Move over, Gordon Gekko. The ruthless cinematic protagonist in "Wall Street" may have met his match in Nicholas William Leeson, a real-life trader in Singapore who appears to have brought down the venerable British investment house of Barings PLC. The 233-year-old firm filed for bankruptcy after Leeson, now reported missing, blew about $1 billion in volatile, Computer-Age financial instruments known as derivatives.
The British affair, not unlike Orange County's derivative-linked bankruptcy, raises major questions about accountability and oversight related to these arcane transactions. Derivatives are financial contracts that derive their value from another asset, such as stocks. They involve using "swaps" or futures to diminish risk. Risk can never be eliminated because derivatives involve a gamble on things like the direction of the market or interest rates.
Savvy investors throughout the world understand this; perhaps that's why the financial markets, in general, didn't overreact to the bad news. For Barings, the first big question focuses on oversight within the company. How and why was it so obviously caught off guard? Where were the checks and balances that should have prevented Leeson, 28, from trading such huge blocks of Japanese stock index futures contracts? After all, he was making high-risk bets on where the market index would stand at specified dates. And he lost. Big.
The Barings trading reportedly had caught the attention of some Japanese institutional investors, who could not understand the aggressive activity. But back at Barings in London, there was little anxiety--until last Thursday. The other question arising from the affair concerns the basic nature of derivatives: friend or foe? These financial instruments, when used prudently, can serve a useful purpose in high finance. But regulators and management need to require stricter disclosure and transparency (i.e., public visibility and accessibility) so that everyone understands the dimension and nature of the risks involved in derivatives.