Delta one concerns could lead to a further reduction of liquidity

The rogue trading incident at UBS that led to a £29.7 million fine for the Swiss bank may cause a further contraction of prop trading activity, further limiting access to liquidity for the buy-side.

The rogue trading incident at UBS that led to a £29.7 million fine for the Swiss bank may cause a further contraction of prop trading activity, further limiting access to liquidity for the buy-side.

A joint investigation by the UK’s Financial Services Authority and Switzerland’s FINMA uncovered a number of failings at UBS that allowed Kweku Adoboli, a former trader for the bank’s London-based global synthetic equities division, to incur and disguise losses totalling US$2.3 billion between June and September 2011. The losses were accumulated on exchange-traded index futures and hidden by the use of late bookings of real trades, booking of fictitious trades to internal accounts and the use of fictitious deferred settlement trades.

"Failures of this type in firms of the size and standing of UBS not only damage the firms concerned but also wider confidence in the integrity of the markets and the financial system,” said Tracey McDermott, director of enforcement and financial crime, FSA. “It is imperative that the markets we regulate are seen by investors to be orderly and a safe place to do business.”

Last week, Adoboli was jailed for seven years after being found guilty on two counts of fraud by Southwark Crown Court, London.

In a trading environment that is already beset by lower market activity and increased regulatory pressure, some buy-side traders believe that the incident may affect the way large brokers facilitate client trades.

“This incident is likely to lead to a further contraction of the big risk books held by banks, which will mean the willingness of the large full-service brokers to commit capital will be severely diminished,” Tony Whalley, investment director, head of derivatives and equity dealing at Scottish Widows Investment Partnership, told “The reduction in liquidity stemming from the shrinking of banks’ prop desks will be exacerbated by on-going regulatory pressure and the shrinking attraction of equities, as investors increasingly favour bonds and other fixed income instruments.”

Banks that take deposits are facing a limitation of their proprietary trading activities in both the US and Europe. The Volcker rule included in the US Dodd-Frank Act bans deposit-taking institutions from engaging in prop trading, while Europe is still mulling whether to impose a similar separation following the recent publication of the Liikanen review. The report, authored by Finnish central bank governor Erkki Liikanen, recommended that banks with trading assets exceeding €100 billion, or 15-25% of total assets, should separate retail banking from prop trading. Meanwhile, Basel III, the latest set of capital constraints to be imposed following the financial crisis, will make it more costly for banks to hold risky assets on their balance sheets.

Looking inwards 

But the sheer amount of new regulation on capital requirements could mean that greater attention is instead focused on internal risk management controls.

Simmy Grewal, Aite Group“Banks will take action based on the UBS case but it is more likely to focus on enforcing stringent criteria for employees that have access to proprietary capital,” said Simmy Grewal, senior analyst at Aite Group. “I hope this incident highlights the need for better internal risk measures that cant just be clicked through and ignored.”

The FSA noted that supervision of front-office activities with UBS’ global synthetic equities division was lacking and that excessive risk taking on the desk was not actively discouraged or penalised.

The UBS case has also led to further scrutiny on the use of synthetic exchange-traded funds (ETFs), the instruments used by Adoboli that replicate the exposure of sectors or a collection of securities without holding the underlying assets. Synthetic ETFs use swaps and derivatives to replicate an exposure and can lead to greater counterparty risk as the underlying instruments used are typically unknown to the end investor.

"The incident has again highlighted the opacity of synthetic ETFs and I would expect it to result in a further move away from these instruments in favour of physical ETFs,” said Paul Squires, head of trading at AXA Investment Managers.

But while investors appear to be favouring physical ETFs – providers Lyxor and db x-trackers both announced the launch of their first physical ETFs in recent months – the wider range of exposures synthetic instruments offer mean they will continue to be sought after by investors.

“Synthetic exposures wont ever go away, especially with things like the financial transaction tax, which are leading investors to seek alternatives to equities,” added Grewal.