If the $2 billion loss that ETF trader Kweku Adoboli has allegedly racked up was just about the worst news that UBS could have expected, it was also just about the worst news that the ETF market could have braced itself for as well. There has been sustained regulatory focus on the ETF industry for some time – partly as a result of the breakneck growth it has enjoyed (an annual 40% over the past 10 years). But it was the development of the kind of synthetic ETF exposures that Adoboli seems to have built up that has worried both market practitioners and regulators for some time. “We agree with concerns arising from the potential conflict of interest where swap-based ETFs and their derivative trading counterparts are within the same group,” Joe Linhares, head of Blackrock-owned iShares EMEA recently said, adding that he “particularly notes the concern that risks increase if the bank considers the synthetic structure as a stable and inexpensive source of funding for illiquid securities”.
Adoboli was a director of ETF and Delta One trading on the Delta One derivatives desk at the Swiss bank. The exact nature of the loss that he has incurred is not clear but speculation has focused on the possibility that it might have been triggered by a currency swap on an ETF. Synthetic ETFs constitute only 2% of OTC equity transactions but their development risks tarnishing the entire ETF market with a reputation for ill-defined risk – something that the UBS scandal will do little to assuage. “The drift of ETFs away from their original bearings is striking,” observed Bank of England deputy governor Paul Tucker in a July speech, calling for the regulators to act on ETFs that incorporate leverage, active management and synthetic structures. Memories of the damage wreaked by synthetic structures such as CDOs are driving much of the regulatory concern, as is the fact that these products are sold to retail investors. Lobbying by the industry against further regulation will have been dealt a mortal blow by Adoboli’s activities – and tighter regulation is now inevitable.
