In 1994, Nick Leeson, a trader in Baring Bank’s Singapore office began trading in derivatives based on index futures. His unauthorized actions were the cause of the collapse of Barings Bank, one of Britain’s oldest financial institutions, founded in 1762.
Mr. Leeson engaged in futures trading with a definitive lack of good judgment, but compounded by a lack of corporate and government oversight. His transactions, valued at around $1.4 Billion were poorly executed and subject to many outside influences, including the earthquake that hit Kobe, Japan in 1995.
The actions taken by Mr. Leeson should have taught government regulators around the world the dangers of derivatives and lack of close monitoring of speculative trading. Unfortunately, it did not and regulatory bodies around the world ignored Mr. Leeson’s lesson, permitting the trading of derivatives, many of them off-balance sheet.
The collapse of Barings Bank should have been a warning of clear and present danger to the financial world. Some regulation was implemented around the world, yet in January 2008, it happened again, with more than $7 Billion in losses at Société Général in France through the misuse of futures contracts.
Derivatives are in a nutshell, gambling. Two parties get together, one offering future delivery of a product, the other in need of that product. The risk is whether the product can be delivered and on-time, and whether the buyer can execute when the product is ready to be delivered. While both parties are at risk, most of the risk is taken by the buyer. Derivatives can therefore be defined by one-sided risk.
They’re traded in all sorts of highly speculative things ranging from economic conditions to weather. Not much different than putting money on a horse.
These speculative investments use leveraging – a future transaction, but are incapable of factoring any outside influences, hence our definition of them as gambling. Realistically, there’s no difference than someone sitting at a Roulette table and putting their money on a particular number – the wheel spins and depending on outside influences (the strength of the turn, the angle of the croupier’s hand, etc) the outcome is simply a win or loss.
Is it wise for the Securities and Exchange Commission to allow these products to be sold? Candidly, we’re not sure. Most derivative contracts are executed without difficulty. However, they do lead to economic bubbles and thus, these products pose a serious risk to the economic welfare of the nation.
If two parties want to get together and make a contract for future delivery of a product or service, that’s their business, however those contracts, in our humble opinion, have no business on Wall Street, nor in the investment houses around the globe.