The Hindu Business Line : Of greed, ignorance and derivatives

By allowing Nick Leeson to deal both with the proprietary account and client account and making him in-charge of both trading and back-office operations, the Barings Bank had clearly dug its own grave.

V. Pattabhi Ram

Derivatives have been the villain in the Great Global Meltdown of 2008. Everyone is all praise for Warren Buffet’s ominous statement that “Derivatives are financial weapons of mass destruction.”

Whether derivatives by themselves caused the trouble or whether it was the deadly cocktail of greedy bankers and ignorant customers that spelt the death knell is a point to ponder.

Read on to the mother of all derivative disasters (1995) when a ‘rogue trader’ named Nick Leeson single-handedly brought a 200 plus years old bank, the Barings Bank, to its knees.

Sometime in 1992, the board of directors of the Barings Bank sent the 20-something Nick Leeson to Singapore to manage its derivative operations. Derivative was a game that few people knew and fewer still understood. The result: Leeson was authorised to trade in proprietary (i.e. for the Bank) account and clients’ account. Not just that. He was also allowed to trade on behalf of a few other Barings’ subsidiary as well.

Risk-free play

Nikkei 225 futures (Nikkei is the Japanese stock index similar to our Sensex) are traded both in SIMEX (Singapore Stock Exchange) and in OSE (Japanese Stock Exchange). The Nikkei futures for a variety of reasons would be quoted at one price on SIMEX and at a different price on OSE, throwing up an arbitrage opportunity.

This would mean that Nick Leeson could buy in the market where it was priced lower and instantly sell in the market where it was priced higher making risk-free profits. That’s exactly what he did, initially.

So if it was risk-free play, how did the bank go belly up? Ha, there in comes the rub. Leeson did not always play arbitrage. He often had mismatched positions.

These did not get thrown up because the rogue trader was in-charge of both trading and back-office operations. How did this elementary lack of internal control went unnoticed is anybody’s guess.

Obviously, the folks at Barings were greenhorns. Otherwise, they should have asked questions. For instance, Leeson was showing huge profits. This should have alerted them to the fact that he was taking huge risks.

Every Finance 101 class tells that returns are always commensurate with risks taken. He continued to ask for money for margin payments from headquarters.

This should have again alerted the mandarins to the trouble, because margins are needed only when you are losing money and not when you are winning money.

Straddling

The reality was that Leeson was playing a derivative strategy called ‘Straddle’. Here you sell both call options and put options on the same underlying asset (Nikkei 225). The call gives you the right to buy and the put gives you the right to sell the underlying asset at the Exercise price. You make a killing if the markets move sideways but you get killed if the markets gyrate violently. The Nikkei gyrated violently! And in the process killed Barings Bank.

By allowing Leeson to deal both with the proprietary account and client account and making him in-charge of both trading and back-office operations, the bank had clearly dug its own grave. And then you go about blaming derivatives for all the ailments. What crap?

Nick Leeson was arrested, sentenced, spent time in prison and was released early for good behaviour. He has gone on to lead a new life. Needless to say he did not personally profit from his shenanigans. In India, a portly broker called Harshad Mehta was arrested, the courts hawed and pawed until the man himself died of a heart attack before judgment could be delivered.

As you read more stories of derivatives that went wrong, you will realise that behind all that lay both greed and ignorance.

(The writer is a Chennai-based Chartered Accountant)

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