UBS story – We have heard this before!

Kweku Adoboli is now a famous personality and figures prominently in the Hall of Fame along with Nick Leeson and Jerome Kerviel. It appears that Kweku was not very original in his act. He followed Jerome to a large extent. However, he could not match Jerome in the amount as Kweku could notch up only $ 2.3 billion against Jerome’s $ 7 billion.
The modus operandi of Kweku is becoming a bit more clearer now. From media reports, we can make out the following:
• Kweku was a dealer in the “Delta One” desk of UBS in London. This desk typically trades in securities like Exchange Traded Funds(ETFs) which can be easily hedged by buying their underlying components. This near perfect correlation explains the name –as two instruments with a delta of one rise and fall in near unison.
• This is a high-volume and low- margin business making money on bid-offer spread on client trades.
• But the investment banks often try to supplement slim market making profit with arbitrage (trading) income, say by spotting tiny differentials between the price of traded ETF and its underlying stocks. Such opportunities commonly arise due to high volume and very liquid market.
• Kweku built up loss making positions over the past three months in ‘Index Futures’ of S&P 500, DAX and Euro Stoxx.
• UBS says that these positions were taken within the normal business flow of a large global equity trading house as part of ‘properly hedged’ portfolio.
• UBS further said that the true magnitude of the risk exposure was distorted because the positions had been offset in Bank’s systems with fictitious, forward settling, cash exchange trading positions, allegedly executed by Kweku.
• UBS has said that no client positions have been affected.

This is almost the same tactic used by Jerome at French bank Societe Generale in 2008, leading to a $7billion losses as the trades were unwound. The same area of business could suffer two colossal failures in risk management in a span of three years at two European banks is really astonishing.
However the episode raises mainly the following questions:
a. If there are huge mismatches (i.e., positions covered with fictitious transactions), it should have become apparent with cash-outflows which would be huge.
b. Trade confirmations with clients should have been obtained independent of the traders by the back-office
c. There is a practice in most of the large trading banks to check the intra-day positions, apart from end of day positions. Whether such a check was inadequate?
d. The market risk and operational risk oversight was not effective or is there something which is yet to come out in the open?

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