Case Risky Business: Nick Leeson, Global Derivatives Trading, and The Fall of Barings Bank

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RISKY BUSINESS: NICK LEESON, GLOBAL DERIVATIVES TRADING, AND THE FALL OF BARINGS BANK
Derivatives need to be well controlled and understood, but we believe we do that here. Peter Baring, chairman, Barings Brothers, October 1993. Im sorry. Note left by Nick Leeson, February 1995

Introduction
In February 1995, the nancial world was shaken by the revelation that unauthorized derivatives trading by a 27-year-old Englishman, Nick Leeson, employed at the Singapore ofce of Britains oldest bank, Barings Plc,

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had amassed losses of at least $950 million (the gure was later revised upward to $1.33 billion). The debacle resulted in the collapse of Barings and its purchase, for the princely sum of 1, by a Dutch bank, International Nederlanden Groep NV (ING). So ended the history of a 233-year-old aristocratic bank whose clients at the time of its collapse included Queen Elizabeth II of England. To many critics, the collapse of Barings offered more proof that the rapid rise of derivatives trading in global nancial markets was a dangerous and potentially destabilizing inuence in the world economy. Barings joined a growing list of organizations that had lost vast sums of money on derivatives trading, including Metallgesellschaft AG of Germany (lost $1.3 billion), Procter & Gamble (lost $102 million), Kidder Peabody & Co. (lost $350 million), and Orange County of California (lost $1.7 billion). These critics used the collapse of Barings to intensify their calls for tighter regulation of global derivatives trading. But there were those who argued that when employed correctly, derivatives can be used to reduce risk, not increase it. They attributed the losses at Barings to the actions of a rogue nancial trader who was engaged in risky speculation and to poor internal management controls at Barings. Further, they argued that the ease with which the worlds nancial markets absorbed the shock of the Barings collapse is proof that the world nancial system is sound and should not be encumbered by unnecessary government regulations.

Financial Derivatives
A derivatives transaction is a contract whose value depends on (derives from) the value of an underlying asset, reference rate, or index. Derivatives include forward, future, swap, and option transactions that are based on interest rates, currencies, equities, and commodities (for a detailed exposition of the mechanics of forward and swap transactions based on currencies, see Chapter 9). Derivatives have been in use for at least 100 years, although their popularity in recent years has grown rapidly. In 1986, derivative contracts with a notional value of about $1 trillion were traded annually. By 1990, this gure had risen to $5 trillion, and it approached $20 trillion by 1994. This rapid growth in the volume of derivative trading has raised fears that derivatives might destabilize the world nancial system. A major factor leading to the growth of derivatives trading in currencies was the collapse of the Bretton Woods agreement in 1971 and the resulting shift from a xed to a oating exchange rate regime (see Chapter 10 for details). Under a oating exchange rate regime,

exporters and importers hedged (insured against) adverse currency changes by purchasing foreign currency through forward exchanges or by engaging in currency swaps. During the 1970s and 1980s, corporations and traders increasingly turned to derivatives contracts to insure against possibly adverse future changes in a wide range of other assets such as commodities, bonds, or stocks. For an example of a derivative contract for a commodity, consider a company that knows it will need to purchase 1 million barrels of oil in six months. Imagine that the current price of oil is $15 per barrel, but the company fears that the price may rise substantially over the next six months because of turmoil in Saudi Arabia, the worlds largest oil exporting nation. The company can either wait and bear the risk that the price of oil might rise in six months, or it can enter into a futures contract today. Under this contract, it might agree to purchase the price of oil in six months at $16 per barrel. The $1 difference between the price of oil today and the price specied in the contract represents an insurance, or hedge, against a possible rise in the future price of oil. By entering into the contract, the company has reduced its exposure to future rises in oil prices; it has reduced its risk. Another common form of derivative is a stock option. A stock option is a contract that gives the owner the right to purchase or sell a specic number of shares at a xed price within a denite time. For example, imagine that you hold 1,000 shares of Compaq Computer, which is trading at $50 per share (the market value of your holding is $50,000). You fear that due to a temporary slowdown in the growth rate of personal computer sales, the price of Compaq might fall in the near future, but you dont want to sell the stock because you like Compaqs long-term prospects. You know that it is by no means a sure thing that sales are slowing, and Compaq could continue to do well even if sales do slow. You might decide to take out insurance against the possibility that the stock will fall by purchasing a put option. The put option contract might give you the right but not the obligation to sell 1,000 shares of Compaq in three months at $50 per share to the writer of the option. The put option might cost you $1 per share, or $1,000. If the price of Compaq shares does not fall, the put option contract might expire worthless in three months. However, if Compaq shares fall to $40, the put option contract will rise to about $10 per share. You can either sell the shares for $50 each to the writer of the put option, or your could sell the option contract for $10,000 (1,000 shares at $10 per share) and pocket the $9,000 prot while holding onto the shares. Whatever action you choose, although the value of your Compaq stock has fallen from $50,000 to $40,000 over the three

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months, your actual loss is limited to just $1,000, the price of the put option contract. By purchasing a put option contract, you have limited your exposure to a fall in the price of Compaq shares. In addition to put options, one can also purchase call options. Call options are simply the reverse of put options. They are an option that gives you the right to purchase a certain number of shares from the option writer at a xed price within a specied time. For example, if you think that Compaqs price might rise from $50 to $80 per share, but you are unwilling to purchase another 1,000 shares for $50,000 at this time, you could enter into a call option contract that gives you the right to purchase 1,000 shares from the call option writer in three months at $50 per share. Again, the option contract might cost you $1 per share. If the price of shares goes up to $80, you will make a large prot. If the price falls, your loss is limited to the $1,000 cost of the call option contract. You might be wondering why anyone would want to write an option contract. The option writer pockets the price of the option contract if it expires worthless, which happens enough to make the practice worthwhile. To increase their potential returns further, many option writers write uncovered or naked options. For example, consider a trader who writes a call option that gives the buyer the right to purchase 1,000 shares of Compaq at $50 per share in three months. If the option writer deposited 1,000 shares of Compaq with her stockbroker, this would be termed a covered call, because the writer (or seller) has enough shares in her account to pay the buyer if he exercises his call option to purchase 1,000 shares at $50. An uncovered call occurs when the option writer does not deposit enough shares to cover the eventuality that the buyer of the option will exercise his call option. An option writer can write such an uncovered call option in a margin account, which is an account where the broker lends the money to the option writer (at an appropriate rate of interest) to cover the cost of meeting the call obligation. Brokers will do this if the option writer can show that she has sufcient funds elsewhere to cover the cost of meeting her potential call obligations and/or servicing any interest payments that must be incurred on funds borrowed to meet call obligations. Writing uncovered calls (or uncovered puts) is a risky strategy, but it does have the advantage of leverage. For a relatively small deposit in a margin account, the option writer can write a relatively large volume of options and potentially earn substantial returns on this relatively small deposit. Option contracts are not limited to stock equities. They can also be written for many other nancial assets. One popular form of options are index options, where the value of an option is linked to the value of a basket

of stocks that make up a popular stock index, such as the Dow Jones Industrials, the S&P 500, or the Nikkei 225 stock market index.

Barings Bank
Although a relatively small player in the investment banking world with about 4,000 employees and assets of $10 billion in 1994, Barings was a widely respected bank that was considered a strong niche player in the emerging markets of Asia, Latin America, and Eastern Europe. Its money management arm managed about $46 billion for a variety of individual and corporate clients, including the Queen of England. The bank was also considered to have a talented corporate nance team with good connections in British industry. The bank was established in 1762 by two sons of German immigrants, and it ourished. Barings was the rst bank to reopen trade with America after the Revolutionary War; it helped the US government nance the Louisiana purchase from France; and it played a major role in nancing Britains wars against Napoleon. For its help in the Napoleonic wars, a grateful British government bestowed ve noble titles on the Baring family. The family became prominent members of the British ruling class. The family continued to maintain close ties with the bank, and in 1995 the chairman was Peter Baring. For most of its 233 years, Barings concentrated on the old-fashioned business of investment banking, taking in deposits and lending money to corporations and governments. In a departure from this focus, Barings in 1984 established a securities trading arm, Barings Securities, to take advantage of and prot from the trading opportunities presented by the rapid growth of international nancial markets. The trading arm quickly established itself as a protable operation. However, a clash of cultures soon began to emerge between the investment banking and securities operations. Part of the problem seems to have been linked to the different backgrounds and attitudes of the personalities involved. The investment banking arm, known as Barings Brothers, was staffed by products of the British establishment, but many of the traders came from a different class background. In distinct contrast to the blue-blooded investment bankers typied by Peter Baring, Nick Leeson, whose unauthorized trades sunk the bank, was the son of a North London working-class family. A securities trader who once worked for Barings Securities in Tokyo had the following recollections:
There was always an uneasy tension between Barings Brothers and Barings Securities. Were the bankers, they seemed to say, heirs to a 200-year tradition, and youre the

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and where from one month to the next . . . The team that had been built up from the late 1980s (in the Asian securities operations) was scattered to the four winds . . . The pool of derivatives-based knowledge in the region virtually disappeared.

jumped up guys from Liverpool. What seemed to make things worse was that Barings Securities was phenomenally protable for a while. But the attitude persisted: OK you guys did great for ve years, but weve been here for 200. Dont tell us how to run the business . . . When Peter Baring came to Tokyo to visit the securities department, it was like a visit from the queen.

Another former employee had similar observations:

You had a situation where the securities side was still at loggerheads with the banking side. On top of that, the derivatives side was little understood by either... Working in derivatives was a little like working in a vacuum. To most of the senior guys on both the securities side and the merchant bank, it was like we were talking a foreign language. They just let us get on with it. We did our own controls and regulated ourselves to all intents and purposes. In hindsight, there wasnt anyone for us to report to.

The British newsmagazine The Economist had a similar view of the relationship between Barings Brothers and Barings Securities:
The old-style bankers who dominated Barings senior management have long looked down their aristocratic noses at the traders who run the banks security operations.

Things came to a head in 1992 when tumbling stock prices in Tokyo pushed the normally protable Barings Securities into a $20 million loss. In an attempt to turn things around, Christopher Heath, the head of Barings Securities, lobbied for more capital to boost proprietary trading (trading on the rms own account). Andrew Tuckey, the deputy chairman of Barings, objected that this would leave the group too exposed to volatile nancial markets. In response, Heath resigned, and he was followed by a number of other key directors at Barings Securities. According to one former Barings Securities employee,
It was effectively a takeover of the securities operation by the (investment) bank. You had the unworkable situation of investment bankers supposedly overseeing investment traders.

Nick Leesons Little Trades

It was against this chaotic background in Barings Asian securities operations that Nick Leeson arrived in Singapore in 1991 to help unravel some backroom trading problems. Within a year, Leeson had joined the trading team on the oor of the Singapore International Monetary Exchange (SIMEX). By day he executed trades in the Nikkei Stock Averages futures contracts under the direction of Barings traders in Japan. By night he partied in the yuppie bars along the Singapore River. According to a former colleague:
He was your average English guy who likes to go out for a beer after work, and sometimes has a few too many. I wouldnt have said anything negative about him.

Barings employees refer to the period that following 1993 coup as The Turbulence. In Asia, it led to a confusing series of personnel moves that ultimately left management dangerously weakened. In Tokyo, for example, the longtime Barings Securities branch manager, Richard Greer, was replaced by Henry Anstey, who was also soon replaced. Barings Securities in Hong Kong lost a team of seven from its proprietary trading and derivatives desk to the start-up operation New China Hong Kong Securities. The Hong Kong operation suffered another blow when Willie Phillips, formerly head of all security business in Asia outside of Japan, left for Salomon Brothers. Also important was the loss of Richard Johnson, who had headed Barings derivative operations in Tokyo until he was transferred to London in 1992. Johnson, who left Barings in May 1993, was the brains of the group, according to a former colleague. His departure opened a large hole in the region. As a result of these management changes, in 1995 a former Barings employee observed:
There has been no continuity of management for the past two years. It was difcult to say who was in charge of what

Leesons primary job at Barings was to arbitrage Nikkei Index futures contracts that were traded on both the Singapore and Osaka exchanges (trading of Nikkei futures in Singapore began in the 1980s when the Japanese government tried to curtail futures trading in Osaka). Such arbitrage involves buying futures contracts on one market and simultaneously selling them on another. Prots are made by exploiting small price differentials for the same contract between the two exchanges. Because the margins are small, the volumes traded by arbitrageurs tend to be very large. However, the strategy is associated with very little risk. Leeson was a successful arbitrage trader. By September 1994, he was viewed as the senior trader for Barings in Singapore, even though he was only 27 years old. At this point Leeson departed from the low-risk arbitrage strategy and started to speculate on the volatility of the Nikkei 225 stock index. Leesons motives for speculation arent entirely clear, although maximizing the size of his bonus, which could have easily run into seven

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gures had his strategy been successful, was a factor. Leesons strategy involved simultaneously writing uncovered put and call options on Nikkei 225 futures. Known as a straddle strategy, the procedures will make money for the option writer provided the market stays within a relatively narrow trading range. However, the strategy required Barings to sell the Nikkei 225 index when it crossed 19,500 and to buy it when it fell below 18,500. Leesons strategy made Barings money as long as the Nikkei stayed within this relatively narrow range. Once the Nikkei went outside this range, Barings started to lose large amounts of moneyabout $70 million for every 1 percent move above or below these limits. The loss was exacerbated by Leesons aggressive use of leverage (he was writing options from a margin account). At rst the strategy seemed to be working. Traders at other banks reckon that Leeson may have earned as much as $150 million for Barings from this strategy by the end of 1994. However, the strategy started to fall apart when the Kobe earthquake struck January 17, 1995. In response to the economic devastation caused by the earthquake, the Nikkei started to plunge. Worried that the market would fall well below 18,500, Leeson seems to have entered the market and purchased Nikkei futures on a huge scale in an attempt to push the market up above 18,500. This is not an easy thing to do; the Tokyo stock market is the second biggest in the world. Leesons position deteriorated further on January 23 when the Tokyo stock market plunged 1,000 points to under 17,800. An increasingly desperate Nick Leeson responded to the crisis by drawing on a margin account to continue purchasing Nikkei futures in what was to prove to be a futile attempt to prop up the Nikkei index. By late February 1995, Barings had accumulated index positions that effectively amounted to a $7 billion bet on the Tokyo stock market. At the height of Leesons trades, Barings accounted for about half of the open positions in Nikkei 225 futures contracts. Such nancial excess did not go unnoticed by other traders in Singapore or by executives at Barings Bank in London. However, Barings executives and other traders were all under the impression that Leeson was acting on behalf of a major client, perhaps a big hedge fund. No one could conceive that the positions belonged to Barings. Apparently much of the cash required to purchase Nikkei futures came from an account for a ctitious client that Leeson had set up as early as 1992. This account contained some of Barings own cash, along with all the proceeds of Leesons option sales and some ctitious prots from falsied arbitrage deals. He used this ctitious account to pay margin calls on his growing futures position. When the account was exhausted, Leeson turned to Barings in London, saying he was executing trades on behalf of a major client who would settle

up in a few days. Barings proved only too willing to send more money to its star trader in Singapore. Bolstered by the arrival of additional funds from London, Leeson kept up the charade until February 23, when the cash owing out to cover margin payments exceeded Baringss limits. With the Nikkei continuing to decline, Leeson apparently realized that he could no longer carry on with the game. He hurriedly faxed a letter to Barings in London tendering his resignation, adding that he was sorry for the trouble he had caused and along with his wife boarded a plane out of Singapore. The next day shocked Barings executives informed the Bank of England that they were technically bankrupt. The liabilities from Leesons trades already exceeded $800 million and were growing by the hour as the Nikkei index continued to fall.

Aftermath
Over the weekend of February 25 and 26, the stunned management of Barings tried to arrange for a bailout by the Bank of England. Several investment banks were summoned to the Bank of Englands ofces to discuss the possibility of raising enough private money to recapitalize Barings before the Tokyo market reopened on Monday morning. However, the attempt failed because of the size of Baringss positions in Japanese derivatives contracts, many of them still open and liable to incur still bigger losses. No bank was willing to take on these contracts without a large fee or a guarantee from the Bank of England that it would cover these losses. The Bank of England, which stated later that such a fee might have amounted to $700 million, decided it was not prepared to put the British taxpayers money at risk. On March 3, the Dutch nancial group ING stepped in and offered to purchase Barings for 1 in exchange for taking on all of the Barings liabilities. With no other offers on the table, Barings directors were obliged to accept the ING offer. In the following weeks, ING moved quickly to replace virtually all of Barings top management, including Chairman Peter Baring, and to tighten controls within the group. Nick Leesons whereabouts were a mystery for several days. Then on March 3, Leeson was detained by German immigration authorities as he tried to board a plane back to Britain. Leeson was eventually deported back to Singapore, where he faced charges for securities fraud. Among other things, it was alleged that he falsied trading data to create paper prots that were then funneled into accounts attributed to ctitious clients. It was from these accounts that Leeson executed many of his trades in the run up to the collapse of Barings. In December 1995, he was sentenced to six and a half years in prison.

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As for the global nancial system, initially there were worries that the revelations about Barings might lead to a loss of condence in the global nancial system and in the nancial position of many banks engaged in derivatives trading. But there was no evidence of a negative effect from the Barings collapse. Rather, the nancial community soon viewed the collapse of Barings as having little to do with derivatives trading per se and much more to do with the lack of internal management controls at Barings. This lack of controls allowed Leeson to speculate using nancial instruments that were designed to reduce risk, not increase it. According to the prevailing view among other traders, the problem lay not in the tool Leeson usedderivativesbut in the way Leeson used that tool and the poor monitoring of his activities. In July of 1995, the Bank of England issued a report on the collapse of Barings. The bank also expressed the view that Barings suffered from poor internal management controls. According to the report:
Signicant amounts were regularly remitted to BFS without any clear understanding on the part of Barings management on whose behalf these monies were to be applied, and without any real demur.

Discussion Questions 1. Why do you think critics are worried that the rapid growth in the use of derivatives might destabilize global nancial markets? 2. Do you think derivatives are risky and speculative nancial instruments or instruments that can be used to reduce an investors risk? 3. Does the collapse of Barings expose a fundamental aw in the global nancial system? If so, how might this aw be xed? 4. What is your view on the basic causes of the collapse of Barings Bank? Sources 1. Bray, N., and G. Whitney. Barings Collapse Tied to Wide Cast. The Wall Street Journal, July 19, 1995, p. A5. 2. Bray, N. Leeson Says Losses at Barings Started with Bailout of Errors by Colleagues. The Wall Street Journal, September 11, 1995, p. A16. 3. A Fallen Star. The Economist, March 4, 1995, pp. 1921. 4. Mark, J., and M. Sesit. Losses at Barings Grow to $1.24 Billion. The Wall Street Journal, February 28, 1995, p. A3. 5. Melloan, G. Leesons Law. The Wall Street Journal, March 6, 1995, p. A15. 6. Nusbaum, D., and J. Reerink. BoE Report Details Barings Guiles and Goofs. Futures, September 1995, pp. 1222. 7. A Royal Mess. The Wall Street Journal,February 27, 1995, p. A1. 8. Shale, T. Why Barings Was Doomed. Euromoney, March 1995, pp. 3841. 9. United States General Accounting Ofce; Report to Congress. Financial Derivatives, May 1994, GOA GGD-94-133. 10. Whitney, G. Dutch Giant Offers to Buy All of Barings. The Wall Street Journal, March 3, 1995, p. A3.

The Bank of Englands report also cited a number of senior managers at Barings, including Andrew Tuckey and Peter Baring, for failing to apply proper controls. In an interview given to BBC Televisions David Frost in September, Nick Leeson, then in a German jail awaiting deportation to Singapore, also gave more insight into the collapse of Barings. According to Leeson, he got away with his trading for so long because of the failure of key executives at Barings London headquarters to understand the business he was engaged in and to look more closely into his activities.
The rst day that I asked for funding (to meet margin calls) there should have been massive alarm bells ringing. But senior people in London that were arranging these payments didnt understand the basic administration of futures and options . . . They wanted to believe in the prots being reported, and therefore they werent willing to question.