Nick Leeson’s strategy to earn trading profits on derivatives?

Originally, trader Nick Leeson was supposed to be exploiting low-risk arbitrage opportunities that would leverage price differences in similar equity derivatives on the Singapore Money Exchange (SIMEX) and the Osaka Exchange. In fact, he made up a strategy to earn trading profits on derivatives where he would have to take much riskier positions by buying and selling different amounts of the contracts on the two exchanges or buying and selling contracts of different types. Leeson was speculating wildly and completely without authorization, in massive amounts on movements in the Japanese stock and bond markets.

Leeson’s trading activities mainly involved three futures markets: Futures on the Japanese Nikkei 225 stock index, futures on 10-year Japanese Government bonds (JGB futures) and European futures. Leeson executed 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, in this case, the Nikkei 225 Index. Most of his trading was a bet on the volatility of the Tokyo stock and bond markets. In his futures positions, he was betting that the Tokyo stock market would rise and the bond market would fall. He was long Nikkei 225 futures, short Japanese government bond futures, and short both put and call options on the Nikkei Index. He was betting that the Nikkei index would rise, but he was wrong; instead it fell, causing him to lose $1.39 billion.

A straddle will generally produce positive earnings when markets are stable but can result in large losses if markets are volatile. He planned his strategy taking into consideration the Japanese futures market as in Japan the margin is posted on a net basis for all costumers and if there are customers who are in short position, firm can take long position without any need to pay the call margin. He utilized this opportunity through his bogus error account 88888 and companies account 99002.

What went wrong that caused his strategy to fail?

Leeson’s strategy failed because he was taking into consideration that the market had

experienced an extended bull run throughout the late 1980’s and after that, it had fallen to

half of its 1989 high. He thought that it had fallen enough and from now it would

only go up, and he continued to bet that it would rise; but the Nikkei 225 index only kept falling. Leeson further increased the size of his open positions even as his losses increased due to volatility in the markets. He did nothing to hedge his position to lay off his potential losses if the markets did move the wrong way. In effect, Leeson was accepting unlimited liability.

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The second thing that was that he was relying on the bank interest rate; that it would decrease but eventually the exact opposite happened and the interest rate increased to a high. He thought if that the interest rates were low at the moment and if they were going to rise they would hurt him as more of the investors would move towards safe earning through the high interest rate returns, making the investment into market to reduce and hence to make himself on the safer side he invested into government bonds futures.

Nick Leeson’s doubling strategy failed because he increased the size of his open positions even as his losses increased due to volatility in the markets and kept doubling his contracts whilst the Nikkei 225 continue to plummet following an earthquake in Japan. However, Leeson’s unauthorized trading positions suffered huge losses, and his operation unraveled. Moreover, interest rates did not rise as he expected which lead to further losses incurred on the Japanese government bond futures. He left the behind with huge liabilities totaling $1.4 billion, leading to the bankruptcy to the one of the oldest bank in Britain.

Why did Nick Leeson establish a bogus error account (88888) when a legitimate account (99002) already existed?

Nick Leeson established a bogus error account (88888) even when a legitimate account (99002) already existed, in order to conceal his unauthorized trading activities. Initially he claimed that he opened the error account (88888) to conceal a single loss of 20,000 pounds sterling that had resulted from an accounting error until he could make up the difference through trading. However, he continued booking various losses into the error account (88888) as a holding area for any premiums or losses that he made and also continued to increase his volume of trading and level of risk taking. It was a loophole he exploited to set up bogus accounts for non-existent clients to mask mounting debts.

While the legitimate error account was known to Barings Securities in London, the bogus account was not. However, the bogus account was known to SIMEX as a customer account, not as an error account. In this way, Leeson could hide his balances and losses from London – but not Singapore. One the other hand, SIMEX thought the bogus error account, 88888, was a legitimate customer account rather than a proprietary Barings account. The account enabled Leeson to take advantage of the rules of Japanese Futures market at that time. In Japan margin was posted on net basis for all customers. Therefore if many customers were short index futures, the firm could take long position without having to post cash margins.

Why did Barings and its auditors not discover that the error account was used by Leeson for unauthorized trading?

The reason why Barings and its auditors did not discover Leeson’s unauthorized trading and fraudulent activities was mostly a lack of internal checks and balances, and because Leeson was hiding in Barings’ organized chaos. Leeson was also given power due to his knowledge and there was no inquiry done into his trading just because he reported a profit to the company. Barings’ was impressed by Leeson’s achievements which lead them not to disclose to SIMEX that he infact had been disqualified from taking the UK trader’s exam (Broady, Roland, & Woods, 2008).

According to Ron Baker, the Head of Financial Products Group for Barings, “There were no clearly laid down reporting lines with regard to Leeson”, and in actual fact, there were several people responsible for keeping an eye on Leeson’s performance, but each one of them assumed that the other was watching closer than them, thus allowing Leeson several “holes” to get through.

An internal auditor audited the Singapore office of Barings in 1994 and he reported that unauthorized trading could have happened because of the fundamental principle of the industry – segregation of front and back office activities. The results were disclosed to the directors as well as some of the auditor’s recommendations, but the directors did not implement these recommendations (Collier & Agyei-Ampomah, 2006). Moreover, Leeson’s actions could have been avoided if the Barings executives had done a comprehensive review of Leeson’s funding requirements, as well as set restrictions to what Leeson could or could not do. However, he also discovered that none of these changes to the internal structure had been implemented when the bank collapsed.

One of the main reasons why Leeson was able to get away with so much was that there was no clear segregation of duties (Broady, Roland, & Woods, 2008). The nature of the Japanese futures market at the time did not require exchanges to have a separation between the customer and the proprietary funds, which made it difficult to separate the funds and the position of the firm or customer.

Leeson was left to be in control of everything that should have been checked by a superior or manager of some other department, which enabled him to track and modify the contents of his rogue account as he wished and keep his activities from being disclosed.

Although the Director of BFS and the Finance Director of BSS, Simon Jones, pledged to the public that he would attend to the issue of segregation, he never actually took any action to separate Leeson’s front and back office doings. The Bank of England made a report on the matter and according to the report, the London senior management actually considered Jones to be an inadequate communicator, and were concerned with the fact that he was not as involved as he should have been in the affairs of BFS. Furthermore, the Bank of London also criticized the process of Leeson’s funding.

Firstly, credit checks should have been performed on the large amounts of funds changing hands, but this was not performed either. Secondly, Bank of London discovered that there was no clear record of whether the funds reported were needed for its clients, or for its own accounts. This made reconciliation virtually impossible. The trading account was also not shown on any files or statements transmitted from Singapore to London, and thus auditors could not find any existence of the error account.

Moreover, SIMEX categorized the 88888 account as a customer account rather than an error account.

Internally, Barings had raised issues about having proper reconciliation in 1992. The risk manager of London’s branch, Gordon Bowser, had strongly recommended a development of a solid reconciliation process. However, Bowser left two others (Simon Jones and Tony Dickel) who had internal conflict over Leeson, to decide on the matter of reconciliation procedures, there was no solid arrangement between the two and Leeson was left to create the procedures for himself, allowing him to dictate the way he managed things. The loss of reconciliation meant that auditors could not trace the nature of these funds and thus they were unable to uncover the error account that Leeson used for his tradings.

Over the years, there were several cases of internal conflict which was beneficial to Leeson’s stealthy activities. A particular example of this was in 1995, where SIMEX became apprehensive about the ability of Barings’ to meet its large margins in Leeson’s “error” account. SIMEX addressed a letter to Simon Jones, with the letter noting that a further $100 million should have been in account 88888. Instead of addressing the matter himself directly, Jones passed the letter to Leeson for Leeson to draft a response on his own.

Lastly, when Leeson’s activities were finally being caught on by SIMEX, but they had not managed to find out exactly what was happening, SIMEX posted another letter to the Singapore branch, expressing doubts about Barings’ ability to fun margin calls. The letter was then referred back to London and from there; SIMEX was assured that opposite positions were being held in Japan. However, the truth was no opposite positions were being held and SIMEX officials made no follow-up checks with Osaka’s Stock Exchange to authenticate the claims.

Why did none of the regulatory authorities in Singapore, Japan, and the United Kingdom not discover the true use of the error account?

None of the regulatory bodies of Singapore, Japan on the UK discovered the true use of Leeson’s error account because firstly, it was visible to them only as a customer account, and SIMEX had also granted an exemption on the number of contracts that Barings could hold with the presumption that Barings was hedging and not speculating. This is in fact due to Barings’ conservative firm reputation, which lulled exchange and clearing houses into a false sense of security. Additionally, Barings’ speculative position was hidden with the use of an omnibus account and with this account, the broker’s customers’ identities could successfully be hidden from the exchange and clearing houses.

A number of happenings in the UK also allowed Leeson to hide and manage his activities easier. At that time, the Bank of England had a rule known as the Large Exposure Rule which stated that a bank is unable to lend more than 25% of its capital to any single entity. Barings’ made a request to Bank of London for an exception and argued that one exchange should not be classified as one entity. The supervisor in charge of Barings’ activities recognized the argument and the request and promised to review it and in the meantime, he offered Barings’ an informal concession for Japan, which Barings extended to Singapore and Hong Kong. On the matter of the Large Exposure Rule, the supervisor failed to respond until one whole year later, and his answer was that there were no exceptions to be made and the positions taken under the informal concession should be unwound. By that time, the damage had already been done.

The Bank of England also found that following the consolidation of Baring Securities Ltd and Baring Brothers and Co., it allowed the two to be categorized as one entity for capital adequacy and large exposure purposes, but the process of this consolidation was too informal and the results of it played a part in Leeson’s unauthorized activities. This not only meant that Leeson could hide his activities, but also the fact that he had access to a much larger pool of capital.

Why was Barings Bank willing to transfer large cash sums to Barings Futures Singapore?

Barings Bank believed that the large cash sums transferred to Barings Futures Singapore was for loans to customers as portrayed on the Barings Futures Singapore balance sheet. The key aspect of Japanese Future market was that exchange did not require a separation between customer and propriety funds. Therefore it was impossible to distinguish between the firm’s and the customer’s position.

Why did the attempt by the Bank of England to organize a bailout for Barings fail?

Throughout that weekend, the Bank of England hosted meetings in London to try to form a consortium to bail out Barings. The attempt by the Bank of England to organize a bailout for Barings failed because no one would assume the contingent risk of additional, but as yet undiscovered losses. Bank of London made a huge effort to organize a bailout for Barings bank. The bailout failed because Barings bank reached the position where losses amounted more than double the capitalization of the bank;, estimated losses approached $1.1 billion. Further losses were inevitable and thus there was no one ready to assume the contingent risk of additional but yet undiscovered losses. The bank was trapped in such a situation that the amount of future losses was unknown and unrevealed due to the unauthorized dealing by Nick Leeson.

Suggest regulatory and management reforms that might prevent a future debacle of the type that bankrupted Barings.

There have been numerous cases of collapses and overwhelming losses to companies in the corporate and banking sector and this called for some serious reformation, with particular attention to derivatives. The entire sector did not sit up and take notice until the Baring Brothers’ bankruptcy. How could an entity steeped with trust and history fall apart with no signs? Following the bankruptcy, reports were created by the Bank of England, SIMEX, and the Group of Thirty to suggest ways in which regulators and legislators could increase monitoring of financial activities.

After the collapse of Barings Bank, an article was published with the name of “Global Institutions, National Supervision and Systemic Risk”, and this article underlines the reforms and changes in the financial sector that have already been implemented.

The reforms that have already been implemented included: the expanded usage of netting and collateral; enhancements in methods to measure risk; greater off-balance-sheet risk disclosure; extensive increases in major financial institutions’ equity capital, financial sector consolidation; and encouragement of growth of securitization.

The Bank of England’s report detailed how the losses occurred, the reason the losses were unnoticed in and out of Barings, and the lessons learnt from the bankruptcy. The following are the five lessons the Bank of England identified (Ambit ERisk, 2010):

Management teams have a duty to understand fully the business that they manage;

Responsibility for each business activity has to be clearly established and communicated;

Clear segregation of duties is fundamental to any effective control system;

Relevant internal controls, including independent risk management, have to be established for all business activities;

Top management and the Audit Committee have to ensure that significant weaknesses, identified to them by internal audit or otherwise, are resolved quickly.

The list that Bank of England came up with seemed simple, but the truth was one (or usually several) points listed were often the reason why corporations lost large amounts of money in the derivatives market.

Other ways in which to prevent future debacles like the Barings collapse would be an increase in supervision of employees. Leeson never had a trading license prior to his arrival to Singapore and there was scarce monitoring of his activities since no one person was directly responsible for supervising his trading activities (Burnett, 2006). Also, a clear reporting line should be enforced because Leeson’s fraud could have been facilitated by confusion in having two reporting lines: one to London for proprietary trading and the other to Tokyo for customer trading.

Top management should also be aware of the business that they are dealing with. In the case of Barings’ Bank, Leeson was reporting huge profits to the company but top management should have known that arbitraging is a relatively low risk and low profit business (Collier & Agyei-Ampomah, 2006), so how on earth could Leeson have been reporting such massive profits? Top management could have identified these flaws immediately if they had known and had they “done their job properly” (Narayanaswamy, 2008). It is thus very important for top management to have sufficient knowledge of the field (or be involved in) to understand the complexities of business and its fundamental concepts.

Based in Washington DC, the Group of Thirty began to be particularly apprehensive of the risks that derivatives posed. The Group has issued numerous periodicals to address these problems, mainly publications like “International Insolvencies in the Financial Sector, Discussion Draft”, which outlined fourteen ideas to reduce risk in the financial sector, particularly with derivatives. Another publication titled “International Insolvencies in the Financial Sector, Summary of Comments from Respondent Countries on Discussion Draft”, which showed member countries’ responses and opinions regarding the proposed changes to financial institutions. It was noted that the support for these changes were generally strong among all the countries that responded, which showed how Barings’ failure rocked the entire world’s confidences in the financial sector.