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Barings Bank and Its Rogue Trader CASE STUDY BARINGS BANK AND ITS ROGUE TRADER Barings Bank background: Barings Bank plc was a British bank and previously as a merchant banker it was known as Baring Brothers & Co. It was one of the oldest merchant banks in Britain having been founded in the year 1762. As a bank, it was much respected in the United Kingdom and had a long history of successful merchant banking operations. The bank in fact, maintained close business relationship with British monarchy till its failure in February 1995. It started Barings Securities Ltd. (BSL) in 1984 by acquiring a small stock broking firm Henderson Crosthwaite, with a staff of 15 based in London, Hong Kong and Tokyo. The idea was to take advantage of the stock market boom in 1980. BSL was separately and liberally managed company and proved to be very successful by trading in Japanese equity warrants – kind of bonds sold with warrants, which were exercisable into shares. Encouraged by the success in Asian market, it decided to diversify into the field of derivatives. They considered that making profits through arbitrage was a good opportunity in Asian markets. They therefore established Barings Futures (Singapore) Pte Ltd. (abbreviated as “BFS”) as a subsidiary of Barings Bank. The subsidiary was set up to trade in derivative products on Singapore International Monetary Exchange (SIMEX) in 1986. The subsidiary started its operations in SIMEX from July 1992. The Exchange was trading in futures and options in currencies, equities & commodities. Mr Nicholas (Nick) Leeson, who had earlier been successful in making profits for BSL on currency and stock derivatives – mainly through arbitrage, was promoted and posted in Singapore as the trader in charge of BFS operations on SIMEX. The bank aspired to become one of the first banks to trade on derivatives in this region and the Board gave Nick Leeson considerable freedom for his activity though the terms given to him was to make money through arbitrage which was considered to be risk less profit. In 1993, Nick was appointed General Manager of BFS and was authorized to trade proprietary as also Clients’ accounts on far east exchanges and on behalf of many Baring Group companies. Nick Leeson dealt with mainly six futures and some options on them: 1. Nikkei 225 contract traded on SIMEX; 2. Nikkei 225 contract traded on OSE (Osaka Stock Exchange) Japan; 3. 10-year JGB (Japanese Government Bonds) contract traded on SIMEX; 4. 10-year JGB contract traded on TSE (Tokyo Stock Exchange) Japan; 5. 3-month euroyen contract traded on SIMEX and 6. Three-month euroyen contract traded on TIFFE (Tokyo Financial Futures Exchange), Japan. [Please note that the euroyen refers to yen currency traded in the global market outside Japan. It has nothing to do with the currency Euro, which came into existence much later.] Arbitrage business made significant contribution to the profitable business of BFS. Initially, it was in the form of cash / futures arbitrage in Tokyo. However, soon Nick Leeson started studying and exploiting the arbitrage between SIMEX and OSE on Nikkei 225 futures contracts. He would buy and sell these futures contracts simultaneously on SIMEX and OSE platforms taking advantage of the small difference between identical contracts. He would buy at a lower price and sell at a slightly higher price. This made tremendous business sense since SIMEX and OSE had different market conditions. While OSE had business from mainly local participants, SIMEX dealt mainly with international clients or “off-shore” business. Even the speeds of operations were different on these exchanges. OSE operations were slower vis-à-vis those of SIMEX. As a result of these circumstances, there were plenty of opportunities for making gains through trading on arbitrage. Similarly, market for JGB also offered opportunities since it witnessed considerable volatility. Leeson would make profits by trading on JGB futures contracts simultaneously on SIMEX and TSE platforms. He also encashed on arbitrage opportunities on euroyen futures contracts traded on SIMEX and TIFFE platforms to make profit. Arbitrage is strictly “risk less” profit and hence, everything was going in positive direction for Leeson and BFS as long as Leeson matched (squared off) positions. However, Leeson started keeping unmatched positions (whenever they went wrong i.e. whenever they could have incurred a loss) open for a long time. He was also able to conceal such unauthorized open positions for over a year. This was possible because he was allowed to manage both, the front office and back office functions of the trading activities of BFS carried through the Simex. Also the senior managers at Barings could not find out about the correct position of BFS on these futures since they came mostly with a merchant banking background and knew very little about trading. Even when Leeson showed huge profits through arbitrage, the management did not become alert or think that substantial risks were taken. Large profits, which are usually not possible in arbitrage, failed to alert the senior management about the accumulated open positions on futures contracts. On the contrary, they believed that Nick Leeson was making low risk profit and held only matched positions on the SIMEX and the OSE and hence was making a low- risk profit. However, the reality was altogether different. Though Leeson started with arbitrage profits, he had started keeping his loss making positions open for a long time. Not only this, he started trading derivatives contracts on the two exchanges that were of different types or in mismatched amounts. For example, he resorted to a trading strategy known as a "straddle," with the objective of making a profit by selling put and call options on the same underlying financial instrument i.e. Nikkei 225 Index. A Straddle involves selling call and put options simultaneously on the same underlying asset practically at the same strike price. Selling options ensures that you are earning premium on them, though it also means that you are taking unlimited risks (while selling call options) and almost unlimited risks while selling put options. While selling a straddle can make money for the investor when the markets are stable, the strategy is almost suicidal when the markets become volatile!! As shown in the diagram above a short straddle will generally produce positive earnings when markets are stable i.e. when the markets move within a very small / narrow range of price for the underlying. In other words, when the markets are not Payoff diagram for Short Straddle volatile and remain more or less close to strike price, the speculator stands to gain. However, the strategy could result in to huge losses if markets become volatile and the price of the underlying goes on either side. As the General Manager of the subsidiary, Nick Leeson was running the bank’s trading activities on Simex. Unfortunately, Leeson kept his unmatched positions Profit Net Payoff X Price Short Put Short Call Loss and concealed them for over a year since he was managing both the trading and back office operations himself without any supervision or auditing by his seniors. Trading and Back office functions: While the front office actually puts through all the trading transactions, like buy / sell orders, the back office keeps track of settlement process and accounting records of all transactions. Mr Nick Leeson, thus, had responsibilities both for trading and the accounting and settlement activities. As a matter of fact, the prudent business policy dictates that the functions of front office (trading) and back office are to be segregated and different persons were put in charge of the two sections to avoid any fraudulent activity. This had not been done in the case of Singapore subsidiary of Barings. It was an error of judgment on the part of the bank’s management to entrust both types of activities to Mr Leeson, who later brought down the bank through unauthorized deals and became known as the “rogue trader” Account No. 88888: Mr Leeson, as a trader in July 1992 itself (remember that he became the general manager of the BFS in 1993) had opened an account titled 88888 in the Exchange. On the BFS system, this account was described as an Error account. It is a common practice for a trader to maintain similar accounts with exchanges for the purpose of netting minor trading differences. As a routine practice, banks and other institutions sometimes maintain suspense account to temporarily put through transactions which could not be reconciled immediately. However many times the suspense account itself would be the beginning for bigger fraud. No body imagined that the so called error account 88888 would seal the very existence of the bank itself in a matter of few years. Leeson’s intentions: Leeson’s intention to open account 88888 seems to be with different idea. In the first month of its opening itself, a large number of transactions were booked through the account. Normally, error account should have fewer entries and should be used only for reconciling small value differences. Further, the error account should be closed on daily basis and net difference – positive (gain) or negative (losses) should be recorded as profit or loss. However, account number 88888 was used to put through a large number of transactions on daily basis from the beginning itself. In other words, the account did not seem to be intended to serve as an error account. The error account itself was operated as a regular trading account. Shuting out account 88888 from the system: In fact, Leeson gave specific instructions to his staff, right in the beginning of the opening of ‘error’ account, to modify the office software to exclude transactions in account 88888 from the system and from all market activity reports.
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