September 19, 2011 / 1:32 PM / 9 years ago

BREAKINGVIEWS - Five questions the UBS investigations must answer

(The author is a Reuters Breakingviews columnist. The opinions expressed are his own)

The paint covered Union Bank of Switzerland (UBS) logo is seen on the headquarters of the bank in Zurich in this January 18, 2009 file photo. REUTERS/Christian Hartmann/Files

By Peter Thal Larsen

LONDON (Reuters Breakingviews) - 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 picture that is emerging raises questions about UBS’s risk management. It also suggests possible flaws in the market for exchange-traded funds. Here are the five areas that investigators and regulators should focus on.

1. 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 profits or losses would have quickly raised the alarm. That is why the UBS trader allegedly created fake transactions which appeared to hedge the risk.

The fake trades fooled UBS’s 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’s trading desks. The investigators should make clear how such mistakes can be avoided in future.

2. 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 because 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.

3. 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 exchange-traded funds (ETFs) were created. These transactions were set up to settle in the future, which means that 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 will 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 because the transactions were fictitious. However, investigators will have to establish whether this was a loophole in UBS’s systems, or a broader market flaw.

4. Who was supervising Adoboli?

Even setting aside the red flags raised by cash flows, internal futures and ETF loopholes, questions specific to the Adoboli case remain. His alleged actions suggest he was very busy handling trades — both the unauthorised positions and the fake hedges — that did not involve UBS clients. Given that the positions produced a $2.3 billion loss, there must have been lots of them. Even if UBS’s risk systems failed to spot the problem, it’s surprising that the trader’s managers weren’t aware of it earlier.

5. 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 that risk management systems may not have kept up.

UBS has tightened up 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’s rogue trader scandal sends a stark reminder that relatively straightforward businesses like trading equities are far from risk-free.

CONTEXT NEWS

— UBS said on Sept. 18 the final bill arising from rogue trading at its investment bank was $2.3 billion, $300 million higher than the Swiss lender had originally estimated.

— In its first explanation of the fraud, UBS said the rogue trader had engaged in unauthorised speculative trading in futures contracts based on the S&P500, DAX and EuroStoxx indices.

— This activity was hidden by fictitious positions in exchange-traded funds, allegedly entered into by the trader, which offset the unauthorised contracts. UBS said its control functions had questioned the trader’s positions, prompting him to reveal the unauthorised activity on Sept. 14.

— Kweku Adoboli, a 31-year-old trader, was charged with fraud on Sept. 16.

— UBS said its board of directors has set up a special committee to conduct an independent investigation. The committee will be chaired by David Sidwell, former finance director of Morgan Stanley.

— The UK’s Financial Services Authority and Swiss regulator FINMA said on Sept. 16 that they had launched an investigation into the scandal, which would be conducted by a third party firm independent of UBS.

-- UBS statement: here

editing by Robert Cole and David Evans

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