TEAM ONE: BUSINESS DISRUPTION AND SYSTEM FAILURE

KERVIEL ASSET MANAGEMENT

BACKGROUND

KAM was established five years ago and is based in New York, New York. It currently has $1
billion in assets under management, and it invests in distressed securities. Last year it produced
a 16 percent return. There are 35 staff: Mr. Kerviel owns and manages the firm. He has a team
of five lead managers, each of whom manage a fund and have a team of three traders each. Mr.
Kerviel handpicked the lead managers (four men, 1 woman), and the lead managers selected
their own teams. There is no formal compensation structure; salary and bonuses are at the
discretion of Mr. Kerviel.

KAM has support staff that includes marketing, administrative, legal and compliance, and
accounting, and it outsources its human resources (HR) and technical support functions. It also
outsources its operations function through the use of prime brokerage services. Any disputes or
issues regarding trading activity are dealt with by phone by the traders and their prime
brokerage contacts. They receive monthly prime brokerage statements.

KAM purchased new information technology (IT) equipment when it started the fund five years
ago. It has not purchased new equipment since then. It leases half a floor in a new office block
near Grand Central Station and has a common reception area that it shares with the other
tenant, a bankruptcy law firm.

Its clients are high-net-worth private investors, who receive quarterly performance reports.

It conducts research using externally provided market data sources and through their
investment banking relationships.

Mr. Kerviel has recently hired an operational risk manager, who is conducting operational risk
assessments.

Your team has been asked to assess the risks at the firm for the operational risk Basel II
categories. Read the real cases for your risk category and review the Basel II definition of your
category. Use the real cases and the definitions to help you identify at least five risks in your
category that could occur at Kerviel Asset Management. Propose at least one control for each
risk that could mitigate the risk exposure.

Read the following real cases to assist you in determining what types of Business Disruption and
System Failure risks exist at KAM. Consider all of the Basel II Level 2 and 3 examples that are
listed at the end of your reading materials below.

Real Events for Business Disruption and System Failure

Event 1
On April 30, 1997, the Securities and Futures Authority (SFA) fined Fidelity Brokerage Services GBP 200,000
and asked the discount brokerage to pay investigative costs of GBP 162,500, for failing to properly implement a
new computer system and failing to train and supervise its employees sufficiently. Before it was fined, the
company had been given a nonmonetary penalty by the SFA, which prohibited the firm from soliciting new
customers for six months.

This technology risk incident arose because Fidelity converted to a new computer system at the same time that it
was trying to increase business. The new system was not tested adequately, and when its glitches were
combined with an increased volume of users, the brokerage encountered problems with its accounting and
reconciliation processes. A Fidelity spokesman said that the glitch included “things like dividends not being paid
on time.” It affected backroom trade settlements for customers in London.

Event 2

The London Metal Exchange (LME) was forced to delay the launch of its new “e-mini” contracts by two weeks
until December 4, 2006, after a software glitch shut down the LME Select electronic dealing platform for two
successive days; this forced the LME back to floor trading. The software vendor Cinnober Financial Technology
of Sweden, which runs LME Select, is investigating the platform’s most serious disruption since 2000.

The LME was testing the new LME e-minis when the system failed. Although it is not known how much business
was lost due to the shutdown, it affected customers of banks that depend on the electronic system. These
included Dresdner Kleinwort and Bear Stearns, which operate electronic systems that are connected to the LME
network. According to an LME trader: “It has clearly had an impact on volumes ... there are a lot of funds and
clients now that will only accept particular stop-loss executions if there is a print on Select.”

The LME installed the Select software upgrade around 0100 London time on November 6, when Asian markets
opened, and it shut down the electronic trading system completely around 1030, after European traders had
signed on. Similar problems forced a shutdown of the system at about 0010 on November 7, about 10 minutes
after trading reopened at midnight. The shutdowns forced the exchange to fall back on twentieth-century
technology for a while—to open-outcry floor trading—until a rollback was possible.

Lessons Learned

This case illustrates the dramatic impact that the new software implementation and new products can potentially
have on a trading platform. The disruption has been called the most serious to occur in the Select system since
its launch in 2000. The two-day shutdown, which Reuters called “embarrassing and untimely,” also raises
questions among futures traders about the stability of the Select system and whether it will be scalable to the
desired increase in volume.

In the wake of the malfunction, traders were concerned about the lack of transparency when trading only
occurred in the open-outcry LME floor and over the telephone. Hedge funds, which are expected to be a major
market for e-minis, may choose to hold off if their strategies depend on intraday price movements. One hedge
fund manager told Reuters “It might be a problem for some of our competitors, which trade intraday. But there
isn't anyone I know who, if they didn't close, would be declared insolvent.”

Event 3 The largest electricity failure in the modern history of the United States occurred on Thursday, August
14, 2003, and resulted in a blackout that spread through New York City and parts of New Jersey, Ohio, Michigan,
Connecticut, and Canada. An unprecedented 50 million people were estimated to be without power for
approximately 24 hours.
Basel II Risk Category: Business Disruption and System Failure

Category (Level 1) Categories (Level 2) Activity Examples (Level 3)

BDSF: Systems ❖ Hardware
❖ Software
Losses arising from ❖ Telecommunications
disruption of business ❖ Utility outage/disruptions
or system failures

Team One Solution

1. What are the losses which are called BDSF? What could be the demerits of not buying
any new equipment (IT) for long time?
2. What is better in doing research with reasons?
a. Use externally provided data
b. To generate own data
3. Identify at least five risks in your categories that could occur at Kerviel Asset
Management.
4. Propose at least one control for each risk that could mitigate the risk exposure.

Risk Proposed Control (s)