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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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 12:10 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