Sunday, September 18, 2011

No lessons learnt - The UBS ETF scam

The $2 bn loss incurred by the rogue UBS trader Kweku Adoboli is surely another big blow to the confidence of the embattled European banking sector. It is also a reiteration of the fact that financial market regulators and governments have learnt little from the bitter lessons of the sub-prime mortgage meltdown.

Adoboli headed the Exchange Traded Funds (ETF) trading desk, which packaged ETF-based derivatives and transacted its trades for clients, and which are typically hedged to minimize risks. But Adoboli did not always hedge them, thereby exposing the bank to huge swings.

ETFs track financial indices and its value arises from either directly from an underlying index fund or a derivative with the index fund as the counterparty. It is the later which makes ETF's risky. If the counterparty suffers a huge loss, leaving it without the funds to service the derivative contract, then the ETF owner suffers huge losses.

Further, depending on the complexity of the packaging of the underlying index funds, the risk is dispersed far and widely across, making it difficult to accurately locate and price risk. In recent years, as ETFs have gained popularity, investment banks have even been packaging ETF derivatives to create "synthetic" ETFs (the counterparty is another set of derivatives). In this regard, it is similar to the complex and highly opaque Collateralized Debt Obligations (CDOs) and synthetic CDOs constructed by splicing and dicing and then packaging pools of mortgage loans.

The risks from activities of traders like Adoboli go beyond these. His 'Delta One' trading desk effectively conducted both client and proprietary trading. Investor clients were promised certain benchmark returns, with the excess returns going to the bank (and those in the trading desk), an incentive for the traders to take extra risk, often leveraging their employer's (bank's) balance sheet. Sometimes, even as banks sell ETF's to their clients, they themselves form the derivative counterparty (positions often taken with their proprietary capital), thereby creating the potential for deeply undesirable conflicts of interests.

Adoboli is only the latest in the long history of such rogue traders - Tomonori Tsurumaki of Sumitome, Nick Leeson of Barings, and Jérôme Kerviel of Société Générale - who caused huge losses to their employers and clients. Incidents such as these lend further weight to the argument that even the best monitoring cannot firewall a determined trader who tries to systematically mislead his employer, even over long periods of time. This naturally revives calls about separating commercial and investment banking operations in big financial institutions. An editorial in FT succinctly sums up the need of the hour,

"The narrow lesson is that derivatives can conceal risk as well as manage it. The broad lesson is that inherently risky investment banking must not be allowed to contaminate utility banking or the wider economy. It is a call to speed up efforts to increase investment banks’ capital buffers and the ease with which they can be resolved if the buffers are worn through. If this is done, the risks investment banks take on and the gains and losses that ensue are largely a matter between banks and their shareholders – provided that shareholders are not defrauded or misled."


The final report of the Independent Commission on Banking, appointed by the British Government to improve stability and competition in the British banking system, and headed by John Vickers, which was released a few days before, has much the same to say. It calls for ring-fencing investment and deposit taking retail banking and alos higher capital buffers for investment banks to limit systemic risks.

Ring-fencing will limit the taxpayer guarantees to individual and business depositers and will not cover the risks taken by traders within the investment bank. Today, the deposit insurance guarantee within the large universal banks (that combines all activities, not spearated from each other), acts as an effective public subsidy for their private investment banking activity. As Martin Wolf has argued, ring-fencing, and not outright separation (as was the case during the Glass-Steagall era in the US, which was replaced with the Gramm-Leach-Bliley Act in 1998), will retain the benefits of a single management - like an investment bank bailing out its failing retail banking division.

In this context, Matt Taibi raises an important point about inherently risk-taking investment banking traders and the apparent incompatibility of their activities with the need to protect the interests of retail depositers and tax payers. He argues that there is little distinction between rogue traders and most investment bankers, in so far as both have the freedom to take excessive risks with their client's money and bear limited direct and immediate responsibility to their clients' interests. He writes scathingly about the adverse consequences of the legal end to separation of retail and investment banking and the inherent risk-taking nature of investment bankers,

"the brains of investment bankers by nature are not wired for "client-based" thinking... it just defies common sense to have professional gamblers in charge of stewarding commercial bank accounts... Investment bankers do not see it as their jobs to tend to the dreary business of making sure Ma and Pa Main Street get their $8.03 in savings account interest every month... investment bankers by nature have huge appetites for risk...

The influx of i-banking types into the once-boring worlds of commercial bank accounts, home mortgages, and consumer credit has helped turn every part of the financial universe into a casino... They’re not "rogue" for the simple reason that making insanely irresponsible decisions with other peoples’ money is exactly the job description of a lot of people on Wall Street... they don’t call these guys "rogue traders" when they make a billion dollars gambling.

The only thing that differentiates a "rogue" trader like Barings villain Nick Leeson from a Lloyd Blankfein, Dick Fuld, John Thain, or someone like AIG’s Joe Cassano, is that those other guys are more senior and their lunatic, catastrophic decisions were authorized... if you're a well-groomed 60 year-old CEO who uses his authority to ignore quality control and internal audits in order to make disastrous trades that could sink the company, you get a bailout, a bonus, and heroic treatment in an Andrew Ross Sorkin book... rogue companies are protected at every level of the regulatory structure and continually empowered by dergulatory legislation giving them access to our bank accounts."


Felix Salmon's makes this excellent case for separating or atleast ring-fencing retail/commercial and investment banking activities,

"When you’re hiring people for the UBS trading floor, you’re hiring men who love to win, congenital risk-takers. And then you surround them with risk-management protocols designed to keep them under some semblance of control. There’s a natural tension there. And if you take the hundreds of thousands of risk-takers working on trading floors in London and Hong Kong and New York and Paris, it’s a statistical inevitability that one or two of them will go rogue every year or so.

Risk-managment protocols are important, but they can never be foolproof, because they’re run by humans. So we really shouldn’t let investment bankers — by which I mean risk-hungry traders with access to billions of dollars of balance sheet — anywhere near the systemically-important balance sheets of our largest commercial banks. Losses like the $2 billion at UBS are manageable. But they’re small beer compared to the entirely legitimate losses made by the likes of Morgan Stanley’s Howie Hubler during the financial crisis. He managed to lose $9 billion, and get paid millions for doing so."

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