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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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