LONDON — IN December, California's Orange County went belly up. Now, the misuse of derivatives - a risky financial instrument - has claimed another casualty.
This weekend, Barings Brothers & Co., Britain's oldest and most prestigious merchant bank, collapsed after a rogue derivatives trader in Singapore bet and lost an estimated $1 billion - wiping out the bank's total capital. The bankruptcy sent shock waves through global markets yesterday.
In Tokyo, stock prices fell sharply. In London, selling eased by late yesterday as traders put the collapse in perspective. In New York, stocks opened with only slight losses. But the British pound hit a new low against the German mark.
The Barings crisis highlights a much larger problem, say analysts in London's financial district. Derivatives are ``public enemy No. 1,'' in terms of international financial-market stability, one merchant banker says. He calls them ``time bombs waiting to explode.''
Eddie George, governor of the Bank of England, led attempts over the weekend to bail out Barings, which was founded 233 years ago and is used by Queen Elizabeth II. But Mr. George was forced to admit failure late Sunday night.
By that time the bank's losses had spiraled to 700 million British pounds ($1.1 billion). The Tokyo Nikkei index fell 3.8 percent yesterday, adding a further 180 million British pounds to Barings's losses.
In a statement, the Bank of England said several Barings contracts in the Far East were still open, exposing the bank to ``unquantifiable further losses.''
Will Hutton, a London-based financial analyst, stresses the global dimensions of the crisis. ``The Japanese will take a dim view of what has happened, reinforcing their instincts that it was wrong to allow foreign banks into their markets,'' he says.
Until now, the Bank of England has insisted that control of the derivatives market should be minimal. But George and other leading bankers are under pressure to review their stance.
In Britain, the Barings collapse immediately sparked sharp political reaction. Kenneth Clarke, chancellor of the exchequer, on Monday made an emergency statement in the House of Commons. Gordon Brown, his opposition Labour Party ``shadow,'' demanded to know why internal controls at Barings had been ``so lax.''
Barings's troubles began when Nicholas Leeson, a 28-year-old trader in the bank's Singapore office, took what George called ``a long position'' on Japanese equities, hoping they would rise in price. Instead, they fell, and Mr. Leeson somehow concealed the losses from senior management. Leeson then disappeared.
British bankers say Leeson was able to operate out of control because few people fully understand how the derivatives trade works. Essentially derivatives are complex financial instruments that ``derive'' their value from the underlying price of other investments such as commodities, stocks, and bonds. Traders bet that their value will rise or fall.
The special attraction of derivatives comes from the fact that only a small down payment is needed to stand a chance of making huge profits. But derivatives are also considered a valuable tool by many corporations and financial institutions because they can be set up to hedge against securities losses.
The multibillion-dollar global derivatives business began to grow in the late 1980s when stockbrokers were looking for new ways of increasing business, after the world stock-market crash of 1987. Regulating the trade, analysts says, will be difficult.
``You can order controls, but you cannot be sure they will be obeyed,'' says Hugh Pye, banking analyst with Barklays De Zoete. ``In the case of Barings, the trader concerned defrauded his own masters.''
``Short of banning banks' participation in the derivatives markets, it is hard to see how regulations can prevent such losses,'' London's Financial Times said in an editorial. There were limits to regulators' ability ``to protect the system if banks' internal information system is faulty.''