How Leeson Broke Barings part 3
The BoBS report notes "In each instance, the entries in the Contac system reflected a number
of spurious contract amounts at prices different to those transacted on the floor,
reconciling to the total lot size originally traded. This had the effect of giving
the impression from a review of the reported trades in account '92000&' that these had taken place at different times during the day. This was necessary to deceive Barings Securities Japan into believing the reported profitability in account '92000' was a result of authorised arbitrage activity. The effect of this manipulation was to inflate reported profits in account '92000&' at the expense of account '88888', which was also incurring substantial losses from the unauthorised trading positions taken by Leeson. In addition to crossing trades on SIMEX between account '88888&' and the switching accounts, Leeson also entered fictitious trades between these accounts which were never crossed on the floor of the Exchange. The effect of these [off-market trades, which were not permitted by SIMEX], was again to credit the 'switching' accounts with profits whilst charging account '88888' with losses."
The bottom line of all these cross-trades was that Barings was counterparty to many of its own trades. Leeson bought from one hand and sold to the other, and in so doing did not lay off any of the firm's market risk. Barings was thus not arbitraging between SIMEX and the Japanese exchanges but taking open (and very substantial) positions, which were buried in account '88888'. It was the profit and loss statement of this account which correctly represented the revenue earned (or not earned) by Leeson. Details of this account were never transmitted to the treasury or risk control offices in London, an omission which ultimately had catastrophic consequences for Barings shareholders and bondholders.
Figure 10.32, below, shows the number of cross-trades executed by Leeson. It is the difference between the solid line which represents all the Nikkei trades of account '92000' not crossed into account '88888' and the broken line which reflects the position Leeson reported to Barings management. The figure graphically illustrates the chasm between reported and actual positions. For example, Barings management thought the firm had a 'short' position of 30,112 contracts on SIMEX on 24 February; in fact it was long 21,928 contracts after ignoring the trades crossed with account '88888'.
Figure 10.3 Graph to show the Nikkei Position of Account '92000'. Reproduced by permission from the Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings.
Footnotes:
1, 2) Report of the Banking Supervision Inquiry into the Circumstances of the Collapse of Barings, Ordered by the House of Commons, July 1995, Her Majesty's Stationery Office, London