By Douwe Miedema and Huw Jones
LONDON (Reuters) - UBS's $2.3 billion loss has uncovered a gap in the oversight of widely-used investment products which allow traders to hide their dealings and will take regulators years to close.
Exchange Trade Funds (ETFs) -- the instruments at the heart of the alleged rogue trade debacle announced by UBS last week -- are not covered by European financial markets law.
This leaves dealers free to book trades without confirmation from a counterparty and means a bank's internal risk officers are essentially relying on the dealer's word when checking if price and delivery dates have been entered accurately -- and even whether a trade has actually been agreed or not.
"If (the alleged rogue trader) used some types of ETFs, currently there is no reporting obligation to regulators," a regulatory source with knowledge of the rules said.
The European Union's Markets in Financial Instruments Directive (MiFID) does not cover ETFs, and a rewrite of the law looking to include the rapidly growing sector will only come into force in 2014 at the earliest.
A draft version of the coming revision to close the loophole is due in October.
Large parts of the ETF markets in Europe are traded over the counter -- from bank to bank -- making them far less transparent than securities listed on exchanges, and subject to convention.
"Generally, orders are not displayed to regulators. MiFID demands execution confirmation for clients, but not for "in house" or similar activities," the regulatory source said.
That said, many market operators expressed surprise that a bank would put itself at risk by not asking for confirmation of a trade in its books, whether required to do so or not.
"When I found out banks were not confirming forward ETFs until settlement date, I was pretty surprised," Conrad Voldstad, chief executive of the International Swaps and Derivatives Association (ISDA) told reporters at a conference on Tuesday.
An ETF trader said it was common practice for banks to delay confirmation of forward trades until the settlement date.
"Often they will not do this unless someone has specifically requested them to do so," the trader said, speaking on the condition of anonymity.
The UBS scandal reignites the debate about whether watchdogs are doing enough to control bets made on the trading floors of banks, many of whom were bailed out at a heavy cost to taxpayers during the credit crisis.
Only days before UBS announced its loss, Britain unveiled some of the world's toughest regulations, requiring its banks to insulate retail lending activities from investment banking operations and store up billions in extra capital.
Sales and trading is often the biggest money-spinner for investment banks, with the fixed income, currencies and commodities businesses (FICC) alone often generating roughly half of their revenues.
The banking community has been left guessing what exactly went wrong at UBS, which has declined to comment other than to say that an employee had faked positions in "forward-settling cash ETF positions" in order to appear to be hedged.
London trader Kweku Adoboli was charged on Friday with fraud and false accounting dating back to 2008.
ETFs were initially sold to retail investors as a cheap way to gain exposure to an underlying asset such as a stock exchange index, but have since come to play a large role in banks' hedging and other internal activities.
Rapid growth in the sector meant that profits have sometimes come first to the detriment of checks and balances, some of the people working in the market said.
"These markets are at an early stage and there simply hasn't been the investment in systems to keep up with the complexity of trading these products," said Hirander Misra, an advisor to Plus Markets, a small stock exchange.
"When new trading products emerge, often the links into risk and credit control systems are an afterthought."
(Additional reporting by Luke Jeffs; Editing by Sophie Walker)