The UBS rogue-trader scandal may dent enthusiasm for ETFs.
Last Thursday, news broke of another rogue-trader meltdown, this time at Swiss banking giant UBS.
$2.3 billion and counting
A UBS trader, 31-year-old Kweku Adoboli, was alleged to have carried out a string of false trades dating back to 2008, in an attempt to cover up growing losses.
According to the latest press release from UBS, Adoboli's unauthorised losses now total $2.3 billion (£1.5 billion), $300 million more than the initial estimate of $2 billion. On Friday, Adoboli was charged with 'fraud by abuse of position' and remanded in custody by City of London magistrates.
Adoboli worked in the UBS Global Synthetic Equity business in London, hedging and balancing the trading flows arising from the group's exchange-traded funds (ETFs) business. Although the bank's equities business is 'again operating normally within its previously defined risk limits', it seems extraordinary that a single trader could run up huge losses from hedging at an ETF desk.
Other huge rogue trades have originated in equity index futures (Nick Leeson at British bank Barings), commodity derivatives (Yasuo Hamanaka at Japanese giant Sumitomo) and currency derivatives (John Rusnak at Allfirst, a US bank owned by Allied Irish Banks). Hence, I'm rather surprised that a 'boring' market such as ETFs has been hit by such a scandal.
ETFs under scrutiny
Even though no UBS client positions were affected by this massive, unauthorised trading loss, it shows the problems that can arise when back-office workers move onto trading desks.
Armed with inside knowledge of an investment bank's settlement procedures, traders such as Jérôme Kerviel at French bank Société Générale were able to outwit compliance procedures and exceed their trading limits to disastrous effect.
What's more, this latest scandal will undoubtedly shine a light on the somewhat opaque world of ETFs. To me, this is no bad thing, because the growing lack of transparency in the ETF world makes me nervous.
Although I'm broadly a fan of ETFs, I much prefer the plain-vanilla ETFs which track established market indices at very low cost. What make me nervous are leveraged ETFs, short ETFs and synthetic ETFs that use derivatives to reproduce returns, rather than directly holding the underlying assets.
Nevertheless, the market for ETFs has exploded in recent years. Since the launch of the first ETF in 2000, trading volumes for ETFs have risen by 40% a year. Also, there has been strong growth in esoteric, higher-charging ETFs, which go against the low-cost culture behind such traded funds.
Beware of TLAs
Once again, this scandal involves TLAs -- the three-letter acronyms much favoured by banking wizards and army soldiers alike. Personally, I'm very wary of TLAs and never use them without first explaining what they mean, because insiders often use such jargon to disguise information from the unwary.
For example, writing in last Friday's Financial Times, Gillian Tett pointed out the 'uncanny echoes' between this ETF scandal and the spectacular blow-up of CDOs (collateralised debt obligations made by slicing up mortgage bonds into various tranches). Ironically, it was UBS's heavy investment in AAA-rated subprime CDOs that cost the bank $50 billion in 'authorised' trades in 2007.
In short, investors buying specialist, complex and innovative ETFs may be taking on more risk than they realise. This is particularly the case when ETF promoters also act as counterparties to the derivatives underpinning a fund's returns.
Hence, this news from UBS could deal a blow to Mr Market's enthusiasm for ETFs, especially the synthetic ETFs that account for nearly half of ETF sales nowadays.
In reality, it seems that ETFs are not nearly as 'safe' and 'transparent' as their designers and promoters claim!
More from Cliff D'Arcy: