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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Fri, 18 Jun 2010

Is UK imitating Ireland on Financial Regulation?

There is too little detail in the new UK plan (also here) to abolish the Financial Services Authority (FSA) by folding it into a subsidiary of the Bank of England. But the more I think about it, the more it looks like the pre crisis Ireland model.

If imitation is the sincerest form of flattery, Ireland must be feeling quite flattered right now. It is a different matter that the Irish Central Bank itself in its post mortem of the crisis now thinks that their model had nothing to commend it:

Though few would now defend the institutional structure invented for the organisation in 2003, it would be hard to show that its complexity materially contributed to the major failures that occurred. (page 42)

The grass is always greener on the other side!

Posted at 21:09 on Fri, 18 Jun 2010     View/Post Comments (0)     permanent link


Wed, 16 Jun 2010

Why market surveillance can no longer be left to the exchanges

I wrote a column in the Financial Express today arguing that the financial market regulators need to get directly involved in real time market surveillance.

Traditionally, securities regulators globally have regarded the exchanges as the front line regulators with primary responsibility for market surveillance. As a result, regulators have traditionally not invested in the computing resources and the human capital required to perform real time surveillance themselves. A number of developments are making this model unviable in the developed markets and the same factors are at work, a little more slowly, in India as well.

I think it is time for Indian regulators like Sebi, FMC and RBI to develop in-house real time market surveillance capabilities rather than rely on the capabilities that may currently exist at the exchanges or exchange-like entities that they supervise (NSE, BSE, MCX, NCDEX, NDS).

I believe there are two key factors that make this regulatory shift necessary. First is the dramatic change in the nature of exchanges themselves. In the past, exchanges were regarded as ‘utilities’ providing key financial infrastructure and regulatory services. In recent years, they have evolved into businesses just like any other financial services business. Many observers in India (including some of the exchanges themselves) have been concerned about this transformation, but this is a global phenomenon and it is delusional to deny this reality. Concomitantly, there has been a blurring of the line between exchanges and brokers. Globally, alternative trading systems and dark pools have gained market share in recent years, and the operators of these systems are half way between traditional exchanges and large broker dealers, in terms of their business models and regulatory incentives.

In India, too, we have seen the blurring of the line between exchanges and non-exchanges. Examples include the subsidiaries of regional stock exchanges that trade on national exchanges; the exchanges in the commodity space whose promoters had or have large trading arms; and RBI regulated entities that perform many functions of an exchange but are not legally classified as exchanges.

The second and even more important factor is the rise of algorithmic and high frequency trading that links different exchanges together at much shorter time scales than in the past. Each exchange looking only at the trading in its own system has only a very limited view of what is happening in the market as a whole. It becomes very much like the story of the six blind men and the elephant.

The best example of this is the flash crash in the US on May 6, 2010. The US SEC, which like other regulators had never dirtied its hands with real time surveillance, found itself struggling to figure out what happened in those few turbulent minutes on that day. In an interim report, the SEC stated: “To conduct this analysis, we are undertaking a detailed market reconstruction, so that cross-market patterns can be detected and the behaviour of stocks or traders can be analysed in detail. Reconstructing the market on May 6 from dozens of different sources and calibrating the time stamps from each source to ensure consistency across all the data is consuming a significant amount of SEC staff resources. The data are voluminous and include hundreds of millions of records comprising an estimated five to ten terabytes of information.”

This is what happens when a regulator leaves it to others to do its job, but is forced one day to do the job itself. Is it not scandalous that a systemically important institution like an exchange or a depository is not required to synchronise its clocks to a standard time (say GPS time) with an error of not more than a few microseconds at worst? Exchanges are willing to spend a fortune to bring down the latency of their trading engine to a millisecond or so to attract trading volume, but are unwilling to spend a modest amount to synchronise their clocks because nobody asked them to.

There is another important hidden message in this. Modern finance is increasingly high frequency finance and those who do not dirty their hands with it become increasingly out of touch with the reality of financial markets. Doctoral students in finance today, for example, have to learn the econometrics of high frequency data and grapple first hand with the challenges of handling this data.

Unless regulators collect this high frequency data and encourage their staff to explore it, they risk becoming progressively disconnected with the reality that they are supposed to regulate. Interestingly, the US derivatives regulator, CFTC, is moving rapidly to develop this capability. They already collect all trade data on a T+1 basis and run their own surveillance software on that data. Over the next year, they hope to enhance this to receive the entire order book data from the exchanges that they regulate. All regulators worldwide need to move in that direction.

It is true that this will be difficult, expensive and time-consuming for Indian regulators. That is all the more reason to start immediately.

Posted at 12:19 on Wed, 16 Jun 2010     View/Post Comments (3)     permanent link


Fri, 11 Jun 2010

Why do we not have high quality investigative reports in India?

As the global financial crisis rolls on, I have read a bunch of outstanding investigative reports from around the world:

Surprisingly, apart from Lehman, there are too few high quality official investigative reports about other US financial firms that have suffered badly in the crisis. We do not really know what happened at Merrill Lynch or Citi. We know a lot more about the problems at UBS for example thanks to the shareholders report produced at the insistence of the Swiss regulators. US regulators have been acting as if everything related to the crisis is a state secret. On AIG, we know a little more due to the efforts of the Congressional Oversight Panel, but even this picture is incomplete.

The US does however have an adversarial system of congressional testimony and all this testimony is available online. Apart from the Financial Crisis Inquiry Commission there are many congressional committees that have held hearings and released valuable information during the process. The quality of the official reports that emerge at the end is not that important. Years ago while studying what happened at Enron, I had found the same thing – the testimony and trascripts of the hearings are far more useful than the reports themselves.

While the investigative reports of the Nordic countries have been exemplary, and those of the US have been very good, India has simply been unable to produce data rich investigative reports of a quality useful to a researcher. A Joint Parliamentary Committee (JPC) was set up to investigate the securities scam of 1991, but the factual details in this report were not sufficient from a researcher’s point of view. The Indian parliamentary committees tend to hold closed door meetings and treat all testimony as confidential. The regulators have also not filled the void. In early days of the scam, the Reserve Bank of India published the Janakiraman report which was rich in factual detail, but this report had a narrow remit. I do not think that we still have a comprehensive authentic data source on what happened in this scam two decades ago.

The situation is not any better in the Ketan Parikh scam that took place a decade ago in technology stocks. Again there was a JPC on this scam, but again the report was not data rich. Turning to more recent times, the Satyam fraud took place a year and a half ago and we still have no authentic information at all on what happened.

I do not believe that developing countries are incapable of producing good investigative reports. I remember being impressed with the Nukul Commission Report in Thailand in the aftermath of the Asian Crisis of 1997, but the report is not available online and I have not been able to refresh my memory. Outside of finance, the Truth and Reconciliation Commission in South Africa produced a series of reports with an enormous amount of factual detail and careful analysis.

India’s failure to produce outstanding investigative reports into financial disasters is something that needs to be remedied. As Andrew Lo has been arguing for some time now, such detailed post mortems are very important. Lo recommends that even the US should go much further than it is doing currently:

The most pressing regulatory change with respect to the financial system is to provide the public with information regarding those institutions that have “blown up”, i.e., failed in one sense or another. This could be accomplished by establishing an independent investigatory agency or department patterned after the National Transportation Safety Board, e.g., a “Capital Markets Safety Board”, in which a dedicated and experienced team of forensic accountants, lawyers, and financial engineers sift through the wreckage of every failed financial institution and produces a publicly available report documenting the details of each failure and providing recommendations for avoiding such fates in the future.

Posted at 16:19 on Fri, 11 Jun 2010     View/Post Comments (3)     permanent link


Thu, 03 Jun 2010

How do regulators cope with terabytes of data?

Traditionally, securities regulators have coped with the deluge of high frequency data by not asking for the data in the first place. The exchanges are supposed to be the front line regulators and leaving the dirty work to them allows the US SEC and its fellow regulators around the world to avoid drowning under terabytes of data.

But the flash crash seems to be changing that. The US SEC had to figure out what happened in those few minutes on May 6, 2010. When it attempted to reconstruct the market using data from different exchanges, it ended up with nearly 10 terabytes of data. The SEC says in its joint report with the CFTC on the preliminary findings about the flash crash:

To conduct this analysis, we are undertaking a detailed market reconstruction, so that cross-market patterns can be detected and the behavior of stocks or traders can be analyzed in detail. Reconstructing the market on May 6 from dozens of different sources and calibrating the time stamps from each source to ensure consistency across all the data is consuming a significant amount of SEC staff resources. The data are voluminous, and include hundreds of millions of records comprising an estimated five to ten terabytes of information. (page 72)

It turns out that the CFTC which regulates the futures exchanges is well ahead in the learning curve as far as the terabytes of data are concerned:

The CFTC also collects trade data on a daily, transaction date + 1 (“T+1”), basis from all U.S. futures exchanges through “Trade Capture Reports.” Trade Capture Reports contain trade and related order information for every matched trade facilitated by an exchange, whether executed via open outcry or electronically, or non-competitively (e.g., block trades, exchange for physical, etc.). Among the data included in the Trade Capture Report are trade date, product, contract month, trade execution time, price, quantity, trade type (e.g., open outcry outright future, electronic outright option, give-up, spread, block, etc.), trader ID, order entry operator ID, clearing member, opposite broker and opposite clearing member, order entry date, order entry time, order number, customer type indicator, trading account numbers, and numerous other data points. Additional information is also required for options on futures, including put/call indicators and strike price, as well as for give-ups, spreads, and other special trade types.

All transactional data is received overnight, loaded in the CFTC’s databases, and processed by specialized software applications that detect patterns of potentially abusive trades or otherwise raise concern. Alerts are available to staff the following morning for more detailed and individualized analysis using additional tools and resources for data mining, research, and investigation.

Time and sales quotes for pit and electronic transactions are also received from the exchanges daily. CFTC staff is able to access the market quotes to validate alerts as well as reconstruct markets for the time periods in question. Currently, staff is working with exchanges to receive all order book information in addition to the executed order information already provided in the Trade Capture Report. This project is expected to be completed within the next year; at present such data remains available to staff through “special calls” (described below) requesting exchange data. (page B-15 in the Appendix)

However, the flash crash did not put the CFTC’s data handling abilities to the test because most of the action was in the cash equity market and the only action in the derivatives exchanges was in a handful of index futures and options contracts.

Finally, I am puzzled by the statement of the SEC quoted above that “calibrating the time stamps from each source to ensure consistency across all the data is consuming a significant amount of SEC staff resources.” Regulators should perhaps require that exchanges synchronize their computer clocks with GPS time to achieve accuracy of a few microseconds. With the exchange latency times close to a millisecond these days, normal NTP (internet) accuracy of 10 milliseconds or so is grossly inadequate. I would not be surprised if some exchanges do not even have formal procedures to ensure accuracy of their system clocks.

All of which goes to show that traditional securities regulator strategies of not dirtying their hands with high frequency data is a big mistake. This should be a wake call for regulators around the world.

Posted at 18:00 on Thu, 03 Jun 2010     View/Post Comments (1)     permanent link


Wed, 02 Jun 2010

FASB says IFRS is for less developed financial reporting systems

The FASB’s criticism is buried inside a couple of hundreds of pages of dense accounting proposals, but it is unusually direct and clear:

What may be considered an improvement in jurisdictions with less developed financial reporting systems applying International Financial Reporting Standards (IFRS) may not be considered an improvement in the United States.

This is part of its description of why the FASB is putting aside its convergence project with IASB and is pushing ahead on its own on a new accounting standard for financial instruments. The IASB’s description of the divergence is more muted:

However, the ... efforts [of the FASB and IASB] to achieve a common and improved financial instruments standard have been complicated by the establishment of different project timetables to respond to their respective stakeholder groups in the light of the financial crisis.

The stumbling block in improving the accounting for financial instruments is not technical but political. The key ideas for reform were put forth in a report ten years ago by a Joint Working Group consisting of representatives from the FASB and IASB as well as standard setters from twelve other countries (Joint Working Group of Standard Setters, “Recommendations on Accounting for Financial Instruments and Similar Items”, FASB, Financial Accounting Series, No. 215-A December 22, 2000).

From there we have progressed to the pot calling the kettle black. The global financial crisis has not been good for the reputation of either the FASB or the IASB. Both have appeared vulnerable to pressure from the politicians and lobbying by the big banks.

Posted at 20:10 on Wed, 02 Jun 2010     View/Post Comments (0)     permanent link


Tue, 01 Jun 2010

When is a foreign exchange swap not really a foreign exchange swap?

The answer is when it is a swap between the US Federal Reserve and a foreign central bank under the famed swap lines. Last month, the New York Fed described the operational mechanics of these swap lines in considerable detail in its publication Current Issues in Economics and Finance:

The swaps involved two transactions. At initiation, when a foreign central bank drew on its swap line, it sold a specified quantity of its currency to the Fed in exchange for dollars at the prevailing market exchange rate. At the same time, the Fed and the foreign central bank entered into an agreement that obligated the foreign central bank to buy back its currency at a future date at the same exchange rate. ...

The foreign central bank lent the borrowed dollars to institutions in its jurisdiction ... And the foreign central bank remained obligated to return the dollars to the Fed and bore the credit risk for the loans it made.

At the conclusion of the swap, the foreign central bank paid the Fed an amount of interest on the dollars borrowed that was equal to the amount the central bank earned on its dollar lending operations. In contrast, the Fed did not pay interest on the foreign currency it acquired in the swap transaction, but committed to holding the currency at the foreign central bank instead of lending it or investing it. This arrangement avoided the reserve-management difficulties that might arise at foreign central banks if the Fed were to invest its foreign currency holdings in the market.

What this means is that the foreign currency (say, the euro) that the Fed purportedly receives under the swap is completely fictitious because (a) the Fed earns no interest on the euros and (b) the euros are not available to the Fed if it wishes to lend the euros to a US bank or for any other purpose. In fact, in April 2009, the Fed entered into a different swap agreement with the ECB and other central banks to obtain foreign currency liquidity. This would not have been needed at all if the original swap had been a genuine swap.

The so called swap is simply a loan of dollars to the foreign central bank. Why does the Fed want to call it a swap instead of a loan? I think the reason for this use (or rather abuse) of terminology is that a swap with a foreign central bank sounds politically more palatable than a loan to a foreign central bank. All the more so when the swap is for an unlimited amount!

This is another reminder that deceptive disclosure practices are not limited to companies like Enron or to sovereigns like Greece – they are all pervasive.

Posted at 21:10 on Tue, 01 Jun 2010     View/Post Comments (4)     permanent link