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Asia ETF risk watched post-UBS rogue trades

Asia-focused ETFs are unique in that they allow foreign funds to gain exposure to markets like India.

Written by Agencies | Singapore |
September 20, 2011 4:50:56 pm

The rogue trades that cost UBS $2.3 billion have turned attention to certain trading instruments that may carry risks unique to Asia.

Banks across the region,which have been busy peddling Asia-focused exchange traded funds (ETFs),are now scrambling to ensure similar nasty surprises are not lurking on their books,according to financial industry sources in Hong Kong and Singapore.

Asia-focused ETFs are unique in that they allow foreign funds to gain exposure to markets that have difficult foreign investment rules,such as China and India. The ETFs also offer a cheap and effective hedge against existing stock portfolios.

UBS stunned markets last week after announcing unauthorised trades,allegedly concealed by executing fake exchange-traded funds positions,had racked up huge losses. London trader Kweku Adoboli was charged with fraud and false accounting dating back to 2008.

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ETFs focused on countries and sub-regions in Asia-Pacific managed about $138 billion at the end of August,up 25 percent from a year earlier,according to Thomson Reuters Lipper data.

Deutsche Bank,BlackRock and Societe Generale’s Lyxor are some of the biggest ETF providers in the region.

However,the growing popularity of what are called synthetic ETFs is causing particular worries.

A synthetic ETF uses derivatives to track the movements of an underlying share index rather than using the shares themselves. Because they rely on some kind of swap contract,usually with an investment bank,they come with an inherent counterparty risk.

Investors want exposure to India and China so it’s natural there’s a market for these products here,but you mustn’t forget there’s got to be a market maker and if they see too much profit in that kind of contract then history tells us it will become bigger beyond what they can manage,said Professor Jin-Chuan Duan,director of the Risk Management Institute at the National University of Singapore.

Another area of concern are quanto products. These are derivative instruments such as stock index futures that are denominated in a currency other than the base currency.

A trader of equity derivatives including index products at an Asian bank in Hong Kong said that an example of these would be the MSCI Taiwan futures contract listed in Singapore but denominated in U.S. dollars.

For the investors,the product offers a fixed rate of interest thereby eliminating the currency risk. For the bank offering the instrument,however,it means that they have to not only hedge against the movements in the Taiwan share index but also the movements of the Taiwan dollar against the US dollar.

Quanto products are not as popular in Asia as they are in Europe,said the trader,but the recent volatility in Asian currencies could make them vulnerable to errors in risk management.


Mounting fears about a Greek default have recently prompted foreign investors to slash their bets on Asian currencies,which had only a month ago been widely expected to keep appreciating. That has caused,for example,30-day realized volatility in the South Korean won to jump to the highest since early January.

As a result,many fund managers have been scrambling to hedge their exposure to Asian currencies.

Regulators aren’t ignoring the risks. Hong Kong’s market watchdog,the Securities and Futures Commission,said last month that synthetic ETF managers needed to ensure their products were 100 percent collateralized to mitigate the risk of an investor losing their money.

The SFC’s tough stance has caused some ETF providers to decide not to list in the city.

We have seen some cases where overseas ETF issuers have decided not to cross-list their ETFs in Hong Kong because they are unable to comply with the Hong Kong requirements,said Eva Chan,a lawyer at Simmons & Simmons in Hong Kong,who specialises in advising investment funds.

But a tough policy in one jurisdiction may not be enough to guard against the wider systemic risks when other regulators have laxer policies in place.

ETF growth is good for financial market growth and many jurisdictions like to see that happen,said Duan at Singapore’s Risk Management Institute.

He argues regulators should consider limiting the proportion of synthetic ETFs within an investment bank’s trading portfolio.

It’s always very hard politically to make a financial institution retract from its current position when it’s already too big as they have the whole infrastructure and payroll in place,so it’s better to stop it getting to that position,he said.


Banks in Asia are already likely to be reassessing the risks of these products,even if there is little evidence yet that it was anything specific about them that caused UBS’s rogue trades.

‘Delta One’ trading desks,like the one where UBS’s Adoboli worked,were generally regarded as a low-risk type of dealing compared to other investment banking activities.

The desk would give a client exposure to a particular market such as Indian equities by selling them an ETF and then cover the risk they were taking on by buying the underlying equities or derivatives linked to them.

Market veterans say ‘Delta One’ trading is relatively straight-forward compared to the complex derivatives linked to securitised mortgages and commercial paper that were at the centre of the 2008 financial crisis.

You don’t need a cast of thousands and you don’t need rocket scientists to do this,that’s maybe why it slipped under the radar – it was a very vanilla business,said Charlie Brown,a former product structurer at UBS,who now runs derivatives consultancy MathFinance Asia.

Now market sources in Asia say banks’ risk-control departments are scrambling to check their ‘Delta One’ desks to ensure they have no unpleasant hidden surprises.

Obviously this affects traders across the street because every compliance department,every risk-control manager are calling over these guys now worried that they would be doing the same thing,said a banker in Hong Kong who looks after synthetic equities and ETF sales but declined to be identified.

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