Rogue trader: The complex trades that increased the risk of disaster

Comment:

To some in the City it came as no surprise that ETFs are connected to the extraordinary losses at UBS.

Exchange Traded Funds - artificial pools of shares, bonds and whatever else you fancy - have been around since the early 1990s. But they really took off a few years ago - a reaction, it is said, to how poorly fund managers have lately proved to be at picking individual stocks.

The merit of ETFs is that they are cheaper to run, because they generally track indices rather than attempting to outperform them.

Terry Smith, the Tullett Prebon chief executive who is probably UBS's most famous ex-employee, has been warning about the risks of these devices for some time.

His point is that they have now become so complex that not enough investors truly understand the risks they are taking.

They have stopped being merely passive funds, and were increasingly actively managed and traded with gusto.

This raised the risk profile and the chances that the performance of an ETF would diverge from the (supposedly) underlying index.

Asked today if there will be more fallout from ETFs in the near future, he replied: "If a major bank can't understand the risks in ETFs and losses $2 billion trading them, what chance do retail investors have?"

He thinks ETFs should be restricted to matching major indices, avoid all derivatives and only sold to institutional investors.

As it stands, some ETFs are leveraged - they seek to maximise performance by borrowing to bet.

In such cases it only needs a small number of trades to go wrong before losses begin to mount.

At UBS, the desk that ran into trouble was called "delta one". That supposedly indicates a crack team of dealers, though its performance suggests they may have been closer to a team of crack dealers.

The desk's brief was to trade Global Synthetic Equities - about as far from a simple index tracking ETF as it is possible to get.

UBS says, rather lamely, that the trading was unauthorised.

As our old colleague Christopher Fildes liked to remark, all losses in the City are unauthorised.

It is hard to escape the suspicion UBS was unconcerned about this trader's activities for as long as he was winning. Same as it ever was.