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

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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