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Alpha players on Delta desks echo regulatory tango

THE $US2 billion ($A1.95 billion) trading loss that has rocked Swiss bank UBS has also cast a spotlight on a relatively unknown but increasingly profitable corner of Wall Street Delta One desks.

THE $US2 billion ($A1.95 billion) trading loss that has rocked Swiss bank UBS has also cast a spotlight on a relatively unknown but increasingly profitable corner of Wall Street Delta One desks.

Both Kweku Adoboli, the UBS trader in London arrested on Thursday over the loss, and Jerome Kerviel, the Societe Generale trader who was responsible for $US6.8 billion in losses in 2008, worked on such desks.

While Delta One may conjure up images of Top Gun fighter pilots, the desks get their name from the financial definition of "delta", which refers to the change in a price of a derivative against the change in the price of a customised underlying asset, like a basket of stocks.

Most Wall Street firms have such desks for their clients. Buying a derivative that closely tracks an underlying asset can be easier or less risky than buying the asset itself. Instead of buying bars of gold, a hedge fund manager may buy an exchange-traded commodities fund, or even a gold fund. These derivatives can also be attractive because they typically require little upfront capital.

In some cases, the Wall Street firms themselves try to profit from the tiny differences between the values of the derivatives and the underlying assets.

In recent years, the desks have generated billions of dollars for Wall Street firms. In a research note last year, Kian Abouhossein, an analyst with JPMorgan Chase, said that he expected revenue from the business of about $11 billion this year, growing on average about 9 per cent from 2010 through to 2012.

A reason for the success of this particular desk is the explosive growth of exchange-traded funds an investment class that tracks indexes or baskets of assets. On average, exchange-traded funds are expected to grow about 20 per cent a year, as retail clients, hedge funds and institutions increasingly rely on these products for both exposure to the markets and as protection against volatility.

Also helping the growth of these desks is increased demand from investors for computer program trading, which uses mathematical models to execute lightning-fast transactions.

Delta desks are a profitable business and, on the surface at least, not a particularly risky one. But like many things on Wall Street, the practice can become perilous if not properly policed.

UBS has not provided any details on the trading losses. The UBS trader suspected of the losses, Adoboli, was a director of exchange-traded funds on the Delta One desk in London.

The bank said that trading was being investigated but said "no client positions were affected".

The significance may not be in the trade itself, but in what oversight the bank had on the trader's position or whether the trader hid the risk from compliance officers. It could well have started as a trade for a client where the bank took on a position to make a market that was allowed to balloon. The trade may also have come about after the firm made the market and then decided to hold on, essentially making a directional bet with its own money.

Whatever the cause, the UBS trading losses are likely to rekindle the debate over proprietary trading, which has drawn increasing scrutiny from regulators since the financial crisis.

Yet the definition of what constitutes proprietary trading can be fuzzy. Many on Wall Street consider proprietary trading, or "prop trading", to involve only trades made by dedicated traders who are using the bank's capital and do not have access to client information. The trading done on Delta desks, they contend, is done on behalf of clients.

Those boundaries, however, can blur. A bank may buy a derivative or security from a client in order to make a market, then decide it is worth hanging on to, turning it into a proprietary bet.

Delta One operations are profitable. Societe Generale will generate a return on equity greater than 100 per cent, while the other leader in the business, Goldman Sachs, will generate a return of 52 per cent, according to the JPMorgan report. UBS will notch about 72 per cent.


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