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 the last three months.
UBS says that these positions were not in themselves extraordinary. Rather they were taken within 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. 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 all positions due for future settlement with outside counterparties and then manage associated cash flows and valuation adjustments.
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 which banks do not require confirmation and so be able put on “fictitious trades” with them.
It is to be hoped that all participants in the forward-settling cash ETF market are now reviewing their procedures.
Three investigation are underway 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 demand independent confirmation of trades.
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, the offsetting long and short positions often have to be very large and the episode has shown that banks overlook this at their peril.
Senior managers inside UBS would very much like the alleged fraudulent trading loss to be considered a speed bump, albeit a large one, in the road to rebuilding businesses that were almost shuttered in 2009 and not a reason to abandon the investment bank.
Already they will be struggling with how to stretch the inevitable restrictions on bonuses for this year to reward the most important individuals that have done a good job of rebuilding many of its businesses.
But tough questions will have to be answered. It has been suggested that Kweku Abodoli, 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.