Nicholas Leeson sinks Barings single-handedly. Outline. How Leeson traded The damage Who’s to blame: The anatomy of a murder Management’s responsibility & red flags Conclusion. Who’s who. Baring Brothers in London: Britain’s oldest merchant bank
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Baring Brothers in London: Britain’s oldest merchant bank
Nicholas Leeson: The general manager of Barings Futures Singapore (BFS) starting in 1993
Leeson started his career as a derivative trader
“Arbitrage” futures between SIMEX and OSE
Involves going long in one market and short in the other one.
Leeson’s went long in Osaka.
(His position was public knowledge since the OSE publishes weekly data)
Leeson should have gone short in Singapore; he went long instead (unauthorized trades).
Straddle = Sell one put and one call with same strike and maturity
Benefits the seller if prices don’t change much (i.e., the options expire worthless)
Leeson sold straddles on the Nikkei 225
Note: Leeson did not have the authority to sell options
On January 17, 1995, the Kobe earthquake hit Japan, causing the Nikkei to fall below 18,000.
Put options moved deep in-the-money.
When you speculate in long futures and prices drop = you lose
When you sell straddles and prices drop = you lose
Keep in mind: Losses from selling call options are potentially unlimited!
Barings collapsed because it could not meet its obligations:
(Courtesy of Nicholas Leeson)
Leeson was very astute, but reckless
Senior management was utterly incompetent
Lack of adequate organizational structure to allow for proper checks & balances and effective monitoring
Leeson set up an error account - the infamous account 88888 (not known to senior management in UK).
He then engaged into a significant volume of cross trading between account 88888 and other accounts
Cross trading = matching the positions of two accounts belonging to the same client
Ex: If Barings owed US$500m to Daiwa Bank from one type of transaction but also expected to receive US$300 from Daiwa from another type of transaction, it could net the two amounts through a cross trade.
After executing these cross-trades, Leeson would instruct the settlements staff to break down the total number of contracts into several different trades, and to change the trade prices to cause profits to be credited to account 92000, while charging losses to account 88888 account
What appeared to be an arbitrage was in fact a speculation disguised with the help of account 88888.
Leeson was in charge of the front and back office
From the front office he was conducting trades
From the back office (records office) he confirmed and settled trades undertaken by the front office
Leeson was in charge of his own supervision!
An internal audit in August 1994 concluded that Leeson’s dual responsibility was an excessive concentration of powers
BFS was asked by SIMEX to explain some margin inconsistencies related to account 88888
Leeson was put in charge of responding to SIMEX
No one in London knew how Barings acquired a US$83m receivable from Spear, Leeds & Kellogg.
Leeson’s cash requests for the first two months of 1995 amounted to US$1.2 billion
No one asked for justifications
Staff in London could not reconcile funds remitted to BFS to both proprietary in-house and individual client positions.
Mgmt. failed to follow up on the internal audit
Mgmt. had a poor understanding of derivatives
Mgmt. failed to understand the risks of the business
Mgmt. failed to supervise properly
Senior mgmt. believed that Leeson’s positions were hedged because the alternative was inconceivable
Senior mgmt. should have made sure it was hedged
Probably they also believed in market efficiency and natural selection:
They were right, but headed for extinction
An unlikely series of events in the market +
One rogue trader +
Incompetent management =
The demise of one of world’s oldest and most respectable bank