In this case study we will discuss the losses sustained by Allfirst Financial Inc. and Allfirst Bank in foreign exchange trading. The primary person responsible is john N. Rusnak.

In this first part we look at the relationship between AIB/Allfirst, treasury and foreign exchange trading.
<h2>The AIB/Allfirst relationship</h2>
Allfirst, formerly knows as First Maryland Bancorp, was partially acquired by AIB in 1983. By 1989, Maryland was merged into AIB as a wholly-owned subsidiary. It's name was changed to Allfirst in 1999.

AIB thus allowed Allfirst to have its own management team and board of directors (with minority representation from Dublin). However, AIB wanted more control in Allfirst's treasury operation. AIB believed that it had more sophisticated treasury operation and by having presence in this area, they will also be able to monitor Allfirst. This was done by sending David Cronin (a senior AIB executive) as treasurer into Allfirst's senior management.

Mr. David Cronin had vast experience in treasury operations, especially currency trading.

Initially, the new treasurer was not well received, but soon. things became more open and comfortable for the treasurer.

The treasurer reported to the CEO and at times the CFO. The treasurer also maintained strong tied with AIB in Ireland. He applied AIB's treasury policies in Allfirst, and also maintained relation with former colleagues with whom he discussed business issues.

AIB's senior management respected Mr. Cronin for his treasury expertise. Even though Allfirst’s senior management continued to believe in the treasurer’s competence, over time Allfirst’s management had increasing problems with his performance.

As a result due to this dual reporting, the Allfirst treasurer had less consistent and reliable supervision than would otherwise have taken place.
<h2>Structure of Allfirst's Treasury</h2>
Allfirst’s Treasury was divided into three “offices”: Treasury Funds Management; Asset and Liability Management and Risk Control; and Treasury Operations. Each office has been headed by a Senior Vice President who reports directly to the Allfirst treasurer.
<h3>Treasury Funds Management (Front office)</h3>
The front office has four functions: treasury funding; interest rate risk management; investment portfolio management; and global trading.

It is headed by Mr. Ray. Reporting to Mr. Ray in the global trading division are two managing directors. One of the two global trading managing directors is responsible for interest rate derivatives and supervises one other trader.

The other is Mr. Rusnak, who was responsible for foreign exchange trading. Mr. Rusnak was promoted to the managing director position in June 2001. Since that promotion, Mr. Rusnak had supervised another foreign exchange trader, one who joined Allfirst in 1986 and is currently the trader with primary responsibility for serving the currency needs of Allfirst’s corporate customers. This trader sat next to Mr. Rusnak on a very small trading floor.
<h3>Asset and Liability Management and Risk Control (Middle office)</h3>
The middle office has two vice presidents and an assistant vice president responsible for asset and liability management, a vice president in charge of financial analysis for the Treasury, and a risk control officer.

The risk control officer had responsibility for reporting on the traders’ compliance with Allfirst’s limits on value-at-risk, trading losses and counterparty credit.
<h3>Treasury Operations (Back Office)</h3>
Back Office is the division responsible for processing, confirming, settling and booking the trades executed by the bank’s foreign exchange and interest rate derivatives traders, including Mr. Rusnak’s trades. Treasury Operations also includes a portfolio operations function and a vice president in charge of systems and technology.

An important point here is that unlike many institutions, the same senior executive charged with ensuring profitable trading was also responsible for effective controls on that trading.

AIB/Allfirst Structure, Treasury and Forex Trading

<h2>John Rusnak’s Role</h2>
In July 1993, Allfirst hired Mr. Rusnak. The hiring process was led by the head of treasury funds management for Allfirst, Mr. Ray. Mr. Rusnak had extensive experience in currency trading.

Mr. Rusnak promoted himself as a trader who used options to engage in a form of arbitrage, attempting to take advantage of price discrepancies between currency options and currency forwards. Allfirst had until then engaged in “directional” spot and forward trading, simple bets that particular currencies would rise or fall. Messrs. Cronin and Ray were intrigued by Mr. Rusnak’s style of trading, as he claimed it would diversify the revenue stream arising from simple directional trading.

Mr. Rusnak ws earlier reporting to a trading manager, when in 1999, when the trading manager left, he started directly reporting to mr. Ray. Mr. Ray's knowledge of foreign exchange was limited. However, Allfirst's treasurer, despite his own extensive currency-trading experience, nevertheless relied heavily upon the treasury funds manager to supervise Mr. Rusnak. Mr. Ray however, did not devote significant attention to Mr. Rusnak’s proprietary trading.

The treasury funds manager (Ray) was highly protective of Mr. Rusnak; he often strongly defended Mr. Rusnak in inquiries by the back office and risk assessment personnel.

Mr. Rusnak’s annual bonus was directly related to his net trading profits. In effect, Mr. Rusnak received a bonus equal to 30 percent of any net trading profits he generated in excess of five times his salary.

Mr. Rusnak was regarded by some fellow employees as strong and confident. In the market, Mr. Rusnak was perceived as an active trader and a profitable client for the brokers. Many brokerage firms wanted to cover Mr. Rusnak. The brokers and traders heavily entertained Mr. Rusnak, with meals, hotel stays, golf trips, Super Bowl tickets and other travel. He apparently liked to be wined and dined, and the brokers obliged.
<h2>Mr. Rusnak’s Fraud</h2>
<strong>Trading Strategy: </strong>Mr. Rusnak told everyone that he engaged in an arbitrage between foreign exchange options and the spot and forward markets to make consistent profits.

In fact, however, much of Mr. Rusnak’s trading was linear, directional trading. These were simple bets that the market would move in a particular direction. The majority of his real positions were simple currency forwards. He also bought some foreign exchange options with “high deltas” (options that were “deep in the money” and had large premiums). He traded in “exotic” options, although the trading in these products was infrequent.

<strong>The Bogus Options:</strong><strong> </strong>Mr. Rusnak sustained substantial losses at some point in or about 1997, and it was around that time that his fraudulent activities may have begun. Using currency forwards, Mr. Rusnak apparently bet wrongly on the movement of the Japanese yen— he bought a great deal of yen for future delivery, only to see the value of the yen, and thus his forward positions, decline. To hide his losses and the size of his positions, he created fictitious options. These fictitious options also tended to give the appearance that his real positions were hedged.

Through a clever technique, Mr. Rusnak was able to get the bogus options onto Allfirst’s books. Typically, he would simultaneously enter two bogus trades into Allfirst’s trading system.  The two options would involve the same currency, and the same strike price, and they would offset each other from a cash standpoint: the first would involve the receipt of a large premium; and the second would involve the payment of an identical premium; accordingly, there would be no net cash in or out. There was one significant difference in the terms of the offsetting options: the option involving the receipt of a premium would expire on the same day it was purportedly written, but the other option would expire weeks later.

Mr. Rusnak’s bogus options were designed to exploit weaknesses in the control environment around him. Allfirst prepared no reports listing the expiring one-day options. And so no one at Allfirst paid any attention to them. In part, this was due to the fact that the system being used by Allfirst for options did not automatically alert supervisors if such options were not exercised.

At the same time, Mr. Rusnak took advantage of an even bigger hole in the control environment: a failure in the back-office consistently to obtain transaction confirmations. Initially, Mr. Rusnak created bogus broker confirmations to validate his deals, but, with occasional exceptions, he stopped doing that in September 1998. Mr. Rusnak instead apparently managed to persuade an individual in the back office not to seek to confirm the purported pairs of options. There was no need for confirmations, he apparently argued, because there was no net transfer of cash. Perhaps this practice suited the convenience of the back-office staffer; the bogus options were purportedly with the Tokyo or Singapore branches of major international financial institutions, and to have made confirming telephone calls would have required the employee to work in the middle of the night.

The upshot is that Mr. Rusnak’s scheme empowered him to create, at will, assets on Allfirst’s books— false assets— without ever having to pay for them. At the end of a day when he entered the pair of bogus options, the liability represented by the one day bogus option would not appear on Allfirst’s books. What was left— and what did appear on the books— was the purported unexpired deep-in-the-money option for which Allfirst had supposedly paid a large premium. The Allfirst balance sheet would reflect that the bank was holding a valuable asset— one that concealed the losses in Mr. Rusnak’s directional spot and forward trades. Mr. Rusnak would effectively keep the seemingly valuable but nonexistent asset on his book by repeatedly rolling it over into new bogus options as the original ones purportedly came due.

<strong>The Prime Brokerage Accounts: </strong>In his real trading, Mr. Rusnak  continued to lose money in spot and forward transactions, and as he did so, he wrote more and more of the bogus options to cover up his losses. (There were a few months in late 1999 when he apparently made some money back and reduced his bogus options positions, but that was short-lived.) From 1999 on, the majority of the real, money-losing trading activity was conducted pursuant to “net settlement” agreements that Mr. Rusnak established with various financial institutions, including Bank of America and later Citibank (when his principal trading contact at another institution moved there). The net settlement arrangements with Bank of America and Citibank subsequently evolved into “prime brokerage accounts.”

Under the prime brokerage agreements, spot foreign exchange transactions between Allfirst and its counterparties were settled with the broker and “rolled” into a forward transaction. At the end of each day, all spot foreign exchange trades were swapped into a forward foreign exchange trade between the prime broker and Allfirst.

These forward trades were cash settled in dollars at a fixed date each month. No settlement or cash collateral moved on these accounts on any other date. Prime brokers make money by receiving an agreed upon fee for settlement of foreign exchange spot transactions ($8 to $10 per million settled) and also typically charge full bid-offer pricing on the forward transaction rolls.

These accounts enabled Mr. Rusnak to increase significantly the size and scope of his real trading. Prime brokerage accounts are commonly used by hedge funds and other active traders, and— except for the monthly settlements and lack of collateral requirements (most prime brokerage arrangements call for daily mark-to-market collateral)— the terms of Allfirst’s arrangements with its prime brokers were not particularly unusual. Such accounts are, however, unusual for banks and are not used by AIB’s foreign exchange traders.

Nonetheless, Mr. Rusnak managed to convince his supervisors, including the Allfirst treasurer, that the accounts made sense for Allfirst because they would eliminate the need for extensive back office operations.

The investigation revealed bogus deals in Allfirst’s records of prime brokerage activity. Such deals were input by Mr. Rusnak in the DEVON system (the system used to record prime brokerage account trades) and later reversed prior to the monthly settlement.

<strong>Mr. Rusnak’s usage of Allfirst’s balance sheet</strong><strong>:  </strong>Through his use of the prime brokerage accounts, Mr. Rusnak’s trading activity grew. So did his losses and the bogus option positions. And so grew his use of Allfirst’s balance sheet. At some point in 2000, the Allfirst treasurer directed that trading income should reflect a charge for the cost of balance-sheet usage.

In 2001, Mr. Rusnak’s balance sheet usage drew the attention of the finance department, auditors and others (including Mr. Ray, who noted that Mr. Rusnak’s earnings were inadequate to justify his use of the balance sheet).

<strong>The deep-in-the-money options: </strong>Mr. Rusnak’s solution, beginning in February 2001, was to sell real yearlong, deep-in-the-money options. These options enabled Mr. Rusnak to fund his losses and keep trading. He sold five such options for a total of $300 million. These options thus raised a large amount of cash that was used to help fund the monthly settlement of Mr. Rusnak’s foreign exchange forward transactions. The options also allowed Mr. Rusnak to augment his core directional position.

These real, deep-in-the-money options were essentially synthetic loans made to Allfirst by the counterparties, which included Citibank and Bank of America.

<strong>More bogus options:</strong><strong> </strong>The real options Mr. Rusnak sold were liabilities of Allfirst. And they were recorded as liabilities on Allfirst’s books— initially. But to disguise his losses and his new method of funding them, Mr. Rusnak needed to get them off the books. To do that, he turned again to bogus options— deals that were purportedly transacted with the counterparties to the original deep-in-the-money options, and that gave the impression that the original options had been repurchased. The result, of course, was that Allfirst was saddled with massive, unrecorded liabilities.

<strong>Manipulation of the Value at Risk calculation: </strong>Mr. Rusnak manipulated the principal measure used by Allfirst and AIB to monitor his trading: <a title="Value at Risk (VaR)" href="https://financetrain.com/value-at-risk-var/">Value at Risk</a> (VaR). One way in which Mr. Rusnak manipulated the VaR figures was through the bogus options he created: those options, as noted, appeared to hedge his real positions, and so they reduced the VaR.

But Mr. Rusnak had another technique to manipulate VaR: false figures for so-called “holdover” transactions. Such transactions created the illusion of reducing Mr. Rusnak’s open currency position.

Mr. Rusnak achieved this scheme by directly manipulating the inputs into the calculation of the VaR that were used by an employee in Allfirst’s risk-control group. Thus, while that employee was supposed to independently check the VaR, she relied on a spreadsheet that obtained information from Mr. Rusnak’s personal computer and that included figures for so-called “holdover” transactions—transactions entered into after a certain hour toward the end of each day. But these transactions were not real and, indeed, unlike the bogus options, were not even entered on to the bank’s trading software.

Mr. Rusnak also engaged in a practice of entering false foreign exchange forward transactions in DEVON and reversing them before the next settlement date.

<em>This article is based on the Report to the Boards of Allied Irish Banks, p.l.c., Allfirst </em><em>Financial Inc., and Allfirst Bank Concerning Currency Trading Losses, which is a part of the FRM syllabus.</em>

AIB Currency Losses: John Rusnak's Role and the Fraud

<h2>Discovery of the Fraud</h2>
Mr. Rusnak’s fraud scheme started unravelling in early December 2001. This happened when the back office supervisor came to know that the option trades were not being confirmed and the back office employee explained to him that they did not require confirmation because they offset each other and were with Asian counterparties.

The back office supervisor replied that all trades require confirmations. He also pointed out that the trades in question did not offset each other because the options had different expiration dates. He also directed the employee to confirm the two option trades, and all similar trades in the future.

Apart from this, in early December 2001, the Allfirst treasurer had directed that the currency-trading balance sheet position be reduced to below $150 million. By January the balance sheet position had fallen to $150 million but the treasurer noticed that in mid-january it had spiked to $200 million in one day. This increased his concerns about Mr. Rusnak's trading.

In January, the treasurer decided to close all Mr. Rusnak's positions and instructed the supervisor to do so.

Even after that they noticed that Mr. Rusnak had some small trading in options. On scrutiny they found these trades to have similar pattern with no confirmations. They then found that there were 12 such unconfirmed trades with the Asian counterparties. When they contacted the counterparties to confirm the trades they found that such trades did not exist at all.

They checked this with Mr. Rusnak who told that he will cross check with the brokers who handled these trades and will get the confirmations by next morning. By next morning, Mr. Rusnak had left twelve written confirmations on the back-office employee’s desk. The back-office personnel reviewed the confirmations and concluded that the confirmations looked bogus. Subsequent investigation revealed that Mr. Rusnak had created these confirmations. When the back office manager asked Mr. Rusnak to confirm the trades, he did not.

Mr. Rusnak failed to appear for work on Monday morning, February 4, 2002. At that point, Mr. Rusnak’s supervisor and the senior back-office manager reported the bogus transactions to Allfirst’s treasurer. The treasurer reported the problem to Allfirst senior management, who in turn informed AIB.
<h2>The Magnitude of Losses</h2>
The total loss figure from Mr. Rusnak’s trading as of February 8, 2002, the end of the week the fraud was discovered, was $691.2 million, which was the figure reported by Allfirst to the public on February 20. That amount consisted of $291.6 million in bogus assets, $397.3 in unrecognized liabilities, as well as $2.3 million in legitimate trading losses incurred in 2002.

AIB: Discovery of Fraud, and Magnitude of Losses

There were many control deficiencies in Allfirst Treasury that made the fraud by Mr. Rusnak possible. The key control deficiencies are listed below:

<strong>1. The failure of the back office to attempt to confirm bogus options with Asian counterparties</strong>

This is one of the most important control deficiencies in the Allfirst’s treasury. Even though they had the policy that all the trades need to be confirmed, Mr. Rusnak was able to skip that from the process. In some way, he convinced the back office employees that these trades were offsetting transactions and need not be confirmed and that they were trades with Asian counterparties.

<strong>2. The failure of the middle and back offices to obtain foreign exchange rates from an independent source</strong>

The Allfirst’s internal audit and risk was unable to uncover the problems in the Treasury at many occasions. Even when they reported any problems or concerns, they were addressed by the treasury but relapsed quickly, for example the failure to obtain FX rates from independent sources.

Instead of obtaining the rates from independent sources, Mr. Rusnak got them to design the systems in such a way that rates were downloaded from Mr. Rusnak’s Reuters terminal to his personal computer’s hard disk drive, and then fed into a database on the shared network, making it accessible to the front, back, and middle offices. This issue was highlighted by internal audit but could not be controlled. This helped Mr. Rusnak to engage in price manipulation.

<strong>3. Other Deficiencies</strong>

There were also deficiencies in internal audit, as well as in the treasury risk control and credit risk review areas.

For example, the internal audit's samples failed to reveal any bogus option trades. Allfirst internal audit also appeared to have suffered from inadequate staffing, lack of experience, and too little focus on foreign exchange trading as a risk area. The entire risk assessment department only amounts to two people who are responsible for assessing risk company-wide at Allfirst.

For their part, the middle office and the credit risk review area failed to investigate the frequent instances where Mr. Rusnak exceeded the counterparty credit limits that AIB and Allfirst had established for foreign exchange trading. Neither the middle office nor the credit group considered itself responsible for investigating such excesses.

Control Deficiencies at Allfirst Treasury That Led to Fraud

There were many early warning indicators or missed opportunities for AIB or Allfirst to have detected Mr. Rusnak’s fraud. These missed opportunities are discussed below:

<strong>1. Failures of Rusnak’s superiors to adequately supervise his activity</strong>

Mr. Rusnak’s supervisors— his departed trading manager, the treasury funds manager, and the treasurer— failed to examine in any depth Mr. Rusnak’s positions and trades. Such a review should have occurred as a matter of course, but certainly should have taken place given the overall size of Mr. Rusnak’s positions, of which Mr. Rusnak’s superiors in Allfirst treasury, were aware.

<strong>2. Inadequate responses to issues with Rusnak’s trading that were identified</strong>
<ul>
	<li><strong>Prime brokerage account issues: </strong>Beyond this, Allfirst treasury personnel failed to give sufficient attention to issues about Mr. Rusnak’s trading that were identified. One such issue was the prime brokerage accounts. Treasury risk control was concerned about the usage of prime brokerage account. The Allfirst treasurer directed that the treasury funds manager bar Mr. Rusnak from using the prime brokerage accounts for a period of time. After a brief hiatus, Mr. Rusnak was allowed to resume trading, with the guidelines in the future there be an audit trail of each prime account trade entered into during the day.. There is no evidence that the front office supervisors scrutinized each of Mr. Rusnak’s trades. And the back office did not always confirm the end of day prime settlement.<strong></strong></li>
	<li><strong>Difficulties confirming Mr. Rusnak’s trades: </strong>The back office continuously had difficulty in confirming Mr. Rusnak’s trades.  The failure by treasury management to follow through on back office inquiries may have contributed to an attitude among operations staffers that the confirmation process was a pointless formality.<strong></strong></li>
	<li><strong>Citibank enquiry: </strong>AIB’s Group treasurer, Mr. Ryan, had received an inquiry from Citibank about a large gross monthly prime-account settlement that was due to occur at the beginning of April. the exposure was more than $1 billion. AIB and Allfirst did not look into this satisfactorily.<strong></strong></li>
	<li><strong>AIB’s contact with the Allfirst treasurer on market information:</strong> In late May 2001, a market source suggested to AIB that Allfirst was engaging in very heavy foreign exchange trading. This prompted a telephone call directly to Allfirst’s treasurer from Mr. Buckley. After looking into the matter, the Allfirst treasurer responded orally and in writing that there had been no unusual or extra large transactions in the last two weeks, and that Allfirst’s average turnover was $159 million. This response satisfied AIB.<strong></strong></li>
	<li><strong>The SEC comment letter: </strong>In September/October, the SEC had sent a comment letter on Allfirst financial statements which contained an inquiry into the cash flow related to foreign exchange activity. In researching the issue, the Allfirst financial reporting unit determined that Allfirst had at that time, large offsetting foreign positions. As a result of their concerns, they asked internal audit to pay special attention to trading in an upcoming treasury audit.</li>
</ul>
<strong>3. Failure of adjacent trader to notice or report on Rusnak’s activity</strong>

The trader responsible for covering customer foreign-currency trading sat next to Mr. Rusnak on the trading desk. They had separate telephone lines and a common one. They also shared a Reuters terminal. At times when Mr. Rusnak was away from the desk, Mr. Rusnak would communicate with the other trader about his (Mr. Rusnak’s) trading activity. The customer trader has denied any knowledge of improper conduct.

<strong>4. Failures to fully implement audit and supervisory recommendations</strong>

The reports of internal audit and risk assessment and supervisory examinations contained a number of recommendations relating to treasury control structures that were noted over time. While some of these recommendations were implemented, a number of others do not appear to have been fully addressed. There does not appear to have been any rigorous procedure in internal audit for ensuring that suggestions made by audit, risk assessment or in supervisory examinations were fully followed through in the context of the Allfirst treasury operations.

Early Warning Indicators: AIB Currency Trading Losses

Below are the recommendations with respect to improving the control environment at Allfirst and AIB. The controls in AIB should be benchmarked against these to ensure consistency
<ul>
	<li>First, business strategy in the trading areas should be reconsidered, specially proprietary trading. The scope and location of all proprietary trading activity within the AIB Group should be carefully reconsidered. Trading activities should be limited only to those markets where AIB has a real competitive advantage.</li>
</ul>
<ul>
	<li>Second, AIB should conduct a careful and thorough review of risk management architecture</li>
</ul>
<ul>
	<li>Third, there should be changes in the relationship between Allfirst and AIB. Lines of reporting for Allfirst treasury and other functions, particularly risk taking functions, should be crystal clear. There should be greater representation on the Allfirst Board by non-management directors of AIB and at least one such member should sit on the Allfirst audit committee.</li>
</ul>
<ul>
	<li>Fourth, AIB and Allfirst should conduct personnel reviews in light of the management and control failures that have been identified. Our findings make clear that AIB and Allfirst should review each and every member of the Allfirst Treasury department to determine if they have the necessary expertise to remain in their positions.</li>
</ul>
<ul>
	<li>Finally, if any proprietary trading and client-trading activities continue at Allfirst, they should be conducted only under the most controlled circumstances. The same types of rigorous controls should be applicable throughout the AIB Group wherever proprietary trading is conducted.</li>
</ul>

Recommendations for Improving Control Environment at AIB/Allfirst

Currency Trading Losses: Allied Irish Banks / Allfirst

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COURSE

Currency Trading Losses: Allied Irish Banks / Allfirst

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