Progress report
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28/09/2011
Comment: Christopher Miller
I remember a few years back when I was holding a prime broker beauty parade, one of UBS’s proud selling points was its ultra-cautious Swiss approach to risk. But apparently now it considers sartorial excellence to be more important than basic trade confirmation. Yes, I am referring to the leak of the UBS dress code last year, in which were listed extensive and detailed rules for everything from the type of underwear that should be worn, to what not to eat in case of odours.
UBS’s rules were widely covered and ridiculed at the time, but there is one particular rule that was remarkably apt then, and perhaps even more relevant today. The advice for men (women are chivalrously spared from this diktat) is “La veste doit couvrir complètement votre postérieur.” Roughly translated, this means “Cover your posterior”. Now that is some good advice that works on many levels.
Kweku Adoboli, who is alleged to have caused UBS a $2.4bn loss from ETF trading, is said to have covered his posterior with fictitious hedges. According to Reuters, he was able to do this because some ETFs are not adequately covered by European or UK financial markets law, leaving dealers free to book trades without counterparty confirmation. Consequently, risk and back office personnel were unable to verify that the trades actually occurred.
According to sources, UBS is not the only bank operating like this. It seems that banks are interpreting the EU’s Markets in Financial Instruments Directive (MiFID) to mean that in situations where ETFs are traded over the counter, instead of on-exchange, and they are not for a client account, the execution confirmation is not required.
Personally, I would argue that the FSA’s overarching requirement – that firms should have adequate systems and controls – means that execution confirmations should be required for all firms and all trades. That was certainly the approach I took when designing a hedge fund back office system for currency trades that were also out of MiFID’s scope.
But let’s consider for a moment the hypothetical effect of allowing banks to behave in this way. It means that traders are potentially able to create fake trades in exactly the same way that
they would normally make a real one. This is far from a complex fraud, and Adoboli, who previously worked in the back office, would easily know it was possible.
In a hypothetical bank, fake trades would still show up in the gross risk and counterparty exposure reports, and I’m guessing that extra-large positions like Adoboli’s should ideally be
flagged up quite quickly by an alert risk team.
However, the trades would not be counted on a net basis for calculation of bank capital adequacy. In fact, hypothetically, this is a potential route that a rogue bank could use to turn a blind eye
to profitable prop trading, without the annoyance of having to allow capital for it. But the downside of the hands-off approach to prop trading is that you rely on the trader’s own risk
management. And sometimes traders are tempted to go double or quits when things are going wrong, which is how losses can mount very quickly indeed.
Lawmakers and regulators would do well to make sure this can never happen again. Ironically, in the FSA’s posterior-covering requirement for firms to maintain adequate systems and controls, there already exists a mechanism to ensure that it should not happen. But it is becoming clearer and clearer that banks cannot police themselves, and regulators are always one step behind the practitioners. So, at the very least, this is a superbly-timed exposition of the need to ring-fence retail banking from riskier activities.
However, as John Kay in the Financial Times discusses, ring-fencing could take up to eight years to implement in the UK, during which time the plans could be significantly watered down. In a brilliant piece of posterior covering, the Independent Commission on Banking has ensured that it won’t be around when the measure is implemented.
Christopher Miller is CEO of Investment Quotient, a financial research consultancy
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60 seconds with... Kenneth Turchin
CAN YOU DESCRIBE YOUR CURRENT ROLE?
I have worked in public accounting and hedge funds and in the past eight years have been selling middle- and back-office services to the alternate investment industry. My role is to build relationships with clients, teach them about SS&C’s products and services, and ensure seamless transactions every time the firm launches a new fund.
IF YOU WERE DOWN TO YOUR LAST £1,000, HOW WOULD YOU INVEST IT?
I would buy THREE shares in Apple and hope for a repeat 383% return in the next five years.
WHAT WOULD YOU DO IF YOU WERE IN PRESIDENT OBAMA’S SHOES?
That’s one pair of size 12 shoes I do not want to be in!
WHO WOULD PLAY YOU IF THEY MADE A MOVIE ABOUT YOUR FIRM?
Kevin Bacon. He is a versatile actor and the centre of the entertainment universe. I am in sales. Everyone in the industry would be linked to me in six steps or less. My client list would be ridiculous.
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