May 15, 2013

Another Trader Bites the Dust - Barings' Collapse: Story of a Risk Management Disaster

Nick Leeson

Last week I started a series of posts about Risk Management disasters (see here and here). The main goal was to highlight what didn't work out and why and hopefully to prevent their recurrence. Today's post is about Barings and its former 'super star' trader (if you haven't seen the movie about him you should, see here) Nick Leeson. There is probably no better example than this one to understand the dynamics of risk and the violation of it at several levels. Also, Barings provides an outstanding example of banks' fragility. An open window to systemic risk. Before it collapsed in 1995, Barings was the oldest merchant bank and one of the most respectable financial institutions in the UK and elsewhere. It expanded its operations in Singapore in an attempt to exploit the new and tempting opportunities of emerging markets. Nick Leeson was not simply a bank's trader in Singapore but the bank's trader as the top management felt he had an innate 'feel' for the markets. Indeed, Leeson had contributed up to 18% to the bank's profits since he moved to Singapore in 1992, reaching 133% in January 1995. Yes, 133%! Barings was risk-adverse and based its business model on risk-free policies. So, rather than deriving its profits from pure trading activities, it preferred to make money out of commissions on buying and selling financial products. Barings understood Leeson's profits were deriving from exploitation of arbitrage opportunities and it was perfectly fine with that as almost totally risk-free. The big difference between 'arbitraging' and, for example, buying and selling options is that by arbitraging your positions are supposed to match (buy-sell) and the only risk arises in the narrow time frame between an order is issued and executed. The arbitrageur's goal is to exploit small price mismatch between markets. For example, if corn is cheaper in Chicago than in London, an arbitrageur would buy some corn in Chicago and sell it in London, where corn is slightly more expensive. Leeson instead, was trading and selling options at a discount in order to generate attractive premiums. By trading options, you are trading 'volatility', which means you are betting on a stock's moves in both direction, up or down. Pricing option is complicated and requires a high level of mathematical knowledge, something that Leeson lacked as he mis/underpriced the products he was selling. As his positions lost value, Leeson didn't have other choices than borrowing heavily in an attempt to cover the losses. A doubling strategy, with catastrophic effect ('gambler's ruin'). He also submitted for three years daily reports to Barings which were full of lies making Barings believing everything was fine although he was requesting the bank millions of pounds for collateral coverage. A key component of the story is that Leeson was in charge of the front office (where all the trading happens) and the back office (where all the transactions are recorded). So he could cover up these losses and justify his positions! Also, Leeson shorted a straddle. In financial jargon, shorting a straddle refers to a kind of options strategy, where the seller sells to a buyer a call and a put option with the same strike price. As one can easily see from the graph below (thanks to The Options Guide), potential losses can be illimited. The $400 in the example represents the money the seller makes by selling the two options. 


Leeson's straddle was based on the Nikkei, betting it would stay stable. When the Kobe earthquake occurred on January 17, 1995, the Nikkei fell 1000 points to 17,950 forcing Leeson to borrow more to cover the losses! In addition to all of this, Leeson was betting on Japanese stocks and interest rate rising, being long Nikkei futures and short JGB futures (see graph below, from Global Macro Monitor). 


Losses totaled $1 billion! The bank failed to promptly investigate Leeson's profits (they thought positions were matched) and the numerous cash flow requests for margin calls and collaterals. Also, when a single trader makes such a big percentage of a bank's profits, an alarm bell should ring! Front and back office were NOT clearly demarcated and this allowed Leeson to cover up losses and justify his positions. Finally, Leeson was allowed to trade on behalf of customers and this kind of trading should have strict account management as well as credit risk management for each customer. 

References: 
Helga Drummond (2006) - Living in a fool's paradise: the collapse of Barings' Bank. 
John Gapper & Nicholas Denton (1997)-  All That Glitters: The Fall of Barings

FOLLOW @DvegaDtime ON TWITTER

No comments:

Post a Comment