derivatives world



Delta One — what does it do?


fter the rogue trading scandals at Société Générale in 2008 and UBS this year, one begins to wonder if the trouble lies with the trading strategies of banks rather than the traders themselves. Both Jérôme Kerviel of Société Générale and Kweku Adoboli of UBS were on Delta One trading desks. Terry Smith, a veteran London City broker, seems to think that Delta One trading strategies are frighteningly complex. “Management doesn’t understand what goes on in the Delta One desks. If you sat down with a CEO and asked him to explain what happens, he would try but he couldn’t give you an accurate answer because he doesn’t understand,” he told the Financial Times. Recent e orts in re-regulation have curtailed the involvement of investment banks in hedge fund activities, private equities and proprietary trading. However, many market players will agree that investment banks have found another outlet for Delta One — flowprop trading. Yet other industry players maintain that proprietary trading by Delta One is not new to the market because market-making activities naturally involve hedging. Any trading desk will want to find the cheapest hedge and will create innovative hedges to maximise profits. Hence, traders will engage in all kinds of trading and arbitrage activities in various derivatives, which could be seen as proprietary trading. Although trading is done on behalf of clients and arbitrage is necessary to smooth prices in the market, the bank is in control of how to manage its portfolio. Such conduct further blurs the definition of proprietary trading. In this article, I will describe some common trading strategies of the Delta One desk that have been prevalent in recent times.

Chart 1: Equity Swap

derlying securities and the index future. Exchange-traded funds (ETFs) are heavily involved in arbitrage activities as they often reflect most indices. Arbitrage activities use algorithmic trading, which is essential to take advantage of price misalignments that last only a few seconds.

Futures and index arbitrage

Frequently, clients want to gain exposure in A client who wants returns from a specific group equities or other assets in di erent countries. of assets could enter into a swap arrangement In the case of equities, instead of buying a with Delta One. For instance, if the chosen aswhole basket of stocks, Delta One could buy sets are Indonesian banking stocks, the client an index future and pass on the returns to the enters into an equity swap with the desk. The client in the form of a structured product like client pays a fixed fee to Delta One. In return, an index-linked bond. he will get all the returns (dividends and capFor clients who may want exposure in cer- ital gains) — positive or negative — from the tain equities in selected sectors, the bank could selected equities (see Chart 1). still buy the index and Delta One, which then go short in other has synthetically gone areas with different short on the equities, tailor-made derivawill want to hedge its tives (swap or options) position by going long Jasvin Josen to “trim the edges” and on those equities. The synthetically create trader could buy the the client’s portfolio. In doing this, the desk’s equities outright or he could just go long on objective is to generate fees from the client for swaps or options to gain a synthetic long expothe service as well as to profit from its trading sure. Again, the desk will cleverly find ways to activities. The latter means that the desk will enter the most cost-e ective hedge to make the try to generate more profits from its trades than highest spread possible from the whole deal. the returns promised to the client. Another activity linked to the above is arbi- Traditional ETFs traging between two similar indices in di er- In an investment bank, Delta One functions as ent countries or arbitraging between the un- a market maker for ETFs. When clients want


to buy ETFs from the desk, it must take the other side of the trade. Keeping in mind that Delta One always strives to be “covered”, the traders at the desk have a few options to fulfil this obligation: • The desk may already have some ETFs in its inventory, which it just sells down; • The desk could buy ETFs on the market, depending on the liquidity and depth of the ETF secondary market; • The trader could go long on index futures in the case of an index ETF (like the SPDR that tracks the S&P 500 in the US); or • The trader could obtain the underlying stocks that mirror the ETF. At the end of the day, the desk may need to create more ETF shares for the market. It simply delivers the underlying share basket to the ETF provider (which operates like a fund manager) which then gives new ETF shares in return. If the desk does not have the underlying shares, it simply borrows the shares (via short sale trades) from the market and delivers the shares to the ETF provider in exchange for new ETF shares.

Synthetic ETFs

This new generation of ETFs do not follow the above physical replication model.They use derivatives to achieve exposure in certain markets or assets. Here, the desk receives the new ETF units in exchange for cash instead of the underlying assets. The desk then passes the ETF shares to clients for cash as well. Let us say there is an ETF providing returns on a basket of food commodities (rice, sugar and so on), defined in a predetermined index that is usually created by the ETF provider.The ETF value should go up and down with the prices of the commodities that are defined in the index. The ETF provider that sold the ETF to the market must cover his position. He could achieve this by entering into a total return swap (TRS) with a counterparty (often in the same banking group). The ETF provider will invest the cash received for the ETF in liquid assets (and call this collateral). Returns from the collateral basket are swapped with the counterparty in exchange for the total return on the commodities in the ETF. The connection between the ETF provider and Delta One here is questionable and open to interpretation, depending on how the synthetic deal is arranged.



Traditionally, products are traded with clients and hedged with external counterparties. Now, a trading desk like Delta One trades various strategies with its clients with a nice and wide selection of products (ETF shares, underlying assets, swaps and futures). On the other side, the desk can hedge (or trade) the exposure with external counterparties (or other clients) and at the same time arbitrage between the products. We can imagine a web of intertwined trades floating around with the sole objective of maximising the spread (profit) for the desk. Rogue trading has occurred in the past and at present, and over and over again, internal controls have been responsible for it. But the recent scandals that took place on the Delta One desk seem to suggest a new aspect. Perhaps the pressure to show profits in these challenging times is forcing traders to be more creative than ever, leading them to take more risk in devising products and strategies. When they fail, the responsible trader tends to hide the losses, hoping to quickly set it o with potential profits from future riskier strategies. Jasvin Josen is a specialist in developing methodologies for the valuation of various credit products. She has over 10 years’ experience in investment banking and the financial industry in Europe and Asia. Comments: Readers can also follow her at http://derivativetimes.

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