Following the money

UBS: UBS is beginning to lift the lid on its rogue trading scandal. Four days after dropping the bombshell, the Swiss bank released more details about how trader Kweku Adoboli allegedly ran up a $2.3-billion loss. The emerging picture raises questions about UBS’ risk management. It also suggests possible flaws in the market for exchange-traded funds (ETFs). Here are the five areas investigators and regulators should focus on:

Who was watching the cash?
UBS says the rogue trader took unauthorised speculative positions in futures contracts linked to the S&P, Eurostoxx and Dax indices. Though traders who handle such transactions for clients are allowed to take some risk, their exposures are normally subject to strict limits. Any big profit or loss would have quickly raised an alarm. That is why the UBS trader allegedly created fake transactions which appeared to hedge the risk.

 

The fake trades fooled UBS’ risk systems. However, the mismatch should still have been apparent from the bank’s cash flows. As the unauthorised positions fell in value, they would have triggered margin calls, prompting payments to UBS’s counterparties. Had the trades been properly hedged, UBS would have simultaneously received matching cash inflows. But, because the hedges were fake, the loss-making transactions consumed cash. This clear warning signal appears to have been lost in the huge volumes of business that flow through UBS’ trading desks. The investigators should make it clear how such mistakes can be avoided in future.

Why didn’t the alarm bells go off sooner?
According to a person familiar with the matter, the unauthorised positions were initially hidden through the creation of fictitious trades with other parts of UBS. These trades, known as “internal futures”, do not require confirmation as they are conducted inside the bank. UBS controllers questioned this activity as early as July, and did not receive a satisfactory explanation. This looks like a big missed opportunity to stop the scandal at a much earlier stage.

Is there a flaw in the European ETF market?
Once the discovery of the use of internal futures raised questions, UBS says fictitious positions in ETFs were created. These transactions were set up to settle in the future, which means no cash had to change hands immediately. Here, UBS was left exposed by a crucial market weakness. According to a person familiar with the matter, some European banks enter into ETF transactions with other lenders without requiring confirmation of the trades. The UBS rogue trader allegedly knew which counterparties would not require confirmation, and created fictitious transactions with them. It’s unclear which banks do not require confirmation for such trades. They are not directly implicated in the scandal, as the transactions were fictitious. However, investigators will have to establish whether this was a loophole in UBS systems or a broader market flaw.

Who was supervising Adoboli?
Setting aside the red flags raised by cash flows, internal futures and ETF loopholes, questions specific to the Adoboli case still remain. His alleged actions suggest he was very busy handling trades — both unauthorised positions and fake hedges — that didn’t involve UBS clients. Given the positions produced a $2.3-billion loss, there must have been many of them. Even if UBS’s systems failed to spot the problem, it’s surprising the trader’s managers were unaware of it.

Is this something that could only happen at UBS?
The details that have emerged so far suggest UBS’s risk management systems have multiple flaws. However, the fact that one of the world’s largest equity trading businesses could suffer such a loss raises the question of whether its rivals are any safer. On the face of it, structural weaknesses in the ETF market may have contributed to the breakdown. Trading in ETFs has grown very quickly in recent years, suggesting the risk management systems may not have kept up.

UBS has tightened its risk management since the financial crisis. But, like other banks, it has concentrated on improving controls in more complex businesses, such as structured finance, that were responsible for the biggest losses. UBS’ rogue trader scandal sends a stark reminder that relatively straightforward businesses like trading equities are far from risk-free.