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 (BFS) Nicholas Leeson: The general manager of Barings Futures Singapore (BFS) starting in 1993 Leeson started his career as a derivative trader

Leeson’s Trading “Arbitrage” futures between SIMEX and OSE Sell straddles

“Arbitrage” 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).

Selling straddles 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

Tough luck On January 17, 1995, the Kobe earthquake hit Japan, causing the Nikkei to fall below 18,000. Put options moved deep in-the-money.

It ain’t no brain surgery 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!

Bottom line Barings collapsed because it could not meet its obligations: (Courtesy of Nicholas Leeson) Over US$7 billion on the Nikkei 225 equity contracts Over US$20 billion on Japanese bonds and Euroyen contracts

How was it possible? 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’s part Leeson set up an error account - the infamous account (not known to senior management in UK). cross trading He then engaged into a significant volume of cross trading between account 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 account What appeared to be an arbitrage was in fact a speculation disguised with the help of account

Faulty organizational structure and delegation of powers 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

Other red flags BFS was asked by SIMEX to explain some margin inconsistencies related to account 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.

Senior Management’s part 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

Wishful thinking 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

Conclusions 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