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Derivative Case Study
Derivatives Debacles
Case Studies of Large Losses in Derivatives Markets
Anatoli Kuprianov

To avoid all mistakes in the conduct of great enterprises is beyond man’s powers. Plutarch, Lives: Fabius.

ecent years have witnessed numerous accounts of derivatives-related losses on the part of established and reputable firms. These episodes have precipitated concern, and even alarm, over the recent rapid growth of derivatives markets and the dangers posed by the widespread use of such instruments. What lessons do these events hold for policymakers? Do they indicate the need for stricter government supervision of derivatives markets, or for new laws and regulations to limit the use of these instruments? A better understanding of the events surrounding recent derivatives debacles can help to answer such questions. This article presents accounts of two of the costliest and most highly publicized derivatives-related losses to date. The episodes examined involve the firms of Metallgesellschaft AG and Barings PLC. Each account begins with a review of the events leading to the derivatives-related loss in question, followed by an analysis of the factors responsible for the debacle. Both incidents raise a number of public policy questions: Can government intervention stop such incidents from happening again? Is it appropriate for the government even to try? And if so, what reforms are indicated? These issues are addressed at the end of each case study, where the lessons and public policy concerns highlighted by each episode are discussed.
Alex Mendoza assisted in the preparation of this article. Ned Prescott, John Walter, and John Weinberg provided valuable comments on earlier drafts. Any remaining errors or omissions are the responsibility of the author. The views expressed are those of the author and do not necessarily represent those of the Federal Reserve Bank of Richmond or the Federal Reserve System.

R

Federal Reserve Bank of Richmond Economic Quarterly Volume



References: BNA’s Banking Report. “Schapiro Defends CFTC Action against Two MG Subsidiaries,” vol. 65 (September 25, 1995a), p. 503. . “IOSCO Endorses Value-at-Risk Models for Capital Adequacy Calculations,” vol. 65 (July 17, 1995b), pp. 120–21. . “Schapiro Says CFTC, Industry to Craft Customer Protection Proposals,” vol. 65 (July 3, 1995c), pp. 15–16. A. Kuprianov: Derivatives Debacles 37 . “World Futures Regulators Adopt Plan of Action in View of Barings,” vol. 64 (May 22, 1995d), pp. 1017–18. . “CFTC Undertaking Regulatory Review: Schapiro Address[es] Failure of Barings PLC,” vol. 64 (March 6, 1995e), pp. 469–70. . “CFTC Chairman Schapiro Tells Congress Barings-Type Disaster Unlikely in U.S.,” vol. 64 (March 6, 1995f), pp. 468–69. Board of Banking Supervision. Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings. London: HMSO, 1995. Culp, Christopher L., and Steve H. Hanke. “Derivative Dingbats,” The International Economy (July/August 1994). Culp, Christopher L., and Merton H. Miller. “Basis Risk and Hedging Strategies: Reply to Mello and Parsons,” Derivatives Quarterly, vol. 1 (Summer 1995a), pp. 20–26. . “Hedging in the Theory of Corporate Finance: A Reply to Our Critics,” Journal of Applied Corporate Finance, vol. 8 (Spring 1995b), pp. 121–27. . “Auditing the Auditors,” Risk, vol. 8 (April 1995c), pp. 36–39. . “Metallgesellschaft and the Economics of Synthetic Storage,” Journal of Applied Corporate Finance, vol. 7 (Winter 1995d), pp. 62–76. . “Letter to the Editor,” Risk, vol. 11 (November 1994a), p. 18. . “Hedging a Flow of Commodity Deliveries with Futures: Lessons from Metallgesellschaft,” Derivatives Quarterly, vol. 1 (Fall 1994b), pp. 7–15. The Economist. “The Barings Collapse: Spot the Smoking Receivable,” October 21, 1995, p. 79. . “Revolution at Metallgesellschaft,” December 25, 1993, p. 90. Edwards, Franklin R. “Derivatives Can Be Hazardous to Your Health: The Case of Metallgesellschaft,” Derivatives Quarterly, vol. 1 (Spring 1995), pp. 8–17. , and Michael S. Canter. “The Collapse of Metallgesellschaft: Unhedgeable Risks, Poor Hedging Strategy, or Just Bad Luck?” The Journal of Futures Markets, vol. 15 (May 1995a), pp. 211–64. . “The Collapse of Metallgesellschaft: Unhedgeable Risks, Poor Hedging Strategy, or Just Bad Luck?” Journal of Applied Corporate Finance, vol. 8 (Spring 1995b), pp. 86–105. Falloon, William. “Who’s Missing from the Picture?” Risk, vol. 8 (April 1995), pp. 19–22. Fox, Justin. “2 in House Fault Futures Trading Panel on Over-the-Counter Derivatives Ruling,” American Banker, December 26, 1995. 38 Federal Reserve Bank of Richmond Economic Quarterly Futures Industry Association Global Task Force on Financial Integrity. Financial Integrity Recommendations. Washington: Futures Industry Association, 1995. Global Derivatives Study Group. Derivatives: Practices and Principles. Washington: Group of Thirty, 1993. Irving, Richard. “Beyond Barings,” Risk, vol. 8 (April 1995), p. 6. Kawaller, Ira. “Hedging with Futures Contracts: Going the Extra Mile,” Journal of Cash Management, vol. 6 (July/August 1986), pp. 34–36. Mark, Jeremy. “With Leeson in Singapore Prison, Focus Shifts to Barings Executives,” The Wall Street Journal, December 4, 1995. McGee, Suzanne. “Nineteen U.S. Exchanges To Share Data on Dealings,” The Wall Street Journal, September 6, 1995a. . “New U.S. Futures Chief Is Crafting a Global Role,” The Wall Street Journal, May 17, 1995b. . “Reform Sought to Prevent Future Barings,” The Wall Street Journal, March 17, 1995c. Mello, Antonio S., and John E. Parsons. “Hedging a Flow of Commodity Deliveries with Futures: Problems with a Rolling Stack,” Derivatives Quarterly, vol. 1 (Summer 1995a), pp. 16–19. . “Maturity Structure of a Hedge Matters: Lessons from the Metallgesellschaft Debacle,” Journal of Applied Corporate Finance, vol. 8 (Spring 1995b), pp. 106–20. Miller, Merton H., and Christopher L. Culp. “Rein in the CFTC,” The Wall Street Journal, August 17, 1995. Rance, Brian D. “The Commodity Futures Trading Commission Order of Settlement with MG Refining and Marketing, Inc. and MF Futures, Inc.,” Derivatives Quarterly, vol. 2 (Winter 1995), pp. 13–17. Roth, Terrence. “German Firm’s Bailout Package Gets Approved,” The Wall Street Journal, January 17, 1994a. . “Metallgesellschaft Sets Shareholder Vote Despite Worries over Financial Package,” The Wall Street Journal, January 14, 1994b. Sapsford, Jathon, Michael R. Sesit, and Timothy L. O’Brien. “How Daiwa Bond Man in New York Cost Bank $1.1 Billion in Losses,” The Wall Street Journal, September 27, 1995. Springett, Pauline. “The Barings Rescue: ‘Apologies, but the pressures have become too much to bear,’ ” The Guardian (London), March 7, 1995. Stoll, Hans R. “Lost Barings: A Tale in Three Parts Concluding with a Lesson,” The Journal of Derivatives, vol. 3 (Fall 1995), pp. 109–15. Szala, Ginger, David Nusbaum, and Jack Reerink. “Barings Abyss,” Futures, vol. 24 (May 1995), pp. 68–74. A. Kuprianov: Derivatives Debacles 39 Taylor, Jeffrey. “Securities Firms Agree to Set Controls on Derivatives,” The Wall Street Journal, March 9, 1995a. . “Documents at MG Appear to Contradict Fired Chairman’s Stance on Derivatives,” The Wall Street Journal, January 27, 1995b. . “MG Corp. Aims to Stay Active in Oil Business,” The Wall Street Journal, March 14, 1994. U.S. Commodity Futures Trading Commission. “Order Instituting Proceedings Pursuant to Sections 6(c) and 8(a) of the Commodity Exchange Act and Findings and Order Imposing Remedial Sanctions,” CFTC Docket No. 95-14 (1995a). . “CFTC Order Imposes $2.25 Million Civil Penalty against MG Refining and Marketing, Inc. and MG Futures, Inc.; Other Remedial Sanctions Include Review of Internal Control Systems for Risk Management,” Release No. 3859-95 (July 27, 1995b). U.S. General Accounting Office. Financial Derivatives: Actions Needed to Protect the Financial System. GAO/GCD-94-133, May 1994. The Wall Street Journal. “Former CFTC Chief Scores Agency’s Move in Derivatives Case,” December 1, 1995. . “Metallgesellschaft A.G. Dismisses Chairman and Finance Chief,” December 20, 1993.

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