The ETF loophole (almost) everyone missed

September 21, 2011

by Paul Amery

This post originally appeared at

For the webinar we ran last week on the subject of regulation, I put together a slide listing the ETF-related warnings that have been issued by an alphabet soup of international supervisory bodies since 2009.  In repeated public statements, regulators have reiterated their concerns over ETFs’ structure, their collateral and counterparty risks, possible contagion effects from ETFs to the broader financial market, short selling, leverage, and fallible liquidity.  Ironically, though, given what’s just happened at UBS, not one warning mentioned the issue of clearing and settlement as a potential concern.

Although we still don’t know the full details of the fraud at the Swiss bank, and my colleague Kumaara Velan reminded us yesterday of the danger of jumping to conclusions on the basis of insufficient evidence, multiple reports now point to loopholes in the way ETF trades are reported, cleared and settled in Europe as the key to unlocking the latest rogue trading scandal.  We tried to fill in some of the details ourselves a couple of days ago.

For many observers, it’s still hard to understand how UBS could have traded in ETFs using settlement dates that extended weeks into the future—as they apparently did—without the requisite post-trade checks occurring.

“When I found out banks were not confirming forward ETF [trades] until settlement date, I was pretty surprised,” Conrad Voldstad, chief executive of ISDA, the trade association for the world’s over-the-counter (“OTC”) derivatives market, said yesterday, according to Reuters.

Many criticisms of European ETF market transparency have focused on the fact that a large proportion of trades is conducted OTC.  However, the simple fact that transactions may be conducted away from a public exchange doesn’t relieve the counterparties involved from the obligation to record, administer and settle them properly, Voldstad is implying.

“Trillions of dollars trade every day in the OTC market…these trades are verified by back and middle office personnel, generally within 24 hours. For the operations department [at UBS] not to have called or e-mailed the fictitious counterparties to verify these multi-billion dollar trades does not make sense. Given the magnitude of the losses on the real trades, the fake trades must have had a multi-billion dollar gain, creating a large counterparty credit risk which should have been elevated to the credit risk department for vetting, margin calls or other action,” one industry insider commented yesterday on a Wall Street Journal article, making exactly the same point as Voldstad.

Details of how exactly the UBS fraud escaped the attention of the bank’s supervisors, and why trades were apparently not documented properly, will emerge in due course.  However, according to many press reports over recent days, several involving apparent leaks from people inside UBS, there’s been a widespread practice in Europe of failing to confirm immediately those ETF trades that are conducted on a bilateral basis.  Two days ago asked two European investment banks with large “delta-one” desks—Deutsche Bank and Credit Suisse—whether they send out confirmations as a matter of course following trades in ETFs.  Neither bank has yet responded. I should add that there’s no suggestion that either institution was involved in the UBS scandal.

On the basis of the available evidence, it appears that the UBS rogue trader combined two key bits of knowledge: awareness of the fairly liberal trade settlement rules in London (where there’s little sanction for late settlement, a compulsory “buy-in” of unmatched trades only occurs 30 days after the intended settlement date, and so by itself the forward settlement of an ETF transaction might not have raised suspicions);  and the knowledge that many counterparties wouldn’t automatically request trade confirmations.

Taken together, these two loopholes may have enabled the creation of fake transactions in UBS’s systems.  Even if this was the immediate cause of the fraud, the bank’s risk controllers seem to have missed other warning signs.  High gross trading positions, even if the trader reported his position as hedged, plus what were presumably significant cash outflows in margin as the result of losing futures positions, might together have been expected to flag that something was wrong.  Perhaps this is how the fraud was eventually spotted.

But it’s now clear that there’s a specific ETF element to the story too.

When I wrote about the issue of settlement “fails” in ETFs over two months ago, I was prompted to do so after hearing a passing comment from a trader to the effect that timely settlement of exchange-traded fund trades in the UK market was the exception, rather than the norm.

Unlike some commentators, who claim to have had foreknowledge of an impending ETF-related scandal, I admit I had no idea that lax settlement practices in ETFs might be disguising a major fraud.  I approached the subject more from the assumption that a hidden tax might be being imposed on people buying ETFs (for example, via higher bid-offer spreads than ought otherwise to occur) by those taking liberties with settlements procedures.

The subject of ETF settlements in Europe proved remarkably difficult to investigate. Traders were—with a couple of exceptions—unwilling even to discuss the subject.  One leading ETF issuer told me it didn’t monitor secondary market settlement efficiency in its ETFs, only whether primary market trades settled on time.  My enquiries to the three largest European stock exchanges, to regulators (BIS, the FSA, the Bank of England) and to clearing systems (EMCH, LCH.Clearnet), all met with similar responses: we don’t have any data on ETF settlement efficiency; or we have, but it’s confidential.

Only one organisation involved in clearing was prepared to help research the issue, but even then only on a non-attributable basis.  As I reported in my article, the data that organisation put together pointed to a specific practice of delaying ETF settlements in London, by comparison with other European trading centres, although not quite to the extent that my trader contact had reported.

Compare the relative openness in the United States.  There, the Depository Trust and Clearing Corporation (DTCC) reports regularly on settlement “fails” in both ETFs and equities.  The New York Fed does so for Treasuries and other bonds. It was as a result of the public availability of this data that some researchers, like Basis Point Group’s Fred Sommers, started writing about the disturbing rise in failed securities settlements (not just in ETFs, by the way) in the first place.

I’ve read reports over the last couple of days to the effect that compulsory post-trade reporting for ETFs can’t be brought in until 2013 at the earliest, with the next MiFID review.  The harmonisation of European securities settlement procedures, via the European Central Bank’s Target 2 Securities project, is even further away from implementation.

However, Europe’s ETF market participants surely need to move as a matter of urgency to throw light on the murky world of OTC trading and on ETF settlement efficiency.  All bilateral, off-exchange trades in ETFs must be reported so that the average investor can get a fair idea of what’s going on. Clearing houses and settlement systems—and I realise that there are many of them in Europe—should publish data on the efficiency of the post-trade processes in ETFs just as their counterparts do in the US market, and in the same way as Europe’s stock exchanges regularly publish data on bid-offer spreads and turnover.  Such data should be published both for individual funds and for ETF market makers, so we can see where potential problems lie.

Without such steps, public confidence in the ETF market, which must already be at a low ebb after the UBS scandal, is likely to wane further.  John Bogle, founder of Vanguard and the father of index-based investing, repeated his long-standing criticisms of ETFs in a CNBC interview on Monday, calling them “a bastardised version of the index fund” and adding that “only an idiot would want to trade indices all day in real time”.  The onus is on the ETF industry to prove him wrong.

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