The Role of the Regulators in the Collapse of Barings

The failure of Barings Brothers occurred because Mr Nicholas W. Leeson conducted trading which at one point extended Barings' positions on Nikkei 225 futures contracts to a total nominal value of £27bn. When Mr Leeson's strategy proved wrong Barings was unable to support these positions and collapsed. Mr Leeson's authorised activity was arbitrage. He was supposed to exploit marginal differences between the prices of stocks and bonds on the Tokyo and Osaka markets by simultaneously buying on one exchange and selling on the other. The arbitrage carried out by Mr Leeson was largely on futures contracts for the Nikkei index of the 225 leading stocks in the Tokyo Market. Apparently Mr Leeson abandoned his authorised activity of arbitrage, which is a low risk form of trading, towards the end of January and starting taking part in transactions known as straddles. A straddle is effectively a bet that a market will not rise or fall outside a certain range. Mr Leeson bet that Nikkei prices would remain within the 18,500–19,500 range and sold an equal number of ‘puts’ and ‘calls’. A seller of calls is speculating that the market will fall, while a seller of puts is speculating that the market will rise; if the market rises sharply the seller loses money on the calls, if the market falls sharply, as it did in Mr Leeson's case, the seller loses money on the puts. A straddle is only profitable if market prices remain within a specified narrow range.