According to the bank, the loss resulted from what it calls "unauthorized speculative trading" in various S&P 500, DAX and EuroStoxx index futures over three months. UBS says that these positions were not in themselves extraordinary. Rather they were taken within what it calls the normal business flow of a large, global equity-trading house as part of a properly hedged portfolio.
"However, the true magnitude of the risk exposure was distorted because the positions had been offset in our systems with fictitious, forward-settling, cash ETF positions, allegedly executed by the trader," the bank said. "These fictitious trades concealed the fact that the index futures trades violated UBS’s risk limits."
In most traded markets a bank’s finance, risk-control and audit functions would be required to confirm within a day or two at most all positions with outside counterparties and then manage associated cashflows, margin and valuation adjustments in the run-up to settlement.
It seems that a particular loophole existed in forward cash-settling ETFs, because the convention among European banks that trade these instruments does not automatically require such confirmations. Some banks do require them, but not all. So a rogue trader with experience in the back office might know against which bank names to enter "fictitious trades".
It is to be hoped that all participants in the forward-settling cash ETF market are now reviewing their procedures.
Three investigations are under way at UBS, a speedy one being conducted by the bank itself to work out what went on, and two further independent investigations for the bank’s board of directors and its lead regulator. Each must ask why a bank with UBS’s unfortunate track record through the credit crisis did not adhere to the very strictest standards of risk control and itself request confirmation of trades, even with counterparty banks that do not send these out routinely.
Such index versus cash trading activity is designed to wring tiny margins out of discrepancies in large but market-neutral matching positions in cash and derivatives. However, while the risks are small in theory, the offsetting long and short positions often have to be very large. Banks overlook this at their peril.
It has been suggested that Kweku Adoboli, the trader charged by the UK authorities, had come to the attention of the bank’s risk controllers some three months before the loss that will wipe out most of the investment bank’s profits for the year came to light. Sources say that when his activity attracted attention, he then changed to dealing in the forward-settled ETFs.
Benefit of hindsight is a wonderful thing of course. But if a warning light was already flashing against a trader’s name, it seems extraordinary that the bank did not make greater efforts to verify his position-taking.
There’s also a delicious irony in the fact that, as Euromoney discovered, UBS’s operational risk unit used a database with detailed information of other unauthorized trading losses such as those at Barings and Société Générale.
After UBS took such enormous losses in the sub-prime crisis that it had to be rescued by the state, it published its own investigation into what went wrong.
This showed, among other horrors, that the bank’s risk assessment of CDOs of ABS failed to look through to the quality of the underlying collateral and, because it used a five-year history of low volatility, decided that once it had insured against the first 2% of potential losses on super-senior positions it could designate them as completely de-risked. They didn’t even show up in its value at risk calculations.
That report showed the bank had been ill-equipped to take risk in such complex instruments. This latest episode suggests that, three years on from a near-death experience, its controls weren’t up to putting on the simplest basis-risk trades. The bank should not have been conforming to loose standard practice but rather to the highest standard of market best practice.
UBS seems to think that the more entrepreneurial ultra-high-net-worth clients of its private banking division want it to maintain a top-rank investment bank. But its efforts to boost earnings through such big synthetic equity trades put on by traders with little experience hints at a certain desperation.
And amid such market turbulence its more sophisticated clients must look at UBS losing such sums through simple control errors and see a toddler playing with a loaded pistol.
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