Mr. Quinn is executive director of the Bank of England. The following discussion of the failure of Barings PLC has been condensed from a speech at the Chicago Fed's annual conference on bank structure and competition.
Clearly, derivatives played an important, if not central, role in the Barings collapse. But the question is whether the role was decisive. And there are some important aspects to consider in arriving at an answer.
The collapse came as a result of losses in trading derivatives. That is not in dispute.
The Barings unit in Singapore primarily was an arbitrage trader between the Singapore, Osaka, and Tokyo exchanges, of futures in particular. That was its job. And although the risk-taking involved in that can be very meaningful indeed, Barings' operations in Singapore and Osaka were supposed to be strictly offsetting.
But as we all now know, Barings was running very large open positions in derivatives.
But couldn't that exposure have happened in the cash markets? What's different about derivatives that might lead you to the view that involvement in that category of financial instruments explains why Barings failed?
One thing said about derivatives is that they are more complex than corresponding cash instruments.
But what Barings was doing in Singapore did not involve sophisticated and complex instruments, such as structured notes. Barings was either doing straightforward matching arbitrage or taking positions in straightforward futures.
So I think you can see that the complexity of derivatives is not an explanation of the problems Barings ran into.
The second thing that is said is that derivatives permit you to build an open position with great speed. And that is true.
But if corresponding controls are not in place, (such speed) is also possible in spot markets.
So, to my mind, it is not open and shut that the speed of position- building at Barings was solely a function of derivatives trading. It could possibly have been done using cash instruments.
The third attribute of derivatives which is often mentioned is leverage.
Well, again, many cash markets have leveraged features. I don't profess to know all the details of the Orange County affair, but it appears it was not essentially a derivatives problem. It was a problem more of excessive gearing on more complex instruments.
So leverage is not unique to derivatives. And it did not necessarily provoke what happened at Barings.
A fourth concern is that derivatives are not transparent.
I think there is something to this point, but I think it has limited applicability to Barings. The derivatives products used in that case were exchange-traded (although there could have been disparities between exchanges in regard to the publication of data).
In an exchange-traded system, where there are published data, it is not evident that a lack of transparency could bring about problems of the magnitude we saw at Barings.
So, was Barings a derivatives problem?
Well, clearly the difficulties arose out of derivatives. But, nonetheless, I think it is possible to argue - and I am not definitive about this - that the difficulties also could have arisen in the cash markets.
But I still retain a feeling that the speed with which the open positions were built and the related aspect of leverage, which together created exposures of very considerable magnitude, represented the potential for the emergence of large position-building - not a problem in itself, provided, of course, controls are in place to manage it.
That, of course, poses the question of whether it wasn't so much derivatives as it was a matter of controls. And the answer to that, I hope, will be found as we complete the official investigation.
