All Things in Moderation

Regarding the fictitious positions, UBS is apparently claiming that the trader booked false exchange-traded transactions to make it appear that he was within his liimits. This doesn’t makes sense at all, as such fake trades would be very difficult to hide. Exchange traded transactions generally require daily margin calls. This means that, each day, as the positions started to lose money, the exchange would have been calling for UBS to post daily cash/collateral as margin to cover the losses. But, from UBS’ side, if it thought that the positions were hedged by what it now knows to have been fictitious covering trades, it would have expected not to have to post much or even any margin at all. So how is it that UBS did not think something was amiss when the exchanges started calling for margin that UBS thought it didn’t owe?

I can think of only 3 reasons.

First, the front office trader was somehow in control of back office functions, allowing him to post margin that he knew he owed, while manipulating reports to make it appear that it wasn’t being posted. This is essentially what happened 15 years ago when Nick Leeson took down Barings Bank with unauthorized trading in Singapore. Allowing a single person to be engaged in both front office and back office functions is a major breach of control rules, a fact that ought to be obvious but was reinforced in the wake of the Leeson debacle with the introduction of many more regulations, as control issues were all the rage for several years following that event. Hence, I find it pretty much impossible to believe that any such thing is still going on at a place like UBS.

Another possibility is that the back office controllers at UBS were wholly incompetent. This is possible, but still highly unlikely. Each day the back office would have had to confirm with the exchange not only the amount of margin to be posted, but also the existing positions held there. This is one of the most basic functions performed by the back office. If false trades had been entered into UBS’s system, the daily checks would never have matched with the exchange. The level of incompetence needed to overlook this, and post margin on it despite the discrepancy, is too big to be plausible.

Lastly, the trader could have had assistance from someone in the back office helping him to cover up the fraud. This, to me, is the most plausible explanation. Control systems can never make fraud or unauthorized trading impossible. Some degree of trust in employees is necessary and inevitable. What they do is to make it difficult to engage in a prolonged fraud by spreading essential responsibilities across different people, making it impossible for a single person to maintain it. Hence, for this to have gone on for at least the 3 months they claim it was going on, I think he needed help.

UBS says that this trader was acting alone. I will be very surprised if this turns out to be true.