Narach Investment


With the introduction of index futures and options many years ago in the stock markets as derivative products, the stock market itself shifted from a single-product market to a multi-product environment. Options quite like futures are leveraged products applied by market participants to manage the risks associated with the underlying market. It is for the investors both individual and institutional to take it upon themselves to learn and understand the risks and returns associated with such derivative financial instruments.

Many individuals perceive options to very risky as a financial instrument; and this misconception is further fed by debacles like the Barings episode. At this juncture, when options along with futures as financial instruments have been in use for many years in the stock markets in India, it would be prudent to understand what actually happened in the Barings case; mainly with a view to preventing similar incidents from occurring in the future.

The episode: The man behind the widely reported debacle, Nicholas Leeson, had an established track record of being a savvy operator in the derivatives market and was indeed the blue eyed boy of the top management at the Barings headquarter in London. As the head of derivatives trading, Leeson was responsible for both the trading and clearing functions of Barings Futures Singapore, a subsidiary of the London based Barings PLC.

Leeson engaged himself in proprietary trading on the Japanese stock exchange index Nikkei 225. He operated simultaneously on the Singapore Exchange & Derivatives Trading Ltd (SGX-DT), Singapore and Osaka Securities Exchange, Japan in Nikkei 225 futures and options.

A major part of Leeson's trading strategy involved the sale of options on the Nikkei 225 index future contracts. He sold a large number of option straddles (a strategy that involves the simultaneous sale of both call and put options) on Nikkei 225 futures. Without going into the intricacies, it may be understood that straddles result in a loss, if the market moves in either direction (up or down) drastically. His strategy amounted to a bet that the Japanese stock market would neither rise nor fall substantially.

But events took an unexpected and dramatic turn. The news of a killer earthquake in Kobe sent the Japanese stock market tumbling. The futures on Nikkei 225 started declining and Leeson's straddle position started incurring losses. Desperate to make some profit from his straddles, he started supporting the index by building up extraordinarily huge positions in Nikkei 225 futures on both the exchanges; namely the Singapore exchange (SGX-DT) and the Osaka Securities Exchange.

However, the Barings management was made to understand that, Leeson was trying to arbitrage between the Singapore Exchange (SGX-DT) and Osaka Securities Exchange with the Nikkei 225 index futures.

When the Osaka Securities Exchange warned Leeson about his huge long positions on the exchange in Nikkei 225 futures, the trader claimed that he had built up exactly the opposite position in the Nikkei 225 futures on the Singapore Exchange (SGX-DT). He wanted to suggest that if his positions in the Nikkei 225 at the Osaka Securities Exchange suffered losses, they would be made up by the profits by his positions in the Singapore Exchange (SGX-DT). A similar impression was given to the Singapore Exchange authorities, when they inquired about Leeson's positions.

While Leeson misled both exchanges with wrong information, neither exchange bothered to cross-check the trader's positions on the other exchange because they were competing for the same business. Both exchanges were concerned about protecting their financial integrity; and in doing so allowed the continuation of the exceptionally large positions of Leeson after securing adequate margins for these positions.

We all know the consequences; a single operator could not take the market in the desired direction and the market crashed drastically. Consequently, Barings registered losses on Leeson's futures and straddles positions. But, we must note that the flames of the Leeson disaster did not singe the financial integrity of either exchange, as they were both protected with proper margins.

The Lessons:

A single operator cannot move the market: Leeson was trying to drive up prices by buying index futures on the Nikkei 225 but could not succeed as the market was gripped by pessimism emanating from the devastating Kobe earthquake. The point is that, a single operator cannot change market direction; and it is always prudent to live with the market movement strategically.

In this instance, a better strategy for Leeson would have been the dynamic management of his portfolio. For example, with the falling value of the index, his put leg of the straddle started incurring losses and the call was to expire worthless; and he had the choice to square his put options off at the pre-determined level (cut-off loss strategy). But Leeson, instead of squaring off his short put option position chose to support the index price by buying futures on the Nikkei 225 and failed.

Traders should have clearly defined and well communicated position limits: Position limits mean the limits set by top management for each trader in the trading organization. These limits are defined in various forms with regard to financial product, market or traders' total market exposure, etc. Any laxity on this front may result in unbearable consequences to the trading organization. These limits should be clearly defined and well communicated to all traders in the organization.

Meticulous monitoring of position limits is a must on the part of top management. We may note that Leeson too had position limits set by top management, but he exceeded all of them. This attempt at crossing limits did not come to the notice of the top brass at Barings as Leeson himself was also in-charge of supervising back office operations at Barings Futures Singapore. It is also understood that he sent fictitious reports about his trading activities to the Barings headquarters in London. Had the top management been aware of the real situation, the disaster could probably have been avoided.

Therefore, scrupulous monitoring of the position limits is as important as setting them. The top management's job of monitoring the positions of each dealer in the dealing room may be facilitated by bifurcating the front office and back office operations; and such operations should be under the charge of different people. So that any exposure by dealers over and above the limit set would be detected and reported immediately. This would mean having proper checks and balances at various levels to ensure that everyone in the organization has the disciplinary approach and works within set limits. In fact, trading systems should be capable enough to automatically disallow traders any increase in exposure as soon as they touch pre-determined limits.

Exchanges should compete professionally: Both the competing exchanges (Singapore Exchange and Osaka Securities Exchange) were unconcerned about cross checking Barings' position at the other exchange; while safe guarding themselves through appropriate margins. People must appreciate and realize the fact that, the effect of a big failure like Baring goes well beyond the financial integrity of a system.

The point to be noted is that the exchanges can compete; but at the same time must cooperate and share information. It would also help in deterring attempts and efforts at price manipulation.

Big institutions are as prone to risk as individuals: One broad issue from an overall market perspective is that, big institutions are as prone to incurring losses in the derivatives market as is any other individual. Therefore, irrespective of the entity margins should be collected by the clearing corporation or house or the exchange itself on time. It is the timely collection of margins that would protect the financial integrity of the market exchange as has been seen in the Barings case.

The above mentioned points of reference are relevant to trading organizations and individuals with regard to their transactions in the derivatives segment of the stock exchange. They would be required to intelligently work in-house to avoid mishaps like the Barings episode at any point of time in the present and in the future.

Securities and Exchange Board of India has done a good job in the Indian derivatives market by making margins and margin calls thereof universally applicable to all categories of participants including institutions. This provision would go a long way in creating a financially safe derivatives market in India. However, in more recent times the index of the National Stock Exchange the Nifty is traded in the Singapore Exchange as the SGX Nifty; and further caution would be advisable on the part of individual and institutional investors on the one hand and sharing of relevant information amongst the two stock exchanges on the other; while not forgetting that further supervision on the part of the regulator would be quite in order.

With regard to the Barings episode under study; it would come to light that it was not a derivatives failure but a failure on the part of the management. In fact, after the investigations were concluded in the Barings case, the Board of Banking Supervision's report also placed the responsibility of the failure on the poor operational controls at Barings rather than the application and use of derivatives.

An important lesson from the entire episode is that we need a disciplinary and self-regulatory approach. The moment a trading organization or individual goes against the fundamental rules, this leveraged derivatives market would threaten their very existence.