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UBS Rogue Trader Exposes Massive Systemic Risk

Breakout

Yesterday, on the third anniversary of the collapse of Lehman Brothers, Swiss bank UBS (UBS) announced a greater than $2 billion loss due to a "rogue" trader. The trader in question, London-based 31-year old Kweku Adoboli, was arrested on suspicion of fraud at 3:30 in the morning after UBS ratted him out to British authorities. He's since reportedly admitted to creating losses. The BBC reports that UBS didn't learn about the bad trades until Adoboli told them himself.

So he clearly didn't sneak into UBS and cause troubles under the veil of anonymity. Until his arrest, Adoboli was reportedly a director on UBS's "Delta One" derivatives desk. While the title of director perhaps means something different in Europe, in the States it means someone with the authority to make higher-level decisions such as "should this trading desk make a trade exposing us to a $2b loss?" Adoboli wasn't operating outside the system, but rather was very much part of it.

Was this a one-off instance of a single employee operating outside the rules or evidence of systemic issues not just at UBS but the teetering Investment Banking system as a whole? To explore the issue, or at least bandy about conspiracy theories and mock efforts to regulate an inherently risk-laden business, Breakout welcomed Jon Najarian, the co-founder of Trade Monster and Friend of Breakout.

Since UBS isn't owning the bad trades and Adoboli is busy doing things other than laying out his trading book, the most obvious question is what on earth Adoboli was trying to do that went so wrong. With markets this volatile the answer could be just about anything.

"You could have lost money a whole bunch of ways," says Najarian, quickly adding that the losses didn't come from trades made on the CBOE or via other regulated traditional exchange floors. "You couldn't have hidden it in exchange-traded products," he says. Adoboli was operating on a desk charged with creating customized products for specific clients, among other activities. In effect, these desks trade against their own clients until they can offload the risk to someone else by chopping up the trade and selling the pieces to other clients.

If in fact this type of activity is what happened to UBS, it is only slightly different than what happened during the housing crisis when hedge fund managers like John Paulson were able to make exotic bets against mortgage back securities with the help of trading desks. Remember "Fabulous" Fabrice Tourre of Goldman Sachs (GS) infamy? There's a decent chance Adoboli was putting together a similar trade, but the difference is that UBS got caught holding the bag.

Najarian lays out a hypothetical scenario where a UBS client would have called upon the "Delta 1" desk to help him get long "the 20 highest beta stocks of the DAX." That would make UBS short those stocks unless and until Adoboli could find a client willing to short those same stocks. Under this scenario the 10% rally of the DAX, like the one seen in recent days, could have caught UBS both levered and short, easily causing $2b in damage.

In fact, Najarian says UBS got off relatively easy. With the extreme volatility of late Najarian says it would have been entirely possible for a bank and/or their clients to rack up losses into the hundreds of billions. While he has yet to be accused of anything more specific than being a bad trader, Adob0li may not have even violated existing trading laws. According to Najarian, none of the regulations created in wake of the '08 financial crisis, or at least Dodd-Frank in the U.S., would cover the type of trade outlined above.

All of which is mere informed speculation. What is certain is that now is a particularly bad time for UBS to lose $2 billion. As a Swiss domiciled company, UBS is subject to tighter regulations than other European banks. A need for greater liquidity was already one of the issues hitting them; obviously a single trading desk hammering an entire quarter's worth of earnings as well as the overall balance sheet doesn't help assuage Swiss parliamentary regulators.

So who's minding the store and could this happen here? Najarian says "it's incumbent on UBS, Goldman Sachs, Credit Suisse (CS), Deutsche Bank (DB)... anybody who does this kind of trading to really monitor" people like Adoboli and his Delta 1 desk.

In other words, the lunatics are running and regulating the asylum. It's a chilling prospect even for the most adamant advocates free markets.