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INTRODUCTION
Nicholas (Nick) William Leeson was relaxing at a luxury resort in Malaysia when he heard that Barings Bank PLC, 1 Britains oldest bank, had lost $1.2 billion (860 million) and was in administration (i.e., Chapter 11 bankruptcy). He was shocked, but Leeson should not have been: it was his massive speculative losses on the futures market over a brief three-year period that wiped out the net worth of this venerable bank. Leeson worked at the Singapore branch of Barings Bank PLC, the blue-blooded British merchant bank founded in 1763 that catered to royalty and was at the pinnacle of the London financial world. Among its many accomplishments over the centuries, Barings financed both the Louisiana Purchase in 1803 and the Napoleonic Wars. But the road to success was not always smooth. The bank endured both wars and depressions, and it overcame near-bankruptcy in 1890, surviving only because it was bailed out at the last minute by the Bank of England. In spite of these sporadic periods of turmoil, Barings was always one of the most well-placed

1PLC

is an abbreviation for Public Limited Company, which is like an incorporated public stock company (i.e., Inc.) in the United States.

194

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and highly regarded players in Londons financial hub. How ironic that this centuries-old bank would be toppled by one man operating out of Barings remote Singapore affiliate. Leeson was the chief trader for Barings Singapore affiliate, dealing mainly in futures contracts on both the Nikkei 225 index2 and 10-year Japanese government bonds. Due to his huge trading profits, Leeson earned a reputation among Barings management in London, Tokyo, and Singapore as a star performer, and he was given virtually free rein. Many of Barings Banks top management believed that Leeson possessed an innate feel for the markets, but the story of this rogue trader reveals that he had nothing of the sort. How, one wonders, could Barings management have been so seriously mistaken and for so long? This chapter addresses two main questions about the Barings collapse: why did the bank give Leeson so much discretionary authority to trade, allowing him to operate without any effective trading restraints by managers and internal control systems; and what trading strategy did Leeson employ to lose so much in such a short time?

NICK LEESON
Nick Leeson (Exhibit 7.1) came from humble origins compared to most of Barings officers. He had no family ties to the nobility, did not attend Eton, and did not serve in the Coldstream Guards. The son of a Watford plasterer, Leesons first job at Barings was as a clerk, but he rose swiftly. His big break came when he was sent to the Barings Indonesian office to sort out a

2The

Nikkei 225 Stock Average is an index of share prices for the 225 largest stocks trading on the Tokyo Stock Exchange. Since its initiation in 1950, the Nikkei Stock Average has been the most widely used measure of Japans stock market activity. See Nikkei Net Interactive, http://www.nni.nikkei.co .jp/nikeii.

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EXHIBIT 7.1 Nick Leeson

Photo credit: PANDIS MEDIA/CORBIS SYGMA

tangled mess in the back office.3 The Indonesia office had a large number of stock trades that did not reconcile, because the trading volume on the Indonesian stock exchange had grown so fast that the procedures for delivering stock certificates could not keep up with the volume. The bank had hundreds of small discrepancies between the stock certificates it held and the certificates it was supposed to hold. The banks stock trading business was profitable, and most of the discrepancies were small. Sooner or later the vast majority of these discrepancies would be resolved as the paperwork finally caught up with the backlog. It was Leesons job to sort out the problems in Indonesia so branch operations ran smoothly. Barings internal guideline was to post discrepancies to a special account, called the 88888 Account. That way, the banks books would balance, discrepancies would be isolated and dealt with separately, and the bank could make its regulatory filings without delay. The bank intended for these discrepancies to be recorded and closed out within a day, but Leeson realized that Barings internal guidelines were not followed.

3The

back office handles the administrative functions of a banks or brokerage houses business. Its specific duties include, inter alia, trade confirmation, settlement, recordkeeping, accounting, regulatory compliance, reconciling, and clearing. The front office is involved with direct customer interface and other operating aspects of the business.

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Leeson did such a good job cleaning up the back-office problems in Indonesia that the bank promoted him. His rise after that was meteoric. In January 1992, Barings assigned Leeson to its newly opened Singapore branch; shortly thereafter, he became head of derivatives trading at Barings Singapore office, Barings Futures Singapore (BFS). Leesons rise to prominence was reflected in his annual bonuses, which were more than twice as large as his annual salary.4 While in Singapore, Leeson focused his trading activities on futures contracts in three major markets: the Japanese Nikkei 225 stock index, 10-year Japanese government bonds, and euro-yen deposits. Because they were traded simultaneously on the Osaka Securities Exchange (OSE) and the Singapore International Monetary Exchange (SIMEX), Leesons job eventually became one of taking advantage of arbitrage opportunities between the two markets. But Leeson was not just arbitraging, and between July 1992 and February 1995 (about two and a half years), he incurred losses of over $1 billion. How was this possible? While he was working on reconciling the discrepancies in Indonesia, Leeson learned that the discrepancies account (the 88888 Account) did not appear in reports used to control traders. Not surprisingly, they did go into other reports, such as position statements to the exchanges for margin 5 calculations, but internally, this information was prepared less frequently, and it went through different channels to employees at the bank who had little familiarity with trading. For many types of financial transactions and banking operations, there are temporary imbalances. Cash management systems often allow intra-day overdrafts, and these overdrafts can be large. For instance, a client may send out wire transfers every morning and receive incoming wire transfers every afternoon or may make transfers from different time zones. Every cash management account is supposed to balance at the end of the business day, and if a customers account shows an overdraft, the amount is supposed to be less than the customers credit limit. In that same spirit, it is logical that securities trading systems should allow overdrafts that match the length of the delivery period for securities. For example, U.S. stockbrokers allow their customers to sell a stock and then immediately use the proceeds to buy a different one even though the funds from the sale will not arrive until several days later. The customers account is potentially in overdraft,

1993 and 1994, Leeson earned bonuses of 130,000 and 450,000, respectively, while his salary was approximately 50,000. See Bank of England, Bank of England Report on the Collapse of Barings. Available at: http://www.numa.com/ref/barings/bar00.htm (18 July 1995). 5See Content Highlight 7.1: What Is Margin?

4For

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CONTENT HIGHLIGHT 7.1

What Is Margin?
Derivative contracts, such as futures and short options, require brokers (i.e., the clearing members of an exchanges clearing house) and investors/speculators to post initial margin, which is usually a fixed dollar amount per contract and represents a very small percent of the overall value. Futures and option contracts are agreements that are directly between a clearing member (e.g., broker) and the clearinghouse. As a result, there are separate margin requirements for the broker relative to the clearinghouse and for the customer relative to the clearinghouse. The exchange sets minimum customer margin requirements, but brokers are allowed to charge customers amounts in excess of this minimum. The minimum exchangeset margin requirement depends on factors such as price volatility (e.g., worst daily movement) and general market liquidity. Margin is not really a down payment on the security as much as it is a performance bond that ensures the broker and exchange that the contract will be settled in due course. Initial margin can be posted in cash or acceptable security (e.g., cash, Treasury bonds, Treasury notes, Treasury bills, and letters of credit), and it is held by the broker in a customer-segregated account. By law, brokers are required to hold customer margin money in an account separate from their operating funds. Derivative contracts are repriced daily, with the winners being paid from the losers margin

account. This process is called marking to market. Margin accounts can be depleted by adverse price fluctuations, so the exchange also sets the maintenance margin level. If a margin account falls below the exchange-determined maintenance margin level, the customer must replenish the margin account to the level set by the initial margin requirement. Marking to market ensures the contract holder and the clearinghouse that sufficient funds will be available to cover any loss resulting from the change in price of the derivative instrument. Assurances such as this are necessary when you consider that the margin requirements are as low as 5% of the contracts face value. If everything runs smoothly, the clearinghouse should have a perfectly matched book, with losers paying winners on a daily basis from their margin accounts. As a result, counterparty credit risk in this market should be very low. At the Chicago Board of Trade, the Board of Trade Clearing Corporation (BOTCC) calculates margin requirements for both clearing members and their customers twice per trading dayonce during the day and once at the end of the day. Clearing members must meet their end-of-the-day margin requirements by 6:40 A.M. on the following business day.6
6Chicago

Board of Trade, Ensuring Financial Integrity at the Chicago Board of Trade and the Board of Trade Clearing Corporation, Developed by the Office of Investigations and Audits of the Chicago Board of Trade in conjunction with the Board of Trade Clearing Corporation, Origins of the Chicago Board of Trade and the Board of Trade Clearing Corporation. Available at: http://www.botcc.com/about/ensure.html.

because if the proceeds from the sale did not arrive, the customer would still have to pay for the purchased shares. Big gaps can form between what clients have and what they owe, and these temporary imbalances pose risks. Even if these imbalances arise and are resolved in the normal course of business (and thus seem innocuous), they can still do harm. For one thing, discrepancies introduce delays in rec-

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ognizing exposures, but equally important, they create opportunities for clever and unscrupulous employees to figure out how to take advantage of the permissive treatment of temporary imbalances. Nick Leeson was certainly both clever and unscrupulous. Barings had strict trading limits and believed that it was diligently monitoring all its traders to make sure they did not exceed their limits, but the banks systems were not prepared for the level of fraud and misrepresentation that Leeson committed, and Barings was not aware of the secret passageway Leeson found to its crown jewels. In July 1992, shortly after being assigned to Singapore and only a couple of days after Barings gained membership on SIMEX, Leeson opened an 88888 Account, just like the one he uncovered in Barings Indonesia branch.7 By 1993, just a year after his arrival, Leeson began reporting extraordinary profits. From the perspective of Barings London, there was nothing suspect about Leeson setting up the 88888 Account. After all, a separate account for settling transaction discrepancies was normal, but what went on in this account was apparently off the radar screen of Leesons managers in London and Singapore. Leeson set himself the goal of becoming the protector of his newly discovered door to fortune and fame. Within a week of opening the 88888 Account, he had its reporting software changed so that transactions in the account did not appear on the daily internal performance reports.8 You may ask, What well-managed bank would allow its chief trader to be in charge of the back office, as well? The answer is easier to understand once you realize that, initially, Barings Singapore branch was supposed to be executing orders placed exclusively by Barings affiliates worldwide on behalf of their customers. It was some time afterward that BFS also began to conduct independent arbitrage transactions, but from the standpoint of Barings London, this new line of business posed no major security breach. BFS was not supposed to be involved in any trading for the houses account, so Barings management might have reasoned that any loss of control by putting Leeson in charge of the front and back offices was offset by the cost savings of having one person cover two tasks. As competition for customers became keener and profits declined, BFS gradually began to take on positions of its own. Leeson was put in charge of Singapores arbitrage activities, which meant he was supposed to have large blocks of offsetting Nikkei 225 futures contracts traded simultaneously on
7Bank

of England, Bank of England Report on the Collapse of Barings. Available at: http://www.numa.com/ ref/barings/bar00.htm (18 July 1995). 8In August 1994, a Barings internal auditors report identified the risks of having Leeson in charge of both the front and back offices, but Barings chose either to ignore or not to follow up on the warnings and the recommendations in the audit report.

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Barings Bank PLC: Leesons Lessons the OSE and SIMEX. Because Leeson still controlled the 88888 Account, he was able to assign any trades he desired to itand he did. As a result, an inspection of Leesons normal trading activity showed moderate amounts of futures contracts with positions and activity within authorized trading limits. Leeson used the 88888 Account in two major ways. Whenever he traded more contracts than his limits allowed and whenever he had losing trades that would have blemished his reputation as a brilliant trader, Leeson assigned the extra trades and the losing transactions to the 88888 Account. He also used the account to conceal the fact that he was speculating and not arbitraging. Remember that Leeson was supposed to be long and short in approximately equal amounts on the different exchanges, and it was for this reason that his supervisors allowed him to have such large positions. In reality, he was long in amounts that were two or three times larger than his supervisors realized, and he did not have short positions to offset these enormous exposures.9 Leesons trades in the 88888 Account shrouded his accumulation of massive losses that were threatening the solvency of the bank, and because the trades in the 88888 Account were outside Barings daily scrutiny, they were the ones that broke the bank.

LEESONS TRADING STRATEGY

Leeson quickly acquired a reputation as a hotshot trader. Even during his first few months at Singapore, he made profits for the bank. Asian stocks and currencies were in fashion, and they rose. In violation of Barings internal rules, Leeson traded using leverage,10 and he rode Asias rising wave of stock market appreciation. Success gave Leeson credibility with his managers and colleagues, and so his trades were not scrutinized the way they should have been.

and the Bank of England had rules that limited credit exposures. Large exposures to any customer were supposed to be limited to 25% of Barings equity. In a remarkable breach of regulations, the Bank of England gave Barings an informal concession to temporarily exceed this limit. As a result, the Bank of England was not notified when Barings exposure to the OSA reached 73% of its equity, and the banks exposure to the SIMEX reached 40% of equity. See Bank of England, Bank of England Report on the Collapse of Barings. Available at: http://www.numa.com/ref/barings/bar00.htm (18 July 1995). 10Financial leverage gave Leeson the ability to lay claim to assets with borrowed funds or by depositing margin with brokers. Leverage amplified his gains and losses from what they would have been had 100% of the assets value been purchased with Barings own funds.

9Barings

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Doubling Strategy
After the other Asian stock markets cooled down in 1994, Leeson concentrated his trading on Japanese stock index futures and Japanese government bond futures. He bet that Japanese stocks and interest rates would rise at precisely the time Japanese market was sinking. Share prices and interest rates plummeted. Instead of selling to neutralize his position, Leeson viewed every dip in the Nikkei average as a buying opportunity. As a result, his losses piled up in the 88888 Account. To recoup his losses, he began the fatal strategy of doubling, which requires a trader to double his bets each time he loses. Doubling is a do-or-die strategy that called for Leeson to multiply the size of his bets in the 88888 Account so that any slight recovery in Japanese stocks would bring him back to even. To understand Leesons doubling strategy, lets experiment with a fair coin. Suppose we wanted to win $1, so we flipped a coin and bet $1 that it would come up heads. If it came up tails, we would lose $1, so to win the $1 we originally wanted, we would try again, but this time, we would bet $2 that the coin would come up heads on the next toss. If we lost again, we would already be out a total of $3, so to win our elusive dollar, the next bet would be for $4, and so on it would go. If we lost three consecutive times, our bet on the fourth try (just to win $1) would have grown to $8, and after the seventh consecutive loss, we would be betting $128 for the chance of gaining just $1 (see Exhibit 7.2). Statisticians call it the gamblers ruin, and the term accurately describes what happened as Leeson compulsively took bigger and bigger risks. Doubling strategies are dangerous for two major reasons. First, they can quickly result in gigantic losses, which have to be doubled once again just to break even or to make a small gain. Betting wrong at such high speculative altitudes can threaten the solvency of even the most well-capitalized institutions. The second, and perhaps most frightening, reason the doubling strategy is so dangerous is because evidence has shown that, up until the end, individuals who use it often appear to be conservative, talented traders who earn relatively stable investment returns.11 As a result, they are relatively unsupervised, which means that when this strategy goes wrong (i.e., when there are repeated losses), the financial roof falls in virtually overnight and the common reaction of supervisors is one of shock and utter surprise.

11This is a fact about the strategy and not the people who use it. See Stephen J. Brown and Onno W. Steenbeek, Doubling: Nick Leesons Trading Strategy, Pacific-Basin Finance Journal 9 (2001), 8399.

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EXHIBIT 7.2 Losses from Consecutive Gambles with 50-50 Odds to Win $1
Amount paid for bet to win $1 $1 $2 $4 $8 $16 $32 $64 $128

Bet 1 2 3 4 5 6 7 8

Win/Lose Lose Lose Lose Lose Lose Lose Lose Win?/Lose? $1 $1 $2 $1

Cumulative Losses from Betting $1 $1 $1 $1 $2 $4 $8 $2 $4 $8 $16 $2 $4 $8 $2 $4 $8 $3 $7 $15 $31 $63 $127

$16

$2 $4

$16 $32

$32 $64

Either a loss of $255 or a gain of $1

A frequently quoted riddle concerning ecological catastrophes can help to show how quickly the doubling strategy can result in catastrophe. It goes like this: A lily pad is placed in a pond. Each day thereafter the number of lily pads doubles (i.e., two lily pads on the second day, four on the third day, eight on the fourth, etc.). On the thirtieth day, the pond is covered completely by lily pads, and all life is choked off. A warning bell sounds when the pond is half full. On what day will the warning bell ring? (See footnote for the answer.) 12 Had Leesons activities been identified and stopped just one month prior to the Barings collapse (i.e., in January 1995 rather than in February 1995), total losses would have been approximately one quarter as large and the bank would have survived. Leeson used his doubling strategy several times to recoup significant losses in the 88888 Account. Meanwhile, he continued to report profits in his regular trading account. After one brush with disaster in 1993, when the 88888 Account was 6 million in the red, Leeson managed to bring it back

12Answer:

It will ring on the twenty-ninth dayjust one day before life in the pond ceases. This riddle can found in Lester Russell Brown, The Twenty-Ninth Day: Accommodating Human Needs and Numbers to the Earths Resources. W.W. Norton, 1978.

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up to zero and swore to himself that he would never use the account again. But like a moth attracted to a flame, Leeson could not resist the twin lures of temptation and access to a seeming limitless supply of funding. Within a month of swearing off further use of the 88888 Account, he was back at it, and his transactions were on a larger and grander scale. Leeson had become addicted to fame, which meant he needed to keep his reputation as a brilliant trader, and that required him to keep earning large profits for the bank. Leeson was sure that the Japanese stock market would recover, and the banks control system did not restrain him from speculating with the banks money. During his next round of speculative trades, Leesons losses in the 88888 Account reached 70 million (more than $100 million), and he was well into his doubling strategy again, but this time he faced a major problem. The purchase or sale of futures contracts required the bank to deposit funds in a margin account with SIMEX and OSE, the two exchanges on which Leeson was placing most of his trades. His positions were marked to market13 on a daily basis, and as his losses grew, BFS did not have enough cash to meet Leesons growing margin calls, so Barings London had to wire BFS the needed funds. Without sufficient oversight at Barings, the only effective restraint on Leesons reckless doubling strategy was margin calls. He had to be conscious of them because, if his positions grew too large, Leeson would not be able to raise the cash needed to meet the margin calls. To cover his tracks, Leeson convinced Barings London that the margin calls were not a problem. He fabricated a story that the transfers were needed mostly to meet the margin calls of Barings customers, many of whom lived in different time zones and had trouble clearing checks in time. He also convinced Barings London that part of the large margin calls was a normal counterpart of his profitable arbitrage trading activities. Leeson argued that arbitrage transactions, in general, earn so little profit per transaction that he needed large gross positions to conduct his deals. Because these positions were on two separate exchanges, each with its own margin requirements and therefore having no mutual netting provisions, he had to pay margins on the gross positions in both markets. As a result, Leeson persuaded Barings London that the cash flow difficulties were more apparent than realbasically, an illusion. No one at Barings London seemed to question Leesons explanation even though it should have been obvious that, if he were paying increasingly

13See

Content Highlight 7.2: Marking to Market.

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CONTENT HIGHLIGHT 7.2

Marking-to-Market
To protect the exchange and the counterparties from default, futures contracts are markedto-market each day, which means the contract is revalued each trading day, and funds are transferred from the losers margin account to the winners margin account, as if the contract had been closed out and then reopened. If any traders account falls below the maintenance margin requirement (i.e., the minimum level to which the margin account is allowed to fall before a broker calls the trader for more funds), a margin call is issued to the trader, and the account has to be brought immediately up to the full initial margin level. The futures exchange monitors how much is on deposit for each contract that is in existence. Through brokers, it demands and gets additional funds from traders who are on the losing side of any price change. For example, if a trader buys a stock index futures contract and the index falls, the futures exchange takes

funds from the traders account, and if this reduction pulls the margin account below the maintenance level, the trader has to supply enough funds to bring the margin account back to its full, initial margin requirement level. The futures exchange issues margin calls to protect itself, because if the trader went bankrupt, the exchange would have to honor the traders commitments. By marking the futures contract to market each day, even if the index kept changing by substantial amounts, the daily transfer of funds and periodic replenishment of the margin account would ensure that the exchange had collected enough cash to pay the winning counterparty when the contract matured. If the exchange issued a margin call, and the trader did not provide sufficient cash before the deadline, the exchange would close the traders position. If the traders losses exceeded the amount in her margin account, the exchange would attempt to collect the deficiency from her.

more margin on one exchange, he should have been earning it on the other. After all, he was supposed to be arbitraging. It is hard to understand why Barings London was unable to expose Leeson far earlier than it did. For instance, his explanation that the excessive and growing margin payments were due to customers in different time zones should have been questioned immediately, because the only exclusive third-party client that BFS had was Banque Nationale de Paris (Tokyo). All of BFSs other clients were existing customers of Barings London and Tokyo offices. It is even more astonishing that Barings London never asked Leeson to substantiate his requests for margin funding. Not only had they risen to stratospheric levels (i.e., from $354 million at the end of December 1994 to $835 million and then $1.2 billion during the first two months of 1995), but also, the day-by-day amounts he requested were identically split between OSE and SIMEXan event that should have occurred perhaps once a century and not every day.

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EXHIBIT 7.3 Nikkei Index Closing Quotes: July 1994July 1995

22,000
Barings Bankrupt

20,000 Index Value

14See

18,000

16,000

14,000
94 g-94 p-94 t-94 v-94 c-94 n-95 b-95 r-95 r-95 y-95 n-95 l-95 ulu c p a 1-J 1-Au 1-Se 1-O 1-No 1-De 1-Ja 1-Fe 1-M 1-A 1-Ma 1-Ju 1-J

Through his deception and Barings carelessness, Leeson was able to pursue the doubling strategy of recouping losses by piling up long positions in Nikkei 225 futures contracts and short positions in Japanese government bond futures. In 1994 and 1995, Leeson had increased his positions in Nikkei futures and Japanese government bond futures to approximately 8% and 24% of SIMEXs total trading volume, respectively.14 But Japanese stock prices kept falling, with only occasional rallies. During these rallies Leeson recovered slightly, but never enough to satisfy his needs. Exhibit 7.3 shows the daily closing quotes for the Nikkei index, the barometer of Japanese stock prices, and the roller-coaster ride that took Leeson and Barings to ruin between July 1994 and February 1995. In fact, the Nikkei fell almost continuously until July 1995, but that was overkill, because in February 1995, Barings had already failed. The chronic weakness of Japanese stock prices pushed the 88888 Account deeper into the red each time, and Leeson kept buying more futures contracts, so that when (and if) Japanese stock prices ever rallied, the 88888 Account would be pulled back up to zero.

Bank of England, Board of Banking Supervision, Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings London (ordered by the House of Commons), (July 1995), and Lim, Michael Choo San, Barings Futures (Singapore) Pte Ltd: Investigation Pursuant to Section 231 of the Companies Act (Chapter 50): the report of the Inspectors appointed by the Minister for Finance / Michael Lim Choo San, Nicky Tan Ng Kuang. Singapore: Singapore Ministry of Finance, 1995, xi, 183p.

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FICTITIOUS TRADES, FALSIFIED RECORDS, AND OPTION SALES TO RAISE FUNDS

The need to make margin deposits was a thorn in Leesons side. He did not want to alert London by asking for too many wire transfers, yet he needed funds to keep buying futures contracts. Only by having enormous futures positions could he recover his losses when the market bounced in the right direction. The need for cash to meet margin calls drove Leeson to desperation. He began to record fictitious trades, falsify internal transfer records, and sell straddles on the Nikkei index. All of these actions were clearly and explicitly outside his authority to transact. The purpose of the first two activities was to reduce the size of his margin calls by lowering his exposures. The purpose of the third activity (i.e., selling straddles) was to generate funds in order to finance his margin calls. Leesons fictitious trades were blatant and illegal deceptions. He got away with them for as long as he did, because the trades were usually taken late in the day and then reversed early the next morning. Similarly, his falsification of records was a financial shell game, in which he pretended to transfer and trade large blocks of stocks between the accounts of the various Barings affiliates and the 88888 Account. In this way, Leeson gave the impression that his net exposures were small and his profits were high. As well, he duped exchanges into charging him less margin than he should have paid. All of these shenanigans had the effect of buying Leeson a stream of oneday stays of execution. Meanwhile, he hoped for full exoneration by unwinding his positions at a profit. One way to better understand the corner into which Leeson painted himself is by diagramming the profit-and-loss profile of his combined positions. The graphic explanation in the next section is a must for anyone interested in what really went wrong at Barings.

LEESONS TRADING POSITION: THE NET PROFIT-AND-LOSS PROFILE OF HIS EXPOSURES Leesons Sales of Short Straddles
Leeson earned revenues to pay his margin calls by selling short straddles. As Exhibit 7.4 shows, a short straddle is the derivative hybrid created when a short put option and a short call option with the same strike prices are simultaneously combined. The only way a short straddle can earn profits is if

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EXHIBIT 7.4 Profit-and-Loss Profiles of a Short Put, Short Call, and Short Straddle Hybrid

20 0

1: Short Put
0 50 100 150 200

20 0

2: Short Call
0 50 100 150 200

20 40 60 80 100

20 40 60 80 100

3: Combined Position
20 0

20 40 60 80 100

50

100

150

200

4: Short Straddle: Hybrid

40 20 Profits 0 Losses

20 40 60 80 100

50

100

150

200

Stock Index Price

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EXHIBIT 7.5 Profit-and-Loss Profiles of a Long Futures Position and Short Straddle

60 Long Futures 30
Profits

0
Losses

20 Short Straddle

40

60

80

100 120 140

160

180 200 Short Straddle

30 60 90 120

Futures Price and Strike Price

the price of the underlying asset does not move substantially in either direction. A short straddle looks like a mountain or an iceberg, with most of its mass underwater (i.e., below zero). Notice how little of the straddle is above zero, compared to the total profit-and-loss profile. The portion of the short straddle that is above zero depends on the size of the premium relative to the total exposure.

Combining a Short Straddle and a Long Futures Contract

It is important to remember that the short straddle positions taken by Leeson did not occur in isolation. As Exhibit 7.5 shows, Leeson combined his short straddles with long futures positions. For every straddle he sold, Barings got cash, and Leeson used the cash to pay the required initial margin deposits on new trades and also to meet the mounting margin calls on his existing stock index futures positions. Exhibit 7.5 shows that, to profit from the long futures position, the stock price had to rise above the futures price,15 but if it rose too much, every yen of gain made on the futures position would be offset by losses on the short straddle (or more specifically on the short call portion of the straddle). On the down side, the situation was much more risky. A decline in the stock price caused simultaneous losses on the futures position and the straddle position (or more specifically, the short put portion of the straddle). The only thing

15To simplify the explanation in this example, the futures price is set equal to the strike price. Of course, this equality did not have to be the case.

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standing in the way of losses at almost every price level was the premium that was collected up front, at the time the straddle was sold. Exhibit 7.6 shows the profit-and-loss profile created when the short straddle and a long futures position (see Exhibit 7.5) are combined. It is similar to a short put, except that the downward-sloping portion of the profile is even steeper than usual, because the long futures contract incurs losses as the underlying assets price falls below the futures price, and the short straddle incurs losses as the underlying assets price falls below the strike price. As you can well imagine, the combination of his short straddles and long futures made it more difficult, but certainly not impossible, for Barings to audit Leesons net exposures. Exhibit 7.6 shows that the gains from a short put position are capped. By contrast, the potential losses could be enormous if the asset price (e.g., the Nikkei 225 index) fell.

Combining a Long Futures Position and Numerous Short Puts

The profit-and-loss profile from combining a short straddle and a long futures position (see Exhibit 7.6) gives the illusion that Leeson had a viable trading strategy, and he just guessed wrong in terms of the price movement. Exhibit 7.6 shows a large span of prices to the right of the strike price, which offer, at least, a glimmer of hope that profits could be earned. Unfortunately, we will find that this was not the case. In fact, Barings would have been lucky if Leeson had put the bank in such a position. The illusion is

EXHIBIT 7.6 Profit-and-Loss Profile of One Long Futures Short Put With Amplified Downside Risk

One Short Straddle

50
Profits

0
Losses

20

40

60

80

100

120 140 160 180

200

50 100 150 200

Stock Index Price

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EXHIBIT 7.7 Leesons Iceberg: Profit-and-Loss Profile From Combining a Long Futures Contract With Many Short Straddles
Leesons Iceberg

200 100 Profits 0 Losses 100 200 300 400 500

20

40

60

80

100

120 140 160 180

200

Stock Index Price

revealed once you realize that Leesons need for large sums of cash to fund his margin calls forced him to sell disproportionate numbers of short straddles for each long futures position he took. Exhibit 7.6 shows the results if one long futures contract is combined with one short straddle, but this one-forone combination was not what Leeson did. Rather, he combined numerous short straddles with each long futures position. Exhibit 7.7 shows the profit-and-loss profile when numerous short straddles are combined with a long forward contract. The hybrid payoff profile looks, again, like an iceberg (Leesons Iceberg), because 90% or more is underwater (i.e., in the red). The only outcome that could have been even slightly profitable was if Japanese stock prices hovered at or near their current levels, in which case the stock index futures contracts would have generated small gains, and the put and call options would have expired out of the money.16 If stock prices rose too much, the gains on the futures contracts would have been overwhelmed by the losses on the mountain of short calls. If stock prices fell, the losses on the long futures would have been amplified by the losses on the mountain of short puts.

LEESON ACCUMULATES LOSSES

By 31 December 1994, Leeson had accumulated losses of 208 million. Japanese stocks never rose above 19,000, there was an earthquake in Kobe on 17 January 1995, and Japans long-awaited recovery was pushed farther
16This

meant the Nikkei 225 index would stay at approximately the 19,250 level.

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EXHIBIT 7.8 Nikkei 225 Stock Index Prices From January 1995 to December 1995
20,000 19,000 18,000 17,000 16,000 15,000 14,000
-95 -95 b-95 ar-95 pr-95 y-95 y-95 n-95 l-95 g-95 p-95 ct-95 ct-95 v-95 c-95 u a a an an u e -O -O -No -De e Ju 3 28 22 1-J 26-J 20-F 17-M 11-A 6-M 31-M 25-J 20- 14-A 8-S 17

and farther into the future. After the earthquake, the Nikkei Index fell to 18,950, forcing Leeson to engage in an even more frantic and massive operation that looked, in retrospect, like a single-handed effort to hold Japanese stock prices at the 19,000 level. Over the next five trading days, Leeson bought a total of more than 20,000 futures contracts, and by 22 February 1995 his aggregate position was over 61,000 futures contracts. Despite his frantic buying, Japanese common stocks fell sharply, and on Monday, 23 January 1995, the Nikkei index fell 1,000 points to 17,950. For Leeson, the end was near. By February 1995, his losses had reached an astounding 830 million.17 As enormous as his losses were after the stunning drop in Japanese stock prices, Leesons strategy could still have worked if he had been able to buy enough contracts to pull the index back up above 19,000, and it was for this reason that Leeson continued to sell straddles. As Exhibit 7.8 shows, if Barings could have held on until December 1995, Leesons spectacular losses would have turned into gains, because the Nikkei 225 stock index prices rose by more than 5,000 from July until the end of the year. Leeson continued trying to raise Japanese stock prices through the last weeks of January 1995 and into February 1995, but the wave of selling was too great, and he was unsuccessful in his attempts. Then Leeson went on vacation with his wife.

17Bank

of England, Bank of England Report on the Collapse of Barings. Available at: http://www.numa.com/ ref/barings/bar00.htm (18 July 1995).

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BLAME BEYOND LEESON: MANAGEMENT CONTROL OF TRADING OPERATIONS

Banks are in the business of trading financial instruments, such as currencies, bonds, common stocks, and many other financial assets, including derivatives. This trading can be done as a service to clients and/or to earn outright trading profits. For auditing and control purposes, the difference is important. Trading that is done only as a service for customers requires the bank to have strict rules concerning account management and credit risk management for individual customers. By contrast, trading done for the house requires strict exposure limits on the banks traders, because this type of trading puts the banks equity directly at risk. In either case, derivative trading requires top management to have a clear idea of how profits are earned and the risks associated with such returns. On both counts, the managers at Barings Bank were deficient. Traders profit by taking advantage of small movements in market prices. Because there are so many different markets and so many different instruments, these traders tend to specialize and become experts in their own narrow segments of the financial world. To do their jobs well, traders need to feel that they are a jump ahead of the other people who trade the same instruments, and so they become very knowledgeable about the particular instruments they trade. Sometimes this depth of knowledge leads traders to believe that they can actually predict in which direction the market will move.18 Such confidence can be dangerous, because there is no room for selfdelusion or ego trips. When they suffer losses, traders have to close out their losing positions quickly before the losses get too large, and then move onward, with their self-assurance as strong as ever. In other words, they have to have an unshakable conviction that their superior knowledge and trading skills will make them net winners in the long run, but they also have to pay due homage to the capricious and inscrutable movements of the market. Because the risks of carrying open trading positions can be very high, most traders need special permission from their managers at the end of each day to carry an unbalanced position overnight. The activities of traders have to be controlled closely, which means their positions have to be strictly monitored and audited; yet, within a bank,

18Skeptics

define traders as individuals who know more and more about less and less until they know everything about nothing. There is no clear evidence that traders can beat the market on a consistent, longterm basis.

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there is another type of employee whose activities are supposed to be much more benign. This is the arbitrager. Arbitrage is the simultaneous buying and selling of assets to earn profits. Because assets are simultaneously bought and sold, arbitragers net positions at the end of the day, and for most points within a day, are supposed to be balanced (i.e., flat), and therefore the risks of arbitrage trading are supposed to be small or nonexistent. Nick Leeson was in charge of arbitrage trading for Barings Futures Singapore (BFS), but his positions were nowhere close to being flat at the end of each day, and the losses from these positions caused the eventual bankruptcy of Barings. It is a sad and ironic fact that the demise of this venerable financial institution was due to the activities of someone who was supposed to be conducting risk-free transactions. From all their years of trading and security dealing, one would expect banks to have learned from their successes and failures how to control the positions of their employees. But control is an elusive goal when banking activities have so many dimensions and when each trading operation and each new instrument offers its own secret passageways to the bank vault. In short, controlling bank-trading operations is harder than it sounds, and this task is made even more difficult by rogue traders who actively search for ways to evade controls and exceed their trading authority. Derivatives can involve huge amounts of leverage, and their net risks can be masked by joining them in countless combinations, permutations, and variations. Studying the Barings fiasco reveals that no onenot the traders, bank management, board of directors, or Bank of Englandwas adequately supervising Barings derivative risks. The breakdown inside Barings was partly because Leesons derivatives transactions were complicated, but the heart of the breakdown was much more elementary. In a nutshell, there was no effective oversight at Barings, and as a result, Leeson was able to circumvent the banks internal checks and balances. The managers and directors in London did not know exactly what Leeson was doing, and neither did his supervisors in Singapore or Tokyo. Due to the 88888 Account, only a part of Leesons trading results showed up in the banks routine tabulations of trading activities, and warnings from internal auditors as well as external auditors and regulators were largely ignored. It seemed that, so long as Leesons performance was stellar, there was no urgency to ask hard questions. The attitude within the bank was that Leeson had the Midas touch, and too much restraint would cramp his style and hold down the profits his trading could bring. Most things are obvious in retrospect, but for Leeson and his managers, one question begs to be asked. If he was truly supposed to be conducting

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Barings Bank PLC: Leesons Lessons only arbitrage trades, why were there no red flags waving and alarms sounding when Leeson reported such large profits? In 1993, Leesons office brought in about 20% of Barings worldwide profits, and during the first half of 1994, it was responsible for about 50% of the banks earnings. By yearend 1994, Leesons reported profits were 500% of his budgeted estimate.19 Instead of critical scrutiny, Barings management seems to have convinced itself that the source of the banks competitive advantage over rivals came from its simultaneous membership on the Japanese and Singapore exchanges. Management also seemed to have prided itself for having the wisdom to hire Leeson, the golden boy of arbitrage trading.

A BANK FOR A POUND

It was not until the Singapore futures exchange issued a mega-margin call in January and February 1995 that Barings directors in London realized that Leesons trading was not arbitrage and that he was not a star trader. The reckless trader had finally been identified. Barings sent a team of auditors to Singapore, but it was too late. The losses continued to mount, and soon exceeded the banks net worth of $500 million. Barings had no way to recover, and efforts to extricate itself from financial ruin failed. Unlike the near bankruptcy of 1890, no white knight came to the rescue. In the end, ING Bank in the Netherlands bought Barings for 1. Leesons trip to Malaysia turned from a vacation into a pathetic attempt to escape. He went into hiding by traveling to Borneo and then on to Frankfurt, where he was apprehended and extradited to Singapore. Leeson pleaded guilty to fraud and spent three-and-a-half years of a six-and-a-halfyear sentence in a Singapore jail. While in prison, he was diagnosed and treated for colon cancer, and his marriage dissolved.

AFTERMATH OF THE BARINGS FAILURE

The failure of Barings Bank PLC shocked the financial industry into realizing just how powerful one traders undiscovered and unsupervised transactions could be. As a result of this catastrophe and others that occurred in the 1990s, the financial industry set its sights on the target of implementing

19See

BBC Online Network, Business, The Economy: How Leeson Broke the Bank (Tuesday, 22 June 1999). Also see Stephen J. Brown and Onno W. Steenbeek, Doubling: Nick Leesons Trading Strategy, PacificBasin Finance Journal 9 (2001), 8399. http://news.bbc.co.uk/2/hi/business/375259.stm. Accessed on 9 May 2003.

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new and improved risk-management measures. Today, measures and systems such as Value at Risk and enterprise risk management have grown in popularity due to the lessons learned in the 1990s. Although it is true that ING Bank eventually purchased Barings and none of the depositors or creditors was hurt by the collapse, shareholders and loan note holders still suffered terribly.20

CONCLUSION: LEESONS LESSONS

The Barings-Nick Leeson story is a spectacular anomaly that provides some valuable lessons. Effective risk management requires a clear line of demarcation between the back office (i.e., the individuals responsible for recording, confirming, settling, reconciling, and reporting transactions) and the front office (i.e., the traders). Otherwise, there will always be temptation to fix the books to enhance performance. Without this separation, control systems that monitor risks, such as trading limits, credit, liquidity, and cash flows, lose most of their significance. Barings allowed Nick Leeson to settle his own trades, by giving him authority over both the front and back office, and as a result he could manipulate accounts at the Singapore branch, while reporting fraudulent totals that appeared accurate. Giving Leeson authority over both functions was equivalent to a farmer giving the fox responsibility for counting the chickens in the chicken coop. Perhaps the most embarrassing aspect of the Barings-Leeson catastrophe was the role played by senior management (i.e., Leesons direct supervisors, the banks management committee, and the board of directors), whose errors were ones of omission rather than commission. Simply put, there was a gaping lack of management control that gave too much autonomy to Leeson, who was, in more ways than one, far beyond the scrutiny of his supervisors. The directors in London thought Leeson was arbitraging, when, in reality, he was taking outright positions and selling naked (i.e., unhedged) puts and callsboth of which were clear violations of Barings rules. No one in the bank seems to have fully understood the risks that Leeson was taking, and because he was reporting such large profits, no one posed the hard questions that should have been asked. Leesons supervisors should have had direct and immediate knowledge of his activities. Barings management committee should have set up reporting systems to ensure that important information on operational risks reached them, and the

20Bank

of England, Bank of England Report on the Collapse of Barings. Available at: http://www.numa.com/ ref/barings/bar00.htm (18 July 1995).

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Barings Bank PLC: Leesons Lessons board of directors should have put the management committee under constant pressure to formulate these risk reporting systems. Senior Barings managers ignored internal audit reports, as well as inquiries from the Bank for International Settlements. They even ignored (for a while) the cold reality of Leesons call for cash, when trading losses required Barings London to borrow the needed funds and wire them to Singapore. Barings management thought Leeson was arbitraging, and therefore, it funded his margin calls without demanding full explanations. Arbitrage traders are not supposed to be superstars. They are not supposed to earn enormous profits. Rather, they should be earning small profits on numerous trades with almost zero net exposures. When an arbitrage trader begins to earn 20% to 50% of a multinational banks annual profits on riskless trades, as Leeson claimed to be doing, warning bells and sirens should sound immediately. Had Leeson been fully hedged, then the margin calls on one exchange would have eventually been offset by gains on the other. To be sure, he would have needed to post larger and larger amounts to his margin accounts as his positions expanded, but they would have been nowhere near the level of funding he requested. The truth is that Leesons supervisors seemed to bend over backwards looking for reasons to believe that he was staying within the banks guidelines and the eye-popping trading profits he was generating were legitimate. Whatever arguments Leesons supervisors concocted, they were invalid and shallow. Barings had rules and regulations in place that were supposed to stop traders (including Leeson) from activities such as carrying open overnight positions, exposing the bank to any one customer for more than 25% of the banks capital, and selling options. Almost no twisting and turning can reverse the fact that many levels of management above and around Leeson failed to function properly. It is sobering to think how many individuals with brilliant minds and the opportunity to study at universities like Oxford and Cambridge were duped by a lone rogue trader in Singapore.

REVIEW QUESTIONS
1. Why did Nick Leeson sell numerous short straddles for each long futures contract he bought? 2. Explain Nick Leesons doubling strategy. 3. Has Nick Leeson drawn too much of the blame for what went wrong at Barings Bank? Who else bears some of the responsibility? Why?

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4. Was the Barings board of directors culpable for the losses of Nick Leeson? What is a fair way to evaluate the performance of Barings board of directors? 5. Nick Leeson traded simultaneously on two exchanges in two different time zones. Does the fact that he was trading on two exchanges simultaneously automatically mean he was speculating, or is it what he was doing that made the trades speculative? 6. Nick Leeson sold short straddles and combined them with long futures contracts. What hybrid would he have created if he combined long call options on the Nikkei Index and with short forward contracts? Why did he sell options instead of buying them? 7. Was the existence of the 88888 Account one of the fundamental problems at Barings Bank PLC, or was the problem with its use?

BIBLIOGRAPHY
Anonymous. Anatomy of a Scam. Asiaweek.com Magazine. Available at: http://asiaweek .com/asiaweek/95/0825/ bizl.html (25 August 1995). Accessed on 9 May 2003. Anonymous. Billion-Dollar Man. Asiaweek.com Magazine. Available at: http://www. asiaweek.com/asiaweek/95/1229/feat5.html (undated). Accessed on 9 May 2003. Anonymous. How Leeson Broke Barings. Available at: http://risk.ifci.ch/137560.htm (undated). Accessed on 9 May 2003. Bank of England. Bank of England Report on the Collapse of Barings. Available at: http://www.numa.com/ref/barings/bar00.htm (18 July 1995). Accessed on 9 May 2003. BBC Online Network. Business: The EconomyHow Leeson Broke the Bank. Tuesday, 22 June 1999. Available at: http://news.bbc.co.UK/2/hi/business/375259.stm. Brown, Stephen J. and Steenbeek, Onno W. Doubling: Nick Leesons Trading Strategy. Pacific-Basin Finance Journal 9 (2001), 8399. Chin, Yee Wah. Risk Management Lessons From the Collapse of Barings Bank. Japan Insurance News (MarchApril 2002), 1217. Fay, Stephen. The Collapse of Barings. New York: W.W. Norton, 1997. Knowledge@Wharton. How Bad Choices Lead to Billion-Dollar Mistakes. Available at: http://nes.com.com/2009-1017-252688.html?legacy cnet (17 February 2001). Accessed on 9 May, 2003. Lim, Michael Choo San. Barings Futures (Singapore) Pte Ltd: Investigation Pursuant to Section 231 of the Companies Act (Chapter 50): The Report of the Inspectors Appointed by the Minister for Finance/Michael Lim Choo San, Nicky Tan Ng Kuang. Singapore: Singapore Ministry of Finance, 1995 xi, 183p. Thackray, John. Leesons Story Rings True. Derivatives Strategy. Available at: http://www.derivativesstrategy.com/magazine/archive/1995-1996/0496play.asp (April 1995). Accessed on 9 May 2003.