With the introduction of index options, the derivatives market is all set to shift to a multi-product environment from a single-product market. Options like futures are leveraged products used by participants to manage the risk in the underlying market. Many people perceive options to be very risky. Debacles like the Barings episode are responsible for this misconception.
At this juncture, when options are being introduced in the Indian capital market, it would be prudent to understand what happened in the Barings case to prevent similar incidents from occurring here.
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 the darling of the top management at the Barings headquarters in London.
As head of derivatives trading, Leeson was responsible for both the trading and clearing functions of Barings Futures Singapore (BFS), a subsidiary of 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) (erstwhile Singapore International Monetary Exchange, SIMEX), Singapore and Osaka Securities Exchange (OSE), 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 futures contracts. He sold a large number of option straddles (a strategy that involves simultaneous sale of both call and put options) on Nikkei 225 index futures.
Without going into the intricacies, it may be understood that straddle results 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 fall nor rise substantially.
But events took an unexpected and dramatic turn. The news of a killer earthquake in Kobe sent the Japanese stock markets tumbling. The futures on the 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 long positions in Nikkei 225 futures on both exchanges - SGX – DT and OSE.
However, the Barings management was made to understand that Leeson was trying to arbitrage between the SGX-DT and OSE with the Nikkei 225 index futures.
When OSE authorities 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 positions in the Nikkei 225 on SGX - DT. He wanted to suggest that if his positions in the Nikkei 225 at the OSE suffered losses, they would be made up by the profits by his position in the SGX - DT.
A similar impression was given to SGX - DT authorities, when they inquired about Leeson's positions. While Leeson misled both exchanges with wrong information, neither exchanges bothered to cross-check the trader's positions on the other exchanges because they were competing for the same business.
Both exchanges were more concerned about protecting their financial integrity and in doing so, allowed the continuation of the exceptionally-large positions of Leeson after securing adequate margins.
We all know the consequences. A single operator couldn't take the market in the desired direction and the market crashed drastically.
Consequently, Barings registered losses on Leeson's futures and straddle positions. But, we must note that the flames of the Leeson disaster did not singe the financial integrity of either market. This was because the markets were protected with proper margins.
The lessons
A single operator can't 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 the direction of the market 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 (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 organisation. These limits are defined in various forms with regard to product, market or trader's total market exposure etc.
Any laxity on this front may result in unbearable consequences to the trading organisation. These limits should be clearly defined and well communicated to all traders in the organisation.
Meticulous monitoring of position limits is a must: 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 in charge of supervising back office operations at BFS.
It is understood that he had 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 and back office operations.
Different people should be in charge of front and back-office operations so that any exposure by dealers, over and above the limits set, can be detected immediately. It means having proper checks and balances at various levels to ensure that everyone in the organisation has the disciplinary approach and works within set limits.
In fact, trading systems should be capable enough to automatically disallow traders any increase in exposures as soon as they touch pre-determined limits.
Exchanges should compete professionally: Both the competing exchanges, SGX – DT and OSE, were unconcerned about checking Barings' position at the other exchange.
While both the exchanges were safeguarded through margins, people must appreciate the fact that the effect of a big failure like Barings goes much beyond the financial integrity of a system.
The point to be noted is that exchanges can compete, but at the same time, must co-operate and share information. It could also help in deterring 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/ house and/ or exchange on time. Only timely collection of margins can protect the financial integrity of the market as we have seen in the Barings case.
The above-mentioned points are relevant to trading organisations in derivatives market. They have to intelligently work in-house to avoid any mishaps like the Barings episode at any point in time.
SEBI has done a good job in the Indian derivatives market by making margins universally applicable to all categories of participants including institutions. This provision will go a long way in creating a financially-safe derivatives market in India.
Conclusion
Clearly, the failure of Barings was not a 'derivatives' failure' but a failure of management. After the investigations were through in the Barings case, the Board of Banking Supervision's report also placed responsibility on poor operational controls at Barings rather than the use of derivatives.
An important lesson from the entire episode is that we all need a disciplinary and self-regulatory approach. The moment we go against this fundamental rule, this leveraged market is capable of threatening our very existence
Source: Bombay Stock Exchange.
For Stock advice : Saturday watch on Market Outlook
