Ross Hilton ross.hilton@uni.sydney.edu.au

  Barings Bank was the oldest Merchant Bank in the World. It was highly trusted and risk averse. The Queen was a customer. It had financed the Louisiana Purchase, helped fund most of the US railways, and was heavily involved in overseas operations.

  The bank was still in family hands but was owned by a charity foundation for tax purposes.

  The Barings Foundation Trust was established in 1969.

  It removed tax implications but also removed equity from the family.

  This was compensated by a very rewarding bonus scheme, which handed out 50% of profits.

  The family and staff soon became accustomed to the bonus rewards.

  The Barings Bank that most people knew was the merchant banking side. However there was another side to the bank, Baring Securities.

  Barings Bank was located at 8 Bishopgate, London

  Barings Securities was located at America Square, London.

 Barings Bank was formed in 1762, and highly risk averse. It looked at long term relationships to make modest profits.

 Barings Securities was formed in 1984, and had a high risk appetite. It looked to short term high value transactions to make large profits.

Barings Bank Old Conservative Risk Averse Long term profits Tightly regulated

Barings Securities Young Brash Risk takers Short term profits Loosely regulated

  By 1989 the traditional Baring Bank equity broking activity was bringing 19 million pounds profit compared to 78 million from Barings Securities trading.

  The bank was sharing the profits from Securities across the entire bank operations. In the 6 years of its existence to 1990 Barings Securities had made 82% of Barings total profits.

  Despite this, very few in Barings Bank understood or cared about the Securities trading activities.

 The 1990s saw the original hard nosed securities traders being usurped and replaced by technocrats, whom they nicknamed “techno-peasants”.

 These technocrats were mathematicians and scientists, used to calculating risk and finding opportunities buried in numbers.

 Barings Bank, who already didn’t understand or care about Securities trading, had no real understanding how these technocrats found and exploited opportunities.

  Barings Securities originally made vast profits from trading Warrants, especially Japanese share warrants, which were seriously mispriced in the 1980s.

  By the 1990s the Warrants mispricing had disappeared, however a similar opportunity was discovered in Japanese Equity Futures and Options.

 By the early 1990s most of the profits were being made by a very small number of highly skilled specialists like Khoo and Gueler, making vast profits in esoteric and complex trades.

 Su Khoo – a highly rated Malaysian mathematician, made over 16 million pounds in one month by exploiting opportunities.

 Fernando Gueler - a Harvard Economist, was making similar profits.

  So by the 1990s a small number of highly skilled specialists within Barings Securities were making a vast percentage of the Barings Bank profits, and no one else understood how they were doing it.

Large number of gung ho traders

Small number of technocrats

Warrant Trading Futures and Options

Growing reliance on Barings Securities profits

Growing lack of understanding on how the profits are made

1980s 1990s

  Bearings Bank required minimal capital to operate, and had assets of around 300 million pounds.

  Prior to 1990 Barings Securities had been self funding, using the income from warrant trading.

  The 170 million pounds profit generated by Barings Securities in the last 6 years had been used to prop up Barings Bank and paid out as bonuses, and was not available to support trading operations.

  The move to futures and options trading created a gap in funding and a demand for capital. It was needed to “buy” seats in trading systems, and to pay security bonds for trading, together with capital to support the trading.

  When Barings Bank proved unable to provide the finance, Bearings Securities formed Barings Securities Financial Services and Barings securities International Holdings to raise capital on the world markets.

  By 1990 it had used BSFS and BSIH to raise 31 million pounds from 10 banks, and desperately needed a further 33 million to support growth.

  By late 1990 Barings Securities estimated it needed 120 million pounds to continue and expand trading, which they estimated could generate 45 million pounds a year in profits.

  Barings Bank didn’t understand Securities but it did understand Capital.

  It realised that the massive profits from warrant trading were ending.

  It knew that Barings Securities were prone to over spending.

  Barings Bank forced Securities to downsize, losing over 100 staff in 1992, and in 1993 it executed a coup, replacing most of the top staff with Barings Bank staff.

  Barings then forced Securities to work within its means, only allowing borrowing to fund margin calls that would be repaid by the client. This assumed there really was a client who would pay the call.

  By 1995 Barings had borrowed 740 million pounds to fund margin calls for which there was no customer.

  Six years in back office settlements

  No degree. Straight into banking from school

  Twenty eight years old

  Sent overseas to run a trading office – with no prior experience of trading.

  Desperate to become a trader - resigned from Morgan Stanley because they refused to let him trade.

  Nick Leeson was involved in two Nikkei trading operations, SIMEX in Singapore and Osaka Futures Exchange in Japan.

  SIMEX was “Open Cry”, with traders standing in a pit in close physical proximity, buying and selling off each other.

  Osaka used electronic screen trading.

  Osaka electronic screen trading allowed multiple concurrent transactions.

  This meant that a large purchase of contracts could be made simultaneously from multiple sellers without any of the other sellers realising the overall volume of the the transaction.

  SIMEX open cry meant that multiple concurrent transactions were difficult to achieve, and trades tended to be a smaller groups of sales or purchases.

  These smaller non simultaneous transactions signaled buyers or sellers intentions to the market and affected prices.

  SIMEX was also smaller, and purchases were easily noticed.

  Both SIMEX and demanded margin payments.   Osaka demanded 9% initial margin, followed by a

series of margin calls 3 to 4 days after market movement of the securities.

  SIMEX had a similar system but the margin payments were much smaller, attracting customers.

  In 1990 the Japanese government commenced price keeping actions, buying Nikkei futures to keep the price up. This led to excessive trading in Nikkei futures.

  To reduce trading activity the margins in Osaka were raised from 9% to 15% and then 20%. In addition trading hours were shortened.

  Osaka introduced rules limiting contract price movement to 0.2% every 5 minutes. A 5% fall would shut the trading for 2 hours.

  These rules did not apply on the SIMEX floor.

  Leeson noticed that large purchases on SIMEX invariably pushed the price of the security up, as other traders watched the activity.

  This was reported to Osaka, and the price was reflected on the electronic trading screens.

  He realised that he could purchase contracts in Osaka at the current price before placing his customers purchases, which would then drive up the price. He could then sell at Osaka at a profit.

Leeson SIMEX OSAKA

1. Learns of new order from customer.

2. Places Barings order on Osaka

3. Places customers order on SIMEX

4. Sells the Barings order on Osaka

  Leeson spotting the Nikkei opportunity led Barings to think that he was another Techno-Peasant. A mathematically gifted opportunist who could find and exploit opportunities for Barings Securities.

  In fact he had a very basic education, and had spent most of his career in back office settlements.

  Leeson wasn't a technocrat. He had wanted to get into trading 4 years before when it was full of gung ho “barrow boy” traders, now it was a different workplace full of mathematicians and MBAs. He was out of his depth.

  Barings Bank didn’t understand the Securities industry and could not monitor Leeson. But they were addicted to the bonus payments that came from Barings Securities.

  Barings Securities had been milked of operating capital by the Barings bonus scheme. They were desperate to generate profits to fund expansion.

  Everyone wanted people like Leeson to succeed.

  Driven by a desire to be a star trader, Leeson tried to influence the market by trading in long futures.

  Initially successful, he began to lose money due to inexperience. He adopted the gamblers strategy of doubling up, hoping that sooner or later it would balance out.

  This collapsed with the Kobi earthquake in January 1995. The Nikkei went into freefall, and Leesons position became a disaster.

  All of his attempts to extricate himself for the position from then on were unsuccessful. No matter how much of Barings money he spend the Nikkei continued to fall.

  On 23rd February 2005 Leeson quietly slipped out of Singapore. He left Barings owing 827 million pounds.