Please observe the following statements and case study and respond accordingly in the examination booklet provided.

Derivatives are highly leveraged, sophisticated and efficient instruments that are used to manage financial risk. However, they can and have been easily misused. Derivative losses have ranged from relatively small amounts to extraordinary sums of money. The following Barings PLC case is perhaps the most spectacular of derivatives losses over the years.

Barings PLC: How One Man Blew Up a Bank

Barings PLC was a British investment bank that had been founded in 1763. It had played a major role in British history, financing the Napoleonic Wars, and included Queen Elizabeth II among its many well-heeled clients. One weekend in February 1995, Barings was forced to declare bankruptcy, a result of losses of about $1.2 billion, or nearly twice its capital. The losses were attributed to futures trading in its Singapore office by 28-year-old former clerk named Nick Leeson. Barings was rescued by the Dutch Banking concern Internationale Nederlanden Groep (ING), which purchased its assets (approximately $900 million) and assumed most of its liabilities for about $1.60 (yes, thats right $1.60). ING immediately injected about $1 billion in capital. Some of Barings liabilities, however, were not assumed, and those bondholders suffered big losses.

Lesson had joined the bank in July 1989, having previously worked in London for the American bank Morgan Stanley. As a clerk handling the settling of transactions, he proved to be exceptionally well organized, and his work in Barings back office impressed his superiors. In March 1992, he requested and received a transfer to the Singapore office, which was actively in futures trading in Tokyo and Osaka, Japan, and at the Singapore International Monetary Exchange (SIMEX). Again Leeson proved to be excellent at organizing the back office. All the while, Leeson was learning the ropes of trading futures. Soon he was executing arbitrage transactions, buying Japanese stock index futures in Singapore and simultaneously selling the same contract in Osaka, capturing the differences in the prices of the same contract on the two exchanges.

Transactions of this sort should be low risk. One position will gain, and the other will lose a similar amount. The net should be a small profit resulting from slight differences in the prices of the contract on the two exchanges. As Leeson relates the story in his book, Rogue Trader, in 1992, he began hiding his losses in a special account. Soon it began appearing that Leeson was generating huge profits. Because Leeson was responsible for the back office and his employees were loyal to him, he was able to keep the losses tucked safely away whenever reports were required or auditors showed up. In 1994, he reported profits of about 28 million but had hidden losses of 180 million. From January 1, 1995, to February 24, Barings last day, Leeson produced profits of almost 19 million and losses of over 600 million, and it was getting increasingly difficult to cover his trail.

Leeson was generating more funds by entering into short straddles, a total of almost 20,000 contracts. This meant that Leeson profited as long as the market stayed fairly stable. With high volatility, he would lose big. In late January 1995, Leeson held over 3,000 contracts long of the Japanese Nikkei 225 stock index futures at the Osaka exchange. On January 17, an earthquake

struck the Japanese city of Kobe, and the index fell about 13 percent over the next five weeks. Leeson was generating large losses but increased his bets the market would turn around. Ultimately, Leeson held a $7 billion position that would gain if the market moved up and lose if it moved down. He held about 17,000 contracts in Osaka and over 40,000 in Singapore. He also had huge positions in Japanese government bonds and Euroyen.

The evidence suggests that Barings executives in London had been warned about Leesons trading as early as 1992. In 1994, an audit concluded that while Leeson had done nothing wrong, although in fact he had, the potential for wrongdoing was there. It noted that Leeson was running both the front office and back office, although generating large profits, with little risk.

Thursday, February 23, was Leesons last day of work at Barings Singapore office. He and his wife secretly fled Singapore the next day. They went to several Asian countries before eventually flying to Frankfurt, Germany, where he was arrested by German police a week after fleeing Singapore. Singapore sought extradition while Leesons British lawyers worked toward having him charged and extradited by England. British authorities were unable to determine that he had violated any of their laws, and in October 1995, a German court agreed to turn him over to Singapore. Leeson returned to Singapore and plea-bargained a potential 14-year prison sentence down to 6.5 years for fraud.

The Barings story shocked the financial world. There were concerns that the SIMEX clearinghouse might fail or use customer funds to cover its losses. The Bank of England, which had rescued Barings in 1890, considered doing so again, but it quickly became apparent that only investors and not customers would lose money over the Barings failure. While the financial system suffered a shock, it showed no threat of wide-spread failure, the systemic risk that we previously mentioned. When ING purchased Barings about a week after the failure, the market settled down quickly and no further shocks were felt.

Barings is a classic story in bad risk management. The London office was under the impression that this 28-year-old clerk with no university degree was earning large profits arbitraging price differences in two markets. They never questioned how unlikely these profits really were. Barings was a wake-up call to the rest of the financial world. Risk management became of paramount importance.

Chance & Brooks (2016, pp. 592-593)

The experience of Barings PLC highlights how the mismanagement of derivatives can quickly escalate and the path of destruction that follows. Such experiences have undoubtedly provided lessons for other organisations in avoiding similar losses and embarrassment....we hope!

Your task here is to critique this case and identify and discuss strategies senior management could have adopted to avoid the derivative losses encountered by Barings PLC.