Tuesday, September 20, 2011

Delta Desks Pose Banking Risks

I don't categorically exclude any particular sector from my quantitatively-based equity selection process. Rather, I let the specific performance of each company either qualify or disqualify the entity.

That said, over the past 20+ years I've operated the portfolio selection process, to my knowledge, only one investment bank- Goldman Sachs- and no more than two or three commercial banks, briefly, have managed to merit inclusion.

My experience with Chase Manhattan Bank in the 1980s provides me with an understanding of what occurs inside these large financial institutions which tends to exclude them from my process' portfolios. It's a combination of size, diversity and asymmetric payoffs to traders and managers while limiting their risks.

Consider this recent Wall Street Journal article concerning UBS' recent admission of $2.3B in losses by their so-called rogue trader.

Delta Desks Emerge as Mine Fields

A Key Revenue Source for Banks Has Been at the Center of Two Recent Scandals.
By Carrick Mollenkamp

The scandal at UBS AG is casting a harsh spotlight on a corner of the financial world—so-called Delta trading—that Wall Street has been counting on to boost revenue in the wake of a financial crisis.

Kweku Adoboli, the UBS trader formally accused Friday of fraud in UBS's $2 billlion loss, worked on UBS's "Delta One" desk in London. Delta trading—the name is derived from the fourth letter of the Greek alphabet—is a gauge of risk exposure for bets made on the movements securities such as stocks and securities.

The transactions generally involve two parts. First, a client would request a "derivative" trade, effectively a bet on the direction of a group of stocks or other securities. When the bank executes the trade, it actually acquires the securities in question.

In the second part of the trade, the bank creates a mirror of the derivative to mitigate the risk.

The "delta" is a measure of how the value of the derivatives would change compared with the underlying stock or other asset. Delta has become a term to indicate that a bank can customize a security for a client and then closely replicate it on the banks books.

At UBS, Mr. Abodoli's Delta One desk specialized in exchanged-traded funds and other securities positions, according to people familiar with the situation. On Friday, Mr. Abodoli was charged on three counts: two counts of false accounting and one count of fraud. He didn't enter a plea during a court hearing.

Delta trading has gained momentum in a markets environment in which the mortgage-bond trading business is on the skids and global regulations require banks to set aside expensive capital for loans.

Wall Street is counting on trading large volumes of stocks and derivatives to bolster revenue.

There is nothing inherently improper about such Delta trading. And many large financial institutions employ this strategy, including Société Générale SA, BNP Paribas SA and Goldman Sachs Group Inc. in Europe and Goldman and Morgan Stanley in the U.S., according to a J.P. Morgan Chase & Co. report.

The trading requires state-of-the-art technology systems and can produce as much as $1 billion in annual revenue at top banks, J.P. Morgan said, which noted, "Delta One products in one area of growth in our view, with strong growth in client volumes, resilient margins and untapped potential in emerging markets."

But it earlier gained notoriety in 2008, when French bank Société Générale said that Jérôme Kerviel had worked on a Delta One desk while trying to hide $7.2 billion in losses in another rogue trading scandal. Last year, Mr. Kerviel was sentenced to three years in prison.

I recently wrote this post placing these 'delta desk' type trades and losses in a larger perspective.

Except, perhaps, for Goldman Sachs, which has a reputation, and performance record, for better risk management than its competitors, extensive and deep participation in these delta trades in a proprietary fashion by large financial institutions seem to create their own pattern of volatile earnings or, more specifically, large losses.

Now, of course, these firms are supposed to be sunsetting their proprietary trading activities. Which makes them less loss-prone, but, also, prone to lower growth rates, as well.

However, reading a companion Journal article (to the above piece) detailing UBS' efforts to improve, overhaul and generally tackle risk management since 2007, and how it has failed, gives me little hope that firms of that ilk will ever get this right.

Years ago, I actually knew and played squash with Barry Finer, the guy who was the risk manager on the desk where Joe Jett ran his trading scam at GE's Kidder Peabody unit. I subsequently compared notes with colleagues at then-independent consulting firm Oliver, Wyman & Co., who had been hired by GE to do a post-loss review of what had happened.

We all agreed that Finer had done his job, but essentially been ignored in the typical fashion that occurs in so many large financial institutions. Until line/desk risk managers and the risk management function is better-compensated, insulated from desk managers, and reports directly to a CEO, with penalties for failure commensurate with compensation, these unpleasant trading loss surprises will continue to be a periodic staple of large investment and commercial banks.

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