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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Wed, 13 Dec 2006

Google Transferable Employee Stock Options

Google has introduced another financial innovation in relation to its own stock by allowing its employee stock options to be transferred after they have vested. Details on the transferable stock options (TSO) are available on its blog and several links in that blog entry. Google says:

When the options are sold to a bidder under the TSO program, three changes occur:

  1. The remaining life is shortened to two years unless the remaining life is less than two years. If the remaining life is less than two years, then the transferable life is further reduced from two years in six-month increments (e.g., 18 months, 12 months, six months) until the remaining transferable life is zero. For example, an option with a remaining life of 23 months will, upon sale in the TSO program, have an 18-month life.
  2. The forfeiture provisions related to the employee's employment with Google are removed.
  3. We anticipate the anti-dilution provisions will be changed to conform to market-standard provisions.

Some conclusions are obvious. Any employee who is leaving Google should sell all long maturity options since that allows them to realize at least the value of two year options. If they do not sell, they would have to exercise the options within three months of quitting so as to avoid forfeiting the options. Employees should also sell options that have residual maturity of around two years or less to diversify their portfolios. They should ideally sell the options on dates when the residual life of the options is a few days more than an integral multiple of six months.

The hard part is those who do not intend to leave Google soon and who have options with much more than two years to maturity. Finance theory would suggest that they are better off delta hedging those options rather than shortening the lives of the options. If they are really sure that they will stay with Google for a long time they might also want to hedge the gamma and vega of their stock options with exchange traded options. But in practice, shorting stocks is not very easy for individuals and many might choose to sell the options rather than hold on to them. Probably, only the most financially sophisticated employees will hold on to the options and most others will sell. Incidentally, the possibly most sophisticated employees (the executive management group) is excluded from TSOs altogether.

All in all, Google has added value to its stock option programme and created a model that many other companies will try to emulate. There is an accounting charge as the existence of the TSO increases the expected life of the employee stock options and therefore their fair value. But this is I think a small price to pay for the added benefits. Perhaps, this effect might also be offset by issuing less number of options.

The most interesting question is whether this can be done with unlisted companies. I am sure some hedge funds would be quite willing to bid for even these options if there is reasonable assurance of a liquidity event in the not too distant future. That would add a lot of value to the employees.

Posted at 13:25 on Wed, 13 Dec 2006     View/Post Comments (1)     permanent link

Sat, 09 Dec 2006

US court rules that IPO market is inherently inefficient

The ruling of the US Court of Appeal in Miles et al v Merrill Lynch et al (In Re: Initial Public Offering Securities Litigation is a sweeping judgement on the inherent inefficiency of the IPO market that effectively makes it impossible to use private litigation to deal with IPO fraud. The court not only tightened the legal standard for class action but then went on to decide the matter itself rather than remand it to the District Court. In the process it presented a dim view of the IPO market that effectively puts many kinds of wrong doing in this market beyond the purview of a class action law suit. This effectively rules out private litigation and makes the market dependent entirely on timely action by the regulator. This is extremely unfortunate.

The court’s views on the IPO market are as follows:

In the first place, the market for IPO shares is not efficient. As the late Judge Timbers of our Court has said, sitting with the Sixth Circuit, “[A] primary market for newly issued [securities] is not efficient or developed under any definition of these terms.” Freeman v. Laventhol & Horwath, 915 F.2d 193, 199 (6th Cir. 1990) (internal quotation marks omitted); accord Berwecky v. Bear, Stearns & Co., 197 F.R.D. 65, 68 n.5 (S.D.N.Y. 2000) (The fraud-on-the-market “presumption can not logically apply when plaintiffs allege fraud in connection with an IPO, because in an IPO there is no well-developed market in offered securities.”). As just one example of why an efficient market, necessary for the Basic presumption to apply, cannot be established with an IPO, we note that during the 25-day “quiet period,” analysts cannot report concerning securities in an IPO, see 17 C.F.R. 230.174(d), 242.101(b)(1), thereby precluding the contemporaneous “significant number of reports by securities analysts” that are a characteristic of an efficient market. See Freeman, 915 F.2d at 199.

Some good might still come out of it if these strong words induce the SEC to drop the unwarranted quiet period during IPOs.

Posted at 05:11 on Sat, 09 Dec 2006     View/Post Comments (1)     permanent link

Sun, 03 Dec 2006

US Capital Market Regulation

I was reading The Social Construction of Sarbanes Oxley by Langevoort when the Committee on Capital Markets Regulation published its interim report The interim report, the National Venture Capital Association Statement on this report, and the Statement of the Council of Institutional Investors on this report conform quite nicely to the social construction proposed by Langevoort.

Posted at 12:54 on Sun, 03 Dec 2006     View/Post Comments (0)     permanent link

Fri, 01 Dec 2006

UK Bill about Light Touch Regulation of Exchanges

I have been reading the bill that the UK has introduced to ensure that a foreign acquisition of the London Stock Exchange does not endanger the “light touch regulation” of UK exchanges. When I blogged about this idea three months back, I was mildly in favour of it, but when I see the actual law, my reaction is quite negative.

First of all, the law is far too wide. It says

A requirement is excessive if –

  1. it is not required under Community law or any enactment or rule of law in the United Kingdom, and
  2. either–
    1. it is not justified as pursuing a reasonable regulatory objective, or
    2. it is disproportionate to the end to be achieved.

Second, the law requires any exchange that proposes to make any regulatory provision to give written notice of the proposal to the FSA. The provision can be introduced only if the FSA does not veto it during a 30 day period. The only saving grace is that the FSA has been empowered to limit the applicability of this clause to “specified descriptions of regulatory provision or in specified circumstances”.

It appears to me that in the name of preserving a light touch regulation, the law is introducing a whole new layer of regulation that is not light touch at all. The motivation for the law was to deal with certain extreme situations and it would have been better to limit the law to such situations. As it stands, the law only illustrates the general principle that knee jerk legislative responses end up as disasters.

Posted at 17:05 on Fri, 01 Dec 2006     View/Post Comments (0)     permanent link

Wed, 29 Nov 2006

Foreign Investment in Indian Exchanges

I wrote a piece in the Economic Times on Monday about permitting foreign investment in Indian exchanges. I wrote:

The ownership of exchanges should be largely left to market forces with minimal regulatory intervention. The regulatory goal should be to ensure that the securities trading industry is highly competitive. The death of the trading floor and the rise of electronic trading platforms have completely changed the nature of exchanges.

From being cosy clubs, they have become complex businesses that are technology driven. In the process, they have also become highly capital intensive. The ability to respond to the demands of a highly sophisticated and global user base has become paramount. SEs and derivative exchanges now require investors with deep pockets and willing to make the strategic investments required to grow the business.

Any attempt to exclude such investors tends to favour incumbent exchanges and perpetuate existing monopolies and duopolies. From the social point of view, this would lead to a less competitive and therefore less vibrant, less innovative and less investor-friendly capital market.

We must welcome foreign investment in our SEs and commodity derivative exchanges as well as the exchange-like entities that trade currency and fixed income products. SEs and derivative exchanges enjoy very attractive valuations in global markets today and we must allow our exchanges to tap these global markets to raise capital. Foreign exchanges and other strategic investors could also help revive and strengthen the less well performing exchanges and thereby foster greater competition.

India’s position on foreign ownership should be the same as that of the Financial Services Authority of the UK which has stated: “We will be indifferent to the nationality of the owners or the managers of the London Stock Exchange, and will be concerned to ensure that the future operation meets our regulatory standards.”

We too should focus on strengthening our regulatory framework so that ownership of the exchanges becomes irrelevant. We must not allow the incumbent exchanges to wrap themselves in the flag and appeal to our xenophobia to block much-needed competition.

Posted at 18:56 on Wed, 29 Nov 2006     View/Post Comments (2)     permanent link

Sat, 25 Nov 2006

SEBI Disgorgement Order - Response to Comments

Some of the comments on my previous post have made me realize that I did a poor job of explaining why it is incorrect to simply make restitution to the genuine retail applicants in the so called IPO scam. As I started fleshing out the details, I found that it takes a rather long post to explain why I say this though issuers have the freedom to price their shares and the price paid by the retail segment is the same as that paid by others. There are two aspects to my argument.

The first point is that in equilibrium in an efficient market, a person who has not applied to an oversubscribed offering would not expect to make any gains by applying. The costs of applying (including the costs of analysis, costs of financing and the transaction costs of applying and bidding) offset the expected gains of a successful application (times the probability of success) after appropriate adjustment for the risk that during the period up to listing, the fundamental value of the share could drop below the issue price.

This equilibrium is achieved by a rise in the rate of over subscription and a concomitant fall in the probability of success falling until equality of costs and benefits is achieved. In the non retail segment this happens at high levels of over subscription because of the lower transaction costs and the ability to make large applications. In the retail segment, this equality is achieved at lower levels of over subscription because of higher search and analysis costs, higher financing costs and the higher transaction costs of applying in multiple names (legally or illegally).

The fictitious applications reduce the allotment rate and thus the expected benefits from applying. They thus reduce the gains to those who do apply. But they also deter many retail investors from applying at all because the reduced expected gains are now below their costs. Thus the fictitious applications inflict some losses on those who applied and some losses on people who did not apply at all. The key point is that in the absence of the fictitious applications, some genuine applicants (with high costs of applying) would have applied and reduced the success rate of the actual genuine applicants. It is thus a mistake to compute the losses suffered by the actual applicants by simply recomputing the allotment proportion after deleting the fictitious applications. True restitution would have to be to a much larger pool of potential applicants and not to the actual applicants. This is operationally very difficult. More importantly, even this analysis is flawed because of the analysis that follows next.

The second point is that the retail segment is permitted to bid at the cut off price. This has the potential to substantially reduce the contribution of this segment to price discovery. The under pricing of IPOs is a complex subject but at bottom under pricing can be regarded as a compensation for price discovery in the presence of asymmetric information. Succesful applicants normally earn their gains by contributing to price discovery. Those whose costs of analysis are lower earn more and those whose costs are higher earn less and the marginal investor earns nothing at all (this last statement simply rephrases my first point). But the retail segment has the ability to benefit from under pricing without contributing significantly to price discovery. The under pricing of the retail segment is then a dead weight loss to the company and its shareholders. The gains made by this segment are “rents” earned without doing anything economically useful and are thus “ill gotten”.

This argument can be made even without the ability to bid at cut off prices, but the argument then becomes more subtle. The point then would be that the retail segment crowds out more efficient investors whose information processing costs are lower and thereby forces the company to pay more (in the form of under pricing) to obtain price discovery. This again results in a dead weight cost on the company.

Therefore, I argue that the best way of achieving restitution of the ill gotten gains of the fictitious applicants is to pay this amount to the company and through it to its shareholders. Theoretically, the next best alternative is to pay it to all potential applicants to the issue. This is operationally infeasible. The naive alternative of restitution to those who happened to apply to the issue is simply wrong and indefensible.

Posted at 20:49 on Sat, 25 Nov 2006     View/Post Comments (2)     permanent link

Wed, 22 Nov 2006

SEBI Disgorgement Order

The Securities and Exchange Board of India has passed a bizarre “disgorgement” order for over rupees one billion (approximately $25 million) against both the depositories in India as well as a number of depository participants involved in the IPO scam that I blogged about last year. The most charitable explanation is that this is a penalty masquerading as a disgorgement. The less charitable explanation is that SEBI is merely behaving like class action lawyers who routinely proceed only against those with deep pockets because that increases the likelihood of recovering something if they succeed on the merits.

The IPO scam involved people submitting multiple applications in fictitious names to increase their allotment in a fixed price IPO. The disgorgement order does not target any of those who perpetrated the fraud but is directed against the depositories and the depository participants who opened the demat accounts used by the fraudsters. SEBI says in its order that “it stands to reason that the Depositories and Depository Participants who enabled the opening of numerous demat accounts (afferent accounts) in fictitious / benami names either by turning a Nelson’s eye to the compliance with KYC norms prescribed by SEBI or by actively participating in the scheme designed by the key operators and the financiers, should be held liable for the loss caused to innocent retail investors. Had each market participant played their respective roles diligently with a degree of real time sensitivity, the rampant cornering of IPO allotments, particularly on this scale would not have taken place. The failure of each intermediary in the hierarchy of intermediaries contributed cumulatively, (jointly and severally) to the market abuse.”

There are many problems with this theory. First of all, disgorgement is not about liability for loss caused to investors. In its own order, SEBI states the legal position regarding disgorgement as follows:

It is well established worldwide that the power to disgorge is an equitable remedy and is not a penal or even a quasi-penal action. Thus it differs from actions like forfeiture and impounding of assets or money. Unlike damages, it is a method of forcing a defendant to give up the amount by which he or she was unjustly enriched. Disgorgement is intended not to impose on defendants any demand not already imposed by law, but only to deprive them of the fruit of their illegal behavior. It is designed to undo what could have been prevented had the defendants not outdistanced the investors in their unlawful project. In short, disgorgement merely discontinues an illegal arrangement and restores the status quo ante (See 1986 (160) ITR 969). Disgorgement is a useful equitable remedy because it strips the perpetrator of the fruits of his unlawful activity and returns him to the position he was in before he broke the law. The order of disgorgement would not prejudice the right of the regulator to take such further administrative, civil and criminal action as the facts of the case may warrant.

Similarly a report prepared by the US Securities and Exchange Commission pursuant to the Sarbanes-Oxley Act describes the legal position regarding disgorgement:

Disgorgement is a well-established, equitable remedy applied by federal district courts and is designed to deprive defendants of “ill-gotten gains.” In contrast to actions for restitution or damages in private actions, which are brought to compensate fraud victims for losses, disgorgement orders require defendants to give up the amount by which they were unjustly enriched. Before exercising their discretion to order defendants to pay disgorgement, courts have required findings that a causal connection exists between the defendants’ wrongdoing and amounts to be disgorged. “[D]isgorgement extends only to the amount with interest by which the defendant profited from his wrongdoing.” To assist in determining the amount of disgorgement, the Commission often seeks, and courts require, that defendants provide an accounting of the funds and other assets they received in the course of their wrongdoing. In ordering disgorgement, courts have not required the Commission to determine the exact amount of the defendant’s ill-gotten gains. The Commission has the burden, though, of showing that the amount sought is a “reasonable approximation of profits causally connected to the violation.” Once the Commission has satisfied its burden, a defendant who asserts that the amount should be less has the burden of demonstrating that the amount should be reduced. As long as the measure of disgorgement is reasonable, courts have held that the wrongdoer should bear the risk of uncertainty regarding the precise amount. [footnotes omitted]

The only ill gotten gains for the depositories and their participants would be the account opening charges and transaction fees that they levied on the fraudulent demat accounts. This would be a miniscule fraction of the billion rupee disgorgement that has been ordered.

The second problem is that the deficiencies pointed out in the SEBI order against the depositories and their participants are largely in the nature of negligence or lack of diligence. The appropriate response to that is a penalty or a suit for damages.

Another problem is the joint and several liability that is imposed by this order. Joint and several liability is rooted in the principle that a wrongdoer is liable for the reasonably foreseeable acts of his fellow wrongdoers committed in furtherance of their joint undertaking. US courts have held that joint-and-several liability is appropriate in securities cases when two or more individuals or entities collaborate or have close relationships in engaging in the illegal conduct. It is difficult to see how this applies to several depository participants acting largely independently of each other.

Above all, it must be remembered that from a finance purist’s point of view, the notional gain made by even the genuine applicants in the retail quota of the IPO are in some sense “ill gotten gains” as they were given shares at less than their fair value. This gain really comes at the cost of the existing shareholders of the company and of those who bought shares under the non retail quota. Thus we should not get into the trap of believing that the IPO scamsters defrauded the genuine applicants in the retail quota. The correct way of looking at the situation is that the retail quota itself amounted to looting the company and the scamsters only changed the proportion in which this loot was shared. If the so called disgorgement were ever to be turned into a restitution, the recompense must go the company that did the IPO (and therefore to all its shareholders) and not to the genuine applicants in the retail quota.

Finally, the SEBI order raises serious questions about the capital adequacy of the depositories. If this is the kind of liability that SEBI intends to fasten on the depositories, they need to have a lot more capital than they currently have. The joint and several liability that the order imposes on the country’s largest depository, NSDL, represents 45% of its net worth as disclosed in the the 2005-06 annual report. It needs to have a lot more capital to protect against actual losses caused to investors by failures in its systems.

Posted at 15:08 on Wed, 22 Nov 2006     View/Post Comments (5)     permanent link

Wed, 15 Nov 2006

Edgar Full Text Search

The US SEC has at long last enabled full text searching of its Edgar database of corporate filings. The new search page is here. In the past, searching Edgar was quite painful and I usually went to Edgar only after identifying the form type and approximate filing date through other sources. Now it is much simpler. For example, I clicked on “advanced search” and typed in “pretexting” in the “text” field and “Hewlett Packard” in the “Company Name” field and I obtained links to the two 8-K filings on this issue that I have blogged about earlier.

Under Chairman Cox, the US SEC seems to be taking the internet quite seriously. Cox posted a comment on a blog recently in his official capacity. He is also pushing for adoption of XBRL in Edgar filings. Regulators elsewhere have a lot of catching up to do. I hope that the Securities and Exchange Board of India (SEBI) upgrades its Edifar database to include the full text of the financial statements (and not just the summary financial numbers) as also the material event disclosures that companies currently make only to the exchanges. Only after that can one start asking for search capabilities!

Posted at 13:34 on Wed, 15 Nov 2006     View/Post Comments (0)     permanent link

Tue, 07 Nov 2006

XBRL and Financial Statement Preparation

I wrote an article for CFO Connect about the use of (eXtensible Business Reporting Language (XBRL) in the preparation of financial statements rather than just for their dissemination and analysis. Scanned image is available here.

Financial analysts have begun to love XBRL and the US SEC is also now pushing companies to use XBRL in their Edgar filings. Companies however tend to think of this as another investor relations expense rather than as a productivity tool for themselves as preparers of financial statements. I argue on the other hand that it is high time that we got rid of all those spreadsheets and word processor files and used XBRL to automate the process completely and integrate it completely with the corporate ERP systems. This would improve reliability, increase speed and reduce manual interventions.

Posted at 14:19 on Tue, 07 Nov 2006     View/Post Comments (0)     permanent link

Sat, 04 Nov 2006

Ownership of Exchanges in India

I participated in a discussion on the CNBC TV channel last night on the ownership of Indian exchanges. This issue has become controversial because of the reported desire of the government and the regulators to discourage Indian companies and foreign entities from becoming strategic investors in Indian stock exchanges

My views on this are very simple. It is far more important to ensure that the securities trading industry is highly competitive than to regulate the ownership of exchanges. Stock exchanges are highly capital intensive technology driven businesses which require deep pocketed investors who are willing to make the strategic investments required to grow the business. Any attempt to exclude deep pocketed investors tends to favour incumbent exchanges and perpetuate existing monopolies and duopolies. From the social point of view, this would be a most unfortunate outcome as it would lead to a less competitive and therefore less vibrant, less innovative and less investor friendly capital market.

Much has been written about the alleged conflict of interest that would arise if certain categories of investors were to become controlling shareholders of exchanges. It has been suggested that ownership by financial institutions is the best solution. I do not agree with this view at all. Almost any potential owner of an exchange is conflicted because of the pervasive role of stock exchanges in a modern market economy. Financial investors are among the most highly conflicted of all potential owners. Some of them own broking subsidiaries and it is surely absurd to get rid of broker ownership only to reinstate it through the back door. All banks and term lending institutions live in mortal fear of the capital markets disintermediating them out of existence. Sixty years ago, the conflict of interest between banking and capital markets was taken so seriously that the US passed the Glass-Steagal Act prohibiting banks from owning securities firms. That was surely silly, but the idea that they are the best possible owners of stock exchanges is even more silly.

It is only an anti capital market mind set that can think of financial institutions as preferred investors in exchanges. Unfortunately, that mind set is in abundance in policy making circles in India.

Posted at 14:19 on Sat, 04 Nov 2006     View/Post Comments (4)     permanent link

Thu, 02 Nov 2006

US CFTC Policy on Foreign Exchanges: Lessons for India

The US Commodities and Futures Trading Commission (CFTC) has issued a statement of policy regarding foreign exchanges offering their products in the United States. This issue had become controversial in the context of the UK based ICE Futures trading US energy contracts in the US that I blogged about here.

The CFTC has decided to maintain the existing policy framework of exempting exchanges like ICE from US regulation. In particular, the CFTC states that:

  1. the trading volume originating in the US is not determinative of US location
  2. the fact that the contract is based on a US produced or economically important commodity is not probative of location

These put to rest the two critical arguments that were raised against ICE Futures.

I think the CFTC has shown the way for regulators in India to allow foreign exchanges to offer their contracts directly in India through electronic trading platforms. The RBI now allows Indian citizens to remit up to $50,000 a year outside India for investment purposes. What better thing can we give these investors than the ability to buy foreign stocks or bonds or derivatives sitting in front of their computer screens in India? We must not let protectionist arguments prevail in denying Indian residents the best investment opportunities in the world and force them to park their money in foreign bank deposits.

What is more, acceptance of the CFTC principles would allow foreign exchanges to offer trading in India on ADRs of Indian companies provided the Indian investor pays for them in dollars. This would produce better price discovery in the ADR market and reduce the price gap between the Indian and offshore markets.

Posted at 13:29 on Thu, 02 Nov 2006     View/Post Comments (0)     permanent link

Wed, 18 Oct 2006

Another electronic platform buys out another trading floor

The acquisition of CBOT (Chicago Board of Trade) by the CME (Chicago Mercantile Exchange) fits a now familiar pattern of an electronic platform buying out and gradually digesting a trading floor. One of the big benefits of the deal will be that CBOT products start trading on Globex. ICE (Intercontinental Exchange) buying NYBOT (New York Board of Trade) was also in the same mould. Viewed in this light, the deal between NYSE and Euronext will ultimately mean that Euronext’s electronic platform absorbs the NYSE trading floor though in financial terms, it is the NYSE that is buying Euronext. Of course, the NYSE deal with Archipelago was also similar, but Euronext would take the process much further.

Posted at 13:32 on Wed, 18 Oct 2006     View/Post Comments (0)     permanent link

Thu, 28 Sep 2006

UK Regulation of US Energy Markets

While I blogged about the potential regulation of the UK equity market by the SEC nearly two weeks ago, it took the collapse of Amaranth to draw my attention to the fact that a growing part of the US energy derivatives market is now regulated by the UK.

In January 2006, the Intercontinental Exchange (ICE) was permitted to use its trading terminals in the United States for the trading of US (WTI) crude oil futures on ICE Futures in London (formerly the International Petroleum Exchange or IPE). This was not a totally new contract because ICE simply took its electronically traded, standardized OTC contracts and offered them on ICE Futures. Therefore, these contracts have seen high initial adoption and rapid growth in the last few months. WTI volumes in ICE Futures are now about half of the NYMEX volumes. We now have a liquid contract on a US commodity that is predominantly traded by US participants using terminals in the US, but the contract is on an exchange (ICE Futures) which is located and regulated in the UK, though it is owned by a US entity (ICE).

More interesting is the fact that ICE also runs a large quasi futures market in energy derivatives. These are OTC contracts for regulatory purposes but are standardized, electronically traded and cleared through London’s LCH. LCH is UK regulated, but it is also a Designated Clearing Organization in the US. Amaranth served to remind us that when it comes to natural gas “futures”, ICE is today larger than NYMEX.

Even before Amaranth, the US political system was worried about this just as the UK is worried about potential regulation of UK equities by the US. The US Senate has prepared a report arguing for greater US (CFTC) regulation of the derivatives traded at ICE (“The role of market speculation in rising oil and gas prices: A need to put the cop back on the beat”, Staff Report prepared by the Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs, United States Senate, June 2006).

Incidentally, this week the US SEC met with Euronext regulators about the potential acquisition of Euronext by NYSE. The SEC’s press release states: “The regulators also affirmed that joint ownership or affiliation of markets alone would not lead to regulation from one jurisdiction becoming applicable in the other and stated their shared belief in the importance of local regulation of local markets.” That sounds categorical until one reads it again more carefully and realizes that it means nothing at all. Today there are no purely local markets. US investors do trade UK stocks at the LSE and the LSE is no longer a purely local market. All bets are then off.

Posted at 14:15 on Thu, 28 Sep 2006     View/Post Comments (0)     permanent link

Sat, 16 Sep 2006

Nasdaq, LSE, Cadbury Schweppes and extra-territoriality

The UK has in the last week been involved in two tussles about extra territoriality but has been on opposite sides in the two tussles. In the case of the possible acquisition of the London Stock Exchange (LSE) by Nasdaq, the UK has been eager to ensure that the extra-territorial jurisdiction of US law (particularly Sarbanes Oxley) does not affect companies listed at LSE. In the case of Cadbury Schweppes, it is the UK that has been told to stop exerting territorial jurisdiction to impose a tax on the UK company’s Dublin subsidiary which is subject to low taxes there.

The fear of extra-territorial jurisdiction of US laws over a US owned LSE is quite well grounded. Way back in 1979, in the wake of the US hostage crisis, President Carter issued Executive Order 12710 under the International Emergency Economic Powers Act stating: “I hereby order blocked all property and interests in property of the Government of Iran, its instrumentalities and controlled entities and the Central Bank of Iran which are or become subject to the jurisdiction of the United States or which are in or come within the possession or control of persons subject to the jurisdiction of the United States.” Nearly half of the blocked money was in deposits outside the US (principally in London). While the Iranians did sue in London to release these funds, the courts and governments were slow in resisting the extra-territorial demands of the US order and since the entire hostage crisis lasted only 14 months, the legality of the US freeze was not adequately tested. A good account of this episode is provided by Robert Carswell’s article “Economic sanctions and the Iran experience”, in Foreign Affairs, Winter 1981/1982.

In later sanctions against other countries, the US was less successful. For example, “a U.S. bank in the United Kingdom was ordered by a British court to release a Libyan bank’s assets blocked under U.S. unilateral sanctions in 1986. The United States subsequently authorized the release of the assets.” (GAO-04-1006 “Foreign Regimes’ Assets: The United States Faces Challenges in Recovering Assets, but Has Mechanisms That Could Guide Future Efforts”, Government Accountability Office, 2004)

Extra-territorial reach over UK listed companies through a change in exchange regulations would be less vulnerable to judicial challenge. The UK government therefore wishes to have a statutory weapon against it. In a speech on September 13, 2006, Economic Secretary to the Treasury, Ed Balls stated “ the UK Government will now legislate to protect our regulatory approach. This legislation will confer a new and specific power on the FSA to veto rule changes proposed by exchanges that would be disproportionate in their impact on the pivotal economic role that exchanges play in the UK and EU economies. It will outlaw the imposition of any rules that might endanger the light touch, risk based regulatory regime that underpins London's success.”

The Financial Services Authority has made its view clear in February 2005 and again in June 2006.

[W]e will be indifferent to the nationality of the owners or the managers of any future combined operation, and will be concerned to ensure that the future operation meets our regulatory standards. If the LSE remains a UK exchange under a new parent it will continue to be subject to FSA regulation as a Recognised Investment Exchange (RIE).

The LSE, as a UK RIE, plays a key role as a focal point for the wider regulatory framework, including capital raising and corporate governance. The attractiveness of the UK financial markets, and ultimately the competitiveness of EU capital markets, depends, in part, on a system of corporate governance and of regulation which is of a high standard, but is proportionate and adaptable and attuned to the requirements of users. (“Potential longer term implications of a change of ownership of the London Stock exchange”, FSA/PN/015/2005, 4 February 2005)

However, we believe that there could be circumstances where a more complex regulatory position might arise. Theoretically, in the longer term, a new entity might seek to achieve further benefits from rationalisation of its regulatory structure. This could at the extreme involve the LSE no longer being subject to UK regulation as an RIE. Its services might be provided from outside the UK, either from the US, another EU member state or an alternative location, through the provision of trading screens in the UK and with securities admitted to trading on the market operated from elsewhere. Such a move, were it to occur, would potentially have significant implications for various aspects of the wider regulatory regime as indicated in our February 2005 statement. If such a market were to be operated from the US it would require member firms and issuers to be registered with the SEC and subject to its oversight. (“Implications of ownership of a UK Recognised Investment Exchange by a US entity”, FSA/PN/055/2006 12th June 2006).

It is ironic therefore that the UK had to be reminded this week about the extra-territoriality of its own tax laws by the European Court of Justice. Though the tax rate in Dublin’s International Financial Services Centre is only 10%, the UK claimed an additional 20% tax on the Dublin subsidiaries of Cadbury Schweppes on the ground that these were “controlled foreign companies”. The European Court ruled that if the foreign subsidiary has offices, staff and operations in the foreign country, then the fact that it was set up with an intention to obtain tax relief does not make it a wholly artificial arrangement that justifies levying UK tax rates. Ireland is a country that has built up a vibrant financial services industry on the strength of a sound regulatory and tax regime. The court ruling will hopefully allow this to survive.

In general, I like regulatory competition. I think of a regulator as being in the business of manufacturing and providing regulatory products and services. Consumers of these products and services (investors, issuers and others) benefit if this industry is competitive. Similarly, healthy competition in tax rates also helps put a bound on the rapacity of the nation state. A vigorous defence of the competitive structure of the market for regulatory services is therefore very much welcome.

Posted at 15:41 on Sat, 16 Sep 2006     View/Post Comments (0)     permanent link

Wed, 13 Sep 2006

Household Financial Leverage in India

Buried inside the Global Financial Stability Report of the IMF (September 2006) is a graph showing India and New Zealand as the outliers in terms of high financial leverage in the household sector, but the data does not seem right. Figure 2.10 on page 55 shows Indian household leverage (ratio of financial liabilities to financial assets) as about 60%, exceeded only by New Zealand’s 80%. India does not publish sectoral balance sheets, but the flow of funds data is grossly at variance with this number of 60%. If we cumulate the last several years’ change in financial assets, liabilities and physical assets from Tables 10 and 11 of the RBI’s Handbook of Statistics, 2005, the following picture emerges. Cumulative household financial savings are about 100% of GDP, cumulative household financial liabilities are about 20% of GDP and cumulative household physical savings are about 80% of GDP. This would imply household leverage of 20/180 or about 11%. This broad picture does not change whether I cumulate the last 35 years of data or just the last 10. I am struggling to understand how the IMF gets a number more than 5 times this estimate of about 11%. If one considers that most household assets (equities, real estate or gold) would have appreciated in value over the years while most liabilities would be fixed in nominal terms, the financial leverage evaluated at market prices must be even lower than the above estimate of 11%. Of course, the IMF says that it got the number from national authorities. So does the RBI/MOF/CSO see some household leverage out there that we are not seeing? Or is it all a mistake?

Posted at 13:28 on Wed, 13 Sep 2006     View/Post Comments (1)     permanent link

Fri, 08 Sep 2006

HP Boardroom Leaks and Disclosure

While corporate disclosure in offer documents and to a lesser extent in annual reports is reasonably informative and neutral, material event disclosure still tends to consist of sanitized half truths. I have spent some time comparing:

The New York Times reports that Thomas Perkins resigned from the HP Board in protest when he found that HP had used private detectives to monitor telephone calls by board members. It also reports that these detectives approached the phone company with the last four digits of Perkins’ social security number and tricked them into “revealing the multidigit code that would allow a person to set up an online account for access to billing statements ”. Using this the detectives viewed the list of his phone calls. According to the news report, Perkins regards this as “possible fraud, identity theft and misappropriation of personal records”

The same events are described in HP’s SEC filing as follows: “the Chairman of the Board, and ultimately an internal group within HP, working with a licensed outside firm specializing in investigations, conducted investigations into possible sources of the leaks of confidential information at HP. ... some form of ‘pretexting’ for phone record information, a technique used by investigators to obtain information by disguising their identity, had been used. ... The Committee was then advised by the Committee’s outside counsel that the use of pretexting at the time of the investigation was not generally unlawful (except with respect to financial institutions), but such counsel could not confirm that the techniques employed by the outside consulting firm and the party retained by that firm complied in all respects with applicable law.”

The SEC filing also asserts that the “Date of Earliest Event Reported” in the filing is August 31, 2006. Since the “pretexting” in question happened in May 2006 or earlier and had not previously been disclosed by HP, it would appear that this statement at least is false. Probably, HP wants to avoid an impression that it was tardy in filing the Form 8-K. Or perhaps, HP wants to claim that what is being disclosed is not all the sordid mess about the undercover investigation, but that as a result of the investigations, the Board decided on August 31, 2006 not to renominate George Keyworth who was reportedly the source of the leaks.

The Form 8-K filed by HP appears to me to be excessively sanitized to the extent of failing to communicate the gravity of the events. For example, “disguising their identity” is quite different from impersonating somebody else. It is evident that material event disclosure has a long way to go even in the US. In countries like India, the state of affairs is much worse.

Posted at 13:46 on Fri, 08 Sep 2006     View/Post Comments (0)     permanent link

Tue, 05 Sep 2006

More on Capital Account Convertibility 2.0

Sandeep Parekh tells me that my posting yesterday is not quite clear. So let me restate my views differently.

Posted at 16:28 on Tue, 05 Sep 2006     View/Post Comments (2)     permanent link

Mon, 04 Sep 2006

Capital Account Convertibility 2.0

The Reserve Bank of India (RBI) has published the report of the Committee on Fuller Capital Account Convertibility chaired by S. S. Tarapore. A committee with the same chairman and almost the same set of members gave a report on Capital Account Convertibility to the RBI in 1998. Therefore, in line with phrases like Web 2.0 and Bretton Woods 2.0, I have chosen to call it CAC 2.0.

I resolved not to blog about CAC 2.0 until I had read the report fully. Since the report is over 200 pages long, it was only with great difficulty that I have managed to adhere to this resolve. My first set of comments are as follows:

Posted at 16:22 on Mon, 04 Sep 2006     View/Post Comments (0)     permanent link

Sun, 27 Aug 2006

Quattrone and Regulating Initial Public Offerings

It is not often that I disagree vehemently with a Financial Times editorial, but that is what I found myself doing when I read “Quarter for Quattrone: A reminder that regulating is more efficient than prosecuting” Financial Times, August 25, 2006. Analysing the lessons from the prosecution’s failure to establish its charges against Frank Quattrone, the star technology analyst of the dot com era, the Financial Times writes:

In retrospect, and certainly in light of what happened this week, it would have been far better if regulators had stepped in earlier to impose some discipline, perhaps by insisting that companies show some record of profit before coming to market. Prevention could be far more effective than prosecutions have proved.

The big advantage of a capital market dominated financial system over a bank dominated system is its ability to provide risk capital to innovative enterprises that have not established any track record. The Financial Times appears to be saying that we must stop the capital market from performing this function. I am reminded of the old age that a ship is safest when it is in the harbour but that is not where it is intended to be. A capital market that does not allocate risk capital will be much safer and much less scandal prone, but it will not be a market worth having.

The Financial Times would have been on much stronger ground if it had asked why the regulators chose the easy path of focusing the Quattrone prosecution on his alleged role in destroying potentially incriminating emails rather than on the substantive wrongs that he is alleged to have committed in the IPO process.

Posted at 21:16 on Sun, 27 Aug 2006     View/Post Comments (0)     permanent link

Sat, 19 Aug 2006

Alleged Manipulation of CME Cash Cheese Market

The cash cheese market at the Chicago Mercantile Exchange (CME) has been in the news recently for alleged price manipulation. (For example, "CME in cheese price fix investigation", Financial Times, August 17, 2006.). Six senators including Hillary Clinton have demanded an investigation.

A decade ago, the cash cheese market used to be at the National Cheese Market and one reason for moving the market to the CME was the hope that oversight by the Commodities Futures Trading Commission (CFTC) would clean up the market. It appears that the political establishment is still not satisfied about the integrity of the market.

On closer analysis, it is difficult to see how the integrity of this market can ever be ensured as long as the US government manipulates the US milk market with the Federal Milk Marketing Order (FMMO). FMMO sets minimum prices paid to farmers for liquid milk based partly on cheese prices. Essentially, FMO regards liquid milk as a combination of butterfat, proteins and other solids. The weighted average price of hard (cheddar) cheese, dry whey and butterfat determines the price of what FMMO calls Class III milk. It then adds a price differential (varying across regions) to this to get the price of liquid milk (Class I milk).

The FMMO relies on cheese prices reported from surveys by the National Agricultural Statistical Service (NASS), but since practically all large cheese transactions are based on CME prices, NASS reflects CME prices with a lag. Thus by manipulating CME prices, the big diary companies can affect prices determined under the FMMO.

This means that the big diary companies have every incentive to manipulate CME cash cheese prices. Milkweed reported in May 2006 that “A major focus of CFTC’s investigation centers on Cheddar cash market activities by Dairy Farmers of America – the nation’ largest dairy farmers’ cooperative” over the last five years. Complaints have also been made against Kraft.

The best that the US senate can do to clean up the market is to get rid of the depression era legislation that mandates government intervention in the milk market.

Posted at 15:19 on Sat, 19 Aug 2006     View/Post Comments (0)     permanent link

Wed, 16 Aug 2006

Global Diversification and Indian Mutual Funds

Ajay Shah has a detailed analysis of the regulations governing international investment by Indian mutual funds. His conclusion: “Small pieces of progress on economic policy in India seem to take a long time.” I entirely agree. There is a need to move much faster. Moreover the first thing that needs to be liberalized is access to global index products. The actual regulations appear to reflect not only the fear of a more open capital account, but also some degree of regulatory capture. Obstacles in the path of exchange traded funds serve to protect management fees in the fund management industry.

Posted at 12:42 on Wed, 16 Aug 2006     View/Post Comments (0)     permanent link

Financial Regulators and the Media

Nouriel Roubini’s Global Economics Blog has an aside on the interaction of Fed Chairmen with the media.

In 1987, the relatively inexperienced Greenspan did not know how to properly communicate his message and he rattled markets. He presented his views in the wrong forum by giving an interview to a Sunday television news show where he expressed his concerns about inflation; the next day stock markets sharply wobbled. He learned his lesson, realized the risks to his reputation, made a mea culpa, never again gave a TV interview for the following 20 years and became altogether Delphic in his public pronunciations. Ditto for Bernanke: after a congressional testimony on April 27th that was read by investors as dovish, he made the famous flap with CNBC anchor Maria Bartimoro telling her that he had been misunderstood and was more hawkish than the market perceived him. The next day – when Bartimoro reported this – equity markets sharply contracted and Bernanke’s reputation was shaken. Bernanke then made his own public mea culpa and you can be sure that – like Greenspan – he will never speak again to any TV reporter, either in private or in public.

This set me thinking about the issue of financial regulators interacting with the media. Should the selective disclosure regulations that apply to corporate managements apply to financial regulators? In principle, I think the answer is yes. The ideal solution would be for every financial regulator to maintain a blog and use that as the primary means of communicating with the outside world. If the regulator wants to respond to a reporter’s query, the response should be on the blog with due credit to the reporter who raised the query. If the media wants sound bytes and visuals that is fine so long as the regulator does not go beyond what is there on the blog. If there is any deviation, that should hit the blog very rapidly.

Transparency is imperative and a blog is today the most transparent medium available.

Posted at 12:31 on Wed, 16 Aug 2006     View/Post Comments (0)     permanent link

Wed, 09 Aug 2006

Hedge funds are not unregulated!

The Chairman of the US Securities and Exchange Commission declares boldly that hedge funds are not unregulated. Announcing the SEC’s decision not to appeal a court verdict invalidating the hedge fund registration rules, Chairman Cox states:

Finally, notwithstanding the Goldstein decision, it is important to point out that hedge funds today remain subject to SEC regulations and enforcement under the antifraud, civil liability, and other provisions of the federal securities laws. The SEC will continue to vigorously enforce the federal securities laws against hedge funds and hedge fund advisers who violate those laws. Hedge funds are not, should not be, and will not be unregulated.

One can well imagine an excerpts from this paragraph adorning the publicity material of a hedge fund to reassure its investors that a hedge fund is a well regulated entity not too different from a mutual fund!

I understand the feeling of “sour grapes” that underlies the statement of Cox. But one expects a little more care and circumspection from the top securities regulator in the world. A good deal of anti fraud and civil liability exists even under contract law. Push the logic a little further and one could argue that the SEC does not need to exist. Ha! Ha! Perhaps we should all re-read Stigler’s classic paper on that subject once again (Journal of Business, Volume 37, 1964, page 117-142 and 382-422).

Posted at 14:15 on Wed, 09 Aug 2006     View/Post Comments (0)     permanent link

Tue, 08 Aug 2006

Binary options on the Fed Funds Target Rate

Many exotic options leave one wondering whether they serve any real purpose other than producing fat margins for the investment banks that manufacture them. Binary options on the Fed funds target are an interesting exception where there is a clear rationale for a binary rather than a vanilla option.

Every six weeks, the US Federal Reserve (Fed) meets to decide on changes to its monetary policy. The key instrument that the Fed uses is the Fed Funds target. This is essentially a target that the Fed sets for the overnight inter bank interest rate. The Fed supplies or withdraws liquidity from the market so as to ensure that the interest rate on Fed funds does not deviate by more than a few basis points from the target set by it. In the bad old days, the Fed did not announce this target but left it to be inferred by market participants from the behaviour of the Fed. However, for several years now, the Fed annnouces this target explicitly at the end of each meeting.

Most hedging activity related to the Fed funds target happens in the Fed Funds Futures market which trades monthly contracts that settle using the average Fed funds rate in that month. The difficulty is that since the Fed Comitttee meets once in six weeks, this meeting will often happen in the middle of the month. Fed funds target changes will also happen mid way through the month. Ignoring the differences between the actual Fed funds rate and its target, the settlement rate for the monthly Fed funds contract will then be close to the weighted average of the old target rate and the new target rate. It will not be exactly equal to this weighted average because of the slight deviation of a few basis points between actual and target rates.

All this is very messy compared to the CBOT’s Binary Options on the Target Federal Funds Rate. These binary call and put options are available for the next four Fed Comitttee meetings at strikes ranging from 250 basis points below the current target to 250 basis points above the target at intervals of 12.5 basis points. The payout is $1,000 if the option expires in-the-money, and $0 if it does not.

Though this contract was launched only a month ago, it has picked up a tiny but fast growing open interest (less than 3,000 contracts compared to over 0.5 million contracts on vanilla Fed fund options). The Financial Times has an interesting report.

For those who use Fed Fund derivatives to hedge Fed fund interest rate risk itself, the binary offers nothing truly exciting, but for those who treat changes in the Fed Fund target as a driver of risk appetite in other markets, the binary clearly makes a lot of sense. For example, if you believe that a change in the target rate impacts emerging market bonds or equities, then the binary is the right hedging tool.

The usual arguments about discontinuous and unhedgeable Greeks of binary options do not apply in this case because the discontinuity is characteristic of the risk being hedged.

Posted at 18:31 on Tue, 08 Aug 2006     View/Post Comments (0)     permanent link

Tue, 01 Aug 2006

Does it take three years to register securities?

Yesterday, the US SEC issued an exemption order allowing NASDAQ members to continue to trade (till August 2009) a handful of securities that have not been registered with the SEC nor are deemed to be registered with it. The vast majority of NASDAQ listed stocks are covered by a separate order under which the SEC treats them as registered securities on the basis of the information that they have already filed with the SEC under different statutory provisions. The exemption order that I am focusing on covers only four insurance companies and nine private foreign issuers. Even for these issuers, I can well understand the need for a transitional provision as the NASDAQ converts itself into an exchange, but I am amazed that this exemption lasts for as long as three years. An SEC registration is an expensive and time consuming process, but to the best of my knowledge the time involved is measured in months and not in years. A one year exemption would have been much more appropriate especially when the number of issuers involved is so small.

By granting a three year exemption, the SEC is signaling that it regards the conversion of NASDAQ into an exchange to be a mere change of nomenclature in which nothing substantive changes.

Posted at 16:10 on Tue, 01 Aug 2006     View/Post Comments (2)     permanent link

Wed, 26 Jul 2006

IPO Quiet Periods

There has been a lot of discussion in the press about the reported move by the Securities and Exchange Board of India to introduce a “quiet period” prior to public offering of securities. Ajay Shah blogged in support of this idea here. The financial press in India also seems to have been largely supportive. Sandeep Parikh provides links to several press reports in his blog. Sandeep Parikh himself has been supportive of the quiet period.

The quiet period is a long established practice in the United States though as Sandeep Parikh points out, US regulations have been dramatically liberalized this year. The purpose is clearly to ensure that securities are sold using a carefully written prospectus and not on the basis of advertisements and other marketing material.

While the goal may be laudable, I think that the quiet period is basically a bad idea. First of all, I am very sceptical about any restraints on the freedom of speech. To my mind, free speech comes much higher in the hierarchy of rights than the right to property. Therefore, if somebody’s free speech conflicts with somebody else’s property rights, I would think that normally it is the free speech that must prevail. I can understand the desire to ensure that any advertising is not misleading, but I cannot understand a ban on general corporate advertising.

Secondly, in practice, the ban extends only to written material. The SEC has now clarified that written material includes videos placed on a website but it excludes communications that are carried live and in real-time to a live audience. This is immensely anti competitive and benefits only a cosy club of investment banks and other financial intermediaries. What it means that an issuer can carry a “soft” advertising message to the investor only through road shows to investor groups. Typically, it is only an investment bank that can organize these road shows. All that the SEC is doing is helping these banks collect their rents. To understand the implications of this, let us take this out of the securities setting. Imagine a rule that said that soft drinks cannot be advertised but live road shows to live audiences are allowed. The Cokes of the world would then have to pay the Walmarts to do road shows in their various retail stores and the Walmarts would surely lobby vigorously for such a rule to be kept in place. Or imagine a rule that said that election meetings and door to door campaigns are allowed but no election related advertising is allowed. Cadre based parties would love this because it increases the entry barrier for new political formations.

These general principles applies to the securities industry as to any other industry. Restrictions on advertising are anti competitive. They favour incumbents. They allow intermediaries to earn rents. Unfortunately regulators are captured by these intermediaries and it is often this regulatory capture that leads to such anti competitive regulations. Sadly, all this is done in the name of consumer protection or investor protection.

Posted at 18:05 on Wed, 26 Jul 2006     View/Post Comments (1)     permanent link

Thu, 20 Jul 2006

FSA as a Regulatory Role Model

Ajay Shah discusses the regulatory successes of the UK’s Financial Services Authority (FSA) in an article in the Financial Express and on his blog. The discussion is related to the common law versus civil law orientation that I blogged about a few days ago.

So is the FSA more common law oriented than other securities regulators? That depends on whom you compare it with. I would imagine that Ajay Shah was comparing the FSA with the Indian regulators (the Securities and Exchange Board of India and more importantly the Reserve Bank of India) and perhaps also with the US Securities and Exchange Commission. If these were his benchmarks, then Ajay Shah is undoubtedly right. The conclusion would also remain valid if the comparison is with the other super regulator that all UK institutions have to contend with - the European Commission. By these benchmarks, the FSA has been a success story that other regulators could seek to emulate.

However, these reference points set the bar too low. I would put forward three other reference points against which the FSA’s performance looks much less impressive.

  1. The first and most obvious comparison would be with the regulator across the border in Ireland which has established itself as a global centre of excellence for hedge funds and other alternative investment vehicles. Most people that I have talked to agree that the IFSRA is one of the smartest and most flexible securities regulators in the world. Before the formation of the IFSRA, the Central Bank of Ireland also had a similar well deserved reputation. In comparison to the IFSRA, the FSA comes across as much more of a check-box or civil law oriented regulator.
  2. Another comparator is the plethora of self regulatory organizations that existed prior to the formation of the FSA. Most observers think that the formation of the FSA saw the emergence of a more rule oriented regulation than what existed earlier. A large part of the staff of the FSA came from the Bank of England and brought with them a more heavy handed regulatory style. The FSA of course had to operate within the limits of its statute and this prevented an excessive civil law orientation.
  3. The last point of reference is the US SEC in its heyday. All regulators are more flexible and competent in their youth. As they age, they tend to ossify and lose their brilliance. Since the FSA is in its early days of existence, a comparison with the Douglas or Landis SEC would be appropriate. A comparison across such a long time gap is problematic. Markets have become more complex and therefore there is a case to be made for more complex regulations. Yet, as I read the situation, the SEC of those days was probably smarter and more flexible than the FSA of today. Though the SEC was a product of a civil law era in US administration (the New Deal), Douglas made the SEC the most successful and least civil law oriented of all the New Deal agencies.

I do have an uneasy feeling that both Ajay Shah and I are relying on anecdotal evidence and an intuitive understanding of how the FSA and other regulators function. There is a need for a more rigorous academic evaluation based on measurable and quantifiable parameters.

Posted at 13:45 on Thu, 20 Jul 2006     View/Post Comments (0)     permanent link

Tue, 18 Jul 2006

Legal Origins and Modern Stock Markets

Mark Roe has written a fascinating paper at SSRN challenging many of the conclusions of La Porta, Shleifer and others that a common law regime favours the development of stock markets and a civil law regime impedes it.

Roe’s first line of attack is to show empirically that the intensity of labour regulation is a better predictor of financial market development than legal origin. Roe goes on to link this with the devastation that the core civil law countries suffered in the world wars. “Early twentieth century ruin strongly predicts late 20th century financial markets’ strength. It may explain both post-World War II strong labor policy in the devastated nations and the weaknesses of securities markets in the same nations.” Roe has a nice theoretical argument to provide the linkage: “If a nation’s middle class’ financial savings were devastated first by inter-war hyper-inflation and depression and then by war-time destruction of the underlying physical assets, then voters for decades after 1945 could have cared little about financial capital because their well-being was tied more to their human capital. ”

The second line of attack is to deny that modern securities regulation in common law countries has any common law characteristics left anymore. I think Roe is on strong ground here when he says that SEC regulations are more in the civil law tradition than in the common law tradition. People like me who thought that was merit in the common law approach would then have to conclude that the direction in which the SEC has taken securities regulation in the last few decades is a big mistake.

All said, Roe has written a very thought provoking paper

Posted at 20:32 on Tue, 18 Jul 2006     View/Post Comments (1)     permanent link

Mon, 10 Jul 2006

Accounting Standard Setters Capitulate to Financial Economics

The International Accounting Standards Board and the US Financial Accounting Standards Board have issued preliminary drafts of the first two chapters of their proposed joint Conceptual Framework for Financial Reporting. This available at the FASB web site.

The draft document appears to me to represent the triumph of financial economics over traditional accounting. For example:

Posted at 15:55 on Mon, 10 Jul 2006     View/Post Comments (0)     permanent link

Thu, 29 Jun 2006

A First Cut Estimate of the Equity Risk Premium in India

Prof S K Barua and I wrote a paper estimating the equity risk premium in India using data for the last 25 years. We address the shortcomings of existing indices by constructing our own total return index for the 1980s and early 1990s. We use our estimates of the extent of financial repression during this period to construct a series of the risk free rate in India going back to the early 1980s. We find that the equity risk premium is about 8.75% on a geometric mean basis and about 12.50% on an arithmetic mean basis. There is no significant difference between the pre reform and post reform period: the premium has declined marginally on a geometric mean basis and has risen slightly on an arithmetic mean basis. The reason for this divergence between the sub period behaviour of the two means is the increase in the annualized standard deviation of stock market returns from less than 20% in the pre reform period to about 25% in the post reform period. The higher standard deviation depresses the geometric mean in the post reform period.

Posted at 15:14 on Thu, 29 Jun 2006     View/Post Comments (0)     permanent link

Tue, 27 Jun 2006

Volatility so far has been benign

Yesterday, I wrote an article in the Financial Express saying that volatility in the Indian stock market so far has been benign and there is no need for regulatory intervention. You can also read the story here. The article concludes by saying that:

The volatility that we have witnessed so far has been benign. While there have been large losses, there have been no major defaults or bankruptcies. Risk management systems at the exchanges have held up well. The volatility has been large enough to grab headlines but not large enough to cripple the markets. Volatility on this scale serves to focus attention on the huge fundamental uncertainty that exists. Several years of booming economies and rising asset prices have led to a reduction of risk premiums to the point where risk is probably under priced in many markets. A period of heightened volatility serves as a gentle reminder that prices can go down as well as go up. If this reminder leads to a re-pricing of risk in domestic and global markets, that is also welcome.

Posted at 14:27 on Tue, 27 Jun 2006     View/Post Comments (0)     permanent link

Fri, 23 Jun 2006

Partnoy on Rating Agencies

Frank Partnoy has an interesting paper entitled “How And Why Credit Rating Agencies Are Not Like Other Gatekeepers”. I have talked about rating agencies on this blog here and here. Partnoy brings several new insights into this discussion.

Partnoy also has an extended discussion criticizing the way ratings agencies rate CDOs and argues that CDOs are there only because of rating arbitrage: “Put another way, credit rating agencies are providing the markets with an opportunity to arbitrage the credit rating agencies’ mistakes”. I would not agree with this part of Partnoy’s analysis. The intense competition between the two major rating agencies to produce better CDO rating models would rather suggest that rating arbitrage is a passing phase in a maturing market.

But Partnoy has written a very informative and thought provoking paper on rating agencies. I entirely agree that the time has come to eliminate the regulatory use of ratings completely.

Posted at 18:40 on Fri, 23 Jun 2006     View/Post Comments (3)     permanent link

Thu, 22 Jun 2006

Governance of Investment Institutions

Just before my long vacation, I wrote an article for CFO-Connect arguing that the corporate governance problems of the twentieth century are essentially problems of governance at the big investment institutions. These problems meant that shareholder empowerment ceased to be an effective corporate governance weapon. I also argue that I expect this century to be different because of the rise of hedge funds and also improvements in governance at other institutions. If shareholder empowerment works, empowerment and reform of the Board becomes less important than reconnecting the Board to the company. That leads to a different way of looking at Sarbanes-Oxley.

The text of this article as I wrote it is available here. The scanned image of the article as it appeared in print is also available.

This is my first post after a long vacation.

Posted at 11:01 on Thu, 22 Jun 2006     View/Post Comments (2)     permanent link

Mon, 24 Apr 2006

I am off for six weeks

I am on vacation for about six weeks till early June. I will not be posting on my blog during this period.

Posted at 18:46 on Mon, 24 Apr 2006     View/Post Comments (0)     permanent link

Thu, 13 Apr 2006

Have risk premiums declined?

The IMF’s Global Financial Stability Report, April 2006 has a discussion about risk premiums (Box 1.2) which states

There is a widely held view that investors’ appetite for risk has increased over the past few years, leading to higher prices for risky assets and narrower spreads on credit and other risky products. ... However, the analysis here suggests that investors’ overall attitude toward risk appears not to have changed appreciably

Basically, the IMF says that that while the credit risk premium seems to have declined, there is little change in the equity risk premium. Therefore, on balance, the IMF seems to say there is no evidence of under pricing of risk.

This conclusion is problematic for several reasons. First the evidence on falling risk premium is not based only on a declining credit spread. The term structure spread also has a large risk premium component and this component appears to have declined sharply. Similarly, there is surely some evidence that currency risk premiums have declined. Some observers are even talking of the end of ‘original sin’. So even if we accept the claim regarding stable equity premium, I would think that the score is 3-1 in favour of a decline in premium rather than the 1-1 draw that the IMF seems to portray.

But even the claim regarding the equity risk premium has to be taken with more than a pinch of salt. First, equity risk premiums declined sharply in the late 1990s and even an unchanged premium is still quite low by longer historical standards. Second, the estimate of risk premium is based on the earnings yield without any adjustment for growth. Most discussions on over pricing of equity today emphasize the apparent disconnect between the high growth expectation embedded in current valuation and the low long term interest rate. Thus any discussion of equity risk premium that treats the earnings yield as the return on equity simply misses the point.

Posted at 15:26 on Thu, 13 Apr 2006     View/Post Comments (0)     permanent link

Wed, 05 Apr 2006

Foreign investment in rupee debt

Ajay Shah has written an interesting piece about what is wrong with India’s policy on foreign debt. His most important point is that India restricts foreign investment in rupee debt while being much more liberal about Indian companies borrowing in foreign currency internationally. I agree with Ajay Shah that this is truly absurd but it is fully explained by the political economy of the situation. The corporate sector usually gets what it wants through intensive lobbying. This happened in East Asia before the crisis and it is happening in India now.

We should work towards getting rid of ‘original sin’ and replacing foreign currency debt with rupee debt. There are though two caveats. First if foreign investors are allowed to hedge currency risk, then the true national exposure may still be that of foreign currency debt if it is an Indian entity that stands on the other side of the hedge. In fact, the effective position of the nation can be that of short term foreign currency debt. This problem is not insurmountable but some thought needs to be given to it.

Second, as Martin Wolf points out, many countries have been able to overcome ‘original sin’ and borrow in their own currencies “once they have persuaded their own citizens to lend to them”. We need a proper government debt market instead of the captive market that we have now.

Posted at 13:55 on Wed, 05 Apr 2006     View/Post Comments (0)     permanent link

Tue, 04 Apr 2006

Australian Insider Trading Case against Citigroup

There has been a lot of discussion in the press and in the blogs about an insider trading case launched by the Australian Securities and Investments Commission (ASIC) against Citigroup Global Markets Australia Pty Ltd. ASIC’s press release provides some details and has published the full text of ASIC’s Statement of Claim

The facts are that while Citi’s investment bankers were advising a potential acquirer, its proprietary trading desk was buying the target’s stock. When the investment bankers came to know about this, they informally communicated to the traders that they should not be buying. The traders then stopped buying and in fact sold some shares. Since the shares rose sharply when the bid was announced, the traders would have made more money if they had continued buying or held on to what they had already bought.

Much of the comments that I have read are sceptical about whether ASIC has any case at all. Several authors have pointed out that Citi did not profit from its selling and that the client actually gained. But after reading the statutes that ASIC cites, it appears to me that ASIC has framed its claim very well.

These statutory provisions seem to imply that in the absence of adequate Chinese Walls any trading in the securities concerned becomes insider trading regardless of whether Citi benefited from such trading or whether anybody suffered due to it.

Some commentators have suggested that modern financial conglomerates would find it impossible to function in such a situation. I think this is totally wrong. Conglomerates can still function freely provided they ensure that they have strong Chinese Walls and adequate mechanisms for managing conflicts of interest. If ASIC has its facts right, Citi’s systems were simply inadequate.

Posted at 14:39 on Tue, 04 Apr 2006     View/Post Comments (0)     permanent link

Sat, 01 Apr 2006

London and New York

Peter Weinberg, a former CEO of Goldman Sachs International has a piece in the Financial Times (“How London can close gap on Wall Street”, Financial Times, March 30, 2006) arguing why London could catch up with New York as the world’s leading financial centre. He believes that two factors give London a chance today:

  1. The huge amount of Arab money that goes to or through London because of political reasons.
  2. The preference for new issuers to list outside the United States due to Sarbanes-Oxley and other reasons.

Weinberg also suggests that an acquisition of the London Stock Exchange by a US exchange could facilitate this process.

We know that the United Kingdom has historically paid a big price for the success of London in the form of subordinating its domestic economic policies to the needs of the City. The United States has clearly shown that it is unwilling to do so. This would mean that even if London does gain, this will be a pyrrhic victory that does little good to the United Kingdom. See my post last year on whether financial centres are worthwhile.

Weinberg does however make an important point that New York’s dominance of global finance cannot be taken for granted. Those of us who had loosely interpreted Kindleberger as implying that a global centre is more or less secure in the absence of war or other serious upheaval should probably think again.

Posted at 15:08 on Sat, 01 Apr 2006     View/Post Comments (0)     permanent link

Tue, 21 Mar 2006

Informed trading or insider trading

Regulators seem to have great difficulty in distinguishing between informed trading and insider trading.

A study published in the Occasional Paper Series of the Financial Services Authority of the UK demonstrates that there are large (and statistically significant) abnormal stock returns ahead of takeover announcements. This is clearly evidence of informed trading but not necessarily of insider trading. After all, there is a lot of informed speculation ahead of any bid. The authors try to finesse the problem with an inappropriate definition of insider trading:

Throughout this paper the term “insider trading” is used to mean acting or causing others to act on material non-public information which could affect the value of an investment. This term is not a legal one but is intended to include the UK legal offences of insider dealing and misuse of information.

The financial press has been quoting the study extensively as evidence of insider trading. John Gapper writes in the Financial Times “Last week, [the FSA] said there were signs of insider trading before 29 per cent of UK mergers and acquisitions announcements.” Steve Goldstein wrote an article in headlined “Insider trading rife in U.K. M&A: study ”. The opening sentence of the article uses the phrase “insider trading” while the second paragraph uses the phrase “informed trading”.

This confusion is unfortunate. Informed trading is the life blood of financial markets and if the only way to stop insider trading is to shut down informed trading, then it is far better to live with insider trading.

Posted at 13:37 on Tue, 21 Mar 2006     View/Post Comments (0)     permanent link

Mon, 20 Mar 2006

Advantages of Single Regulator

An interesting IMF Working Paper by Martin Cihak and Richard Podpiera present evidence that single regulators (covering banking, securities and insurance) are associated with higher quality of supervision and with higher consistency of regulation across the three sectors. One of the problems that they face is that integrated regulators are typically found in more developed countries with more mature regulatory environments. They control for both of these in their study. Controlling for income reduces the effect a great deal but it remains positive and in many cases, it also remains statistically significant.

The authors measure quality of regulation by conformance to various international standards on core principles of regulation.

Posted at 18:36 on Mon, 20 Mar 2006     View/Post Comments (2)     permanent link

Tue, 07 Mar 2006

Tobin Tax and Capital Gains

In response to my comments on the Indian budget, Prof. Ramesh Gupta states that the securities transaction tax can be justified as a kind of Tobin tax to discourage speculative transactions. I disagree on two counts. Frist, I do not like the Tobin tax, but I will not get into this in detail because there is a huge literature on the Tobin tax and I do not think I have anything original to say on this subject. My second point of disagreement is more subtle. A Tobin tax and a revenue maximizing transaction tax are very different in terms of the tax rate. As Tobin himself emphasized, the rate of the Tobin tax should be exceedingly small so as not to affect true price discovery. A revenue maximizing transaction tax on the other hand would be much higher.

In India, the transaction tax was introduced as a substitute for the capital gains tax. This I think is a mistake. It forces the government to progressively move the rate towards a revenue maximizing rate and thereby endanger price discovery in the market. I believe that the current rate of the transaction tax is much higher than what a Tobin tax would be. More important is the question of fairness. Ideally, the real returns on all investments should be taxed at the same rate. Today, the return earned on equities is taxed at a negligible rate. Return earned on bonds is taxed at much higher rates as is salary income (which is return earned on investment in human capital). This is unacceptable from a fairness point of view. From a merit point of view also, it is difficult to make out any case for preferring investment in equities to investment in human capital.

Posted at 17:30 on Tue, 07 Mar 2006     View/Post Comments (1)     permanent link

Thu, 02 Mar 2006

Capital gains tax

I wrote a piece in yesterday’s Financial Express about the budget proposal related to capital gains taxation and securities transaction tax. I wrote that the government seems to have realized that its decision two years ago to replace the capital gains tax on securities with a tax on securities transactions was a mistake. My article makes the following points:

Posted at 14:19 on Thu, 02 Mar 2006     View/Post Comments (2)     permanent link

Wed, 22 Feb 2006

FSA Loses Minmet Insider Trading Case

The Independent pointed me to a very interesting decision by the Financial Services and Markets Tribunal overturning an insider trading decision of the Financial Services Authority in the United Kingdom.

The most damaging part of the tribunal’s decision is towards the end when it states:

We have kept in mind that the burden of proof lies on the Authority, and the standard of proof (the balance of probability) must take into account the gravity of the allegation made. But our decision in the applicants favour does not depend on the burden of proof. On consideration of the whole of the evidence we are satisfied that there was not a telephone conversation between Mr Nolan and Mr Baldwin on 29 July 2003, and are satisfied that WRT’s trading in Minmet and Tiger shares was innocently conducted.

Usually when courts and tribunals acquit somebody they are quite happy to take shelter under the assertion that the prosecution has not met the standard of proof. Here the tribunal goes beyond this to assert that the accused have proved that they are innocent. It is difficult to imagine a more comprehensive defeat for a regulator.

Interestingly, the tribunal avoids even a suggestion that the main prosecution witness was lying. Even while stating categorically that they preferred the evidence of the accused to that of the key prosecution witness, the tribunal states:

We found no reason to doubt the good faith of any of the witnesses, who we considered were all doing their best to assist us.

The experts that the FSA relied on are also treated kindly but the tribunal does find that the experts were “inappropriately constrained” by the remit that the FSA gave them. At the end of it all, only the FSA comes out as the loser in this decision.

Posted at 13:39 on Wed, 22 Feb 2006     View/Post Comments (0)     permanent link

Mon, 13 Feb 2006

Reliance Demerger as Backdoor Delisting

I wrote an article in today’s Financial Express about the Reliance demerger.

In January 2006, Reliance Industries Limited demerged four companies accounting for about a quarter of its market capitalization. The delay in listing these new companies means that about a quarter of the original company (representing a market value of over $7 billion) have been effectively delisted since January 18, 2006.

This has three consequences

  1. Millions of shareholders in these companies cannot trade these shares.
  2. The corporate governance provisions regarding independent directors and investor protection do not apply to these companies.
  3. These companies are under no obligation to provide the continuing material event disclosures to the exchange that a listed company is required to provide.

The result is that a company with a million shareholders is subject only to the disclosure and governance regime that applies to a mom and pop company with a dozen shareholders.

I argue that the exchanges and the regulator should not look at the listing of the demerged companies through the framework of initial public offerings that are obviously designed to make it difficult for a company to list. Rather they should use the framework of the delisting guidelines which are designed to make it difficult for a company to delist. The situation in a demerger or delisting is that the public has already put in its money and the regulator’s priority is to ensure that the company does not slip away from the clutches of the listing regulations.

Posted at 18:36 on Mon, 13 Feb 2006     View/Post Comments (1)     permanent link

Tue, 07 Feb 2006

Leverage in banks and derivatives

Commenting on my blog about an Economist column on CDOs, Ajay Shah wrote in his blog that the comparison between derivatives and banks is equally instructive when looking at leverage. He points out that leverage in banking is more than in derivatives and correctly argues that the (inverse of the) capital adequacy ratio is not the correct measure of leverage for a like-for-like comparison with derivatives leverage.

I completely agree with Ajay on this. I present below a few like-for-like comparisons of varying levels of sophistication all of which point to the same reality that banks embody high levels of risk:

Posted at 15:38 on Tue, 07 Feb 2006     View/Post Comments (1)     permanent link

Thu, 02 Feb 2006

Economist Buttonwood on CDOs

When I first read the Buttonwood column on Collateral Debt Obligations (“Of Scorpions and Starfighters”, Economist, January 31, 2006), I disagreed strongly with it but put it aside without much further thought. But then Anuradha suggested that I should blog about it; so here I go.

Buttonwood paints a picture of CDOs as being dark and mysterious things and so I began to wonder what is it about CDOs that creates unease in the minds of many. A CDO is a fairly straightforward and legitimate instrument. After all, a commercial bank is at bottom nothing but a CDO — though doubtless it is a rather crude and old fashioned way of creating a CDO.

I therefore went through the Buttonwood column replacing CDOs by banks and bank loans. A large part of the column goes through quite nicely. This is a sample of a few paragraphs:

If most of the borrowers stay solvent, the bank makes good money. If more than a handful default, then depositors and investors begin to take a hit ... The precise mixture of risks and payouts depends on how the bank is managed.

Moreover, the value of a bank loan portfolio depends not just on expected rates of default, but also on what might be recovered from defaulting companies’ assets. ... Bank loan portfolios are dynamic: they are in the hands of managers who can weed out the exposure to companies before they default, or trade credit risk with the aim of improving the portfolio.... Banks slice themselves into tranches of differing risk — deposits, (subordinated) debt and equity. Thus in theory investors can pick the collection of risks that suits them. They are helped by the existence of credit ratings, at least for the safer tranches (the riskiest equity tranches, which bear the first loss in the event of default, usually have no rating). But they must also consider the likely market price of the tranche they invest in, both for accounting reasons and in case they want to sell before maturity.

Bank loans are not that actively traded .... So it is often near impossible to establish a market price for them. Accountants have a horrible time when auditing books of illiquid bank loans, being forced to use numbers that they know are nearly meaningless.

One can go on with much of the rest of the column. For example, Buttonwood decries CDOs of CDOs, but in reality a CDO squared is not very different from a bank lending to another bank or investing in the subordinated debt of another bank. But let me not belabour the point.

Buttonwood also seems to think that cash settlement of credit derivatives is a bad thing that somehow disconnects them from reality. This is not true at all — the only difference between cash and physical settlement is one of transaction costs. Buttonwood is also worried about the notional vlaue of credit derivatives exceeding the total amount of debt that the company has issued. Again this is quite common in derivative markets. People are quite willing to take a little basis risk to operate in a more liquid market and therefore the largest derivative contracts usually attract a volume and open interest that is much larger than the direct risk exposure to the underlying of this contract. It is natural for people to use Delphi related CDSs or CDOs to hedge exposures to the entire auto component industry and also to cross hedge some General Motors or even auto industry risk. It is not at all surprising that the notional far exceeds the outstanding debt of Delphi

Let me end with a provocative question. Having invented banks first, humanity found it necessary to invent CDOs because they are far more efficient and transparent ways of bundling and trading credit risk. Had we invented CDOs first, would we have ever found it necessary to invent banks?

Posted at 21:54 on Thu, 02 Feb 2006     View/Post Comments (3)     permanent link

Mon, 30 Jan 2006

FASB may kill fair value accounting by permitting it

I have long argued that the alternative to fair value accounting is unfair value accounting and so I should normally be cheering the proposal by the Financial Accounting Standards Board (FASB) to permit fair value accounting for financial assets and liabilities. But actually, I am not happy at all.

The FASB’s Exposure Draft entitled The Fair Value Option for Financial Assets and Financial Liabilities “would create a fair value option under which an entity may irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities on a contract-by-contract basis, with changes in fair value recognized in earnings as those changes occur.” There are two problems with this exposure draft. First is that the fair value option can be exercised on a contract by contract basis allowing the company to chery pick profitable contracts to show on fair value basis while showing the loss making contracts on historical cost basis. The requirement that the fair value election is irrevocable provides only partial protection against this. The second problem that aggravates the cherry picking danger is that there are no safeguards at all on how this option can be exercised. Comparing its proposal with International Accounting Standard 39 (IAS 39), the FASB states:

This Statement has no eligibility criteria for financial assets and financial liabilities, whereas IAS 39 (as revised in 2005) indicates that, for other than hybrid instruments, the fair value option can be applied only when doing so results in more relevant information either because it eliminates or significantly reduces a measurement or recognition inconsistency (that is, an accounting mismatch) that would otherwise arise from measuring assets or liabilities or recognizing the gains and losses on them on different bases, or because a group of financial assets, financial liabilities, or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity’s key management personnel.

The FASB proposal thus threatens to make fair value accounting very attractive to the scoundrels. The market recognizing this would penalize any entity that exercises this option. Thus fair value accounting would be killed by a proposal that professes to permit it.

I think fair value accounting should be the default method for all financial assets and liabilities. Companies should be allowed to irrevocably elect historical cost accounting (on an asset class by asset class basis) if they can show that this is more relevant and reliable because (a) market prices are not readily available and (b) fair values estimates have too much subjectivity.

Posted at 16:54 on Mon, 30 Jan 2006     View/Post Comments (0)     permanent link

Wed, 25 Jan 2006

Exchange Software Bugs Yet Again

Three instance of software glitches from Japan, United Staes and India during the last two months have convinced me that exchange software must go open source. This software is too important to be kept under wraps. The complete source code must be disclosed to the whole market to prevent recurrence of such problems.

Today’s Business Standard (N Mahalakshmi, “Sebi to audit NSE systems”, Business Standard, January 25, 2006) reports that the Securities and Exchange Board of India intends to conduct a systems audit of the National Stock Exchange (NSE) in response to the software bug in the computation of the index last week.

The NSE’s description of the error is as follows:

The special session for Reliance Industries Ltd was held from 8 a.m. to 9 a.m. so as to discover the price after the demerger. ... After the close of the special session the volume weighted average price for Reliance Industries Limited was Rs. 714.35. The adjustments to the base index value were suitably carried out to compute the index value so as to give effect to the demerger of Reliance Industries Ltd.

Trading was resumed as per normal market timings ... The market opened and the correct adjusted index value of NIFTY was also displayed to the market at the opening trade. The activity of NIFTY index computation was closely monitored after market opening and it was seen that the first few NIFTY index values were computed correctly taking into account the adjusted base index value. However once the first trade in Reliance Industries Ltd. was executed, it was observed that the NIFTY Index reflected incorrect value. The problem was analysed and found that due to memory initialization failure the last traded price being reckoned for index computation purpose was carrying an incorrect value. This resulted in a wrong NIFTY index value being displayed. The problem was identified and changes were carried out to reflect the correct value of the NIFTY index. The NIFTY index dissemination was stopped at 10.30 a.m and the correct display of NIFTY index value was made available to the market from 10.56 a.m onwards. The other indices remained unaffected.

This is the third serious exchange software bug that I have come across in the last two months. The other two errors happened in the two largest capital markets of the world:

  1. Last month, a software bug at the Tokyo Stock Exchange prevented a trader from cancelling a large erroneous order. I blogged about it here and here.
  2. Last week, a computer glitch at the Nasdaq casued closing prices of NYSE listed stocks to be misreported. Yahoo! News reported that “at approximately 5:50 p.m. Eastern time Wednesday, ... 16,669 transactions involving NYSE- and AMEX-listed stocks that had been made at 9:50 a.m. were reposted to the consolidated list. In many computer systems, those transactions overwrote the final closing price posted earlier that afternoon.

I am therefore completely convinced that exchange software must go open source. Alternatively, exchanges must take out large insurance policies to compensate any aggrieved party. By large, I mean something like 10% or 15% of the daily trading volume. For the NSE this may be therefore be in the range of a billion dollars.

Posted at 12:30 on Wed, 25 Jan 2006     View/Post Comments (3)     permanent link

Tue, 24 Jan 2006

UK Indexed Bond Bubble

John Plender has an interesting article in the FT (Risk aversion and panic buying, Financial Times, January 23, 2006) on the bubble in the UK inflation indexed bonds. Yields on the 50 year indexed bond have fallen to the extraordinarily low level of 0.38%. Plender argues that unlike other asset classes where bubbles arise from irrational exuberance, here it arises from panic or high risk aversion.

Compared to typical estimates of the historical average real long term interest rate of around 3%, the yield of 0.38% does appear ridiculously low. However, the situation is not so bad when we compare 0.38% with the historical average real short term interest rate of around 1%.

Morgan Stanley economists Richard Berner and David Miles discuss the issue of low long term yields in the US. They refer to the interesting FEDS paper by Don Kim and Jonathan Wright of the US Federal Reserve which decomposes the long horizon forward rate into four components. Recasting that analysis in terms of the real interest rate of a long term nominal bond we get three components:

The last of these is not present in an indexed bond and therefore the yield on an inflation indexed bond is likely to be lower than the real yield on a nominal bond. The interesting part is the real term structure premium. Kim and Wright show that this premium has collapsed from 2% in 1990 to 0.5% in 2005. From a theoretical point of view this premium can fall further and can in fact be negative. Only the liquidity preference theory of the term structure predicts a positive term structure premium. The expectations theory predicts a zero premium and the preferred habitat theory is agnostic about the sign of this premium.

Plender believes that indexed bond yields are depressed because pension funds are buying these assets for regulatory reasons and that the bubble could be pricked if either they turn to other assets or if the government could signal an intention to issue more long term indexed bonds. In the terminology of the preferred habitat theory, this merely states the truism that the term structure premium will change dramatically if some lenders or borrowers change their preferred habitat.

In the days when indexed bonds yielded say 3%, this yield would have decomposed into a expected short term real interest rate of say 1% and a term structure risk premium of say 2%. An yield of 0.38% would imply a term structure premium of -0.62% assuming that the short term real interest rate is unchanged. It is difficult to understand why a fall in the absolute value of the risk premium from 2% to 0.62% could be interpreted as a rise in risk aversion let alone as panic.

I share the view that there is a global asset market bubble and am quite sympathetic to the view that there is a bubble in UK indexed bonds as well. But I believe that Plender’s analysis is over simplified.

Posted at 12:44 on Tue, 24 Jan 2006     View/Post Comments (0)     permanent link

Wed, 18 Jan 2006

Best Price Rule in Takeovers

Two recent developments have brought into focus the right of all shareholders to receive the same price in a takeover (the “best price” rule). Many countries including India impose this requirement while the United States imposes it in a very narrow and almost meaningless way. One of the developments that I will talk about is that the United States is proposing to relax even further the already minimal best price rule that it has.

But I would like to begin with the United Kingdom. The Lex column in the Financial Times (“Lex: Virgin Mobile”, Financial Times, January 17, 2006) raises an interesting pricing issue in the proposed sale of Virgin Mobile to NTL in the United Kingdom. Lex calculates that if NTL rebrands its entire business as Virgin and pays the same royalty to Richard Branson as what Virgin Mobile pays currently, it would effectively add about 10% to what Richard Branson would get for selling his 72% stake in Virgin Mobile. Lex believes however that minority shareholders have no valid complaint:

Sir Richard does have more incentive than other shareholders to back the takeover, but under the City Code minorities do not have to sell out. They do not own the Virgin brand and have no independent entitlement to its value.

This is fair enough particularly because the Virgin brand is indeed separable from the cellular business. But in many other cases of this kind, there has been a problem in valuing the brand. Moreover, the brand is often inextricably intertwined with the business itself. There have been such instances in India as well.

The United States is proposing to cut right through this Gordian knot. Under its current regulations, the best price rule applies only to tender offers. If an acquirer takes a statutory merger route to an acquisition, the regulation does not apply at all. The two most important rules in tender offers are that:

  1. “The tender offer is open to all security holders of the class of securities subject to the tender offer ” (the all holders rule)
  2. “The consideration paid to any security holder pursuant to the tender offer is the highest consideration paid to any other security holder during such tender offer” (the best price rule)

Many (but not all) courts in the US have taken the view that the best-price rule applies to all integral elements of a tender offer, including employment compensation and other commercial arrangements that are deemed to be part of the tender offer, regardless of whether the arrangements are executed and performed outside of the time that the tender offer formally commences and expires. The US SEC believes that this interpretation has led many acquirers to disfavor tender offers in favor of statutory mergers where the best-price rule is inapplicable.

The SEC is therefore proposing amendments that establish that the best-price rule applies only to consideration “paid for securities tendered” instead of “during such tender offer” or “pursuant to such tender offer”. In addition, the SEC also proposes to introduce a blanket exemption for employment compensation, severance or other employee benefit arrangements.

The US regulations have always been fatally flawed because they provide almost no protection to minority shareholders in two step takeovers where large shareholders are bought at a high price and then other shareholders are bought out in a tender offer at a lower price. The best price rule looks only at price paid in the tender offer and does not look back to the price paid in transactions prior to the tender offer. Moreover, the ability to use the statutory mergers instead of tender offers has provided another loophole. It is strange that instead of plugging these glaring deficiencies in its regulations, the SEC is proposing to relax whatever little protections currently exist.

Posted at 13:46 on Wed, 18 Jan 2006     View/Post Comments (0)     permanent link

Mon, 16 Jan 2006

Financial Repression in China and India

Raghuram Rajan, Economic Counselor and Director of Research, International Monetary Fund says that “uniquely among fast-growing Asian economies, China has not raised its share of value added coming from high-skilled industries significantly, even as its per capita GDP has grown” and that the inadequacies of the Chinese financial system are to blame for this:

It is unlikely the chairman of a state owned corporation, cash rich because he no longer has to meet his social obligations to workers, will prefer to return cash to the state via dividends rather than retaining it in the firm, particularly when banks are under orders to restrain credit growth. And with financial investments returning so little, far better to reinvest cashflows in real assets. Indeed, liquidity plays a greater role than profits in determining real investments.

Similarly, the chairman of a private firm knows that financing from either the stock market or the state-owned banks is very uncertain. So he too will be unlikely to pay dividends, preferring instead to retain the capital for investment. Again, instead of storing this as financial assets and awaiting the right real investment opportunity, given the poor returns on financial assets, he has an incentive to invest right away.

These tendencies imply a lot of reinvestment in existing industries especially if cashflow in the industry is high, which inexorably drives down their profitability. And they imply relatively little investment in new industries. The inadequacies of the financial system would thus explain both the high correlation between savings and investment and the oft-heard claim that over 75 percent of China's industries are plagued by overcapacity. They also suggest why uniquely among fast-growing Asian economies, China has not raised its share of value added coming from high-skilled industries significantly, even as its per capita GDP has grown.

This is an interesting argument against financial repression. It is useful to remind ourselves once in a while that the occasional stock market scandal that we have seen in India since the beginning of economic reforms is a small price to pay for getting rid of financial repression. It is also necessary to recall that as a percentage of GPD, the annual losses to Indian households from financial repression were higher than the amount involved in even the biggest of the stock market frauds since 1991. For example, during 1980-81 to 1989-90, time deposits at commercial banks averaged over 25% of GDP. I have estimated that financial repression in the 1980s was about three percentage points. This implies that holders of time deposits at banks lost 0.75% of GDP annually. If we add the losses on other repressed financial assets (especially life insurance and provident funds), the total would certainly exceed 1% of GDP annually. By comparison, the total amount of fraud in the scam of 1991-92 (involving Harshad Mehta and others) was about 0.75% of GDP. The total amount of fraud in the scam of 2000-01 (involving Ketan Parekh) was less than 0.2% of GDP.

Posted at 14:26 on Mon, 16 Jan 2006     View/Post Comments (0)     permanent link

Mon, 09 Jan 2006

Some interesting titbits

The new year has brought with it a number of interesting titbits related to financial markets

Posted at 13:16 on Mon, 09 Jan 2006     View/Post Comments (4)     permanent link

Sat, 07 Jan 2006

Trading Error at BSE, India

Another new listing, another country, another trading error and a strange resolution. It is much smaller than the Mizuho trade that I have blogged about here and here. But its resolution is utterly strange.

On listing day a trader placed a sell order for about 400,000 shares of Tulip IT Services Limited at a price of Rs 0.25 at the BSE in Mumbai when the market price was around Rs 170. Since circuit filters do not apply on listing day in BSE, the trade executed causing a modest loss of about US $ 2.6 million.

What is interesting is the way that the exchange has resolved the issue. It says that:

  1. The buy orders at a price higher than Rs.96/- and matched against the said order, shall be deemed to have been transacted at such prices at which the trades were executed. The cut-off price of Rs.96/- has been arrived at by applying circuit filter limit of 20% on the issue price of Rs.120/- on the lower side on the lines of the existing practice of application of standard Circuit Filter of 20% in the regular market.
  2. All other existing orders below Rs.96/- and which got executed against the said sale order will be deemed to have been transacted at a price of Rs.171.15. The said price of Rs.171.15 has been arrived at by taking the weighted average price of the trades executed at or above Rs.96/- against the said sale order.
  3. All other orders placed subsequent to said sale order and which were matched against the said sell order will be deemed to have been transacted at a price of Rs.171.15.

In response my first Mizuho blog, Piyush Mishra commented that an erroneous trade is due to “the lack of oversight on the part of the broker/dealer” I agreed with that and wrote that “By nullifying erroneous trades, exchanges may actually be reducing the incentives for traders to install and use such software checks.”

I have therefore little sympathy for the BSE bailing out the offending trader by changing the traded price at all. But putting that objection aside for the moment, the solution adopted is still perverse. A trader who bought at Rs 97 pays Rs 97 while another who bought at Rs 95, is asked to pay Rs 171.15. That two traders in very similar situations are treated so differently is manifestly absurd and unfair. That the person who bid a lower price pays higher makes the solution even more ridiculous.

I recall a similar situation in the US in 2001. A hedge fund offered to buy Axcelsis Technolgies at $95 instead of $9.50 on the Nasdaq. Nasdaq cancelled all trades at prices below an arbitrary threshold of $22 and let the other trades stand. Floyd Norris wrote (“At the Nasdaq Casino, the Winners Get Stiffed”, New York Times March 2, 2001) about a day trader who sold into the erroneous trade and then covered his short position at a profit of $145,908. When the Nasdaq cancelled the trades selectively, this trader found that his share sales had been cancelled while his purchases stood producing a loss of $130,065 instead of the profit of $145,908. That the offending hedge fund was bailed out while an innocent day trader was penalized was clearly absurd. In a scathing comment, Floyd Norris wrote ”Nasdaq looks a lot like a casino that values a customer's business only until he starts winning.”

Clearly exchanges can not be trusted with the discretion that is vested in them. The rule should be very simple. Traders should bear the responsibility (and the losses) of their erroneous trades.

Posted at 17:17 on Sat, 07 Jan 2006     View/Post Comments (6)     permanent link

Wed, 04 Jan 2006

Tokyo Stock Exchange Trading System: Why Not Open Source?

The Financial Times reports that “The Tokyo Stock Exchange is considering replacing its trading system, even though it is merely a year old, following computer problems that have shattered the exchange's reputation and damaged Tokyo's status as a financial centre.”

Clearly the Mizuho trading error that I blogged about last month has been the main driving force behind this move. I would argue that open source is the better way to go if the goal is to make the trading system more robust.

I have been reading the official explanation that the Tokyo Stock Exchange (TSE) put out on the Mizuho incident. As I understand it the sequence of events was as follows.

Summing up the nature of the problem, the Tokyo Stock Exchange states:

“This is an incident that occurs when an issue is newly listed on the TSE directly and, as in this case, while a special bid quote is displayed, such a large amount of orders is placed that the net amount exceeds the number of the special quote order, and many sell orders still remain after the initial price is determined, to which deemed processing is then applied and then orders are placed at that price. As such, we are committed to strengthening supervision of newly listed issues in the near future and conduct extensive, detailed investigations of our system while considering the possibility of this and all other cases in the future, in ensuring irregularities such as this do not occur again. Also, the TSE will conduct a prompt, thorough analysis of the details of the cause of this recent irregularity in cooperation with the trading system developer, Fujitsu, Ltd.”

It appears that the irregularity that was observed would have occured only under very special circumstances that may never be repeated in future. It is also evident that in a complex trading system, the number of eventualities to be considered while testing the trading software is quite large. It is very likely that even a reasonable testing effort might not detect all bugs in the system.

Given the large externalities involved in bugs in such core systems, a better approach is needed. The open source model provides such an alternative. By exposing the source code to a large number of people, the chances of discovering any bugs increase significantly. Since there are many software developers building software that interacts with the exchange software, there would be a large developer community with the skill, incentive and knowledge required to analyse the trading software and verify its integrity. In my view, regulators and self regulatory organizations have not yet understood the full power of the open source methodology in furthering the key regulatory goals of market integrity.

Also, there is a case for simplifying the trading system. The trading system at TSE is unnecessarily complex because of the existence of price limits and the complex combination of call auction (Itayose method) and continuous auction (Zaraba method). TSE needs to question the very need for special quotes.

Posted at 14:37 on Wed, 04 Jan 2006     View/Post Comments (2)     permanent link