It is becoming clear that the UBS scandal that rocked financial markets last week is not just about a single trader suddenly gone awry. UBS’s controls – both in risk management and auditing – failed miserably. Top bankers in the investment banking arm of UBS didn’t have a clue about what was going on in the trading desks and in the back office. When a kid can so easily blow a $2.3 billion hole in the balance sheet, and cause so much damage to the reputation of a top tier bank, there’s something awfully wrong.
But the failures of the system go beyond UBS alone. Kweku Adoboli made trades that apparently didn’t require prompt confirmation with its counterparties. Why? Because in Europe, where UBS’s Delta-One trading desk is based, the vast majority of trading in exchange-traded funds (ETF) occurs over the counter (OTC), in bilateral trades. The rapid growth in ETF trading (a profit center) has outpaced spending in back-office and reporting activities (a cost). According to the Wall Street Journal, a report published in 2009 states that over three quarters of European ETF trading didn’t require any reporting. The Bank of England, among other supervisory authorities, has called attention to the growing complexity and interconnectedness of ETFs. Unregulated OTC trading also makes them obscure. The inherent lack of transparency of OTC markets provides a fertile ground for misrepresentation and outright fraud. It is also likely that opacity makes it much harder to measure the risks taken by ambitious traders.
The European Commission is now carefully saying that it will look into the possible regulatory implications of the case. The Commission, scared to death by the banks’ threat to leave if new regulations are imposed, has ignored the lessons of the 2008 Jerome Kerviel affair, responsible for Societé General’s $7.2 billion mishap with ETFs and related OTC derivatives transactions. It would serve the European Union well if it learned from the US, where ETF trades are reported and cleared through public and open exchanges. No opacity, less room for cheating.