COLUMN – Rogue traders, delta trading and exchange-traded funds

October 7, 2011

By Helen Parry, the views expressed are her own.

LONDON, Oct. 7 (Thomson Reuters Accelus) – There are many common features in cases of rogue or unauthorised trading, including the use by ostensibly riskless arbitrage traders of fictitious trades on internal systems to mask their unhedged positions. One obvious feature that is present in many rogue trader cases has been a failure in trade confirmation systems and controls. This feature frequently appears conterminously with the fact that a trader has intimate knowledge of and/or power and influence over middle and back office systems.

Nick Leeson and Toshihide Iguchi were in positions of total control, while John Rusnak and Jerome Kerviel managed to respectively bully or charm back office staff into doing their bidding. Kerviel, for example, was reported to have promised bottles of champagne to back office supervisors, to have taken out all the young women from the support desk, and to have been one of the few traders who spoke to them politely. One commentator on the Kerviel episode remarked that, as long as treasury organisations failed to recognise the importance of the women in the back office, and glorified only their male traders, they would be failing in support of their first line of defence against rogue traders.


“Delta One trading” also features in several of these cases. In the context of derivatives trading the “delta” is a mathematical measure of the derivative instrument’s sensitivity to changes in the price of the underlying asset. Delta One products are financial derivatives which have a delta value of no more than one, which means that for a given percentage move in the price of the underlying asset there will be a near-identical move in the price of the derivative. Delta One products often incorporate a number of underlying securities and, as such, give the holder exposure to a basket of securities in a single product. Examples include equity swaps, forwards, futures and ETFs and plain vanilla options.


Another feature of Delta One trading is that it often involves hedging and arbitrage so that, theoretically, the trader is not exposed to naked speculative positions. The index arbitrage featured in the Leeson affair was ostensibly a variety of Delta One trading. Such trading is designed to be engaged in in high volumes with relatively low profit margins. When Lesson started to make unusually large profits, questions were raised. One Barings executive cited in the Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings Bank commented that in response to the question “Was it a source of great surprise that that there was this apparent disjoint where you could print money in this way day after day?” responded: ” Yes, people talked about it almost incessantly. I have to say that a load of people, all of us really, found it very puzzling, but I have to say equally, and maybe you will say naively, we accepted it.”


Leeson was able to bat these inquiries away by citing three reasons for the unusual profitability of his “riskless” arbitraging activities, one of which was clearly of dubious legality: proprietary positioning on the back of large orders which Barings Futures Singapore (BFS) possessed (or came to know of) on one of the exchanges. For example, if BFS had a large buy order from a client for SIMEX Nikkei contracts, BFS could buy up the equivalent value of contracts for its own account and, if the market went up, simply sell them out for a profit on the Osaka Stock Exchange. Such trading was, as the report suggests, “akin” to front running. It was not simply akin to front running, it was front running.

The fact that senior management was willing to countenance such inappropriate (though in those days, before the Market Abuse Directive, not criminal) methods in some way echoes the suggestion that some clients of Bernard Madoff may have suspected that his unusually healthy returns may have been the result of some sort of front running, given his key insider position in the market. Beneficiaries of unusually large returns sometimes fail to question them too deeply, however.


According to UBS the loss resulted from unauthorised speculative trading in various Standard & Poor’s 500, DAX, and Euro Stoxx index futures and the magnitude of the risk exposure was distorted because the positions had been offset in their systems with fictitious, forward-settling, cash ETF positions, allegedly executed by the trader, which concealed the fact that the index futures trades violated UBS’s risk limits.


Exchange-traded funds were created in the early 1990s by the American Stock Exchange (AMEX) which was suffering a decline in business in an increasingly competitive market and which reversed its fortunes by devising what has been described by Lawrence Carrel, author of “ETFs for the Long Run” as the small investor’s revenge for the 1987 crash. During the course of that crash, according to Carrel, mutual fund investors whose 401K pension pots were invested in those products found to their cost exactly what the fact that the fund’s price (the net asset value (NAV)) was calculated on the close really meant in such circumstances. On the day of the crash investors who tried to sell their funds thought they would get out when they called their broker, only to find out that they got the price at the end of the day, after all the stocks had fallen. Retail investors were locked in to the worst price of the day.


Conversely, after the Great Crash of 1929 this feature of the open-ended fund model was viewed as having protected investors in such products, relative to investors in closed-end funds, as their policy of redemption at NAV meant that they could not hold a large proportion of their portfolio in unmarketable securities. Closed-end funds did not disclose the contents of their portfolios and were able to value their shares at whatever price the fund managers wished. Speculation before the crash drove prices of closed-end funds higher than the prices of the securities they owned, leaving their shareholders with a steeper downward dive when the crash finally came.


A mutual fund (which is otherwise known as an open-end company) is a company in which many people of moderate means have pooled their resources for the purpose of investing, reinvesting and trading in securities. One of the main features is its commitment to stand ready to redeem (repurchase) its shares at any time at their then-net asset value. The NAV is calculated by taking the market value of all portfolio securities plus the value of all other assets plus liabilities and dividing the resulting figure by the total number of shares. Most mutual funds also engage in a continuous offering of their shares for sale to the public at the NAV plus a sales “load” (commission).


A closed-end company is commonly referred to as a closed-end fund. It is, however, just as “mutual” as a mutual fund, but has inexplicably not been dubbed as such. Unlike the open-end company, the closed-end company neither repurchases its shares nor engages in a continuous public offering of its shares. If the board of directors of a closed-end company deems it advisable to increase the amount of its resources available for investment, it will make a single public offering of its shares or other securities in the conventional way. Shares of closed-end companies are readily available to the public investor at any time. The price will bear some relation but will rarely be identical to the NAV. It will be controlled by supply, demand and other market forces.


Another type of pooled investment entity in the U.S. is the unit investment trust, which buys and holds a generally fixed portfolio of stocks, bonds or other securities. “Units” in the trust are sold to investors (unit holders) who receive a share of principal and dividends (or interest). It has a stated date for termination that varies according to the investments held in its portfolio. A UIT investing in long-term bonds may remain outstanding for 20 to 30 years. UITs that invest in stocks may seek to capture capital appreciation over a period of a year or a few years. When these trusts are dissolved, proceeds from the securities are either paid to unit holders or reinvested in another trust.


Terminology in these markets is, as ever, highly confusing to the uninitiated. The English investment trust and the U.S. unit investment trust, for example, are not “trusts” but specialist companies. The position is further confused by the fact that the UIT is defined as a company which may be organised under a trust indenture. A trust indenture is not a classic “trust”, however. It is defined as an agreement in a bond contract made between a bond issuer and a trustee that represents the bondholder’s interests by highlighting the rules and responsibilities to which each party must adhere. It may also indicate how the income stream for the bond is derived. In the UK there is a type of investment company originally referred to as an “open-ended investment company”(OEIC) but is now called an investment company with variable capital (or ICVC).


In the aftermath of the 1987 crash, the Securities and Exchange Commission (SEC) proposed, inter alia, that the New York Stock Exchange should consider creating special areas on its floor for the trading of entire baskets of stock, such as those comprising popular indexes, which would relieve some of the strain on the capital of the specialists responsible for trading those individual stocks. The SEC also suggested that if an exchange did propose a market-basket instrument based on the Standard & Poor’s 500, it would receive a quick approval.


In March 1988, the Philadelphia Stock Exchange took up this implicit invitation and filed cash index participation contracts, or CIP shares, with the SEC for approval. These allowed investors to buy or sell an index of stocks in the same manner as they might buy or sell individual shares of stock. The CIPs held each stock in the same proportion as the index. They were designed to last indefinitely and paid dividends from the underlying stocks in the index. They tracked the S&P 500 and the Dow Jones Industrial Average. AMEX and the Chicago Board Options Exchange (CBOE) both filed similar products with the SEC, with AMEX’s equity index participations (EIPs) and CBOE’s value of index participations (VIPs).


Fearing unwelcome competition, the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) filed formal objections with the SEC. They already traded stock index futures and suggested that the new products were simply a variant of those products and should therefore fall within the Commodity Futures Trading Commission (CFTC)’s bailiwick. The matter eventually went to court and resulted in a victory for the CFTC. All trading in those products ceased.


The first real EFTs were based on the Standard and Poor’s 500 index and were called Standard and Poor’s Depository Receipts ( SPDRs, known as “spiders”). Designed and developed by AMEX executives Nathan Most and Steven Bloom, they were structured as an innovative form of unit investment trust which included features of open- and closed-end funds and, as such, prima facie contravened many sections of the Investment Company Act 1940 which had been drafted to address abusive practices in the markets for investment management companies.

As a startling indication of how pervasive abusive practices had been in the years preceding the Great Crash, Robert E Healy, the SEC Commissioner who led the commission’s post-crash investigation into the industry, noted in a statement before the subcommittee of the Committee on Banking and Currency, which was scrutinising the proposed Investment Company Act, that at one of their examinations two witnesses had been describing the manner in which they had depleted the assets of some investment trusts which they had formerly dominated. He had later learned that these same individuals “almost literally took time off from the public examination in order to complete their arrangements to loot some other investment trusts which had come under their control”.


It was necessary, therefore, for the SEC to grant formal exemption from various sections of the Investment Company Act and related rules so that ETF shares could be registered and for trading to commence. The sections included: 4(2), 14(a), 17(a)(1) and (2), 22(d) and (e), 24(d), 26(a)(C) and rule 22c-1. Clearly this was a highly technical legal exercise. In Carrel’s account of the process of seeking exemption for the first SPDR he noted that a single paragraph of the application, addressing the subject of underwriting, had cost half a million dollars in legal fees. Crucially, unlike open-end funds, which can only be bought or sold at the end of the trading day for their net asset value, ETFs can be traded throughout the day much like a closed-end fund.


ETFs do not sell shares directly to investors but only issue them in large blocks called “creation units” to “authorised participants” who effectively act as market-makers. Investors then buy or sell individual shares in the secondary market on an exchange at prices based on the NAV of the fund without attracting subscription or redemption charges. In the primary market, APs will purchase creation units from ETF sponsors with securities that comprise the ETF rather than with cash. Given the limited redeemability of ETF shares, ETFs are not technically considered to be mutual funds in the U.S.. In Europe, this distinction is not made and ETFs can be established under the Undertakings for Collective Investments in Transferable Securities (UCITS) directives, similar to those for mutual funds.


The original form of ETF uses physical replication schemes to gain index exposure. In this structure, authorised participants purchase a basket of securities in the markets that replicate the ETF index and deliver them to the ETF sponsor. For example, the constituents of the Standard & Poor’s 500 Index would be delivered if the ETF was benchmarked against this index. In exchange for this, each market-maker receives ETF creation units, typically 50,000 or multiples thereof. The transaction between the market-maker and ETF sponsor takes places in the primary market. Investors who buy and sell the ETF then trade in the secondary market through brokers on exchanges. The market value of the basket of securities held by the ETF sponsor forms the basis for determining the NAV of the ETF held by investors.


In addition, many synthetic structures are now employed by ETFs. One popular synthetic structure involves the use of total return swaps (TRS) and is referred to as the “unfunded swap structure”. A TRS is a swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains. In total return swaps, the underlying asset, referred to as the reference asset, is usually an equity index, loans, or bonds. This is owned by the party receiving the set rate payment. Total return swaps allow the party receiving the total return to gain exposure and benefit from a reference asset without actually having to own it.

The total return on a reference asset includes all cash flows as well as the capital appreciation or depreciation of that reference asset. The floating rate is a reference interest rate (typically LIBOR) plus or minus a spread. The party that agrees to make the floating rate payments and receive the total return is referred to as the total return receiver or the swap buyer; the party that agrees to receive the floating rate payments and pay the total return is referred to as the total return payer or swap seller. Total return swaps are viewed as unfunded credit derivatives because there is no upfront payment required.


The authorised participant receives the creation units from the ETF sponsor against cash rather than a basket of the index securities, as in the physical replication scheme. The ETF sponsor separately enters into a total return swap with a financial intermediary, often its parent bank, to receive the total return of the ETF index for a given nominal exposure. Cash is then transferred to the swap counterparty equal to the notional exposure.

In return, the swap counterparty transfers a basket of collateral assets to the ETF sponsor. The assets in the collateral basket could be completely different from those in the benchmark index that the ETF tries to replicate. The total return on this collateral basket is then transferred to the swap counterparty, which constitutes the second leg of the total return swap. In effect, what is happening is that the provider (typically a bank’s asset management arm) sells ETF shares to investors in exchange for cash, which is then invested in a collateral basket, the return of which is swapped by the derivatives desk of the same bank for the return of an index.


An alternative replication scheme is the funded swap structure under which the sponsor transfers cash to the swap counterparty, who then provides the total return of the ETF index replicated. The counterparty posts eligible collateral into a ring-fenced custodian account to which the ETF sponsor has legal claims, but who is not the beneficial owner of the collateral assets as in the case of the unfunded structure. This arrangement is not exactly a total return swap arrangement. It is more accurately described as an arrangement whereby the sponsor buys a structured note secured by a collateral pledge.


(Helen Parry is a regulatory intelligence expert in the Compliance and Regulatory Risk division of Thomson Reuters; the views expressed are her own.)

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus.  Compliance Complete ( ions/regulatory-intelligence/compliance- complete/) provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

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