Calls for ETF ban in wake of UBS rogue trader scandal

City veterans called for a ban of Exchange Traded Funds (ETFs) yesterday as the UBS rogue trading scandal put a spotlight on to the financial market's latest money-spinning wheeze.

ETFs have become increasingly popular, and until recently were the only place trading desks were hiring. Yet they have also been dogged by criticism from some in the City and faced scrutiny both in London and on a European and global level, and regulators have been threatening to derail their recent spectacular rise.

Terry Smith, the chief executive of FundSmith, has been a vocal critic, and yesterday said there were so many issues with ETFs "perhaps they should be banned. Or if not they should be regulated all the way until they are little more than index-tracking funds."

Richard Reid, the head of research at the International Centre for Financial Regulation, said the rise of ETFs was "one of the potential sources of systemic risk in recent months," adding it would raise questions about the funds "as well as the effectiveness of the risk control systems implemented since the onset of the financial crisis".

One trader who specialises in the asset class, which has grown at 40 per cent a year according to official figures, admitted that after yesterday's $2bn losses at UBS, "there will be more regulatory scrutiny, as well as a fair bit of consolidation in the sector".

The Financial Services Authority has already expressed concerns, as have the Financial Stability Board, the International Monetary Fund and the Bank for International Settlements.

Another trader in the City said: "There will be a fear now about how much risk these ETF providers actually have. It's a fragile market and this could well have a knock-on effect."

Mr Smith said: "Some of them are like index funds, but many aren't. In particular, the performance of short ETFs and leveraged ETFs may diverge markedly from what an investor who believes they are simply index funds would expect."

Where it becomes more complicated is some ETFs do not actually contain the underlying securities or assets they track, instead relying on asset swap agreements which aim to replicate the performance. Mr Smith said that such agreements were likely to lead to issues commonly seen during the credit crisis.

He feared retail investors could be hurt. "If UBS didn't understand how they worked, how is the man in the street going to?"

The Financial Stability Report, produced by super-regulatory body the Financial Policy Committee, said the complexity and innovation around ETFs was a "key area of concern".

One trader said: "The growth in the market has been extraordinary. People can gain access to asset classes with ease. And for the banks it's a great way of bringing in management fees. Everyone's fighting to get involved.

"There are risks but only in extreme circumstances," the ETF specialist said. "In this case it looks like either an unhedged position or he has gone way outside his remit."

Mr Reid said: "Regulators, conscious of the pressure they are under to consider ways of heading off systemic risks to financial stability, will be keen to think about what steps they should be taking now to supervise this market segment."

At UBS and other banks, ETFs are traded on their Delta One desks, which are more general derivative trading operations and which also hedge those trades. Sarah Butcher, editor of eFinancialCareers, said: "Delta One has been incredibly popular over the past couple of years and is one of the areas banks have continued hiring for recently."

She added: "Delta One isn't proprietary trading exactly, but the traders usually have a lot of freedom in how they construct a derivative to track the underlying product, so it leaves room for 'inventiveness'." The desks are likely to remain popular despite yesterday's losses. "They may not reduce demand for Delta One people in future, but it will substantially increase the investment in the risk infrastructure monitoring Delta One desks," Ms Butcher said.

UBS, however, will certainly be left counting the cost. Jemej Omahen, at Goldman Sachs, said it would have a "material impact on the perception of UBS's private bank". Mr Omahen said the news "adds to the long list of arguments, and pressure, for a substantially smaller investment bank".