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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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


Sun, 18 Mar 2018

Do we need banks?

More than a decade ago, in the days before the Global Financial Crisis, I asked a provocative question on this blog: “Had we invented CDOs first, would we have ever found it necessary to invent banks?” (I followed up in the early days of the crisis with a detailed comparison of banks with CDOs).

I am revisiting all this because I just finished reading a fascinating paper by Juliane Begenau and Erik Stafford demonstrating that, banks simply do not have a competitive edge in anything that they do. Specifically, the return on assets of the US banking system over the period 1960-2016 was less than that of a matched maturity portfolio of US Treasury bonds. This is a truly damning finding because banks are supposed to earn a return from two sources: maturity transformation (higher yielding long term assets funded by cheaper short term financing) and credit risk premium (investing in higher return risky debt). What Begenau and Stafford found is that their actual return does not match what you can get from maturity transformation without taking any credit risk at all.

That raises the question as to why banks have survived for so long. Another finding of Begenau and Stafford can be used to provide an answer: maturity transformation (even without any credit risk) with typical banking sector leverage is not viable in a mark-to-market regime. The banking regulators have acquiesced in the idea that the loan book of the banks need not be subject to mark to market. Making illiquid loans and taking credit risk is the price that banks have to pay to become eligible for hold-to-maturity accounting of their loan book. Banks are able to undertake maturity transformation with high levels of leverage without wiping out their equity because the loan book is not marked to market.

Hold-to-maturity accounting allows banks (and only banks and similar institutions) to carry out leveraged maturity transformation. This competitive advantage means that banks are able to make money on maturity transformation. However, they are so bad in their credit activities that they lose money on this side of their business. This offsets some of the returns from maturity transformation, and so they underperform a matched maturity portfolio of risk free bonds.

It is important to keep in mind that credit risk earns a reliable risk premium in the bond markets. Therefore, if banks manage to earn a negative reward for bearing credit risk, it is clear that either their credit risk assessment must be very poor or their intermediation costs must be very high. Interestingly, Begenau and Stafford do find that maturity transformation using risk free bonds has no exposure to systematic risk (CAPM beta), banks have CAPM betas close to one. The credit activity of the banks creates risks and loses money; in short, banks are really bad at this business.

I have always been of the view that banks are an obsolete financial technology. They made sense decades ago when financial markets were not developed enough to perform credit intermediation. That is no longer the case today.

This is particularly relevant in India where we have spent half a century creating an over-banked economy and stifled financial markets in a futile attempt to make banking viable. The crisis of bad loans in the banking system today is a reminder that this strategy has reached a dead end. As I wrote nearly a year ago:

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

After the recent multi-billion dollar fraud at a leading Indian public sector bank, there has been a chorus of calls in India for privatizing state owned banks. We would do better to shut some of them down. Time and money are better spent on developing a bond market unshackled from the imperatives of supporting a weak banking system.

Posted at 16:06 on Sun, 18 Mar 2018     View/Post Comments (2)     permanent link


Mon, 26 Feb 2018

Is there a bank-sovereign feedback loop in India?

Between early October 2016 (shortly before demonetization) and today, the Reserve Bank of India (RBI) has cut its policy rate twice (October 4, 2016 and August 2, 2017) to bring the repo rate down by 50 basis points from 6.5% to 6.0%. But the ten year Government of India bond yield is roughly 100 basis points higher than it was in early October 2016. Apparent monetary easing has been accompanied by a substantial tightening of financial conditions. This looks like a reverse of Greenspan’s Conundrum of 2005 in which the concern was that 150 basis points of rise in the US policy rate was accompanied by a falling trend in the long term yield.

Is it possible that the Indian situation could be a mild form of the bank-sovereign feedback loop?

  1. A deterioration of the health of the public sector banks (non performing assets) causes fiscal stress because the sovereign has to recapitalize the banks.

  2. The enhanced borrowing requirement of government causes a rise in government bond yields.

  3. Rising bond yields cause more stress in the public sector banks because they hold a large amount of long term government bonds (unlike the private and foreign banks who tend to hold shorter term bonds). Rising bond yields may also act as a drag on the economy and worsen the non performing assets of the banks. In either case, the deterioration of the health of the public sector banks takes us back to Step 1 and the cycle can begin all over again.

If this analysis is correct, what can be done to break the bank-sovereign feedback loop? Several possibilities come to mind:

The bank-sovereign feedback loop should not be a big problem for a currency issuing sovereign. This does not require any appeal to MMT, but is simply a reflection of the fact that banking sector liabilities are all nominal liabilities, and a currency issuing sovereign should not have any problem in backstopping these liabilities. If we still see evidence of such a loop, it should reflect some degree of mismatch between monetary policy, fiscal policy, and the bank recapitalization framework. And it should not be hard to fix the problem.

Posted at 16:54 on Mon, 26 Feb 2018     View/Post Comments (0)     permanent link


Tue, 20 Feb 2018

Can radical blockchain transparency decrease banking frauds?

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

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

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

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

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

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

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


Tue, 13 Feb 2018

Are banks too opaque to manage?

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

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

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

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

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


Sun, 04 Feb 2018

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

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

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

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


Sat, 27 Jan 2018

Regulation as Pigouvian stealth taxation

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

Turk argues that:

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

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

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

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

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


Fri, 26 Jan 2018

Financial Crisis and Response History

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

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

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


Fri, 05 Jan 2018

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

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

Saturday’s post on LWN was very cryptic:

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

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

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

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

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

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

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

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

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

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

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


Mon, 01 Jan 2018

Madness on both sides

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

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

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

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


Sun, 31 Dec 2017

Why do banks use Credit Default Swaps (CDS)?

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

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

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

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

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

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

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

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


Sun, 17 Dec 2017

Bitcoin and bitcoin futures

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

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

Krugman explained this with a direct example:

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

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

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

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

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

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

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

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

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

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

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

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


Sat, 09 Dec 2017

SEC Regulatory Overreach

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

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

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

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

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


Thu, 07 Dec 2017

Surveillance by countervailing power

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

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

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

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

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

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

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


Fri, 01 Dec 2017

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

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

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

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


Thu, 30 Nov 2017

Large asset auctions: Russian versus East Asian models

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

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

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

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

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


Mon, 20 Nov 2017

The Indian retail credit boom

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

Two questions arise at this point:

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

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

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

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


Sun, 22 Oct 2017

Bitcoin as a way to short bad things

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

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

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

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

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

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

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

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

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

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


Fri, 20 Oct 2017

Building credit bureaus that have no personal information

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

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

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

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

Suppose there is only one bank

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

Extension to Multiple Banks

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

Allowing the individual to verify all computations

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

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

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

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

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

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

Conclusion

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

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


Mon, 16 Oct 2017

Credit bureaus as fundamentally dangerous businesses

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

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

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

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

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

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

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

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

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

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

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


Fri, 29 Sep 2017

How insider trading laws became the crooks' best friend

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

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

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

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

First, the prosecutors had other priorities.

...

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

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

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

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

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

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

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

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


Sat, 23 Sep 2017

Norway and the tail risk of bonds

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

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

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

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

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

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

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


Sun, 17 Sep 2017

Bonds markets are not different

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

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

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

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

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


Wed, 13 Sep 2017

Should Equifax be shut down?

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

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

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

...

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

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

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


Mon, 04 Sep 2017

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

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

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

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

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

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

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


Tue, 29 Aug 2017

Operational creditors yet again

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

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

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

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

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


Mon, 07 Aug 2017

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

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

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

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

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

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

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