Rogue trader scandal highlights buy-side caution on delta one

The recent rogue trading incident at UBS has reinforced buy-side concerns over brokers' delta one desks, but opinion is divided on whether a European Volcker rule might have made prevented it.
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The recent rogue trading incident at UBS has reinforced buy-side concerns over brokers' delta one desks, but opinion is divided on whether a European Volcker rule might have made prevented it.

With an announcement due this week on UBS's internal investigation, buy-side traders have expressed unease over the scope for risk-taking on some delta one desks and a trend towards promoting back office staff to front of house.

Ahead of its upcoming results announcement, UBS today disclosed that it expected to report a “modest” net profit for Q3 2011, despite the rogue trading that cost the investment bank US$2.3 billion. Meantime, former delta one trader Kweku Adoboli has been remanded in custody until 20 October, facing fraud and false accounting charges. Adoboli's actions led to the resignation last week of UBS chief executive Oswald Grübel and strengthened calls in Switzerland to separate retail from investment banking.

A total of four investigations have been initiated. In addition to the bank's internal investigation is a Scotland Yard inquiry headed by the UK's Serious Fraud Office. The UBS board has also commissioned an independent probe and two regulators – the Swiss Financial Market Supervisory Authority (FINMA) and the UK's Financial Services Authority (FSA) – have hired accounting firm KPMG to head a joint investigation into the affair.

While claiming no insider knowledge of the case, few buy-siders have been surprised that the opportunity to rogue trade arose on a delta one desk. “These desks have the biggest potential for blow-ups,” said one buy-side trader, speaking on condition of anonymity.

According to UBS, Adoboli conducted unauthorised speculative trading alongside ”real' trades, hiding his positions within UBS's systems with fictitious cash exchange-traded funds (ETFs) positions.

Many buy-siders believed the reason Adoboli was able to fly under the radar for so long was a combination of the nature of delta one desks and Adoboli's experience in the back office.

Prop trading conflict

Although the name may suggest an elite special forces unit, delta one is no crack team. The delta measures the rate of change of the value of an option in relation to changes in the underlying asset's price: the closer to the value of one, the more the option behaves like a regular stock. Hence, delta one desks are often viewed as more similar in nature to cash desks than to complex derivatives.

“There is nothing intrinsically different or special about a delta one desk,” said the head of a buy-side trading desk. “Their danger comes from straddling trading for clients with prop trading.”

One buy-sider spoke to said there was a clear conflict of interest if prop trading is permitted on a delta one desk underneath or alongside client money.

“Prop trading in this environment should not be allowed but the reality is it has always taken place. And delta one desks are specifically designed to do it,” he said. “If a bank cannot differentiate between dark and lit pools, how can you expect them to differentiate between prop trading and trading for their clients?”

“There is a lack of transparency on delta one desks which is breath-taking,” said another buy-side trader who declined to be named.

In particular, Adoboli's actions have thrown a harsh light onto synthetic ETFs, which have been criticised for their lack of transparency and complexity in design.

An on-going review of the instrument by financial watchdog, the European Securities and Markets Authority (ESMA) has recently highlighted unanticipated systemic risks in ETFs.

ESMA said while actively-managed ETFs used the standard structure of an ETF, the manager had discretion in relation to the composition of the portfolio. This can lead to a widening disparity between the ETF and the underlyings in the event of a market dislocation. It is also the discretion and opacity of synthetic ETFs which many believe allowed Adoboli to hide his positions.

A European Volcker rule?

In the United States, a new piece of legislation dubbed the Volcker rule will effectively ban proprietary trading alongside client money. While the new law – which is part of the sweeping financial regulatory reform contained in the Dodd-Frank Act – is currently facing severe delays, it aims to limit deposit-taking institutions' involvement in riskier activities.

Europe has so far been unwilling to consider similar measures, but if such a law had existed, it may have prohibited the actions of Adoboli. However, many buy-side traders believed the idea of a European-style Volcker would be a knee-jerk reaction, albeit sound in principle.

“At the moment, on delta one desks, the line between prop trading and client trading is hard to differentiate,” said one buy-side trader. “Customers should be made more aware of this situation or it should be banned entirely.”

Other buy-siders disagreed. “A European Volcker rule would not have made any difference,” said one trader. “A Volcker rule would not have stopped a trader going rogue. It simply would have been one more rule he was prepared to break.”

For many buy-siders, key to the problem is the promotion to the front office of back-office personnel who know how to hide trades.

“If you don't know the tricks – how to log-on under a different name or hide trades – then you can't be tempted to do it,” said one buy-sider, who railed against a culture of promoting people through the back office.

“Even though in many cases, promoting back-office staff works well, when it doesn't, it can blow a hole in your organisation,” he said. “There must be a Chinese wall and often times there just isn't.”

One head of a buy-side trading desk went so far as to say if staff had previously worked in settlements, there should be a barrier to entry to the front office. “I won't employ back-office people in the front office,” he said.

Epic control fail

While there are usually mitigating circumstances, many buy-side traders believed rogue trades incur maximum damage when they are caused by a breakdown of normal control factors.

“This raises the need to scrutinse systems and controls,” said Peter Snowdon, partner, financial services group, at London law firm Norton Rose. “Inevitably, when you are dealing with bright people who are encouraged to take risks, you must have the controls in place. It seems something was missed here.”

Providing his own business as an example, the head of one buy-side trading desk said he renewed his staff's passwords and system access annually: “If someone moved from the back office to the front, they would be required to relinquish any previous access they had to back office systems.”

While there are no such specific regulatory requirements, in 2008, the FSA released suggested guidelines for banks after Société Générale rogue trader Jérôme Kerviel – who, like Adoboli, was also promoted from the back office to work on a delta one desk – lost the French bank €4.9 billion.

At the time, the FSA suggested one effective control was to require users to change their passwords from time to time and perform ”location checks' to ensure, for example, a front-office person could not log on to a computer in the back office.

“Firms should consider whether IT security and access controls are properly implemented to ensure that users may only access those functions that their duties require,” the FSA said at the time.

“The real issue is about risk and how it is monitored,” said a buy-side trader. “As far as buy-side traders are concerned, many of us look at delta one desks and see real investment and reputational risk.”