Last Updated: 22 November 2023
In a short statement released on Sunday afternoon by UBS, the Swiss bank explained that “fictitious, forward-settling, cash ETF positions” entered into the bank’s risk systems contributed to a US$2.3 billion loss at the firm. But how, specifically, were ETFs involved in the trading scandal?
In outline, the fraud allegedly committed by Kweku Adoboli, the UBS trader arrested last week, appears straightforward. In a typical combination of transactions at an investment bank’s “delta-one” desk, one type of index-related trade is supposed to be offset, or hedged, by another.
However, UBS explained yesterday, the hedges supposedly entered into by Adoboli to offset long positions in futures on the S&P 500, DAX and Euro Stoxx 50 indices didn’t actually exist. The exit from long positions in those stock futures, now heavily in loss after recent equity market declines, resulted in a US$2.3 billion shortfall for the bank.
There’s so far little detail when it comes to the fictitious hedging transactions apparently contracted by Adoboli. UBS, however, has given a hint to the nature of the deals by its disclosure of the terms “forward-settling” and “cash ETF”. According to market convention in Europe, transactions in ETFs, like those in equities, are settled on the second or third day after the initial contract is agreed. By agreement, however, and particularly in bilateral (“over-the-counter” or “OTC”) transactions, settlement can occur either sooner or later.
There is also a widely reported problem of settlement delays when it comes to ETFs, particularly in Europe. Such delays are usually attributed to inefficiencies resulting from the fragmentation of the region’s clearing and settlement systems. One trader, quoted in a recent IndexUniverse.eu article, said that more than half of ETF trades contracted in London—where Adoboli worked—involve late settlement.
However, UBS’s statement appears to suggest that the fictitious ETF trades (presumably short sales) created by Adoboli were specifically designed to have long settlement periods. According to several market makers contacted by IndexUniverse.eu this morning, all of whom requested anonymity, trades in ETFs with lengthy, non-standard settlement periods are very unusual if undertaken between banks and other professional traders, though slightly more common if contracted between traders and their institutional investor clients.
Why Adoboli reportedly used ETFs for the alleged fraud, rather than another type of equity derivative instrument, was a question that perplexes many market observers.
“If you wanted to enter a long-dated forward contract on an equity index, you’d be better off using an equity swap than an ETF,” said one trader. “ETFs complicate things as you’d need to finance the position, make an adjustment for the ETF fee, and so on.”
At first glance, the reported UBS fraud is reminiscent of the deceptions committed by Jérome Kerviel at Société Générale in 2008 and by Nick Leeson at Barings Bank in 1995. In his fraud, for which he received a five year prison sentence, Kerviel entered fictitious trades in securities and warrants, using deferred start dates, into his bank’s computer systems, as well as entering futures trades with a counterparty which was lax in requesting the confirmation of transactions. At Barings, Nick Leeson created fictitious trades in futures contracts tracking Japanese equities, bonds and interest rates, while simultaneously conducting unauthorised trades in options. The combined losses from Leeson’s trades eventually brought down the bank.
In all three cases—Leeson, Kerviel, and now Adoboli (if proven responsible for defrauding UBS)—a common theme appears to have been the individuals’ familiarity with banks’ back-office procedures and a knowledge of how to circumvent the relevant systems.
But—despite the fact that the Barings, Société Générale and UBS frauds were committed using a variety of index-related financial instruments—several commentators have pointed the finger at ETFs as specifically responsible for the latest rogue trading scandal.
“I have long thought and written that there is a certainty that ETFs are being mis-sold to the retail market and that the risks that are being incurred in running, constructing, trading and holding them are not sufficiently understood,” argued fund manager Terry Smith in a blog entitled “ETFs—you were warned”, published on Friday. Gillian Tett, the US editor of the Financial Times, wrote that she had warned in May of an impending ETF-related scandal, but had not expected one to arrive so soon. “ETFs are market parasites,” exclaimed Jim Cramer of thestreet.com, more colourfully, in response to the UBS loss. “ETFs have the potential to become the next toxic scandal,” wrote Tom Stevenson, an investment director at fund manager Fidelity, in an article published in the Daily Telegraph on Saturday.
Several ETF industry participants contacted by IndexUniverse.eu disagreed.
“In my opinion this story has nothing to do with ETFs whatsoever,” said the head of market making at one specialist trading firm, who did not wish to be quoted. “It’s simply a case of unauthorised trading. Kerviel had millions at risk in Euro Stoxx 50 futures, while Leeson was involved in Nikkei 225 futures, but I don’t recall anyone saying that the futures contracts were responsible for the banks’ losses in those cases.”