Rogue Trader and the Barings Collapse
Gabriel Chen
Nick Leeson clearly understood the
risks inherent in the futures and options he bought and sold with such
abandon. However, he did not act upon this understanding, triggering one of the
most spectacular bank crashes in the City of London’s history. Given that
Leeson was aware of the nature of the derivative securities he traded, why did
he continue to buy futures or sell options? After all, Leeson had said that
buying options or futures was a “gamble,” and that by selling options, he would
be “exposing Barings to a capital risk” in that the value of the options he
held could either rise or fall i.e., he would effectively take on “an illicit
proprietary position” (61). The reason could be that Leeson was already drawn
deep into an escalating series of commitment due to the basic structure of
rewards and sanctions he faced as an agent while falling into debt in his
trading. Once Leeson created his 88888 account, the use of this secret “error”
account had become “an addiction,” and he found himself in a position where he
could “operate on both sides of the balance sheet” (64). Although incurring
further financial losses would have been very damaging for Barings, it posed
little additional problem to Leeson. The penalties for losing five hundred
million pounds were not much different from those for losing five hundred
thousand pounds. As Leeson said, “I had been surprisingly unmoved by how the
numbers had added up – for me it was the principle which mattered. The numbers
were just a load of zeros” (64).
The young trader engaged in what gamblers call “over and under” betting, which involved buying and selling futures contracts pegged to the Nikkei 225, an index of the value of 225 Japanese stocks. Just as gamblers speculate whether the score of a football game will be above or below a certain number of points, Leeson was betting the “over” on the Nikkei 225. When he racked up huge paper losses after an earthquake in Kobe played havoc with Japanese stock prices, he began laying huge bets on a subsequent rebound. “This is gambling at its simplest,” Leeson said. “If you double up, you halve the amount the market needs to turn for you to make your money back, but you double the risk” (81). Believing the market would stay stable, Leeson sold straddles, which he found attractive due to their large premiums. As Leeson found himself pulled into losing positions, he became increasingly risk-seeking versus risk-avoiding. His response to losses was to “double-down,” that is, to invest still further in the hopes of being able to recoup his initial losses. Leeson traded harder and risked more. Although he was well down, he was increasingly sure that his doubling up and doubling up would pay off. As the market traded through the strike price of the options, Leeson “redoubled his exposure by buying futures which hedged the short calls.” It worked and the market kept going up. But Leeson said “the risk was that the market could crumble down” (63). Moreover, despite admitting that an unhedged position was “the most dangerous gamble,” Leeson’s position to protect his exposure remained unhedged. “I needed all the premium I could get to cover the losses already accrued,” Leeson said. “It was a gamble, and a messy one at that” (63).
Leeson had fabricated a $79 million credit from Spear, Leeds & Kellogg to offset his losses. When Barings’ external auditors questioned the entry, Leeson forged faxes from Spear, Leeds & Kellogg, Citibank and one of his superiors in London to show that the money had indeed been paid to Barings. Leeson knew he was “damned” once he forged the documents (176). “I felt hot tears of shame pricking behind my eyes: I was behaving like a criminal…,” Leeson said. “I’d been caught up in my own web of deceit, and I was drowning in the tangle – a tangle of 8s. I needed something, anything, to get me out, and morals no longer mattered” (177). While there might be contention that Leeson’s activities crossed the line from merely dubious to genuinely criminal when he began “forging documents like a petty criminal,” I believe Leeson’s activities breached the fine line when he created the 88888 account to hide every loss so that his office would always appear in profit (176). The truth was that it did not need to be the act of unvarnished forgery for Leeson to acknowledge to himself that he had crossed the line and was, in fact, a criminal; Leeson’s fall into purgatory simply began over a miscue on the trading floor. A trader bought shares when she should have sold them. Trying to protect his errant trader, he hid the trading mistake in an illicit error account that he kept hidden from the London office. His “neat solution” consisted of booking a fictitious trade to the customer Fuji Bank in order to cut the £20,000 loss, which brought him “a little breathing-space,” but inevitably starting a chain of events that led to his disgrace (43).
Fast forward a few years and examples aplenty on how dodgy accounting “shook the financial world.” Enron, WorldCom and Global Crossing are now the three largest bankruptcies in recent corporate history. Given the spate of corporate shenanigans today and the prevalence of companies who conceal their true financial position from the outside world, it seems reasonable to chastise such false accounting practices i.e., Leeson’s 88888 manipulation, as genuine criminal activities. Leeson did ponder over whether hiding the losses was truly a crime: “I couldn’t bear it if Jones then used this loss – which has nothing to do with me – to slam me back down into Settlements. I hardly had time to wonder whether it was a crime or a convenient solution” (45). At that point, Leeson’s train of thought might have been dubious, but once it was anteceded by the actual act of doing, that is, creating a secret account in which he piled up millions of dollars of losses in risky trades, then his activities were arguably unlawful. Leeson was willing to do almost anything to keep his house of cards from falling and believed that this would be justified if in the end things worked out. However, this line of reasoning meant that for Leeson to get out of his financial difficulties, he would have to take huge risks. Leeson thought he could make up for the losses in this account by other means. The problem, though, was that the stocks in the account kept losing money. Mistakes by other traders were also added to the account. A $500,000 shortfall soon became $1 million in losses and then $1.5 million. As his losses grew, Leeson asked Barings in London for extra funds to continue trading, hoping to extricate himself from the mess.
Although it
does seem simple to pinpoint Leeson, rogue trader extraordinaire, as the main
cause of the Barings collapse, much fault must lie with the bank’s management.
Leeson’s immediate supervisors should have known the risks inherent in the
futures and options Leeson bought and sold, and should have kept an eye on him,
especially when he reported high profits and yet asked for funds to cover his
margin payments. If Leeson’s profits were real, the likelihood of him needing
extra funds for margins would be low. Moreover, was it wise for Leeson to be
both chief trader and settlements clerk of Baring Futures Singapore? It proved
to be an unwise decision since Leeson was in essence responsible for keeping
himself honest. He basically made sure the checkbook balanced, that all
deposits had to be made, and that no unauthorized expenditures were made. This
was a gross institutional error by Barings, which eventually led to their
demise.
Leeson, Nick. Rogue Trader. Little, Brown and Company,
1996.