Handle with care – Largest Derivative Disasters
Posted on: July 27, 2009
Derivative markets
Derivatives are often referred to as financial instruments of mass destruction. After all the bad publicity of derivative losses and companies going bankrupt a negative perception has been formed that perhaps make derivatives untouchable for some of us. But is it not equivalent to thinking that nuclear energy is bad because nuclear bombs in Japan had caused unimaginable destruction or saying that Chernobyl tragedy occurred due to harmful effects of nuclear radiations? Derivatives undoubtedly are risky but the recent events occurred because of the greed, over optimism of financial institutions and lack of precautions. We all know that counter to the perceived notion of derivatives being risky; they are ideally used for hedging and acts as insurance against future uncertainty.
Ideally it would not be prudent to expect profits and losses from derivatives. Derivatives as instruments were not created keeping profit and losses in mind. They are used as a risk transfer techniques and can be viewed as insurance which any one of us can sell in the economy. The investor here by investing in derivatives tries to merely protect himself against the unexpected changes in the prices of the underlying commodity. But still we see a loss in derivatives to a financial decision gone horribly wrong and attribute the gain in derivatives to the efficiency of firm. A conversation below can explain this situation correctly –
CEO – Mr X. this year we have lost USD 10 million in currency forwards. How do you explain that?
Mr X – Sir it is because of the fall in our currency rate that we have lost this money
CEO – But how do I explain this to our shareholder who are asking for justification on investing in derivatives
Mr X – But derivatives are never supposed to be for earning profits they are just instruments for hedging risk. You would not have said this if we would have instead earned USD 10 million through derivatives.
CEO – I don’t understand all this. Sorry Mr X. you are fired for misappropriation of funds.
Irrespective of the inherent use of derivatives 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 firms in seconds. There are numerous instances of huge losses from derivatives trading but there are few cases in the derivatives history which stand out. Let’s look at some of the biggest derivatives disasters and learning we can gain from them.
Barings Bank
One of the biggest and the most infamous derivative disaster was the Barings Bank collapse. French Foreign Minister, Duc de Richelieu in 1818 had said: “There are six great powers in Europe: England, France, Prussia, Austria, Russia and Baring Brothers.” It took one man – Nick Leeson, whose equity derivative fiasco brought about the fall of one of this 242 year old bank.
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 in Barings. This scope of operations did not involve much risk. But instead of simple arbitrations Leeson started taking substantial unauthorized risk and kept his positions open. He also ventured into short straddeling which significantly increased the risk. Once Leeson started incurring losses it was a spiral effect and he took even further long positions 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 in BSS (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 forge the accounts information. Instead of mounting losses, profits were showed to the management which got him huge money as bonuses. 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 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 would have been possible.
China Aviation Oil
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 future prices of the 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 presented the case 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 inherent dangers of instruments but due to ill conceived and poorly defined strategies. There were 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 restraint 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 properly encapsulated in 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 2.5 billion in the copper derivatives. This is a classic case of – ‘Running on the top of tiger not knowing how to get off without being eaten.’ 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 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 the figure of USD 2.6 billion as the loss on derivatives 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 client 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 practical with the advent of complex and high leveraged instruments like derivatives. Prevention here is always better than prosecution. Companies should also restrain themselves from vesting too much power on 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 labeled as star trader. Hoping for the repeat performance Hunter again took 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 supplier 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 asset to avoid risk. One single mistake led to the fall of Amaranth. Sound risks management should be in place to tackle the 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.
There are a lot more derivative disasters which we can review and they all present more or less same learning. But 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 causes 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.
Nevertheless derivative instruments give lot of options, 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”.
(This article got the Article of the Month recognition at IIM Shillong monthly financial magazine Niveshak – http://www.iims-niveshak.com/)
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