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

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Fri, 30 Dec 2005

Short selling in India

The Securities and Exchange Board of India has put out a discussion paper recommending that all market participants should be permitted to short sell shares and that a transparent system of securities lending should be introduced. These are recommendation that I enthusiastically agree with.

However, I see no reason why short selling should be restricted to stocks on which derivative contracts are permitted. Short selling should be seen as a defence against market manipulation and therefore a measure to improve market integrity. It is therefore more necessary in stocks that are prone to market manipulation. On the other hand, derivative contracts are typcially not permitted on precisely the stocks on stocks that are prone to market manipulation. The proposal is therefore best seen as a convenient resting point on the path to allowing short selling in all stocks.

The other critical issue is of regulatory risk that retail short sellers have faced in the past. Though short selling by individuals has been permissible most of the time, SEBI has on certain occasions banned short selling peremptorily in response to market fluctuations. An assurance that this would not happen again would be welcome. Any future restriction on short selling should only be after due process of consultation and with a reasonable transition arrangement

Posted at 14:16 on Fri, 30 Dec 2005     View/Post Comments (6)     permanent link

Tue, 27 Dec 2005

FSA Resilience Benchmarking

The Financial Services Authority of the United Kingdom has put out a discussion paper on its Resilience Benchmarking Project. This study seeks “to assess how the UK financial services sector would be able to cope in the event of major operational disruption (e.g. terrorist attacks, natural disasters) and how quickly it could recover afterwards”. It contains valuable guidance for those involved in preparing business continuity and disaster recovery plans in the financial sector anywhere in the world. For example:

“The data suggest that reasonable target ranges for the recovery of wholesale payments, trade clearing and settlement would be 60-80% of normal values and volumes within four hours, rising to 80-100% by the next working day. The overall aim within these targets would be to complete material pending transactions on the scheduled settlement date”. (emphasis in original)

My own sense is that these would be demanding targets for firms in most other countries. However, I also believe that these are reasonable goals to work towards even in emerging markets like India.

A broader question in this context is the relative importance of regulation and competition in ensuring the resilience of financial systems. The example of the London Stock Exchange during the Second World War is illuminating. Ranald Mischie (The London Stock Exchange; A History, Oxford University Press, 1999) tells us that the LSE closed on September 1, 1939 when the war broke out. But an outside market developed immediately and within a week, the exchange was forced to reopen. After that, during the rest of the war, the exchange was closed for only one day (on September 14, 1940) after physical damage to the stock exchange building itself in an air raid.

It is fascinating to read how the exchange coped with “the ever-present threat of fire due to bombing, which could have destroyed the Stock Exchange building completely”.

“As the enemy are now dropping incendiary bombs in the City it is more necessary that a careful watch must be kept on the roof and top floors of the Building, otherwise fires could start and gain hold before they were discovered. The only time when any discretion can be given is when aircraft are immediately overhead and shrapnel is falling, then cover should be taken in the Fireman's shelter which had been specially constructed for this purpose”. (London Stock Exchange: Trustees and Managers, September 18, 1940 quoted by Machie, p 290).

It is also interesting to observe that during the war, the stock exchange which normally believes in the indispensability of the trading floor and discourages trading methods that bypass the floor actively encouraged members to use the telephone to trade. Competition does indeed work wonders.

In this light, I do wonder whether regulators that are overly protective of their regulatees during periods of market disruption are inadvertently making markets less resilient. For example, after September 11, 2001, Instinet was in fact in a position to provide a trading facility for US stocks in London. However, regulators did not permit this. This allowed the New York Stock Exchange to be shut down for a few days. I still find it odd that the US government securities market which suffered the heaviest human casualties on September 11, 2001 reopened sooner than the stock exchange where the human casualties were proportionately far lower. Once the decisions regarding disaster recovery are moved from the markets to the regulators, the decisions clearly become more political and the end result is a market that is less resilient to operational disruption.

Perhaps therefore the best thing that the regulators could do is to leave things to the market with a clear signal that when disaster strikes, no market participant should look to the regulator for protection.

Posted at 08:08 on Tue, 27 Dec 2005     View/Post Comments (0)     permanent link

Thu, 22 Dec 2005

Mizuho photographs

Underthecounter has an interesting set of photographs from Triple Witching Friday about the chaos at Mizuho securities after the trading error that cost the firm $335 million. If the photographs are genuine (one comment says that they are doctored photographs of the Taiwan parliament), some of our preconceptioms of Japanese cultural nuances need to be revised. Perhaps trading rooms around the world are the same regardless of the host culture. Financial markets are indeed a great leveller.

The trading error also led to the resignation of the head of Tokyo Stock Exchange. Photographs of the scene there would be interesting!

Posted at 11:10 on Thu, 22 Dec 2005     View/Post Comments (2)     permanent link

Tue, 20 Dec 2005

IPO Frauds

IPO procedures were in the limelight again last week, this time in India (see my post last month about the United Kingdom).

In India, small investors (applying for shares worth less than Rs 50,000 in a share offering) are given preference in allotment when the issue is oversubscribed. In the case of the Yes Bank IPO, the portion reserved for these investors was oversubscribed 9.96 times while the portion available for larger non institutional investors was oversubscribed by 43.68 times. This meant that the proportionate allotment to an investor applying in the small investor category was four times more than the proportionate allotment to larger non institutional investors.

This of course presents an arbitrage opportunity to those who are willing to break the rules. The Securities and Exchange Board of India found that one investor had put in more than 6,000 different applications in different names in the small investor category. This allowed her to receive allotments of nearly a million shares worth about Rs 43 million at the issue price. On listing, the shares of Yes Bank traded at a price approximately 36% higher than the issue price. The profits earned by flipping the shares in the market immediately after listing were obviously quite large.

While an investor applying in 6,000 different names is rather exceptional, multiple applications on a less ambitious scale are quite common. The same IPO witnessed another investor putting in over 1,300 applications. Those who put in only a hundred or so applications were probably not detected at all.

Clearly, the system of cross subsidizing small investors in the allotment process is the root cause of this abuse. A month ago, when an official was murdered while trying to prevent the adulteration of diesel with subsidized kerosene, many commentators in India were quick to point out that the irrational cross subsidy in the pricing of petroleum products was the root of the problem. There seems to be less willingness to recognize that a similar cross subsidization is the root of the problem in the IPO abuse as well.

Today the technology exists to ensure that IPO allotments are made to all investors at the same market clearing price in a completely non discriminatory manner. There is no need to reserve shares for some categories of investors. Nor is there any need to give issuers or their investment banks any discretion in the process of allotments. There is no reason at all why the primary market should be any less efficient than the secondary market. The path that Google took in its IPO was clearly the right one. There is no need to permit any other way.

Posted at 15:47 on Tue, 20 Dec 2005     View/Post Comments (4)     permanent link

Tue, 06 Dec 2005

Does the BIS care about insider trading?

Governments are today extremely careful to ensure non discriminatory disclosure of sensitive data at the same time to all. Supranational bodies also normally observe this discipline. Even where they hold press conferences ahead of public disclosure, they are subject to clear embargoes that are complied with. In this context, the early disclosure of BIS data on petrodollars is quite disturbing. Steve Johnson reported the data in the Financial Times a day before it became public.

The following chronology would put things in perspective

This chronology establishes that the issue of what was happening to petrodollars was important to market participants, analysts and academics. This was an issue being debated quite earnestly. It is also clear that the BIS report contains data pieced together from a number of sources that adds materially to our understanding of the situation. By any standards, it constitutes "material price sensitive information" that should not have been disclosed in a selective manner. It is even more lamentable that the central bankers’ central banker should be guilty of such a lapse.

Posted at 14:38 on Tue, 06 Dec 2005     View/Post Comments (3)     permanent link

Fri, 02 Dec 2005

Suing or Regulating Rating Agencies

Dr. Ajay Shah has provided some very interesting comments on my earlier post about Private Sector Watchdogs: Reputational Capital and Financial Capital.

While agreeing with my post in so far as it relates to auditors, he has a different point of view with which I agree only partly. Ajay says

In contrast, the work of a credit rating agency is necessarily gray. The Agency merely gives you it's opinion that the Pr(default) is (say) 10%. After that, it cannot be held accountable whether default takes place or not, because these outcomes do not serve as a performance evaluation upon the probability statement.

Even auditors do not guarantee that they will pick up any fraud. They can sued only for negligence in their attempt to fix fraud. Some aspects of credit rating are actually close to audit. For example, in many ABS transactions, the market is relying on the rating agency for a lot of things. Only the rating agency sees the actual pool of car loans underlying an ABS. If the statements about the pool are wrong, the rating agency has some responsibility. Similarly in ABS/CDO deals, the investor probably relies on the rating agency even for the legal validity of the SPV structures and possibly even the CDS transactions underlying the transaction. They should be amenable to a negligence suit.

Ajay goes to say:

I feel that a credit rating should have the status of an `analyst report' on the stock market. It's the view of an individual. You may want to chat about it in a cocktail party, but for the rest, it should have no special status.

For individual companies, I agree. But for securitization and other complex structures, I am not so sure.

I fully agree with what Ajay has to say about regulatory use of ratings:

Given the lack of accountability of credit ratings or (worse) corporate governance ratings, I am a big skeptic on their role in public policy. When credit ratings go into pension fund regulation or (worse) Basle II, I think we are merely setting up an expensive diversion of resources with no clear accountability.

I agree. Today, there is the ability to have a completely open and objective rating based on the Merton model for large issuers. It should be possible for SEC or SEBI to say that if the distance to default (computed by an open source software) is less x standard deviations, it is investment grade and otherwise not. The only difficulty is that there is no Merton model for sovereigns. But then sovereign ratings by S&P and Moodys are also of dubious value as can be seen from the sovereign default data complied by the rating agencies themselves. In any case, the single best predictor of sovereign rating is per capita income and so these ratings are not really capturing default probability at all. I think the regulators should work on the equivalent of the Altman Z score for sovereigns. Since the performance of the rating agencies is not very high, achieving a comparable level of accuracy with a scoring model should be feasible. Once this is done, the rating agencies can be completely eliminated from all regulatory frameworks.

Posted at 10:41 on Fri, 02 Dec 2005     View/Post Comments (1)     permanent link

Thu, 01 Dec 2005

Creditor Committees in US Bankruptcy

A recent SEC cease-and-desist order brings out some unpleasant facts about official bankruptcy committees and informal bondholders committees in the US. The order is against Mr. Van D. Greenfield and his securities brokerage firm, Blue River LLC. The facts as stated by the SEC are as follows:

18. WorldCom filed for bankruptcy protection on July 21, 2002 (the “Petition Date”). On the Petition Date, Blue River owned only $6 million in face value of WorldCom unsecured 7.5% notes due 2011 (the “Notes”) and $500,000 in face amount of WorldCom 6.25% Notes due 2003.

20. On July 26, 2002, Greenfield directed Reybold ... to execute, “as of” July 19, 2002, a short sale of $400 million in face value of the Notes in one Blue River proprietary account and a purchase of $400 million in face value of the Notes in a another Blue River proprietary account. ...

21. Also on July 26, Greenfield sent a letter to the U.S. Trustee for the Second Circuit requesting that Blue River be appointed to WorldCom’s official unsecured creditors’ committee. On a questionnaire attached to his letter, Greenfield represented that Blue River held a $400 million unsecured claim against WorldCom based upon the Notes. The letter did not disclose that Blue River had no net economic interest in the notes because it also held a $400 million short position in the Notes, that the transaction in the Notes had not yet settled, or that the purchase had occurred after the Petition Date but was backdated to a date prior to the Petition Date. A $400 million unsecured claim would have put Blue River among the top 20 unsecured creditors of WorldCom as disclosed in WorldCom’s schedule of the 50 largest unsecured claims against it that was filed on the Petition Date.

22. On July 29, 2002, the U.S. Trustee for the Second Circuit appointed Blue River to WorldCom’s official unsecured creditors’ committee and Greenfield became co-chair of the committee. On or about July 30, 2002, Greenfield directed Reybold to cancel the $400 million short sale and associated purchase of the Notes, leaving Blue River only with its original $6.5 million position in WorldCom debt. The $6.5 million face value claim was much smaller than the smallest unsecured claim listed by WorldCom in the schedule of the 50 largest unsecured claims against it, which exceeded $100 million.

The order goes on to raise issues about insider trading or as the SEC puts it “potential misuse of material, nonpublic information in light of the conflicts of interest arising from Greenfield’s serving as Blue River’s representative on the committees at the same time that he was also Blue River’s compliance officer, principal owner, and general securities principal.”

The more troubling question is the total lack of diligence in the appointment of creditor committees. Any bankruptcy process leads to a detailed listing of all creditors and their claims. That a co-chair of an official creditors’ committee can be appointed so casually on the basis of an unsubstantiated letter indicates either that there are no processes governing such appointments or that such processes broke down completely in the WorldCom case. Since WorldCom was the largest ever corporate bankruptcy in the US, one would have expected greater care in the appointment of official committees in this case.

The incident also highlights the need to reexamine the whole idea of providing confidential information to such committees. In the old days, when everything was on paper, the idea of making thousands of copies would have been infeasible. In this day of internet and email, it should be possible to provide information in a non discriminatory manner to all. The committees would still play a role in negotiating and designing a restructuring but they need not have privileged access to information other than any documents that the committee itself drafts. It is possible to specify that the moment the company submits a written proposal to the committee or the other way around, these documents would be publicly disclosed. The SEC states in relation to another creditor’s committee that “Greenfield on occasion had access to the terms of proposed offers by third parties to purchase Globalstar, L.P.’s assets before the terms of those offers were disclosed publicly.” There was no reason no justification at all for this to happen.

Posted at 14:29 on Thu, 01 Dec 2005     View/Post Comments (0)     permanent link

Wed, 30 Nov 2005

Validating my RSS feeds causes old posts to reappear

Today some of my old posts reappeared as new posts in some RSS readers. This is because I have been validating my RSS feeds. While my blog has been valid XHTML for quite some time, I found yesterday that the RSS feed was not valid XML and therefore not valid RSS 2.0. I corrected the errors and have now made the feed a valid RSS feed. Because of these corrections the RSS aggregators regard the posts as different though I took care to ensure that the time stamp of the original post remains unchanged

Posted at 18:44 on Wed, 30 Nov 2005     View/Post Comments (0)     permanent link

Fri, 25 Nov 2005

Private Sector Watchdogs: Reputational Capital and Financial Capital

In my earlier posting on private sector watchdogs, I argued that these watchdogs can be sued for negligence while government regulators cannot. Commenting on my post, Dr. Ajay Shah asked whether there are many private sector watchdogs who can pay serious money in the event of a lawsuit.

My initial response was that audit firms and investment banks have often paid large amounts of money to settle lawsuits against them. But this exchange set me thinking about the capitalization of private sector watch dogs. Information about the capital and financial position of audit firms is rather scanty. But some information is available from the July 2003 report of the US General Accounting Office ( “Public Accounting Firms: Mandated Study on Consolidation and Competition”) and the July 2004 report of the UK Office of Fair Trading (“An assessment of the implications for competition of a cap on auditors’ liability”).

The US data indicates that audit fees are about 0.15% of the revenues of the firms being audited while the UK data suggests that the audit firms have capital of about 4-5 times their annual audit fee income. Combining the two suggests that capital is less than 0.75% of the revenues of the companies being audited. To my mind, this is a very low amount of capital in relation to the potential liability. The low capital might be an important reason why the audit firms have lobbied hard for a cap on auditor liability.

The low capital might also explain the extremely high degree of concentration in the audit business with the Big Four accounting for practically the entire audit business of large companies. When audit firms rely on reputational capital rather than monetary capital, this becomes a very strong barrier to entry. A different approach to auditing would involve audit firms with large amounts of financial capital. Regulatory changes would be needed to allow audit to be done by public companies rather than private firms. Regulatory changes would also be required to allow audit firms to solicit business and advertise aggressively. This would dramatically ease entry into the audit business and make it highly competitive. For example, one could imagine a Warren Buffet starting a new audit company with say $10 billion of capital and gaining business by aggressively advertising more stringent auditing standards than the existing audit firms. Many institutional investors may then put pressure on companies to use the new audit firm even if it is significantly more expensive.

There is no reason why the same strategy of relying on financial rather than reputational capital cannot be applied to credit rating agencies and other private sector watchdogs.

Posted at 18:30 on Fri, 25 Nov 2005     View/Post Comments (1)     permanent link

Thu, 24 Nov 2005

FSA’s Concerns about Competitive IPOs

The Financial Services Authority of the United Kingdom has expressed its concerns about competitive Initial Public Offerings. It was in fact so worried about them that it highlighted them in a supplement to its quarterly newsletter List!. The FSA wrote that “we felt we needed to tell the market about [these issues] immediately, rather than waiting until our next full edition”.

The FSA expressed its concern about the new form of conducting Initial Public Offerings as follows.

“In a standard IPO, the lead manager and other brokers involved in the IPO are appointed at a very early stage of the process, forming a syndicate of brokers. Under competitive IPOs, the syndicate members, their roles and remuneration are not defined until late on in the process. This maintains competitive pressure on the potential syndicate members as not all the firms involved in the competitive IPO process will be appointed to the syndicate after the initial ‘beauty parade’. In a standard IPO, the lead manager and other brokers involved in the IPO are appointed at a very early stage of the process, forming a syndicate of brokers. Under competitive IPOs, the syndicate members, their roles and remuneration are not defined until late on in the process. This maintains competitive pressure on the potential syndicate members as not all the firms involved in the competitive IPO process will be appointed to the syndicate after the initial ‘beauty parade’.. This may create ‘pressure points’ and new conflicts of interest — particularly around the preparation of pre-deal research and pre-marketing activities. We understand that one of the reasons issuers favour competitive IPOs is that it gives them greater control over the IPO process and greater leverage over the firms involved.

In a competitive IPO the issuer may be able to exert pressure on the competing firms, directly or indirectly, to produce research that is favourable or which justifies a higher valuation range. This is because firms could be providing their draft research to the issuer in circumstances where the firm is still trying to win a role in the syndicate. In a competitive market, firms may find it difficult to resist such pressure. Even where individual firms have some reservations about the process, they may feel compelled to participate so they are not excluded from transactions.”

This concern of the FSA appears quite strange to me. It suggests that regulators have not learnt the right lessons from the IPO scandals that took place during the dot com boom in the United States. Those scandals showed that the investment banks were not trying to get the best possible price for the shares in the IPO. Competition between investment banks was of the non price variety. Worse, in some cases, it took the form of allotting hot stocks of other underpriced IPOs to the CEO and other key decision makers in an attempt to win the IPO mandate. An IPO process that increases competition on the basis of price is a move in the right direction.

Regulators however continue to act as if anything unfamiliar is worse than the status quo even when it is potentially better. The US SEC did the same when Google decided to auction shares instead of doing a normal IPO. The risk factors that the SEC forced Google to incorporate in its offer document showed that the SEC too had not learnt any lessons from the IPO scandals that took place under its own watch.

Posted at 12:49 on Thu, 24 Nov 2005     View/Post Comments (0)     permanent link

Fri, 04 Nov 2005

Negligence, Misfeasance and Private Sector Watchdogs

The collapse earlier this week of the misfeasance suit by the liquidators of BCCI against the Bank of England highlights the importance of private sector watchdogs. The key difference is that many private sector watchdogs can be sued for negligence, but regulators can usually be sued only for misfeasance.

In the case of Bank of Credit and Commerce International (BCCI), most observers believe that the Bank of England was negligent in the discharge of its regulatory duties. But the sovereign cannot be sued for mere negligence. The liquidators of BCCI therefore had to invoke the charge of misfeasance. Misfeasance consists essentially of an intentional misuse of public power. It required the liquidator to prove not merely that the actions of the Bank of England were improper but that they were malicious or dishonest (not necessarily in a financial sense). In most cases of regulatory failure, malice or dishonesty is very unlikely to exist. It is difficult to imagine why the officials of the Bank of England would act with malice against the depositors of BCCI. It is much easier to see why they might be negligent.

Another recent case of a failure of a misfeasance suit again in the United Kingdom was the suit by the shareholders of RailTrack against its renationalization. Here there was much greater plausibility to the claim that the sovereign acted with something approaching malice. But the claim could not be proved in court and the judge dismissed the claim completely.

If misfeasance is either unlikely or difficult to prove, then the victims of regulatory negligence are left with no recourse at all. This makes private sector watchdogs attractive. When they fail, it is possible to sue them for negligence and to recover monetary damages. It is noteworthy that in the Worldcom and other scandals in the United States, the major part of the financial recovery by investors has come from private sector gatekeepers and watchdogs.

Posted at 14:33 on Fri, 04 Nov 2005     View/Post Comments (2)     permanent link

Mon, 24 Oct 2005

Regulators Shooting Their Mouth Off

Last week the Chairman of the US Securities and Exchange Commission, Mr. Christopher Cox made a series of comments quite unbecoming of a regulator. On October 16, 2005, Mr. Cox made the following remarks before the US - China Joint Economic Committee at Hebei in China (

“Let me illustrate this point by briefly considering the upcoming IPO for China Construction Bank, which has been very much in the news here. This is simultaneously an example of what’s going right, and what more remains to be done.

The roadshow that kicked off in Hong Kong a week and a half ago was a success. And there’s a strong likelihood that CCB will be heavily oversubscribed. For that, China deserves congratulations.

We’d be kidding ourselves, however, if we didn’t recognize that CCB could have done even better if it had been listed in New York rather than Hong Kong.

We’d also be foolish not to notice that even with the success of the CCB’s roadshow, there’s now speculation in the press about the health of its balance sheets; how many of CCB’s existing loans will become non-performing; and how much management has really changed.

Perhaps, the exacting process of listing on a U.S. exchange would have helped CCB avoid these concerns, which go directly to the question of investor confidence. Of course that process would be expensive and time consuming. But no one should pretend that the avoidance of strong securities laws and tough enforcement, which is admittedly cheaper on the front end, isn’t more expensive in the long run.”

Two days later, in remarks before the Securities Industries Association/Tsinghua University Conference on October 18, 2005 in Beijing, Mr. Cox was more circumspect in raising the same issue (

“But it would appear that many other Chinese companies are seeking to avoid higher regulatory standards by not listing in the U.S.

This year, there has been a significant drop in the amount of money Chinese companies have raised in the United States as compared to last year.

The truth is, no honest company need worry that the bar is too high to list in America. It is precisely because our markets are the gold standard that listing in the U.S. remains the benchmark of investor confidence for companies around the world.

Going through the listing process in the U.S. will improve Chinese company disclosure practices. And this will serve to achieve China’s objective of upgrading the governance of its firms. That, in turn, will benefit every investor, saver, and worker in China.”

Even these later comments may appear too self laudatory to some, but they are not objectionable. The comments of October 16 on the other hand, are completely unbecoming of a regulator:

Posted at 16:21 on Mon, 24 Oct 2005     View/Post Comments (1)     permanent link

Mon, 17 Oct 2005

T+1 Settlement of Securities Trades

I wrote an article in the Financial Express today about T+1 settlement of securities trades. The argument in this article is that the separation of trading and settlement made sense when settlement was time consuming and laborious. Today with electronic settlement, trading and settlement must be brought closer together. T+1 is the way forward, but it is by no means the destination. The article can also be read at my website.

Posted at 17:40 on Mon, 17 Oct 2005     View/Post Comments (0)     permanent link

Tue, 11 Oct 2005

Hedge Fund Frauds

In August 2005, investors in the Bayou Group of hedge funds in the United States discovered that the $400 million of assets that Bayou purported to have did not really exist. For several years, the accounts of the fund had been completely falsified. Since then there have been many proposals for tighter regulation of hedge funds.

Many of these proposals which try to make hedge funds look more like mutual funds do not make sense. Academic research going back several decades has consistently shown that buying an index funds (or perhaps even better, an Exchange Traded Fund or ETF) out performs actively managed mutual funds. Research has also generally shown that by and large those who beat the market in any single year are not likely to do so year after year on a consistent basis. In short (apart from ETFs) mutual funds provide a completely useless asset class - they do not expand the investment opportunity set for investors.

Basically, the regulatory restrictions on leverage, derivatives and short selling mean that all mutual funds are just more expensive versions of an ETF. Like branded gasoline, mutual funds are a branded commodity where one uses expensive marketing efforts to demonstrate that one’s product is somehow different from (and superior to) the competition.

Academic research on hedge funds is more recent and perhaps therefore less conclusive. But the limited evidence that is there suggests that hedge funds do expand the investment opportunity set. They provide absolute returns that are weakly correlated with the market. Risk compensation per unit of beta is therefore excellent, and risk compensation per unit of standard deviation is respectable. This makes them a useful addition to the portfolio of many investors.

If we defined investor protection in objective finance theory terms therefore we should make mutual funds more like hedge funds rather than the other way around.

So what is the right regulatory response to Bayou? Jenny Anderson has an interesting proposal on this subject (“A Modest Proposal to Prevent Hedge Fund Fraud”, New York Times, October 7, 2005) which requires only a simple modification to the SEC’s registration requirememt for hedge funds that comes to effect in February 2006.

“The [SEC] should ask for two other pieces of information: the name of the accountant responsible for auditing the fund and the name of the broker-dealer through which the hedge fund trades - including whether that broker-dealer is affiliated with the hedge fund.

These issues were critical red flags in the fraud at Bayou. Its auditor, Richmond-Fairfield Associates, was a fake accounting firm created to produce false audits of Bayou. Bayou Securities was the broker-dealer through which trades were made to create real commissions for Bayou’s principals, who used them as compensation on top of 20 percent incentive fee they made on their fraudulent returns.”

This is perhaps the most sensible response to Bayou.

Posted at 17:42 on Tue, 11 Oct 2005     View/Post Comments (2)     permanent link

Tue, 04 Oct 2005

Is a fraud an offence only if there is a foreign listing?

The Securities and Exchange Board of India (SEBI) has issued an order against Pentamedia Graphics Limited in respect of an issue of fake shares by the company. The order makes the perfectly valid statement that:

“Issuing fake shares is a major offence”

Since the days when Jay Gould and Vanderbilt fought for the control of the Eire Railroad in the United States in the nineteenth century, issuance of fake shares has been rightly seen as one of the worst capital market offences that a company can commit. A speedy and effective response from the regulator is therefore most welcome.

However, at the fag end of a perfectly unexceptionable order, SEBI goes on to make a very disturbing statement:

“the GDRs issued by the company are listed and traded in foreign countries. In case of such companies, it is all the more essential for companies to adhere to the highest standards of corporate governance in keeping with global benchmarks.”

This statement is disturbing in two ways. First it seems to put a fraud (issuance of fake shares) on par with a mere lapse from the highest standards of corporate governance. Second, it raises the distressing thought that SEBI might not have acted with equal alacrity if the company did not have a foreign listing.

Posted at 10:38 on Tue, 04 Oct 2005     View/Post Comments (1)     permanent link

Mon, 26 Sep 2005

HealthSouth and Whistle Blower Protection

After the Enron debacle, the US enacted whistle blower protection into Section 806 of the Sarbanes-Oxley Act. Many companies around the world adopted whistle blower policies in accordance with the requirement of this law.

But much of this protection is quite useless if judges and prosecutors are insensitive to the organizational ground realities within which whistle blowers have to function. The verdicts in the HealthSouth case in the United States provide an excellent example of how things can go badly wrong. HealthSouth's founder Chairman and CEO was acquitted on all counts in June. A few other employees and former employees received mild sentences. As if to compensate for all these failures, the prosecution sought tough penalities against the whistle blower himself. Last week, the judge imposed the longest prison sentence in the case so far on the whistle blower Weston Smith!

Posted at 12:30 on Mon, 26 Sep 2005     View/Post Comments (2)     permanent link

Mon, 12 Sep 2005

Financial Development, Financial Fragility, and Growth

A recent IMF Working Paper by Norman Loayza and Romain Ranciere entitled Financial Development, Financial Fragility, and Growth ( tries to disentangle the short run and long run effects of financial development on economic growth.

In the process, the authors also seek to reconcile the apparent contradictions between two strands of the literature on the subject.

“On the one hand, the empirical growth literature finds a positive effect of financial depth as measured by, for instance, private domestic credit and liquid liabilities. On the other hand, the banking and currency crisis literature finds that monetary aggregates, such as domestic credit, are among the best predictors of crises and their related economic downturns. This paper accounts for these contrasting effects based on the distinction between the short- and long-run effects of financial intermediation.”

Essentially, Loayza and Ranciere measure financial development by the ratio of private credit to GDP. Using data for 75 countries from 1960 to 2000, they show that in the long run, a rise in this financial intermediation ratio increases economic growth. However, the short run effect is negative and this effect is several times the long term effect.

In their detailed analysis however the authors show that the short term effect is entirely due to the countries that have experienced a banking crisis. “In fact, for the non-crisis countries, the average short-run impact of intermediation on growth is statistically zero.”

This suggests that it is rather misleading to claim that financial development reduces economic growth even in the short term. First., while the title of the paper uses the term financial development and the text of the paper uses the term financial intermediation, the measure used is purely a measure of credit and ignores other financial claims. Second, the negative impact even in the short term is restricted to crisis countries where presumably the institutional structures required to support rapid credit growth were less well developed.

Posted at 13:21 on Mon, 12 Sep 2005     View/Post Comments (0)     permanent link

Tue, 06 Sep 2005

Transparency in Bond Trading

The FSA has put out a discussion paper on Trading transparency in the UK secondary bond markets ( This paper is in response to the possibility that greater transparency may be mandated under MiFID, the European Union’s Market in Financial Instruments Directive. MiFID currently imposes transparency obligation on the equity market but Article 65 requires the Commission to report on whether the pre and post-trade transparency obligations should be extended to transactions in bonds as well.

The FSA discussion paper provides a nice review of the academic literature on the role of transparency and also provides a comprehenseive description of the bond market in the UK. It is onstensibly neutral on whether more transparency is needed, but on closer reading it is clearly biased towards maintaining the status quo. It argues that the basic question to be asked before imposing a transparency obligation is whether there is a market failure that needs to be corrected. The problem is that market failure is too strong a word to describe the effect of opaque markets. Opaque markets may be unfair to classes of investors and may also be inefficient, but these do not probably rise to the level of market failure.

For example, the discussion paper while pointing out that post trade information is not publicly available observes that this information is available to those who subscribe to the services of various vendors. The point is that this may well be enough to prevent market failure but not sufficient to meet the regulator’s obligations regarding investor protection.

Posted at 18:42 on Tue, 06 Sep 2005     View/Post Comments (0)     permanent link

Thu, 01 Sep 2005

Henry Blodget’s Irreplaceable Exuberance

In the New York Times of August 30, 2005, Henry Blodget tries to justify some of the things that happened during the internet boom and bust of the late 1990s. Henry Blodget was a well known internet stock analyst of that era and his actions invited regulatory sanctions that cut short his career.

Blodget is not saying anything new when he says that “stock prices and strategic decisions are based on predictions, and predicting the future in an industry’s early days is hard”. What is more interesting is his point that “our exuberance helps build industries, however boneheaded it may later seem”.

This is true if we define exuberance as a temporary reduction in risk aversion. Such a reduction will lead to investments with higher expected returns and from the point of view of a risk neutral observer, this is more rational. Since we are always risk neutral about the past, posterity will be happy that those investments were made.

Unfortunately for him some of the investments that were made at that time were not justifiable even if we ignore risk aversion. Yet, it must be said that compared to some of the nonsense that Blodget wrote as an analyst, what he is writing now contains a grain of truth even when it is largely self serving.

Posted at 10:06 on Thu, 01 Sep 2005     View/Post Comments (0)     permanent link

Mon, 29 Aug 2005

Is the Feldstein Horioka puzzle dead or dying?

In today’s Financial Times, Martin Wolf writes that

“The principal determinant of the pattern of capital flows is, it turns out, divergent savings rates. ... because investment rates were closer together than savings rates, the world's capital exporters were countries with high savings rates and the importers were ones with low savings rates.” (Martin Wolf, “Capital flow must change course”, Financial Times, August 29, 2005.)

Does this mean that one of the oldest puzzles of international financial economics, the Feldstein Horioka puzzle is dead or dying? Feldstein and Horioka showed that the cross sectional regression coefficient of investment rates on savings rates was close to unity. (Feldstein, M. and C. Horioka, 1980, “Domestic savings and international capital flows”, Economic Journal, 90, 314-329). This coefficient has fallen since then. Obstfeld and Rogoff noted that the regression coefficient had fallen to 0.60 for the early and mid 1990s as opposed to the 0.89 obtained by Feldstein and Horioka for the 1960s and early 1970s (Obstfeld, M. and K. Rogoff, 2000, “The six major puzzles in international macroeconomics: Is there a common cause?”, NBER Working Paper 7777).

Perhaps, freer capital markets are destroying what is left of the puzzle?

Posted at 11:16 on Mon, 29 Aug 2005     View/Post Comments (3)     permanent link

Mon, 22 Aug 2005

Institutional Investors

Granit San has an interesting paper at SSRN about institutional and individual trading (San, Granit, “Who Gains More by Trading - Individuals or Institutions?”, June 2005.

The conclusion of the paper is that institutions are momentum traders who buy stocks that have done well in the last few quarters and sell those that have not done well. On the other hand individual investors trade in a more contrarian manner and earn higher returns. The superior performance of individuals persists after adjusting for risk using (a) the CAPM or (b) the three factor model of Fama and French or (c) the four factor model of Carhart. The data is consistent with the hypothesis that institutions are noise traders while individuals are informed, rational traders.

What is more interesting is that the same conclusion is true even during the technology stock bubble of the late 1990s. Individual entered technology stocks and exited them more rationally than institutions and earned superior returns during the process as well.

In India, the regulatory regime for foreign portfolio investors has been that foreign institutional investors (FIIs) are welcome while foreign individuals and hedge funds are barely tolerated. San's results would suggest that this policy is completely misguided. If FIIs are momentum investors, then their presence would exacerbate the booms and busts in the stock market. Encouraging non institutional investors would be a far better idea.

Posted at 16:55 on Mon, 22 Aug 2005     View/Post Comments (1)     permanent link

Tue, 09 Aug 2005

Markets, marketplaces and eBay

In a free-wheeling article on markets and market places, in today's Financial Times, columnist John Kay discusses the problems at the big exchanges in Chicago, London, Frankfurt and New York. He also finds time to talk about the Fulton fish market in New York and the world's largest produce market at Ringis near Paris (John Kay, “In search of a quiet courtier”, Financial Times, August 9, 2005). After that, he has this to say about eBay:

“The most successful for-profit marketplace today is eBay. But it has not yet made much money and the issue for its future is whether it can reconcile shareholder expectations with the iron law of natural monopoly - to exploit it is to lose it”.

Though Kay does not mention this, the big difference between eBay and the rest is that while eBay centralizes trading like the others, it does not centralize settlement. This allows eBay to handle millions of separate non fungible physical settlements - something that none of the big exchanges or clearers can even dream of.

Posted at 11:33 on Tue, 09 Aug 2005     View/Post Comments (0)     permanent link

Thu, 28 Jul 2005

Are Financial Centres Worthwhile?

The Times of London reported earlier this month that London was the most successful financial services industry in the world with record net exports of £19 billion ($33 billion).

I was struck by the smallness of this number. If this is what the world's premier financial centre can achieve, then is it at all worthwhile for a country to promote itself as a regional or global financial centre? For example, does it make any sense for India to build Mumbai up as a regional financial centre? Perhaps not.

It is reasonable to assume that in a few years time, India‘s software and BPO exports will be above $33 billion. On the other hand, any new financial centre will have a fraction of the net exports of London. Not only will it be smaller, it will most probably not have institutions like Lloyds of London which contribute significantly to those net exports (insurance accounted for a third of London's net exports). We might be better off importing financial services and exporting software!

My colleague, Prof. Sebastian Morris, points out however that the advantage from having a regional financial centre is likely to last for a very very long time. If London‘s experience is any guide, that is certainly true. If we present value all that, it might make the whole effort worthwhile. But Prof. Morris also adds that the real sector of the UK economy may have lost out in the pursuit of London‘s interest as a financial centre. If we subtract that, where does that leave us?

Posted at 12:05 on Thu, 28 Jul 2005     View/Post Comments (1)     permanent link

Mon, 11 Jul 2005

Overpricing of Emerging Market CDS?

A recent IMF working paper (Manmohan Singh and Jochen Andritzky (2005), “Overpricing in Emerging Market Credit-Default-Swap Contracts: Some Evidence from Recent Distress Cases”, IMF Working Paper 05/125) claims that there is significant overpricing of Credit-Default-Swaps on emerging market sovereigns.

The authors claim that the market prices CDS on an assumed recovery assumption of 20%. Under this assumption, the CDS spread can be used to compute an implied probability of default. The authors then show that even during periods of financial distress and restructuring (for example Argentina) the cash market price of the distressed bonds (even the cheapest to deliver bond) is well above 20% of par (it is typically 40% of par). The authors then compute an implied recovery rate from the cash market price of the cheapest to deliver bond by assuming the implied probability of default computed from the CDS spread under the 20% recovery assumption. They then compute the theoretical CDS spread using the implied probability of default from the CDS market and the implied recovery rate assumption from the cash market. This theoretical CDS spread is below the actual CDS spread.

It is difficult to understand what this whole exercise really proves. Yes, it does show that emerging market sovereign CDSs should not be priced under a 20% recovery assumption. Perhaps, it also shows that there was a divergence between the CDS market and the cash market — either the CDS was overpriced or the cash market was underpriced. To arbitrage this difference away, it would be necessary to short the cheapest to deliver bond in the cash market. This is where the first author’s earlier paper (Manmohan Singh (2003) “Are Credit Default Swap Spreads High in Emerging Markets? An Alternative Methodology for Proxying Recovery Value”, IMF Working Paper 03/242) throws some light. In that paper, Manmohan Singh explains that the cheapest to deliver bonds were squeezed and were on special repo. Moreover, the sovereign itself was trying to push up the price of the cheapest to deliver bond by buying up as much of it as possible. The price of the cheapest to deliver bond rose during the period of distress. All this points to a very different conclusion — that the cash bonds were overpriced. If so, it is not that the CDS spreads were too high but that the cash bond yields were too low.

Posted at 14:05 on Mon, 11 Jul 2005     View/Post Comments (0)     permanent link

Fri, 01 Jul 2005

Reputational Cost of Cooking the Books

Karpoff, Jonathan M., Lee, Dale Scott and Martin, Gerald, “The Cost to firms of Cooking the Books” (June 14, 2005) provide an interesting analysis of the penalties for financial misreporting in the United States.

They claim that the legal penalties are dwarfed by what they call the reputational penalty imposed by the market: “the reputational penalty is twelve times the sum of all penalties imposed through legal and regulatory processes.”

The difficulty is in the way that the reputational penalty is estimated. The authors take the drop in market value of the firm when an investigation is announced and subtract from this the monetary penalty imposed by the regulator as well as the amount paid in any class action suit. They then proceed to subtract the valuation impact of the accounting write-off required to reverse the financial misreporting. What is left is the authors’ estimate of the reputational penalty imposed by the market. The authors assume that the valuation impact of the accounting write-off is captured by multiplying the amount of the write-off by the price to book ratio.

consider the hypothetical example of an all-equity firm that has book value of assets equal to $100 and a market-to-book ratio of 1.5. The market value of the firm’s assets, and its shares, is $150. Assume the company then issues a misleading financial statement that overstates its asset values by $10. If the firm's market-to-book ratio stays the same, its share values will increase temporarily by ($10 x 1.5) to $165. But when the financial misrepresentation is discovered, the book value will be restated by $10, back to $100. If there is no other impact, the market value will fall by $15, back to $150. Thus, a $10 restatement in the firm’s books implies a $15 change in the market. This $15 drop in market value is what we seek to capture with the accounting write-off effect.

This estimate can be badly wrong because the accounting restatement can change the price to book ratio itself. A restatement that is relatively small in relation to the net worth of a company can make a large difference to the growth rate in earnings. If this changes the estimate of future growth opportunities, then the price to book ratio can fall dramatically. This is because the price to book reflects the relative importance of the present value of growth opportunities (PVGO) in relation to the present value of continuing operations (PVCO) and a relatively small change in growth rates can make a large change to the PVGO.

This is best seen in the context of a constant dividend growth model. Under this model, the market capitalization of the company is given by E(1-b)/(k-g) where E is the earnings of the company next year, b is the fraction of earnings that is retained (1 minus the payout ratio), k is the cost of equity and g is the growth rate in earnings and dividends. In this model E/k is the present value of continuing operations (PVCO) and is a rough estimate of what the book value would be. The balance is the present value of growth opportunities (PVGO).

Let us consider a numerical example. If last year’s earnings are $108 million, the dividend payout ratio is 40%, the cost of equity is 10% and the growth rate is 8%, the dividend growth model predicts a market capitalization of about $2.3 billion since the projected earnings next year are $116 million and the price earnings multiple (1-b)/(k-g)is 20. Of this, the PVCO is only about half ($108 million discounted at 10%), while PVGO accounts for slightly more than half. Assuming that book value is a rough approximation to the PVCO, the price to book for this company would be about 2. Consider an accounting restatement that changes the earnings last year from $108 million to $106 million. as against $100 million the year before last. This reduces the observed growth rate from 8% to 6%. If the market regards 6% as the true estimate of future growth, then the price earnings multiple would fall to 10 and the price to book ratio would fall to 1 as the PVGO simply vanishes. (The 6% growth amounts to only the required 10% return on the 60% of earnings that is retained and ploughed back into the business every year.) The market capitalization would then halve from $2.3 billion to $1.1 billion or a loss of over $ 1 billion. As against this, the authors’ estimate of the valuation effect would be $2 million times the price to book ratio of 2 or $4 million. The true valuation effect is then about 250 times what the authors estimate it to be.

If this is so and the bulk of the alleged reputational penalty is actually a valuation effect of the restatement itself, then the author’ findings can be interpreted very differently. The legal penalties are only a small fraction (only 1/12 or around 8%) of the true losses suffered by investors. Considering that creditors recover about 60% of the value of a defaulted bond, this is a very poor track record

Posted at 16:38 on Fri, 01 Jul 2005     View/Post Comments (0)     permanent link

Wed, 29 Jun 2005

FSA Fine on Citigroup is total nonsense

The order that the Financial Services Authority (FSA) of the UK has passed against Citigroup Global Markets Limited (CGML) in the Euro MTS case imposing a fine of $25 million is total nonsense. Clearly, the FSA lacked either the evidence or the courage to say that Citigroup had manipulated the markets. At the same time, the FSA was unwilling to let them off without any penalty. What they have done therefore is to impose a penalty under regulations that have no bearing on the case at all. This means a penalty is imposed without having to prove any serious charges against Citigroup.

The event that led to the fine was quite simple. On 2 August 2004, Citigroup “executed a trading strategy on the European government bond markets which involved the building up and rapid exit from very substantial long positions. The centrepiece of the strategy was the simultaneous execution of a large number of trades on the MTS platform using specially configured technology.”

FSA claims that in executing these trades, Citigroup contravened the following two Principles of Business of the FSA:

On the face of it, it is difficult to see how Citigroup's trading violated either of these principles. On the contrary, it would appear that its actions demonstrated a high degree of skill and sound risk containment systems.

FSA however believes that due skill and care were lacking because Citigroup did not consider the likely consequences of the execution of the trading strategy could have for the efficient and orderly operation of the MTS platform. This statement is absolute nonsense. The whole strategy was predicated on a clear understanding of these consequences which were highly beneficial to Citigroup. More importantly, Citigroup's understanding of these consequences was quite correct.

FSA also believes that there were

This would be a perfectly valid argument provided the FSA had first established that the trading strategy itself violated the rules of market conduct. The FSA does not however want to assert that the trading strategy was manipulative. If it does not do so, then it is difficult to see why a trade, even if it is very large, needs clearance from senior management.

I think the FSA has simply taken the easy route out. Perhaps, for Citigroup too, paying a $25 million fine is an easy solution to its problems.

Posted at 12:56 on Wed, 29 Jun 2005     View/Post Comments (0)     permanent link

Thu, 23 Jun 2005

Credit derivatives versus cash markets

In a recent paper (Packer, F.and Wooldridge, P. D. (2005), “Overview: repricing in credit markets”, BIS Quarterly Review, June 2005), the BIS compares the resilience of the credit derivative markets and the cash markets during the turbulence of May 2005 after the GM and Ford downgrades. They write:

“ the downgrade of the auto makers had the potential to cause dislocation in credit markets. In the event, cash markets appeared to adjust in an orderly way to the downgrade. Credit derivatives markets were more adversely affected, with CDS spreads ‘gapping’ higher on several days in the first half of May and lower in the second half ... Yet spillovers from credit derivatives markets to other markets were limited.”

They also contrast the lack of contagion to other markets in May 2005 with the massive contagion from the Russian default and the collapse of LTCM in 1998.

While the statements are factually correct, the implicit suggestions that the credit derivative market is less resilient and less important is misleading. As the paper itself points out, the major trigger for the turmoil of May 2005 was a sharp fall in default correlations. Since contagion is by definition a sharp rise in correlations, it is not surprising that a fall in default correlations is not accompanied by contagion. Similarly, it is correlated defaults that cause the greatest stress on the cash bond markets. Uncorrelated defaults are quite benign in their impact. It is only in the credit derivative markets - n‘th to default credit swaps and the lower tranches of a CDO - that a fall in default correlations can cause havoc. It is precisely in these markets that players lost a lot of money.

The relative resilience of the cash market and the credit derivative market can be truly tested when there is a credit event which is more symmetric in their impact on the two markets.

Posted at 18:39 on Thu, 23 Jun 2005     View/Post Comments (1)     permanent link

Sun, 10 Apr 2005

MCI-Verizon: Some shareholders are more equal than others

Verizon is buying out MCI’s largest shareholder at a higher price than what it is offering to others. Once again, we see a big flaw in US takeover regulations. Michael Jensen pointed out long ago that the US got its takeover regulations badly wrong in the 1980s. I think they are yet to get it right. All the corporate governance reforms post Enron have not touched this area at all. Interestingly, very little of the takeover regulation in the US comes out of the capital market regulator.

India’s takeover code has a number of deficiencies but in this respect at least it is a lot better.

Posted at 19:34 on Sun, 10 Apr 2005     View/Post Comments (0)     permanent link

Thu, 31 Mar 2005

More on who owns the bonds?

The issue of who owns the bonds is still not fully resolved. Bloomberg quotes the New York judge as saying ‘Both sides have raised serious issues, good faith issues’. The judge ruled that the creditor could not seize the defaulted bonds held by the the exchange agent for swap becuase these bonds still belong to the bondholders not to Argentina. But, he then went on to say that the creditor may be entitled to attach Argentina's right to receive the bonds, if not to attach the bonds themselves before the exchange takes place.

Posted at 16:23 on Thu, 31 Mar 2005     View/Post Comments (0)     permanent link

Tue, 29 Mar 2005

Do bonds belong to the lender or borrower?

A creditor of Argentina has got a New York court to attach bonds issued by Argentina. Normally one hears of assets being attached, but here it appears that a liability is being attached. This peculiar situation has arisen because Argentina is going through a debt restructuring. The bonds in question had defaulted and the bond holders had surrendered them for conversion into new bonds of reduced face value as part of this debt restructuring.

In this context, the surrendered bonds could conceivably be an asset. To compound the problem, the bonds are actually held by a custodian bank. The question will then be whether this custodian is an agent of the bond holder or of the issuer. If it is an agent of the issuer (Argentina) then the attachment may be tenable. Otherwise the bonds do not belong to Argentina and the attachment would not make sense. It is a strange legal situation and Argentina is trying hard to get the order vacated

Posted at 18:20 on Tue, 29 Mar 2005     View/Post Comments (0)     permanent link

This is a test

This is a test posting. Please ignore.

Posted at 15:39 on Tue, 29 Mar 2005     View/Post Comments (3)     permanent link

Sat, 26 Mar 2005

Coming Soon

I am in the process of setting up my blog using Blosxom. Why Blosxom?

  1. It is open source so that I can use and customize it the way I like
  2. It does not use MySql or PHP. So I do not have to go to my web administrator to set up MySql accounts and other permissions. Yes, it needs CGI access, but I already have this and I would not dream of hosting my website on a server that does not give me this
  3. It is written in Perl, so I do not have to learn yet another programming language
  4. The core of Blosxom is small enough (less than 500 lines) so that it is easy enough to understand and modify. But, a large number of plugins are available to add whatever functionality is desired. This site uses the following plugins:

Posted at 12:15 on Sat, 26 Mar 2005     View/Post Comments (0)     permanent link