Disasters can take place in any system. The 1992 Security scam is a case in point. Disasters are not necessarily due to dealing in derivatives, but derivatives make headlines...
Here I have tried to explain some of the important issues involved in disasters related to derivatives.
Careful observation will tell us that these disasters have occurred due to lack of internal controls and/or outright fraud either by the employees or promoters.
Barings Collapse
1. 233 year old British bank goes bankrupt on 26th February 1995
2. Downfall attributed to a single trader, 28 year old Nicholas Leeson
3. Loss arose due to large exposure to the Japanese futures market
4. Leeson, chief trader for Barings futures in Singapore, takes huge
position in index futures of Nikkei 225
5. Market falls by more than 15% in the first two months of ’95 and
Barings suffers huge losses
6. Bank looses $1.3 billion from derivative trading
7. Loss wipes out the entire equity capital of Barings
The reasons for the collapse:
• Leeson was supposed to be arbitraging between Osaka Securities
Exchange and SIMEX -- a risk less strategy, while in truth it was an
unhedged position.
• Leeson was heading both settlement and trading desk -- at most
other banks the functions are segregated, this helped Leeson to cover
his losses -- Leeson was unsupervised.
• Lack of independent risk management unit, again a deviation from
prudential norms.
There were no proper internal control mechanisms leading to the
discrepancies going unnoticed – Internal audit report which warned of
"excessive concentration of power in Leeson’s hands" was ignored by the
top management.
The conclusion as summarised by Wall Street Journal article
" Bank of England officials said they did not regard the problem in this
case as one peculiar to derivatives. In a case where a trader is taking
unauthorised positions, they said, the real question is the strength of an
investment houses’ internal controls and the external monitoring done by
Exchanges and Regulators. "
Metallgesellschaft
1. Metallgesellshaft (MG) -- a hedge that went bad to the tune of
$1.3 billion
Germany’s 14th largest industrial group nearly goes bankrupt from losses
suffered through its American subsidiary - MGRM
2. MGRM offered long term contracts to supply 180 million barrels of
oil products to its clients -- commitments were quite large, equivalent to
85 days of Kuwait’s oil output
3. MGRM created a hedge position for these long term contracts with short term futures market through rolling hedge --, As there was no
viable long term contracts available
4. Company was exposed to basis risk -- risk of short term oil prices
temporarily deviating from long term prices.
5. In 1993, oil prices crashed, leading to billion dollars of margin call to
be met in cash. The Company was faced with temporary funds crunch.
6. New management team decides to liquidate the remaining
contracts, leading to a loss of 1.3 billion.
7. Liquidation has been criticised, as the losses could have decreased
over time.
Auditors’ report claims that the losses were caused by the size of the
trading exposure.
Reasons for the losses:
• The transactions carried out by the company were mainly OTC in
nature and hence lacked transparency and risk management system
employed by a derivative exchange
• Large exposure
• Temporary funds crunch
• Lack of matching long-term contracts, which necessitated the
company to use rolling short term hedge -- problem arising from the
hedging strategy
• Basis risk leading to short term loss
Here I have tried to explain some of the important issues involved in disasters related to derivatives.
Careful observation will tell us that these disasters have occurred due to lack of internal controls and/or outright fraud either by the employees or promoters.
Barings Collapse
1. 233 year old British bank goes bankrupt on 26th February 1995
2. Downfall attributed to a single trader, 28 year old Nicholas Leeson
3. Loss arose due to large exposure to the Japanese futures market
4. Leeson, chief trader for Barings futures in Singapore, takes huge
position in index futures of Nikkei 225
5. Market falls by more than 15% in the first two months of ’95 and
Barings suffers huge losses
6. Bank looses $1.3 billion from derivative trading
7. Loss wipes out the entire equity capital of Barings
The reasons for the collapse:
• Leeson was supposed to be arbitraging between Osaka Securities
Exchange and SIMEX -- a risk less strategy, while in truth it was an
unhedged position.
• Leeson was heading both settlement and trading desk -- at most
other banks the functions are segregated, this helped Leeson to cover
his losses -- Leeson was unsupervised.
• Lack of independent risk management unit, again a deviation from
prudential norms.
There were no proper internal control mechanisms leading to the
discrepancies going unnoticed – Internal audit report which warned of
"excessive concentration of power in Leeson’s hands" was ignored by the
top management.
The conclusion as summarised by Wall Street Journal article
" Bank of England officials said they did not regard the problem in this
case as one peculiar to derivatives. In a case where a trader is taking
unauthorised positions, they said, the real question is the strength of an
investment houses’ internal controls and the external monitoring done by
Exchanges and Regulators. "
Metallgesellschaft
1. Metallgesellshaft (MG) -- a hedge that went bad to the tune of
$1.3 billion
Germany’s 14th largest industrial group nearly goes bankrupt from losses
suffered through its American subsidiary - MGRM
2. MGRM offered long term contracts to supply 180 million barrels of
oil products to its clients -- commitments were quite large, equivalent to
85 days of Kuwait’s oil output
3. MGRM created a hedge position for these long term contracts with short term futures market through rolling hedge --, As there was no
viable long term contracts available
4. Company was exposed to basis risk -- risk of short term oil prices
temporarily deviating from long term prices.
5. In 1993, oil prices crashed, leading to billion dollars of margin call to
be met in cash. The Company was faced with temporary funds crunch.
6. New management team decides to liquidate the remaining
contracts, leading to a loss of 1.3 billion.
7. Liquidation has been criticised, as the losses could have decreased
over time.
Auditors’ report claims that the losses were caused by the size of the
trading exposure.
Reasons for the losses:
• The transactions carried out by the company were mainly OTC in
nature and hence lacked transparency and risk management system
employed by a derivative exchange
• Large exposure
• Temporary funds crunch
• Lack of matching long-term contracts, which necessitated the
company to use rolling short term hedge -- problem arising from the
hedging strategy
• Basis risk leading to short term loss