When it comes to the trading activities that got UBS in trouble, it turns out everybody’s doing it.
Not everybody is allowing multibillion-dollar losses to skate under the noses of risk managers, of course. But most every large bank with a sizable investment dealer – including Canada’s biggest banks – employs traders on so-called Delta One desks like the ones where rogue traders Kweku Adoboli of UBS and Jérôme Kerviel of Société Générale once worked.
Alas, Delta One isn’t nearly as cool as it sounds. It has nothing to do with that movie with Chuck Norris and Lee Marvin. That was The Delta Force.
It’s supposed to be a low-stakes business of simple hedging and arbitrage. It should be boring. In Canada, it seems it is. The business is exceedingly low risk – in some cases, frustratingly so, say some of those who have dealt with Delta One desks in this country.
The goal of Delta One desks is to profit from the rapid rise of exchange-traded funds and other entities that try to mirror the returns of underlying assets.
Delta One traders will try to capture any differences between the price of exchange-traded funds and the underlying securities, a very basic form of proprietary trading that has been around for many years.
Another money maker is in providing derivatives to ETFs and other big investors such as pension funds and mutual funds. Many large clients want the returns from stocks, bonds and other securities without actually having to go to the trouble of owning those securities.
Suppose a portfolio manager wants to own the S&P 500, or the top 20 dividend stocks on the Toronto Stock Exchange, either for an in-house trading plan or to create an ETF. Buying all those shares is costly and time-consuming. Simply rebalancing requires constant attention and trading, which drives up fees.
For a client as large as a pension fund, it may be impossible to find all the stock it needs to get a big enough exposure. Canada Pension Plan Investment Board, for example has about $92-billion invested in passive investments that are designed to mirror broader market moves. Buying $92-billion of stock and bonds and matching it to underlying indexes would be a colossal headache.
That’s where the brokerages come in. They offer products such as total return swaps, which promise the buyer the returns from a basket of underlying assets without actually having to own the assets. The brokerage gets a fee, but now is essentially short – it is on the hook for any gains in the underlying assets.
The job of the Delta One desk is to go out and find a way to offset that short position so that the brokerage winds up with only minimal risk of loss. Traders that can do it cheaply enough and still find a near-perfect hedge make money for their banks.
It’s very possible to lose money honestly in Delta One, without going rogue. If the hedge turns out to be far from perfect, the bank can be on the hook for the difference between what is owed to the client and the value of the hedge.
Given the growth of the pension funds and the ETF industry, Delta One desks aren’t going anywhere. Royal Bank of Canada just entered the ETF space. Bank of Montreal did it two years ago, and has pulled in $3-billion of assets.
But regulators and risk officers need to be wary. The business is, by nature, a low-margin endeavour. The only way to make significant money is to do a lot of it. The temptation to take slightly bigger risks, in the pursuit of higher returns, is ever-present.
The good news is that people who deal with Canadian banks say they won’t take as much risk as foreign competitors. Yet again, Canada is boring and it looks good.
When hedging, Canadian desks “won’t go and try to find some cheaper product that will reduce the cost to them and potentially try to take a little bit of spread risk,” said Som Seif, president of ETF provider Claymore Investments. Instead, they insist on finding perfect hedges, which makes it difficult to launch ETFs that are tough to hedge.
“When we deal with them on developing a new product in a new area or asset class, it’s not as clean and easy as it is if I was dealing with Goldman Sachs or UBS in another market,” he said.
“When you’re building our business you say to yourself ‘I wish we had players that were a little more innovative in how they hedge that exposure,’ but you feel very good that they hedge themselves very well.”