Regulation is better than cure

Although it may have exercised his mind while he languishes in a Frankfurt prison, one thing that Nick Leeson probably gave little thought to before February 1995 was the flood of paper which he would unleash from regulators and trade associations on the subject of derivatives regulation.

The Securities and Investments Board (the senior UK regulator) and the Commodity Futures Trading Commission (the US regulatory agency for futures markets) jointly chaired a meeting in May at Windsor attended by derivatives supervisors from 16 countries. They issued a declaration with a view to improving the supervision of futures exchanges.

The Windsor Declaration aims to increase co-operation between market authorities, improve protection of customer positions and assets and reduce the potential for systematic risk in the futures markets.

To achieve these aims the authorities agreed to promote increased surveillance of market exposures and to ensure customer positions can be ring-fenced from proprietary positions. Although some details remain unclear concerning the way in which Leeson ran his trading at Barings in Singapore, one aspect that has demanded attention is the relationship between his trading and that which was attributed to customers. Improvements are needed to ensure exchanges and clearing houses have sufficiently good records of positions, cash and other assets and that they have improved information sharing arrangements and default procedures.

Next off the blocks was the multi-national Task Force Report of the Futures Industry Association (a US-based trade association of futures brokers).

This report has been well received. Its strength lies in a detailed exposition of the responsibilities of each party in the chain of relationships that are found on futures exchanges: customer, broker, clearing member, exchange and clearing house.

The report gives 60 recommendations for participants in each category. Recommendations are focused on internal controls and risk management procedures at each level in the chain and, like the Windsor Declaration, it emphasises the importance of communication.

This is clearly something that can be drawn from the Barings collapse. More effective communication between the Osaka Securities Exchange and Simex in Singapore might have led to a more rapid identification by the two exchanges and regulatory authorities that unusual trading activity was being undertaken by Barings.

Mid-July brought the annual meeting of IOSCO (International Organisation of Securities Commissions) in Paris along with a joint report by IOSCO's technical committee and the Basle committee on banking supervision.

This report aims to provide a framework of information which supervisors can draw on when assessing derivatives activities and exposures. The intention is to improve the standard of cross-border supervision and co-ordination.

The framework can be found in an annex to the report. It presents two categories of information: the first is a comprehensive catalogue of data which can be used by supervisors to design an effective system of supervision; the second is a minimum framework of information that should be derived from the catalogue.

IOSCO and Basle recommend adopting a minimum framework as a basis of supervision of any particular firm. Then, different aspects of the data catalogue can be taken by a regulator to build a flexible but tailored approach to supervision of different firms. The catalogue focuses on the different types of risk that are involved in financial markets: credit risk, liquidity risk, market risk and earnings risk.

The minimum framework also fixes on individual derivatives contracts and suggests efforts for analysing potential credit exposure, duration and credit quality. The report also discusses the principles of supervision, arguing that data is only worth collecting if it is done in a comprehensive way – a way in which risks are identified and the business profile of the firm in question is taken into account. Again the theme is seeking out unauthorised and unusual trading activity and anything which suggests internal controls and management are being undermined. The failure of Barings' management to control Leeson's activities drives these observations.

The US Securities and Exchange Commission made a joint announcement with the UK's SIB at the end of IOSCO to the effect that it had agreed with two international integrated securities houses/investment banks that they would undergo a trial of closer supervision and monitoring by these regulatory authorities with a view to testing information flows within multi-national, multiple entity and multiple business financial institutions.

The collapse of Barings illustrated how many regulatory/supervisory authorities had a piece of the picture but no one had the whole picture.

This could provide some of the most interesting ongoing data and conclusions. The names of the institutions concerned have not been disclosed.

The Board of Banking Supervision's report followed shortly after. This tries to analyse the events leading to the collapse of Barings and why the huge losses sustained by Barings Futures Singapore went undetected until a few days before Barings had to be placed in administration in London. Its significance lies in its status as an official explanation of the collapse of Barings and the points within it which may be reflected in Bank of England supervisory policy for other banks.

The board had difficulties in obtaining access to significant documents and staff of Barings, notably Leeson. As a result, it does not reveal the motivations and knowledge of key individuals or verify trading events. However, the report examines, stage by stage, the role played by each key entity in the collapse of Barings. It is one of the few public documents to contain a description of a latter day investment banking structure; how such a structure is developed from a legal and regulatory perspective and what the internal reporting lines may be. It contains a valuable exposition of the arcane world of futures and options trading and the process of executing trades in an open outcry trading environment as well as the difference between client and proprietary business.

The report offers a detailed account of the supervisory process including comments on the control culture within Barings. The role of the Bank of England and external auditors is also explored.

The board's conclusions are unsurprising. The importance of separating the trading and settlement functions in any securities or derivatives operation is acknowledged. The need for an adequate reporting structure is also recognised in the systems employed by other financial institutions.

Another substantial report on the regulatory principles at stake in the Barings collapse appeared towards the end of July. The Tripartite Group is composed of banking, securities and insurance regulators who see their respective industries converging and the report is a reflection of that fact.

Rumours abound that the judicial inspectors reporting to the Minister of Finance in Singapore are close to producing 6,000 pages. If all of those were to be published, they might make good winter fireside reading in England.

Tim Plews is a partner in the international financial markets group at Clifford Chance.