The proceedings launched by the Swiss Financial Market Supervisory Authority FINMA into UBS's trading losses in London have highlighted serious deficiencies in risk management and controls at UBS's Investment Bank. In FINMA's view, the fraudulent transactions executed by the rogue trader would have been detected sooner if these deficiencies had not existed. As soon as the unauthorised trading activities became known, FINMA imposed preventive measures to limit UBS's operational risks. Now that its proceedings have been completed, FINMA is appointing an independent third party to ensure that corrective measures are successfully implemented.
Today, FINMA is publishing a summary report detailing the conclusions of the proceedings and disclosing the measures it has taken as well as those implemented as a first step immediately after the trading losses became known. The far-reaching immediate measures ordered by FINMA include capital restrictions and an acquisition ban on the Investment Bank. Moreover, any important, new business initiative which the Investment Bank intends taking must initially be approved by FINMA. In order to monitor the progress of the measures imposed, FINMA is appointing an independent investigator and, at a later stage, will engage an audit firm to review whether the steps taken by UBS have proved effective. FINMA is also further examining whether UBS must increase capital backing for its operational risks.
Background to the trading lossesIn mid-September 2011, UBS discovered that trader X, who was employed on the Exchange-Traded Fund (ETF) desk of its Investment Bank in London, had been engaging in unauthorised trading. The ETF desk traded in a variety of financial instruments designed to meet the investment needs of UBS clients. The desk also traded on its own account. As a director-level employee, trader X executed transactions for the bank's account in excess of his defined limits and concealed the risk exposures. By using a range of prohibited mechanisms, he succeeded for a substantial period in covering up the actual scale of his trading positions and the risk they posed. The mechanisms used included one-sided internal futures positions, the delayed booking of transactions and fictitious deals with deferred settlement dates. UBS suffered losses of USD 2.3 billion. Trader X also created a mechanism, which he referred to as the "umbrella", for smoothing out profits and losses. On 20 November 2012 trader X was found guilty on charges of fraud by abuse of position and not guilty on charges of false accounting at the end of his trial in London.
Unclear monitoring responsibilitiesResponsibility for monitoring and controlling the ETF desk was split between the line managers in the front office and three separate control functions. The Operations unit was responsible, among other things, for ensuring that the ETF desk's trades were correctly recorded and processed. Product Control, part of the Finance department, was responsible for ensuring correct reporting and plausibility checking of profits and losses, while Risk Control was tasked with monitoring and evaluating the risks from trading activities.
Line managers were uncertain of what their functions and responsibilities were as regards monitoring the ETF desk. One aggravating factor was that, following a reorganisation in April 2011, the direct line manager was located in New York. No specific arrangements were made for transferring responsibility for monitoring. Warnings did not get as far as the new direct line manager in New York and ended up instead with the previous line manager in London. He received and acknowledged them, even though this was no longer his responsibility.
Between June and July 2011, it became clear on at least four occasions that trader X had exceeded his limits. In one of these cases, he revealed to his manager in New York that he had made a profit of USD 6 million by taking a position of more than USD 200 million, far in excess of his approved risk limit. The line manager first congratulated trader X on the profit and only later reminded him that he needed permission to exceed his limit. The inadequacy of the controls was also made clear by an incident in August 2011 in which fictitious ETF trades with deferred settlement dates generated irregularities amounting to half a billion dollars. These warning signals were accepted without further investigation.
Control functions too weakThe three control functions also failed to properly investigate the many warnings triggered by transactions from the ETF desk. For example, the unusually large profits generated by the ETF desk starting in the first quarter of 2011 were not critically examined.
It was common knowledge in the London trading room that the ETF desk caused many reconciliation errors, often as a result of late or incorrectly booked transactions. These concerns were discussed neither with the Product Control unit nor with senior management. Starting in June 2011, the reconciliation errors became substantial, with the unexplained amounts sometimes exceeding USD 1 billion.
Operations saw its role as providing services to trader X and raised no serious questions about his activities. Although reconciliation errors remained unresolved over several weeks, explanations provided were implausible, and inconsistencies were occasionally escalated, trader X's managers and controllers were too quick to accept his explanations. Even at a meeting held on 24 August 2011, managers came to the conclusion that no large amounts of money were at risk.
In August 2011, trader X once again persuaded Product Control that losses of one billion dollars shown in the trading systems were incorrect. His assurance that he would correct these "booking errors" in the near future was accepted without objection. In fact, trader X's aim was to remove the bank's losses, at least temporarily, from the books. In addition, an important control report was not produced at all for a period of several months without anyone noticing this fact.
FINMA's main findingsOn the basis of these findings, FINMA has reached the following conclusions:
- The direct line managers failed to properly monitor the ETF desk in London. Trader X's relationship with his line manager and the internal control functions was based too much on trust and too little on control.
- The front office monitoring instruments deployed by the line manager responsible for the ETF desk had major shortcomings and were not used properly.
- The control functions had too little understanding of the trading activities in question and were therefore unable to challenge the ETF desk's actions.
- UBS's various control functions did not collate their information to produce an overall picture.
- Operational risks were evaluated to a large extent on the basis of a self-assessment process, which was carried out just once a year by traders and internal controllers. Improvements to this process had been in train since January 2011, but were completed too late.
- Reporting channels and responsibilities were unclear and led to confusion.
- The relocation of direct supervision of the ETF desk from London to New York was badly managed and led to a situation in which the London desk was not adequately monitored from April 2011 onwards.
- UBS sent out misleading signals by awarding pay increases and bonuses to a trader who had clearly and repeatedly breached compliance rules, and by accepting him onto a junior management programme.
Immediate measures implemented by FINMAAs soon as the trading losses were discovered, FINMA imposed until further notice a range of preventive measures on UBS:
- Any new business initiatives which UBS intends to take in its investment bank and which are likely to lead to increased operational complexity require prior approval from FINMA.
- The risk-weighted assets of UBS's Investment Bank are subject to an upper limit which reduces gradually over the period 2012 to 2015.
- The risk-weighted assets of the London branch are also subject to an upper limit which reduces over time.
- UBS's Investment Bank is prohibited from making new acquisitions.
UBS's corrective measuresSince the trading losses, UBS has introduced a large number of organisational measures to strengthen its risk management and control capabilities. Action has been taken on the personnel front, core processes in the front and back offices have been modified, and deficiencies in the processing of trades have been addressed. These, along with other measures, are currently being implemented.
Further measures taken by FINMAIn a newsletter to market participants published on 13 December 2011 (FINMA Newsletter), FINMA specified its expectations regarding controls to prevent unauthorised trading. As part of its supervisory remit, FINMA is checking the extent to which the most important supervised institutions meet these expectations.
FINMA is closely supervising the implementation of the corrective measures at UBS and has now decided on the following additional actions:
- FINMA is appointing an independent investigator to control the implementation and completion of the corrective measures at UBS.
- Once the project is completed, FINMA will engage an audit firm to review whether the measures implemented by UBS have proved effective.
- FINMA is further examining whether UBS must increase capital backing for its operational risks.
ContactTobias Lux, Spokesperson, Tel. +41 (0)31 327 91 71, firstname.lastname@example.org
In the wake of UBS losing around $2.3 billion in a rogue trading scandal, Euromoney can reveal that the Swiss bank’s operational risk management unit had installed a database of case studies of loss events. The database holds information on other major unauthorised trading events such as Barings and Societe Generale’s own scandals in order to help UBS identify rogue trading for themselves.
This piece of news does not bode well for UBS’s reputation for risk management which has been called into question over a number of years.
Euromoney has found out that the Algorithmics service is purely a database for case studies of loss events that operational risk management units can use to help them assess rogue trading scandals and prevent one of its own, and while it is not an analytics or quantitative assessment the news is bound to cause embarrassment at the bank.
Algorithmics, a technology company that specialises in risk management solutions, confirmed the nature of the service it provides for UBS, and also emphasised that it is purely a non analytical database and the company does not provide any risk management systems in any capacity for the Swiss investment bank.
Last week, Kweku Abodoli was charged by UK authorities for the unauthorised trading of S&P 500, DAX and Eurotoxx index futures over the last three months. Sources say that when attention was called to the nature of his trades he changed to dealing with forward settled exchange-traded funds (ETF).
UBS says that the positions were not in themselves extraordinary, rather they were taken within the normal business flow of a large, global equity-trading house as part of a properly hedged portfolio.
Currently there are three investigations underway at UBS with one being conducted by the bank itself to work out what went on and two further independent investigations being carried out by the bank’s board of directors and its lead regulator.
Before the sub-prime crisis, UBS thrived for decades on the back of its strong track record in risk management. This was particularly important for its market leading private banking and wealth management division.
However, that reputation was quickly lost as the extent of UBS’s losses across its main divisions were revealed in 2007 and 2008. UBS admitted to structural failings in risk management throughout its business in a report requested in April 2008 by the Swiss Federal Banking Commission.
In the aftermath of UBS’s losses, the bank suffered quarter after quarter of net outflows from wealth management clients. Grubel, the former Credit Suisse chief brought out of retirement to run his former competitor, has spent the past two and a half years attempting to redeem UBS’s reputation. Client business began recording net inflows again last year. Now much of that work risks being undone by the actions of one rogue trader.
Euromoney contacted UBS for comment on the database of case studies of loss events and its risk management practices. At the time of print of this article, Euromoney has not received a response.