How collateralising doubles fraud risk in synthetic ETFs

26 September 2011 | By Rodrigo Amaral

Information released by UBS indicates that Adoboli may have used fictitious ETF positions to conceal speculative bets on index futures. For many a commentator, the episode has confirmed fears about ETFs, expressed by organisations such as the Financial Stability Board, the committee of international regulators.

Regulators worry that synthetic ETFs lack transparency and expose investors to a high level of counterparty and collateral risk. That is partly because, instead of investing in the underlying assets linked to the index they aim to replicate, many synthetic ETFs are collateralised by equities that have nothing to do with the index.

Trading desks that manage such ETFs do not invest their clients’ money in stocks directly, but in swaps that replicate the returns of the ETFs’ benchmark index. They then collateralise them with instruments of roughly equivalent value, which may or may not bear a relationship to the index itself.

Fraudulent traders can exploit two areas: the swaps in which the funds invest, and the securities that collateralise them. In most funds, they can only steal from the underlying investments. (article continues below)

ETF market makers have claimed that the problem is not the products themselves but the use Adoboli alleg­edly made of them. On the available evidence, nobody cleared the ETF trades that Adoboli is accused of using to conceal a series of bets. This makes it harder to blame the products for the losses. ETF market makers’ procedural quirks, however, may make it easier for fraudsters to hide their activities.

In the London market, for instance, traders can delay the settlement of ETF transactions. As a former back-office employee, Adoboli would be aware of how common late settlements were, and also that some banks did not confirm forward transactions with ETFs until the date they were settled. If they were cancelled before that, there would be a bigger chance that the bank would not acknowledge such transactions and question them. A trader might have used fictitious transactions to give the impression of having hedged a trade. As losses mounted, Adoboli would have upped his ETF transactions further as he bet ever more money in a quest to revert them.

Clearing and settlement have not ­figured as a concern in warnings about ETFs issued by regulatory bodies in the past couple of years, although they have in warnings over equity derivatives in general. For investment firms generally, the Adoboli case provides another illustration of the risks of allowing traders to deal under pressure in complex and thinly regulated markets without proper oversight.

The risk management of UBS’s investment banking division in particular, which was criticised after heavy losses during the global financial crisis, is coming under further investigation. Proper risk management looks more of a necessity than ever as growth in the use of off-exchange derivatives creates more opportunities for rogue traders.

As lessons go, this is hardly news. Equity derivatives, though not necessarily ETFs, were freely employed by protagonists of previous scandals such as Jérôme Kerviel at Société Générale and Nick Leeson at Barings (see table, above). It may be unfair to blame financial innovations when rogue traders misuse them. It looks increasingly difficult to deny, however, that equity derivatives may be facilitating their work.

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