Leeson ostensibly was doing arbitrage trading, focusing on differences in prices of Nikkei 225 futures contracts listed on the Osaka Securities Exchange (OSE) in Japan and the Singapore Monetary Exchange (SIMEX). He bought futures on one market and simultaneously sold them on the other. This was a low-riskstrategy , since the two positions offset.
Its success led Leeson to another move, a straddle where he simultaneously sold put options and call options on Nikkei 225 futures. This was a medium-riskstrategy , very effective in stable markets but dangerous in volatile ones.
An earthquake that rocked Kobe, Japan, in January 1995 plunged the Nikkei and terrorized Leeson. As the market roiled, Leeson acted like a heroin addict and adopted the high-risk strategy of buying more Nikkei futures in the vain hope of propping up the fallen market. When the dust settled, Barings’s exposure on the futures contracts ran to a staggering $1 billion, far in excess of Barings’s total capital. The bankfell to its knees. Investigators discovered that Leeson’s positions had been covered by Baring’s margin accounts while he was trading, but after the crash—and after Leeson fled Singapore for Germany—they were not.
During his trading, Leeson told Barings’s main branch in London the plausible story that he was hedging his long futures positions with private contracts and was also making hedged trades on behalf of a client of the bank. In fact, the client did not exist but was a fictitious name given to an account that Leeson invented earlier for his own use.
Leeson allegedly funded that account with proceeds from other trades and used those funds to maintain the margin account balance. He apparently used the fictitious client account to convince Barings in London to provide additional firm capital, which Lesson in turn used to shore up the margin account. In the end, none of that was enough.
The Leeson lesson is admittedly an extreme psychological case tripped up in a mix of exotic securities, excess margins, and fraud. But the drama is a memorable warning that margins and exotica can get you in over your head and that mixing them can get it handed to you on a platter.
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