Ruminations on Rogue Trading

Andy (mod note): 9/23/11 article from Damodaran - but the talk on Rogue trading is still VERY relevant today.
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We are in the midst of a "rogue trading" scandal and the media loves it. It started with this report in the Wall Street Journal about an unnamed trader who had lost $ 2 billion for the Swiss banking giant, UBS. The trader was quickly identified and named as Kewku Abodoli, a director at the UBS Delta One desk (more on that later). Today's story has more details, with a comment from Abodoli's lawyer about how much he regrets his actions (or at least getting caught). If you have a sense of deja vu, it is because you have seen this story play out before. Just to refresh your memory, here are some memorable rogue traders from times past, with one being famous enough (Nick Leeson) that he had a movie (and not a very good one) made about him.

What is rogue trading?
Rogue trading is trading by an individual, that violates his or her employer's norms and rules on investing and risk taking, exposing the entity to catastrophic risk. Note that rogue trading does not require "losses" to qualify. A rogue trader can take "catastrophic risks" and make millions or lose millions. Only the latter join the gallery of rogue traders, tarred and feathered by the media, and forced to do the perp walk. What about the rogue traders who make money? They are richly rewarded, celebrated as master traders and generally leave to start their own hedge funds. Enough said!
Why is there rogue trading?
So, why is there rogue trading? The answers are surprisingly simple and universal:
  1. Trading is addictive: Anyone who has traded knows that the process can be addictive, where trades lead to more trades, and at least for some people, there is no stopping the trading. 
  2. The search for the "big" payoff: It is human nature to aspire for the pot of gold at the end of the rainbow, the mega million dollar prize on the lottery and the trifecta  at the race track. In trading, that big payoff is (or at least seems) closer than in any other profession and many rogue traders start down their chosen path hoping to make the "big trade"...
  3. House money and Breakeven effects: In an earlier post on Jerome Kerviel, I noted that two well documented tendencies in behavioral finance: the tendency to take more risk than you should with other people's or house money and the proclivity to reckless risk taking, once you start losing money, to get back to break even. As you look across the rogue trading episodes, they all share this characteristic. These traders all started with small losses, which they tried to recover from with bigger bets, and the process kept escalating until you get to hundreds of millions of dollars. 
How do rogue traders generate these losses and how do they get away with it?
When we read about the magnitude of the losses that are generated by rogue traders, we are faced with two questions: How do you lose hundreds of millions of dollars? How is it possible to do so undetected?

Let's start with the first question. For a trader to lose hundreds of millions, he or she has to "lever" up and there are at least three ways this can be accomplished:

  1. Buy on borrowed money: You can borrow immense amounts of money on a small capital base, especially if you work at a large bank, and invest the amount in risky assets. You increase the upside on your equity investment, if you are right, but you magnify the downside, if you are wrong.
  2. Derivatives: You can make bets on derivatives that have potentially unlimited losses: this is the case when you buy or sell a futures contract on a commodity or a currency or when you sell options (either calls or puts).
  3. Long-short strategies: You can sell short on some risky assets, collect the proceeds and buy other risky assets, i.e., the hedge fund strategy. If the asset prices move in the right direction (your short sold assets have to drop in value while your long assets have to increase in value), you can make dramatic returns on small investments. However, if asset prices move in the wrong direction, your losses can be many times your equity investment.

Coming back to Kewku Abodoli, the rogue trader of the moment, it is worth noting that he traded on the "Delta One" desk. On the surface, Delta One desks are relatively placid and profitable places, where traders trade derivatives and exchange traded funds (ETFs) to take advantage of movements in the underlying assets (the delta in the desk name references the option delta, i.e., the percentage change in the option value for a unit change in the stock price). However, access to derivatives and ETFs can be a double edged sword, allowing a rogue trader to take very large risk exposures.

As for how rogue traders evade being caught, there are at least three possible explanations:
  1. Time lags in risk measurement/management systems: Given how quickly prices move in financial markets, there can be time lags in marking investments to market and learning about risk exposures. These problems are exacerbated with ETFs, since they are themselves often portfolios of traded assets which have to be marked to market. 
  2. Systematic measurement error in risk management systems: All risk management systems are based upon risk measures that are estimates. Thus, Value at Risk (VAR), a widely used risk measure at banks, has measurement error on many of its inputs, and some of these errors are systematic. For instance, a VAR that is based upon the assumption that asset prices move in a normal distribution will understate the risks of assets whose prices are discontinuous and tend to jump. Traders that learn about these systematic errors can then exploit them to hide real risks in their portfolios.
  3. Avoidance and Denial: It is possible that those who monitor the rogue trader get a sense that something is wrong much earlier than the final denouement. However, in a very human response, the first response is to deny that a problem exists and avoid it, until it blows up.
    How can you stop rogue trading?
    So, how can you stop the next rogue trader from bringing an institution down? As an institution, you can reduce the chance that you will be the next victim by doing the following:
    1. Hire the right traders: In my post on Jerome Kerviel, I pointed to the folly of entrusting trading to young men, a group that tends to take bigger and more reckless risks than any other subgroup of the population. I also suggested, only half in jest, that investment banks hire a few traders' mothers to trade alongside the traders, since older women are the perfect counterweight to young men in risk taking. I am sure that Mr. Abodoli would have been more cautious in his risk taking, if his mother had been sitting at the next desk.
    2. Real time and dynamic risk measurement systems: Risk management systems should track prices in real time and capture bad risk exposures early. 
    3. Restrict trading in illiquid assets: Even the most sophisticated risk management investments have trouble dealing with assets that are illiquid, where the prices are appraised values and not transaction values. As investing choices widen from traded stocks and corporate bonds to ETFs, derivatives and mortgage backed securities, risk management systems have come under more strain.
    4. Simple and focused risk management systems: Since inputs into risk measurement and management systems have systematic measurement error that traders exploit, simpler risk management systems that have fewer bells and whistles are more difficult to game. In addition, investment banks can borrow a technique that El Al, the Israeli airline, has used for years to keep terrorists off their planes. Rather than spreading their resources wide and check every passenger, they profile passengers and focus on those most likely to create problems. Banks can adopt a similar practice: rather than have risk management systems that track every trade in the bank, they can identify those areas, where rules are most likely to be broken and focus attention on them.
    5. Stress testing: Every risk management system will fail. It is a question of when, not whether. The key to good risk management is how you respond to failures in the system, not successes. Rather than assume that everyone is playing by the rules and measuring the consequences, it makes more sense to assume that some will not play by the rules and prepare for the consequences.
    6. Look at outcome and process, not just outcome: I started this post by noting that rogue traders who make millions are feted and celebrated. As long as we continue to do that, we will incite traders to take unconscionable risks. The best way to bring home the point that you will not put up with rogue trading is to fire a rogue trader who makes millions and to deny him his bonus.
    Here is the bottom line. The breast beating that happens after every rogue trading episode will subside. Banks will revamp their risk management systems and tell you that these new systems are now rogue-trader proof. I am a cynic, and I am sure that a few months or years from now, no matter what is done now, there will be another rogue trader at another bank. Consequently, I think it behooves all of us to be proactive about rogue trading:
    1. Top managers at banks: The six suggestions that I have above are all directed at management, but they will reduce, not eliminate, the likelihood of rogue trading. Top managers at banks have to consider rogue trading to be one of the risks that comes with proprietary trading. When allocating capital to different businesses (corporate banking, investment banking, proprietary trading) should incorporate this risk. (Proprietary trading will have to make a higher return on the equity invested in it to break even than commercial banking...)
    2. Investors in these banks: By the same token, investors in banks have to be cognizant of the risks that come with proprietary trading. A bank that generates a higher proportion of its profits from proprietary trading is riskier, other things held equal, than a bank that generates its revenues from traditional banking. If these banks trade at the same multiple of earnings, I would pick the latter over the former. In practical terms, I am suggesting that when screening for bargains among banks, we look at the percentage of profits from proprietary trading as a risk measure.
    3. Regulatory authorities: If rogue trading is part and parcel of proprietary trading, then it follows that institutions where the government provides a backstop should not be allowed to indulge in it. This is the basis for the Volcker rule in the US and the ft.com/intl/cms/s/0/34722f64-06de-11df-b058-00144feabdc0.html">new banking rules that are being discussed in the UK, both of which would bar commercial banks from proprietary trading. I agree.
     

    Bruno is not a rogue trader. Just a trader that was [very] long and [very] wrong. Its tiresome listening to politicians, who are veying for air time, speak about rogue trading and careless traders. Its just the price of doing business, more or less.

    To my knowledge, there was no hiding off his positions, or no blown out risk parameters. Once dealers figured out that there was a big player building a position and figured out what he was doing- Curtains... I personally saw this on the RUNS I was seeing after the original story broke...

    Example: You know a big player is reallllly long protection for XX, and you find out that he is not a long time value guy or hedging a particular name. As a trader, you KNOW he will be in the market to sell soon enough so you begin to proactively sell protection for XX. The story breaks, JPM says 'oh sh-t' now we HAVE to sell some protection on XX (unwind)... LOL too late, 100s of hedgies and dealers have already lifted the hell out of XX and now it trades several bp's tighter...

    You do this on a big enough position, you can easily lose $$. It doesnt take a rocket scientist to do this once his name and firm were put out on blast. But it does not make him a Rogue trader, the fact that he is still employed speaks to this point.

    "Sounds to me like you guys a couple of bookies."
     
    shorttheworld:
    You can lose 2 billion making markets in etfs?

    From the most recent statements from UBS, it looks like the trader did not have huge positions in EURCHF, as many initially suspected. Looks like the rogue trades took place over the course of the last three months, and the trader took on a huge amount of risk in SPX, DAX, and Euro Stoxx futures.

    Client: "Make me a market on a billion SPX futures, a billion DAX, and a billion Euro Stoxx" UBS: [Makes a two-way] Client: "Sold to you." UBS: [does this a couple of times, accrues $10bn long position, unhedged]

    In the last three months, SPX is down approx 5%, DAX down 24%, Stoxx down 27%. If you had an unhedged long that was on the order of $10bn, it's not out of the question that you'd be down $2bn. Seeing that, a $9 or $10bn unhedged position might explain the loss. It's pretty mind boggling. I'm not sure if that could be the whole story there. Over time UBS may provide more information about the specific trades

    Array
     

    How is that possible? You would have thought that after Jerome Kerviel, most banks would have risk assessed their trading to prevent losses tied "rogue trading". Even though I would not be surpised he had made them money in the past "rogue trading". Should that even be the term used?? What do you guys think?

    The dragon dozes off in the spirit which is its dwelling.
     

    Can someone explain what 'rogue trading' is?

    Is that prop trading for a BB gone wrong or something? Or is it a BS term made up for when a BB prop trader loses a fuck load of money?

     
    dmackorth:
    Can someone explain what 'rogue trading' is?

    Is that prop trading for a BB gone wrong or something? Or is it a BS term made up for when a BB prop trader loses a fuck load of money?

    This dude concealed positions from the bank that they claim to be unaware of OR He accessed more capital than he was allowed to and made a bet which failed. Or both :)
     

    Guys please, this whole case is a steaming pile of bullshit. It's pretty clear to me that he's just being made a scapegoat so that UBS can save face to their shareholders for posting a loss this quarter.

    -MBP
     
    manbearpig:
    Guys please, this whole case is a steaming pile of bullshit. It's pretty clear to me that he's just being made a scapegoat so that UBS can save face to their shareholders for posting a loss this quarter.

    Totally agree.

    http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/8764363…

    They just had to rip a wasted picture off FB and showcase it...

     
    ERGOHOC:
    He was a consistently profitable trader and few years back he made 60 mil for his firm and they only paid him 400K bonus. Probably that's why he blew it up.

    Switching firms would have been a lot better option, I believe. Call me crazy.

    [quote=patternfinder]Of course, I would just buy in scales. [/quote] See my WSO Blog | my AMA
     
    Macro <span class=keyword_link><a href=/resources/skills/trading-investing/arbitrage target=_blank>Arbitrage</a></span>:
    Just out of curiosity, did any of the previous rogue traders have an ivy league or target school background? Can't think of any.

    Given that a number were from Asia or Europe, that largely rules out the possibility for them (for Ivies, not sure about their equivalents of targets).

     

    their risk management people are probably going to get hounded and anal=probed, and lol @ the black guy jokes AHahah, there would be more if most of them ever made it to the ibanking level.

     

    Here's some WSO for ya'll.

    Mr Adoboli was hired by UBS after studying at the University of Nottingham (non-target), where he worked as communications officer from 2000 to 2001. He currently works in the bank’s Delta One trading business, responsible for making markets in exchange-traded funds (ETFs), instruments which have already drawn criticism from regulators.

    After he finishes his time in jail, we should bring him in as mentor.

    Array
     
    IronkidMS:
    Word was he was in Ops before joining the trading desk so he was familiar with (and probably) hiding his losses. Losing 2B this quick is pretty absurd esp. in ETFs...

    Just like JK was. And Leeson operated in a small office (Singapore was small, for Barings), where he had some responsibility/authority over ops in addition to his trading.

    Interesting.

     

    See...this is just another (in a long list of reasons) why you shouldn't allow back and middle office guys to move to the front office. Once in the front office, you are NEVER allowed to actually touch the payment systems the bank uses. NEVER. People raised groomed in the front office don't actually have any idea how the back or middle offices work. I, for instance, probably couldn't get away with hiding much in the form of losses. I just don't know the bank's systems well enough to do so.

    All I'm saying is this: if I were managing a bank, and the guy driving the armored car happened to be the very same guy that set up my vault, I'd expect to be robbed after giving him keys to the front door. He knew how to hide the money, manipulate the cash flows, and mask the risk. Then, the bank let him take risk. That's just stupid. You do that 100 times, and someone will cheat you. It's human nature. Some people are always going to look for an edge. This guy had an edge at UBS. He exploited it. He's human. Not all people would do the same thing. In fact, perhaps most wouldn't. But some would.

    You take a greater risk in moving a back or middle office guy to the front office than in training a new employee or hiring laterally.

     
    brotherbear:
    See...this is just another (in a long list of reasons) why you shouldn't allow back and middle office guys to move to the front office. Once in the front office, you are NEVER allowed to actually touch the payment systems the bank uses. NEVER. People raised groomed in the front office don't actually have any idea how the back or middle offices work. I, for instance, probably couldn't get away with hiding much in the form of losses. I just don't know the bank's systems well enough to do so.

    All I'm saying is this: if I were managing a bank, and the guy driving the armored car happened to be the very same guy that set up my vault, I'd expect to be robbed after giving him keys to the front door. He knew how to hide the money, manipulate the cash flows, and mask the risk. Then, the bank let him take risk. That's just stupid. You do that 100 times, and someone will cheat you. It's human nature. Some people are always going to look for an edge. This guy had an edge at UBS. He exploited it. He's human. Not all people would do the same thing. In fact, perhaps most wouldn't. But some would.

    You take a greater risk in moving a back or middle office guy to the front office than in training a new employee or hiring laterally.

    nuff' said.+1, I wish I could tell you all the racist shit that came out of my MDs mouth. According to him this type of news with the kind of lay offs going on is just the start of a "cleansing" in Wall Street.

    "The higher up the mountain, the more treacherous the path" -Frank Underwood
     

    He looks so friendly in all of the pictures on the news. It's strange that he's black and I'm not scared of him at all!

    Under my tutelage, you will grow from boys to men. From men into gladiators. And from gladiators into SWANSONS.
     
    leveredarb:
    shouldnt let people from non targets into the FO duh.

    lol nottingham

    Yeah, because no one from a target school has ever fucked up spectacularly.

    In the big picture, UBS is getting fucked worse by the old guard who are cutting off the ibank's balls.

    Get busy living
     

    Lol, if he lost 2billion who was the firm(s) that won it?

    Wait what if a black box did this to him and he is just a cop out for the big money managers that want HFT removed from exchanges and was paid off??!?!

     
    Massiveattack1987:
    The investment bank will not be get rid of because of this stupid action, but the investment banking will be shrinking and smaller in the future and besides, it will be harder to make money as an inverstment banker.

    Are you asian?

    [quote=patternfinder]Of course, I would just buy in scales. [/quote] See my WSO Blog | my AMA
     
    Massiveattack1987:
    The investment bank will be disposed of because of this stupid action, but the investment banking arm will be shrinking and become smaller in the future. What will happen is that it will become much harder to make money as an inverstment banker.

    I fixed it for you.

     

    BIg up to Bernie lol

    "Seeing this house and your fine sword and hearing how you're importing and exporting chinamen, let me guess, you must be fucking rich." Kenny Powdersss
     

    Fuck Bernie, the man is nothing but a blood sucking cockroach that should have had two in the head and left in an unmarked grave. You guys are giving props to a worm, nothing more. I am not saying I support all rogue traders, but if you want to admire someone look at Boesky, Raj, or anyone else. These guys put their own money at risk and I mean sure they used inside information, but they were just bending the rules of the game (like looking at another person's cards during a poker game when they went to the bathroom). They weren't stealing from people and destroying lives...they were simply improving theirs.

    "Greed, in all of its forms; greed for life, for money, for love, for knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA."
     
    Gekko21:
    Fuck Bernie, the man is nothing but a blood sucking cockroach that should have had two in the head and left in an unmarked grave. You guys are giving props to a worm, nothing more. I am not saying I support all rogue traders, but if you want to admire someone look at Boesky, Raj, or anyone else. These guys put their own money at risk and I mean sure they used inside information, but they were just bending the rules of the game (like looking at another person's cards during a poker game when they went to the bathroom). They weren't stealing from people and destroying lives...they were simply improving theirs.

    Hahaha. Those words, that avatar it's like Mike Douglas rolled up in here and told his cancer "king kong aint' got shit on me". Jokes aside, Gekko...correct me if I'm wrong, but wasn't insider trading approached laissez-faire pre-Boesky? I always wondered who's feathers he ruffled...must of been a mean ass turkey. I always thought Milken got off light in comparison.

     

    Wasn't it Giuliani grandstanding to be mayor that got them? Imagine if it wasn't an election year...

    Sick read by the way Midas.

    People like Coldplay and voted for the Nazis, you can't trust people Jeremy
     
    Jorgé:
    Wasn't it Giuliani grandstanding to be mayor that got them? Imagine if it wasn't an election year...

    Sick read by the way Midas.

    My dad's a Drexel guy... I've heard this about Giuliana over and over again throughout the years.

    looking for that pick-me-up to power through an all-nighter?
     

    Yeah, I am pretty sure it was enforced, but not a lot...probably because it was more difficult to track. With the increased technology it became much easier to get caught (which is why Raj had to employ burner phones). Another reason is because of the size profits that people were making off of it ---I don't know if anyone ever made the sums of money on insider trading like Boesky. Boesky got fucked because of the size of his insider trading operation and because he was a first---govt wanted to send a message. I am not entirely familiar with the Milken story, except that the evidence was not as strong and Drexel was paying for his defense.

    "Greed, in all of its forms; greed for life, for money, for love, for knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA."
     

    I agree, I think it was the size with Boesky. His positions in takeover targets were huge. If I remember correctly I think they got Milken on the LLP's/LLC's he made, not so much on the insider stuff.

    People like Coldplay and voted for the Nazis, you can't trust people Jeremy
     

    matter of fact, i think when you put a human element attached to a mechanical system, it is very likely to find the former chasing to outperform the latter. it is a natural.

    I am a corporate lawyer and I know a few lawyers who sometimes take on a massive risk on behalf their clients to get the extra reward...

     
    <span class=keyword_link><a href=/resources/skills/finance/buy-side>Buyside</a></span> <span class=keyword_link><a href=/resources/careers/designations/cfa><abbr title=Chartered Financial Analyst>CFA</abbr></a></span>:
    Dick Fuld was a thief? How?

    You wouldn't say that those repos LB was three-card monte shuffling on/off the books is tantamount to theft?

    How about: lying to Congress? leaving your whole staff to die while you play naive? etc...etc...

    Perhaps theft is not the most accurate word...is "scumbaggery" a usable term?

     

    I don't know about your assertion that it's 'not as crazy difficult.' They guy obviously took an unusual route. Worked for some real estate firm (not hard), then processed trades at Bear Stearns (operations? not hard), then become a junior trader from operations (very hard), then was good (hard), then got a job focusing on prop at a smaller bank (hard).

    I think part of it was luck. He probably didn't go through college with this planned out- it just happened. To get a BB S&T FT position right of the college and guarantee at least a short-term career in sell-side trading from the getgo- that would have been much difficult for him.

    Anycase the article definitely seems to be on his side. I don't think he was a 'rogue' in the sense of e.g Leeson. It looks like he was under a systematic risk management program and monitoreed by the senior traders. What I think- he was the dumbest trader who was the most to blame- thus they just gave him all the blame (better to ruin one person than every person).

     

    Step 7: Give everyone who works on a trading floor a bad reputation as the 24/7 media circus makes everyone believe that Wall Street is all about cheating, greed, and fraud.

    Metal. Music. Life. www.headofmetal.com
     

    Step 8: Make it that much harder for people who don't come from wealth to get ahead. +1

    In The Flesh:
    Step 7: Give everyone who works on a trading floor a bad reputation as the 24/7 media circus makes everyone believe that Wall Street is all about cheating, greed, and fraud.
    How does John Gapper's theory explain someone like Corzine? He didn't need any understanding of or help from the back office. Perhaps better risk management and security controls are really the bottom line in preventing huge losses...in other words: common fucking sense.

    There's an interesting paralell that I see: remember when 911 first happened, and every hack 'intellectual' started putting forward elaborate theories of why people become terrorists? The simple reality is that a broad spectrum of people with their own personal issues bought into an extreme and pathological worldview and then acted on it. Meanwhile, the worst internal mistakes were things like the Ft. Hood incident where someone contacted radical clerics while frequenting jihadist websites and somehow bypassed basic risk profile screenings...in other words: common fucking sense.

    Get busy living
     
    In The Flesh:
    Step 7: Give everyone who works on a trading floor a bad reputation as the 24/7 media circus makes everyone believe that Wall Street is all about cheating, greed, and fraud.

    Wall Street is all about cheating, greed, and fraud.

     

    The worst part about this is his boss was only there for about 2 months and they fired him. Makes you think UBS had to know about it and was positioning the guy to take the fall

    "You miss 100% of the shots you don't take. -Wayne Gretzky. Said by Michael Scott." - Michael Scott
     
    Short Lucifer:
    The worst part about this is his boss was only there for about 2 months and they fired him. Makes you think UBS had to know about it and was positioning the guy to take the fall
    His case in particular leaves a lot of room for a conspiracy theory: how does someone with so little experience have so much access? This is a rhetorical question, and the bank has itself to blame for leaving itself wide open. The trader is guilty, but the bank shouldn't have even been in that situation. As far as setting him up as a fall guy: at my last job, MDs sometimes came and told me to change shit before anyone saw it. I've often wondered what would have happened if things had gone south.
    Get busy living
     

    I like how this Brit slams Back office people as second tier candidates. At GS and JPM aren't the quants and IT people some of the smartest people by academic standards?

    looking at his contempt of these 'wannabes' i understand why England is such a low upward mobility shit hole.

     

    Same country that has roving vans with lethal injection teams in the back. When you have >1B people, kinda changes your view on the value of human life.

    If I had asked people what they wanted, they would have said faster horses - Henry Ford
     

    I don't understand these scams. They steal money and then buy gold and speculate on futures? I mean, really, if you're going to steal money like that, why wouldn't you invest it in some kind of sustainable income producing asset that would allow you meet at least some future redemptions? You could borrow against the asset too if necessary. Basically, you would get free financing and the ability to own the asset with much less risk than what these clowns are doing -- with some luck, you might even get away with the scam. But seriously, who buys gold with ponzi money? Pathetic.

     

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    - Bulls make money. Bears make money. Pigs get slaughtered. - The harder you work, the luckier you become. - I believe in the "Golden Rule": the man with the gold rules.
     

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    • 1st Year Analyst (202) $159
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    notes
    16 IB Interviews Notes

    “... there’s no excuse to not take advantage of the resources out there available to you. Best value for your $ are the...”

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    From 10 rejections to 1 dream investment banking internship

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