AppId is over the quota
AppId is over the quota
By Douwe Miedema and Tommy Wilkes
LONDON | Fri Sep 16, 2011 11:49am BST
LONDON (Reuters) - Kweku Adoboli, the trader arrested in connection with a $2 billion loss at UBS, worked on a Delta 1 trading desk, a normally low-profile business requiring a deep knowledge of both the front and back-office of an investment bank.
Industry insiders said it was hard to see how the loss that UBS said had been racked up in unauthorised trading could have been caused by what are seen as fairly plain trading strategies, known as "vanilla" in industry parlance.
Jerome Kerviel, the trader sentenced to three years in prison over a 4.9 billion euros loss at Societe Generale (SOGN.PA) also worked in Delta 1 and knew his bank's systems well enough to be able to create fictitious hedging positions.
Market players, who declined to be named, said it was hard to imagine a loss as big as the one revealed by UBS on Thursday as a result of a legitimate trading position on a Delta 1 desk.
"It should be straightforward to see (a trader's accounts) on a daily basis and not have a big surprise ... unless there's a massive move and then you should be able to explain it," one person working in the sector told Reuters.
A good knowledge of both a bank's front and back office in principle makes it easier for a trader to game the system. This played a role in the earlier case of Nick Leeson whose trading in Singapore brought down British bank Barings in 1995.
Delta 1 strategies seek to maintain a high correlation between a derivative and the asset it refers to. Delta is the degree of correlation, and 1 is the highest on the scale.
Adoboli was a market maker in Exchange traded funds (ETFs) who worked in Delta 1 trading, according to his Linkedin page. He previously held a position of Trade Support Analyst, according to listing on the networking site.
ETFs are normally sold as a low-cost way for investors to get exposure to baskets of equities or other assets, and can be traded just like stocks.
In some cases they are designed with the use of derivatives to mimic the underlying asset without owning it. These are known as synthetic ETFs.
Delta 1 trading tends to have very low margins, the person working in the sector said, because the two instruments that are traded are so closely related. That forces traders to be on top of costs more than other desks.
"The traders tend to have a very intimate knowledge of all areas of the activity. They need to know their cost front to back. They tend to have a better understanding of the general set-up of the systems of a firm," the person said.
ETFs have experienced a surge in popularity from investors, disgruntled with the high fees fund managers are charging for picking stocks on their behalf without generating much of a return over the past few years.
REGULATORY GLARE
The instruments have been under scrutiny from regulators. The Financial Stability Board FSB.L, tasked by world leaders to curb systemic risk, told financial markets watchdogs in April this year to take a closer look at their proliferation.
While the most straightforward ETF portfolios mirror the index they are designed to track, many hold derivatives of the underlying securities, like swaps, futures and options.
These synthetic ETFs do not own the underlying securities and instead try to replicate them through derivatives. Regulators have specifically singled out these instruments, saying they are poorly understood.
The Bank of England said in June the product needs closer monitoring and the UK's Financial Services Authority has questioned if complex variants of ETFs were appropriate for small investors.
One ETF market maker explained that it is his job to replicate the securities that make up the ETF and then benefit from any discrepancy between the price for the replicated securities and the price in the market for the actual assets.
Any difference in currency between the derivative and the assets it seeks to track will need to be hedged. For example, market makers trading a Swiss franc-priced ETF that seeks to track the constituents of the S&P 500 may put a swap in place to hedge the move in the two exchange rates.
Getting this hedge the wrong way round could create losses.
"But the quantities involved would have to be so huge to generate a $2 billion loss. That sort of loss could not be created with the levels of market making people do normally," the market maker said.
(Additional reporting by Huw Jones)
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