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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Mon, 31 Dec 2018

Yet more on Equifax data breach

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

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

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

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

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

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

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

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


Sun, 30 Dec 2018

Is index methodology a fundamental attribute of a mutual fund?

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

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

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

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

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

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


Mon, 17 Dec 2018

New Zealand shows the way again?

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

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

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

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

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

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

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

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


Thu, 06 Dec 2018

Does better mathematics win in the markets?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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