Keywords Finance

To date, no derivative disasters of that magnitude have been reported in Canada, where financial institutions and investors have been more conservative about using the volatile financial instruments. Two major Canadian banks, however - the Royal Bank of Canada and the Canadian Imperial Bank of Commerce - are now building large derivative trading operations in New York City so that they can provide a broader range of financial products to their corporate clients. The banks insist that they will handle derivative trading with care because of the risks involved. "Derivatives are like chainsaws," explained Charles Taylor, executive director of the Group of 30, an independent financial think-tank in Washington. "They are immensely useful, but one should read the instructions first."

As the saga of Barings' collapse unfolded last week, it became apparent that executives of Britain's oldest merchant bank had failed to manage the risks. And yet, Barings was no newcomer to the complexities of international markets, where it has been active since its founding by Francis Baring in 1762. Indeed, in 1890 it came close to folding when big investments in Argentina soured. That time, the British government helped bail out the blue-blood company. This time, however, the scale of the losses - which will not be known precisely until the derivative contracts expire later this month - was far too great. Leeson himself was presumably aware of the enormity of his losses when he disappeared from his $9,000-a-month-condominium in Singapore with his 23-year-old wife on Feb. 23, leaving newspapers filled with his exploits to pile up on his doorstep. The couple spent several days at a luxury resort in Malaysia before paying cash for airplane tickets to Germany. When he was apprehended in Frankfurt on March 3, Leeson told authorities he was on his way to London.

By the end of last week, Singaporean authorities had asked the German court to extradite Leeson back to Singapore so that he could face a charge of forging a $113-million bank receipt. Leeson's lawyer said that his client preferred to return to London. Singapore has a reputation for tough laws and even harsher penalties, including flogging, for many offences, although not white-collar ones. In London, the Sun tabloid reported that Leeson had told a friend that his trading had been approved by his bosses. "Senior Barings workers knew what I was doing and they approved it," Leeson is reported to have said.

Leeson had come a long way from Watford, the working-class London suburb in which he was raised. Last week, reporters swarmed around the home of his father, Harry, a plasterer who had gone to stay with relatives in the north of England. Further emphasizing the trader's working-class background, the papers reported that his father's backyard was littered with cooking pans and gasoline cans.

The British media also focused on Leeson's limited education. Although he was smart enough to have been chosen to attend Parmiter's grammar school, he did not go on to university. Parmiter's school was founded by an 18th-century silk merchant to provide education to exceptional boys who lacked the money to attend Britain's elite public schools. John Crow, former governor of the Bank of Canada, attended Parmiter's 30 years before Leeson. But unlike Crow, who went on to Oxford University, Leeson failed his final math exams and took a job as a junior clerk at Coutts & Co., a private bank. He went on to work at investment dealer Morgan Stanley until he married. He then moved to Barings, where his wife also worked.

It was an unlikely background for a derivatives trader. Because of the complex and varied nature of the financial instruments, most traders hone their skills on less complicated instruments for several years before venturing into derivatives. Derivatives are complex - and, under some conditions, highly risky - tools whose value is derived from such ordinary investments as stocks, bonds and currencies. Although derivatives have been at the centre of a growing list of financial disasters, they were originally invented to reduce risk in financial markets.

Indeed, when used for hedging rather than speculation, derivatives do offer a kind of insurance. In the simplest example, an investor buys a share for $10 and at the same time buys a $1 option entitling him to sell that share for $10. By buying both share and option, the investor eliminates the risk of a loss if the share price falls, while ensuring a profit if the price rises above $11.

A far riskier strategy is to purchase the derivative on its own, without the underlying share. If the investor had spent the $10 buying 10 options to sell the shares in the future at $10 each, and the market price of the shares falls in the meantime to $5, his options would be worth $50 - $40 more than he paid. That is a 400-per-cent return, compared with the 50 per cent he would have pocketed had he bought one share for $10 and the price rose by $5. It is this so-called leverage that makes derivatives so enticing to speculators.

The details of Leeson's trading strategy, which resulted in his purchase of millions of dollars' worth of futures on the Tokyo stock and bond markets, were still not clear last week. But it appears that he had bought derivatives that would make money only if Japan's Nikkei stock index rose and if Japanese and European interest rates rose. In fact, Leeson may even have considered those positions to be hedged because stock prices usually rise when interest rates fall and vice versa. (In other words, the Japanese stock market will usually not gain when Japanese interest rates are rising.) Leeson's initial trading strategy, however, may have been thrown off by the Kobe earthquake in Japan on Jan. 17, which caused enormous turmoil in the country's financial markets.

Eddie George, governor of the Bank of England and Barings' chief regulator, quickly blamed Leeson - not the growing popularity of derivatives - for the debacle. "We need to be very careful in drawing conclusions from this episode," George told reporters in London last week. "This was a failure to control a rogue dealer." For his part, Peter Baring, chairman of the family-owned bank, accused Leeson of deliberately sabotaging the bank.

By week's end, however, there was growing evidence that Leeson's bosses had known about his trading practices and should have understood the risks. Indeed, concern about the activities of the firm's Singapore office dates back at least to 1992. In March of that year, a Barings director wrote a memo in which he warned that the company was "in danger of setting up a structure which will subsequently prove disastrous." And in August, 1994, according to an investigation by the Singapore International Monetary Exchange (SIMEX), an internal audit of the Singapore office warned that Leeson had "excessive" power. Yet as recently as Feb. 8, company executives assured SIMEX that they were in full control.

The direct effect of the Barings debacle on Canada is modest. Both Canada's chief bank regulator, John Palmer, and Ed Waitzer, chairman of the influential Ontario Securities Commission, say that they expect losses in Canada to be "insignificant." "But," Palmer added, "it will add to the general concern about derivative products and everyone will look even harder at their internal controls." Waitzer said that it will also encourage the development of international regulations for derivative trading. He says that the draft regulations, which have been in the works for more than a year, call for more and better disclosure of an institution's derivative trading to regulators and shareholders. "Barings and the rest of the problems we've had in the past year," said Waitzer, "just point out the need for these regulations."

In fact, just a week before the Barings collapse, the Royal Bank of Canada and its securities dealer, RBC Dominion Securities, announced that they had hired 25 derivative traders who previously worked for now-defunct Kidder Peabody in New York. Taylor says that RBC Dominion's goal is to expand its product line to better compete for U.S. corporate business. One bank insider noted that the staggering collapse of Barings has not altered the institution's view about derivatives, although "it may mean that we're going to have to get an extra signature on every piece of paper around here."

Leeson, for his part, was both a trader and the trading supervisor in the Singapore office. He also supervised the back office - where his wife worked - which processes and monitors all trading positions. That overlap may have helped him hide his trading gamble from Barings senior managers. Said John Hunkin, president of CIBC Wood Gundy: "When we have all the facts, I don't think the Barings story is going to be about a derivatives' failure, it's going to be about a supervisory failure."

Of course, most derivative users say that they are prudent and cautious. And yet, derivative disasters keep occurring because someone does something that is either not understood or approved by his superiors. At Kidder Peabody, for example, unfamiliarity with the kind of trading that was being done appears to have spread through several layers of management, extending even to the top of the parent company, General Electric Co. In March, 1994, Fortune magazine quoted ge chairman Jack Welch saying that derivatives were a business that "we have chosen to miss" because they lead to excesses and surprises. Just one month later, Kidder Peabody recorded a still-undisclosed loss of as much as $500 million from derivatives trading. Still, as the derivative casualties mount, observers are recognizing that, in the words of one Bay Street saying, "derivatives don't kill, people kill." In the case of Barings, senior managers apparently passed a loaded gun to Leeson - who then pulled the trigger.

Maclean's March 13, 1995

Author BRENDA DALGLISH with BRUCE WALLACE in London