UBS case: How could one trader lose $2 billion?

NEW YORK -- The full story about how a 31-year-old rogue trader arrested for allegedly losing $2 billion of a Swiss banking giant's money in a fraudulent scheme has yet to be told by the bank, Europe market regulators or London police.

And it might be weeks or months before a full accounting of how all the money was lost and the circumstances behind one of the biggest trading miscues in history.

But by analyzing all the snippets of information about the case — as well as information the alleged perpetrator posted about himself on social networking sites, insights into the trading strategy he employed, the charges outlined by prosecutors, and interviews with trading experts — a number of possible yet unofficial scenarios of what might have happened can be stitched together.

The basic facts of the latest scandal to rock the financial world are well known.

Kweku Adoboli, a London-based UBS trader from the bank's investment banking unit, was arrested early Thursday morning amid allegations that he lost up to $2 billion of the bank's money after engaging in "unauthorized trading," according to a terse four-sentence statement by the bank Thursday. In a letter to employees, the bank's executive board said the matter was "still being investigated," and that the bank "will spare no effort to establish exactly what happened."

The fact that the bank's risk-control systems were unable to identify Adoboli's highly risky trades, which date as far back as fall 2008, according to the police complaint, has put the bank under sharp scrutiny.

Type of trades

What is known so far comes mainly from Adoboli's postings on social networking sites, including Facebook and LinkedIn, and details released Friday in the three charges filed against him in a court appearance, where he didn't enter a plea.

On his LinkedIn profile, Adoboli provides two key pieces of job-related information that could be central clues to the case. The first is that he worked on a trading desk that engages in a type of trading referred to as Delta One. The other is that his prior job was as a trade support analyst, better known as the back office.

The Delta One strategy gave him the platform to trade. His prior experience gave him an insider's view into how the firm inputs, tracks and accounts for trades — knowledge that potentially could have been used to cover his tracks.

Delta One trading strategies are among the fastest-growing growth areas for big banks, according to JP Morgan analyst Kian Abouhossein, who put out a report on Delta One in September 2010. Delta One products will generate estimated revenue of $11 billion this year, the report says.

In simplistic terms, Delta One business allows banks to trade or create securities that track an underlying index or asset class, such as the Standard & Poor's 500 index.

There are six types of Delta One businesses, including exchange traded funds. ETFs are similar to mutual funds, in that they track baskets of stocks, such as the S&P 500, but trade like stocks, which allows investors to get broad exposure to an asset class but with the ability to trade them throuhout the trading session. Mutual funds simply give investors a end-of-the-day price, which limits a trader's flexibility to get in and out of a position quickly.

Adoboli was an ETF director as well as a Delta One trader, according to his LinkedIn profile.

So how then did his current and old jobs put him in a position to lose upward of $2 billion, a big enough pile of dough to offset the hoped-for cost savings of a coming wave of layoffs at UBS?

First, Delta One has what mathematicians call a symmetric payoff profile. In layman's terms, that means if the S&P 500 moves up by 1%, then ETFs that track the index or futures contracts that track the index must also move by the same amount.

But according to Fane Lozman, chairman of and an ex-trader of stock options and futures, Delta One trading is among one of the least "exciting" trading jobs. It's also supposed to be low-risk. Profits come when the trader benefits from small deviations in price between the two offsetting investments. In short, the trader profits by capturing the spread, or difference, between the asking price and the sale price.

Large-scale loss

So how might Adoboli possibly have lost so much money in what, on the surface, appears to be a low-risk, plain-vanilla type of investment?

Because in a Delta One trading strategy, all positions must be hedged to offset risks. And it appears that the allegedly rogue trader made the mistake of not putting on the hedge, exposing himself and the bank to greater risk. In Wall Street lingo, that would mean Adoboli took on "naked" risk, a term used when a position is not hedged or offset by another trade to limit risk.

One potential way in which Adoboli might have gotten into trouble is if he went long a basket of stocks such as the S&P 500 (going long is a bet that the price will increase). But instead of hedging that position by placing an offsetting "short" trade that would make money if the S&P 500 fell in value, he could have taken just one side of the trade and lost big when the market went against him, Lozman theorizes.

"You are trying to do a one-to-one hedge," Lozman explains. "But it looks like this guy left a leg of the trade open. He decided to trade one side of the trade without putting ont he hedge. Instead of acting as arbitrageurs like they were supposed to, they likely became day traders."

John Derrick, research director at U.S. Global Investors, didn't want to speculate on what happened but agreed that "the only thing I can think of is that when hedging risk they didn't properly protect themselves."

In Wall Street speak, that would mean Adoboli was trading "naked" and got "legged" out of the trade when the market went in the wrong direction. The trader might have panicked, tried to cover his tracks and then tried to make even bigger bets to get even in later trades, Lozman theorized.

Covered tracks?

What would motivate a trader to take such a risk? The potential to make more money if the trade turned out to be a winner, perhaps.

In the three charges filed against Adoboli, two counts for false accounting and the other for fraud by abuse of position, it appears that he allegedly took steps to hide his activity by "falsifying records," which might be why the bank's risk-controls didn't flag the alleged wrongdoing earlier. The first charge alleges that Adoboli falsified an ETF record transaction between October 2008 and December 2009. The second charge alleges that he falsified other internal records between January 2010 and September 2011. And the third charge alleges he committed fraud between January 2011 and September 2011.

Another possible scenario, according to Lozman, is that Adoboli might have allowed a client, or customer, to place a trade in which they took both sides of the trade. Then after one side emerged as a big winner, he would rejigger documents to show the client placing only the winning side of the trade, leaving the bank saddled with the loss on the other side.

"That would leave his customer with the big winning leg of the trade," Lozman says. "Who knows how he got compensated? We don't know how far the conspiracy went."

So how might someone have concealed those losing trades?

Dan Hubscher of Progress Software, a firm that develops risk-management computer programs, says history shows rogue traders can "make unauthorized changes to back-office systems," engage in trading activities that mask risk or simply get involved in risky trading that is ignored by risk managers "as long as profits are made."

"How exactly the bank's systems missed the mounting risks is unknown," says Hubscher. "What firms really need is to be able to detect every abusive and erroneous trade pattern and adapt real-time alerts and responses as markets change. Trading behavior constantly changes, as do innovations in trading, both legitimate and rogue. Maintaining compliance is like chasing Ferraris on a bicycle."