Risk Management Case Study: Sumitomo Derivatives Losses

Background of the case

This article explains the causes of the losses and the impact on the financial world due to the Sumitomo Copper Derivatives trades caused by excessive manipulation by one of its key and trusted employees Yasuo Hamanaka. He was believed to be an expert in Risk Management. He had a star trader status and was vested with executive decision-making powers by the firm.

Sumitomo owned large amounts of copper that was warehoused and stored in factories as well as numerous futures contracts. Hamanaka controlled 5% of the worlds copper supply, which may sound like a very small and insignificant amount, but given the fact that copper is illiquid because it is physical in nature and the logistics of buying and selling it are not as simple as financial commodities, a five percentage holding is quite significant.

Sumitomo also benefitted from the commissions on the other copper transactions that were handled by the company. Commissions were handled by the percentage of the value of the commodity being sold and delivered.

Causes of the Losses

There were some losses that Sumitomo had incurred just when Hamanaka had taken charge. He tried to recover the losses by taking huge positions in copper commodity futures on the London Metal Exchange. He tried to use the firm’s large cash reserves to both corner and squeeze the market and kept the price artificially high for the entire decade leading up to 1995 and garnished premium profits on the sale of Sumitomo’s physical assets.

This of course attracted the attention of the exchange and it gave a warning to Hamanaka who then struck a deal via Merrill Lynch for USD 150 million, which enabled him to trade at LME. He borrowed money from several banks without any authorization from his seniors. He used the funds either to buy copper or pay for the collateral he was required to deposit at the LME to cover loss making positions. By 1990 he was reporting huge trading profits to the top management by showing invoices of the fictitious options trades which he had created through some nexus with some brokers. Whenever anyone attempted to short the market he would pour more cash into positions thereby sustaining the price and outlasting the shorts, simply because he had more cash. The long cash positions forced anyone shorting copper to deliver the goods or close out their position at a premium.

Unlike the US, the LME had no mandatory position reporting and no statistics showing open interest. Basically traders knew the price was too high, but they did not have the exact figures of how much Hamanaka controlled and how much money he had in reserve. In the end most cut their losses and had Hamanaka have his way. Nearly a decade after this market manipulation took place in 1995 due to the resurgence of the mining in China the price of copper started to revive which further inflated the prices. Sumitomo was exposed to losses because the market was headed for a big drop and shorting the positions then would result in an even bigger loss at a faster rate.