ETF at the heart of UBS $2B debacle: Sources

As Switzerland's central bank imposed a limit on the franc's appreciation against the euro on Sept. 6, UBS AG (UBSN) trader Kweku Adoboli's Facebook profile had a plea for his friends: “Need a miracle.” Just over a week later, at 3:30 a.m. yesterday, police in London arrested the 31-year-old Adoboli on suspicion of fraud by abuse of position. UBS told investors less than five hours later that “unauthorized trading by a trader” it didn't identify caused a $2 billion loss. Adoboli worked on the bank's Delta One desk, a unit that handles trades for clients, typically helping them to speculate on or hedge the performance of a basket of securities. It also takes risks with the bank's own money in arranging trades. It was the same kind of desk as the one worked by Jerome Kerviel, who triggered a 4.9 billion-euro loss ($6.8 billion) for France's Societe Generale (GLE) SA in January 2008. “It couldn't come at a worse time for UBS,” said Fred Ponzo, a former trader at Societe Generale and capital markets adviser at Greyspark Partners in London. “The thing is, it's very hard to go through the fail-safes by error. The only way to dig a hole this big is by design. You have to ask the question that if this is a $2 billion hole, is this is a failure of technology and risk management?” The arrest as global regulators are pressing banks to curb their proprietary trading is likely to revive calls for financial institutions to increase controls on risk and separate their investment banking from their retail businesses. It may also force Chief Executive Officer Oswald Gruebel, 67, to abandon further expansion of UBS's investment bank. ‘Final Straw' The loss is “the final straw in UBS's ambitious build-out to a tier-one investment bank,” wrote JPMorgan Chase & Co. analysts led by Kian Abouhossein in a note to clients yesterday. “First, we think we'll likely see management changes within UBS's investment bank. Second, we expect UBS will come under material pressure from shareholders” and regulators to review its investment banking division. The bank, Switzerland's largest, fell 11 percent in Zurich yesterday, the most since March 2009. The stock climbed 3.3 percent to 10.07 francs as of 1:15 p.m. today. The stock is down 36 percent this year, compared with a 32 percent decline in the 46-member Bloomberg European Banks and Financial Services Index. Moody's Review Moody's Investors Service put credit ratings for UBS under review for possible downgrade. The examination will focus on “weaknesses in the group's risk management and controls that have become evident again,” Moody's said in a statement. The loss itself “would be manageable for the group given its sound liquidity and capital position.” UBS risk officers were examining Abodoli's trades before he informed them of them, according to a person with knowledge of the matter. The bank asked British police at 1 a.m. yesterday to arrest Adoboli, before alerting the U.K. financial regulator or prosecutors, according to two people familiar with the matter. The Financial Services Authority was notified shortly after the police, and prosecutors at the Serious Fraud Office weren't contacted at all, according to two people, who asked not to be identified because the investigations are private. UBS declined yesterday to say how the trading allegedly lost the bank $2 billion. Gruebel called the loss “unauthorized” and “distressing” in an e-mail to employees, without giving details. No client positions were affected, the Zurich-based company said in the statement, issued on the third anniversary of Lehman Brothers Holdings Inc. (LEHMQ)'s collapse. Industry Speculation Traders at other firms speculate that UBS may have failed to adequately hedge the currency risk related to an exchange traded fund, or mistakenly placed a currency swap the wrong way, according to executives at other firms who declined to be identified. When the Swiss National Bank, Switzerland's central bank, announced its limit on the currency Sept. 6, the franc fell more than 8 percent against the euro. “It's most likely to be a currency trade gone wrong,” said Manoj Ladwa, a senior trader at ETX Capital, a London-based broker that trades stocks, bonds, currencies, swaps and exchange-traded funds. “I would be shocked if it happened over a period of days, because you would expect back-office systems to pick it up. It's only the Swiss franc that's moved so sharply over such a short space of time last week.” UBS has been stung by trading losses before. In 1998, Chairman Mathis Cabiallavetta and three top executives resigned, taking the blame for a charge of 950 million Swiss francs stemming from exposure to Long-Term Capital Management LP, the failed U.S. hedge fund. An internal audit found “shortcomings in risk-management processes” before and after the merger between Union Bank of Switzerland and Swiss Bank Corp. that formed UBS, the bank said at the time. Earlier Trading Losses This century, UBS was among the first stung by the subprime mortgage contagion when its Dillon Read Capital Management LP hedge fund, run by former investment banking chief John Costas, lost 150 million francs in the first quarter of 2007. As subprime losses spread to UBS's investment bank, they led to departures by CEO Peter Wuffli, finance chief Clive Standish, Huw Jenkins, the head of the investment bank, and Chairman Marcel Ospel. The investment bank piled up 57.1 billion francs in cumulative pretax losses in the three years through 2009, and UBS had to be rescued by the Swiss government. The bank brought Gruebel, who previously ran rival Credit Suisse Group AG (CSGN), out of retirement in February 2009 after the company posted the biggest annual loss in Swiss corporate history. Since joining UBS, Gruebel has sought to install tighter controls at the investment bank. He started weekly calls with top officers and was personally monitoring traders' positions, together with Carsten Kengeter, who runs the investment bank. Quaker Doctrines Adoboli was a director of ETF and Delta One Trading in London, meaning he was a member of the trading desk. Before that, he worked as a trade support analyst at UBS, according to a profile posted on LinkedIn. Photography, cycling and wine are listed as interests on his Bloomberg biography page. He graduated from the University of Nottingham in July 2003, earning his degree with honors in e-commerce and digital business, the school said in a statement. He also attended the Ackworth School in West Yorkshire as an overseas boarder until 1998, Kathryn Bell, the head of the school, said in an e-mail. “He was an able student who made a very positive contribution to the school community,” Bell said. Frozen on Facebook Adoboli's Facebook account has been frozen, according to a friend who had access to his profile. Calls to Adoboli's office number were answered by a man identifying himself as Owen, who said he wasn't at work today and wasn't able to say when he would return. Adoboli is now shown as inactive on the Financial Services Authority's register. His father, John Adoboli, a former United Nations official, told the U.K.'s Press Association in an interview from Tema, Ghana that the family was “heartbroken because fraud isn't our way of life.” The trader has hired lawyers at Kingsley Napley in London to represent him, according to a spokeswoman. The firm previously advised Nick Leeson, whose $1.4 billion of losses triggered the collapse of Barings Plc in losses in 1995. ‘Complex Areas' Adoboli's desk handled proprietary dealing and trades for clients. Such desks would trade in a variety of securities to enable clients to speculate and hedge baskets of securities. For example, if a client wanted to short Swiss equities expecting the franc to rise, the desk would design a trade and use a combination of equity swaps, futures and ETFs to accomplish it. As the derivatives should mirror the securities they track, they would be insurance against market moves and shouldn't carry extra risk for the bank. “Delta One desks are not necessarily known as risky areas,” said Terry Smith, CEO of the interdealer broker Tullett Prebon Plc and of the asset management firm Fundsmith LLP. “But they are known as complex areas.” Delta One traders profit on cost and margin differences between derivatives and their underlying securities, and by timing the purchase and sale of each element. The derivatives they use include exchange-traded funds, swaps and futures. As a member of the trading desk, Adoboli helped structure ETFs for clients and then hedge the bank's positions to safeguard against potential losses. Societe Generale The desks take the Delta One name because price movements in the derivatives they create move almost in lockstep with the underlying securities. This relationship is defined as having a delta of one or close to one. At Societe Generale, Kerviel used futures to bet the market would go up, just as it collapsed. Futures, unlike ETFs, are leveraged products, causing the buyer to lose more than the initial investment. The European exchange-traded fund market had $324.4 billion of assets at the end of July 2011, 37 percent more than a year earlier, according to data compiled by BlackRock Inc., the biggest provider of ETFs globally. Regulators' Scrutiny That growth has attracted the attention of U.K. authorities. In its June 2010 Financial Stability Report, the Bank of England said there was a danger that “the benefits of ETFs become outweighed by complexity, opacity and contingent risks.” In February, the FSA said it had “heightened our supervisory vigilance in this area.” In July, the Serious Fraud Office announced a probe into the funds. “This comes at a critical time in the debate about how to structure the banking system,” said Richard Reid, head of research at the London-based research firm the International Centre for Financial Regulation. “It makes it much tougher for banks to resist efforts to tighten up regulation just as macro- economic conditions deteriorate.” --Bloomberg News--