How could UBS not have learnt from SocGen?

September 15, 2011

By Margaret Doyle
The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

It has happened again. UBS has $2 billion of losses from unauthorized trading in the Swiss bank’s supposedly safe “Delta One” equities business. This is the area that spawned a massive fraud at French bank Societe Generale in 2008, leading to $7 billion of losses as the trades were unwound.

That the same business area could suffer two colossal failures in risk management in three years is astonishing in itself. But the latest lapse is all the more worrying given the low-risk nature of Delta One. This a high-volume, low margin business, making money on a bid-offer spread on client trades, with a little arbitrage on the side.

Delta One desks typically trade in securities like Exchange Traded Funds, which can be easily hedged by buying their underlying components. The near-perfect correlation explains the name — as two instruments with a delta of one rise and fall in line with each other. Risks are further diminished by the liquidity of this business. Buyers and sellers can often be matched in a highly liquid trading book without the need for the investment bank to sit on lots of inventory.

But investment banks often try to supplement slim market-making profit with arbitrage income — say, spotting tiny differentials between the cost of a traded index security and its underlying stocks. With such a high volume of derivative instruments being traded, opportunities should commonly arise.

It’s hard to know precisely where the losses happened at UBS. The bank’s comment that no client positions were affected suggests that somehow a hedge failed or an arbitrage trade went badly wrong. If these loss-making positions were covered up, then they might have gone further out of the money without being detected.

Whatever the answer, this is the kind of business where mismatches in the trading book should become rapidly apparent in sudden cash outflows. What’s more, other banks say that common practice is to check exposures not just at the end of the trading day, but during it as well. UBS says it will explain what happened over the coming day or so. But it might find it tougher to explain how it happened.

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Thank you, Margaret Doyle, and where were you when the SG scandal happened? In a few short paragraphs, you’ve finally allowed me to understand how ETFs work and how they are hedged. I’m particularly thick on financial matters, so this is no mean accomplishment. This is what journalism should be about — getting people to understand so that they can form their own opinions. Thanks again.

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