Sunday, December 18, 2011

Delta One: What Does it Do?

This article appeared in The Edge, Malaysia on Nov 14, 2012
Delta One – What do they do?
By Jasvin Josen
After the episodes of the “rogue trading scandals” in Societe Generale in 2008 and UBS this year, one begins to wonder if the trouble lies with the bank trading strategies rather than the traders themselves. Both Mr Kerviel and Mr Adoboli were traders in the “Delta One” trading desk.
Terry Smith, a veteran London City broker seems to think that Delta One trading strategies are frighteningly complex. He told the Financial Times, “Management doesn’t understand what goes on in the Delta One desks. If you sat down with a CEO and asked them to explain what happens they would try but they couldn’t give you an accurate answer because they don’t understand.”
Recent efforts in re-regulation have curtailed investment banks’ involvement in hedge fund activities, private equities and proprietary trading. However many market players will concur that investment banks have found another outlet in the name of “flow prop” trading within its Delta One trading division. Yet, other industry players maintain that proprietary trading in Delta One is not new in the market, as market-making activities naturally involves hedging. Any trading desk will want to find the cheapest hedge and will have to create innovative hedges to maximise its own profits. Hence the 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 smoothen prices in the market, the bank is in control of how to manage its portfolio. These conducts only 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.
Futures and Index Arbitrage
Frequently clients want to gain exposure to equities or other assets in different countries. In the case of equities, instead of buying the whole basket of stocks, the Delta One desk could buy an index future and pass on the returns to the client in the form of a structured product like an index-linked bond.
For clients who may want exposure to certain equities in selected sectors, the bank could still buy the index and then go short the other areas with other tailor-made derivatives (swap or options) to “trim the edges” and synthetically create the client’s portfolio. In doing this, the desk’s objective is to generate fees from the client for the service as well as to profit from its trading activities. The latter means that the desk will try to generate more profits from its trades than the returns promised to the client.
Another activity linked to the above is to arbitrage between two similar indices in different countries or arbitrage between the underlying securities and the index future. Exchange Traded Funds (ETF) are also 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 only last for a few seconds.
A client who wants returns from a specific group of assets could enter into a swap arrangement with the Delta One desk. For instance, if the chosen assets are Indonesian banking stocks, the client enters into an Equity Swap with the desk. The client pays a fixed fee to the Delta One desk. In return, he will get all the returns (dividends and capital gains) – positive or negative, from the selected equities. Readers can refer to Chart 1 to see the illustration of the deal.
The Delta One desk, which is now synthetically short the equities, will want to hedge its position by going long those equities. The trader could buy the equities outright or he could just go long swaps or options to gain a synthetic long exposure. Again, the desk will cleverly find ways to enter the most cost-effective hedge to make the highest spread possible from the whole deal.
Chart 1: Equity Swap

Traditional ETFs
The Delta One desk in an investment bank functions as a market maker for ETFs. When clients want to buy ETFs from the desk, the desk must take the other side of the trade. Keeping in mind that the Delta One desk always strives to be “covered”, the traders at the desk have a few options in fulfilling this obligation.
i)     The desk may already have some ETFs in its inventory, where it just sells them down
ii)   The desk can buy ETFs in the market, depending on the ETF secondary market liquidity and depth
iii) The trader could go long index futures, in the case of an index ETF (like the SPDR that tracks the S&P 500 in the U.S. 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. The desk simply delivers the underlying share basket to the ETF Provider (who operates like a Fund Manager) who then passes new ETF shares in return. If the desk does not have the underlying shares, it simply borrows the shares (via short sale trades) in the market and delivers the shares to the ETF Provider in exchange for new ETF shares.

Synthetic ETFs
The new generation of ETFs do not follow the above physical replication model. These ETFs use derivatives to achieve exposure to certain markets or assets. Here, the desk receives the new ETF units in exchange for cash instead of the underlying assets. The desk will then pass on the ETF shares to clients for cash as well.
Let us say for example, there is an ETF providing returns on a basket of food commodities (rice, sugar, etc), defined in a predetermined index, which 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 who sold the ETF to the market must cover his position. He could achieve this by entering into a Total Return Swap (TRS) with another counterparty (often in the same banking group). The ETF Provider will invest the cash received for the ETF, in some liquid assets (and call this collateral). Returns from the collateral basket are swapped with the Counterparty in exchange for the total return of the commodities in the ETF.
The connection between the ETF Provider and the Delta One desk 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 have been occurring in the past and present, and over and over again, the internal controls are rightfully responsible. But the recent scandals that took place in the Delta One desk seems to suggest a new aspect. Perhaps the pressure to show profits in these challenging times are forcing traders to be more creative than ever before, which leads 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 off with the potential profits from future riskier strategies.