An accident waiting to happen?

In May last year, a powerful group of US congressional leaders and officials warned that inadequate regulation of rapidly growing derivatives markets posed a severe threat to the US and international financial systems. Failure or withdrawal by any of the big players "could undermine stability in several markets simultaneously, which could lead to a chain of market withdrawals, possible firm failures, and a systemic crisis".

It remains to be seen if the Barings collapse provides the trigger for the financial Armageddon that Congress foresaw. Even by City standards, Barings is a relatively small player. On a world scale it is tiny. None the less, as many seasoned City observers were saying yesterday, the knock- on effects of what appears to have been a rogue trader off on a jolly of his own could be horrendous.

On the face of it, the losses so far incurred betting against Tokyo's index of leading shares, the Nikkei, are still manageable - £600m as of last night. The sale or liquidation of Barings should be capable of covering them.

The problem is that the positions entered into by the Barings trader are "open ended". The army of investigators now crawling over the bank's books in the Far East warn that they will be difficult and complicated to close; if markets continue to move in the wrong direction, the losses would become multiplied. A few hundred million could be transformed very quickly into a couple of billion.

Without at least a temporary lifeboat - a consortium of City players prepared to guarantee the losses - the effect could be calamitous. Sniffing blood, the markets would bet heavily against the merchant bank's positions. Others would be drawn rapidly into the crossfire and the City's credibility would crumble. The position would snowball as financial institutions across the globe tried to limit their losses.

The chances of this actually happening are probably exaggerated. Even so there is no disguising the urgency of the need to find a support package. Barings is these days a small bank by international standards, but its history and tradition give the collapse a deeper and more symbolic significance. Coming so soon after the extraordinary about turn in the fortunes of the SG Warburg Group, the impression is of the British financial establishment degenerating into a state of chaos. The two calamities, though entirely unrelated, appear to expose common faults in management control, leadership, structure and competitiveness which may be symptomatic of a longer term decline in Britain's once-dominant position in merchant banking and securities trading.

Moreover, City regulators, including the Bank of England, have been notably relaxed, even complacent, in their approach to the explosive growth of derivative markets. In contrast to the more aggressively concerned attitude of some American, Far Eastern and Continental regulators, the Bank of England has tended to dismiss the warnings as exaggerated and wild. So worried are the authorities in Tokyo about derivative trading that they do not allow it. By contrast, the Bank Of England has been happy to allow derivative traders in London a largely uninterrupted ride. Its laid back approach to the problem may be coming home to roost.

Hardly a week goes by without another expensive accident in derivative trading, but so far most have survived; Barings looks like becoming the first significant financial institution to be wiped out by it.

The casualties are now legion - Kashima Oil in Japan and Metallgesellchaft in Germany being the two most notable. Between them they managed to lose $3bn in foreign exchange and oil derivative trading. More recently, Orange County, a Californian local authority, has also had to bear huge derivative losses as a result of the over-enthusiastic activities of some of its officials. Small wonder, therefore, that many US congressmen believe these largely unregulated and unsupervised markets have the capacity to become another Savings and Loans disaster - a series of financial collapses that cost the US taxpayer hundreds of billions of dollars in compensation.

Are they right to be so concerned? And was the Barings episode just an accident waiting to happen - one which with firm and early action by regulators could have been avoided?

The term "derivatives" applies to a huge range of trading instruments such as swaps, options and futures which derive their value from underlying financial assets such as bonds, currencies, shares and commodities. They have always been with us, but the explosive growth of these instruments has been a recent phenomenon. The amount of money being hedged, rehedged and then hedged again, in a seemingly never ending spiral of computer- driven transactions, has gone almost beyond comprehension. In 1992, the foreign exchange options market alone was valued at $5,000bn. In many markets, the amount of derivative activity now regularly outstrips by a very large margin that of the underlying physical assets. The impression is of markets running out of control, unfettered and ill-disciplined in their dash for growth.

If there is a purpose and justification for these developments, it is that derivatives allow international companies and organisations to hedge against movements in markets. In other words, the purpose is to reduce risk, not increase it. A derivative market, defenders claim, is no different from any other market. For every company or portfolio manager that wants to get rid of a risk, there is another with a different set of trading priorities that wants to take it on. In theory, then, these markets are comparatively safe, or at least as safe as the markets they piggy back on.

That's what exponents say, anyway. The truth is rather different. A great deal of derivative activity is "over the counter". As such it is not exposed to the disciplines, controls and demands of traditional regulators. Furthermore, few senior executives in the banks so keen to promote these instruments fully understand the nature of the trades and consequent risk they are taking on.

While the margins to be made out of this sort of business remain high, they seem happy to allow their technicians to run the show. As the profit on more traditional banking and securities trading has declined, derivatives have provided an alluring and lucrative alternative. Attempts by regulators to bring the new markets to heel have been strongly resisted. Derivative trading remains largely opaque and free from regulatory interference.Two factors in particular have significantly increased the chances of risk becoming unduly concentrated in one player or group of them. The first is the growth of proprietary trading - trading on their own account - by the big investment and commercial banks. The second is the tendency among the major global corporations to see their treasury departments as profit centres contributing a substantial proportion of the companies' earnings. The effect has been significantly to increase the amount of essentially speculative trading that takes place.

Add to that the bonus-driven pay structure of many financial institutions and the temptation to stray becomes, in some cases, overpowering. Even among institutions where the requisite internal checks and controls exist, the incentive to step outside accepted boundaries is a potent one.

Barings may be just such a case; like Joseph Jett, the Kidder Peabody hotshot who under the nose of auditors and traders managed to create millions of dollars in fictitious derivative profits to boost his bonus, what has occurred at Barings may be no more significant than a failure of management. If an institution's own controls cannot prevent an abuse of this kind, what hope does a regulator have, particularly when it occurs outside the jurisdiction, the Bank of England might claim.

Part of the function of banking supervisors and regulators, however, is to limit the risk of such failure. In Barings' case, the inadequacy has proved fatal. It is to be hoped that the potential for wider cost to the City and world financial markets is containable. Like all bad accidents, however, a more vigorous approach at an earlier stage might have prevented the calamity in the first place.