Once again the world of investment banking is reeling from a massive loss caused, apparently, by a “rogue trader“.
Kweku Adoboli, a UBS investment bank trader remains in police custody amid allegations that he cost the Swiss bank £1.3Bn. UBS has not officially confirmed Mr Adoboli’s role, however, an entry on his Linkedin site described him as director of exchange traded funds (ETF) and Delta One trading at UBS.
This operation, based within the equities division on the 3rd floor of the UBS office in London, was known regarded internally as being a key profit centre and highly valuable as it was deemed to be a risk free business unit. (There is no such thing!)
Much as with previous infamous traders such as Raj Rajaratnam (galleon Insider Trading), Bernie Madoff (Pozi Schemes), Nick Leeson (Barings Bank), Yasuo “Mr Copper” Hamanaka (Sumitomo Corp) and Jérôme Kerviel, (Société Générale) one has to question if compliance officers and senior management actually knew what was happening on the trading desk, or did they justsee a “black box” that produced money. If so, perhaps they didn’t want to look too closely at the gift horse’s teeth.
What are the trading instruments?
Delta One products are a financial derivatives carrying no optionality. That implies they carry a “delta” that is equal to or very close to 1.
What is “delta”?
The delta is the ratio of the change in price of an option to the change in price of the underlying asset, it can sometimes be called the hedge ratio and it applies to derivative products.
Consider a simple Call Option on a stock or a currency. The call option gives the holder the right, but not the obligation to acquire the said stock or currency at a specified future date or dates if it makes economic sense. So if the call option value is less than the spot market level on exercise day or days the option is in the money. If the stock were actually trading lower than the spot market, the option would not be exercised because the option would be “out of the money”.
For a call option on a stock, a delta of 0.50 means that for every $1.00 that the stock goes up, the option price rises by $0.50. As options near the end of their life or expiry, an in the money call option contract has a delta that approaches 1.0. In contrast an in the money put option (the right but not the obligation to sell) will have a delta that is approaching -1.00. (This is not the place for more complex mathematics)
Delta One have no optionality so their delta is 1 or very close to it…so the leverage or price relationship is perfect unity, for a given percentage move in the price of the underlying asset there will be an identical move in the price of the derivative. Delta One products will be seen as incorporating a number of underlying securities and as such give the holder an easy way to gain exposure to a basket of securities in a single product. (Swaps, Forwards, Futures and ETF). Did he get blind sided by the Swiss National Bank when they intervened in the FX market so forcing the Swiss Franc down by 8% against the Euro in day?
Given that trades have to be processed via the settlement office it does seem puzzling as to how such huge positions can be accumulated. It may be that as all banks have had to accumulate capital and control their costs on expenses and headcount any operation that is making a profit is encouraged to keep up the good work. Of course in C21 markets there is no longer a simple linear market in bonds or equities. Trades are made in cash instruments, futures, forwards, options, structures, special purpose vehicles, collateralized products and can be OTC or exchange based.
If a trader does not book an OTC trade at the appropriate time, red flags should rise as all trades need to be confirmed within a specified time limit from the execution. Still on a busy day, especially when markets are volatile the settlements office may not find out about the trade until the counterparty calls them days later asking why the deal has not been settled yet.
As finance professionals climb the ladder of success they assume more managerial activities that take them further away from the dealing floor and the latest techniques within asset structuring and trading…in the world on “my word is my bond”, the level of trust feels more like a layer of rust.
By Stephen Pope Managing Partner – Spotlight Ideas