Published: November 15, 2011
In the space of a few hours, Kweku Adoboli became as famous as Nick Leeson, Bernard Madoff and Jérôme Kerviel. Without breaking Mr. Kerviel’s record for losses, the UBS trader cost the Swiss bank nearly €2bn. How did he do it? By processing transactions on the ETF (exchange traded funds) market, and more specifically on the synthetic ETF market. ETFs are investment funds that look to reflect the performance of a benchmark index. They are listed index products that grant the bearer either their underlying securities positions (physical replication) or that of derivatives (synthetic replication). Synthetic ETFs are based on a yield swap agreement with a counterparty. The latter determines the basket of securities. By nature, the price of synthetic ETFs can differ from that of its underlying, not only because of the intrinsic performance of each asset making up the underlying, but also the value of the CDS (credit default swap) purchased to insure against the counterparty risk represented by the party with whom the swap was implemented. In this case, these risks are not added together, they are multiplied!
How is it possible that such an event could come to pass, and on such a scale, a mere three years after the Société Générale scandal? How could a major bank drift so far off course? And most of all, what lessons can companies learn from this development?
On the UBS side, the assessment is triply distressing:
1 - Incoherence between words and actions
Indeed, UBS declared to its wealthy clients on July 27, 2009 that “the short-term nature of synthetic ETFs goes against the long-term philosophy that UBS recommends in designing its clients’ portfolios”.
2 - Pusillanimity of the Group CEO
Oswald Grübel, Group CEO of UBS (nicknamed Saint Ossi, since he was appointed to this position to save the bank after the subprime disaster that had cost more than €30bn) admitted responsibility, but not guilt. Like others before him when confronted with this kind of crisis, he firmly and clearly announced his intention to remain at the head of the Group. In the end, GIC, the Singaporean sovereign wealth fund that owns 6.41% of the capital of UBS, decided otherwise.
3 - Failure of internal and external monitoring bodies
Everyone thought the Kerviel scandal had sounded the death knell for such iniquity among bankers, but that is obviously not the case. Moreover, this incident once again sheds light on the inability of auditors to discover fraud when it concerns complex instruments. The event also serves to illustrate that regulators lack the means to properly determine the risks that complex products impose on banks, their shareholders and their clients. Thus the legitimate question: How can we be sure that in the future no bank will experience losses of this magnitude?
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On the corporate side, there are three lessons that the treasurer can learn from this incident:
1 - Show circumspection
When the bank proposes a product, the role of the treasurer is to verify that it is relevant and in the interest of the company. His job is to synthesise the research, which calls for a number of skills, so as to provide the company’s financial management with a substantiated recommendation.
2 - Keep it simple
Banks have few qualms about developing complex derivative instruments, because the greater the sophistication, the higher the expected return. Furthermore, the greater the complexity of an instrument, the less its liquidity is assured. This necessarily causes a problem when seeking a marked-to-market quote, or when the company wishes to unwind it.
3 - Stay humble
Indeed, there is no shame in saying that you do not understand or that you cannot follow up considering the context. For example, one of the main reasons that so many local governments have been swindled by unscrupulous bankers is that local authorities were unfamiliar with the instruments proposed and wanted to deal in ‘fashionable’ financial products.
This kind of event is undeniably harmful to the banking profession. It casts legitimate suspicion on the entire banking system, and on all the projects launched in the wake of the Kerviel incident to increase control and oversight of transactions, including the implementation of Charters of Best Practice. It is therefore normal that companies which are currently very liquid and cannot help linking these suspicions with the sovereign debt crisis, should react by drastically reinforcing their analysis of counterparty risk to the point of distrusting, for their surplus cash, certain financial establishments. But will regulators have the will, and particularly the means, to adopt the measures necessary to bring these frauds to an end and restore confidence?
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