THE BARINGS CRISIS : Treasury encouraged free hand

The fact that the actions of a single man can blow one of the City's most respected institutions out of the water will inevitably lead to accusations that the authorities in the UK have badly mishandled derivatives regulation.

In the US, politicians have if anything gone overboard the other way. Successive congressional inquiries into derivatives have concluded that this is an area where an accident is waiting to happen, and tough new supervision has been advocated to avoid it.

In particular, Congress has advocated tough new rules requiring financial institutions to reveal what their exposure to derivatives are in their results announcements.

But in Britain, the authorities, led by the Bank of England and to a lesser degree the Treasury, have insisted that regulation of derivatives is a matter for the market. The use of such instruments is dominated by professional institutions which are well able to calculate the risks they face, goes the Bank's argument. Central to this approach has been a keen awareness that London's success as an international financial centre has relied on its lack of heavy handed over-regulation. Institutions have been able to innovate and trade freely only because the Bank has kept a light hand on the tiller.

Derivatives have been a fantastic success for the City. Liffe, which has pioneered trading in futures and options, has enjoyed ever-spiralling volumes and is second only to Chicago in the world as a recognised market for such products.

So the fear is that to introduce new regulation, or even worse, legislation, would kill the goose that lays the golden eggs.

But with 1991's BCCI debacle still fresh in the memory, the Bank's head of banking supervision, Brian Quinn, will face another bruising confrontation with politicians - not just from Labour - who will want to know how the Barings fiasco could be allowed to happen.

Even more loud will be the suggestions that, if it could happen to Barings, one of the most sophisticated and well run merchant banks in the City, then what chance the myriad other institutions that use derivatives?

Derivatives have been widely touted as the next banking black hole. Just as over-lending to property speculators led to billions of pounds of bad debts in the early 1990s, so derivatives have been seen as creating a potential systemic risk.

The warning signs have been dramatic. In Britain both Allied Lyons and Hammersmith & Fulham Council have come a cropper with derivatives.

Early in 1994, Kasima Oil, a Japanese company, lost $1.5bn in foreign exchange derivative trading. Germany's industrial giant, Metallgesellschaft, lost $1.4bn in oil derivatives, while US consumer products giant Procter & Gamble lost $102m on interest rate contracts.

Just as worrying for the regulators has been the rise of the "hedge fund" as typified by George Soros's Quantum Fund, which exists simply to take massive bets on the market. Mr Soros used derivatives to make $1bn betting that sterling would have to leave the ERM. This has increased volatility in world markets. Another problem is the global nature of modern markets. Who should have regulated the rogue Barings trader? The Bank of England, which regulates the bank itself, the Singapore authorities, where the trading took place, or the Japanese authorities, who are responsible for the Nikkei index?

Some derivatives trading, such as that of futures and options on London's Liffe exchange, occurs in a well regulated market. But the huge growth in over the counter (OTC) derivatives, traded directly between institutions, is at the forefront of regulators' fears. It was OTC trading that caused the Barings disaster.

In February the SIB, the leading City regulator, formed a working party to look at the international dimension of derivatives regulation. Andrew Large, SIB chairman, said that the use of derivatives was more than a passing fad and was "fundamentally changing the nature of our business and with it the shape of regulation."