came to light after back-office staff at NatWest Markets - those responsible for reconciling trades on a daily, weekly and monthly basis - began to question the values attached to certain options and the way those prices had been fixed.

Martin Owen, chief executive of NatWest Markets, says: "The losses came to light through the book revaluations and testing of methodologies that are carried out on a regular basis. As we tightened our processes we began to discover more."

He does not believe there is evidence of any personal gain being made on the part of anyone. "Our continuing investigation will, however, want to look now at the motivation behind these trades," he said.

For motivation, the bank might take a look at the remuneration which its traders can take home and the pressure under which they work. The pounds 8m docked yesterday from the bonus payments of a handful of high-flyers in NatWest's global debt derivatives business shows the scale of the rewards on offer.

Traders regularly start work at seven in the morning, not finishing before six in the evening and sometimes much later if the trades they are executing involve Far East or US markets.

NatWest Markets' interest rate options division occupies only a small part of the investment bank's headquarters in London's Bishopsgate - home to one of the biggest trading floors in Europe. The division employs about 70 people in London and a further 80 overseas. And yet it is a key part of the bank's overall derivatives business, holding some very large positions out of the notional pounds 260bn on options held on NatWest's books.

In essence an option is the right to buy or sell a property at a pre- determined price in the future. The buyer pays a premium for that right. In the case of interest rates it enables the buyer to fix or hedge their debt exposure on given currencies over given time periods. At its simplest it is like switching to a fixed-rate mortgage.

However, clients of NatWest Markets would be more likely to buy the options to trade their liabilities by, for instance, swapping their exposure to dollar interest rates in five years' time for deutschmark interest rates in three years' time.

Some of the options dealt in by Mr Papouis and the small team of options traders he worked with will have been of a fairly conventional nature, heavily traded on the capital markets. But some will have been more complex options involving a much higher degree of volatility, thus making the pricing of them more subjective.

In the main he would have been trading options with clients - generally other banks or large corporate customers needing to hedge their interest rate exposure. But in addition, there would have been a small amount of proprietary trading using the bank's own capital.

What the independent investigators brought in by NatWest from accountants Coopers & Lybrand and lawyers Linklaters and Paines discovered was regular mis-pricing to obscure losses in certain option books. To make these losses more difficult to detect, the value of options was transferred between books.

In no cases will customers of NatWest have suffered losses by buying the options since the mis-pricing relates to the value that was attached to them in the bank's own books.

The five employees so far suspended by NatWest Markets form a chain of command and supervision within its interest rate options area starting with Mr Papouis.

Martin Owen, chief executive of NatWest Markets, stressed yesterday that the suspensions were not intended to imply guilt or wrongdoing on the part of anyone but were designed to enable the individuals to co-operate fully with the ongoing investigation.

But senior NatWest sources doubt that Mr Papouis could have mis-priced the options he was trading in so systematically over such a long period on his own.

Investigators also believe that the transfer of value between books points to a deliberate attempt to avoid detection as the net closed in.

Michael Harrison

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