Nick Leeson, a British Barings junior trader in Singapore, took speculative derivative positions in an effort to recoup prior trading losses that he was able to hide fraudulently. The losses went undetected due to inadequate control systems.
In 1994, Leeson lost $296 million through his trading activities but reported a profit of $46 million to management. His trading supposedly involved two main strategies— selling straddles on the Nikkei 225 and arbitraging price differences on Nikkei 225 futures contracts that were trading on different exchanges. A short straddle strategy involves selling calls and puts. It is profitable when the underlying index remains relatively unchanged over the life of the straddle, in which case the calls and puts expire worthless, leaving the option writer with the option premiums. The Nikkei 225 futures arbitrage involves taking a long
futures position on one exchange where the price is relatively low and hedging with an offsetting short position on another exchange where the price is relatively higher.
Leeson had previously incurred huge trading losses that would have cost him his job if they were revealed. In an effort to recover those losses, he abandoned the hedged posture in the long-short futures arbitrage strategy and initiated a speculative long-long futures position on both exchanges in hope of profiting from an increase in the Nikkei 225. This move exposed the firm to enormous market risk and event risk, which stems from unexpected major events that, while not directly related to markets, can affect markets.
On January 17, 1995, an earthquake hit Japan. The Nikkei plunged, creating huge losses on both the short straddle and the double-long futures position. The resulting margin calls were satisfied for a time because, in 1994, Leeson had requested and received without question $354 million from the London office because they believed his strategy was riskless. This lack of oversight contributed to Barings’ failure as the Nikkei continued to drop. Between 1993 and 1995, Leeson’s actions resulted in losses of approximately $1.25 billion and forced Barings into bankruptcy.
In addition to being Barings’ floor manager on the Singapore International Monetary Exchange (SIMEX) trading floor, Leeson was in charge of settlement operations. This position allowed him to influence back-office employees to hide his trading losses from the London office. He was able to hide speculative positions by reporting these positions for fictitious customers. He used an old error account to book losing trades for these fictitious customers and used his back-office influence to prevent that trading activity from being reported to the main office in London.
To book profits that would be reported to London, Leeson initiated cross trades on the SIMEX in which the same firm buys and sells a security at the current market price. Again using his back-office influence, he directed settlement employees to modify the execution price, making one side of the trade profitable and the other unprofitable. The profitable trade was booked to the standard trading accounts, which were reported to management, while the unprofitable trade was booked to the old error account that escaped reporting to senior management. By incorrectly booking these losses, Leeson was able to report substantial profits in 1994, which allowed him to earn a $720,000 bonus. Leeson was able to illegally book fraudulent trades because there was little management oversight of the settlement process. Leeson was responsible for reporting to multiple managers in a convoluted organizational structure. This situation created ambiguity concerning who was responsible for performing specific oversight functions. In addition, political power struggles and senior management’s lack of understanding about Leeson’s role eroded oversight and allowed trading losses to be hidden.
Leeson was subject to risk controls that limited the number of speculative trades he was allowed to make. In practice, however, he ignored and vastly exceeded those limits. These violations went undetected because Barings lacked risk management oversight that would have monitored positions, strategies, and risk. This oversight was so poor that the London office transferred $354 million to meet margin calls without questioning Leeson. If management had a better understanding of Leeson’s trading strategies, they would have recognized that his reported profits were disproportionate to the purported riskless trading.
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