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UBS rogue trader puts ETFs in spotlight

AS THEY did when Jerome Kerviel ran up secret trades that cost Societe Generale $US7 billion in 2008, the markets have decided that rogue trading by a London-based UBS employee, Kweku Adoboli is a byproduct of the financial crisis, but not a multiplier.

AS THEY did when Jerome Kerviel ran up secret trades that cost Societe Generale $US7 billion in 2008, the markets have decided that rogue trading by a London-based UBS employee, Kweku Adoboli is a byproduct of the financial crisis, but not a multiplier.

Questions are being asked about how Adoboli was able to construct trades that the Swiss-headquartered UBS says could cost it about $US2 billion ($A1.94 billion), particularly given that the giant group has been upgrading internal controls and risk management after taking write-downs of $US50 billion on toxic assets in the 2007-09 global financial crisis.

European sharemarkets nevertheless rose by between 2 per cent and 3.5 per cent, Wall Street rose by between almost 2 per cent and the Australian market gained 1.9 per cent yesterday, as investors focused instead on news that the European Central Bank, the US Federal Reserve, the Bank of England, the Bank of Japan and the Swiss National Bank would offer three-month US-dollar loans to commercial banks to head off a US- dollar funding bottleneck.

European banks are big holders of European sovereign debt that would be heavily written down on Europe's disaster scenario a Greek sovereign debt default that transmits via a market selloff to similar crises, and perhaps even defaults in other debt-strangled EU economies, including Spain and Italy. Europe's banks have been struggling to roll over US dollar-denominated debt because of the contagion fears, and the central bank commitment to provide open-ended, short-term US-dollar funding buys them and Europe more time.

UBS's loss on the other hand has been crystallised by market volatility (UBS hasn't said much, but the Swiss central bank's currency-crunching declaration on September 6 that it will buy as much foreign currency as needed to prevent a "massive over-valuation" of the Swiss franc as investors buy in to hide from Europe's sovereign debt crisis is the favoured culprit), and it appears to be self-contained. UBS has rebuilt its balance sheet since the global crisis and can digest the loss, and the people on the other sides of the loss-making trades are sitting on profits.

The UBS disaster will, nevertheless, have repercussions, because it has occurred in the exchange-traded funds sector, a part of the market that is rapidly becoming system-critical.

ETFs are listed securities that mirror various assets, including shares, sharemarket sectors, sharemarket indices, commodities and fixed-interest securities and sectors.

When an ETF security is bought, the investment bank or funds management group that is selling the ETF buys corresponding exposure, to pair the ETF's performance with the assets it is tracking. This is sometimes done by purchasing the physical asset shares or a share index, say but as the industry has grown it has become increasingly common for ETF vendors to take the exposure by buying derivatives, and to also use derivatives to insure against unwanted extraneous market movements, in currencies for example if a US share index ETF is being sold outside the US.

And the ETF market is growing rapidly. It was a dot on the financial landscape when the new century began, with investments of just $US74.3 billion, all of it in equities, but had grown to $US797 billion in 2007 when the global crisis erupted, and passed $US1000 billion or $US 1 trillion early last year.

BlackRock, the US-based asset manager that owns the biggest ETF provider, iShares, estimates that ETF assets totalled $US1443 billion on 49 exchanges by June 30 this year (ETFs valued about $US6 billion are listed on the ASX), and also predicts that the total will pass $US2 trillion next year.

ETF funds that track shares and share indices are still dominant, with assets of $US1152 billion at June 30. But fixed-interest ETFs have more than doubled to $US233 billion in three years, and commodity ETFs have almost doubled to $US52.3 billion in five years.

The accelerating growth of the ETF industry is linked to its increasing presence on superannuation and other retail investment platforms, and regulators around the world have been expressing concern that ETFs might be a new source of market instability.

America's equivalent of the Australian Securities and Investments Commission, the Securities and Exchange Commission, has this week launched a probe into whether ETFs are contributing to market volatility, by offering investors a way to quickly lift and reduce their exposure to the markets that, in turn, forces large entries and exits from the underlying securities, or derivatives that mirror them. The Bank of England also warned in June that ETFs were a potentially dangerous vehicle for unsophisticated investors, and the rogue trading event that whacked Societe Generale in 2008 also originated on a desk that was buying on the market to compile portfolios that underpinned ETFs.

Inevitably, there will be moves to increase oversight of the ETF market in the wake of the UBS disaster. And UBS may also reconsider its commitment to investment banking, a business that earns about 22 per cent of total UBS profits. The investment bank also generated most of UBS's global crisis losses, and the Swiss group considered selling it at that time, to tighten its focus on its wealth management division, which accounts for about two-thirds of group earnings. UBS's local arm will be watching closely for any renewed signs that investment banking is out of favour. Unlike UBS in Europe, the Australian operation is predominantly an investment bank and broker, and a highly successful one.

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