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The Collapse of Barings
Not Just "Rogue Trader"
In
February, 1995, England's Barings Bank, a venerable institution with a
centuries-long history, collapsed as a result of massive losses created
by Nicholas Leeson, a lone "rogue trader" in its Singapore office.
Leeson was the manager in charge of the settlements process in Barings
Singapore, but he was also authorized to engage in a limited set of
trading activities involving the arbitrage of Nikkei index futures
between the Tokyo and Singapore exchanges.
You will immediately note the similarities between Leeson and that of
Jérôme Kerviel, the trader who racked up trading losses of over seven
billion dollars at Société Générale (SocGen) in early 2008. | 
Photo credit: BBC
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To understand calamities such as today's subprime crisis, a more thorough description of options and other financial derivatives would be necessary, but a thumbnail description is
useful here. Basically, Leeson was permitted to engage in a very
limited set of speculative investments associated with exploiting the varying values of the same financial instruments
between two separate exchanges. Just as legendary U.S. robber baron Jay
Gould profited by differences in the value of gold between London and
New York, Leeson was permitted to profit from small differences between
Tokyo and Singapore values of secuurities linked to the Japanese stock
market Nikkei index. Organizationally, this arrangement was highly
unorthodox, since trading and settlement are, by convention, under
separate managements for financial control purposes. Ignoring this
basic risk control tenet allowed a relatively small accidental loss to
grow into one that eventually destroyed the 233 year-old institution.
Leeson's
dual role allowed him to engage in unauthorized and highly speculative
trading activities, and then to cover his losses through "fiddling the
books" with the help of an outside computer contractor.
There
are various versions of the Barings story, so the version related here
is not necessarily the only possible truth. (From the early accounts,
SocGen will be no different.) In Leeson's version, the initial
manipulation was done to cover a costly administrative mistake made by
an inexperienced subordinate, and subsequent trading was directed
towards attempts to "make it good." Leeson directed a systems
consultant to remove an error account---known within the company as the
"five 8s account"---from inclusion in various Barings' consolidated
reports, and he then used this account to accumulate trading losses.
Profitable trades were reported in regular accounts and, not
surprisingly, this allowed Leeson to become a trading superstar and a
major contributor to Baring's overall profits. Ironically, Leeson did
not steal from the firm; rather, he was paid gladly and generously for
his apparent success as an arbitrage whiz-kid.
Barings' obvious
organization design error was a failure to separate trading from
settlement, but there were other mistakes that were equally important.
Leeson was not closely supervised, and it appears that none of his
local managers audited his trading activities, or attempted to
understand the source of his success. In addition, nowhere up the line
within Barings, or with its outside auditor, did Leeson's extraordinary
success set off alarm bells, although internal audit reports condemned
the financial control risks of his dual responsibilities. In addition,
there was inadequate investigation of an anomalous request for a large
cash payment from one of the Asian exchanges that would have likely
revealed Leeson's activities, as well as other unusual requests for
funds from Barings' London headquarters. (Early reports suggest that
missed warning signs---known as "weak signals" in the accident
literature---exist in the SocGen case.)
Organizational culture
also significantly contributed to the failure of Barings defensive
systems. As noted by the Bank of England, Barings controls were
generally informal rather than procedurally rigorous. In spite of this,
they were regarded as effective. However, Barings' senior management
was not generally detail-oriented, and thus not prone to close
supervision, careful analysis and fast follow-up. As a result, they
were not fully aware of the activities far down in the organization,
and far a-field from London. (See below.)
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Leeson's Version of Events
Source: The Jamaica Observer, International Edition, Nov. 30, 2004
I was 25 years old when I moved to Singapore to run the futures and options operations of Barings. It was an age which I admit I didn't have the necessary management skills and I believe that most of you will agree that the age wasn't commensurate with the degree of responsibility that I was undertaking.
While I was on the trading floor I lost one day. I did report it to the people in Tokyo who asked me to pass it to London. I didn't do that and it went into the now infamous five eights (88888) account.
I expected to get caught from day one. I had worked in settlements myself and knew that the first thing you do every morning was a position check and that would have exposed the error.
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Nick Leeson today.
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What happened next
Over
a six-month period, I started to take more and more risk to get the
losses back. Any profitable trades I had were booked to Tokyo, and any
loses went into the now infamous five eights (88888) account. The
losses started to mount.
The first audit was three months after the losses started. I didn't have any idea how to hide the loss. There was no pre-thought to any of this. So I asked London for $5 million over the year-end and reflected it as paying off the 88888 account. None of this is rocket science, and I hope you can see there was a serious lack of common sense throughout the whole episode.
I ran a loss of up to $20 million towards the end of that year. In May of 1993, I managed to get it back in credit.
During all of this period, there were visits from auditors and regulators, internal and external. Many of whom saw activity on the 88888 account but did nothing about it.
I was selling at-the-money options and straddles. I'm often asked why, and if there was a strategy. The answer is no. I just needed money, and lots of it, to hide the losses.
What I was doing was postponing the realisation of the losses on a month by month basis. I did that by selling the options. As one month's options expired, I would sell the next available month's options.
Volatility, which is a fairly good indication of price during this period, fell from 50 per cent to seven per cent. So there weren't many more options that I had left for sale.
The markets started falling, my losses started increasing, and, as a result, my position was increasing dynamically with it. The movie ("Rouge Trader") depicts an episode where I'm looking in the mirror and coming to terms with the fact that I lost $50 million in one day. Believe me, that was one of the better days.
The earthquake in Kobe at the beginning of 1995, and its resulting effect on the markets, is often given as a major cause of the collapse. I personally believe that the position that I had in the five eights (88888) account had just got too large, and there was no way I could get out of it.
Barings had a reputation of being at the cutting edge in developing markets, certainly in Asia. When I first went to work for them in Indonesia, they were doing 200 to 300 trades a day, and they were operating out of a hotel room with one person doing all this trading. They were paying for the stock, and they were buying, and trying to deliver it to their customer. Their customers would refuse it because it wasn't signed correctly, or having the relevant chops on it, or the relevant stamps on it. Barings had something like £200 million of unsettled trades that they were at serious exposure on.
Each department was fragmented. No one person or department had a clear overview of anything that was going into the bank. Anybody who was supposed to have some form of control over me was based elsewhere. The people who were looking after the traders were based London. The people in charge of the compliance function were in London. The risk management areas were in Tokyo. I was both the senior trader and settlements person in Singapore. This has very serious and obvious implications. I was exposed to the extreme. This was pointed out regularly in audits, internal and external, but nothing was ever done about it.
 The audits regularly looked at the 88888 account. It's a myth that all the paperwork was hidden. I was only asked for a balance sheet at month-end, so I used this to my advantage. I kn[e]w that once I made the balance sheet to agree on the last day of the month, nobody was going to ask me another question. So that was when I sold the options to hide the position. If anyone had picked up a balance sheet on any other day apart from the month-end, there would be a massive hole in it, which would have been the 88888 account. As I said, I did this by selling options, effectively swapping the P&L item for a balance sheet item, which was the margin that was then deposited with SIMEX. [The Singapore International Monetary Exchange (SIMEX) was a futures exchange in Singapore, founded in 1984. On December 1, 1999, SIMEX merged with the Stock Exchange of Singapore (SES) to form the Singapore Exchange (SGX).]
In over 100 visits to our offices, nobody ever did a position check. Kindergarten stuff. Things you did every morning before the market opened. And nobody ever did it. It was only when I left, that somebody else did.
The regulatory authorities were poor. On a daily basis, I could represent between 60 per cent and 80 per cent of the daily volume on SIMEX and at least 40 per cent of the open interest. These levels of trading should have attracted more of the exchange's attention. If anything, they attracted less. There was a SIMEX awards ceremony in 1994 when the management came out to receive the award for the top customer for volume on SIMEX. The 88888 accounts probably represented 95 per cent of that customer volume. SIMEX [also] paid 100 per cent of the option premium during this period. That's not usual. It doesn't happen in most markets. If they hadn't done that, I wouldn't have been able to do what I was doing.
The Bank of England also messed up. The capital of Barings was only £250 million and I had £500 million of it. I know I failed my math A-level, but even I could add that sum. They allowed Barings to send over 100 per cent of the bank's capital to me in Singapore when the legal limit was only 20 per cent. [Barings] Treasury used to make me daily payments of between $50 million and $100 million without any logical reason. The basic rule of futures and options is that it is a cash-rich business and you receive more money than you pay to the exchange. The treasury also had to breakdown the reasons for their subsidiary lending to the Bank of England. The non-sensical reasons that I was giving them was passed on to the Bank of England.
The bank had, by the end of 1994, basically exhausted all their credit lines with other banks and didn't have any more money to give me. Now, you would think they would look at the situation and investigate. Barings management did quite the opposite. They went to the market and issued a bond for £100 million. As soon as the management received it, they sent it to me in Singapore.
Further Explanations
The Bank of England concluded that Barings' senior management did not understand the particular risks represented by the instruments that Leeson could potentially trade. Although he was not authorized to do so, Leeson engaged in certain options trading strategies that created more or less unlimited downside risk for the firm under particular market conditions.
Leeson sold both options and "straddles," the former to cover-up his activities each month, and the latter to try to speculatively recover his losses. Straddles are a potentially highly profitable trading strategy involving both put and call options that is suitable when one expects a neutral, low volatility market in the underlying security. However, if the underlying security price moves either substantially higher or lower than the strike price before the options expire, the losses can be significant (and are, in fact, potentially unlimited).
Unlike a conventional stock or bond investment in which one can only lose one's capital, certain forms of derivatives trading have much greater risks because they depend on the structure of the trade, the "leverage" provided by the derivative, and the specifics of market performance. In many derivatives-based strategies, the "bounding" of the risk is based upon historical statistical relationships. If these break down, or if statistically rare but not impossible events occur during one's period of exposure, losses can be severe. The Kobe earthquake on January 17, 1995 created just such an event in the case of Leeson's leveraged options-based bets. The Nikkei fell 5.6 percent of its value on that day, a very large move but not unheard of. (For comparison, the U.S. market indices fell over 20 percent on Black Monday, October 17, 1987 and over one-third over the 5 previous days.)
As explained in Flirting With Disaster, in many accident cases, management fails to comprehend the true nature of risk. This can sometimes lead to disaster. In this case, Leeson placed "bet the firm" speculative wagers without anyone's knowledge, and perhaps without their understanding that it was even possible to do so. (As noted above, Leeson's claim has always been that he was simply trying to correct an innocent trading mistake, but that things grew out of hand.)
It may well be that Leeson's spectacular reported profits created disincentives for close investigation of his activities. As a general rule, traders with an edge do not like to share their secrets, lest their tactics be copied and their personal value to the firm reduced. Beyond this, the trading culture generally gives credence to the notion of a "magic touch," and the evidence suggests that Barings management believed that Leeson was the living embodiment. Besides, in light of all the money he was making for everyone, why would they want to believe that he was anything other than the genuine article?
It also seems likely that the idea that Leeson was perpetrating a fraud was unthinkable. In this, management may have been in denial, in the psychological sense, and in this state of mind inhibited from vigorously pursuing the clues or taking timely action. I discuss the role of denial extensively in FWD, but for the moment suffice it to say that either it never entered senior managers' minds that Leeson was a fraud, or they rejected the idea out of hand if it did.
As in all the other cases in Flirting With Disaster, one finds a set of clear proximate causes for the accident, but one also finds a set of systemic conditions that allowed the hazard to escape. It is unarguable that Leeson perpetrated an elaborate fraud, but the organizational structure allowed him to implement it undetected, and lax management and financial controls allowed his deception to persist and escalate to catastrophic scale. Since management did not fully understand the nature of derivatives risk or the vulnerabilities in their reporting systems, they had no felt need to protect the firm from errors or misconduct. Such lack of understanding risks is a common theme in many accidents, but its presence in mainstream finance rather than rocket motors or nuclear reactors may be sobering to some readers. Other derivatives losses, such as those of Procter & Gamble that resulted in a highly visible court case, and the current subprime debacle, share similar elements.
It is also significant, although perhaps obvious, that the informality of Baring's general approach to control also applied to its follow-up of its internal audit concerns, and to the surprising requests for significant settlement funds. These were pursued without urgency, and might well have saved the firm, although there would still have been sizeable losses. Of course, both Barings lack of control disciplines and its lack of follow-up had the same cultural root causes. You will see numerous occurrences of such "double loop" cultural causality in other cases chronicled in FWD's cases.
In the end, what is most stunning about Barings is the scale of the damage wrought by a single individual. However, Leeson was not just a naughty boy playing with matches, he was also playing with gasoline---although nobody knew it.
In one of the curious ironies to the story, Leeson's escapades were made into a book, a newspaper serialization, and a movie, and he is a popular speaker on the lecture circuit. In the end, history may judge him far less harshly than the leadership at Barings that were brought down by his actions.
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