Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Tue, 20 Feb 2018

Can radical blockchain transparency decrease banking frauds?

During the last week, the Indian financial sector has been gripped by the $1.8 billion fraud at Punjab National Bank (PNB). Fingers have been pointed at bank management, at the auditors and at the regulators, but finger pointing and angry denunciations do not solve problems. We did not solve the problem of unfriendly bank tellers by shouting at them; we solved it using technology (Paul Volcker once remarked that the most important financial innovation that he had seen was the ATM). That is probably the route we must take again: we cannot change human nature, but we can change the technology.

The blockchain technology that underpins cryptocurrencies like Bitcoin has the potential to reduce large banking frauds drastically because it enables radical transparency. Every transaction on Bitcoin is public and you do not even need a Bitcoin wallet to see these transactions. Many websites like https://blockexplorer.com/, https://blockchain.info/, https://www.blocktrail.com/BTC, https://btc.com/, and https://live.blockcypher.com/btc/ allow anybody with a web browser anywhere in the world to see every single transaction as it happens. We can use the same technology to allow the whole world to see every large financing or guarantee transaction (above some threshold like a billion rupees).

The shibboleth of bank secrecy can be discarded for large financing transactions because many of them become public anyway:

We could extend this into a uniform requirement to make large loans public:

The natural medium for such a disclosure is the blockchain. The alternative idea of using a credit registry has been an unmitigated disaster (just think of Equifax), and these agencies create more opaqueness than transparency.

If the PNB fraud pushes us to use the blockchain to make finance more transparent and therefore safer, $1.8 billion may end up being a price well worth paying.

Posted at 20:34 on Tue, 20 Feb 2018     View/Post Comments (0)     permanent link


Tue, 13 Feb 2018

Are banks too opaque to manage?

Fabrizio Spargoli and Christian Upper have a BIS Working Paper with a different title: “Are Banks Opaque? Evidence from Insider Trading” with the following findings:

Our results do not support the conventional wisdom that banks are more opaque than other firms. Yes, purchases by bank insiders are followed by positive stock returns, indicating that banks are opaque. But banks are not special as we find the same effect for other firms. Where banks are special is when bad news arrive. We find that sales by bank insiders are not followed by negative stock returns. This suggests that bank insiders do not receive bad news earlier than outsiders. By contrast, insider sales at non-banks tend to be followed by a decline in stock prices.

My interpretation of the result is quite the opposite: banks are so opaque that even insiders cannot see through the opacity when bad things happen. Sometimes, as in the case of the London Whale, a market participant outside the bank has greater visibility to what is going on.

It appears to me that the findings of Spargoli and Upper are evidence that banks are too opaque to manage. Even a very competent chief executive can be clueless about some activities in a corner of the bank that have the potential to bring down the bank or at least cause severe losses. That would be an additional argument for moving from bank-dominated to market-dominated financial systems.

Posted at 15:47 on Tue, 13 Feb 2018     View/Post Comments (0)     permanent link


Sun, 04 Feb 2018

In the sister blog and on Twitter during December 2017 and January 2018

The following posts appeared on the sister blog (on Computing) during December 2017 and January 2018:

Tweets during December 2017 and January 2018 (other than blog post tweets):

Posted at 15:52 on Sun, 04 Feb 2018     View/Post Comments (0)     permanent link


Sat, 27 Jan 2018

Regulation as Pigouvian stealth taxation

“Regulation is stealth taxation,” said US President Donald Trump at Davos yesterday. Can this taxation be Pigouvian, and can this stealth taxation be a good idea? That is the claim in Turk’s thought provoking paper “Securitization Reform after the Crisis: Regulation by Rulemaking or Regulation by Settlement?”

Turk argues that:

can been seen as imposing a Pigouvian tax on the specific market externality associated with securitization, and therefore come surprisingly close to a first-best policy intervention.

missed the mark because it was premised on a flawed theory of the role that securitization played the crisis, which emphasized traditional notions of fraud rather than poor risk-management.

It appears to me that there is no convincing evidence that securitization imposes large negative externalities requiring a Pigouvian tax. On the other hand, there is somewhat more evidence that banking creates large negative externalities, and Basel 3 is a kind of Pigouvian tax on banking. This Pigouvian taxation has also happened by stealth in the name of risk reduction.

We should worry about the knowledge deficit and the governance deficit in these exercises in stealth taxation. Regulators probably think that they have calibrated the Pigouvian tax correctly; but this is more likely to reflect conceit than genuine expertise in this field. Even if the expertise is granted for the sake of argument, the governance issue remains: can taxation be delegated to unelected regulators?

Posted at 20:00 on Sat, 27 Jan 2018     View/Post Comments (0)     permanent link


Fri, 26 Jan 2018

Financial Crisis and Response History

About a month ago, the US Federal Deposit Insurance Corporation (FDIC) published a 278 page document entitled “Crisis and Response: An FDIC History, 2008–2013.” It is a quite sanitized history compared to the excellent accounts of the crisis that came out many years ago (especially the books by Hank Paulson and Andrew Sorkin). Yet, I found that there was much of value in the FDIC book. There is of course a wealth of official and authoritative data, but there are also many interesting insights from the perspective of the regulators dealing with it in real time.

I wish Indian regulators could publish something similar about the various crises in Indian financial markets covering say 1990 to 2010 – the Harshad Mehta scam of 1992, the vanishing companies of 1995, the Ketan Parikh episode (especially the fate of the Calcutta Stock Exchange), the UTI Unit 64 bailout, Global Trust Bank, and Satyam. If the report of the Financial Crisis Inquiry Commission (FCIC) in the US did not affect the ability of the FDIC to publish their history, there is no reason why the reports of the Joint Parliamentary Committees (JPCs) should be an obstacle for the Indian authorities (RBI/SEBI/MOF/MCA) to publish their accounts of these episodes.

Posted at 18:37 on Fri, 26 Jan 2018     View/Post Comments (0)     permanent link


Fri, 05 Jan 2018

Why Intel investors should subscribe to the Linux Kernel Mailing List or at least LWN

On January 3 and 4, 2018 (Wednesday and Thursday), the Intel stock price dropped by about 5% amidst massive trading volumes after The Register revealed a major security vulnerability in Intel chips on Tuesday evening (the Meltdown and Spectre bugs were officially disclosed shortly thereafter). But a bombshell had landed on the Linux Kernel on Saturday, and a careful reader would have been able to short the stock when the market opened on Tuesday (after the extended weekend). So, -1 for semi-strong form market efficiency.

Saturday’s post on LWN was very cryptic:

Linus has merged the kernel page-table isolation patch set into the mainline just ahead of the 4.15-rc6 release. This is a fundamental change that was added quite late in the development cycle; it seems a fair guess that 4.15 will have to go to -rc8, at least, before it’s ready for release.

The reason this was a bombshell is that rc6 (release candidate 6) is very late in the release cycle where only minor bug fixes are usually made before release as version 4.15. As little as 10 days earlier, an article on LWN stated that Kernel Page-Table Isolation (KPTI) patch would be merged only into version 4.16 and even that was regarded as rushed. The article stated that many of the core kernel developers have clearly put a lot of time into this work and concluded that:

KPTI, in other words, has all the markings of a security patch being readied under pressure from a deadline.

If merging into 4.16 looked like racing against a deadline, pushing it into 4.15 clearly indicated an emergency. The public still did not know what the bug was that KPTI was guarding against, because security researchers follow a policy of responsible disclosure where public disclosure is delayed during an embargo period which gives time to the key developers (who are informed in advance) to patch their software. But, clearly the bug must be really scary for the core developers to merge the patch into the kernel in such a tearing hurry.

One more critical piece of information had landed on LWN two days before the bombshell. On December 27, a post described a small change that had been made in the KPTI patch:

AMD processors are not subject to the types of attacks that the kernel page table isolation feature protects against. The AMD microarchitecture does not allow memory references, including speculative references, that access higher privileged data when running in a lesser privileged mode when that access would result in a page fault.

Disable page table isolation by default on AMD processors by not setting the X86_BUG_CPU_INSECURE feature, which controls whether X86_FEATURE_PTI is set.

As Linus Torvalds put it a few days later: “not all CPU’s are crap.” Since it was already known that KPTI would degrade the performance of the processor by about 5%, the implication was clear: Intel chips would slow down by 5% relative to AMD after KPTI. In fact, one post on LWN on Monday evening (Note that Jan 2, 2018 0:00 UTC (Tue) would actually be late Monday evening in New York) did mention that trade idea:

Posted Jan 2, 2018 0:00 UTC (Tue) by Felix_the_Mac (guest, #32242)
In reply to: Kernel page-table isolation merged by GhePeU
Parent article: Kernel page-table isolation merged
I guess now would be a good time to buy AMD stock

The stock price chart shows that AMD did start rising on Tuesday, though the big volumes came only on Wednesday and Thursday. The interesting question is why was the smart money not reading the Linux Kernel Mailing List or at least LWN and getting ready for the short Intel, long AMD trade? Were they still recovering from the hangover of the New Year party?

Posted at 13:21 on Fri, 05 Jan 2018     View/Post Comments (0)     permanent link


Mon, 01 Jan 2018

Madness on both sides

Forbes India has an article on Bitcoin in the January 5, 2018 issue. It has the following quote from me:

Which is more crazy: That bitcoin has a market capitalisation of a couple of hundred billion dollars, or that 11 trillion dollars of bonds are trading at a negative yield, which means that people are lending money with the full knowledge that they will not even receive the full principal back let alone earn any interest? After the global financial crisis of 2008, many feel that the actions of central bankers have been reckless, and it is no wonder that these people are attracted to a currency that is not subject to the whims and fancies of central bankers. There is madness on both sides (fiat currencies of advanced countries and cryptocurrencies) and it is best to view both with equal detachment.

This is not the first time that I have stated the view that virtual currencies are a response to bad things happening in the real world (see for example, this blog post from October 2017).

Posted at 12:17 on Mon, 01 Jan 2018     View/Post Comments (0)     permanent link


Sun, 31 Dec 2017

Why do banks use Credit Default Swaps (CDS)?

Inaki Aldasoro and Andreas Barth have a paper “Syndicated loans and CDS positioning” (BIS Working Papers No 679) that tries to answer this question in the context of syndicated loans. Unfortunately, they frame the problem in terms of hedging and risk reduction; I think this is not a useful way of looking at the usage of CDS by banks, though it makes perfect sense in other contexts. For example, if business is worried about the creditworthiness of a large customer, it might want to buy CDS protection. It is effectively paying an insurance premium to eliminate the credit risk, while earning the profits from selling to this customer. This works because credit risk is incidental to the business transaction.

For the bank, however, credit risk is the core of the business relationship. The natural response to concerns about the creditworthiness of a (potential) customer is to limit the lending to this customer. Granting a loan and then buying CDS protection is just a roundabout way of buying a risk free bond (or perhaps a very low risk bond). It is much simpler to just buy a government bond or something similar.

When we see a bank grant a loan and simultaneously buy CDS on the loan, we are not seeing a risk reduction strategy. Rather the bank has determined that this roundabout strategy is somehow superior to simply buying a government bond. We should be evaluating different scenarios that could cause this to happen:

  1. As in the earlier example of a non financial business, the bank is looking at the profits from the totality of the customer relationship that could be at risk if it did not grant the loan.

  2. The CDS is mispriced, and the bank is able to earn a higher yield than a government bond for the same level of risk. Effectively, the bank is arbitraging the bond-CDS basis. A hedge fund that is expecting an improvement in the credit profile of a company could either go long the bond or sell CDS protection on the bond. The former would require financing the investment at the relatively high funding cost of the hedge fund. In imperfect markets, it can be better for a well capitalized bank to buy the bond (financing the purchase at its low funding cost) and buy CDS protection from the hedge fund. Particularly, after the global financial crisis, this scenario has been quite common.

Aldasoro and Barth find that weaker banks are less likely than strong banks to buy CDS protection on their loans. They argue that weak banks have lower franchise value and have less incentive to hedge their risks. Bond-CDS arbitrage provides a simpler explanation; stronger banks have a competitive advantage in executing this arbitrage, and are likely to do it more than weaker banks.

Similarly Aldasoro and Barth find that lead arrangers are more likely to hedge their credit risk exposures than other syndicate members. This fits nicely with the total customer profitability explanation: the hedged loan may be similar to a government bond, but the syndication fees may make this a worthwhile strategy.

Posted at 17:25 on Sun, 31 Dec 2017     View/Post Comments (0)     permanent link


Sun, 17 Dec 2017

Bitcoin and bitcoin futures

After bitcoin futures started trading a week ago, there has been a lot of discussion about how the futures market might affect the spot price of bitcoin. Almost a decade ago, Paul Krugman discussed this question in the context of a different asset – crude oil – and gave a simple answer:

“Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price.”

Krugman explained this with a direct example:

Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won’t. What direct effect does this have on the spot price of oil – the actual price people pay to have a barrel of black gunk delivered?

The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn’t make any difference.

Back then, I argued in my blog post that Krugman’s analysis is quite valid for most assets, but needed to be taken with a pinch of salt in the case of assets like crude oil, where the market for physical crude oil is so fragmented and hard to access that:

Most price discovery actually happens in the futures market and the physical markets trade on this basis. In an important sense, the crude futures price is the price of crude.

Is bitcoin like crude oil or is it an asset with a well functioning spot market where the Krugman analysis is right, and the futures speculation is largely irrelevant? The cash market for bitcoin has some difficulties – the bitcoin exchanges are not too reliable, and many investors find it hard to keep their wallets and their private keys safe. Are these difficulties as great as the difficulty of buying a barrel of crude, or selling it?

When cash markets are not functioning well, cash and carry arbitrage (and its reverse) futures markets may make the underlying asset accessible to more people. It is possible that A is bullish on bitcoin, but does not wish to go through the hassles of creating a wallet and storing it safely. At the same time, B might be comfortable with bitcoin wallets, but might be unwilling to take bitcoin price risk. Then B can buy bitcoin spot and sell cash settled bitcoin futures to A; the result is that A obtains exposure to bitcoin without creating a bitcoin wallet, while B obtains a risk free investment (a synthetic T-bill). Similarly, suppose C wishes to bet against bitcoin, but does not have the ability to short it; while D has no views on bitcoin, but has sufficient access to the cash market to be able to short bitcoin. Then D can take a risk free position by shorting bitcoin in the cash market and buying bitcoin futures from C who obtains a previously unavailable short position.

When there are many pairs of people like A/B and many pairs like C/D; the creation of the futures market allows A’s demand and B’s supply to be reflected in the cash market. If there are more A/B pairs than C/D pairs, the introduction of bitcoin future would push up the spot price of bitcoin. The reverse would be the case if the C/D pairs outweigh the A/B pairs. If there are roughly equal number of A’s and C’s, then they can simply trade with each other (Krugman’s side bets) with no impact on the cash market.

It appears to me that the introduction of futures has been bullish for bitcoin because there are quite many A/B pairs. There are significantly fewer C/D pairs for two reasons:

  1. There are not too many C’s though there are plenty of people who think that bitcoin is a bubble. Smart investors rarely short a bubble: there is too high a risk of the bubble inflating even further before collapsing completely. As Keynes famously wrote, the market can remain irrational longer than you can remain solvent. The most sensible thing to do for those who see a bubble is to simply stay clear of the asset.

  2. There are not too many D’s because it is not easy to borrow bitcoin for shorting it. A large fraction of the bitcoin supply is in the hands of early investors who are ideologically committed to bitcoins, and have little interest in parting with it. (In fact, bitcoin is so volatile that the most sensible strategy for those who believe in the bitcoin dream is to invest only what they can afford to lose, and then adopt a buy and hold strategy). Moreover, lending bitcoin requires reposing faith in mainstream finance (even if the borrower is willing to deposit 200% or 300% margins), and that trust is in short supply among those who were early investors in bitcoins.

The situation could change over a period of time if the futures market succeeds in moving a large part of the bitcoin supply into the hands of mainstream investors (the A’s) who have no commitment to the bitcoin ideology.

Posted at 15:02 on Sun, 17 Dec 2017     View/Post Comments (0)     permanent link


Sat, 09 Dec 2017

SEC Regulatory Overreach

I have repeatedly worried about regulatory overreach (here, here and here); while most of the examples in those posts came from India, I was always clear that the phenomenon is global in nature. In a blog post (at CLS Blue Sky Blog) Johnson and Barry carry out an analysis of the US Securities and Exchange Commission (SEC) which documents the overreach of that regulator.

The Dodd Frank Act of 2010 greatly expanded the ability of the SEC to initiate proceedings in its own administrative courts before an Administrative Law Judge appointed by the commission instead of filing the case in a federal court. Since around 2013, the SEC has relied more on these proceedings which give substantial advantages to the SEC – less comprehensive discovery rules, no juries, and relaxed evidentiary requirements. A study by the Wall Street Journal showed that the SEC wins cases before its in-house judges much more frequently than before independent courts.

Johnson and Barry show that even this “home field” advantage is not enough – the SEC seems to be overreaching or overcharging its cases to such an extent that it is losing a number of high-profile administrative cases. They conclude:

When it began to shift away from filing cases in district court, it likely believed it would see more success in administrative proceedings, but that has not consistently been the case. Although the SEC is still winning many of its administrative cases, its recent losses reflect a failure to evaluate the strength of its proof, particularly in cases where scienter evidence is thin, or overall evidence of alternative theories consistent with innocence is equally strong.

Posted at 18:24 on Sat, 09 Dec 2017     View/Post Comments (0)     permanent link


Thu, 07 Dec 2017

Surveillance by countervailing power

I have long argued that it is a mistake to think of surveillance as being done solely by disinterested regulators who have no axe to grind. As I wrote in a blog post a decade ago, “complaints by rivals and other interested parties are the best leads that a regulator can get.”

But these rivals and other interested parties can go beyond complaining to the regulator; they can take matters into their own hands. This can often be the best and most effective form of surveillance. A recent order by the US Commodities and Futures Trading Commission (CFTC) against Statoil illustrates this very well.

According to the CFTC, Statoil traders bought physical propane in the Far East with a view to push up the Argus Far East Index (FEI) which was the reference price for Statoil’s derivative contracts on NYMEX. However, Statoil’s plan to profit by creating an artificial settlement price for the Argus FEI did not materialize as hoped. The CFTC quotes one of the Statoil traders:

Also, quite a few of the players in the market have a vested interested in holding the [Argus] FEI down and they have been willing to sell cargoes . . . at discounted prices . . . Statoil have bought 5 cargoes over the last week but this has not been enough to keep the [price] up.

So one group of players are trying to rig the price down, while another set is trying to do the opposite. Their efforts neutralize each other, and the market basically policed itself. The regulator can of course watch the fun and impose a penalty on one (or even both parties), but its actions are largely irrelevant.

Incidentally, the episode also shows that market manipulation is not the exclusive preserve of evil private sector speculators: Statoil is the Norwegian government oil company.

Posted at 21:30 on Thu, 07 Dec 2017     View/Post Comments (0)     permanent link


Fri, 01 Dec 2017

In the sister blog and on Twitter during August-November 2017

There were no posts on the sister blog (on Computing) during August-November 2017 other than cross posts from this blog.

Tweets during August-November 2017 (other than blog post tweets):

Posted at 20:48 on Fri, 01 Dec 2017     View/Post Comments (0)     permanent link


Thu, 30 Nov 2017

Large asset auctions: Russian versus East Asian models

In the context of the large asset auctions that are expected to happen in India as part of the new bankruptcy code for delinquent borrowers, I think it would be instructive to look at the lessons that can be learned from how such auctions were organized elsewhere in the world. Two episodes that come to my mind are:

  1. The large privatizations that happened in Russia after the collapse of the Soviet Union

  2. The massive sale of assets that happened in East Asia particularly Korea and Thailand after the Asian crisis.

Both of these were large operations carried out fairly quickly in a quite challenging environment. There was a huge amount of uncertainty about the true value of the assets, but that is unavoidable in situations like this. But the two episodes differed in many critical respects. All in all, most people would agree that the Russian auctions were a disaster. First they allow a bunch of oligarchs to acquire businesses very cheap because of inadequate competition. Second, the privatizations (at least ex post) have very little perceived legitimacy, and this vitiates Russian democracy even today. The East Asians (partly because of IMF pressure) were much more transparent about the process, and also opened up the sales to foreign bidders in a big way (amending the laws in some cases). This was not politically very pleasant, but was probably the only way to generate enough competitive bidding in an environment where most domestic players were liquidity constrained, and the banking system was ill equipped to support leveraged bidders.

Posted at 18:36 on Thu, 30 Nov 2017     View/Post Comments (0)     permanent link


Mon, 20 Nov 2017

The Indian retail credit boom

In the last 3-4 years, in the face of collapsing corporate credit demand and rising defaults in corporate loans (dating back to the days of a booming economy), the Indian banking system has been focused on growing the retail loan portfolio. Non bank finance companies have also been doing the same. For public sector bankers worried about investigations into suspected corrupt lending, retail lending has another big advantage from a career point of view. Since retail credit decisions are based on computer algorithms, there is much less risk of corruption allegations against individual staff members (and computers cannot be sent to jail).

Two questions arise at this point:

  1. Has this retail credit boom progressed beyond the point of prudent lending? Anecdotal evidence suggests that at least for some lenders, the answer is yes. Since nobody wants to admit that they are lending imprudently, I prefer to ask market participants what CIBIL score cutoffs their competitors are using. During the last couple of years, I have heard this number fall from 650-700 to 600 and recently to 550.

  2. How much of an impact would job losses in telecom and software services have on delinquencies in retail loans? It is too early to say, but clearly the impact would be non trivial.

I would think that the ongoing public sector bank recapitalization needs to keep this in mind. And perhaps at least some private sector lenders might want to think of a pre-emptive recapitalization.

Posted at 18:21 on Mon, 20 Nov 2017     View/Post Comments (0)     permanent link


Sun, 22 Oct 2017

Bitcoin as a way to short bad things

Many people are perplexed that there is no asset underlying Bitcoin. One answer is that there is nothing underlying fiat money either. But, it is more interesting to think about Bitcoin not as being long something good but as being short something bad. Bitcoin is short untrustworthy/incompetent banks/politicians.

Bitcoin has soared in value as trust in G7/G10/G20 politicians has eroded. Capital flight from untrustworthy peripheral countries has historically been to core country safe havens like the US dollar. But when trust in the core is eroded, where does one go? Traditionally, money poured into gold, and to some extent it still does, but today's technology utopians see gold as Luddite and medieval. Bitcoin has many of the key attributes of gold (most importantly, it is beyond the control of politicians), but it is modern and futuristic.

So one way to think about Bitcoin as an investment is to ask yourself whether you are optimistic about today's G7/G10/G20 politicians in terms of trustworthiness and competence. If your answer is yes, you should probably forget about Bitcoin, but if your answer is negative, Bitcoin deserves some serious consideration. In the latter case, you would think of Bitcoin (and Ethereum and the rest) as the way to reinvent capitalism so as to make it less dependent on bad/stupid politicians and their crony capitalists.

In this vein, I have been thinking about two episodes separated by a quarter century. In September 1992, the UK government was battling the Hungarian, and in order to defend the British pound, the Bank of England raised interest rates an unprecedented second time on the same day (the first hike at 11:00 am was from 10% to 12%, while the second hike at 2:15 pm was from 12% to 15%). For the first few minutes, the London stock market fell sharply in response to this shock and awe strategy. At that time, the stock market was essentially short the politicians: if the politicians won, the UK economy would suffer from an overvalued currency and the high interest rates required to sustain it: stocks would fare badly. If the politicians lost, then lower interest rates and a weaker currency would propel the economy and the stock market higher. So the initial response of the market was one of dejection: the politicians seemed to be winning at the cost of inflicting even more damage to the economy.

But within minutes, the London stock market began to rally furiously as it realized that the second rate hike in the day was a sign not of strength but of despair. The market was now convinced that the politicians would lose, and so it turned out. The pound crashed out of the ERM and the second rate hike was canceled before it came into force. Jeremy Siegel tells the whole story quite nicely in his book Stocks for the Long Run (in the section on Stocks and the Breakdown of the European Exchange-Rate Mechanism).

Twenty five years later, in September 2017, a few weeks before the five-yearly Congress of the Communist Party of China, the Chinese government launched a crack down on crypto currencies including Bitcoin. Clearly, the thought of people investing in an asset beyond the control of the state and the party was anathema to the Chinese rulers. Again the initial response of the market was that the politicians would win this fight and Bitcoin dropped about 30% very quickly. It took a couple of weeks for the market to realize that (like the Bank of England's second rate hike), the Chinese crackdown on Bitcoin too was the outcome not of strength but of despair. The ban would only reduce the influence of China in the growing global Bitcoin ecosystem. Bitcoin began to rebound and the centre of Bitcoin trading shifted out of China to elsewhere in the world. When the party Congress began in mid October, Bitcoin was trading at record highs well above the pre ban levels.

It is possible that the Chinese crackdown would come back to haunt them. China's geopolitical rivals (US, Japan, India and others) are surely reflecting on this episode and wondering whether Bitcoin could be the Achilles' heel of the Chinese state's control over their economy. At the same time, Russia and China are probably wondering whether Bitcoin is the Achilles' heel of the US control of the global payment system.

So if you believe that the world is run by somewhat honest and tolerably competent politicians, you could bet that Bitcoin is just a passing fad that we would all be laughing at in a few years' time. If you want to short this rosy view, Bitcoin beckons: it is now too big and strong to be shut down by untrustworthy/incompetent politicians.

PS: I have recently started referring to the man who broke the Bank of England simply as the Hungarian because of the current Hungarian government's extreme hostility to him.

Posted at 12:39 on Sun, 22 Oct 2017     View/Post Comments (0)     permanent link


Fri, 20 Oct 2017

Building credit bureaus that have no personal information

In two blog posts (here and here), I have argued that in an era of widespread hacking, the credit bureau’s business model is unsustainable because it requires storing enormous amounts of confidential information on tens of millions of individuals who are not even its customers.

However, these bureaus serve a useful function of aggregating information about an individual from multiple sources and condensing all this information into a credit score that measures the credit worthiness of the individual, An individual has credit relationships with many banks and other agencies. He might have a credit card from one bank, a car loan from another bank and a home loan from a third; he may have overdue payments on one or more of these loans. He might also have an unpaid utility bill. When he applies for a new loan from a yet another bank, the new bank would like to have all this information before deciding on granting the loan, but it is obviously impractical to write to every bank in the country to seek this information. It is far easier for all banks to provide information about all their customers to a central credit bureau which consolidates all this information into a composite credit score which can be accessed by any bank while granting a new loan.

The problem is that though this model is very efficient, it creates a single point of failure – a single entity that knows too much information about too many individuals. What is worse, these individuals are not customers of the bureau and cannot stop doing business with it if they do not like the privacy and security practices of the bureau.

We need to find ways to let the bureaus perform their credit scoring function without receiving storing confidential information at all. The tool required to do this (homomorphic encryption) has been available for over a decade now, but has been under utilized in finance as I discussed in a blog post two years ago.

Suppose there is only one bank

To explain how a secure credit bureau can be built, I begin with a simple example where the bureau obtains information only from one bank (or other agency) which has the individual as a customer. I will then extend this to multiple banks.

Extension to Multiple Banks

In general, the credit bureau will need information from many (say m) banks (or other agencies).

Allowing the individual to verify all computations

How does an individual detect any errors in the credit score? How does an external auditor verify the computations for a sample of individuals?

The individual k would be entitled to receive a credit report from the credit bureau that includes (a) the unencrypted total credit score (total_scorek), (b) the encrypted disguised_subscorekj for all j, (c) the encrypted modified weights vji for all i and j and (d) sum_rk. Actually, (b), (c) and (d) should be publicly revealed by the credit bureau on its website because they do not leak any information.

The individual k would also be entitled to get two pieces of information from bank j: (a) the attributes xjki for all i and (b) the random number rkj.

With this information, the individual k can verify the computation of the encrypted disguised_subscorekj for all j (using the same homomorphic encryption method used by the banks). The individual can also verify sum_rk by adding up the rkj. Using the public key of the credit bureau, the individual can also encrypt total_scorek - sum_rk and compare this with the encrypted sum obtained by adding up all the disguised_subscorekj homomorphically.

The same procedure would allow an auditor to verify the computation for any sample of individuals.

The careful reader might wonder how the individual can detect an attempt by a bank to falsify rkj. In that case, sum_rk will not match the sum obtained by adding up the rkj, but how can the individual determine which bank is at fault? To alleviate this problem, each bank j would be required to construct a Merkle tree of the rkj (for all k) and publicly reveal the root hash of this Merkle tree. Individual k would then also be entitled to receive a path of hashes in the Merkle tree leading up to rkj. It is then impossible to falsify any of the rkj without falsifying the entire Merkle tree. Any reasonable audit procedure would detect a falsification of the entire Merkle tree. Depending on the setup, the auditor might also be able to audit (a sample of) the secure multi party computation of rkj directly by verifying a (sub) sample of the secret shares.

Conclusion

At the end, we would have built a secure credit bureau. A Equifax scale hacking of such a bureau would be of no concern to the public; it would be a loss only for the bureau itself. Mathematics gives us the tools required to do this. The question is whether we have the good sense and the will to use these tools. The principal obstacle might be that the credit bureau would have to earn its entire income by selling credit scores; it would not be able to sell personal information about the individual because it does not have that information. But this is a feature and not a bug.

Posted at 16:20 on Fri, 20 Oct 2017     View/Post Comments (0)     permanent link


Mon, 16 Oct 2017

Credit bureaus as fundamentally dangerous businesses

I received a lot of push back against my suggestion that Equifax should be shutdown in response to the massive data hack that has been described as the worst leak of personal info ever. Many people thought that this was too drastic: one comment was that it “would shake the ground under capitalism.” Some thought that all computers can get hacked and we cannot keep shutting down a company whenever this happens.

I think of this in terms of the standard legal maxim of “strict liability” which is described for example here:

A strict liability tort holds a person or entity responsible for unintended consequences of his actions. In other words, some circumstances or activities are known to be fundamentally dangerous, so when something goes wrong, the perpetrator is held legally responsible.

I regard credit bureaus as fundamentally dangerous businesses that ought not to exist in their current form. When something goes wrong in these businesses, the liability should be absolute and punitive. What has happened in Equifax is so bad that imposition of a reasonable liability would simply put them out of business. Simultaneously, we start building modern, safer alternatives to this fundamentally dangerous business.

I see the past, present and future of credit bureaus as follows:

  1. Past: Credit bureaus were first formed more than a century ago in the age of paper records and manual systems, and the business was relatively safe at that time. Society therefore encouraged the growth and development of these institutions.

  2. Present: With the emergence of the internet, the business has rapidly become a systemic risk to the entire financial system, but till now we have tolerated them because there seemed to be no viable alternatives.

  3. Future: Recent advances in cryptography today provide much safer alternatives to the credit bureaus in their current form.

We are today at the cusp of the transition from the second to the third stage:

I plan to write a separate blog post on how homomorphic encryption can solve the problems that plague current credit bureaus.

Posted at 16:44 on Mon, 16 Oct 2017     View/Post Comments (0)     permanent link


Fri, 29 Sep 2017

How insider trading laws became the crooks' best friend

Andrew Verstein’s blog post on “Insider Tainting: Strategic Tipping of Material Non-Public Information” at the CLS Blue Sky Blog made me think about the numerous ways in which insider trading laws have become the crooks’ best friend. Verstein gives an example based on a controversial real life episode, but I would prefer to rephrase it as a purely hypothetical situation:

Consider a small company (let us call it SmallCo) which has not been doing too well. The company plans to issue new shares to shore up its capital though this would dilute the existing shareholders. At this point of time, SmallCo's CEO comes to know that the largest shareholder in the company (let us call him John) is on the verge of selling his shares. If John sells his block, that would send a negative signal to the market about SmallCo's prospects and would frustrate its plans to raise new capital. More menacingly, if John’s stake ends up in the hands of an activist investor, that would lead to a lot of pressure on the existing management and even a change of management – SmallCo's CEO could end up losing his job. The CEO comes up with a brilliant plan to stop John from selling his stake (and save his job): he simply calls up John and informs him of the confidential plan to sell new shares. John is now “tainted” with insider information, and may not be able to sell his stake without attracting insider trading laws.

While this is a shocking illustration of how a crooked CEO may be able to recruit the securities regulator itself as his partner in market manipulation, the more important question to ask is why did the securities regulator choose to frame laws that end up having this perverse effect. In my opinion, the true reason for this is the regulatory capture of securities regulators worldwide by the intermediaries that they regulate.

As part of this argument, I would like to draw on a brilliant blog post by Judge Rakoff in 2013 on “Why Have No High Level Executives Been Prosecuted In Connection With The Financial Crisis?” (I blogged about this piece at that time). Rakoff quickly dismisses the argument that no fraud was committed, and that the Global Financial Crisis was simply a result of negligence, of the kind of inordinate risk-taking commonly called a ‘bubble.’ The judge cites various official reports to demonstrate that “in the aftermath of the financial crisis, the prevailing view of many government officials (as well as others) was that the crisis was in material respects the product of intentional fraud.” He then articulates what he regards as the most important reason why no such prosecutions happened:

First, the prosecutors had other priorities.

...

Alternative priorities, in short, is, I submit, one of the reasons the financial fraud cases were not brought, especially cases against high level individuals that would take many years, many investigators, and a great deal of expertise to investigate.

Insider trading prosecutions (Martha Stewart, Raj Rajaratnam and Rajat Gupta) and Ponzi scheme prosecutions (Bernie Madoff) in my view played an important role here. The public’s anger was assuaged by prosecuting some high profile individuals, and this served to deflect attention from the fact that the executives running the large institutions escaped scot-free.

What is interesting about insider trading prosecution is that it allows financial sector regulators to target people who are outside (or at the periphery of) the financial system. It is therefore extremely attractive to regulators who have been captured by its regulatees. It is able to project an image of being a very tough regulator without causing much harm to its own regulatees.

This perspective explains several puzzling facts about the evolution of insider trading law:

  1. Insider trading law and enforcement has expanded though there has been a strong academic argument going back half a century for legalizing insider trading (see for example, Henry Manne and Hu and Noe). Even if one does not go that far, there is a strong argument for decriminalizing insider trading and making it purely a civil liability. I have been making this argument for nearly 15 years now (see for example here).

  2. Regulators have progressively sought to enlarge the definition of insider trading to cover many legitimate activities on the ground that without such an expansive definition, insider trading becomes hard to prove. I often joke that the prohibition of “insider trading” has gradually morphed into the prohibition of “informed trading.”

  3. Regulators have rarely used their powers judiciously and have typically tended to pursue specific high-profile cases for extraneous reasons.

Posted at 16:44 on Fri, 29 Sep 2017     View/Post Comments (0)     permanent link


Sat, 23 Sep 2017

Norway and the tail risk of bonds

I have long been an admirer of the transparent and sound investment policies of Norway’s sovereign wealth fund (Government Pension Fund Global). However, I was perplexed by their recent proposals regarding the bond portfolio of this fund.

In the long term, the gains from broad international diversification are considerable for equities but moderate for bonds. For an investor with 70 percent of his investments in an internationally diversified equity portfolio, there is little reduction in risk to be obtained by also diversifying his bond investments across a large number of currencies.

The benchmark index for bonds currently consists of 23 currencies. Our recommendation is that the number of currencies in the bond index is reduced. This will have little impact on risk in the overall benchmark index.

An index consisting of bonds issued in dollars, euros and pounds alone will be sufficiently liquid and investable for the fund.

I tend to think of the risk of the high grade bonds (of the kind that Norway invests in) as consisting predominantly of tail risk. This is well described by Adam Fergusson’s When Money Dies about the German hyperinflation of the 1920s. A long term investor like the Norway sovereign fund needs to worry about this tail risk. A policy of concentrating the bond portfolio in just three currencies does not appear prudent to me.

The other possibility is that the Norway fund is ceasing to be the long term investor it used to be. As the accumulation phase comes to an end, and the fund enters its draw down phase, it may be prioritizing liquidity over everything else. (In 2016, Norway drew down from the sovereign fund for the first time in its history.) The management of the bond portfolio of the fund then begins to resemble normal foreign exchange reserve management which tends to concentrate holdings in a handful of highly liquid reserve currencies.

Posted at 15:12 on Sat, 23 Sep 2017     View/Post Comments (0)     permanent link


Sun, 17 Sep 2017

Bonds markets are not different

Institutional investors have long argued that bond markets are very different from equity markets and need OTC trading venues because of their peculiar characteristics. More than a decade ago, I remember receiving massive push back for suggesting that an exchange traded government bond market could be better for India than the recommendations of the RH Patil Committee.

In recent years, however, the structure of bond markets in the developed world has started moving closer to that of the equity market. Post crisis reforms like higher capital requirements and the Dodd Frank Act have led dealers to reduce their market making activities. Other players including hedge funds, algorithmic and high frequency traders as well as electronic trading platforms have stepped into the breach. The SEC study on Access to Capital and Market Liquidity submitted to the US Congress last month provides a great deal of evidence on the ability of the new market structure to deliver reasonable levels of liquidity.

Meanwhile, a recent study (Abudy and Wohl, “Corporate Bond Trading on a Limit Order Book Exchange”, July 2017) showed that the exchange traded corporate bond market in Tel Aviv Stock Exchange in Israel is more liquid than the OTC corporate bond market in the US (both in terms of narrower spreads and lower price dispersion). This is so despite the fact that the market for stocks in Israel is less liquid than in the US. An exchange traded corporate bond market in the US could therefore be expected to have even narrower spreads than in Israel.

We should stop doubting the ability of pre and post trade transparency to improve liquidity across asset classes.

Posted at 17:29 on Sun, 17 Sep 2017     View/Post Comments (0)     permanent link


Wed, 13 Sep 2017

Should Equifax be shut down?

The US and India are among the few countries that still retain the death penalty for people, and they should have no qualms about imposing the death penalty on companies. Equifax might be a good candidate for this drastic action after the massive data hack that has been described as the worst leak of personal info ever.

There is probably no criminal activity involved, and so nobody can be sent to jail. Fines and penalties will doubtless be imposed, but companies like Equifax tend to think of any fines as simply the cost of doing business and do not find it a sufficient deterrent. They will continue to spend too little on cyber security. There is little that consumers can do to discipline them either. Adam Levetin at Credit Slips hits the nail on the hand:

Equifax didn’t lose customer records. It lost consumer records. That’s an important distinction, and it goes to the heart of the problem with the CRAs. Consumers can, in theory, avoid harm from a data security breach at a merchant by not doing business with the merchant.

...

It’s not possible for a consumer to withhold business from a CRA because the consumer does not have a business relationship with the CRA. And this is the key problem: we have a consumer financial services market in which consumers cannot vote with their pocketbooks.

A threat far bigger than fines and penalties is needed to force financial firms to take security of consumers seriously. The only credible threat is that of shutting down the company and simultaneously imposing a penalty large enough to ensure that neither shareholders nor creditors of the company receive anything in the liquidation.

Posted at 21:32 on Wed, 13 Sep 2017     View/Post Comments (2)     permanent link


Mon, 04 Sep 2017

The Jorda et al. estimate of the world Market Risk Premium

The Market Risk Premium (expected excess return of equities and other risky assets over risk free assets) is an important element in asset pricing models particularly the Capital Asset Pricing Model. Estimating the Market Risk Premium from historical data is very difficult because of high volatility – the sample mean over even many decades of data is subject to too large a sampling error. For example, reliable historical data on risk premiums in India goes back less than three decades, and we worry whether the realized risk premium over this period is representative of what premium will prevail in future. Data going back around a century is available for the United States, but use of this data raises serious issues of survivorship bias, as the US is clearly one of the best performing economies of the last century.

I think the NBER Conference paper by Jorda, Knoll, Schularick, Kuvshinov and Taylor “The Rate of Return on Everything, 1870–2015” is a valuable new estimate of the Market Risk Premium. First they have put together a large sample: 16 advanced economies over almost 150 years (the length of the sample varies from country to country). Second, they compute the Market Risk Premium using not merely equities, but also housing which is the most important risky asset outside of equities. In finance theory, the Market Portfolio in theory includes all risky assets, and including housing moves the empirical estimation closer to theory. Pooling data across all countries, they arrive at the following conclusion:

In most peacetime eras this premium has been stable at about 4% – 5%. But risk premiums stayed curiously and persistently high from the 1950s to the 1970s, despite the return to peacetime. However, there is no visible long-run trend, and mean reversion appears strong. The bursts of the risk premium in the wartime and interwar years were mostly a phenomena of collapsing safe rates rather than dramatic spikes in risky rates. In fact, the risky rate has often been smoother and more stable than safe rates, averaging about 7% – 8% across all eras.

It is interesting to observe that the Capital Asset Pricing Model was created during the period of high risk premiums in the 1960s, and its obituaries started being written in the 1980s and 1990s when the risk premium collapsed to very low levels (Figure 10 in the paper).

Jorda et al. also provide an estimate of another important risk premium using the same long period multi-currency sample: the term structure premium or the liquidity risk premium (bonds versus bills). This risk premium is around 1.5% for the full sample, but somewhat larger during the last quarter century (Figure 3 of the paper).

Posted at 17:01 on Mon, 04 Sep 2017     View/Post Comments (0)     permanent link


Tue, 29 Aug 2017

Operational creditors yet again

When the Bankruptcy Law Reforms Committee (BLRC) submitted its report nearly two years ago, one of my major concerns was the dubious and unwarranted distinction that it made between operational and financial creditors (see my blog posts here and here). This invidious distinction has come back to haunt us today as home buyers find themselves in the lurch when bankruptcy proceedings are initiated against the developer. Pratik Datta tells the full story of this mess in her blog post at Ajay Shah’s blog.

This is symptomatic of a deeper problem with how bankruptcy reform in India has developed as a bailout of the financial sector rather than as a reform of the real economy. From the Debt Recovery Tribunal to SARFAESI to the Bankruptcy Code, banks were privileged over other creditors and financial creditors over operational creditors. It would appear that the dominant goal has been to save the banks. Jason Kilborn articulates the problem very elegantly in his blog post at Credit Slips:

It seems to me a sign of serious regulatory dysfunction when a government expressly uses bankruptcy law as a means of collection, rather than rescue or at least collective redress, with an aim to treating economic stagnation.

It is particularly telling that there has been a profound unwillingness to apply bankruptcy principles to the financial sector itself: Global Trust Bank was merged instead of being left to die; Unit 64 was bailed out; even today, there is no willingness to liquidate even the worst public sector banks. One has to go back half a century to Palai Central Bank for an example of a bank of any significance being allowed to die (though only after a lot of dilly dallying).

Posted at 14:07 on Tue, 29 Aug 2017     View/Post Comments (0)     permanent link


Mon, 07 Aug 2017

Are bonds both a liability and an asset of the borrower?

I have a special interest in this question because that was the topic of the first post on my blog way back in 2005. Five centuries after Luca Pacioli wrote the first text book on double entry accounting, this issue remains unresolved, and smart litigants are still seeking to attach the bonds issued by the debtor to recover their claims. In 2005, it was Argentina; in 2017, it is Venezuela (hat tip Credit Slips).

Twelve years ago, Argentina was exchanging its old bonds for new bonds as part of its infamous debt restructuring. Some hedge funds moved to seize the old bonds that Argentina had accepted for the exchange on the ground that the surrendered bonds were assets of Argentina which could be sold in the market to satisfy the claims of the hedge funds. Argentina of course argued that the bonds belonged to the tendering holders, and that they could not be Argentina’s assets and liabilities at the same time. The federal appeals court in New York did not decide the legal question, but simply upheld the trial court’s ruling in favour of Argentina on the ground that the trial judge overseeing the overall debt exchange had broad discretion in the matter. Anna Gelpern provides more details in this paper (page 4).

If Argentina’s debt restructuring was a mess, Venezuela promises to be even messier if and when that country gets to that stage. What is happening now are merely some skirmishes before Venezuela defaults and the serious litigation begins. Buchheit and Gulati wrote in a recent paper:

Napoleon’s invasion of Russia in 1812 was a large undertaking. Restructuring Venezuela’s public sector debt will be a very large undertaking.

Early this year, Venezuela issued $5 billion in new bonds to a state owned entity to help raise cash needed for essential imports (“Venezuela issues $5bn in bonds as it seeks cash to ease shortages”, Financial Times, January 3, 2017). In June, Venezuela engaged a Chinese securities firm, Haitong, to resell these bonds reportedly at a steep discount of more than 70% (“Venezuela Discounts $5 Billion in Bonds”, Wall Street Journal, June 6, 2017). Soon, a Canadian firm, Crystallex, obtained a restraining order against Haitong, as a first step towards attaching the bonds. (“Crystallex Moves Closer To Collecting $1.2B Venezuela Award”, Law360, July 17, 2017). Perhaps, this time, the courts will actually decide this question as to whether a debtor’s bonds can be treated as its assets and attached by the creditors.

Posted at 19:05 on Mon, 07 Aug 2017     View/Post Comments (0)     permanent link


Sat, 05 Aug 2017

Markets that are Too Big To Fail (TBTF)

We hear a lot about TBTF banks, but I think in the post crisis world, policy makers are beginning to view some markets as being TBTF. The IMF published a working paper last month by Darryl King et al. on Central Bank Emergency Support to Securities Markets. This paper appears to me to formalize and legitimize this idea. My unease about this paper is that it not only endorse almost everything that the central banks did during the crisis, but also elevates these to the level of best practices. The paper ignores the fact that while these might have helped in the crisis, they would also have unintended effects on the functioning of markets during normal times.

Markets that are highly likely to be bailed out during a future crisis will be perceived as safer even during normal times. Bonds that trade in these markets will therefore command lower yields. The result is a subsidy to the borrowers issuing these bonds. The subsidy to TBTF banks is partially alleviated through more stringent regulation of these banks (SIFIs), but there is no such regulatory pressure on corporate borrowers benefiting from the subsidization of TBTF markets.

I am fond of Kindleberger’s statement that a lender of last resort must exist but his existence should be doubted. In their eagerness to legitimize whatever was done during the crisis, policy makers are removing this doubt and making the TBTF subsidy more certain and more significant. They are picking winners and losers, and since the winners that they choose are the mature companies, they are penalizing the more innovative dynamic firms that are crucial for long term economic growth.

Posted at 21:35 on Sat, 05 Aug 2017     View/Post Comments (0)     permanent link


Wed, 02 Aug 2017

In the sister blog and on Twitter during January-July 2017

The following posts appeared on the sister blog (on Computing) during January-July 2017.

Tweets during January-July 2017 (other than blog post tweets):

Posted at 14:15 on Wed, 02 Aug 2017     View/Post Comments (2)     permanent link


Mon, 31 Jul 2017

Equity Derivatives versus Cash Equities in India

The Securities and Exchange Board of India (SEBI), the Indian securities regulator, put out a discussion paper a couple of weeks ago on the Growth and Development of Equity Derivatives Market in India. The Indian Equity Derivatives Market is one of the success stories of financial market development in India and clearly, it makes sense to study this market to draw lessons that could help replicate this success in other segments (bond markets for example) that have remained under developed after 25 years of reforms.

Unfortunately, the SEBI discussion paper seems to prefer levelling down to levelling up. Rather than bring other markets up to the high standards set by the equity derivatives markets, it seeks to clamp down on this successful market to reduce it to the mediocrity of other lacklustre markets.

The discussion paper is worried about the high ratio of derivative market turnover to cash market turnover, and thinks that therefore there must be something wrong with the derivative market. The correct conclusion is quite the opposite: there is something grievously wrong about the cash market. Several policy makers have conspired to prevent a vibrant cash market from emerging in India:

  1. The Reserve Bank of India (RBI) places severe restrictions on capital market related lending and therefore starves the cash market of credit. Everybody who seeks leverage is therefore forced to move to the derivative market. SEBI has a margin trading scheme, but this scheme has been largely a failure.

  2. For a different set of reasons, the securities lending scheme has also failed to take off, and those desirous of taking a short position in stocks are also forced to turn to the derivative market.

  3. The government in its greed for tax revenue (with near zero collection cost) has pushed up the securities transaction tax to punitive levels in the cash market. Though the difference in price elasticity in the two markets could make the revenue maximizing rate of taxation unequal in the two markets, it is likely that the current rates are not actually optimal even from a revenue maximizing point. More importantly, the rate of transaction tax in the cash market is far too high from a social welfare point of view.

These factors have stunted the growth of the cash equities market in India. The liquid derivatives market has ameliorated this problem for the top 50-100 companies. But that leaves hundreds of other companies in the lurch. In my view, this is a serious problem because a vibrant equity market is important for economic growth. All policy makers (SEBI, RBI and the Finance Ministry) need to come together to fix the flaws in the cash equities market.

I believe that India can create a reasonably liquid market for the top 1000 companies in the country. Market participants laugh at me when I say this, but if the US can do this, I do not see why India cannot. We have all the institutional prerequisites for such a market – world class depositories, exchanges, and clearing corporations; a large ecosystem of intermediaries; a strong regulator; and above all a vast investor base. I hope that regulators will raise their sights and aim for this, rather than try to cripple the derivative market so that it is no longer obvious that the cash market is limping.

Posted at 21:22 on Mon, 31 Jul 2017     View/Post Comments (1)     permanent link


Sun, 30 Jul 2017

The SEC and The DAO

The US SEC has published an Investigation Report concluding that crpyto-currency tokens issued by The DAO constitute securities under US law. I am not a lawyer, and it is not my intention in this post to dispute the SEC’s conclusion which is, on balance, probably correct. What bothers me is that some vital facts seem to me to have been suppressed and misrepresented in the report. In particular, several passages look like the kind of suppresio veri suggestio falsi that one does not expect from a top notch regulator like the SEC which commands global respect:

DAO Token holders’ votes were limited to proposals whitelisted by the Curators, and, although any DAO Token holder could put forth a proposal, each proposal would follow the same protocol, which included vetting and control by the current Curators. While DAO Token holders could put forth proposals to replace a Curator, such proposals were subject to control by the current Curators, including whitelisting and approval of the new address to which the tokens would be directed for such a proposal.

This ignores the ability to split The DAO and create a new “child” DAO with a new curator. The hacking of The DAO (which the SEC refers to as the Attack below) involved exactly this splitting.

Second, the pseudonymity and dispersion of the DAO Token holders made it difficult for them to join together to effect change or to exercise meaningful control. ... This was later demonstrated through the fact that DAO Token holders were unable to effectively address the Attack without the assistance of Slock.it and others.

In reality, it is the DAO Attack that constitutes the biggest obstacle to the theory that The DAO tokens were securities. The tokens looked much more like securities when they were issued than they do in retrospect after the Attack:

  1. The only important events (“investments” in some sense) in the entire life of the DAO were the Dark DAO (the Attacker) and the Robin Hood Group or the DAO White Hat Team. Since neither of these were initiated by Slock.it, this completely demolishes the idea that Slock.it was in a position to control The DAO.

  2. I could not help laughing out loud on reading the sentence: “DAO Token holders were unable to effectively address the Attack without the assistance of Slock.it and others”.

    • If the “others” refers to the Robin Hood Group (White Hat Team), this statement is factually incorrect: (a) the Robin Hood Group were also token holders (and not others) and (b) they were acting not on behalf of Slock.it, but in their individual capacity, struggling with “bad internet and family commitments”.

    • The major assistance that Slock.it provided in reversing the Attack was not in their role as developers of The DAO, but in their role as developers of Ethereum which was the platform on which The DAO ran. What the core developers did was to change the rules of Ethereum to undo the Attack.

      The right analogy is that of a company where the government has been outvoted in a shareholder’s meeting (because it has been reduced to a minority stake), and the government proceed to change the law and use its sovereign powers to get its way. This would establish not that the government still controls the company, but that it has lost control. The analogy is apt because Ethereum was the closest thing to the sovereign when it comes to The DAO.

    • Even this “assistance” (changing the rules of Ethereum) was well beyond the powers of Slock.it. Ethereum is far more decentralized than The DAO; even the SEC has not claimed that the Ethereum coin offering was a securities issue! The Ethereum community did not actually care much about the wishes of Slock.it. Whatever influence was there was the personal influence of Vitalik Buterin. (In much the same vein, the Ethereum community probably did not care much about Cornell University, but listened with respect to Emin Gun Sirer). Even Buterin’s enormous personal credibility could not prevent a split in Ethereum and the creation of the parallel coin, Ethereum Classic

In short, the Attack demonstrated that at truly important junctures, crypto communities are truly decentralized. The events in Bitcoin in the last few weeks provide additional corroboration of this.

These facts diminished the ability of DAO Token holders to exercise meaningful control over the enterprise through the voting process, rendering the voting rights of DAO Token holders akin to those of a corporate shareholder.

The SEC forgets that The DAO did not have a Board or a Chief Executive who run the company on a day to day basis. In the case of The DAO, the day to day administration of the organization was in the hands of the token holders.

By contract and in reality, DAO Token holders relied on the significant managerial efforts provided by Slock.it and its co-founders, and The DAO’s Curators, as described above.

The claim “By contract” is very rich. The DAO was very clear in all its communications that it was governed by its code and repeatedly emphasized that all English language descriptions were subordinate to the smart contract embedded in the code: code is law. And, I am sorry, the code did not contain any promises by Slock.it to provide managerial efforts.

Posted at 20:53 on Sun, 30 Jul 2017     View/Post Comments (0)     permanent link


Sat, 29 Jul 2017

Libor and Nash Equilibria

This week, I read two apparently unrelated things that on later reflection are deeply related:

  1. The FCA, the UK regulator, made a statement that the world’s most important interest rate benchmark, Libor, will be phased out in less than five years because of lack of liquidity. The problem discussed in this speech is very easy to understand: the underlying market is no longer sufficiently active. The reasons for this state of affairs are much harder to diagnose.

  2. A highly esoteric paper was published on the Computer Science and Game Theory section of arXiv more than six months ago, but I read it only recently after FT Alphaville linked to it at one remove a few days ago. This paper by Babichenko and Rubinstein proves that finding even an approximate Nash equilibrium of an n person binary-action games requires an exponential amount of communication, and therefore, it takes an exponential number of rounds of the game for the players to “learn” the approximate Nash equilibrium by playing the game repeatedly.

The link that I see from the esoteric paper to the Libor situation is that markets require very rich communication structures to be viable. One way to facilitate the required amount of multi-way communication is through the high degree of pre-trade and post-trade transparency that is created by trading on an exchange. The other method that was used in the past in various over the counter (OTC) markets was informal communication channels between traders in different firms. Some of these traders might have worked together in the past or might have other personal and social connections. Using various messaging and chat media, these traders used to accomplish an extremely rich communication structure. Of course, these informal communication networks were abused to allow key players to make greater profits (information is money in all markets). After the Global Financial Crisis, regulators shut down the informal communication channels in an attempt to clean up the markets. They succeeded beyond their wildest expectations – there is by definition no manipulation in a market that does not trade at all.

Post crisis, there was a move towards mandatory clearing, but not towards mandatory exchange based trading. This is clearly a huge mistake: the only real alternative to informal communication channels is formal information flows mediated by exchanges. So we see breakdown of previously highly liquid markets. On the other side, central clearing in a market without adequate liquidity and transparency is a prescription for disaster sooner or later. So far, most of the problems have been pushed under the carpet by the central banks that have become market makers of first and last resort in many markets. As they normalize their balance sheets, dysfunctional markets could become a progressively bigger problem.

Posted at 14:15 on Sat, 29 Jul 2017     View/Post Comments (0)     permanent link


Wed, 19 Jul 2017

Why Aadhaar transaction authentication is like signing a blank paper

Using Aadhaar (India’s biometric authentication system) to verify a person’s identity is relatively secure, but using it to authenticate a transaction is extremely problematic. Every other form of authentication is bound to a specific transaction: I sign a document, I put my thumb impression to a document, I digitally sign a document (or message as the cryptographers prefer to call it). In Aadhaar, I put my thumb (or other finger) on a finger print reading device, and not on the document that I am authenticating. How can anybody establish what I intended to authenticate, and what the service provider intended me to authenticate? Aadhaar authentication ignores the fundamental tenet of authentication that a transaction authentication must be inseparably bound to the document or transaction that it is authenticating. Therefore using Aadhaar to authenticate a transaction is like signing a blank sheet of paper on which the other party can write whatever it wants.

All this was brought home to me when I bought a new SIM card recently and was asked to authenticate myself with a finger print. The employee of the telecom company told me that there was a problem and I needed to try again. Being a little suspicious, I stretched forward and twisted my neck to peep at the computer screen in front of the employee (this screen would otherwise not have been visible to me). My suspicion was allayed on seeing an error message on the screen and I tried again only to get the same error message. After three attempts, the employee suggested that I come again the next day. Back home, I saw three emails from UIDAI (Unique Identification Authority of India) stating “Your Aadhaar number ___ was used successfully to carry out e-KYC Authentication using ‘Fingerprint’ on ___ at ___ Hrs at a device deployed by ___.” Note the word successfully.

That is when I realized that the error message that I saw on the employee’s screen was not coming from the Aadhaar system, but from the telecom company’s software. That is a huge problem. This conclusion was corroborated the next day when after one more error message, I found that the employee had left one field in the form partially filled and the error message disappeared when that was corrected.

Let us think about why this is a HUGE problem. Very few people would bother to go through the bodily contortion required to read a screen whose back is turned towards them. An unscrupulous employee could simply get me to authenticate the finger print once again though there was no error and use the second authentication to allot a second SIM card in my name. He could then give me the first SIM card and had over the second SIM to a terrorist. When that terrorist is finally caught, the SIM that he was using would be traced back to me and my life would be utterly and completely ruined.

Actually, even my precaution of trying to read the employee’s screen is completely pointless. The screen is not an inseparable part of the finger print reader. On the contrary. the fingerprint reader is attached by a flimsy cable to a computer (which is out of view) and the screen is purportedly attached to the same computer. It is very easy to attach the fingerprint reader to one computer (from which a malicious transaction is carried out) and attach the screen on the counter to another computer which displays the information that I expect to see.

Another way of looking at the same thing is that a rogue employee of the telecom company could effortlessly execute what is known in computer security as an MitM (Man in the Middle) attack on the communication between me and the Aadhaar system. In fact, I see some analogies between the problem that I am discussing and the MitM attack described by Nethanel Gelerntor, Senia Kalma, Bar Magnezi, and Hen Porcilan in their recent paper (h/t Bruce Schneier). Neither I nor the Aadhaar system has any way of detecting or foiling this MitM attack.

I think the whole model is fundamentally broken, and Aadhaar should be used only to verify identities, and not to authenticate transactions. Transaction authentication must happen with a thumb impression, a physical signature, a digital signature or something similar that is inseparably bound to a document.

Posted at 21:34 on Wed, 19 Jul 2017     View/Post Comments (2)     permanent link


Sat, 15 Jul 2017

Secret deals between exchanges and traders: securities fraud implications

Dolgopolov has a nice paper on the conditions under which secret arrangements between exchanges and high frequency traders might or might not constitute securities fraud. Modern exchanges use complex order types and intricate order hiding and matching rules, and they could claim that any bugs or flaws in their trading protocols are honest implementation mistakes. Smart traders who exploit these trading imperfections and frictions could simply claim to be skillful beneficiaries who discovered the bugs by their own effort. In many cases, there appears to be collusion between the exchange and the HFT firms (the exchanges often disclose undocumented features and bugs privately to their best customers in return for getting more business from these firms), but this is not easy to prove. Dolgopolov proposes legal theories under which securities fraud liability could be imposed on the HFT firms themselves.

For over a decade now, I have been arguing for a different solution: regulators should mandate that critical exchange software be open source (here, here, here and here). At the risk of sounding like a broken record, I would like to reiterate my view that “regulators and self regulatory organizations have not yet understood the full power of the open source methodology in furthering the key regulatory goals of market integrity.”

Posted at 12:57 on Sat, 15 Jul 2017     View/Post Comments (0)     permanent link


Sun, 09 Jul 2017

Global Capital Flows: VIX versus US Fed

Historically, the VIX (the volatility of the US stock market implied by option prices) has been an important barometer of global risk aversion that has a strong influence on global capital flows. A BIS Working Paper published last month (Avdjiev, Gambacorta, Goldberg and Schiaffi, “The Shifting Drivers of Global Liquidity”) demonstrate that this changed in the aftermath of the Global Financial Crisis with US monetary policy becoming the dominant driver of capital flows while the VIX declined in importance. They also point out that this phenomenon peaked in 2013 and there has been a partial return to pre-crisis patterns since then.

The results make intuitive sense: as global central banks pursued unconventional monetary policy, a large amount of duration risk ended up on the ever expanding balance sheets of these central banks. They thus became the marginal risk taker in the economy. (The authors use the Wu-Xia shadow rate as their measure of US monetary policy to take account of the impact of unconventional monetary policy). Since 2013, the central banks have been in tapering mode and they are no longer the marginal risk taker in the economy.

Though the authors do not venture down this path, I think their results explain well why the 2013 taper talk had such a drastic impact on emerging markets while the coordinated tightening by global central banks during the last year has had such a muted impact. The marginal risk taker is now the private investor and the low level of VIX currently indicates that the marginal risk taker is in “risk on” mode. This suggests that we should be looking at the VIX rather than at global monetary policy for the early warning signs of the next wave of turbulence in emerging markets.

Posted at 13:49 on Sun, 09 Jul 2017     View/Post Comments (0)     permanent link


Sat, 08 Jul 2017

Electronic banking liability allocation

A couple of days back, the Reserve Bank of India (RBI) issued new guidelines regarding who bears the loss from online banking frauds. The effect is to limit the liability of the customer and thereby transfer the loss to the banks. This measure has been seen as a customer friendly one. Basic economics teaches us to be careful about coming to such a conclusion. In equilibrium, banks would probably recover all expenses incurred by them from their customers. In fact, today, bank customers in India are probably paying higher fees as banks try to recover their bad loan losses from their customers. Unless banking becomes more competitive, the effect of the RBI regulation would more likely be a transfer from one group of customers (those who do not use online banking or have not been defrauded) to those who have lost money.

I think that the RBI regulation is a very good move for a very different reason: incentive compatibility. The important thing is that the regulation places losses on the party that can do something to reduce frauds. A customer cannot improve the bank’s computer security, she cannot ensure that the bank patches all its software, follows a good password policy, and so on. Only the bank can do all this. Unfortunately, computer security does not receive adequate attention from the top management of banks in India. If the new policy helps concentrate the minds of top management, that would be a good thing. If that does not happen, maybe the bank will wake up when the losses materialize. That is the true benefit of the new regulation – it has the potential to reduce online frauds.

Posted at 21:53 on Sat, 08 Jul 2017     View/Post Comments (0)     permanent link


Sun, 25 Jun 2017

Enterprise without entities

In recent months, a significant amount of money has been raised using smart contracts and initial coin offerings. In May 2016, The DAO raised about $150 million with an “objective to provide a new decentralized business model for organizing both commercial and non-profit enterprises”. It did not have a formal organizational structure or legal entity and consisted only of open source computer code. A bug in this code allowed a hacker to siphon off about $50 million of this money, but this was reversed by a hard fork of the Ethereum blockchain (see here for the details). A few days ago, Bancor raised even more money than the DAO amidst criticism that its business model is seriously flawed.

These smart contracts create business enterprises without creating any legal entity. You cannot sue a piece of code, nor send it to jail, but when this piece of code creates a self enforcing contract, it becomes an enterprise. This seems to create a challenge for the legal system.

It was in this context that I read “Enterprise without Entities” by Andrew Verstein (Michigan Law Review, 2017).

This Article challenges conventional wisdom by showing that vast enterprises – with millions of customers paying trillions of dollars – often operate without any meaningful use of an entity.

This Article introduces the reciprocal exchange, a type of insurance company that operates without any meaningful use of a legal entity. Instead of obtaining their insurance from a common nexus of contract, customers directly insure one another through a web of countless bilateral agreements. While often overlooked or conflated with mutual insurance companies, reciprocal exchanges include some of America’s largest and best known insurance enterprises.

This Article explores how it is possible to run an international conglomerate with essentially no recourse to organizational law as it is normally conceived.

The whole paper is worth reading for the wealth of detail and careful legal analysis. It tells us that enterprise without entities is not some radical new innovation made possible by smart contracts, but is something that has been successfully practised since the early twentieth century.

More importantly, it also tells us that the challenge in making smart contracts work is not going to be legal. The real challenge is the more mundane and much harder task of writing software without nasty bugs.

Posted at 20:29 on Sun, 25 Jun 2017     View/Post Comments (0)     permanent link


Fri, 16 Jun 2017

How to bury zombie companies quickly

Earlier this week I posted about the bankruptcy literature of the 1990s that sought to rely less on judges, administrators and experts and more on contracts and markets. As promised in that post, I now explore the implications of that framework for the widespread corporate distress in India today.

While much of the discussion on the Indian situation emphasizes the problem of bad loans in the banking system, the government’s Economic Survey rightly described it as a twin balance sheet problem encompassing problems in the balance sheets of the banking system and of the corporate sector. Of the two, I would argue that the problem in the banking system is the less serious one for many reasons.

  1. The overt problem is largely confined to the public sector banks and from past experience we know that these banks can run smoothly (without any run on the banks) regardless of how little capital they have. Indian Bank in the mid 1990s is a classic example of the depositors retaining their faith in the bank even after reporting a large loss that resulted in a negative net worth. These days, there is the issue of Basel norms, but strictly speaking, they apply only to internationally active banks. If the overseas operations of the unhealthy public sector banks are shut down or transferred to healthier ones, there is no technical bar on letting them operate with low levels of capital adequacy. By placing restrictions on their fresh lending, any moral hazard problems can be alleviated.

  2. Many observers believe that bad loans are not confined to the public sector banks, and that at least some private sector banks have a large but covert problem. But this issue can probably be addressed by imposing a large preemptive recapitalization on them.

  3. India needs to move away from a bank dominated financial system, and some degree of downsizing of the banking system is acceptable if it is accompanied by an offsetting growth of the bond markets and non bank finance.

In my view, the problem of zombie companies is far more serious than the problem of zombie banks. There is overwhelming anecdotal evidence that these zombie companies are a major drag on the economy. For those who are not swayed by anecdotal evidence, an IMF working paper published this month demonstrates that the decline in private investment in India is linked to over-leveraged companies being unable to start new projects or complete ongoing projects. For India to achieve high growth, it is necessary to sort out these zombie companies.

Bankruptcy is the most effective way of putting an end to the zombie companies, and recycling their assets for more efficient use. Bankruptcy breaks the vicious cycle through which past debt acts as a brake on future growth. As Heidt put it: “Bankruptcy separates the past from the future ... it takes the debtor’s past assets to pay its past creditors.”

Traditional bankruptcy processes may not provide an adequate solution to this problem because the number of companies involved is quite high and because India does not yet have enough trained bankruptcy professionals and judges to do bankruptcy on a massive scale. This is where I am fascinated by the idea in the bankruptcy literature of the 1990s of using markets instead of courts. This is much more scaleable in the Indian context because some Indian financial markets are reasonably deep, and the supply of funds in these markets is quite elastic because they are open to foreign investors.

My preferred solution is basically the same as the AHM procedure that I mentioned in my last blog post. In this approach, the government forces the banks to converts all their loans into equity, and also forces the banks to sell the resulting equity in the stock market within a tight time frame. The new shareholders decide whether to sell the assets or to run the business. In any case, with the debt completely removed, the company is no longer a zombie company, and even a partial or total liquidation would be a voluntary liquidation by the shareholders that does not require significant court intervention. The difficulties with this method are easy to surmount:

  1. It assumes a well functioning equity market, but I think this is more reasonable assumption to make than that banks can suddenly figure out how to restructure all this debt, or that rating agencies can be trusted to provide useful guidance on this (Partnoy’s scathing piece last month should remove all doubts on the matter) or that an omniscient central bank can tell the banks how to restructure all the debt.

  2. One “discretionary” question still appears to remain: how much of the old equity should be wiped before the conversion of the loans. In the original AMH procedure, this problem is solved using Bebchuk options: old shareholders are given the option to buy out the creditors pro rata. In most of the zombie companies, the Bebchuk options are unlikely to be exercised, and the old shareholders would be completely wiped out. Allowing the old shareholders to retain 5-10% of the expanded equity might be another possibility to make it politically more palatable.

  3. The banks would take large losses in this process that could leave them poorly capitalized. I have already discussed this above. For public sector banks, the capital does not really matter, and for the private sector banks, the problem can be solved by imposing a preemptive recapitalization. The important thing is to downsize the banking system so that we do not get into this mess again.

Posted at 18:51 on Fri, 16 Jun 2017     View/Post Comments (1)     permanent link


Sun, 11 Jun 2017

Bankruptcy ideas from the 1990s

During the last few weeks, I had the opportunity to read (and in some cases re-read) the large stream of literature about bankruptcy that emerged in the United States in the early 1990s. (That is one of the benefits of taking a serious vacation). There are a lot of original ideas in this literature because a serious application of the law and economics paradigm to this field probably began around this time. As Aghion, Hart and Moore wrote, prior to the 1990s, “economic analysis – which has been applied with such great success to other aspects of law in the last thirty years – has, with a few notable exceptions, not been used to shed light on optimal bankruptcy procedure”. The radical thinking in the 1990s literature can probably be attributed to the backlash against corporate abuses during the late 1980s and early 1990s. The savings and loan crisis of the 1980s in the United States somehow managed to provoke a greater outrage against financial fraud than the much bigger global financial crisis of the last decade.

Probably the best compilation of the 1990s bankruptcy literature is the proceedings of the Interdisciplinary Conference on Bankruptcy and Insolvency Theory of 1994 published in the Washington University Law Review. This features provocative articles like Adler’s “A World Without Debt” and Heidt’s article that begins with the line “The Bankruptcy Code is fifteen years old and fourteen years out of date”. Above all, there is the famous paper by Aghion-Hart-Moore describing one of the most radical bankruptcy procedures ever proposed – the AHM procedure.

In keeping with the law and economics paradigm, most proposals of that era are based on a greater reliance on contracts and markets rather than on judges, administrators and experts. The complication is that the problem of bankruptcy arises only under imperfect capital markets and there are obvious difficulties in relying too strongly on imperfect capital markets. Yet this 1990s idea underlies a number of the post crisis innovations in reorganization of distressed financial enterprises – contingent equity, contingent convertible bonds (CoCos), and hair cutting of claims against clearing corporations.

My motivation for studying this literature stems from the problem of corporate distress in India today. It is hard to see how India’s zombie companies can be efficiently and speedily resolved without relying much more on markets than on so called experts. That is the subject of a future blog post.

Posted at 19:50 on Sun, 11 Jun 2017     View/Post Comments (0)     permanent link


Wed, 07 Jun 2017

Are markets efficient if you are a particle physicist?

Among the thousands of pages that I read during my two month long vacation were two papers that show that many of the large number of published asset pricing anomalies (Cochrane’s “zoo”) have withered away over time. The papers are Hou, Xue and Zhang (2017), Replicating Anomalies, NBER Working Paper 23394 and Mclean and Pontiff (2016) Does Academic Research Destroy Stock Return Predictability?, Journal of Finance.

Hou, Xue and Zhang show that out of the 447 anomalies that they study as many as 286 (64%) are insignificant at the conventional 5% level. Increasing the cutoff t-value to 3.0 raises the number of insignificance to 380 (85%). Clearly, there are a lot of Type M errors in the anomalies literature and a few Type S errors as well.

I started wondering what would happen if we imposed an even higher standard of statistical significance. This is where particle physics comes in. While the social sciences are quite happy with significance levels of 5% and 1% (implying cutoffs of around 2 or 3 standard deviations), the significance level required for the discovery of a new particle in physics is 0.0001% or one in a million (implying a cutoff of around 5 standard deviations). For example, when the Higgs particle was discovered in July 2012, the official press release from CERN stated: “Today, both the ATLAS and CMS experiments are beyond the level of around one per million that’s required to claim a discovery.” For more discussion on the 5 sigma standard, see here, here and here.

Asset prices exhibit significantly fatter tails than the Gaussian distribution and that would require raising the cutoff even higher. The statistical quality control world uses a shift of 1.5 standard deviations so that 6 standard deviations (six sigma) are required to achieve quality standards that would otherwise require only 4.5 standard deviations.

I pored over Table 4 of Hou, Xue and Zhang that lists the t-values for all the anomalies that are significant at the 5% level. Not one of these is above 6.0 and only two (Abr1 and dRoe1) are above 5.0. Adjusted for fat tails, there is no anomaly that meets a one in a million standard of significance. By this standard, therefore, markets can be assumed to be efficient. More prosaically, finance is still at the Tycho_Brahe stage of assembling enough high quality data to discriminate between competing theories.

Posted at 13:26 on Wed, 07 Jun 2017     View/Post Comments (0)     permanent link


Sun, 26 Mar 2017

Why do economists ignore risk?

Cochrane writes on his Grumpy Economist blog:

Here’s how covered interest parity works. Think of two ways to invest money, risklessly, for a year. Option 1: buy a one-year CD (conceptually. If you are a bank, or large corporation you do this by a repurchase agreement). Option 2: Buy euros, buy a one-year European CD, and enter a forward contract by which you get dollars back for your euros one year from now, at a predetermined rate. Both are entirely risk free.

It is only an economist who today thinks of this trade as risk free. Before the global financial crisis many finance people would have thought so too, but not today. After the crisis, any serious finance professional would immediately think of the multiple risks in these trades:

  1. The US bank could default

  2. The European bank could default

  3. The forward contract counterparty could default

  4. There is euro redenomination risk. In that terrifying state of the world, depending on the nationality of the bank and the forward contract counterparty, one or both of these could be redenominated into some other currency – new francs, marks, liras or drachmas . Theoretically, you could end up being long new French francs (on the euro CD) and short new German marks (on the forward contract).

During the last decade, finance has moved on from simplistic notions of risk. I like to believe that in many top banks today, those who espouse Cochrane’s view of risk would be at risk of losing their job. Or at least they would be asked to enrol in a course on two curve (or multi curve) discounting. In today’s finance, there is return free risk, but no risk free return. Covered interest parity is today only an approximation that you may use for a back of the envelope calculation, but not for actually quoting a price. I wrote about this in a wonky blog post last year, and I have discussed two curve discounting in another wonky post half a dozen years ago.

The wonderful thing about finance is that it provides an opportunity to get rid of bad ideas by marking them to market. The problem comes when we distrust the market and start thinking of model errors as market inefficiencies. Cochrane writes about the violations of covered interest parity:

... this makes no sense at all. Banks are leaving pure arbitrage opportunities on the table, for years at a time. ... But this is arbitrage! It’s an infinite Sharpe ratio!

Rather than accept that the covered interest parity model is wrong in a two curve world, Cochrane thinks that post crisis regulations are preventing the banks from doing this “arbitrage” and bringing the markets back to the old world. It is true that a Too Big to Fail (TBTF) can still do covered interest “arbitrage”. But what that tells us is that a TBTF bank can pocket the gains from the covered interest trade and palm off the risks to the tax payer. A TBTF bank can do the trade, because it is closer to being risk neutral (anybody can be risk neutral with other people’s money). Yes, the covered interest trade has a positive Sharpe ratio but not an infinite one, and perhaps not even a very large one. We need less TBTF banks doing low Sharpe ratio trades, keeping the gains and shoving the losses to the taxpayers.

And both economists and policy makers need to take risk more seriously than they do today.

Posted at 13:35 on Sun, 26 Mar 2017     View/Post Comments (0)     permanent link


Wed, 22 Mar 2017

Indian financial history

My blog post a couple of months ago on financial history books led to a lively discussion in the comments on a similar list for Indian financial history. There was so much useful material in these comments that I thought it useful to hoist it from the comments to a blog post in its own right. As you can see, very little of this post is my contribution. Most of the material is from my colleague at IIM Ahmedabad, Prof. Chinmay Tumbe who is deeply interested in business, economic and demographic history. All that I have done is to add hyperlinks wherever possible, and must in fact confess that I have not yet read most of the material listed here.

Amol Agrawal January 27, 2017 at 5:44 pm

I was also wondering whether you could recommend some books on India’s financial history as well. I guess you might say there are hardly any. But I guess history of RBI (Volume I), History of SBI, Indigenous Banking by LC Jain etc could be a part of the list. But these are just on banking, We have very little ideas on equity markets, insurance, funds etc. Could you please help me with a few titles?

Jayanth Varma January 27, 2017 at 9:07 pm

There are some excellent books on Indian economic history. The Cambridge Economic History of India is absolutely invaluable. There are some books and other material on the history of the East India Company and the Dutch VOC which are also relevant. Adam Smith’s discussion of the English East India Company in the Wealth of Nations is also worth reading. Angus Maddison’s Asia in the World Economy 1500–2030 AD is also useful.

But there is too little of financial history in all this. I would like to know more about the financial transactions of Jagat Seth for example though there is some material here.

Indian monetary history in the nineteenth century is absolutely fascinating: I think at one time or the other, India had every kind of exchange rate regime known at the time. Oscar Wilde famously advised a student to omit this chapter because it is too sensational. If you have access to JSTOR, I recommend: Laughlin, J. Laurence. “Indian Monetary History.” Journal of Political Economy, vol. 1, no. 4, 1893, pp. 593–596.

Way back in 2010, SEBI set up an Advisory Panel on History of Indian Securities Market of which I was a member and some material was collected and made available on the SEBI web site. I do not think that much progress has taken place after that.

Amol Agrawal January 28, 2017 at 8:58 am

I fully agree we have nothing much in financial history which is a puzzle. I have read the Lodewijk Petram work on World’s oldest Stock exchange. We need similar accounts for BSE and other Regional SEs which were important earlier. I have seen SEBI’s links but most are unreadable. Like RBI and SBI have commissioned their history, we need SEBI/IRDA etc to do the same for other markets. From these, students like me can pick up and build.

Likewise Sylla and Homer’s History of Interest Rates could be developed into History of interest rates in India using several RBI publications. There is some data which has to be all put together.

Having said this, I think following books do give some perspective on history of finance in India: 1) Industrial Organisation (1934) by PS Lokanathan 2) Organisation and Finance of Industries in India (1937) by D R Samant and M A Mulky 3) Financial Chapter in History of Bombay (1910) by DE Wacha

There are some others which are mainly on banking. I can add them but I think if one reads History of RBI and History of SBI (by Prof AK Bagchi), banking is pretty much covered.

We clearly need to expand this list and have more works on India’s financial history. I will try and add as and when I find more readings.

Jayanth Varma February 13, 2017 at 9:28 pm

Another useful book is Raymond W. Goldsmith The financial development of India, Japan, and the United States : a trilateral institutional, statistical and analytic comparison, Yale University Press 1983.

Prof. Chinmay Tumbe March 1, 2017 5:10 pm

Adding a few that have not been covered above:

  1. Goldsmith has one book just on India called Financial Development of India, 1860-1977, which is a truly monumental work.

  2. A 2017 book by a friend of mine attempts to synthesise monetary history in India

  3. I have a paper in the Indian Economic and Social History Review on the history of the Post Office as a financial institution; not too many associate that with finance though it is the largest financial institution of India in terms of network and personal deposits.

  4. Tirthankar Roy has a recent paper on seasonality of interest rates in the money market of colonial India.

  5. Dwijendra Tripathi of IIMA wrote the biography of Bank of Baroda in the 1980s and updated that in the late 2000s.

  6. Amiya Bagchi’s edited volume on Money and Credit in Indian History in 2002 has wide ranging contributions to it

  7. P R Brahmananda’s Money, Income, Prices in 19th century India: A Historical, Quantitative and Theoretical Study.

  8. On the 1860-65 Bombay episode, see Wacha’s Financial Chapter; or any biography of Premchand Roychand as in Lakshmi Subramanian’s Three Merchants of Bombay

  9. Some Books:

    Of course, several other banking histories can be added to this list.

The Financial History Review does not have a single piece on India, which goes to show the huge scope for research in this field. Amol’s thesis on south Indian banking history will add to our knowledge.

Posted at 16:41 on Wed, 22 Mar 2017     View/Post Comments (0)     permanent link


Fri, 17 Mar 2017

Towards bank cartelization in India?

I have begun to wonder whether Indian banks have stopped competing aggressively with each other and have started forming an implicit cartel. Rising non performing assets have reduced the appetite for bank lending to a level even lower than the severely depressed demand for bank credit. Obviously, banks do not need to raise much deposits if they are not lending much. It is easier (at least in the short run) to try and charge higher fees from a smaller depositor base than to spend time and money acquiring and retaining customers. And that is what we are seeing. More ominously, some of the attempts to raise fees and user charges seem to a casual observer to be coordinated across banks. If that is the case, then of course these are serious issues for the Competition Commission.

I think demonetization has played some role in this for multiple reasons. First, it boosted the liquidity of the banks virtually overnight and accelerated trends that had been building up slowly over several months. Second, demonetization turned banks into an extended arm of the state: bank officers became quasi government officials with substantial powers. Long after that stage passed, many banks have not gone back to being service organizations again. Anecdotal evidence suggests that this transformation from customer service to bureaucratic conduct has happened in the private sector banks to the same if not a greater extent.

In the long run, this change in the behaviour of the management and employees of the banks would be disastrous for the banking system. On the deposit side, payment banks and mutual funds might find a once in a lifetime opportunity to disrupt banking. On the advances side, non bank finance companies have gained valuable customers turned away by the banks. In the long run, the bond markets could also take business away from the banks.

The first 25 years of economic reforms saw the banking system grow to dominate the financial system previously dominated by the development financial institutions. Shortsighted management and staff could erode this dominance very quickly.

Posted at 18:09 on Fri, 17 Mar 2017     View/Post Comments (0)     permanent link