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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Sun, 15 Sep 2019

Legal theory of finance redux

Six years ago, I blogged about Katharina Pistor’s Legal Theory of Finance, and observed that there seemed to be nothing novel about her claim that powerful institutions at the centre of the financial system tend to be bailed out while the small fry are allowed to die. But if one takes the politics out of the theory, the idea of the elasticity of law is an interesting insight. Pistor wrote:

Contracts are designed to create credible commitments that are enforceable as written. Yet, closer inspection of contractual relations, laws and regulations in finance suggests that law is … is elastic. The elasticity of law can be defined as the probability that ex ante legal commitments will be relaxed or suspended in the future

I was reminded of this when I read Emily Strauss’ paper Crisis Construction in Contract Boilerplate which describes how during the Global Financial Crisis, judges in the US interpreted a boilerplate contractual clause to reach a result clearly at odds with its plain language. She writes:

In the aftermath of the financial crisis, trustees holding residential mortgage backed securities sued securities sponsors en masse on contracts warranting the quality of the mortgages sold to the trusts. These contracts almost universally contained provisions requiring sponsors to repurchase individual noncompliant loans on an individual basis. Nevertheless, court after court permitted trustees to prove their cases by sampling rather than forcing them to proceed on a loan by loan basis.

While the reasoning of these decisions is frequently dubious, they gave trustees the leverage to salvage millions – even billions – of dollars in settlements from the sponsors who had sold the shoddy loans, reassuring investors that sponsors would be forced to stand behind their contracts. However, as the crisis ebbed, courts retrenched, and more recent decisions adhere to the plain language requiring loan-by-loan repurchase. I argue that the rise and fall of decisions permitting sampling reflect a largely unexpressed judgment that in times of severe economic crisis, courts may produce decisions to help stabilize the economy.

This phenomenon is in many ways quite the opposite of Pistor’s theory. The dubious decisions referred to above went against some of the largest banks in the world while benefiting a large and disparate group of investors. While Strauss describes this as an attempt to stabilize the economy, it appears to me to be more of fairness and pragmatism trumping the express terms of the contract. But, at a deeper level, Pistor is right: the law can be very elastic in a crisis.

Posted at 19:05 on Sun, 15 Sep 2019     View/Post Comments (0)     permanent link


Fri, 06 Sep 2019

Reserve Bank of India’s flip-flops on floating rate benchmarks

Earlier this week, the Reserve Bank of India (RBI) issued a circular asking banks to shift from internal to external benchmarks for pricing their floating rate loans. This is the latest in a series of flip-flops by the regulator on this issue over the last two decades:

These flip-flops reflect the failure of the central bank on two dimensions:

In the next few years, India needs to work on creating both a better banking system and better financial markets. One of the pre-requisites for this is that regulators should step back from excessive micro-management. For example, the RBI Master Directions require the interest rate under external benchmark to be reset at least once in three months while elementary finance theory tells us that if the floating rate benchmark is a 6-Months Treasury Bill yield, it should reset only once in six months. Either banks will refrain from using the six month benchmark (eroding liquidity in that benchmark) or they will end up with a highly exotic and hard to value floating rate loan resetting every three months to a six month rate. Neither is a good outcome.

Posted at 16:35 on Fri, 06 Sep 2019     View/Post Comments (0)     permanent link


Fri, 30 Aug 2019

No Easy Fixes for Limited Liability

US senator and presidential hopeful Elizabeth Warren (who also happens to be one of America’s most eminent bankruptcy scholars) has a proposal to make private equity firms liable for the debts of their portfolio companies by ending the limited liability protection that they currently enjoy. Another well known professor of bankruptcy law and financial regulation, Adam Levitin, has weighed in with an attack on the concept of limited liability itself.

Limited liability is a substantial, regressive cross-subsidy to capital at the expense of tort creditors, tax authorities, and small businesses. Limited liability is a relic of the underdeveloped financial markets of the Gilded Age and operates as an implicit form of leverage provided by law. But it’s hardly either economically efficient or necessary for modern business activity.

These extreme claims might have some basis in the Modigliani-Miller theory of corporate leverage, but Levitin does not substantiate them with serious evidence. In fact, the claims appear to be rhetorical in nature because Levitin goes on to say:

In any event the Stop Wall Street Looting Act rolls back limited liability solely for private equity general partners in a surgical manner such that doesn’t affect limited liability more broadly.

…, the problem with private equity isn’t limited liability per se. The problem is limited liability combined with other unique and unavoidable features of private equity. Limited liability plus extreme leverage means that there is a seriously lopsided risk/reward tradeoff that incentivizes excessive risk-taking.

The problem is that this limited excision of limited liability does not work in the presence of derivative markets because limited liability equity can be replicated by a call option. Owning the shares of a company with substantial debt is equivalent to holding a call option on the assets of the company with a strike price equal to the face value of the debt. This is essentially the Merton model of corporate debt (Merton, R.C., 1974. On the pricing of corporate debt: The risk structure of interest rates. The Journal of Finance, 29(2), pp.449-470.)

The converse is also true: it is impossible to ban derivatives without banning debt as I argued in a blog post a decade ago. Many proposals for fixing modern finance ignore the ability to replicate one instrument with another set of instruments.

Posted at 21:14 on Fri, 30 Aug 2019     View/Post Comments (0)     permanent link


Wed, 28 Aug 2019

When do algorithms violate the law

I enjoyed reading the judgement of the Federal Court of Australia on whether Westpac Banking Corporation’s computer operated home loan approval system (known as the automated decision system or ADS) violated Australia’s responsible lending laws. The judgement is fun to read, and that might itself be enough reason to read it since delightful court judgements are relatively rate. More importantly, this issue of evaluating algorithms for compliance is going to become increasingly important in the years to come.

The court threw out the case basically on the ground that the Australian Securities and Investments Commission (ASIC) had not done its homework well enough.

[ASIC] does not allege that the alleged defects in the ADS resulted in Westpac extending loans to any consumers who it ought to have found would be unable to meet their financial obligations under the credit contracts or who would be able to do so only in circumstances of substantial hardship. ASIC did originally make several such allegations in relation to specified loans but it abandoned these on the day before the trial commenced. This then is a case about the operation of the responsible lending laws without any allegation of irresponsible lending.

ASIC was claiming that Westpac’s ADS violated the responsible lending laws simply because the rules in the algorithm ignored some data or used imperfect measures for some variables. The court rejected this approach:

It is not enough to point to an individual rule in the ADS and to submit that it does not comply with Div 3. Westpac’s entire system (including manual assessment where referral is triggered) must be examined, and compliance with Div 3 gauged that way.

Of course, the Court is right on this point, and therein lies the challenge in regulating a financial world that is increasingly run on algorithms. It appears to me that financial sector regulators are by and large unprepared for this challenge.

Posted at 19:55 on Wed, 28 Aug 2019     View/Post Comments (0)     permanent link


Wed, 14 Aug 2019

Can India seize the Hong Kong opportunity?

As Hong Kong moves ever closer to a military denouement, India needs to think hard about the opportunity it could provide to its own fledgling offshore financial centre. Over the last several years, India has built the foundations for an offshore financial centre at GIFT City in Gandhinagar, Gujarat. A lot of physical infrastructure has been created, exemptions have been made from the normal exchange control regime, tax concessions have been provided, and some small beginnings have been made in offering offshore financial services. But the turmoil in Hong Kong presents opportunities of a vastly different order.

Is India willing to take the key steps that would make it an attractive option to businesses and individuals that may wish to relocate out of Hong Kong now or in the immediate future?

Posted at 16:56 on Wed, 14 Aug 2019     View/Post Comments (1)     permanent link


Tue, 06 Aug 2019

QE through unlimited buying of foreign equities

After the global financial crisis, central banks have done many things that were previously considered unthinkable, and Switzerland and Japan have probably been more radical than most others. But as the eurozone slips deeper and deeper into the quagmire of negative yields, the Swiss National Bank and the Bank of Japan are now at risk of being perceived as paragons of sound money.

The situation in the eurozone is so bad that the entire yield curve (all the way to 30 years) is negative in Germany and Netherlands, and it is possible that the ECB will be forced to push policy rates even deeper into negative rates. Both the Swiss franc and the Japanese yen have been pushed higher and even Bitcoin looks like a safe haven currency if you look only at a one week price chart.

The pioneers of monetary easing are reaching the limits of their existing unconventional policies, and will have to turn to something even more unthinkable. To compete with the frightening scale of European easing, Switzerland and Japan have to find an asset class that can accommodate almost unlimited buying without running into capacity constraints, creating excessive market distortions, or provoking a severe political backlash. I think at some point they will very reluctantly be driven to the conclusion that there is only asset class that fits the bill and that is global equities.

A portfolio of global index funds can absorb a few trillion dollars of central bank buying without too much disturbance. Political backlash would be muted for two reasons. First, by buying index funds instead of buying assets directly, they avoid getting involved in the sensitive issues of corporate governance and control. Second, every politician likes a rising stock market. Even America’s tweeter-in-chief who sees currency manipulators wherever he looks will probably tolerate a weaker yen if it takes the S&P 500 index to new highs.

Perhaps – just perhaps – falling global equities provide an opportunity for some ordinary investors to front-run the Swiss National Bank and the Bank of Japan before these central banks get into the game.

Posted at 18:08 on Tue, 06 Aug 2019     View/Post Comments (0)     permanent link


Fri, 26 Jul 2019

Big Tech 2019 = Big Finance 2005 = Big Risk?

That is the title of my post today in the sister blog on computing. In 2005, Big Finance was at the top of the world, but in 2008, it all came crashing down. It appears to me that Big Tech which enjoys a similar situation of dominance today also suffers from the same kind of hubris that destroyed Big Finance a decade ago. A change in fortunes could be as fast and as brutal as was the case with Big Finance a decade ago. Prudent risk management today demands that individuals and organizations take steps to protect themselves against the risk that one or more of the Big Tech companies would go bust or shutdown their services for other reasons.

Posted at 21:00 on Fri, 26 Jul 2019     View/Post Comments (0)     permanent link


Thu, 25 Jul 2019

A petty money dispute holds market to ransom

I am not a lawyer, and so it is with much trepidation that I write about a petty dispute that has been holding the Indian market to ransom. I venture to write only because I am convinced that the issue is not really about legal technicalities, and in any case the entire money dispute is quite petty and trivial compared to the broader issue of market integrity and the sanctity of key market infrastructure.

The facts of the dispute are well brought out in an order issued in May 2019 by the Securities Appellate Tribunal. The genesis of the dispute lies with a brokerage firm, Allied Financial Services, that allegedly stole about $50 million worth of its clients’ securities and pledged them as collateral with its Clearing Member, ILFS Securities, to support an options trade that they had done on the National Stock Exchange (NSE). On the strength of this collateral, ILFS Securities, deposited cash margins with NSE Clearing to support the trade done by Allied. After receiving complaints of fraud, the Economic Offences Wing (EOW) froze the collateral lying with ILFS Securities. When the time came to settle the trade, ILFS Securities asked for annulment of the trade. Even if the trade is annulled, ILFS would have to return the option premium and the benefit to them would be a only marginal reduction in the quantum of loss. ILFS Securities’ gain of probably $5-10 million would of course be the loss of the counter parties to the trade.

I deliberately call this a petty dispute because for some of the institutions involved, $5 million or even $50 million is quite likely a rounding error on their balance sheets. Even for the smaller entities, it is not by itself a bankruptcy threatening event. We are not talking about a poor investor whose lifetime savings could be wiped out by the dispute; we are talking about some big institutions which might be somewhat better off or somewhat worse off depending on which way the dispute is resolved. We are also not talking about recovering money from the alleged fraudster; the dispute is all about allocating the losses among different victims of the alleged fraud.

The tragedy is that as a result of this petty dispute, there has been a stay on the settlement of the trade. If not resolved soon, this settlement failure risks causing serious damage to the integrity and reputation of India’s largest stock exchange and its clearing corporation.

The core function of a stock exchange and its clearing corporation is to allow complete strangers to trade without doing any due diligence on each other. If you do an OTC trade or bilateral trade, you have to worry about whether your counter party is trustworthy. On the other hand, when you sell some shares on an exchange, you do not even bother to ask who was the buyer because it does not matter. The whole function of the exchange is to make that question (whom am I trading with) irrelevant and thereby create a national (or even global) market. OTC markets are a cosy club, while exchanges are open to one and all. At the centre of this magical transformation is the clearing corporation that becomes the counter party to all trades (novation) and thereby insulates buyer and seller from each other.

It is this core promise of the clearing corporation that has been called into question by the way this petty dispute has been allowed to fester and linger. A shadow has been allowed to fall on the sanctity of a key market infrastructure. I do not blame the judiciary for this tragedy because the judiciary adjudicates only issues that are brought before it. And it is the money dispute that has come before the judiciary because all the big and mighty entities involved have the wherewithal to hire the best lawyers to argue that this trivial dispute is the most important thing in the world.

The burden of preventing this tragedy lies primarily with the regulator who has the responsibility and mandate to draw the judiciary’s attention to the systemic issues and national interest involved in the smooth functioning of our market infrastructure. A $5 or even $50 million dispute should not be allowed to threaten the integrity of a $2 trillion stock market. As I said, I am not a lawyer, but I find it hard to believe that SEBI would not receive a patient hearing in the highest courts of the land if it made an earnest plea on its statutory duty to protect the investor interest and the public interest. Instead, it has confined itself to narrow legalistic arguments about who has the power to annul a trade and under what conditions. It has allowed the disputants to frame the debate instead of seeking to change the frame of the debate.

Posted at 16:06 on Thu, 25 Jul 2019     View/Post Comments (1)     permanent link


Thu, 11 Jul 2019

US wants to nurture single stock futures

Two decades ago, when India was trying to set up its equity derivatives market, the most contentious issue was that of single stock futures – market participants were keen on this product, while a large group of sceptics argued that the product did not exist in the US and was in fact confined to a handful of countries. It was also thought to be too similar to the indigenous system of rolling settlement known as badla which was somehow thought to be evil. The compromise was to begin with index futures and defer the launch of single stock futures. In reality, the single stock future was the first equity derivative to become successful in India, and then the earlier products picked up with a significant lag. India also became one of the largest single stock future markets in the world while also creating very liquid index futures, index options and single stock option markets. The Indian experience also demonstrated that each of these four markets catered to a different need. For example, my former doctoral student Sonali Jain in a recent paper, along with my colleagues, Sobhesh Agarwalla and Ajay Pandey and myself found that in India, single stock futures play the role that the options market plays in the US for informed trading around earnings announcements. This implies that single stock futures have some clear advantages over options in informed trading.

With this background, I found it quite amusing to read the joint proposal by the US Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) to reduce margins for retail investors in single stock futures (see press release and proposal). The US set up a single stock futures market a decade ago, but it remains tiny. The SEC is now very clear about its desire to promote the growth of this market:

The security futures market can provide a low-friction means of obtaining delta exposures, and relatively high margin requirements … may have played a role in restraining its development.

To the extent that the proposed reductions in margin requirements encourage significant growth in the security futures markets, it may, in time, improve price discovery for underlying securities. In particular, a more active security futures market can reduce the frictions associated with shorting equity exposures, making it easier for negative information about a firm’s fundamentals to be incorporated into security prices. This could promote more efficient capital allocations by facilitating the flow of financial resources to their most productive uses.

There is also a degree of anxiety about foreign markets that have stolen a march over the US in this product:

Lowering the minimum margin requirement also could enable the one U.S. security futures exchange to better compete in the global marketplace, where security futures traded on foreign exchanges are subject to risk-based margin requirements that are generally lower than those applied to security futures traded in the U.S.

To make things more interesting, there is also a public statement of dissent by one of the SEC Commissioners. I never thought that a day would come when it would be easier to obtain consensus between the SEC and the CFTC than to get consensus within the SEC. What is striking about this dissent is that it does not disagree with the goal of promoting single stock futures. Commissioner Jackson says:

So [stock futures] can provide a valuable price-discovery function in stock markets and give investors an important way to diversify.

But he is not convinced that reducing margins are the best way to accomplish this goal. He believes that there are many alternatives that could and should have been considered. As an example, he suggests that:

rather than asking us to lower margin requirements, an exchange could simply reduce the contract size for single-stock futures. … reducing contract size could also increase access to single-stock futures for the most popular securities and improve efficiency. … Indeed, one of the most liquid contracts in the world, the S&P E-mini Futures contract, is the product of cutting the classic S&P Futures contract in half.

To me, what is noteworthy is that, in two decades, the world has moved from frowning on single stock futures to trying to nurture them.

Posted at 12:23 on Thu, 11 Jul 2019     View/Post Comments (2)     permanent link


Tue, 02 Jul 2019

Deep fakes in finance?

For the last couple of years, I have been following the phenomenon of Deep Fakes with a mixture of cynicism and disinterest. It is only in the last few weeks that I have begun to worry that this is not something that concerns only a few celebrities, but could become a problem for the financial sector in general.

Last week, I read two things that brought the matter to focus. First was the news report about the fake French minister in a silicone mask who stole millions of euros from some of the richest men of Europe (h/t Bruce Schneier). The minister who was impersonated was quite impressed by the quality of the fake video: “They did a pretty good job. Unfortunately some people fell for it. They did a really good impression of my voice. But no-one can truly pass themselves off as me.”

The second was the following recommendation in the report of the Expert Committee on Micro, Small and Medium Enterprises set up by the Reserve Bank of India under the Chairmanship of Shri U K Sinha:

Presently the KYC process is manual and necessitates a physical presence, thus increasing costs and timelines in completing the required KYC processes. As an alternative to enabling e-KYC, the Committee recommends video KYC to be adopted as a part of digital financial architecture as a suitable alternative to performing a digital Aadhaar-based KYC process towards enabling non-physical customer onboarding. (Box XIV- Video Based KYC in Chapter 8)

It appears to me that we will see more of this: only a handful of Luddites will oppose the use of technology that saves cost and eliminates hassles. However, it is part of the folklore of digital security that you can pick any two of Secure, Usable and Affordable – you cannot get all three. Most market architectures would make the natural choice of Usable and Affordable and de-prioritize Security. Deep Fakes would thus emerge as a problem for mainstream finance over a course of time, but I guess it will (perhaps rightly) be treated as a cost of doing business.

Posted at 13:03 on Tue, 02 Jul 2019     View/Post Comments (0)     permanent link


Sat, 29 Jun 2019

The bankers, by contrast, moved on

I just finished reading Hassan Malik’s book Bankers and Bolsheviks: International Finance and the Russian Revolution (Princeton University Press, 2018) which is based on his PhD dissertation. I was struck by the close parallels between the excessive risk tolerance that we are seeing in the world today and the complacency and reaching for yield that Malik documents in international lending to Russia between 1906 and 1917.

In his final chapter, Malik describes the sorry fate of small French investors and Russian technocrats after the Russian default of 1918. He then concludes the book with the line that I have used as the title of this post:

The bankers, by contrast, moved on.

In that respect, not much changed between 1918 and 2008.

Posted at 18:15 on Sat, 29 Jun 2019     View/Post Comments (0)     permanent link


Sat, 22 Jun 2019

Allowing a corporate body to be a director

A few months back, Joseph Franco published a fascinating paper about a commoditized governance model adopted by a small minority of US mutual funds where the entire governance is outsourced to an unaffiliated entity that specializes in providing governance services. (Commoditized Governance: The Curious Case of Investment Company Shared Series Trusts (February 14, 2019). 44 J. Corp. L. 233 (2018) ; Suffolk University Law School Research Paper No. 19-7. Available at SSRN: https://ssrn.com/abstract=3334701). Franco concludes that this model is merely an interesting curiosity:

Where a board’s role primarily involves organizational, rather than strategic, oversight of an underlying business, as in the fund industry, commoditized governance may prove attractive for at least some industry participants. In contrast, where a board’s role encompasses both organizational and strategic oversight of an underlying business, as is more commonly the case, commoditized governance will not be a successful governance model. Accordingly, and consistent with practical experience, commoditized governance will exist largely as an exceptional, rather than common, form of entity governance.

This discussion got me thinking about a related idea – would it make sense to let specialized unaffiliated corporate bodies (like LLPs, LLCs or private companies) to become independent directors of large companies? (I do not want to contemplate the recursion involved in letting the independent director be another listed company.)

The current model of allowing only individuals to become independent directors is not working well. First of all, most independent directors have quite meagre wealth, and so when things go wrong, investors can recover virtually nothing by suing the independent directors (They gain much more by suing the auditors or other gatekeepers). At the same time, prosecutors and regulators are very keen to punish the directors, and this keenness often depends more on the quantum of the loss and less on the degree of negligence of the director. This means that highly risk averse people would be reluctant to become independent directors. If the only people willing to serve on the board are those with a high degree of risk tolerance, then the companies that they govern would naturally tend to pursue high risk strategies as was well illustrated by the Global Financial Crisis of 2008.

Second, most independent directors lack the administrative and analytical support that is often needed to challenge management strategy at a fundamental level. Almost all independent directors can only envy the massive support that non independent directors (venture capitalists, private equity firms, activist investors, nominees of the lenders and representatives of controlling shareholders) get from their respective organizations. Unfortunately, these well endowed non independent directors are often more interested in looking after the interests of their respective constituencies, than the interests of the company itself or its shareholders as a whole.

The governance deficit that we observe in some of the largest companies in the US, in India, and elsewhere in the world, is symptomatic of these fundamental problems of the current model of relying on individuals to serve as independent directors. I think there is much to be gained by shifting to a model of incorporated independent directors. This will also make it easier to impose capital adequacy and skin in the game requirements. Valuation metrics in the financial services industry (for example, asset managers and rating agencies) suggest that a large incorporated independent director service provider would command a valuation of 5 10 times revenue. If independent directors are paid 0.5 1% of profits, and each incorporated independent director serves on boards of 30 100 large companies, then the independent directors of a company would probably have a combined valuation of twice the annual profits of a large company. That would represent a juicy litigation target for shareholders who suffer losses due to a governance failure (probably a more juicy target than the auditors). The large franchise value of the business would motivate these incorporated independent directors to exercise a high degree of diligence in performing their work, and would also make them highly sensitive to reputation risk. Would this not be a major improvement over the current system?

Posted at 15:32 on Sat, 22 Jun 2019     View/Post Comments (1)     permanent link


Thu, 13 Jun 2019

Bonds and loans

Banks give loans, while mutual funds buy bonds. Recent difficulties of Indian debt mutual funds in dealing with corporate defaults suggest, however, that these lines are quite blurred. Illiquid bonds are like loans in all but name, and then mutual funds start looking a lot like banks with all the attendant risks. Problems of this kind are not unique to India. The suspension of dealing in the LF Woodward Equity Income Fund run by one of the UK’s “star” fund managers raises similar questions about the difference between an equity mutual fund and a venture capital fund.

Both in the Indian and the UK situations, the core of the problem is that while regulators insisted on mutual funds investing in listed assets, “listed” does not necessarily mean “liquid”. The core premise of an open end mutual fund is that assets are sufficiently liquid that (a) no external liquidity support is needed and (b) a fair Net Asset Value (NAV) can be reliably computed. The problem is that many listed assets do not meet this requirement (and, on the contrary, some unlisted assets might).

In India, we have created a large debt mutual fund industry without paying enough attention to creating a liquid corporate bond market. The result is that much of what passes as bonds are loans dressed up in the legalese of bonds and listed on exchanges which collect listing fees but do not provide worthwhile liquidity.

More importantly, we have not encouraged the creation of a vibrant Credit Default Swap (CDS) market. A liquid CDS market would facilitate the flow of negative information about bonds (through shorting the CDS) and would thus hopefully provide early warning signals about impending downgrades and defaults. Currently, distressed bonds are often valued close to par right up to the date of default, and then they just fall off a cliff.

Unfortunately, regulators in India have been hesitant to allow markets that can speak truth to power, while being very happy to create a simulacrum of a corporate bond market.

Posted at 16:25 on Thu, 13 Jun 2019     View/Post Comments (0)     permanent link


Mon, 03 Jun 2019

Korean derivatives reforms come full circle

Back in 2011, South Korea embarked on a significant clampdown on retail participation in its equity derivatives market which is one of the largest in the world. The result of these measures was to effectively hand over the Korean derivatives market to foreigners. As for protecting retail investors from speculative misadventures, probably the only effect was to divert the speculative energies into bitcoin, exotic structured products and the like. It took the Koreans eight years to realize that the 2011 measures had basically thrown the baby out with the bathwater. Now they are pedalling back furiously and trying to bring Korean investors back into the market. The announcement last week by the Korean Financial Services Commission (FSC) reads like a mea culpa (if you read between the lines).

This episode holds a lot of lessons for India as well as we too have a host of would-be reformers who would love to clampdown on retail speculation in equity derivatives. There is every reason to believe that if they succeed, the results will be similar to that in Korea – the purported cure will be worse than the purported disease.

Posted at 13:26 on Mon, 03 Jun 2019     View/Post Comments (1)     permanent link


Tue, 02 Apr 2019

Blockchain in Finance

I have a perspectives piece in the current issue of Vikalpa about Blockchain in Finance. I have been teaching an elective course on the Blockchain for over three years now, and my approach has been to treat both mainstream finance and crypto finance with equal dollops of scepticism, cynicism and openness. That is what I do in this piece as well:

Blockchain – the decentralized replicated ledger technology that underlies Bitcoin and other cryptocurrencies – provides a potentially attractive alternative way to organize modern finance. Currently, the financial system depends on a number of centralized trusted intermediaries: central counter parties (CCPs) guarantee trades in exchanges; central securities depositories (CSDs) provide securities settlement; the Society for Worldwide Interbank Financial Telecommunication (SWIFT) intermediates global transfer of money; CLS Bank handles the settlement of foreign exchange transactions, a handful of banks dominate correspondent banking, and an even smaller number provide custodial services to large investment institutions. Until a decade ago, it was commonly assumed that the financial strength and sound management of these central hubs ensured that they were extremely unlikely to fail. More importantly, it was assumed that they were too big to fail (TBTF), so that the government would step in and bail them out if they did fail. The Global Financial Crisis of 2007–2008 shattered these assumptions as many large banks in the most advanced economies of the world either failed or were very reluctantly bailed out. The Eurozone Crisis of 2010–2012 stoked the fear that even rich country sovereigns could potentially default on their obligations. Finally, repeated instances of hacking of the computers of large financial institutions is another factor that has destroyed trust. When trust in the central hubs of finance is being increasingly questioned, decentralized systems like the blockchain that reduce the need for such trust become attractive.

However, even a decade after the launch of Bitcoin, we have seen only a few pilot applications of blockchains to other parts of finance. This is because cryptocurrencies (while being extremely challenging technologically) encountered very few legal/commercial barriers, and could therefore make quick progress after Bitcoin solved the engineering problem. The blockchain has many other potential finance applications – mainstream payment and settlement, securities issuance, clearing and settlement, derivatives and other financial instruments, trade repositories, credit bureaus, corporate governance, and many others. Blockchain applications in many of these domains are already technologically feasible, and the challenges are primarily legal, regulatory, institutional, and commercial. It could take many years to overcome these legal/commercial barriers, and mainstream financial intermediaries could use this time window to rebuild their lost trust quickly enough to stave off the blockchain challenge. However, whether they are successful in rebuilding the trust, or whether they will be disrupted by the new technology remains to be seen.

Blockchain is still an evolving and therefore immature technology; it is hard to predict how successful it would be outside its only proven use domain of cryptocurrencies. History teaches us that radically new technologies take many decades to realize their full potential. Thus it is perfectly possible that blockchain would prove revolutionary in the years to come despite its patchy success so far. What is certain is that businesses should be looking at this technology and understanding it because its underlying ideas are powerful and likely to be influential.

Posted at 13:01 on Tue, 02 Apr 2019     View/Post Comments (1)     permanent link


Thu, 28 Mar 2019

Learning from Crises

Last week, Anwer S. Ahmed, Brant E. Christensen, Adam J. Olson and Christopher G. Yust posted a summary of their research on how banks with leaders experienced in past crises fared in global financial crisis (GFC). Their conclusion is:

We find that banks led by executives and directors with past crisis experience had significantly higher ROA before and during the GFC, fewer failures during the GFC, lower risk-weighted assets in the GFC, less exposure to real estate loans both before and during the GFC, timelier loan loss provisions in the GFC, and more persistent earnings before and during the GFC.

There are two ways of looking at this result. At the micro level, organizations should try to recruit managers with such experience. More important in my view is the macro level implication: it is good for society to have a large pool of managers with past crisis experience. That would ensure that the entire financial system copes better with new crises. But for that to happen, we need crises (at least mild crises) to happen with some degree of regularity.

Already, a decade after the GFC, I think a whole generation of traders and bankers have entered the financial system who have no first hand knowledge of dealing with a crisis. All that they have seen is a financial market numbed by ultra loose monetary policy and policy-puts. Their experience so far is that large economic and geo-political shocks (Brexit or the US-China trade war) have very mild and transient effects on market prices and volatility. The complacency of this generation is probably balanced by the battle scarred veterans who dominate the senior ranks of most banks. But over a period of time, many of these crisis-experienced leaders will retire or leave. It is quite likely that when the next big crisis comes along, there will be a shortage of crisis experience in the trenches.

Outside of finance, it is well understood that preventing small crises is a bad idea: frequent small earthquakes are better than an occasional big one; periodic restricted forest fires are preferred to one rare but big conflagration, and so on. In finance, there is a reluctance to permit even small failures. Regulators and policy makers are rewarded for moving swiftly to “solve” mini-crises. The tragedy is that this leaves institutions, individuals (and even regulators) ill equipped to cope with the big crises when they come.

Posted at 15:01 on Thu, 28 Mar 2019     View/Post Comments (1)     permanent link


Thu, 14 Mar 2019

Inverting the intermediary theory of asset pricing

In the last few years, the intermediary theory of asset pricing has emerged as a single factor model of asset pricing that does as well as the standard four factor model and thus subsumes the size, value and momentum factors (Adrian, T., Etula, E., & Muir, T. (2014). Financial intermediaries and the cross‐section of asset returns. The Journal of Finance, 69(6), 2557-2596). The theoretical justification for this model is that since financial intermediaries are the marginal buyers of many assets, their marginal value of wealth is a more relevant stochastic discount factor than that of a representative consumer. Though the idea that leverage is a good proxy for marginal value of wealth strains credulity, the empirical results seem quite strong, and there is some case to be made that the shadow price of a leverage constraint is related to the marginal value of wealth.

I see two problems with this. First of all, the major risk factors (like Momentum, Value, Carry and BAB) have been demonstrated in two centuries of data (1799-2016) from across all major world markets (Baltussen, Guido and Swinkels, Laurens and van Vliet, Pim, Global Factor Premiums (January 31, 2019). Available at SSRN: https://ssrn.com/abstract=3325720). It is evident that the structure of financial intermediation has changed beyond recognition over the last two centuries; for example, 19th Century giants like the Rothschilds operated with far lower levels of leverage than modern security dealers, and were in fact more principals than intermediaries. If the risk factors are solely due to intermediary leverage constraints, I would not expect to see such strong Sharpe ratios for the risk factors in the 19th Century data.

Second, there is a vertical split within the intermediary theory itself. He, Kelly and Manela presented a competing theory (Intermediary asset pricing: New evidence from many asset classes. Journal of Financial Economics, 2017, 126(1), 1-35) with drastically different results. I sometimes joke that Adrian, Etula & Muir (AEM) and He, Kelly & Manela (HKM) refute each other and so there is nothing more to be said. The first direct contradiction is that AEM find a positive price of risk for leverage, while HKM find a positive price of risk for the capital ratio (which is the reciprocal of leverage). Second, HKM get their nice results when they measure capital of the primary dealers at the holding company level unlike AEM who measure security dealer leverage at the unit level. Finally, AEM find book leverage to be more important, but for HKM, it is the market value capital ratio that is relevant.

I am veering around to the view that risk factors are not priced because of intermediary leverage constraints, but it is the other way around. Factor risk premiums have very long and deep drawdowns (for India, the drawdown plots are available at https://faculty.iima.ac.in/~iffm/Indian-Fama-French-Momentum/drawdown.php). As Cliff Asness put it,

I say “This strategy works.” I mean “in the cowardly statistician fashion.” It works two out of three years for a hundred years. We get small p-values, large t-statistics, if anyone likes those kind of numbers out there. We’re reasonably sure the average return is positive. It has horrible streaks within that of not working. If your car worked like this, you’d fire your mechanic, if it worked like I use that word.

So it is easier to harvest factor premiums if you are gambling with other people’s money especially with a taxpayer backstop for extreme tail events. Since Too Big to Fail (TBTF) banks are ideal candidates for doing this, you could well see significant correlations between the factors and the capital/leverage of these banks, but these correlations might be very sensitive to the measurement procedures that you use. In short, perhaps, we need to invert the intermediary theory of asset pricing.

Posted at 16:15 on Thu, 14 Mar 2019     View/Post Comments (0)     permanent link


Sat, 09 Mar 2019

When do you sell your best businesses?

The traditional recipe for reducing the leverage of an over indebted business conglomerate is to (a) sell non core peripheral unviable businesses, and (b) focus on improving the cash flows of the core profitable businesses. Most companies tend to do this, at least after they have gone past the stage of denial and business as usual.

But there is an alternative view expressed most forcefully two decades ago by a senior Korean government official in response to a restructuring proposal submitted by the Daewoo group: you do not reduce debt by selling unviable business, you do it by selling profitable businesses. (This statement most probably came from the Korean Financial Supervisory Commission (FSC) then led by the no-nonsense Lee Hun Jai, but I am not now able to trace this quote though the tussle between Daewoo and the government was well covered in the international press.)

I do recall one company that sold its best business without any prodding from creditors or government: RJR Nabisco under the private equity group KKR. Way back in 1995, with the tobacco business in the doldrums (as a result of Marlboro_Friday and tobacco litigation), RJR sold a part of the more attractive food business in a public issue, and used the proceeds to pay off some of its humongous debt. Apparently, the reason for not selling off the entire food business was legal advice that this could expose the board members to liability for fraudulent conveyance. (Baker & Smith discuss this episode in some detail in Chapter 4 of their book on KKR – The new financial capitalists: Kohlberg Kravis Roberts and the creation of corporate value. Cambridge University Press, 1998).

There are two arguments in favour of the radical approach of selling your best businesses to reduce debt. The first is that deleveraging is often carried out under acute time pressure and it is the good businesses that can be sold quickly and easily. Dilly dallying over deleveraging can quickly take things out of the control of management, and potentially lead to the complete dismantling and liquidation of the group as happened to Daewoo. The second argument is that financial stress at the conglomerate level acts as a drag on the good businesses that might need capital to grow or might need strong balance sheets to retain customer confidence and loyalty. In times of financial stringency, the functioning of the internal capital markets within the conglomerate becomes impaired and the good businesses tend to suffer the most. When internal capital markets start prioritizing survival over growth, good businesses should be rapidly migrated to stronger balance sheets that can both preserve value and support growth.

Many business groups in India are today trying to deleverage in response to changes in the legal regime that empower creditors, but they are still focused on selling their bad businesses. The risk is that this may prove too little, too late. At least some of them should consider the heretical idea of selling their crown jewels.

Globally, perhaps the largest conglomerate that needs to evaluate the strategy of selling its best business is GE. The aviation business is the crown jewel that is at risk from the troubles in the conglomerate. A year ago, John Hempton explained why this business needs a pristine balance sheet: whoever buys a plane powered by a GE engine needs to be confident that GE will be around and solvent in 40 years to actually maintain that engine. Moreover, the business needs massive investment in research and development, and the ability of a struggling GE to do this might be questionable. John Hempton proposed an equity raising as the solution, but the window for that might be slipping away as the share price continues to slide.

In times of stress, companies need level headed managers who can take rational decisions without being swayed by a maudlin attachment to their crown jewels.

Posted at 18:13 on Sat, 09 Mar 2019     View/Post Comments (3)     permanent link


Thu, 07 Mar 2019

Ignoring operational risk

Operational risk has always been less glamorous compared to market risk, interest rate risk and credit risk which are all now dominated by sophisticated mathematical models and apparent analytical rigour. Regulators too are uncomfortable dealing with operational risk because of its judgemental nature. Yesterday, for example, the US Federal Reserve Board announced that the largest US banks would no longer be subject to the “qualitative objection” which was the rubric under which it dealt with operational risk (see pages 13-14 of the summary instructions).

The reality however is that in big financial institutions with large well diversified portfolios, most risk management failures involve operational risk. This was true for example of JP Morgan’s London Whale, of the Nirav Modi scam at Punjab National Bank, of Nick Leeson, and many other cases. Even in the Global Financial Crisis, many of the largest losses were due as much to operational risk as to systemic events (which is why some banks had much larger losses than others).

Chernobai, Ozdagli and Wang have a paper showing that operational risk is aggravated for large and complex institutions (Business Complexity and Risk Management: Evidence from Operational Risk Events in U.S. Bank Holding Companies (December 18, 2018). Available at SSRN). They show that operational risk increased significantly when the business complexity of banks increased and provide evidence that this results from managerial failure rather than strategic risk taking. A year ago, I wrote on this blog that

banks are so opaque that even insiders cannot see through the opacity when bad things happen … 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.

Ignoring operational risks for the largest and most complex banks because it is too qualitative and judgemental does not appear to me to be a very good idea.

Posted at 14:38 on Thu, 07 Mar 2019     View/Post Comments (0)     permanent link


Wed, 27 Feb 2019

Can a strong Gresham’s law make good money worthless?

Gresham’s law states that if good money and bad money are circulating simultaneously, everybody would hoard the good money and spend the bad money thereby driving the good money out of circulation. Essentially, the good money becomes a store of value, and the bad money becomes the medium of exchange. I am beginning to think that an even more perverse outcome is possible – the good money having ceased to be money can suddenly become nearly worthless (because the store of value function of the previously good money depended on its being money). This strong form of Gresham’s law came to my mind after reading Wiegand’s recent paper presenting a “prisoners’ dilemma” model of Germany’s adoption of the gold standard in the 1870s.

The story as Wiegand describes it is as follows. In the mid 19th century, a large bloc of countries led by France was on a bimetallic standard with both gold and silver being used as money at a fixed exchange rate. New discoveries in California and Australia brought new supplies of gold in the 1850s, leading to relative shortage of silver whose output grew slowly. While in 1849, annual production (by value) of gold was less than that of silver, in the 1850s and 1860s, gold output was 2-3 times that of silver. Gresham’s law operated as expected to cause hoarding of silver in the bimetallic world: the share of gold in the French currency in circulation rose from below 30% in 1849 to over 80% in the 1860s. As the proportion of gold in France approached 100%, the possibility emerged of silver simply ceasing to be money. But if silver was no longer money, its price would decline to its value in cutlery or jewellery (the first photographic rolls using silver halide came only in the 1880s). We know from 40-year old first generation currency crisis models (Krugman, P. (1979). A model of balance-of-payments crises. Journal of money, credit and banking, 11(3), 311-325.), that the transition from France being 90% on gold to 100% on gold would not be smooth, but would happen in a sudden speculative attack that demonitizes silver. My reading of Wiegand is that Germany acted like a mega George Soros in executing this speculative attack by shifting to a gold standard and dumping all its silver on world markets; soon everybody abandoned silver and its price collapsed. (In the French bimetallic standard, it took only 15.5 ounces of silver to buy an ounce of gold; currently it takes more than five times that many ounces of silver to buy an ounce of gold.) Wiegand’s “prisoners’ dilemma” model is that Germany was forced to act pre-emptively to prevent France from launching a similar speculative attack on Germany’s silver standard.

This is what I am calling the strong Gresham’s Law: in a world of competing monies, the good money would be destroyed by a sudden speculative attack if it undergoes excessive deflation. All successful moneys have been mildly inflationary over sufficiently long periods (Triffin’s dilemma also leads to the same insight).

On the other hand, it is well known that the bad (inflationary) money could also become worthless if inflation accelerates beyond a point (Bernolz has labelled this reverse of Gresham’s law as Thiers’ law). The two laws together imply that all moneys are likely to die over multi-century time frames because of the low probability of staying on the razor’s edge between being demonitized by (a) deflation (the strong Gresham’s Law) and (b) inflation (Thiers’ law) for such long periods of time. This is consistent with the historical evidence: the ultimate fate of every fiat money in human history beginning with 11th Century China seems to be to become worthless. Near worthlessness has also been the ultimate fate of every commodity money except gold (and who knows how long gold’s luck will last?).

This has implications for crypto currency money supply rules as well. Seared by an abundance of hyper inflationary episodes in the 20th Century, crypto currencies have been designed with a deflationary bias. Many of them have inbuilt rules that freeze the money supply after an initial period of gradual monetary emission. In the wake of the collapse of crypto currency prices in recent months, some are making their systems more deflationary. Commentators are interpreting the reduced rate of monetary emission under tomorrow’s Constantinople Upgrade in Ethereum as a move to increase its market price. The weak and strong Gresham’s Laws suggests that all this might be misguided. It appears to me that after the rapid appreciation of crypto currencies in 2017, the weak Gresham’s Law kicked in and crypto currencies ceased to be medium of exchange; they became mere stores of value as exemplified by the hodl meme. It remains to be seen whether the 2018 price collapse in crypto currencies is the beginning of the effect of the strong Gresham’s Law that could destroy these currencies. Counter intuitively, an increased rate of monetary emission might actually be the way to salvage these currencies. Models with multiple equilibria are indeed quite messy.

Posted at 21:51 on Wed, 27 Feb 2019     View/Post Comments (0)     permanent link


Sat, 23 Feb 2019

Convergence of insurance and derivatives

During the global financial crisis, it became fashionable to say that a CDS (Credit Default Swap) is insurance in disguise and should be regulated as such. My response used to be that (a) a lot of insurance is derivatives in disguise, (b) an LC (Letter of Credit) issued by a bank is a CDS in disguise, and (c) it might be better for both them to be regulated as derivatives with mark to market discipline and some pre/post trade transparency. Reinsurance for example is best thought of as put options on a portfolio of non traded or illiquid assets as I wrote in a blog post nearly 11 years ago.

More recently, I am beginning to think that a convergence of derivatives and insurance could happen as “parametric insurance” moves from a fringe idea to a mainstream insurance product. The common description of parametric insurance reads almost like a definition of a weather derivative:

Parametric insurance, …, provides coverage monies automatically upon the existence of certain objective weather-related parameters based upon a set formula. (Van Nostrand, J. M., & Nevius, J. G. (2011). Parametric insurance: using objective measures to address the impacts of natural disasters and climate change. Environmental Claims Journal, 23(3-4), 227-237.)

The parametric insurance literature talks a lot about “basis risk” which indicates convergence with derivatives not only in substance but also in terminology. More recently, proposals have emerged to move from digital call/put option payoffs (payout triggered by a variable such as rainfall amount, wind speed, or earthquake magnitude being observed to exceed a threshold) to more complex functional forms depending in non linear fashion on multiple indices (for example, Figueiredo, R., Martina, M. L., Stephenson, D. B., & Youngman, B. D. (2018). A Probabilistic Paradigm for the Parametric Insurance of Natural Hazards. Risk Analysis, 38(11), 2400-2414.) A traditional derivative structuring expert would be quite at home here.

Till now, parametric insurance has tended to be a niche product used for large transactions (often involving sovereigns or multilateral organizations). The derivatives analogy for this would be a transaction between two ISDA (International Swaps and Derivatives Association) counterparties. But that could change as well because FinTech (financial technology) players now see parametric insurance as an opportunity to break into the insurance space. They dream of using smart contracts and IOT (internet of things) to turn parametric insurance into a retail product. In some of these grandiose plans, a sensor in my home will inform the insurance company that it detected flood waters inside my home and the insurance company will automatically transfer the payout (or is it payoff?) to my bank account, and perhaps, all of this will happen on the blockchain. So we will have the equivalent of retail weather derivatives. I hope there will be a mark to market regulation somewhere.

Posted at 18:36 on Sat, 23 Feb 2019     View/Post Comments (2)     permanent link


Wed, 13 Feb 2019

Indian Bankruptcy Code: Morality play reaches a dead end

The Insolvency and Bankruptcy Code (IBC) introduced in India a couple of years ago was from the very beginning a morality play with a thin veneer of economic theory. With the passage of time, the veneer of economic theory has eroded, the morality play has become stronger and the functioning of the code has become progressively more divorced from economic reality.

Until the IBC came along, Indian businesses were well protected from their lenders by mechanisms like the BIFR which were the morality play of an earlier era that had become perverted over time. Originally designed to protect the interests of workers of distressed companies, these mechanisms ended up entrenching incumbent management, and leaving lenders helpless. Since a lot of the lenders were public sector banks, there was a strong political pressure to redress the balance. After a couple of attempts to empower the financial sector (Debt Recovery Tribunals and SARFAESI) proved inadequate, the IBC was introduced to redress the balance decisively.

In this morality play, the corporate sector were the villains, and the banks were the saints. The obvious solution was to hand over insolvent companies to the financial creditors. Of course, companies have operational creditors, but since these tend to be businesses which were classified as villains, a decision was taken to exclude operational creditors from the decision making. Morality was also the path of expediency as the new system also served as a backdoor bailout of the beleaguered financial sector.

Decades of studying finance have taught me that the world of finance is full of villains, but there are hardly any saints. In my first blog post on the Indian bankruptcy reform, I wrote that in the real world bankruptcy was “very much like the familiar scene in the Savannah where cheetahs, lions, hyenas and vultures can be seen fighting over the carcass”. There is no fairness in the jungle, and victory belongs neither to the one that hunted down the prey nor to the one in greatest need of food; victory typically goes to the most wicked of the lot. The story is the same when it comes to distressed debt around the world. Last month, Jared Ellias and Robert Stark wrote a fascinating paper entitled “Bankruptcy Hardball” which documented several episodes of such wickedness in the United States.

The sidelining of operational creditors was initially the most egregious morality play in the IBC and I wrote more than one blog post on this issue (here and here). Moreover, even the morality of this exclusion became suspect when it was realized that home buyers who had paid an advance to an insolvent builder would be operational creditors. Politically, it was impossible to club home buyers with other villainous operational creditors, and exceptions were made for them.

But there was more to come. Very soon, instances arose where the incumbent managements of the insolvent companies were potentially the highest bidders in the bankruptcy auction of their companies. Under the original IBC, they would have prevailed, and this might have been the best outcome from the point of view of maximizing the economic value of the lenders. But since the IBC was from inception a morality play, this could not be permitted. So the law was hurriedly amended to prevent them from bidding.

But this creates another problem. Originally, creditors were put in charge of the decision making because it was supposed to be a purely business decision. As the Bankruptcy Law Reforms Committee wrote in its report:

The evaluation of these proposals come under matters of business. The selection of the best proposal is therefore left to the creditors committee …

However, with the exclusion of tainted bidders, the choice of the best proposal is no longer one of economics, but one of theology. Some of the feverish debates in the courts on which bidders are tainted enough to be excluded reminds me of medieval scholastic debates about “How many angels can dance on the head of a pin?”. From an economic point of view, these debates are ridiculous. As the Roman emperor Vespasian said while imposing a tax on urine, Pecunia non olet (money does not stink). Morality plays tend to forget this principle.

By elevating morality above economics, the IBC is failing to live up to its promise. Instead, we see confusion reign paramount. We see distressed companies boasting of a respectable market capitalization while their debt trades at less than half of book value. We see bankruptcy remote vehicles delaying payment on their obligations after the parent group filed for insolvency. The time has come for us to deemphasize the morality play. It is time to hold our noses like emperor Vespasian, and get on with the ugly business of economics.

Posted at 22:16 on Wed, 13 Feb 2019     View/Post Comments (1)     permanent link


Thu, 07 Feb 2019

Covered Interest Parity yet again

I have blogged several times about how Covered Interest Parity (CIP) is not valid in the multi-curve discounting framework that is the standard in finance after the Global Financial Crisis. (My last post a couple of years ago argued that economists who still believe in CIP unreservedly are simply ignoring risk; earlier posts described the cross currency basis and the multi curve discounting framework).

Recently, I read a paper by Wong and Zhang that is perhaps the most lucid explanation that I have seen of the phenomenon of CIP violations and the emergence of a large cross currency basis. They are able to explain not only why the forward premium is not equal to the Libor differential, but also why the CIP violation persists when Libor is replaced by (near) risk free rates like OIS (Overnight Indexed Swaps) or repo.

Wong and Zhang point out that the Libor-OIS spread reflects two different things. First, Libor carries significant counterparty credit risk because it involves unsecured lending for a non trivial time period, while the overnight tenor of OIS reduces the credit risk to negligible levels. Second, Libor carries an exposure to funding liquidity risk because the lender has to fund the loan till maturity, while OIS involves only an exchange of interest cash flows without any principal funding.

The Cross Currency Basis Swap (CCBS) in its post-crisis form does not expose the counterparties to credit risk because of collateralization and variation margins. But it does involve funding liquidity risk (each party receives liquidity in one currency and gives up liquidity in another currency). Thus the CCBS spread reflects only one part of the Libor-OIS spread – the part that accounts for funding liquidity risk. The empirical results in the Wong and Zhang paper show that in some currencies, the Libor-OIS spread is dominated by credit risk while in other currencies (notably the US dollar) it is dominated by funding liquidity risk. As a result, a CIP violation is observed whether one measures the interest differential using Libor or OIS.

Of course, all this is consistent with the multi-curve discounting framework, but this analysis is probably a lot easier to understand.

Posted at 16:19 on Thu, 07 Feb 2019     View/Post Comments (0)     permanent link


Mon, 31 Dec 2018

Yet more on Equifax data breach

I have written many times about the Equifax data breach arguing that the credit bureau business should be subject to the doctrine of strict liability, that society should not hesitate to impose punitive penalties on them (including shutting down errant entities), and that modern cryptography makes existing credit bureaus obsolete. My excuse for writing about them again is that I just finished reading the US Congress (Committee on Oversight and Government Reform) Majority Staff Report on The Equifax Data Breach.

This report makes it clear that things were even worse at Equifax than I thought. But what I found most interesting is that when the breach occurred, Equifax had initiated the process of making the hacked system compliant with PCI-DSS (Payment Card Industry Data Security Standard) and doing so “would have largely addressed the security concerns flagged”, and would have likely prevented the hack.

PCI DSS compliance requirements include: the use of file integrity monitoring; strong access control measures; retention of logs for at least one year, with the last three months of logs immediately available for analysis; installation of patches for all known vulnerabilities; and maintenance of an up-to-date inventory of system components.

None of this is rocket science and even tiny mom-and-pop stores are required to comply with them before they can accept credit card payments. Yet, one of the largest credit bureaus in the world did not comply with them. The reason is something that Bruce Schneier has been saying for a long time (Eliminating Externalities in Financial Security):

It’s an important security principle: ensure that the person who has the ability to mitigate the risk is responsible for the risk.

If you think this won’t work, look at credit cards. Credit card companies are liable for all but the first $50 of fraudulent transactions. They’re not hurting for business; and they’re not drowning in fraud, either. They’ve developed and fielded an array of security technologies designed to detect and prevent fraudulent transactions. They’ve pushed most of the actual costs onto the merchants. And almost no security centers around trying to authenticate the cardholder.

Equifax was so terrible at computer security because it had no incentives to do a better job: even after one of the worst breaches in history, Equifax faced only minor penalties.

Posted at 19:48 on Mon, 31 Dec 2018     View/Post Comments (0)     permanent link


Sun, 30 Dec 2018

Is index methodology a fundamental attribute of a mutual fund?

Adriana Robertson argues in a recent paper that index investing is not passive investing; it only delegates the active management to the index proviver. (Passive in Name Only: Delegated Management and ‘Index’ Investing (November 2018). Yale Journal on Regulation, Forthcoming. Available at SSRN). This is a problem because mutual funds are regulated, but index providers are not. The paper presents data showing that the vast majority of indices in the United States are used as a benchmark by only 1 or 2 mutual funds, and so it is hard to argue that these index providers are subject to strong market discipline.

She offers an ingenuous suggestion to solve this problem without new intrusive regulation.

While a mutual fund cannot deviate from its fundamental policies, as stated in its registration statement, without a shareholder vote, there is no restriction on an index’s ability to change its methodology.

Fortunately, there is a simple solution to this problem. Once we recognize that delegating to an index is no different from delegating to a fund manager, we can craft a solution based on the existing rules: Any time the underlying index makes a change that, if made by the fund manager in a comparable actively managed fund, would trigger a vote, the fund manager is required to hold a vote on retaining the index. This simple change would harmonize the protections offered to investors in the two types of funds.

I can think of at least two significant index changes that would qualify under this rule, and on both these, I think Adriana Robertson’s solution makes eminent sense:

Posted at 17:09 on Sun, 30 Dec 2018     View/Post Comments (0)     permanent link


Mon, 17 Dec 2018

New Zealand shows the way again?

Three decades ago, New Zealand was the first country in the world to adopt a formal inflation target for its central bank. At around the same time, it also broke new ground in bank regulation with a focus on self-discipline and market-discipline with the regulator focusing mainly on systemic risks (a good summary is available here). Today, the Reserve Bank of New Zealand may be showing the way again with its proposal last week to almost double bank capital requirements.

More than the actual proposal itself, it is the approach that is interesting and likely to be influential. The fact that New Zealand is not a Basle Committee member gives it greater freedom to start from first principles. That is what they have done starting with their mandate to promote a sound and efficient financial system. First, they express the soundness goal in risk appetite terms: “a banking crisis in New Zealand shouldn’t happen more than once every two hundred years”. Second, they interpret the efficiency goal in terms of the literature on optimal capital requirements. This means that they begin by computing the capital requirements that would reduce the probability of a crisis to less than 0.5% per year, and then go on to ask if the optimal capital may be even higher. So the capital requirement is the higher of that determined from soundness and efficiency goals.

Another welcome thing about the proposal is that higher capital is seen as a way for the Reserve Bank of New Zealand to maintain its emphasis on self-discipline and market-discipline:

Capital requirements are the most important component of our overall regulatory arrangements. In the absence of stronger capital requirements, other rules and monitoring of bank’s activities would need to be much tougher.

They end up with Tier-1 capital of 16% as opposed to the existing 8.5% (6% + 2.5% conservation buffer). The 16% includes a countercyclical capital buffer, but unlike in other countries, this buffer would have a positive value at all times, except following a financial crisis. The 16% also includes a 1% D-SIB buffer for the large banks, but excludes the 2% Tier-2 capital requirement (which they are maintaining for the time being, though they would to have only Tier-1 capital).

What is interesting is that 16% is not the regulatory minimum (that remains at the current 6% level). Their idea seems to be that above 16%, it is all self-discipline and market-discipline, but as capital falls below that level, the regulator starts getting involved according to a “framework of escalating supervisory responses based on objective triggers that can provide clarity and much more certainty”. On the other side, when banks are operating above 16%, the Reserve Bank will impose relatively less of a regulatory burden on banks. They are even ready to consider allowing banks to change their internal risk models without regulatory approval at all. Below 16%, the supervisory responses escalate as follows:

One of the dangers of international harmonization of financial sector regulation under the auspices of Basel, FSB and G20 has been the risk of a regulatory mono-culture. New Zealand located at the edge of the world and outside the Basel system is providing a good antidote to this.

Posted at 13:32 on Mon, 17 Dec 2018     View/Post Comments (1)     permanent link


Thu, 06 Dec 2018

Does better mathematics win in the markets?

Last week, the US District Court Southern District of New York issued a judgement dismissing the US CFTC’s complaint of market manipulation against Donald R. Wilson and DRW Investments (h/t Matt Levine). Describing the CFTC’s theories as little more than an “earth is flat” style conviction, the court wrote:

It is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented that product. In the summer and fall of 2010, Don Wilson believed that he comprehended the true value of the Three-Month Contract better than anyone else, including IDCH, MF Global, and Jeffries. He developed a trading strategy based on that conviction, and put his firm’s money at risk to test it. He didn’t need to manipulate the market to capitalize on that superior knowledge, and there is absolutely no evidence to suggest that he ever did so in the months that followed.

In August 2011, DRW unwound its swap futures trade at a profit of $20 million, and the CEO of the biggest firm on the other side Jeffries emailed Wilson: “You won big. We lost big.”. The mathematics behind this trade is well described in a paper by a well known academic quant and two quants who worked for DRW:

Rama Cont, Radu Mondescu and Yuhua Yu “Central Clearing of Interest Rate Swaps: A Comparison of Offerings” available on SSRN.

The purpose of this blog post is to ask a different question: how common is it for traders make money simply by better knowledge of the mathematics than other participants. My sense is that this is relatively rare; traders usually make money by having a better understanding of the facts.

Perhaps the best known mathematical formula in the financial markets is the Black-Scholes option pricing formula, and Black has described his attempts to make money using this formula:

The best buy of all seemed to be National General new warrants. Scholes, Merton, and I and others jumped right in and bought a bunch of these warrants. For a while, it looked as if we had done just the right thing. Then a company called American Financial announced a tender offer for National General shares. The original terms of the tender offer had the effect of sharply reducing the value of the warrants. In other words, the market knew something that our formula didn’t know.

Black, F., 1989. “How we came up with the option formula”. Journal of Portfolio Management, 15(2), pp.4-8.

Many years later, Black did make money with superior knowledge of the mathematics of option pricing. A well known finance academic Jay Ritter has described the sad story of being on the losing side of this trade:

I lost more in the futures market than I made from my academic salary. … Years later, I found out who was on the other side of the trades in the summer of 1986. It was Goldman Sachs, with Fischer Black advising the traders, that took me to the cleaners as the market moved from one pricing regime to another. In the first four years of the Value Line futures contract, the market priced the futures using the wrong formula. After the summer of 1986, the market priced the Value Line futures using the right formula. The September 1986 issue of the Journal of Finance published an article (Eytan and Harpaz, 1986) giving the correct formula for the pricing of the Value Line futures. In the transition from one pricing regime to the other, I was nearly wiped out.

Ritter, J.R., 1996. “How I helped to make Fischer Black wealthier”. Financial Management, 25(4), pp.104-107.

One person who did make money by understanding the mathematics of option pricing was Ed Thorp who kept his knowledge secret till Black and Scholes discovered their formula and published it. Decades later Thorp said in an interview:

… with blackjack, … I thought it was mathematically very interesting, so as an academic, I felt an obligation to publicize my findings so that people would begin to think differently about some of these games. … Moving on to the investment world, when I began Princeton/Newport Partners in 1969, I had this options formula, this tool that nobody else had, and I felt an obligation to the investors to basically be quiet about it. … I spent a lot of time and energy trying to stay ahead of the published academic frontier.

Consulting Submitter, Journal of Investment, “Putting the Cards on the Table: A Talk with Edward O. Thorp”, PhD (July 1, 2011). Journal of Investment Consulting, Vol. 12, No. 1, pp. 5-14, 2011. Available at SSRN

Academics in general have been content to publish their results even when they think it is worth a billion dollars:

Longstaff, F.A., Santa-Clara, P. and Schwartz, E.S., 2001. “Throwing away a billion dollars: The cost of suboptimal exercise strategies in the swaptions market”. Journal of Financial Economics, 62(1), pp.39-66.

Using unpublished mathematical results to make money often has the effect of destroying the underlying market. Nasdaq (which owned IDCH) delisted the swap futures contract within months of DRW unwinding its profitable trade. Similarly, Fischer Black effectively destroyed the Value Line index contract through his activities. Markets work best when the underlying mathematical knowledge is widely shared. It is very unlikely that the option markets would have grown to their current size and complexity if the option pricing formulas had remained the secret preserve of Ed Thorp. Mathematics is at its best when it is the market that wins and not individual traders.

PS: One of the things that has puzzled me about the DRW case is that DRW was a founding member of Eris which offered a competing Swap Futures product. Why didn’t anybody raise a concern that DRW and Eris were conspiring to destroy IDCH? Of course, DRW would have the compelling defence that with $20 million of profits to be made from the arbitrage, they did not need any other motive to do the trade. But still it bothers me that the matter does not seem to have come up at all.

Posted at 15:42 on Thu, 06 Dec 2018     View/Post Comments (0)     permanent link


Wed, 28 Nov 2018

Earnings related trading: Futures or Options

There is a large body of literature (mainly in the US) that a lot of the trading activity in response to earnings information happens in the options market. (The seminal paper in this field is Roll, R., Schwartz, E., & Subrahmanyam, A. (2010). O/S: The relative trading activity in options and stock. Journal of Financial Economics, 96(1), 1–17.) Unfortunately, the US and most other countries do not have a liquid single stock futures market, and so we do not know whether the options market was the preferred choice of the informed traders or it was the second best choice substituting for the missing first choice (the futures market). If what the informed trader wanted was leverage and short selling ability, the futures are a much better vehicle because there is no option premium and no delta rebalancing cost. On the other hand, if the trader believed for example that there was a high probability of a large upside surprise in the earnings, counterbalanced by a more modest risk of downside surprise, then the sensible way to express that view would be with a bull-biased strangle (buy a substantial number of out-of-the-money calls and a somewhat smaller number of out-of-the-money puts). It would be too risky to trade this view in the futures market without the downside protection provided by options.

India provides the perfect setting to resolve this issue because it has liquid single stock futures and single stock options markets (both of these markets are among the largest such markets in the world). In a recent paper, my doctoral student, Sonali Jain, my colleagues, Prof. Sobhesh Agarwalla and Prof. Ajay Pandey and I investigate this (Jain S, Agarwalla SK, Varma JR, Pandey A. Informed trading around earnings announcements – Spot, futures, or options?. J Futures Markets. 2018. https://doi.org/10.1002/fut.21983) We find that in India single stock futures play the role that the options market plays in the US implying that the informed traders are seeking leverage benefits of derivatives rather than the nonlinear payoffs of options. We also find patterns in the data that are best explained by information leakage. Though, Indian derivative markets are often disparaged as being gambling dens dominated by noise traders, our results suggest that the futures markets are also venues of trading based on fundamentals.

Posted at 18:16 on Wed, 28 Nov 2018     View/Post Comments (0)     permanent link


Thu, 15 Nov 2018

Spreads price constraints

Craig Pirrong writes on his Streetwise Professor blog that “Spreads price constraints.” Though Pirrong is talking about natural gas calendar spreads, I think this is an excellent way of thinking about many other spreads even for financial assets. In commodities, the constraints are obvious: for calendar spreads, the constraint is that you cannot move supply from the future to the present, for location spreads, the constraints are transportation bottlenecks, for quality spreads, technological constraints limit the elasticity of substitution between different grades (in case of intermediate goods), while inflexible tastes constrain the elasticity in case of final goods.

But the idea that “spreads price constraints” is also true for financial assets where the physical constraints of commodities are not applicable. The constraints here are more about limits to arbitrage – capital, funding, leverage and short-sale constraints, regulatory constraints on permissible investments, and constraints on the skilled human resources required to implement certain kinds of arbitrage.

Thinking of the spread as the shadow price of a constraint makes it much easier to understand the otherwise intractable statistical properties of the spread. Forget about normal distributions, even the popular fat tailed distributions (like the Student-t with 3-10 degrees of freedom) are completely inadequate to model these spreads. Modelling the two prices and computing the spread as their difference does not help because modelling the dependence relationship (the copula) is fiendishly difficult (see my blog post about Nordic power spreads). But thinking about the spread as the shadow price of a constraint, allows us to frame the problem in terms of standard optimization theory. Shadow prices can be highly non linear (even discontinuous) functions of the parameters of an optimization problem. For example, if the constraint is not binding, then the shadow price is zero, and changing the parameters makes no difference to the shadow price until the constraint becomes binding, at which point, the shadow price might jump to a large value and might also become very sensitive to changes in various parameters.

This is in fact quite often observed in derivative markets – a spread may be very small and stable for years, and then it can suddenly shoot up to very high levels (orders of magnitude greater than its normal value), and can also then become very volatile. If the risk managers had succumbed to the temptation to treat the spread as a very low risk position, they would now be staring at a catastrophic failure of the risk management system. Risk managers would do well to refresh their understanding about duality theory in linear (and non linear) programming.

Posted at 17:43 on Thu, 15 Nov 2018     View/Post Comments (0)     permanent link


Wed, 07 Nov 2018

Aadhaar and signing a blank sheet of paper redux

The Aadhaar abuse that I described a year ago as a hypothetical possibility a year ago has indeed happened in reality. In July 2017, I described the scenario in a blog post as follows:

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. … 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 hand 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.

Last week, the newspapers carried a PTI report about a case going on in the Delhi High Court about exactly this vulnerability:

The Delhi High Court on Thursday suggested incorporating recommendations, like using OTP authentication instead of biometric, given by two amicus curiae to plug a ‘loophole’ in the Aadhaar verification system that had been misused by a mobile shop owner to issue fresh SIM cards in the name of unwary customers for use in fraudulent activities. The shop owner, during Aadhaar verification of a SIM, used to make the customer give his thumb impression twice by saying it was not properly obtained the first time and the second round of authentication was then used to issue a fresh connection which was handed over to some third party, the high court had earlier noted while initiating a PIL on the issue.

This vindicates what I wrote last year:

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.

Posted at 18:15 on Wed, 07 Nov 2018     View/Post Comments (0)     permanent link


Fri, 02 Nov 2018

Indian Single Stock Option Pricing

A recent paper by my doctoral student, Sonali Jain, my colleague, Prof. Sobhesh Agarwalla and myself (Jain S, Varma JR, Agarwalla SK. Indian equity options: Smile, risk premiums, and efficiency. J Futures Markets. 2018;1–14. https://doi.org/10.1002/fut.21971) studies the pricing of single stock options in India which is one of the world’s largest options markets.

Our findings are supportive of market efficiency: A parsimonious smile-adjusted Black model fits option prices well, and the implied volatility (IV) has incremental predictive power for future volatility. However, the risk premium embedded in IV for Single Stock Options appears to be higher than in other markets. The study suggests that even a very liquid market with substantial participation of global institutional investors can have structural features that lead to systematic departures from the behavior of a fully rational market while being “microefficient.”

The good news here is that (a) options with different strikes on the same stock are nicely consistent with each other (parsimonious smile), and (b) the option market predicts future volatility instead of blindly extrapolating past volatility. The troubling part is that the implied volatility of Indian single stock options consistently exceeds realized volatility by too large an amount to be easily explained as a rational risk premium. Globally, there is a substantial risk premium in index options but not so much in single stock options in accordance with the intuition that changes in index volatility are a non diversifiable risk, while fluctuations in the idiosyncratic volatility of individual stocks are probably diversifiable. The large gap between Indian implied and realized volatility is therefore problematic. However, the phenomenon cannot be attributed entirely to an irrational market: we find that the single stock implied volatility has a strong systematic component responding to changes in market wide risk aversion (the index option smile).

There is a puzzle here that demands further research. There is some anecdotal evidence that option writers demand a risk premium for expiry day manipulation by the promoters of the company. I also think that there is a shortage of capital devoted to option writing despite the emergence of a few alternative investment funds in this area. Perhaps there are other less well understood barriers to implementing a diversified option writing strategy in India.

Posted at 13:41 on Fri, 02 Nov 2018     View/Post Comments (0)     permanent link


Sun, 21 Oct 2018

Markets versus Institutions

I had the opportunity to engage in a conversation with Nobel Laureate Robert Merton after he delivered the R H Patil Memorial Lecture as part of the Silver Jubilee celebrations of the National Stock Exchange last week. The video is available here, and a large part of the conversation is about whether financial markets can be trusted more than financial institutions particularly in the Indian context.

Posted at 10:48 on Sun, 21 Oct 2018     View/Post Comments (0)     permanent link


Mon, 08 Oct 2018

Lessons from the Nasdaq Clearing Default

Last month, the loss caused by the default of a single trader in a Nordic power spread contract cleared by Nasdaq Clearing consumed the entire €7 million contribution of Nasdaq to the default waterfall and then wiped out more than two thirds of the €168 million default fund of the Commodities Market segment of Nasdaq (the diagram on page 7 of this document shows the entire default waterfall for this episode).

Nasdaq explained its margin methodology as follows:

The margin model is set to cover stressed market conditions, covering at least 99.2% of all 2-day market movements over the recent 12 month period. In the final step of the margin curve estimation a pro-cyclicality buffer of 25% is applied.

The MPOR (Margin Period of Risk) for the relevant products is two days.

It also provided the following historical data:

There has been a lot of excellent commentary on this episode:

The episode highlights a number of important lessons about risk management that we knew even before this default happened:

Posted at 18:07 on Mon, 08 Oct 2018     View/Post Comments (0)     permanent link


Tue, 02 Oct 2018

Mutual fund redemptions redux

Debt mutual funds are not banks: when mutual fund investors redeem their units at an inflated Net Asset Value (NAV) they simply steal money from their co-investors. This adjacency risk or co-investor risk comes to the fore every now and then, when heightened default risk makes bond prices volatile and unreliable. This happened in India in 2008 during the global financial crisis and is happening again today. Providing liquidity to solvent banks in a crisis makes sense, but providing liquidity to debt mutual funds is a bad idea because it simply allows rich, better informed investors to steal from less informed co-investors. The correct way to provide liquidity is to lend not to the mutual fund but to the unit holder (against units of debt mutual funds).

Unfortunately, I appear to be in a minority on this issue. Even the best analysts appear to support liquidity lines for the mutual fund; for example, the highly knowledgeable and respected Akash Prakash writes in today’s Business Standard (paywall):

Liquidity lines and repo facilities have to be set up for the debt mutual funds. We cannot allow forced selling at panic prices. Panic selling will force other funds to also mark down their bonds, showing paper losses, creating more redemptions, more selling and we will spiral into a negative feedback loop.

My position is the opposite: we must force mutual funds to mark down their bonds so that their NAVs are fair and correct. The way to stop panic selling is side pockets and gates as I have been saying for the last ten years: during the 2008 crisis in India (borrowing and gating), during the Amtek Auto episode, and in response to US money market mutual fund reforms (minimum balance at risk and gates).

Liquidity lines to the mutual funds are a bail out of rich corporations and high net worth individuals at the cost of the ordinary investor. Liquidity lines to unit holders (against the security of units of debt mutual funds) do not have this problem because then the bond price risk remains with the borrower and is not transferred to other co-investors.

Posted at 14:22 on Tue, 02 Oct 2018     View/Post Comments (3)     permanent link


Fri, 21 Sep 2018

Indian banks: quiescent shareholders and activist regulators

The Indian central bank or other government agencies have been instrumental in effecting a change of management in three under-performing private sector banks (ICICI Bank, Axis Bank and Yes Bank) in recent months. While much has been written about the functioning of the boards and of the central bank, the more fascinating question is about the dog that did not bark: the quiescent shareholders of these banks. They have suffered in silence as these banks have surrendered the enviable position that they once had in India’s financial system. The void created by the wounded banking system in India is being filled by non bank finance companies. So much so that one of these non banks (Bajaj Finance) trades at a Price/Book ratio 3-4 times that of the above mentioned three banks and now boasts of a market capitalization roughly equal to the average of these three banks.

The question is why has this not attracted the attention of activist investors. One looks in vain for a Third Point, Elliott or TCI writing acerbic letters to the management seeking change. The Indian regulatory regime of voting right caps and fit and proper criteria has ensured that such players can never threaten the career of non performing incumbent management in Indian banks. The regulators have entrenched incumbent managements and so the regulators have to step in to remove them.

Incidentally, the securities regulator in India has been no better. It too has ensured that the big exchanges and other financial market infrastructure in India are immune to shareholder discipline, and over the last several years many of these too have performed far below their potential.

Indian regulators do not seem to understand that capitalism requires brutal investors and not just nice investors talking pleasantly to the management. Capitalism at its best is red in the tooth and claw.

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


Mon, 17 Sep 2018

The FED’s bite is worse than its bark

If any emerging market thought that the US Federal Reserve is a paper tiger whose bark is worse than its bite, the last few months have shattered that illusion. Already, the bite is hurting a lot more and the tiger still appears to be hungry and on the prowl.

The comparison below is actually biased in favour of a bigger effect for the bark because it focuses on the Fragile Five who were the worst sufferers during the barking phase. I have left out Argentina and China who have suffered only or mainly in the biting phase.

The FED’s bark (Taper Tantrum: April-July 2013)

The data is from Barry Eichengreen and Poonam Gupta, Tapering Talk: The Impact of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets. Following Eichengreen and Gupta, I have measured the exchange rate pressure by the percentage increase in the nominal exchange rate (units of domestic currency per US dollar), though ideally it should be the decline in the inverse of this number. Unlike Eichengreen and Gupta, I have simply added the percentage exchange rate change and the percentage reserve loss for a crude measure of the total effect. For a blog post, I am too lazy to weight the two measures by the inverse of their respective standard deviations (and I am also quite happy with improper linear models).

Depreciation Reserve Loss Total
Brazil 12.52 1.69 14.21
India 9.98 4.77 14.75
Indonesia 3.58 13.61 17.19
South Africa 8.96 5.42 14.38
Turkey 7.61 8.20 15.81

The FED’s bite (Ongoing since April 2018)

The following data is what I have been able to put together from easily available sources on the internet. The currency depreciation is from Yahoo Finance and covers the period from April 16, 2018 to September 13, 2018. The reserve loss is from end March (or mid April where available) to the latest date for which I could get data clicking through to the data links on the National Summary Data Pages (NSDPs) of the IMF’s Dissemination Standards Bulletin Board (DSBB). Except for Turkey, the data for the rest of the countries is not hopelessly out of date, and for Turkey, the reserve loss is totally swamped by its currency depreciation.

If you have better data, please free to provide that in the comments section.

Depreciation Reserve Loss Total
Brazil 22.22 0.26 22.48
India 10.46 5.90 16.36
Indonesia 8.02 6.35 14.37
South Africa 21.36 -0.00 21.36
Turkey 50.86 8.15 59.01

Posted at 16:14 on Mon, 17 Sep 2018     View/Post Comments (0)     permanent link


Sun, 09 Sep 2018

Self-serving self-censorship in a crisis

In a crisis, the only thing that is not censored or self-censored is the market (provided it has not been regulated out of existence or into meek submission). That is the lesson that we can learn from a rare candid admission from a well known columnist at one of the most respected financial newspapers in the world. In his latest “The Long View” column (link behind paywall) in the Financial Times yesterday (September 9, 2018) John Authers writes:

It is time to admit that I once deliberately withheld important information from readers. It was 10 years ago, the financial crisis was at its worst, and I think I did the right thing.

There was a bank run happening, in New York’s financial district. The people panicking were the Wall Streeters who best understood what was going on.

All I needed was to get a photographer to take a few shots of the well-dressed bankers queueing for their money, and write a caption explaining it.

We did not do this. Such a story on the FT’s front page might have been enough to push the system over the edge. Our readers went unwarned, and the system went without that final prod into panic.

There are many things going on here that are worth pointing out:

  1. If we go back to 2005 or 2006, the financial elite was as clueless as anybody else about the crisis that was round the corner.

  2. However, during (or even just before) the crisis, the financial elite had a pretty good idea of the most vulnerable entities in the system. I remember when I discussed the matter with smart finance people back in 2007 and 2008, we could all agree on which banks (both in India and globally) were at grave risk and which were sound. In retrospect, those judgements were largely correct. At the same time, outside of finance, this understanding was often lacking.

  3. This phenomenon was not peculiar to the global financial crisis of 2008, but was true in earlier crises like the Asian Crisis of 1997.

  4. Self censorship is the main reason why the common knowledge of the financial elite does not percolate to the general public. Many factors play a role here:

    • We all fear retribution from the state which can easily accuse the messenger of sedition or treason.

    • There is the risk of defamation suits from the affected entities which might not have enough money to repay their debt, but are never short of money to pay their lawyers.

    • Our views are often based on inferences rather than hard facts, and we shy away from making sweeping statements in public without objective data.

    • Like John Authers, we might worry that what we write might become a self fulfilling prophecy.

  5. But Authers’ story also points to a very uncomfortable fact, that our self censorship is self serving. We might hesitate to write about what we know, but we do not hesitate to act on that knowledge. Authers writes that he shuffled his money around so that he would not lose much if Citi failed. I recall that every company on whose board I served took preventive action to protect the company’s cash surpluses.

This means that, in a crisis, the general public cannot expect the elite (regulators, media, academics) to warn them or to tell them the truth. Meanwhile, the rich, powerful and well-connected are duly warned, and are able to protect themselves. Is it any wonder that the general public listens to wild rumours rather than to mainstream commentators?

There is one place where the public can learn the truth, and that is the financial markets. In the build up to the crisis, the markets are as complacent as everybody else. But during the crisis, the market is the fountain head of information. If I could make sensible judgements during 2008, it was only because I was tracking many different markets. Of course, one needs to know where to look: sometimes the most valuable information is in the spread between two arcane markets.

The governments and regulators know this very well and work overtime to ensure that the markets become uninformative. After Lehman failed, I had two blog posts on how successful government around the world had been in doing this (Towards a market only for buyers and More on market for buyers only).

Months before Lehman failed, I wrote this:

I believe that this crisis has shown the power and utility of financial markets. Policy makers have had at least a year of lead time to deal with the problems in the real economy. Without mark to market and without liquid ABX markets, the crisis would have become evident only when mortgages actually defaulted. By then it would have been too late to act.

It is difficult to persuade people about this in today’s context, but even today it is true that with all their imperfections and tendency to malfunction during crises, financial markets are the closest thing that we have to the crystal ball that reveals the future. Everything else is backward looking.

After reading Authers’ confession, I would add another clause to the last sentence: “Everything else is self-censored.”

Posted at 17:58 on Sun, 09 Sep 2018     View/Post Comments (0)     permanent link


Mon, 03 Sep 2018

Why does the Indian Government mandate proprietary software?

One of my pet peeves has been about the Indian government forcing citizens to buy or use proprietary software to enable them to perform their statutory obligations. Things have got better in some government departments, but worse in others.

In my opinion, it is a gross abuse of the sovereign powers of the state to compel a person to buy and use Windows in order to be a director of a company. Actually, I seriously considered resigning as Director rather than do this, but then that does not solve the problem as different departments of the government are moving in the same direction of e-filing with uncritical dependence on proprietary software.

No, we need to change incentives in the government to prevent the Indian state from becoming a marketing agent of powerful software companies. I think there are many arms of the government itself that can help bring about this change:

  1. Central Vigilance Commission (CVC): The CVC could declare that going forward, it would regard a government action that forces unwilling citizens to buy software from private companies as an act of corruption (on the ground that it provides a benefit to a private party and is also against the public interest). The reality is that the government outsources software development to large software developers who also act as authorized resellers for a large number of software product companies, and have every incentive to push the sales of these products on to their clients. This is fine when all these costs are evaluated as part of the total cost of the project during the bid evaluation. But when the government official allows the vendor to sell software to ordinary citizens using the coercive power of the state, that should count as an act of corruption. The CVC could allow existing applications to be grandfathered with a sunset clause, but it should not permit any new projects.

  2. Competition Commission: As explained in the previous point, the whole business of government software development involves giant software companies using their market dominance in the enterprise market to gain unfair and unlawful market power in the retail market using the coercive power of the state. The Competition Commission can and should investigate all authorized reseller agreements for such anti-competitive conduct.

  3. National Security Advisory Board: Widespread use of proprietary software in critical government applications can pose a threat to national security, and with the increasing threat of cyber attacks on India from some of its neighbours and other countries, this is also a reason for reconsidering the design of government applications like the MCA Portal. For example, under the so called Government Security Program the Microsoft Windows source code has been shared with Russia and China which are both associated with large scale state sponsored hacking activities. This means that when you and I use Windows, the hackers can see the source code, but you and I cannot. With open source software like Linux, the hackers can read the source code, but so can you and I. It is important that the national security apparatus in India takes these risks seriously and start advising other arms of the government to move away from proprietary software in citizen facing applications.

  4. Law Ministry: If rapid technological change and product obsolescence leads to Adobe going bankrupt and the Adobe Reader being discontinued, the government might find that it cannot read any of the PDF files that constitute the source documents for its entire database. Many people of my generation have old Wordstar files which are almost impossible to read because the Wordstar software is now defunct: truly desperate people do try to buy the old Wordstar diskettes on EBay and then try and find a disk drive that can read the diskettes. For those readers who are too young to remember, Wordstar was the undisputed market leader at its time, just as Adobe is today. The law ministry should recognize that storing critical source documents in a proprietary format is an unacceptable legal risk.

Until one or other of these branches of the government steps in and forces a redesign of citizen facing government applications, we will be doomed to pay money to rich multinationals to use insecure software to interact with our own governments.

Posted at 18:15 on Mon, 03 Sep 2018     View/Post Comments (0)     permanent link


Mon, 20 Aug 2018

Long hiatus ending soon

This blog has been on a hiatus for the last five months due to some disruptions on the personal front. This phase is now getting over and I hope to start blogging again soon, hopefully, early next month.

Posted at 15:40 on Mon, 20 Aug 2018     View/Post Comments (2)     permanent link


Wed, 21 Mar 2018

Corporate pivots and corporate ponzis

Companies that repeatedly pivot from one business to another (more glamorous) business could be indulging in a ponzi scheme designed to hide business failure and lead investors on a wild goose chase for an ever elusive pot of gold. There are some very large companies in India and in the United States about whom one could harbour such a suspicion.

The question is how can one distinguish these corporate ponzis from genuine pivots. After all it makes sense to change your business as situations change. Warren Buffet’s Berkshire Hathawy pivoted from the textiles business to insurance and finance and if its next elephant size deal is like its last one, it could pivot again to a non financial conglomerate. In India, Wipro became a software giant after a pivot from vegetable products.

One indicator of a ponzi is that the pivot typically chases a prevailing stock market fad rather than any particular competence or competitive advantage in the new business (unless one counts cheap capital as a competitive advantage). But even that is not determinative as the case of GE makes clear. As a Financial Times FT View pointed out a couple of months ago “In the dotcom bubble, GE was valued as a tech stock; in the credit bubble, it was valued like a leveraged debt vehicle (which, in large part, it was).” To which one could add that till recently it was trying to position itself as a leader in the industrial Internet of Things. That makes GE a stock market opportunist, but not a ponzi. Even after returning to its old industrial roots in the last few months, GE remains a valuable business.

The corporate ponzis that I worry about are something else altogether. This kind of company is a graveyard of serial failures, even though the future always looks rosy. In the heyday of each of these failed businesses, the market would not have bothered about current losses, because it would have valued the business on multiples of current or future revenues. After the company pivoted away from the business, the market would not bother about the losses (and revenue collapse) in the old business because the market is always “forward looking”. The corporate ponzi’s challenge is to find the next big thing (and make it bigger than the last big thing). When their luck runs out and the corporate ponzi finally fails, everybody wonders why nobody saw through the fraud earlier.

Posted at 18:41 on Wed, 21 Mar 2018     View/Post Comments (1)     permanent link