Barclays Scandal Was Born of Diamond's Derivatives Bet

Updated to reflect Barclays emails, testimony and U.K. chancellor statement

NEW YORK ( TheStreet) -- In the casino-like world of the over the counter (OTC) derivatives trading market, Barclays ( BCS) and its former chief executive Bob Diamond played a winning hand.

Until they lost it all this week.

Diamond said Tuesday that he plans to step down from Barclays' top spot and is preparing to face a U.K. Treasury panel over a market manipulation probe at the bank's interest rate swap trading unit. The scandal prompted a $450 million fine paid to regulators in the U.S. and U.K last week.

The ascension of Barclays Capital and its leader Diamond in the world of high finance, highlighted by its scrappy growth through the 2000s and a crisis-time acquisition of Lehman Brothers' U.S. investment bank, and their recent turmoil underscores the risks that banks run by relying on opaque earnings sources like derivatives trading.

For those who are mystified by Diamond's sudden resignation and that of a top lieutenant Jerry Del Missier, it's key to understand how Barclays Capital transformed from a fringe investment banking player, to one that is challenging mainstays like Goldman Sachs ( GS), Morgan Stanley ( MS) and JPMorgan ( JPM).

Prior to acquiring Lehman Brothers' U.S business in 2008, Diamond ran Barclays Capital with a mission for it to be the "leading European investment bank for financing and risk management," and largely succeeded. By risk management -- which are Diamond's words taken from annual reports -- he mostly means providing hedging products for credit and interest rate risks that other financial institutions and corporations face.

By the onset of the financial crisis, Barclays Capital was recognized as a top derivatives player and had the market share to prove it; however, few of its other investment banking businesses were prominent outside of Europe.

In 2008, Barclays was anointed interest rate derivatives "house of the year" by industry trade publications International Financial Review and Risk Magazine as its unit grew into a top five global player in most key markets. Those accolades came on the heels of trading growth that was largely done before Diamond acquired Lehman Brothers traders and bankers at the nadir of the credit crunch. With Lehman onboard, Barclays Capital moved to the top of most interest rate and credit derivative trading markets.

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