Sumitomo Corporation

Sumitomo Corporation – The story of Copper derivatives

Incident:

This study is a classic example of – ‘Running on the top of the tiger not knowing how to get off without being eaten.’

Yasuo Hamanaka, the chief copper trader at Japan's Sumitomo Corporation caused $2.6 billion losses to the company through his unauthorized trading activities in the physical and futures market in copper at the London Metal Exchange. It was the largest unauthorized trading-related loss incurred by any Japanese company during that time.

Analysis:

Initial Profits – Result of Manipulation

Yasuo Hamanaka the head trader of Sumitomo Corporation manipulated the world copper prices through his operations on the LME (London Metal Exchange) copper futures market over the period of 1991-95. This artificial increase in copper price resulted in increased profits for Sumitomo Corporation from selling copper. Moreover Hamanaka was reporting inflated trading profits to the top management by showing invoices of fictitious option trades, which he had created through a nexus with some brokers. Whenever any hedge fund or speculator who was aware of manipulation tried to take short positions, Hamanaka invested more money into his positions thus sustaining the high price. However despite these faulty practices no action was taken against Hamanaka because of the profits he generated for the company.

Lack Of Transparency

Successful manipulation of the copper prices was possible due to lack of transparency in the reporting positions of large clients at LME.

Action Taken Too Late

During late 1995, due to increased copper production facilities particularly in China, copper prices started declining. This was ominous for Sumitomo as they had long positions in the futures market. Hamanaka failed to get rid of his positions. He tried to recover the losses by taking huge positions in copper commodity futures on the London Metal Exchange. However the huge volume of trading attracted the attention of the exchange and it gave a warning to Hamanaka. Hamanaka then struck a deal with Merrill Lynch for US $150 Mn, which enabled him to trade via Merrill at LME. Later however when LME started investigating on the alleged manipulation of copper prices Hamanaka was taken off from his position of head trader. This brought the short traders and hedge funds into the act causing the copper prices to fall further on LME.

Lack of Proper Managerial Supervision and Operational Control Systems

Transactions were made solely by Yasuo Hamanaka himself. He abused Sumitomo's name, and continued on with unauthorized trading and even borrowed money from several banks without any authorization from his seniors. Hamanaka a middle-level manager got so much power only because of the fact that he had helped Sumitomo garner a lot of profits in the past. He was given a great deal of responsibility by the company, a star trader status and his only regulators were overseas, far from Tokyo.

Lack of Monitoring

Trading in commodities and financial instruments was not being properly monitored by the government regulatory agencies and by the companies undertaking these transactions. This conclusion can be derived from the fact that in a short span of 16 months three major derivative disasters were seen:

· UK's 233-year-old Barings Bank, which lost $ 1.4 bn in February 1995 due to Nick Leeson's unauthorized trading activities in the Singapore futures market

· Japanese bank Daiwa which lost $1.1 bn in America's Treasury bond market in September 1995 due to the unauthorized trading activities of Toshihide Iguchi.

· Japan's Sumitomo Corporation $2.6 billion losses due to unauthorized trading activities in the physical and futures market in copper at the London Metal Exchange.

The debacle was the result of Sumitomo's poor managerial, financial and operational control systems. Due to this, Hamanaka was able to carry on unauthorized trading activities undetected by the top management. The vesting of excessive decision power on a single employee and failure to implement the job rotation policy were the other reasons cited.

Damage Control Measures

In order to control mounting losses, Sumitomo began aggressive liquidation of its uncovered positions in the copper physical and futures market under its new president Kenji Miyahara. It cancelled its plans to buy back 20 million of its shares and award Yen 120 million ($1.1 million) of bonuses to its senior managers. Sumitomo was able to overcome the losses since it had a net worth of $6 bn and another $8 bn in hidden reserves. The losses estimated to be $2.6 bn amounted to only 10 per cent of Sumitomo's annual sales.

Conclusion & lessons learnt from derivatives

“Derivatives” are complex bank creations that are very hard to understand, but the basic idea is that you can insure an investment you want to go up by betting it will go down. The simplest form of derivative is a short sale: you can place a bet that some asset you own will go down, so that you are covered whichever way the asset moves.

Particularly, the Sumitomo case resulted in tighter internal supervision and control procedures by trading firms and financial institutions the world over. Disclosure must lead to a serious introspection among various financial regulators and trading firms to improve the existing regulation and supervision procedures.

Regulators have now become more aware and proactive than ever before as the possibilities to manipulate the markets have become more practical with the advent of complex and high leveraged instruments like derivatives. Prevention here is always better than prosecution. Companies should also restrain themselves from vesting too much power on a single employee and follow a job rotation policy. By entering into fictitious trades and manipulating accounts, Hamanaka successfully misled the management to believe that he was making huge profits. Sound operational and monitoring system need to be in place to keep track of activities of traders. Successful traders might require more, not less, scrutiny.

What needs to be done in the future?

1. Resolving and Prosecuting Insider Crimes

2. Reducing False Positives

3. Protecting Customer Data

4. Investigate irrational spurts in revenue as much as drop in profitability.

5. Fix the remuneration and fix the bonus as a fixed percentage of the CEO’s salary

6. Create policies and procedures on risk management and educate the employees regarding the same.

“Major crises are major opportunities for change”