Delta One Desks Are Big Moneymakers
The $2 billion trading loss that has rocked the Swiss banking giant UBS has also cast a spotlight on a relatively unknown but increasingly profitable corner of Wall Street — Delta One desks.
Both Kweku Adoboli, the UBS trader in London arrested on Thursday in connection with the loss, and Jérôme Kerviel, the Société Générale trader who was responsible for $6.8 billion in losses in 2008, worked on such desks.
While Delta One may conjure up images of “Top Gun” fighter pilots, the desks get their name from the financial definition of delta, which refers to the change in a price of a derivative against the change in the price of a customized underlying asset, like a basket of stocks.
Most Wall Street firms have such desks for their clients. Buying a derivative that closely tracks an underlying asset can be easier or less risky than buying the asset itself. Instead of buying bars of gold, a hedge fundmanager may buy an exchange-traded commodities fund, or even a gold fund. These derivatives can also be attractive because they typically require little upfront capital.
In some cases, the Wall Street firms themselves try to profit from the tiny differences between the values of the derivatives and the underlying assets.
In recent years, the desks have generated billions of dollars for Wall Street firms. In a research note last year, Kian Abouhossein, an analyst with JPMorgan Chase, said that he expected revenue from the business of about $11 billion this year, growing on average about 9 percent from 2010 through 2012.
A reason for the success of this particular desk is the explosive growth of exchange-traded funds— an investment class that tracks indexes or baskets of assets. On average, exchange-traded funds are expected to grow about 20 percent a year, as retail clients, hedge funds and institutions increasingly rely on these products for both exposure to the markets and as protection against volatility.
Also helping the growth of these desks is increased demand from investors for computer program trading, which uses mathematical models to execute lightning-fast transactions.
Delta desks are a profitable business, and on the surface at least, not a particularly risky one. But like many things on Wall Street, the practice can become perilous if not properly policed.
UBS has not provided any details on the trading losses. The UBS trader suspected of the losses, Adoboli, was a director of exchange-traded funds on the Delta One desk in London.
The bank said that trading was being investigated but said “no client positions were affected”.
The significance may not be in the trade itself, but in what oversight the bank had on the trader’s position — or whether the trader hid the risk from compliance officers. The losses could have resulted from a trade on a behalf of a client, in which case the bank would have taken the other side of the trade. But the bank may have mistakenly allowed its position to grow excessively, or failed to hedge it. Or the bank could have decided to hold on to the position after making the trade for the client, thereby putting its own money at risk.
Whatever the cause, the UBS trading losses are likely to rekindle the debate over proprietary trading, which has drawn increasing scrutiny from regulators since the financial crisis. The so-called Volcker rule, under the Dodd-Frank overhaul of financial regulation, would prohibit such trading, although the details of the rule are still being written.
Yet the definition of what constitutes proprietary trading can be fuzzy. Many on Wall Street consider proprietary trading, or prop trading, to involve only trades made by dedicated traders who are using the bank’s capital and do not have access to client information. The trading done on Delta desks, they contend, is done on behalf of clients.
Those boundaries, however, can blur. A bank may buy a derivative or security from a client in order to make a market, then decide it is worth hanging onto, turning it into a proprietary bet.
The Volcker rule of the Dodd-Frank act is named after Paul Volcker, the former Federal Reservechairman who proposed it. It is intended to prevent American banks from taking on too much risk. The fine print, however, has yet to be worked out, and regulators are debating just how comprehensive to make the definition of proprietary. (Under Dodd-Frank, foreign firms like UBS can still run prop-trading desks abroad.)
Goldman Sachs was among the first Wall Street firms to close its proprietary trading desks after Dodd-Frank became law. And Bank of America said this summer that its proprietary trading operation was officially closed.
Yet Goldman has one of the largest Delta One businesses in the industry, making an estimated $1.2 billion this year, according to the JPMorgan report. UBS, in comparison, has a smaller operation, generating about $500 million a year, the report said.
Delta One operations are profitable. Société Générale will generate a return on equity greater than 100 percent, while the other leader in the business, Goldman, will generate a return of 52 percent, according to the JPMorgan report. UBS will notch about 72 percent.
Abouhossein added in his note that Delta One desks were expected to weather the regulatory overhaul better than other trading businesses.
On Thursday, advocates for the Volcker rule used the UBS trading loss to highlight the need for increased regulation. A statement from Americans for Financial Reform said the incident “once again highlights a central problem with our financial system — that the largest banks have grown so big and so complex that even their own management cannot fully understand or control the risks they take”. The statement further noted: “Stories of rogue traders point to a larger problem which must be addressed with these kinds of structural changes,” like the Volcker rule.