A number of highly publicized cases of derivatives-related losses have highlighted the potential dangers in the use of derivatives such as futures and options. Although not all these losses involved the use of currency derivatives, several lessons for risk management can be drawn from these cases, which include the bankruptcies of Orange County and Barings PLC and the huge losses taken at AIG, Merrill Lynch, Kidder Peabody, Sumitomo, Daiwa, Allied Irish Banks, Union Bank of Switzerland, and Citic Pacific. The most important lesson to be learned is that risk management failures have their origins in inadequate systems and controls rather than from any risk inherent in the use of derivatives themselves.7 In every case of large losses, senior management did not fully understand the activities of those taking positions in derivatives and failed to monitor and supervise their activities adequately. Some specific lessons learned include the following.
First, segregate the duties of those trading derivatives from those supposed to monitor them. For example, Nicholas Leeson, the rogue trader who sank Barings, was in charge of trading and also kept his own books. When he took losses, he covered them up and doubled his bets. Similarly, the manager responsible for the profits generated by trading derivatives at UBS also oversaw the risks of his position. No one else at the bank was allowed to examine the risks his department was taking. And a rogue trader at Sumitomo, who lost $1.8 billion, oversaw the accounts that kept track of his dealings. These conflicts of interest are a recipe for disaster.
Second, derivatives positions should be limited to prevent the possibility of catastrophic losses, and they should be marked to market every day to avoid the possibility of losses going unrecognized and being allowed to accumulate. As in the cases of Barings and Sumitomo, traders who can roll over their positions at nonmarket prices tend to make bigger and riskier bets to recoup their losses.
Third, compensation arrangements should be designed to shift more of the risk onto the shoulders of those taking the risks. For example, deferring part of traders’ salaries until their derivatives positions actually pay off would make them more cognizant of the risks they are taking. Fourth, one should pay attention to warning signs. For example, Barings was slow to respond to an audit showing significant discrepancies in Leeson’s accounts. Similarly, Kidder Peabody’s executives ignored a trader who was generating record profits while supposedly engaging in risk-free arbitrage. A related lesson is that there’s no free lunch. Traders and others delivering high profits deserve special scrutiny by independent auditors. The auditors must pay particular attention to the valuation of exotic derivatives—specialized contracts not actively traded. Given the lack of ready market prices for exotics, it is easy for traders to overvalue their positions in exotics without independent oversight. Finally,