Introduction

On 16 September 2011, the FSA announced that it will launch an investigation into the conduct of Kweku Adoboli, the alleged rogue trader who is thought to have made losses in excess of $2.3bn while working on the UBS Delta One Exchange Traded Funds (ETF) trading desk.

In a press release the FSA stated that “UBS has discovered a loss due to unauthorised trading by a trader in its Investment Bank. The matter is still being investigated, but UBS’s current estimate of the loss on the trades is in the range of $2.3bn. It is possible that this could lead UBS to report a loss for the third quarter of 2011. No client positions were affected.”

The FSA has stated that it will be working in conjunction with the Swiss Financial Market Supervisory Authority to conduct a “comprehensive independent investigation into the events surrounding the trading losses incurred by UBS in its London operations”. The Serious Fraud Office has announced that it may join the FSA in investigating Adoboli’s conduct.

To understand how Adoboli was able to make such huge losses before UBS became aware of his unauthorised activity, a number of compliance questions need to be considered. First, how did Adoboli make such huge losses and what checks and controls were in place to attempt to prevent unauthorised trading? How did the reforms, introduced after the conviction of Jerome Kerviel, the rogue trader at Societe Generale, not prevent further rogue traders? Finally, are there systemic problems with the ETF market or is this a solitary occurrence?

What we know so far

It has been reported that Kweku Adoboli is a 31-year-old trader who joined UBS in 2002. He began his career working in the UBS back office and progressed to work in UBS’s ETF trading department.

We understand that Adoboli allegedly incurred a $2.3bn loss by using false trades to mask his trading activity. He has been charged with both fraud and false accounting while working on the UBS Delta One desk which is part of the UBS Global Synthetic Equity Business in London.

The Financial Times reported on 18 September 2011 that, according to a UBS statement and accounts from those working in the industry, Adoboli had been taking speculative positions on a range of S&P 500, Dax and EuroStoxx index futures during the last three months. The bets were all cash-settled futures contracts.

On 19 September UBS said that despite the apparent size of these positions, they were within the “normal business flow of a large global equity trading house, as part of a properly hedged portfolio”. The enormity of the positions that Adoboli accumulated was not apparent to UBS because he was masking them with fictitious hedging positions. By recording false forward-settling cash ETF transactions it seems Adoboli was able to create the impression of a hedged position.

It seems that some of the false hedging positions were not detected because the fictitious trades were entered into with other parts of UBS (internal futures). No trade confirmations were required because they were internal futures contracts and this may have assisted Adoboli to avoid detection.

Adoboli’s experience of working in the back office is likely to have provided him with the necessary information to disguise his actions. He would have been fully aware that some banks did not give confirmation of trades therefore preventing detection by UBS.

Generally, ETFs are listed on an exchange and can be traded like regular stocks. They often track a designated market and offer exposure to that market but incur lower costs than stocks and shares and are tax efficient. The positions entered into by Adoboli were due for settlement on 22 September but Adoboli’s actions were discovered when compliance officers at UBS began to investigate the extent of the false positions and the degree of exposure he had taken. The police were called to UBS’s office at 1 a.m. on Thursday 15 September after Adoboli had revealed the extent of his unauthorised transactions.

Following the announcement of the $2.3bn loss Singapore’s sovereign wealth fund, GIC, which is the largest shareholder in UBS with a 6.44 per cent shareholding, criticised UBS for failing to prevent the unauthorised trades. GIC said, “We discussed the alleged fraudulent trading that led to the large financial loss for UBS. GIC expressed disappointment and concern at the lapses and urged UBS to take firm action to restore confidence at the bank”.

On 24 September 2011, Sergio Ermotti was named as the UBS Chief Executive Officer on an interim basis following the resignation of Oswald Grubel. Grubel has taken responsibility for allowing Adoboli’s alleged unauthorised trading and has decided to resign.

An independent committee has been set up by UBS and chaired by David Sidwell, former chief financial officer at Morgan Stanley, to conduct an independent investigation of the “unauthorised trading activities and their relation to the control environment.” On 23 September 2011, the FSA announced that UBS has appointed KPMG to conduct an independent investigation into the failings at UBS which led to Adoboli losing $2.3bn in unauthorised trades.

Lessons from Societe Generale

On 18 January 2008, Societe Generale (Soc Gen) discovered that Jerome Kerviel had taken unauthorised open positions in futures of approximately €50bn on three separate European indices. The total losses to Soc Gen amounted to €4.9bn before the trades were discovered and the positions were unwound. Kerviel was subsequently found guilty of fraud by a Paris court and sentenced to three years’ imprisonment.

It appears that Adoboli used fake trades at UBS in a similar way to Jerome Kerviel in 2008. Kerviel removed the fake trades from the system before inspections could be performed only to re-enter the false positions once the inspections had been completed.

Following the discovery of the rogue trader at Soc Gen, the FSA published guidance for investment firms on how best to prevent rogue traders in the future. The FSA’s Market Watch Newsletter (Issue 25) sets out the key issues for firms to consider when deciding how to implement systems and controls to effectively prevent rogue trader activity.

The guidance is the result of the FSA’s discussion with many of the largest investment firms. While the details of implementation will vary between different firms, the general principles are universal to all investment firms. Some of the FSA recommended action points include the following.

  1. Front office culture and control

The clarity of reporting lines and responsibilities should be considered. Also, systems should be in place to ensure that control and oversight by front office management is promoted and rewarded. Compulsory two week holidays could prevent rogue trading and allow for colleagues to take over their books during this time.

  1. Trading mandates and Limits

Trading mandates for each individual trader, establishing the products the trader is permitted to trade coupled with corresponding risk limits should be introduced. The mandate should then be used as a frame of reference for monitoring the activities of the trader by both front office and independent control functions.

  1. Control functions: culture and challenge

Firms should ensure that those in control functions have sufficient understanding and authority to challenge front office staff when the agreed parameters or trading mandates have been breached.

  1. Risk management and limits

Systems should be in place to monitor traders’ positions in the context of the trading mandate of the individual trader.

  1. IT security

Ensuring correct implementation of access controls and enforcing a security conscious culture will help to prevent rogue traders.

Ultimately, current reports suggest that there was not the appropriate degree of supervision that should have been in place at UBS. The extent of Adoboli’s losses suggests that he must have placed a significant number of unauthorised trades and internal fake hedges. It seems Adoboli, a junior trader, did not have close enough supervision for the extensive unauthorised trades and the fake hedged positions to be identified. Coupled to this, it seems there were failings of the supposedly sophisticated risk systems to identify the unauthorised and fraudulent activity.

We expect that the independent committee will consider the operational supervisory measures on UBS’s Delta One ETF trading desk in detail.

Insufficient regulation of ETFs?

It would appear that some lessons from Soc Gen may not have been learnt and the FSA recommendations may not have been implemented. However, some suggest that the problems seen here are not unique to UBS but are symptomatic of structural flaws in the way in which ETFs are traded and regulated.

Adoboli’s conduct has revealed a loophole in the financial regulation of ETFs. The lack of a confirmation from counterparties once the trade has been booked means that the price and date of the trade as entered by the trader cannot be verified by reference to a counterparty. Adoboli was able to book trades which never took place to give the illusion of a fully hedged position. Without confirmations from the counterparty Adoboli’s deceit appeared legitimate.

As ETFs are traded OTC (bank to bank) they are currently not subject to the same transparency requirements as shares admitted to trading on a regulated market under the Markets in Financial Instruments Directive (MiFID) transparency requirements. The European Commission, in its MiFID review, has proposed that the same general transparency requirements should apply to ETFs as currently apply to shares admitted to trading on a regulated market, subject to slight variations to account for specific differences in the nature of ETFs.

Although Adoboli created false positions to give the impression that he had hedged his trades, the mismatch and the lack of hedging should have become evident from the UBS cash flows. The falls in value should have triggered warnings and “margin calls” which would have prompted payments to UBS counterparties. Appropriate hedging arrangements which had been correctly entered would have brought cash into UBS when the unauthorised positions fell in value. These warning signs should have been noticed. The independent investigation will need to examine how mistakes such as this can be averted in future.

Post credit crunch, much attention has been given to regulating the complex area of structured finance. However, Adoboli shows how relatively simple trading activities can be extremely damaging when not subjected to rigorous supervision. In future, the trading of ETFs is likely to be subject to much closer scrutiny.

The recent ICB report on banking reform has recommended that, generally, the retail operations of banks should be ring-fenced to protect depositors from exposure to the higher risks associated with investment banking divisions. The discovery of the UBS rogue trader highlights the importance of the recommendations in protecting depositors from unnecessary risk.