One thing we’ve learnt about Delta One is that it’s head-scratchingly, mind-bogglingly tricky to explain.

And exactly how the division makes money, outside of the fees it charges investors is even harder to work out.

David Miller at Cheviot Asset Management, however, has come across one of the best explanations we’ve seen yet. It comes from his colleague Karl Williamson, who in a previous professional incarnation spent four years as a derivatives market maker.

The explanation goes like this (our emphasis):

Delta One may evoke images of fighter pilots but the name comes from the financial term delta which is the sensitivity of the price of a derivative to a change in the underlying index. A delta of one implies a one for one change in relation to the underlying asset.

In return for a small fee these Delta One desks which exist in many banks offer to provide the return of a particular index without all the hassle of buying the underlying securities. They then buy the underlying securities or various derivatives to gain the exposure required. Around the edges they trade to generate a profit on top of their fees.

These trades tend to be in very large size because margins are miniscule. Terms like flow trading, algos, edge and swaps add to the smoke and mirrors effect, but the actual strategies should be relatively simple, although not risk free, like arbitraging and lending out shares held as collateral.

Exchange traded instruments can be synthetic or physical. Physical Funds are backed by investment in real securities; although not always all the stocks in the index. At first glance this appears entirely safe, but the assets may be lent to other institutional investors probably banks. Synthetics are backed by a swap contract with a bank.

Normally they have a cost advantage and tend to track the underlying index more closely than physical funds, but involve counterparty risk. In other words the security of the underlying bank. Both are sold as low cost solutions to investors.

However, I doubt many understand what goes on underneath the surface, let alone the potential risks relying, as they do, on the intertwined banking system which is only as safe as the weakest link.

Delta One desks are not covered by the new proprietary trading restrictions.

This is attractive to banks as the returns can be exceptional. Goldman Sachs made $1.2 billion this year according to a recent JPMorgan report. The whole UBS event points towards a combination of failures.

Firstly, complex strategies may not have been fully understood by senior executives.

Secondly, the incentive structure may have encouraged traders to take risk without penalty.

Finally many Delta One trades are OTC (over the counter) rather than listed on a stock exchange and so valuing positions on a day by day basis is difficult.

In the end, as is the case in many businesses, trust and integrity are a vital component.

In the relatively opaque world of the Delta One desks the scope to exploit the system was there and this is what seems to have happened at UBS.

Kweku Adoboli worked his way up from the bank’s back office and so would have known the internal systems inside out. Internal controls were avoided or neutralized and it was only when another part of the UBS risk management team asked questions that the problem was discovered.

They were conducting a routine check on outstanding trades with French banks, presumably because of concerns about the extent of their own counterparty risk and had nothing to do with monitoring the trading activities of the Delta One desk.

Management not understanding complex strategies. Skewed incentives that work against client interests. Risk mis-assessment. Over dependence on OTC mark-to-market valuations.

Dare we say it all sounds frightfully familiar?

Related links:
UBS loss throws light on ‘synthetic’ problem – FT
The curse of Delta one strikes UBS – FT Alphaville
Delta one: the special ops of equity trading – FT Alphaville

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