Should you worry about ETF fraud?

The $2.3bn loss incurred by Swiss bank UBS was down to the activities of a relatively junior trader on the bank's so-called Delta One desk. Delta One trades are supposed to be relatively simple, involving the offsetting of one type of index-related exposure by another. However, the two largest recent financial market frauds that at UBS, and the €4.9bn loss recorded by Jrome Kerviel at Socit Gnrale in 2008 both involved Delta One employees.

Why? We'll have to wait for full details of the UBS fraud. But there seem to be remarkable similarities between the cases. Both men were promoted from their banks' back offices and so knew how to process transactions. Both may have made money before their gambling streaks ran out of control. And in both cases, bank control staff were either unable or unwilling to ask the right questions.

However, it seems that Kweku Adoboli, UBS's trader, may also have taken advantage of the complex network of European clearing and settlement systems, where trades in exchange-traded funds (ETFs) and equities are processed and where changes of ownership are recorded. These complexities mean ETF trades often fail to settle by the prescribed deadline (typically the third day after the initial transaction). In London, for example, a whole month can pass before a trader who fails to deliver an ETF gets fined. So the idea that Adoboli could record fake ETF trades in his bank's systems, using unusually long settlement periods, may not be as strange as it sounds. Apparently helping him was an ETF-specific loophole, where trades conducted between banks away from official exchanges are not always confirmed (ie, agreed) between the two parties right away.

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Do ETF investors need to worry? In principle, no. The UBS fraud appears mainly to have been one of poor bank internal controls, and UBS has stated that no client money was ever at risk Adoboli speculated using the bank's money, and so UBS took the loss. However, for any European investor there is a cost that results from the region's fragmented systems: higher bid-offer spreads for ETFs than would otherwise be the case. This doesn't invalidate the advantages of ETFs they still cost less than your average fund but they could be still cheaper. Unfortunately, such market inefficiencies will take a long time to iron out.