UBS loss puts ETF ‘delta one’ desks under spotlight

The $2 billion (£1.3 billion) loss stemming from a trader at UBS has emerged from the Swiss bank’s ‘delta one’ desk, throwing up questions surrounding the nature of delta one operations.

Simply put, ‘delta’ refers to securities or products that track an index or asset class as closely as possible, therefore attempting to provide returns in line with movements in the underlying, without any leverage. The type of products involved in the delta one business includes exchange traded funds, equity swaps, forwards, and futures.

Delta, in other words, is the probability that an option will expire in the money. An ‘at the money’ option will have a delta of 50% when it is issued, making it equally likely it will be in or out of the money on expiration. Delta one, on the other hand, means there is 100% certainty that the contract will expire in the money, so there is no optionality.

Exchange traded funds (ETFs) fall under the description of delta one trading and, much like passive index tracker funds, are extremely low cost, with some having total expense ratios (TER) of around 0.10%. The low TERs largely derive from the lack of active management, while tight bid/offer spreads are created by market makers.

Increased trading by delta one desks also helps to drive down trading spreads, keeping ETF trading costs low, but perhaps with a risk to the bank as appears to have been the case with these rogue trades.

Banks’ delta one desks engage in trades to provide clients with exposure to certain securities or indices, and the types of asset classes and clients they deal with can range from hedging services to providing swap transactions for synthetic ETFs.

When engaging in these trades, the desks hedge their exposure to protect themselves from any market movements. In other words, a delta one trading desk could sell a FTSE 100 swap, and buy FTSE 100 shares, or futures, as the hedge.

In terms of ETFs, banks are able to make small profits many times over through transacting these trades in ETFs, or indeed any other delta one security, by capturing any spreads between the bid and offer prices of the securities being exchanged.

Take a FTSE 100 ETF, for example. With the sheer volume behind banks’ trading desks, they could access the stocks in the FTSE 100 at a cheaper price than the trader at the other end. The bank could then buy all the FTSE 100 stocks at a lower cost and then sell the ETF at a slightly higher price. The difference between these trades is where the banks can capture profits.

As part of these trades, the banks could hedge their positions in their exposure to the underlying index, until the separate parts of the trade are closed out on the delta one desk at the end of the day. The desk, which deals in many trades from equity swaps to ETFs, has enough flows to be able to match exposures across the desk to cover positions, or will at least seek to create hedges as cheaply as possible.