EurapeanManagementJournalVol. 14, No. 2, pp.

167-175, 1996
Copyright © 1996 Elsevier Science Ltd
~ Pergamon Printed in Great Britain. All rights reserved
0263-2373(95)00060-7 0263-2373/96 $15.00 + 0.00

Whatever Happened at
Barings? Part One:
The Lure. of Derivatives
and Collapse
PAUL STONHAM, Associate Professorof Finance, EAP-European School of Management,
Oxford

On 27 February 1995, Barings, one of the UK's

oldest merchant banks and a well-known name, was
placed in administration following the disclosure
that one of its Singapore traders, Nick Leeson, had
accumulated losses of over £ 8 0 0 million on trading
futures and options contracts.

Part One of this Case Study considers the scale of

this disaster, placing it in the perspective of similar
banking losses of recent years, as well as the
damage that was caused to creditors. It reviews
features of futures and options - the main financial
products used in Leeson's authorised operations - as
well as the kind of risks that are encountered. It also
considers Barings' ill-fated corporate strategy since
the 19S0s.

Run Up to the Collapse

Late on Thursday, 23 February 1995, a man was seen
hurriedly leaving his office, Ocean Towers, the
gleaming, glass-fronted headquarters of Baring Futures
(Singapore) (BFS), in Raffles Place, the heart of
Singapore's business district. This was Nick Leeson,
general manager of Baring Futures and the company's
senior floor trader on the Singapore Intemational
Monetary Exchange (SIMEX). He was never to retum.

That evening, he and his wife Lisa drove to Kuala

Lumpur, then flew to Kota Kinabalu. The following
Wednesday, he flew alone to Frankfurt where German
police took him into custody on the grounds of criminal
charges notified to them by the Singapore Government.

Earlier, in the small hours of Friday 24 February,

EuropeanManagementJournalVol 14 No 2 April 1996 ~6 7

WHATEVER HAPPENED AT BARINGS? PART ONE: THE LURE OF DERIVATIVESAND COLLAPSE
following growing suspicions, several senior Baring staff
visited the offices of BFS and, after inspecting docu-
ments, were unable to obtain a reconciliation of BFS's
cash position, detected a large fraudulent receivable, and
found a concealed account listing massive losses mainly
on futures contracts traded on SIMEX and Japanese stock
exchanges.
This information was fed to an emergency meeting at
the headquarters of the Barings Group in London on
Thursday evening local time (London GMT is eight
hours behind Singapore). At that meeting, Tony Gamby,
Settlements Director of Baring Investment Bank and a
Director of Baring Brothers and Co Ltd (effectively the
merchant bank and corporate finance advisory arm), was
reported as saying that alarm bells were ringing.
With colleagues, Gamby flew to Singapore the next day
and all through Saturday, local time, worked o n papers in
the BFS offices. He was forced to confirm to HQ that BFS
was apparently insolvent; the profits that Leeson had
previously reported in 1993 and 1994 were illusory and,
worse, the losses which were found could not be debited
to client accounts, they were entirely to Barings' account.
In London, on Friday, local time, the directors of the
parent company, Borings plc, allowed the Barings Group
to continue trading, but notified the Bank of England
(the supervisory authority) of apparent insolvency as the
result of fraud. Over that weekend, the Bank of England
failed to secure financial support from the international
banking community and decided not to rescue Barings
with tax-payers' money. Barings plc and most of its
subsidiary companies were placed in administration with
Ernst and Young. In Singapore, on Monday 27 February,
SIMEX obtained approval from the Singapore High
Court to appoint Price Waterhouse as judicial managers
of BFS, and the company ceased trading.
Early Press Comment
This was a major shock to the international financial
community and, predictably, made headlines in the
world's Press. Even at this early stage, several bbtes noires
were aired alongside comment on the immediate effects
of the collapse, like the inherent risk of financial
derivatives trading and lack of proper regulation by
trading markets and official regulators. These were to be
explored in detail as the months went by.
In the UK, the Sunday newspapers were the first to break
the news to the general public, following news agency
reports on Sunday 26 February. A heading in the Sunday
Times screamed,
'Queen's bank near collapse in ¢.400m loss. Bank desperate to
find buyer after losing $600m in derivatives trading.'
The 'Queen's bank' was a reference to the fact that the
Queen was a depository" client of the merchant bank.
168
£400m was an early, and much understated, calculation
of the cumulative loss.
By Monday 27 February, all the UK newspapers had the
story. The Financial Times, under the banner, 'Barings
forced to cease trading,' said,
'Barings, the UK merchant banking group, was last night
placed in administration owing more than ~500m on
financial derivatives contracts after the Bank of England
failed to organise a rescue by other banks.'
The estimate of the loss had increased. Then, on
Thursday 28 February, the FT along with other
newspapers began more detailed analysis of the collapse
under the heading, 'The box that can never be shut', an
apparent reference to the Bank of England's alleged
inability to control the 'Pandora's box' of financial
derivatives and the exposure to risk that they can entail.
The newspaper went on to say,
'At the close of business on Friday, Barings enjoyed a
reputation as one of the best managed of Britain's second-tier
merchant banking groups. Before the markets had re-opened
on Monday morning, the oldest name in British banking
{founded 1762) had been reduced to beggary.'
In fact, the accolade to Barings was unjustified. Later
inquiry found the banking group's management of its
securities business lax and confused, a factor contributing
to the demise of BFS and the whole group, as important
as the local wild trading and deceptive accounting which
had taken place in Singapore.
What Exactly was the Scale of the
Disaster?
Although first estimates varied widely, by 28 February
the British Press was talking in terms of £700m losses.
There were reasons for this imprecision apart from the
fact that a full investigation had not yet taken place.
First, was the devious and untrustworthy nature of the
accounts being kept by BFS, and second, the losses had
resulted from one-way (unmatched) bets on futures
contracts which still had open positions (had not been
sold in this case) and on which the losses were increasing
daily.
Eventually, a committee of inquiry (the Board of Banking
Supervision)I which reported to the House of Commons
on I8 July 1995, calculated cumulative trading losses
incurred by Leeson to amount to £827m on 27 February
1995 when trading ceased, and £927m when additional
expenses to close out (sell), foreign exchange losses
through revaluations, and SIMEX costs for taking over
and closing out remaining open positions, were added in.
The immediate damage to markets (foreign exchange
and stock markets) was less than might have been
expected - mostly resulting from falls in confidence. The
European ManagementJournalVo114 No 2 April 1996
 WHATEVER HAPPENED AT BARINGS? PART ONE: THE LURE OF DERIVATIVESAND COLLAPSE
Pound dropped by about three pfennig to DM2.302,
more than a pfennig below the previous record low of
DM2.3125 reached in February 1993 after leaving the
Exchange Rate Mechanism. The Tokyo Stock Exchange
Index (Nikkei 225) fell 1000 points, a slump of 5 per cent
on 27 February when markets re-opened, but finished
that day down 3.8 per cent at the close of trading. The
London Stock Exchange Index (FTSE 100) lost only 12.4
points on 28 February to close at 3, 025.3.
Neither was there 'systemic' damage to the banking
system. Partly this was because, in international terms,
Barings was a 'tiddler', a tiny player in intemational
banking in comparison with the huge American and
Swiss banks. Barings' £354m plus capital resources
(assets £5.9 billion) were dwarfed by banks whose
resources ran into several billions. Midland Global
Markets, for instance, which is owned by HSBC
Holdings, has capital resources of £11.7 billion (assets
£201 billion), and is the tenth most active derivatives
trader; Barclays de Zoete Wedd (BZW), owned by
Barclays Bank, is one of the top 15 global derivatives
operators, and has capital resources of £10.5 billion
(assets £166 billion).
To place Barings' loss in a wider perspective, Barings'
loss would have wiped out Barclays' 1993 profits of
£664m, of which £501m came from BZW, but not its
1994 profits of around £2 billion. In 1993, Midland
made £844m in profits, of which £585m came from its
derivatives arm. It is interesting to note that in 1994,
Midland's derivatives trading contributed just £33m to
group profits of £905m. The bank attributed the £552m
drop to 'losses from dealing in derivatives on the bond
market'. In other words, the Midland profit shortfall was
more than half the loss that caused Barings to collapse,
but there was much less agonising over the reduced
Midland profit position, and less recriminatory comment
on the riskiness of derivatives.
However, as far as Barings was concerned, the losses
were catastrophic - £827m in relation to shareholders'
funds of £354m. There was much speculation in the
business Press in the clays following the collapse about
which creditors of Barings would suffer. Although BFS
had incurred one-way losses on futures contracts traded
on SIMEX and the Osaka Exchanges, because of the
system of 'margining' (daily instalments of money paid
to the Clearing House on falling market values of the
contracts), SIMEX was owed only a few days' unpaid
margins.
The problem was not that the counterparties to the BFS
contracts (in effect the Clearing Houses) would not be
paid the increased value of their contracts due to their
more successful price forecasting, it was that BFS had
been trading 'for the house' (proprietary trading), that is
to say, with its own money, not as an agent on behalf of
client corporations paying margin with their funds. The
£827m cumulative payments had been funded by
Barings London either directly with cash or by borrowing
(apart from some dishonest funding by Leeson).
European ManagementJournalVo114 No 2 April 1996
There was therefore much newspaper speculation about
which creditors of Barings would lose money. For
example, there appeared to be some 3,000 depositors of
Baring Brothers Bank with around £2.5 billion at risk.
These included local councils, pension funds, banks,
charities and building societies.
There were four 'main arms' to the Barings group -
Baring Asset Management (managing £27 billion in
funds), Baring Brothers and Co (the merchant bank),
Baring Securities, and Baring Investment Management.
The last subsidiary managed investment funds for
charities, pension funds and wealthy individuals, and
was the only arm not placed in administration - it
continued trading. Although the fund management side
of Barings was 'ring-fenced' (its assets held separately
from Baring Brothers Bank), unfortunately around
£633m of cash was deposited in Baring Brothers Bank,
and was therefore at risk. Similarly, offshore funds and
investment funds of Barings were 'ring-fenced', but had
cash on deposit with the separate banking arm.
Among other major creditors were holders of Baring
Brothers' 9.25 per cent Perpetual Subordinated Notes,
issued in January 1994 (bond-holders) which initially
drew in £100m of bond-holders' money. In 14 months,
these lost 100 per cent of their value. Barings plc's share
capital was privately subscribed by senior managers and
the owners, and this was also at risk. Fifteen Japanese
banks had a total of £425m of assets in Baring Securities
(Japan); about £312m was likely to be written off as bad
assets. Finally, a number of Japanese banks lent money to
BFS in the form of govemment bonds to cover margin
payments lodged with the Osaka Securities Exchange to
the value of around £390m. There was great uncertainty
about whether these would be repaid.
Did Barings Increase its Risk Through
Trading Derivatives?
There has been a catalogue of disasters arising from
derivatives trading by banks and corporations in recent
years, some of them like Barings, large enough to have
very damaging consequences. The list includes London-
based food and drink manufacturer Allied Lyons in early
1991 ($220m loss on foreign exchange options), Nippon
Steel Chemical in 1993 ($128m), Showa Shell Sekiyu in
1993 ($1.05 billion), Kashima Oil in 1994 ($1.45 billion
on foreign exchange losses), the US washing powder
and consumer goods company Procter and Gamble in
1993 (around $423m on interest rate swaps), Chile's
State-owned copper company, Codelco in 1994 ($207m
on copper futures trading), the German industrial
company, MetaUgesellschaft in 1993 ($660m on
mismatches between its derivatives hedges and long-
term oil contracts with customers), and Japan's twelfth-
largest commercial bank, Daiwa Bank, in its New York
Office in 1995 ($1.1 billion on unauthorised bond and
possible derivatives trading), and the Finnish bank
Postipankki in 1995 ($100m).
169
W H A T E V E R HAPPENED AT BARINGS? PART ONE: THE LURE OF DERIVATIVES A N D COLLAPSE
Yet, these derivatives-related trading losses should be
put into wider perspective before it is thought that
derivative financial products are inherently dangerous.
While it is true that the volumes and value of futures,
options and swaps contracts traded have increased
astronomically in recent years, the amount of capital at
risk in derivatives transactions is far less than the face
value of these contracts. For example, some 153m
contracts were traded on the London International
Financial Futures Exchange (LIFFE) in 1993 compared
with only 241,881m in 1982, the market's first year of
trading. In 1994, the volume increased by another 50 per
cent on the four US exchanges - the Chicago Board of
Trade, the Chicago Mercantile Exchange, the Chicago
Board Options Exchange and the New York Mercantile
Exchange, and volumes of futures and options increased
26 per cent in 1994 to reach a total of 658.5m. Yet a
1994 Survey conducted by Arthur Andersen of the
riskiest derivative transactions - privately-negotiated
over-the-counter (OTC) transactions - showed that of
the total notional value of swaps (principal amounts of
contracts) of $8,133 billion, the cost of replacing the
cashflows in these contracts was a mere one per cent to
two per cent of the notional value. The International
Swaps and Derivatives Association (ISDA) always
boasts of the size and value of derivatives business,
but this has led to confusion arising from using notional
amounts to describe the amount
of risk assumed by market
participants. It is because
In I818,
derivatives contracts are Richelieu said,
leveraged - buyers incur only a
small cost of the principal sum in
great powers in Europe:
acquiring the contract, and most England, France, Prussia,
contracts are closed out before
maturity. Austria, Russia and Baring Europe: England, France, Prussia,
Brothers'
A further report 2 by the
Economist Intelligence Unit indicates that international
companies are making rapidly growing use of
derivatives despite the well-publicised corporate
collapses, including Barings. From responses of 100
international companies, 95 per cent reported a
continuing favourable attitude to derivatives, with 52
per cent regarding derivatives as 'an essential and
regularly utilised tool'.
On the other hand, Touche Ross published a study 3 in
1995 of the use and control of derivatives by 26
companies in the London FTSE 100 Index. Touche Ross
found thaL despite knowledge of corporate losses from
derivatives trading, only 6 5 per cent of the companies
surveyed had a written policy on the use of derivatives,
and in many of these, the policies were inadequate. Only
50 per cent said their policies specified the types of
derivatives allowed, and 50 per cent had policies which
imposed limits on the volume and principal amounts of
derivatives transacted. Only 58 per cent of companies
calculated the market value of their derivatives on a
frequent basis. However, less than 10 per cent reported
that derivatives were used for speculative purposes.
1 70
Another point places the drama of derivatives into better
perspective. Whilst the lightning speed with which an
ancient but small British establishment bank's collapse
from reckless futures trading is rightly frightening, the
scale of this demise is small beside other banking losses
in the cash markets. Barings cost the British taxpayer
nothing, yet Credit Lyonnais, the French State-owned
bank, had accumulated losses of FFr13.3 billion (£1.9
billion) by early 1995 from bad loans and poor
investments all in traditional, non-derivative-linked
banking business. These were not only large losses,
but they were illiquid in terms of laying them off
compared with derivative risks on exchanges. All of the
international banking community's losses on overseas
investments and property in the '80s, and bonds in the
'90s, dwarf derivatives' losses. Banks have not found it
difficult to lose huge sums of money without going
anywhere near derivatives.
Was Barings' Over-aU Corporate
Strategy Ill-fated?
Aside from the question of whether derivatives are
inherently dangerous (to which the simplistic answer is
that as well-managed insurance instruments, they are
not), it may properly be asked if the Baring Group's
corporate strategy was well-
considered in the years running
the Duc de up to 1995.
'There are six
Barings was an illustrious name.
In 1818, the French Foreign
Minister, Duc de Richelieu said,
'There are six great powers in
Austria, Russia and Baring
Brothers'. This accolade did not
apply so well eighty years later when Barings had to be
rescued by the Bank of England for huge non-performing
loans in Argentina.
From then on, however, Barings continued in traditional
merchant banking, building up a reputation based on
corporate finance, strong investment management, and
the trading it did for one of the best client lists in
London including the Royal Family. But by the time of
'Big Bang' in London in 1987, it was in danger of being
side-lined. Unlike its rivals, it did not attempt to create
an integrated investment bank as others did following
'Big Bang'.
Up to 1984, Baring Brothers and Company (BB and Co)
was a merchant bank spedalising in corporate finance
and debt trading. In 1984 it acquired the stockholding
business of a small stockbroking company, Henderson
Crosthwaite, a company with a staff of 15 based in
London, Hong Kong and Tokyo. BB and Co then
established Baring Securities Limited (BSL), as a
separately (and liberally) managed business within the
group. The head of BSL came from Henderson
EuropeanManagementJournalVol 14 No 2 April 1996
 WHATEVER HAPPENED AT BARINGS? PART ONE: THE LURE OF DERIVATIVESAND COLLAPSE
Crosthwaite, Christopher Heath. In the 1980s he was
very successful, enjoying the fruits of the 1980s Tokyo
Stock Market boom and specialised in Japanese equity
warrants - bonds sold with warrants exercisable into
shares. Heath briefly earned notoriety when he was
identified as Britain's highest-paid employee, earning
£2.6m annually. At one point, in 1985, Barings bought
Heath a £5m Asian securities business to develop which
quickly returned £150m. Such was the expansion of the
securities side of the business, and the growth of
business in emerging markets, that Barings decided to
consolidate BB and Co and BSL, the banking and
securities side of its operations, for Bank of England
reporting purposes. Between 1992 and 1995, Barings
instigated a major internal reconstruction and manage-
ment reorganisation designed to combine BB and Co and
BSL into a new and integrated structure, Baring
Investment Bank (BIB). This reorganisation had not been
completed by the time of the collapse. Derivatives
trading was, of course, part of BSL.
The success of Christopher Heath in the 1980s (he
resigned in 1993), contributing a disproportionate share
of Barings' overall profits, proved to be a blessing and a
curse. Heath's strength lay in understanding the
securities markets in the Far East, and he paid less
attention to client positions than the traditional
merchant banking style would have done. There were
definite problems of culture difference between the two
sides of the group - stockholders versus bankers -
mainly in terms of perception and management of risk,
and also in technical understanding. Ironically, Heath
departed after anxieties about the risk positions he was
developing, although he never entered into unmatched
derivatives trades like Leeson, even when doing
proprietary business.
But growth became addictive, and after the departure of
Heath, Barings still sought the high returns it had
previously enjoyed from emerging markets and the new
financial products, like equity warrants which had
proved so profitable in the past. The gap between BB
and Co and BSL seemed as big as ever, though. One
former staff member is quoted as saying,
'The distance between 8, Bishopsgate (the banking office) and
1, America Square (the securities office) was a few hundred
yards and 150 years.'
It was into this confused culture with its mixed reporting
lines that Leeson took up his appointment in Singapore
(in March 1992) to 'head up the SIMEX operation and
also act as floor manager'.
In general terms, Barings fell into the same trap in the
1980s as did many other financial services organisations.
World-wide banking profits were being eroded in their
traditional lines of business, like lending at interest, by
'disintermediation' - the growth of securities business
like commercial paper at the expense of bank loans.
Increased competition and technological innovation
narrowed their margins further so that the banks were
European ManagementJournal Vo114 No 2 April 1996
forced either to reinvent themselves or go out of
business. A major new strategy was to push into new
markets, like derivatives and new financial products, and
to engage in proprietary trading on these and existing
capital markets. Until its collapse, bank proprietary
trading in bonds proved very profitable.
This was probably a mistake for a bank with
shareholders' funds (in 1994) at only £354m. Such a
narrow capital base was insufficient to run proprietary
trading positions, especially in trades where the returns
were leveraged and the risk high and complex to
understand. Most dangerous of all, the experience of
Christopher Heath and later from Leeson was that it
seemed possible to make large profits from derivatives
on what appeared to be a risk-flee basis. But this trading
everywhere was conducted by people who were able to
profit from fast-moving markets, not by those schooled
in the meticulous internal controls associated with
traditional banking.
Ironically, by 1995, Barings was enjoying modest
success in its merchant banking business and corporate
finance. Among purely UK merchant banks it handled
the largest number of acquisitions in Europe in 1994
after S G Warburg. Among all banks it was sixth
advising on 29 transactions with a combined value of
£8.7 billion - three times the 1993 value. In 1995 it was
adviser to the pharmaceutical company Wellcome in the
UK's largest-ever takeover by Glaxo. Other corporate
advice included the giant 1994 flotation of 3i and Lloyds
Bank's bid for the Cheltenham and Gloucester Building
Society. In all in 1994, it advised 70 quoted corporate
clients increasing the 1994 fee and commission income
by 47 per cent over the previous year.
Barings Securities also did well in other respects. In 1994
and 1995, it was a leading equity broker in Asia and
Latin America; in fact, one-third of the company's
employees of 4,000 staff were in emerging market
countries. Emerging markets were also a speciality of
Barings' third leg, Baring Asset Management, which had
over £30 billion in funds under management.
None of this relatively profitable business was, however,
able to save Barings from the debacle in the Far East.
Futures and Options in Risk
Management
The derivatives which Leeson traded in the Far East were
of the simplest type - futures and options. All derivative
financial contracts are tradeable ins~uments whose value
reflects, at least partially, that of the underlying asset -
in Leeson's case equities, bonds and currencies - but also
interest rates and commodities can be involved. Future
contracts are agreements to buy or sell these assets at an
agreed future date and price. Options are agreements
that give the buyer the right - but not the obligation -
to buy or sell an asset at or by an agreed future date.
1 71
WHATEVER HAPPENED AT BARINGS? PART ONE: THE LURE O1. DERIVATIVESAND COLLAPSE

Table 11 The Tokyo Stook Exolwnge JCIII Futures Gontraot

Trading Minimum Tick size Contract Last trading Initial margin

unit price and value months day requirements
movement

Standardieed 6% 1/100 point ¥10,000 March, June, Ninth business 2% of nominal

10-year JGB with Sept. and Dec. day prior to each transaction value for
a face value of Cycle (5 contract delivery date members, The higher
¥100m m onths at all 3% of nominal
times) transaction value or 6m
for clients (of which at
least one-third must be
cash)

Both futures and options can be traded on offidal
exchanges or over-the-counter (OTC).
Futures and options evolved as instruments to manage
(hedge) risk. With recent liberalisation of exchange rates
and increased volatility in currency markets, their use
became more widespread, and the volume and value of
contracts traded rocketed. Similarly, with greater
freedom on capital markets and increased international
borrowing and lending, the opportunities to lower costs
of borrowing and to stabilise interest rate risk similarly
became more available.
But all of this activity can legitimately be called
'hedging' or insurance. With fine business margins,
particularly internationally, it is important to safeguard
those margins against external movements in currency
prices and interest rates. The use of financial futures and
options can offset that risk sometimes completely.
The principle is very simple - the hedger (bank, pension
fund, corporate treasurer, etc) takes a position in future
contracts (buys or sells) that is equal and opposite to an
existing or anticipated position in the cash market. The
hedger 'locks in' to currency prices or interest rates
which he regards as acceptable and therefore guarantees
them. Unfortunately, it means that the benefit of any
favourable move in prices or rates is foregone. So, for
instance, a long (buy) hedge in interest rates can be used
to protect against exposure to falling interest rates or
protect the return from a planned investment by buying
futures contracts. Conversely, a short (sell) hedge can be
used to protect against exposure to rising interest rates.
Futures and options are normally dealt with on official
exchanges like the Tokyo Stock Exchange and are
standardised contracts so that the only variable is price.
An example is the 10-year Japanese Government Bond
(JGB) Future traded on the Tokyo Stock Exchange, one
of the three main instruments traded by Leeson. It has
the characteristics shown in Table 1.
Futures contracts can also be used to hedge investment
portfolios against future unfavourable movements in
share prices. And this was another instrument traded by
Leeson. A stock index futures contract is one in which
the underlying asset is a specific stock index (like the
Nikkei 225 stock index). An investor or portfolio
manager who buys a stock index futures contract agrees
to buy the stock index, and conversely, the seller of a
stock index futures contract agrees to sell the stock
index. The value of a stock index futures contract is the
product of the futures price and the futures contract
multiple. For the Nikkei 225 stock average future on
SIMEX, the multiple is 500. Therefore, put another way,
a stock index future is a contract to buy or sell the face
value of the underlying stock index, where the face value
is the value of the index multiplied by a specific amount.
The advantages of stock index futures to hedgers are
important:
°~' They allow investors to participate in a stock market
without actually buying and selling the shares
themselves.
°**° The margining system allows this participation
without the commitment of very large amounts of
capital.
°~' Buying and selling futures positions costs much less
than buying and selling shares.
°~° Positions can be closed out quickly.
However, the overwhelming bulk of deals in derivatives
markets like futures and options by volume and value is
undertaken by traders (speculators) not hedgers, and are
unconnected with underlying cash or trade transactions.
Some of this speculation is risk-controlled but other
forms can be very risky indeed. Whilst traders clearly
add much-needed liquidity to derivatives markets, they
can incur considerable risk themselves. In trading futures
contracts, there are generally thought to be three trading
strategies, in increasing order of risk:
o'o Arbitrage trading - t u m i n g a profit from the
simultaneous purchase and sale of futures contracts
and cash instruments on the same or different
exchanges where there is a temporary price
mismatch.
o~° Spread trading - taking a view on the way price
differences between different future contracts will
trend.
g" Position trading - making one-way bets on changes
in interest rates or currency rates buying or selling
futures contracts.

1 72 EuropeanManagementJournalVo114No 2 April 1996

 WHATEVER HAPPENED AT BARINGS? PART ONE: THE LURE OF DERIVATIVESAND COLLAPSE
Two features of financial futures and options contracts
are especially relevant for trading - leverage and the
margining system. It was also these features that caused
particular problems for Leeson.
An example of the extreme effects of leverage is given
by Derek Ross.4 A trader wishing to establish a long
position of $Imillion in Eurodollar time deposit rates,
could buy one futures contract on the London
International Financial Futures Exchange (LIFFE), and
he would be asked by LIFFE to deposit just $750 as the
initial margin. If the futures price rose by 50 basis points
(0.5 per cent), since the value of each point is officially
$25, he would show a profit of $1,250 (50 z $25) or
nearly 100 per cent return on his original investment. If,
however, the rates had gone the other way, he would
stand to lose nearly 100 per cent of his original
investment.
The margining system has been established by official
exchanges like LIFFE and SIMEX to avoid or at least
reduce counterparty risk on futures and options. Margins
are 'good faith' money. The initial margin on the Osaka
Stock Exchange for the Nikkei 225 average future is 10
per cent of the transaction value. On other exchanges
the percentage of initial margin can be much lower. A
speculator could bet on a rise in paces in the British gilt
market through buying long gilt futures contracts on
LIFFE. He could achieve a position of £1m in gilts for an
outlay of just £20,000, and this initial margin could be
deposited in interest-bearing securities rather than cash -
a gearing of 50 times. It is the margin system that gives
rise to the (unlimited) potential for gain and loss on a
levered basis. But it is also this leverage possibility that
reduces the cost of reducing price risk for hedgers.
Although the exchange clearing house could not suffer
large losses because of each day's marking to market in
cash, an investor can lose large (levered) sums of money
through a steady stream of margin calls.
For exchange-traded options, the buyer has no margin
requirements because he pays the option price in full - it
is the maximum amount he can lose. The option writer
(seller) takes on all the risk of the position of the
underlying asset, he is required to put up the option
price received as margin and is usually also required to
deposit additional margin as the position is marked to
market daily. This gives rise to different risk/reward
characteristics of options and futures. Futures provide a
symmetrical risk/reward relationship - buyers and sellers
lose/gain equally when the price of the future changes.
The most the buyer of an option can lose is his option
price; but the writer's downside risk is unlimited.
Leeson's Legitimate Business
Nick Leeson was authorised to conduct both proprietary
and client account trading on Far Eastern exchanges, on
behalf of other Barings companies, specifically, Baring
Securities Limited (Singapore), Baring Securities
European ManagementJournal Vo114 No 2 April 1996
(London) Limited, Baring Securities (Japan), Baring
Securities Hong Kong Limited and Banque Nationale
de Pans (Japan). He dealt in six main financial futures and
some options on them, as follows:
oIo the Nikkei 225 contract traded on SIMEX in
Singapore:
oIo the Nikkei 225 contract traded on OSE in Japan;
o~o the 10-year JGB contract traded on SIMEX in
Singapore;
o~o the 10-year JGB contract traded on TSE in Japan;
o~o the 3-month Euroyen contract traded on SIMEX in
Singapore;
o~o the 3-month Euroyen contract traded on TIFFE
(Tokyo Financial Futures Exchange) in Japan.
Around 1993, arbitrage business began to be an
important part of Baring's Far Eastern operations.
Initially this took the form of cash/futures arbitrage in
Tokyo, and soon after the rapid build up of arbitrage
between SIMEX and OSE on Nikkei 225 futures
contracts. The Barings' management called this
authorised business 'switching' although it would
normally be known as a form of inter-exchange
arbitrage. Leeson would buy and sell Nikkei 225 futures
contracts simultaneously on SIMEX and OSE, benefitting
from small differences in identical contracts - buying at
the cheaper price and selling at the higher. These
opportunities existed because OSE and SIMEX have
different market conditions - OSE has local business,
SIMEX mostly 'off-shore' business, and OSE, being
electronic, conducts business more slowly than SIMEX.
Leeson also 'switched' JGB futures contracts on SIMEX
and TSE. This arbitrage market provided good
opportunities since the JGB market was rather volatile.
He also did arbitrage business on SIMEX and TIFFE
Euroyen contracts, although the opportunities here were
limited.
Arbitrage business can generate only very small profits
on large volumes of contracts traded. Even then, there is
a built-in limit to the amount of profits that can be
generated since, if orders for large quantities are placed
on two exchanges, the price differences tend to
diminish,s
As well as exploiting price differences in this way,
Leeson could match client orders on SIMEX when
liquidity was not available to execute it immediately,
taking the other side and laying off the risk with the
equivalent number of contracts on the more liquid OSE.
He could therefore proprietary trade by 'riding on the
back' of large client buy orders for SIMEX Nikkei
contracts, hoping to benefit from the markets being
moved favourably. If the markets moved unfavourably,
he could arbitrage between OSE and SIMEX. SIMEX
later reporteds that this may have constituted the
offence of 'bucketing' under the Futures Trading Act.
Theoretically, arbitrage is risk-free since orders are
matched, but timing differences between exchanges give
1 73
WHATEVER HAPPENED AT BARINGS? PART ONE: THE LURE OF DERIVATIVESAND COLLAPSE
rise to some risk of prices moving unfavourably. For this
reason, Leeson was allowed to take unhedged positions
on the following number of contracts during a single
day: 200 OSE Nikkei contracts, 100 TSE JGB contracts
and 500 Euroyen contracts. All open positions on the
contracts had to be closed out at the end of a day's
trading. Leeson was not authorised to undertake
proprietary trading in options, therefore no gross limits
were set.
The products and kind of client/proprietary operations
described above were all authorised by Barings HQ and
supposedly subject to the Group's various levels of
management control. However, even before Barings'
collapse, there were curious features of Leeson's
operations.
First, his supposedly low-risk arbitraging with Nikkei
225 and JGB futures produced apparently large returns,
quite out of proportion to the type of business involved,
even if the number of contracts traded was very large.
From accounts disclosed for 1994 (later found to contain
false reporting), Leeson's 'switching' business con-
tributed £28.5m to the Barings Group operating profits,
about 8 per cent of total profits, and nearly as great as
the Banking Group's operating profit (£36.9m). Of this
switching activity, £23.4m was generated solely from
JGB arbitrage.
The second curious feature was the continuing call by
BFS on the rest of the Group for funds for margin
payments. The transfer of funds was unremitting and in
the end, cumulatively enormous. Table 2 shows the
build-up.
By 24 February 1995, this cumulative funding
represented well over the reported capital of the Barings
Group. This astonishing situation was allowed to
develop as the result of no reconciliation of the funding
with client records. But even common sense would have
been enough to make anyone realise that, if indeed
Leeson's arbitrage was successful, and making real
profits, then margin cash should have been received in
large amount, not paid. Such receipts of margin would
have been used for calls. A stream of margin calls
building up to stratospheric cumulative sums could only
have meant the contracts were losing value for Leeson as
they were daily marked to market.
Third, Leeson was building up substantial long positions
on SIMEX and short positions on TSE. Because BSF had
continued to pay margin calls, the exchanges were
satisfied. There was no apparent attempt by the Barings
Group or the exchanges themselves to investigate the
size of the open positions which resulted, although it
must be said that Leeson was concealing the true size of
these positions and even fraudulentlycomputing margin
payments to SIMEX. It was common knowledge among
SIMEX, OSE and TSE traders in the firsttwo months of
1995 that BFS had enormous open positions in the
exchanges. Since also most participantsin the exchanges
were known to each other, and no-one seemed to know
174
Tablo 2 Margin Paymonts to Blip from tho Roat of tho
Barings Group
Company 1 Jan 1994 31 Dec 1994 24 Feb 1995
£ millions £ millions £ millions
BSLL 7 13 105
BSL 33 142 337
BSJ (1) 66 300
Total 39 221 742
Source: Board of BankingSupervision Inquiry, 1995.Inquiry team
based on analysis prepared by Barings
the clients on whose behalf BFS was acting, it did not
seem a poor guess to assume these were proprietary and
unmatched trades.
To give some idea of BFS's huge participation on
SIMEX, in the months of January and February 1995,
BFS was the largest trader holding between 12 and 8 per
cent of SIMEX volume. In 1993 it ranked 9th and in
1992, 26th. In December 1994 it held about 2 per cent of
outstanding contracts of Nikkei 225 futures traded on
SIMEX, and in January 1995, 34 per cent. In January
1993 it held 1 per cent of outstanding contracts of
Nikkei 225 options traded on SIMEX, and in January
1995, 35 per cent.
The three warning signals described briefly above are
ones which might have appealed to a simple common
sense view of derivatives hedging and trading as per-
ceived by anyone concerned with these markets and
contracts. In fact, there was in place a range of controls
internal and external to Barings and available to the
regulatory and supervisory authorities which could have
picked up more precise and factual information even
though concealment was taking place. These will be
dealt with in more detail in Part Two of this Case Study.
These 'common sense' waming signals should have
alerted controllers and supervisors that Leeson's
operations were not normal. It could, of course, have
been possible that he was transacting authorised trades,
but had simply exceeded his trading limits. But this could
still not have accounted for the kind of warning signals
of excess described above.
In Part Two of this Case Study, Leeson's unauthorised
trading is analysed together with the techniques he
employed to disguise trades and the losses on them.
That such huge losses were built up over a considerable
period of time is also an indication of the failure of
internal and external controls in Barings and of adequate
supervision by regulatory bodies. These are examined
and recommendations made.
Notes
1 Report of the Board of Banking Supervision Inquiry into the
Circumstances of the Collapse of Barings, London, HMSO, 18
luly 1995.
2 Strategic Derivatives: Successful Corporate Practicesfor Today's
EuropeanManagementJournalVo114No 2 April 1996
 WHATEVER HAPPENED AT BARINGS?PART ONE: THE LURE OF DERIVATIVESAND COLLAPSE

Global Marketplace, Economist InteUisence Unit, London,

1995. PAUL STONHAM,
The Corporate Use of Derivatives, Sarah Welch, Touche Ross, EAP-European School of
London, 1995. ManagemenL I2, Merton
Derek Ross International Treasury ManagemenL 2nd edition, StreeL Oxford OXI 4]H,
Woodhead Faulkner, Cambridge, 1990. UK
Baring Futures (Singapore) Pte Ltd., Investigation Pursuant to
Section 231 of the Companies Act (Chapter 50). The Report of the Paul Stonham is Associate
Inspectors Appointed by the Minister for Finance, Singapore,
MOF, 6 September 1995. Professor of Finance at the
EAP-European School of
Management in Oxford.
He is also Editor of the
European Management
Journal and the Series Editor of the European
Casebook Series on Management which began
publication in 1994. His career includes university
teaching in Australia, training at UNCTAD,
Geneva, and the Bank of England. Current research
interests are corporate valuation and restructuring,
and the integration of finance into overall corporate
strategy. His most recent book (with K. Redhead) is
European Casebook on Finance, Prentice-Hall,
I995.

European ManagementJournal Vo114 No 2 April 1996 1 75