There has been a fresh flurry of criticism of exchange-traded funds (ETFs) in the wake of yesterday’s news that a “rogue” trader on UBS’ “delta one” desk incurred some $2 billion in trading losses. The specific details of the failed trades have yet to be released, but many are already pointing the finger at ETFs.
By way of background, delta one trading desks deal in derivative instruments whose objective is to mimic the performance of an underlying asset or benchmark on a 1-to-1 basis. Such instruments include swaps, futures, forwards, and ETFs. Delta one desks most frequently engage in a variety of arbitrage trades aimed at exploiting price discrepancies that arise between these different instruments.
Regardless of the actual instrument involved in this incident, it is not the vehicle that is at fault. Responsibility for this loss lies with the person that incurred it.
This episode also highlights a lack of adequate risk controls at UBS--a fact that is made clear in this piece of reporting from the BBC--and again, not any risks specific to ETFs.
Unfortunately, much of the subsequent coverage in the financial media has missed this point.
ETFs--much as any financial instrument--have many inherent risks. This incident arose out of a risk that is non-specific to any particular financial instrument--investment risk.
A bad trade was made--plain and simple.
All this said, it is important to understand the real risks inherent to the variety of exchange-traded product (ETP) structures. To the extent that this loss impaired UBS’ financial standing, the incident underscores the very real and potentially growing (as measured by the widening CDS spread for a number of major synthetic ETF providers’ parent banks) counterparty risks inherent to the ETF structure.
This is a topic that we have covered at length in a variety of venues. Most recently, we conducted an in-depth analysis of the practices employed by Europe’s providers (including UBS) of synthetic ETFs to highlight the specific risks inherent to these structures, the risk mitigants employed to protect investors, and the compensation investors receive for assuming this risk. We will be issuing a similar study of securities lending practices amongst providers if physical ETFs next week. And later this month we will be conducting a live webinar, where we will discuss counterparty risk across all the unique ETP structures in detail.
