Asian markets are no stranger to financial scandals. However, in 1995, a scandal broke that may not be history’s largest in monetary terms but arguably is the most infamous. By losing about $1.4 billion, Nick Leeson single-handedly brought about the collapse of the Barings Bank, one of the oldest and largest banks of the United Kingdom.
We can learn a lot from the collapse of Barings Bank. Indeed, before its downfall, Barings Bank was expanding significantly.
At that time, Barings was trying to absorb a recent merger, leaving Leeson without a direct supervisor. Moreover, the bank wanted to expand the Singapore operation, which started in 1987. Next, Leeson had a reputation as a star trader. However, he actually was much more than that. Leeson’s effective role had grown to trader/general manager/back-office manager. Bottom line, he was able to operate with few or no checks and balances.
Leeson’s broad and powerful role should have sent warning signals to management. However, his seniors either did not notice the conflicts of interest or were plain careless. Problems eventually, possibly inevitably, arose as Leeson misused his authority due to greed and hubris. He went so far as to create a fictitious account to cover up his errors instead of arbitraging them out to mitigate risk. Account No. 88888 took a lot of abuse at the hands of Leeson.
Leeson speculated primarily on Nikkei 225 futures and Japanese government bonds (JGB) futures, as well as Nikkei options. All this had dramatic implications for the bank, which had few positions in the markets that Leeson was trading to spread out institutional-wide risk.
Unfortunately for the rogue trader, he continuously lost money. However, he kept increasing his position and by mid-February 1995, he accumulated half the open interest in Nikkei and 85% of the open interest in the JGB. Amazingly, no one noticed his losses.
Stephen J. Brown and Onno W. Steebeck analyzed the markets that Leeson traded, with respect to price and volume patterns. They also studied the daily volume, open interest, opening, closing, and highest and lowest price. Their findings are documented in Doubling: Nick Leeson’s Trading Strategy published in the Pacific-Basin Finance Journal in 2001. Leeson also tells his tale at: www.nickleeson.com. In short, as prices fell, Leeson doubled his position. The rationality was an assumption that the price and volume are correlated (asymmetric relationship). Thus, in the case of a long (short) position, a price fall (rise) would be followed by a significant volume increase, while a price rise (fall) would not. Moreover, a trader following the above strategy would start doubling his position only after the price crosses a certain threshold. The idea is that by doubling you are attempting to exploit some perceived market inefficiency.
Brown and Steebeck analyzed the price, volume and open interest data, plus Leeson’s equity curve. They determined that Leeson’s losses would increase with a falling Nikkei index and rising JGB futures prices. Then, they broke the period before, during and after the scandal into five different intervals and analyzed the numbers relative to Nikkei and JGB futures returns the day before.
1. Base period: July 1, 1994 - Oct. 31, 1994
2. Heavy trading: Nov. 1, 1994 - Jan. 16, 1995
3. Between the Kobe earthquake and Leeson’s departure: Jan. 17, 1995 - Feb. 23, 1995
4. Uncertainty prevails; ING takes over Barings Liabilities: Feb. 24, 1995 - March 10, 1995
5. Stabilization: March 11, 1995 - July 1, 1995
Following the Kobe earthquake, Leeson increased his trading volume considerably. He ramped up his already considerable position in Nikkei futures on the Osaka Securities Exchange (OSE) of 3,000 contracts by six times or more. Although it appeared he had this position offset by an equivalent position on the Singapore International Monetary Exchange (Simex), that was a mirage. In fact, Account 88888 held an equal number of long positions that were not offset.
Market prices reflected Leeson’s shenanigans. The premium of the Simex contract increased with Leeson’s heavy trading and expanded significantly following the earthquake and the acceleration in Leeson’s position size. The lesson we can learn from this story is that markets can be, have been and will be manipulated again.
IN THE WAKE OF DISASTER
If a single trader can bring about such a turn in the markets, what about governments? Due to the official policies of Japan, that country’s economy and stock market have not yet recovered from the real estate and stock market crash of 1989-1990.
One of the key features of the Japanese economy has been artificially low interest rates. Due to this, the carry trade, borrowing of money in Japan and putting the same in U.S. bonds, worked well for a long time. However, if interest rates appear artificially low for some time, then inflation can occur, which if left uncontrolled can lead to stagflation.
Japan has even gone so far as to change how they calculate their consumer price index (CPI). In 2000, the reformulation occurred during disinflation; the goal was to make prices appear more stable. Then in 2005, items with decreasing prices were added while items with increasing prices were removed. The result was to reduce reported inflation numbers by as much as two thirds.
Consider this difference. In May 2006, the reported inflation rate was 0%, while under the old calculation method it would have been a whopping annual rate of 6% or 7.2%. The underlying reason was to remove any evidence for the Bank of Japan from tightening monetary policies. The bank had already begun to drain more than $200 billion worth of yen from the system and was unwinding a five-year policy of 0% overnight-lending rates. So, who benefits from such policies? It’s not necessarily the Japanese people, nor is it domestic Japanese companies. It’s the Japanese companies that sell goods to other countries, such as the Japanese automobile industry.
The wrench in the works for the Japanese, however, is that the U.S. government also reformulated its inflation and unemployment rate calculations in the mid-1990s, which also has resulted in keeping rates lower than they were measured at previously. The recent loosening of the Fed’s monetary policy will counteract Japanese plans to weaken the yen to help out Japanese exporters. However, there are long-term ramifications to the Fed cutting its target federal funds rate, which could result in an economic downturn that might last as long as three years.
There are many other examples of the Japanese government interfering with free markets. There were the plans in February 2002 for the Ministry of Finance to purchase stocks worth Y2 trillion directly from banks and to shore up the value of Nikkei futures by excessive purchases and strict short-selling rules. However, these efforts were restricted to the Nikkei. The broader Topix index was left to market forces.
WAGGING THE DOG
Intermarket analysis is one of the most powerful tools in analyzing and trading the interest rate markets. We’ve shown over the years how this approach can be used in U.S. interest rate markets. It can be just as effective in Japanese interest rate markets, such as JGB futures.
U.S. interest rates have had a strong upward bias since the 1980s. Even so, Japanese 10-year bonds have been even stronger than the U.S. bond. The “JGB vs. treasuries” depicts the movement of the U.S. and Japanese bonds over the years; the upper graph shows the JGB, and the lower one is the U.S. 10-year bond. Analyzing this graph, we can tell that the Japanese bond market did not have a major correction like the U.S. bond market experienced in 1994. The only major correction in the JGB was in 2003. Since then, the JGB has kept its upward bias. Among the major problems in performing intermarket analysis on interest rate markets is this upward bias. Because of this, we can break our analysis into two periods: before June 2003, when the JGB bubble was burst, and after. We shall examine several markets and their relationship to the JGB:
1. U.S. eurodollar futures
2. U.S. 10-year T-notes
4. Euro bund
5. Sterling (three-month Euronext)
6. U.S. CRB index
Intermarket divergence occurs when the markets based on a fundamental relationship do not move in alignment with this fundamental relationship. In developing our intermarket analysis model, we define these two things:
a. An uptrend: Price is above its price moving average
b. A downtrend: Price is below its price moving average
Our intermarket divergence models will fall into two categories: positively correlated markets and negatively correlated markets. For the positively correlated markets, the rules are as follows:
a. If the traded market is in downtrend and the intermarket is in uptrend, then buy the traded market.
b. If the traded market is in uptrend and the intermarket is in downtrend, then sell the traded market.
Regarding the negatively correlated markets, the rules are as follows:
a. If the traded market is in downtrend and intermarket is in downtrend, then sell the traded market.
b. If the traded market is in uptrend and intermarket is in uptrend, then buy the traded market.
We can define the intermarket divergence as a type of arbitrage; wherein if any of the market relationships get too out of line, they must revert. The assumption is that the intermarket is predictive of the traded market. Now, let’s consider the performance.
In the period of the pre-JGB bubble breakup, from Nov. 23, 1990, to June 15, 2003, we found that the U.S. eurodollar futures, euro bund and sterling were the most predictive of the JGB. The JGB had an incredible upward bias during this period, and these three markets produced the only combinations that came even close to being profitable on the short side (see the first table in “Trading the JGB”).
Taking the first parameter as an example, when using eurodollars with a positive intermarket relationship, using a five-period moving average for JGB and a 20-period for eurodollars, we produce $556,265.53 in profits. We also can conclude that during this period, none of the sets of parameters made money on the short side, but with this upward bias, it was amazing that we could account for 75% to 80% of the gains while being exposed to the market half the time.
In the period following the JGB bubble, June 15, 2003, to the present, there were many combinations of intermarket selections and parameters for the moving averages that produced profits both on the long and short side (see the second table in “Trading the JGB”). Because of this, we can draw the conclusion that these markets produced short-term profits and winning percentages on the short side. Moreover, during this period, after the burst of the JGB bubble, the JGB followed other bond markets, which were actually predictive of the JGB.
Asian markets are some of the most unique ones that we have available today. While they offer considerable opportunity, they also can bite you if you aren’t prepared for their idiosyncrasies, which include the prospect of both large trader and government interference. Once you get a handle on these markets, they can provide a wealth of opportunity to exploit.
Murray A. Ruggiero Jr. is a consultant in East Haven, Conn. His firm, Ruggiero Associates, develops market-timing systems. He is vice president of research and development for TradersStudio and author of Cybernetic Trading Strategies (John Wiley & Sons). E-mail him at firstname.lastname@example.org.