Swiss bank UBS said a trader had lost it around $2bn (£1.26bn) in unauthorised deals, and police in London arrested 31-year-old Kweku Adoboli in connection with the case.
Adoboli - a director of exchange traded funds and "Delta 1" working in the bank's London office, according to his profile on networking site LinkedIn - was arrested on suspicion of fraud, sources told Reuters.
"I can confirm that an employee of the bank was arrested in London in connection with the statement," a UBS spokesman said.
UBS said it might post a third-quarter loss after the rogue trades, a huge blow as it struggles to rebuild its credibility after years of crises.
The loss effectively cancels out the 2 billion-franc (£1.5bn) saving that the bank had hoped to make in a cost-cutting programme announced last month in which it will axe 3,500 jobs.
It also threatens the future of UBS's investment bank, which is being reviewed by chief executive Oswald Gruebel as part of a wide-ranging restructuring following heavy losses in the credit crisis and a damaging scandal over bankers helping rich U.S. clients dodge taxes.
UBS, which said no client positions were affected, is scheduled to hold an investor day on November 17 at which it was expected to announce major restructuring of the investment bank.
"The matter is still being investigated, but UBS's current estimate of the loss on the trades is in the range of $2 billion," the bank said in a statement.
UBS employed almost 18,000 people in its investment bank at the end of June, most of them outside Switzerland, particularly in London and the United States.
UBS shares were down 9.1 percent at 9.935 Swiss francs at 2:20 p.m. British time, while the European banking sector was up 4.78 percent.
"(This) is a staggering demonstration that all the clever systems that the banks now have, especially after the financial crisis, still cannot stop a determined individual getting round them if they want to," said Chris Roebuck, Visiting Professor at Cass Business School in London.
"It will yet again confirm to the majority of shareholders who are Swiss that investment banking is not 'proper' banking, as private banking is."
UBS had started to see client confidence return this year after it had to be rescued by the Swiss state in 2008 following massive losses on toxic assets held by its investment bank. The bank has had a history of major risk management glitches followed by repeated pledges to fix risk systems.
Any losses in its investment bank risk scaring UBS's rich clients and prompting a further flight from its huge private bank, the core of its business that used to be the world's biggest wealth manager but has slipped to third place.
"This loss has the scope to have a material impact on the perception of UBS's private bank, impacting its future operating trends," Goldman Sachs analysts Jernei Omahen and Peter Skoog said in a note.
"Today's announcement therefore adds to the long list of arguments (and pressure) for a substantially smaller investment bank."
UBS's news caused disbelief among market operators.
The last similar case was when Jerome Kerviel, then a trader at Societe Generale, racked up a $6.7 billion loss in unauthorised deals revealed in 2008. Kerviel was sentenced to three years in prison in October 2010.
Both Kerviel and Adoboli were the same age when the scandal broke and both worked with so-called Delta 1 products, derivatives which closely track the underlying securities and give the holder an easy way to gain exposure to several asset classes. Examples include equity swaps, forwards, futures and exchange-traded funds.
"It is amazing that this is still possible," said ZKB trading analyst Claude Zehnder. "They obviously have a problem with risk management. Even when the amount isn't so high, it is once more a loss of confidence that casts UBS in a poor light."
"With this they are losing a lot of credit that they had regained with effort," he added.
Switzerland's financial markets regulator FINMA said it had been informed of the case and was in close contact with UBS.
City A.M. Reporter