Last Updated: 24 May 2021
What if, immediately after Japan’s tsunami and the subsequent Fukushima meltdown, we had decided to stop and decommission all outstanding nuclear plants around the world?
With the exception of extreme environmentalists, most people would probably prefer to avoid such a drastic, knee-jerk reaction.
It is not that nuclear plants, per se, have become any more dangerous after the tsunami. It’s the lack of suitable risk management procedures and the decision to build the Fukushima reactor at close proximity to the sea that should be questioned.
The case of the alleged rogue ETF trader, Kweku Adoboli, at UBS is not very different. Why?
In its press statement on 18 September 2011, UBS said:
“The loss resulted from unauthorized speculative trading in various S&P 500, DAX, and EuroStoxx index futures over the last three months. The positions taken were 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.”
The reference to the use of fictitious positions employed to conceal true economic exposure suggests an uncanny resemblance between the UBS case and the activities of Jérome Kerviel, the trader at Société Générale, who was jailed last year after incurring €5 billion of losses via unauthorised trading in 2008.
To understand the thin line of separation between so-called “rogue trading” and legitimate market-making activities that are the essential drivers of financial markets, some explanation is needed.
In addition to pocketing revenues from setting a small spread between the bid and ask prices for a security, market makers can also look to index arbitrage as a source of income. Such index-based trading, conducted on a so-called delta-one desk, was part of both Adoboli’s and Kerviel’s responsibilities. A delta-one trader continuously monitors the market to arbitrage away price differentials between baskets of stocks and related derivatives, such as stock index futures, swaps and ETFs. A characteristic feature of a trader working in this role as an arbitrageur is that both long and short positons are held, one offsetting the other. So, when the market moves in either way, gains made in one of the positions will be offset by the other exposure almost completely, leaving only small arbitrage gains to be extracted.
Kerviel succeeded in fooling risk managers at Société Générale in 2008 by building up huge long exposures to major European stock indexes, and, rather than offsetting them with opposite trades, registering dummy transactions on the bank’s computer system. Because one side of the hedging transactions was non-existent, namely the short position that would have gained should the market plummet, Kerviel had deviated from the arbitraging function of a trader to one of a speculator. He made unidirectional bets on the market. And, it’s worth reiterating, he did not need ETFs to accomplish this.
From UBS’s description of “fictitious, forward-settling, cash ETF” positions used to hide risk exposures, it’s clear that Adoboli claimed the economic benefit of having sold (short) the ETFs without physically delivering them to counterparties, making use of lengthy settlement periods. Bilaterally negotiated trade agreements are quite common in the over-the-counter markets where many European ETFs are traded, even if setting long settlement periods by design is not.
But immediate reactions to the UBS scandal that incriminate ETFs without investigating the full story are misleading and unhelpful. Calling ETFs parasites is not unlike claiming that nuclear power plants, in and of themselves, will end the existence of humankind. There is a reason why we have resorted to nuclear power. The benefits should outweigh the dangers for any pursuit to be rational.
It may well be that Adoboli exploited a loophole (see this IndexUniverse.eu article) in the way ETFs are structured, traded, and settled in order to make his speculative one-sided bet on European markets. But the pressing problem here is surely much bigger than ETFs and involves poor risk management procedures that need to be fixed and, more broadly, the misaligned incentive structures inherent in banks. It is very difficult to argue that such rogue trading would not have occurred if ETFs did not exist. Look at Kerviel.
Conceptually, the alleged UBS scandal is no different from Kerviel’s. But the scandal’s association with ETFs has spooked many. We should certainly try and root out the problem, but let’s be careful before drawing incorrect conclusions from inadequate evidence.