Dodd-Frank: One hedge against rogue traders

UBS shares drop on reports of $2 billion trading loss

NEW YORK (CNNMoney) -- If there's an upside to the embattled Dodd-Frank laws, it's made it less likely that a rogue trader could topple a major U.S. financial institution.

It's also more difficult now for a rogue trader to cause a U.S. bank to lose, say $2 billion, the amount that a UBS trader may have cost the Swiss bank this week via unauthorized trades.

Contained within the Dodd-Frank legislation, which was passed in 2010, is the Volcker Rule, named after former Fed chair Paul Volcker.

It sets limits on U.S. banks' ability to trade their own funds. That wasn't the case in 2008, when losses from bad bets that banks made on mortgages led to the ensuing meltdown of Bear Stearns and Lehman Brothers.

Implementation of the Volcker Rule is expected to be pushed back from its original deadline of July 21, 2012. Yet most of the largest U.S. banks have already sold or shuttered the desks that make these trades -- the so-called "prop" or proprietary trading desks.

"Banks can put themselves under with dangerous trading and take the commercial side with them as they go down," said Robert Prentice, a professor of business law at the University of Texas' McCoombs School of Business. "A big part of what the Volcker Rule will do is separate out the risky trading from the deposits."

Traders at firms backed by the Federal Reserve, including Goldman Sachs (GS, Fortune 500), Morgan Stanley (MS, Fortune 500), JPMorgan Chase (JPM, Fortune 500) and Bank of America (BAC, Fortune 500), now have minimal opportunities to trade the bank's own capital.

Bank of America, Goldman Sachs and JPMorgan Chase said they've all closed their "prop" desks. Morgan Stanley has previously said it will be out of proprietary trading by the end of 2012 when it finalizes the spin-off of its "Process-Driven Trading" unit.

JPMorgan Chase moved its traders into its asset management division, where traders will make bets with clients' money not the banks.

Banks, in theory, could still be on the hook for significant losses if traders make bold bets with client money. Using financial instruments like options and derivatives, traders can magnify the loss or gain made on individual trades. Not only could a trader lose the clients' funds but the financial institution still must provide a backstop for these trades.

UBS: 'Unauthorized' trades cost us $2 billion

Early Friday, U.K. police chaged UBS trader Kweku Adoboli with fraud over the $2 billion of unauthorized trades. Adoboli is said to be part of the UBS division that makes bets around exchange traded funds.

While the reported $2 billion loss will hurt the Swiss bank's balance sheet, analysts say it's unlikely to topple it.

Shares of UBS (UBS) rose about 3.5% midday Friday, a day after tumbling 10%.

Several traders and analysts speculate that Adoboli's bad bet probably involved a wrong call on the direction of the Swiss Franc or another asset tied to it.

In August and early September, investors raced into the Swiss Franc, which was seen as a safe haven amid all the European turmoil. On Sept. 6, the Swiss government intervened and said it would halt the rise in its currency by selling francs and buying euros in unlimited quantities.

Under the Volcker rule, traders wouldn't have access to the funds needed to make unauthorized bad bets.

But just like UBS, U.S. banks must still wrestle with the right mix of oversight and risk control measures.

"Traders who fail will always want to double down," says Stephen Brown, a professor of finance at New York University's Stern School of Business, who has researched other rogue traders. "When you have supervisors who rely on computer software rather than human contact, there's a false sense of security."

Much of the banking system relies on computers for spotting unusual trading activity that could signal unauthorized trades.

Many industry watchers still wonder whether the Volcker Rule in its final form will mandate the spin-off of prop trading from banks or whether it will ultimately be watered down.

"You can't underestimate the lobbying ability of the banking industry in the U.S. and the U.K." said Stewart Hamilton, a professor of finance and accounting at IMD Business School in Lausanne, Switzerland. "It's huge."