Derivative Mishaps and Learnings

Nevertheless, derivative instruments give a lot of options, and flexibility to the businesses. A decision gone right or gone wrong can turn the fortunes of the firms and sometimes the industry. Traders have to be on their toes and, each second counts. Opportunities are unlimited; the returns are high, and a lot is at stake. But all this come, with a warning – “Handle with Care”.

Irrespective of the traditional use of derivatives as instruments for hedging risk, they have been historically used by traders to speculate and gamble in pursuit of windfall gains. 

Traders in lure of big money take positions which are out of their authority and control. The MONEY at stake is sometimes so huge that a derivative decision gone wrong WIPES OUT the complete company and spoils the hard reputation earned by the firm IN SECONDS. 

There are numerous instances of huge losses from derivatives trading but there are a few cases in the derivatives history which stand out. 

Let’s look at some of the biggest derivatives disasters and what we can learn from them.

Barings Bank

One of the biggest and the most infamous derivative disaster was the collapse of the Barings Bank. It took one man – Nick Leeson, to bring about the fall of this 242 year old bank through his equity derivative fiasco.

Nick Leeson was supposed to be exploiting the inter-exchange arbitrage by trading Nikkie 225 futures simultaneously on SIMEX (Singapore International Monetary Exchange) and OSE (Osaka Stock exchange). He was also authorized to trade option and futures for other clients of Barings Bank. This scope of operations did not involve much risk. But instead of simple arbitrage, Leeson started taking substantial unauthorized risk and kept his positions open. He also ventured into taking straddle positions which significantly increased the risk.

Once Leeson started incurring losses, it was a spiral effect and he took even further long positions in futures to offset the previous losses. Unfortunately, Japanese market collapsed because of the earthquake in 23rd January 1995, resulting in loss of around USD 1.4 billion for Barings Bank.

What was surprising is that Leeson was able to hide all this from the management. Leeson, before working as a trader (Barings Securities Singapore), was involved in the back office activities. Later, when he started trading as head trader of BSS, he was also the head of BSS operations. He was, therefore, easily able to misrepresent and fudge the accounts information. Instead of mounting losses, profits were showed to the management which got him huge money as bonus. Management of Barings was clueless about derivatives business and could not see anything fishy in the windfall gains that Leeson was showing.

Learning from Barings Episode

Barings disaster happened predominantly because of improper control and supervision. Audits were not conducted properly and the trader himself was involved in presenting the financials to the management. Improper assessment of risk on the part of Leeson which can be attributed to over optimism or over confidence was a major reason for the fraud. Had management kept proper control and supervision, the damage control could have been possible.

China Aviation Oil (CAO)

CAO was one of the 25 companies in China to enter into overseas energy market. These companies were allowed to trade in futures to hedge the risks due to volatile spot markets. In the company prospectus, company had mentioned to its shareholders that if company’s trading losses exceed USD 5 million, the open positions of the company would be closed unless an exception was authorized from CEO Chen Jiulin.

The company was bearish on the futures prices of oil and started speculating on the oil price in the year 2003, and by March 2004, the short derivative position resulted in USD 5.8 million in losses for CAO. Instead of closing the positions, CAO kept increasing the size of trades in the hope of offsetting the losses already incurred. Later, Chen Jiulin also bought futures contract betting the oil prices to continue to rise. However when he had to deliver on his futures contract, oil prices dropped and again he incurred huge losses. As the losses kept mounting, CAO wasn’t left with enough money to meet the margin calls of the counter parties. In November 2004, CAO announced that it had lost USD 550 million through trading in crude oil swaps, futures and options.

This case also proved to be a case of poor corporate governance. One month before making the derivative losses public, CAO’s parent company China Aviation Oil Holding Company (CAOHC) sold USD 108 million CAO stocks to investors. This money was used to meet the margin call requirements. Chen was charged with 15 counts including fraud and failure to disclose the losses.

Learning from CAO Scandal

The derivative mishap was not due to inherent dangers of instruments but due to ill-conceived and poorly defined strategies. There were a number of rollovers of loss generating positions whereby options on bigger volumes were sold to generate sufficient cash to settle the losses on an existing position. The traders should restrain themselves from doubling down but rather look towards moving out of the existing position in case of losses. Chasing the losses can further compound problems. There should be good corporate governance and risk management in place which was absent in case of CAO. Speculative trading started without being proper risk management policies. There must be well-defined rules in the financial management activities to create accountability. Proper valuation of the open positions is also important as improper valuation leads to erroneous financial statements.

Sumitomo Corporation

Sumitomo Corporation lost around USD 2.6 billion in the copper derivatives. This is a classic case of – ‘He who rides a tiger is afraid to dismount.’ Yasuno Hamanaka the head trader of Sumitomo Corporation manipulated the world copper prices through his operations on the LME (London Metal Exchange) copper futures market over the period of 1991-95. This artificial increase in copper price resulted in increased profits for Sumitomo Corporation from selling copper. Whenever any hedge fund or speculator who was aware of manipulation tried to take short position, Hamanaka invested more money into his positions thus sustaining the high price.

During late 1995, due to increased copper production facilities, particularly in China, copper prices started declining. That was ominous for Sumitomo as they had long positions in the futures market. Hamanaka failed to get rid of his positions. Later when LME started investigating on the alleged manipulation of copper prices Hamanaka was taken off from his position of head trader. This brought the short traders and hedge funds into the act causing the Copper prices to fall further on LME. In September 1996, Sumitomo Corporation showed USD 2.6 billion as the loss on derivative trading which was about 10% of Sumitomo’s annual sales.

This disaster was the result of successful manipulation of the copper prices due to lack of transparency in the reporting positions of large clients at LME. CFTC (Commodities Futures Trading Commission) which regulated US futures market required regular reporting from the large clients on all US exchanges which was not the case with SIB (Securities and Investments Board) which oversees regulation of all London Financial markets. Financial Services Act under which the financial markets of Britain are governed also failed to provide any explicit provisions in case of price manipulation. Thus, it was difficult for the regulators to identify the potential manipulating position.

Learning from Sumitomo Fiasco

Regulators must now be more aware and proactive than ever before as the possibilities to manipulate the markets have become more real with the advent of complex and high-leveraged instruments like derivatives. Prevention here is always better than cure. Companies should also restrain themselves from vesting too much power in a single employee and follow a job rotation policy. By entering into fictitious trades and manipulating accounts, Hamanaka successfully misled the management to believe that he was making huge profits. Sound operational and monitoring system need to be in place to keep track of activities of traders. Successful traders might require more, not less, scrutiny.

Amaranth Advisors

This was the largest hedge fund collapse in history when Amaranth Advisors lost USD 6 billion in natural gas futures. Large part of Amaranth Advisors was in energy trading and the hedge fund was performing well providing consistent return to its investors. Energy desk used to contribute around 30% of the annual returns and energy trading was initially quite conservative in nature.

After Brain Hunter joined the fund, he took large speculative positions by using natural gas futures in the year 2005. It worked as natural gas supplies were disrupted due to hurricanes like Rita and Katrina and natural gas prices went through the roof. This earned Amaranth USD 1 billion profits and Hunter was labelled as a star trader. Hoping for the repeat performance, Hunter again went long on the natural gas contracts leveraging their position 8:1. Hunter had put 50% of the USD 9 billion hedge fund at stake on natural gas. But that year US did not experience any major storm and on the back of increased supplies, the natural gas prices plummeted. This gave a body blow to the hedge fund and the firm shed USD 6 billion in losses.

Learning from Amaranth Debacle

While venturing in instruments and positions with high risk, the firms should go for position sizing. Position of Amaranth in natural gas should have been a small proportion of funds to avoid risk. One single mistake led to the fall of Amaranth. Sound risk management should be in place to tackle unforeseen events. Appropriate hedging strategy is crucial as there is a thin line between a good trading decision and speculation. Leveraging beyond the firms’ values is a huge risk which should never be taken particularly if investing in unpredictable instruments like derivatives. And lastly, each trader is worth the last trade. Often it is seen that traders once reaching the height of glory are given too much of freedom which ultimately leads to the fall of the firm as in this case.

Some Important Learnings for Financial Institutions

a) Define risk limits.

Define the limits to financial risks that can be taken in a clear and unambiguous way. Overall risk limits should be set at board level. These should be converted to limits applicable to the individuals responsible for managing particular tasks. Procedures to be set up for ensuring that the limits are obeyed.

b) Take the risk limits seriously.

It is tempting to ignore violations of risk limits if profit is made. This is short-sighted. Traders who make losses will then increase their bets in the hope that profits would result. The penalties for exceeding risk limits should be just as great when profits result as when losses result.

c) Do not assume that you can outguess the market.

Some traders are possibly better than others. But no trader gets it right all the time. If a trader has an outstanding record, it is likely to be a result of luck rather than superior trading skill.

d) Do not underestimate the benefits of diversification.

The benefits from diversification are huge. It is unlikely that any trader is so good that it is worth foregoing these benefits to speculate on just one or a few market variables.

e) Carry out scenario analysis and stress tests.

These are very important to understand the impact of some worst case scenarios. Pro-active actions can then be taken in time.

f) Monitor traders carefully.

Do subject the high-performing traders the same scrutiny as other traders.

g) Separate the front, middle and back office.

The front office consists of traders who execute trades and takes positions

h) Do not blindly trust models.

Trading and valuation models should be checked and rechecked. Getting too much business of a certain type is as risky as getting too little business of that type. Models also have model risks.

i) Be conservative in recognizing inception profits.

Suppose an instrument has been sold to a client for $10 million more than it is worth. Recognizing this inception profit immediately is dangerous. It encourages traders to use aggressive models, take their bonuses and leave before the model and the valuation are under close scrutiny.

j) Do not sell inappropriate products to clients.

Doing this is short-sighted. At the end FI gets bad publicity and losses.

k) Do not ignore liquidity risk.

Often data (volatility, zero rate etc.) generated from liquid instruments are used to value illiquid instruments resulting in higher valuation. In case of “flight to quality” in the markets, such instruments may suffer large losses.

l) Do not finance long-term assets with short-term liabilities.

Match the maturities of assets and liabilities. Otherwise a significant interest risk will be taken. Savings and loan crisis in 1980s in USA was primarily due to funding long-term mortgages with 3-month deposits.

m) Beware when everyone is following the same trading strategy.

Assess the big picture in financial markets. When many market participants follow essentially the same trading strategy, it creates a dangerous environment liable to big market moves, unstable markets and large losses. In late 1990s, British insurance companies wrote contracts with individuals promising interest on annuity on retirement as greater of the market rate and agreed rate. They hedged part of the risks by buying long-dated swap options with FI, who in turn hedged by buying long-dated sterling bonds. As a result, bond prices rose and sterling interest rates declined. FIs lost money and as long interest rates declined, insurance companies found them in worse situation.

n) Market transparency is important.

One aspect of the sub-prime mortgage crisis of 2007 was that investors traded highly structured products without any real knowledge of the underlying assets. All they knew was the credit rating of the security being traded. With the meltdown, the investors lost confidence in structured products and withdrew from that market. There was a flight to quality and credit spreads increased. With hindsight, wish that the investors knew the asset-backed securities before buying. If the market was transparent, the subsequent impact could have been less severe.

Some Important Learnings for Non-Financial Corporations

a) Make sure that you fully understand the trades you are doing.

Know the trade and its valuation before agreeing to a trade. Do not blame investment bankers after a big loss.

b) Make sure that a hedger does not become a Speculator.

It should be remembered that the goal of a hedging program is to reduce risks, and speculators are required to take risks.

c) Be cautious about making the Treasury department a profit center.

The danger is that the treasurer is motivated to become a speculator.

Conclusion

There are a lot more derivative disasters which we can review, and they all present more or less same picture. One thing that comes out quite clearly is the importance of self-regulation. Often, the traders and firms are lured by greed in search of huge gains. Human greed is perennial; therefore, traders will be lured of big money and risks will be taken. But a proper control system and regulation can prevent such mishaps which rob investors of their hard earned money and cause downfall of firms. Time and again, lessons are not learnt and mistakes are repeated as in the case of Societe Generale scam which was a replay of Barings Bank episode.