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The fine line between bad luck and rogue trades

September 27, 2011: 9:07 AM ET

Losing a client $2 billion is called a streak of bad luck. Losing the bank $2 billion is called fraud.

By Moshe Silver, Hedgeye

UBS sign featuring logo including three keys

Image via Wikipedia

What exactly makes a person a "rogue"? We checked at thefreedictionary.com and found the first definition as "an unprincipled, deceitful, and unreliable person." Using this definition, we are not sure that Kweku Adoboli, the UBS employee alleged to have fumbled some $2.3 billion of the bank's money, would be the only employee on his desk to merit the characterization. Clearly, what makes Adoboli's actions "rogue" activity is not the fact that he allegedly lost over $2 billion, but that he lost the bank's own money. 

Lest you think us unnecessarily cynical, we offer the following:

Last year the World Federation of Exchanges did a study of same-day affirmation (SDA) by country. Trade affirmation is a small furry rodent that inhabits the musty shadows of an un-sexy corner of Wall Street known as Operations and Back Office. This is the part that, as people are only now finding out, is held together by paper clips and rubber bands, while the high frequency traders run computer arrays that would make the chief weapons officer of Battlestar Galactica drool.

The revenue generating part of the business – sales and trading – has glommed all the glamour, all the publicity, and all the assets. The transaction processing piece, meanwhile, has almost always had to play catch-up. The UBS scandal has brought the post-trade piece of the business to public attention. According to the Financial Times, the accused UBS (UBS) trader had intimate knowledge "of how confirmation that trades have been done… can happen after settlement." It is possible for a firm to receive payment for a trade before the seller has confirmed the transaction to the buyer. And while it is not so simple to take the buyer's cash out before seller's the securities have been delivered, the seller can show the cash on their own books as having been received, and can even spend it in further transactions.

The FT explains that this risk is particularly prevalent in over the counter markets, where ETFs, foreign exchange options and a number of commodity derivatives trade. It is also where money market instruments trade, and we do not fancy the notion of a failure to deliver on a few hundred billion dollars' worth of short term commercial paper in what our brokerage statement misleadingly calls our "cash" balance.

One way to mitigate this risk is to require both sides to affirm a trade same day, even if the formal trade confirm document – paper or electronic – is not issued until a day or two later. The industry group review found the highest rates of SDA were in Japan, India and Hong Kong, all well above 90%. A second tier – in the 80%-plus range – includes Germany, France, the UK and China. Among leading global markets, the U.S. ranked dead last, with only 46.9% of trades being same day affirmed. One could argue that this is still a larger number of actual trades than the other markets process, but the fact remains that we rank dead last among the ten leading markets in the world – fifteen percentage points behind Brazil, fans of President Rousseff will note. There is an initiative afoot to harmonize settlement practices among some thirty different nations, each with different regulatory regimes, bank and market conventions, and different current back-office practices. We wish them luck.

Shortly before the UBS scandal broke the FT reported on a phenomenon known in the industry as fails to deliver. Fails – when the buyer does not deliver cash on settlement date, or the seller does not deliver the securities – have spiked in recent months and now average $200 billion a day in the U.S. market alone, according to the FT. At least in the U.S. the number is known. There is no equivalent data available for Europe.

Failing for survival

Some observers are convinced that banks are deliberately failing "as a way of dealing with financial stress." For a period of time – say the time between accounting cycles, or between departmental audits – fails permit a trader, a trading desk, or even an entire institution to carry on its books both the value of the securities it has sold, but not delivered, and the value of the cash it has booked, but not received. Margin rules and trading system conventions generally allow the proceeds of a sale to be used for new purchases before the cash is actually delivered, so a fail on a cash payment may go unnoticed if it is resolved before too many downstream transactions settle. Or it can set off a cascade where successive trades have to be broken, with the firm eating both its own losses, and those of its counterparties on the trades in question. This appears to be roughly the case facing UBS.

In the U.S., there is a further Never-Never-Land called "ex clearing," where aged fails go into permanent limbo. They become an off-book contract between the counterparty brokers, who agree not to pursue the matter. There is no way of knowing the dollar value of fails that have been thus dispatched, and consequently it is impossible to know what amounts of money on bank balance sheets are actually phantom capital that will never be recovered.

The FT reports that only in May 2009, after the Lehman collapse, was a fail penalty introduced in the US Treasurys market. In that month alone daily Treasury fails reached $569 billion. The U.S. now plans to introduce fails charges for mortgage backed securities, which traders say will force fails into other segments of the market. The FT reports that ETFs are now more likely to fail than are normal equity trades.

This brings us back to our rogue trader. Adoboli worked in UBS's equities division, where he was charged with running a rather "sedate trading book," according to the Wall Street Journal. The losses reportedly stemmed from one-way bets on the direction of the market, using unhedged index futures. The losses were reportedly masked with falsified entries showing offsetting trades. Adoboli reportedly created fictitious trades using ETFs, which settle over a longer cycle than the instruments on which he was actually losing money, recording them with European counterparties who were not obligated by market rules to confirm ETF trades.

In a revealing comment, the Journal article said UBS's internal risk monitoring focuses on proprietary trading in fixed income – because that is where the bank took a $50 billion write-down in 2008-2009, partly because of heavy concentration in one class of securities. "The overhaul of its risk-control system didn't address the danger of a back-office employee finding a way to fake trades." Fair enough. If an employee is determined to break the law, he will figure out a way to do it. But the equities business is in general not closely monitored "because it had typically been a client business that carried less risk." Losing a client $2 billion is called a streak of bad luck. Losing the bank $2 billion is called fraud.

UBS chief Oswald Grubel has resigned as head of UBS. Adobli sits in a British jail as he waits for his fate to be decided. Unlike SocGen's Jerome Kerviel, he does not yet appear to have taken the position that his superiors knew of his activities. We doubt there is another major shoe to drop in this matter. The bank did not have adequate controls. In retrospect everyone will clamor that it was idiotic not to anticipate employee fraud. On the UBS trading desk, a trading book was handed over to an idiot who got in well over his head, and who was apparently overseen by idiots whose risk management process consisted of initialing reams of printouts every day, rather than getting to know the trading style of their employees. The best advice we can give to UBS: don't hire any more idiots.

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Hedgeye

Hedgeye, a real-time investment research firm founded in 2008 by former Carlyle-Blue Wave portfolio manager Keith McCullough, operates as a virtual hedge fund. Staffed by research analysts from across Wall Street, Hedgeye offers fundamental, macro and sector analysis, present picks in a transparent way to its clients. It has built a stable of subscribers, which includes hedge funds and mutual funds, and recently launched a retail investor product.

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