Barings, 1995

At a glance

What happened

Barings' Singapore office was meant to run low-risk arbitrage, buying Nikkei futures on one exchange and selling them on another for tiny price differences. Instead a single trader built a large, hidden directional position. After the Kobe earthquake on 17 January 1995 the Nikkei fell sharply, and the position was increased rather than cut. By late February the losses were larger than the bank's entire capital, and the 233-year-old firm was sold to ING for one pound.

Why it went wrong

The trader controlled both the trading and the settlement of his own book, so the records of what he had done were produced by him. Losses sat in an error account outside the reported numbers. Head office kept sending hundreds of millions to meet margin calls without reconciling what that money was paying for. Underneath were an outright long futures position and short straddles: a bet that the index would stay in a range, at a size nobody in London knew existed.

What it teaches

Profits that do not fit the strategy are a warning, not a success: a near-riskless arbitrage cannot produce large, steady gains. Money leaving the firm for margin can always be checked against positions. Separate front and back offices, mandatory leave and independent reconciliation became standard because all of them were missing here.

Key terms

Segregation of duties

Keeping trading, confirmation and settlement in separate hands so no one person can both trade and record.

Error account

An account for correcting mistaken bookings, and here the place concealed losses were parked.

Short straddle

Selling a call and a put at the same strike: premium now, unbounded loss if the market moves far.

Index arbitrage

Trading the same index future on two exchanges for a small price difference, with little directional risk.

Reconciliation

Checking the firm’s records against the exchange’s and the cash actually paid — the control that was absent.

Operational risk

Loss from failed processes, people or systems, as distinct from market or credit risk.

Where it sits in the course

Case studies like this one are used throughout risk management teaching, including FRM® preparation, as worked examples of operational risk: rogue trading and missing segregation of duties. In OTC Learn the lesson runs in five steps: what happened, the position, why it broke, what it cost and what it teaches, followed by a worked example with the numbers. See the lesson outline.

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The instruments behind it

OTC Learn lessons on the products this case turns on:

• OTC Equity OptionA custom, bilaterally negotiated option
• Execution and ReportingHow a trade gets done, and who has to know about it