Core Path · L1.7.12

Derivatives disasters and their lessons

14 minDerivativesRisk managementHistory

By the end you will be able to

  1. 1Draw the risk management lessons from Metallgesellschaft, Barings and AIG.
  2. 2Explain how a hedge can be sound in value yet fail for lack of cash.
  3. 3Identify the control failures (segregation of duties, limits, oversight) behind a rogue-trading loss.
  4. 4Link each disaster to the rules that followed it.

Why it matters

A German industrial group with a sound hedge. A 233-year-old British bank. One of the world's largest insurers. Each was brought down, or nearly so, by derivatives. Not because derivatives are evil, but because of how they were used, funded and controlled.

Core explanation

Three stories, three lessons

Each of these cases has been studied for years, and some details are still argued over. What follows sticks to the facts that are widely agreed. Pick a story, then step through it.

The three cases

Pick a case

Metallgesellschaft, 1992 to 1994

1 / 5

1992–93

Fixed prices for up to ten years

MG Refining & Marketing, the US oil unit of the German group Metallgesellschaft, sold petrol, heating oil and diesel to customers at fixed prices for up to ten years ahead. The commitments added up to more than 150 million barrels.

The common threads

MetallgesellschaftBaringsAIG
InstrumentOil futures and swapsNikkei futures and optionsCredit default swaps
What failedFunding of marginInternal controlsConcentration, collateral
TriggerOil price fallKobe earthquakeMortgage losses, downgrade
LessonPlan for cash, not just valueSeparate trading from checkingLimit one-way risk; margin it

Which case shows it?

5 cards

  1. One person traded and also recorded and settled his own trades.

  2. Losses on a hedge had to be paid in cash now; the offsetting gains came over years.

  3. A downgrade of the firm's own credit rating triggered demands for collateral.

  4. Rolling short-dated contracts forward cost money every month.

  5. Reported profits looked too good, and nobody senior asked why.

Try it

A stylised version of the Metallgesellschaft squeeze, with made-up round numbers. A firm has sold 100 million barrels for delivery over ten years at fixed prices and hedged with short-dated futures on the whole amount. Push the oil price down and add a roll cost: the value roughly matches, the cash does not.

Try itRight in value, short of cash

Cash flows, USD millions: year 0 is the margin paid on the futures; years 1 to 10 are the gains on customer deliveries, less roll costs.
-400-2000012345678910
Cash paid now500
Customer gains, total500
…worth today (5%)386
Roll costs, total330
Most cash needed at once514

Illustrative: 100m barrels sold for delivery over 10 years, hedged with short-dated futures on the whole amount.

Worked example

The squeeze in numbers

The stylised firm above: 100m barrels over 10 years, oil falls $5.00 today, money is worth 5% a year, and rolling the stack costs $0.05 a barrel a month. Amounts in USD millions.

Value against cash

Step 1 of 5
  1. 1

    The futures loss

    The stack is long 100m barrels: 100 × 5.00 = 500, paid in variation margin now.

Regulatory lens

Each case left a mark on the rules. After Barings, supervisors and banks stressed segregation of front and back office, and independent risk control. Metallgesellschaft helped put funding liquidity risk on the map; the Basel III Liquidity Coverage Ratio (L4.5) now counts the extra cash a bank would need if a downgrade triggered collateral calls. AIG drove the G20 reforms of L1.7.11: central clearing, trade reporting and mandatory margin for uncleared derivatives.

Sparks

SparkSold for £1
Barings, founded in 1762, had helped finance the Louisiana Purchase in 1803. After Leeson's losses, ING bought it for a single pound, taking on its debts.
SparkWhy 88888?
Leeson's hidden error account was numbered 88888. Eight is considered a lucky number in Chinese culture, a detail that made the account's number one of the most quoted facts of the case.

Key takeaways

  • Metallgesellschaft: a hedge that matches in value but not in cash timing creates funding liquidity risk.
  • Barings: without segregation of duties and challenge from management, one trader can hide losses until they sink the firm.
  • AIG: a huge one-way position in sold protection, with collateral triggers tied to its own rating, became a cash crisis.
  • In each case derivatives magnified a failure of funding, control or concentration.
  • The reforms that followed (segregation, liquidity rules, central clearing and margin) are the lessons written into law.

Reaction

Check what stuck

Question 1 · objective 1

What was the central control failure at Barings?

Question 2 · objective 1

What turned Metallgesellschaft's hedge into a crisis?

Question 3 · objective 1

Which feature of AIG's CDS business turned losses into a cash crisis in September 2008?

Question 4 · objective 2

A firm hedges 50m barrels of fixed-price sales with short-dated futures. The oil price falls by $4 a barrel. How much variation margin must it pay on the futures, in USD millions?

USD m

Question 5 · objective 2

Customer contracts gain USD 20m a year for 5 years (100m barrels, $1 a barrel, delivered evenly). What is that stream worth today at 5% a year, in USD millions, to two decimal places?

USD m

Glossary

Funding liquidity risk
The risk of not having enough cash to meet payments when they fall due, even if you are solvent on paper.
Stack and roll
Hedging a long-dated commitment with a pile of short-dated futures, rolled forward into the next contract as each one expires.
Contango
A market where futures for later delivery cost more than those for sooner delivery, so rolling a long position forward costs money.
Segregation of duties
Keeping the people who trade apart from the people who record, confirm and settle the trades.
Rogue trader
A trader who takes positions far beyond their authority and hides them.
Rating trigger
A clause that requires a firm to post collateral if its credit rating is cut.
Concentration risk
Having too much of one kind of risk, so a single event can cause a large loss.

Deep Dives & Origins

Deep Dives

  • John C. Hull, Options, Futures, and Other Derivatives, 11th edition (Pearson, 2021), the chapter “Derivatives Mishaps and What We Can Learn from Them”. Beginner.
  • Christopher Culp and Merton Miller, “Metallgesellschaft and the Economics of Synthetic Storage”, Journal of Applied Corporate Finance 7(4), 1995; and Antonio Mello and John Parsons, “Maturity Structure of a Hedge Matters: Lessons from the Metallgesellschaft Debacle”, Journal of Applied Corporate Finance 8(1), 1995. Intermediate.

Origins

  • Bank of England, Board of Banking Supervision, Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings, HMSO, July 1995.
  • Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report, January 2011.
  • Congressional Oversight Panel, June Oversight Report: The AIG Rescue, Its Impact on Markets, and the Government's Exit Strategy, June 2010.
  • Culp and Miller (1995); Mello and Parsons (1995), as above.

Module complete

You have finished Module 1.7 Derivatives. Try the Lab Test: multi-step problems that bring forwards, futures, swaps, options and credit derivatives together.

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Clearing, margin and collateral

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Accounting basics