It is of real importance that the current crisis leads to changes in the method by which bank regulators monitor and control the use of derivative financial instruments. There have been too many warnings about their potentially destabilising effect for governments and market regulators to be able to plead ignorance of the risks involved. Paul Volcker, the former chairman of the Federal Reserve, is just one of several eminent bankers to have warned of the dangers in a world where fast-moving financial markets are now inextricably linked.
So far, the burden of trading losses from derivatives has tended to fall mainly on big industrial companies: Procter & Gamble, Volkswagen and Allied Lyons have all incurred heavy losses. But the risk that an important bank would one day follow has long been regarded as dismally inevitable.
If the official account of events is to be believed, this crisis was triggered by a single Barings trader in Singapore who took huge, unauthorised positions in the futures market. What was designed to be a relatively simple hedging operation became, in the hands of a wayward individual, a huge bet on the Tokyo stock market. The position moved against Barings. In less than four weeks, the losses escalated to the point where they threatened to wipe out the entire capital of the parent bank. The first the Bank of England knew about it was when Barings came to them last Friday.
Nothing could more clearly underline why derivatives are such a potential risk: it is the speed and magnitude with which losses can escalate that underline the need for prudent and careful controls. On this occasion, the Singapore authorities apparently knew of the scale of the position the Barings trader was adopting. It is not clear whether they failed to spot the danger signals, or merely chose to ignore them. The same questions must be asked of Barings itself.
Either way, the case for central bankers taking urgent steps to tighten up the international regulatory system for derivatives is now unanswerable. The response of the Bank of England and the Bank for International Settlements has, to date, bordered on the complacent. They are right to argue that derivatives fulfil an important function - even the humble fixed interest mortgage would be impossible without them - and that regulation is a heavy- handed weapon which often fails to achieve its objectives. No purpose would be served by seeking to abolish derivatives. But it is patently absurd that a capricious trader in Singapore can single-handedly wipe out a bank as eminent as Barings, let alone threaten the good name and credit of the City of London.Reuse content