Nicholas Leeson sinks Barings singlehandedly

1
Nicholas Leeson sinks Barings single-handedly

2
Outline

• How Leeson traded
• The damage
• Whos to blame The anatomy of a murder
• Managements responsibility red flags
• Conclusion

3
Whos who

• Baring Brothers in London Britains oldest
  merchant bank
• Nicholas Leeson The general manager of Barings
  Futures Singapore (BFS) starting in 1993
• Leeson started his career as a derivative trader

4
Leesons Trading

• Arbitrage futures between SIMEX and OSE
• Sell straddles

5
Arbitrage between SIMEX and OSE

• Involves going long in one market and short in
  the other one.
• Leesons 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).

6
Selling straddles

• Straddle Sell one put and one call with same
  strike and maturity
• Benefits the seller if prices dont 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

7
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.

8
It aint 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!

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Bottom line

• Barings collapsed because it could not meet its
  obligations
• (Courtesy of Nicholas Leeson)
• Over US7 billion on the Nikkei 225 equity
  contracts
• Over US20 billion on Japanese bonds and Euroyen
  contracts

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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

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Leesons part

• 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 US500m to Daiwa Bank from
  one type of transaction but also expected to
  receive US300 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.

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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
  Leesons dual responsibility was an excessive
  concentration of powers

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Other red flags

• 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
  US83m receivable from Spear, Leeds Kellogg.
• Leesons cash requests for the first two months
  of 1995 amounted to US1.2 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.

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Senior Managements 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

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Wishful thinking

• Senior mgmt. believed that Leesons 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

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Conclusions

• An unlikely series of events in the market
• One rogue trader
• Incompetent management
• _________________________________
• The demise of one of worlds oldest and most
  respectable bank