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, 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