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
jrvarma@iima.ac.in

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Wed, 26 Dec 2007

Short Selling at Long Last?

In February 2007, the Indian Finance Minister announced in his budget speech that institutions would be allowed to short sell and that a securities lending mechanism would be put in place. Nearly ten months later, The Securities and Exchange Board of India has announced the Broad framework for securities lending and borrowing and the Broad framework for short selling but it is not yet clear as to when the exchanges would operationalize these products. Given the considerable similarities in software requirements between the proposed securities lending mechanism and the old ALBM system, I would think that the exchanges should not need more than 2-3 weeks to get this off the ground. So the absence of a specific timetable is disturbing.

Globally, the corporate world hates short selling and does its best to discredit it and even prevent it if possible. In the US for example, the SEC took 70 years to remove short sale restrictions and even that happened only after Enron had weakened the credibility of corporate America. Even now, the SEC is to my mind unduly harsh on what it calls “abusive short selling” as I discussed in my blog post earlier this year.

In India too, I know from my conversations with corporate leaders that corporate India does not like short selling and would like the proposals to be diluted and delayed as much as possible. After I expressed this fear publicly in a television interview earlier this week, I have been assured by the regulators at the highest level that they do not feel any pressure from the corporate sector and would not be swayed by any pressure even if it were sought to be applied. I can only conclude that the corporate lobby is concentrating on those whose convictions on short selling are weaker and can therefore be more easily swayed. Since the short selling and securities lending framework require concurrence of the tax authorities and of the central bank while operationalization requires action by the exchanges and perhaps the depositories, opponents of short selling have many avenues open to them to delay if not block much needed reform.

I have been arguing the case for free short selling for several years now to the point of beginning to sound like a broken record:

In India, [severe restrictions on short selling] are the single most important culprit for the frequency and severity of episodes of stock market manipulation that have taken place in this country during the last decade. Indian Journal of Political Economy, October-December 2002

A market without short selling is an open invitation to company managements and other manipulators to rig up the prices of stocks.(Business Line March 15, 2004)

Removal of all restrictions on short-selling would be the single most important step towards making Indian capital markets cleaner, safer and more efficient.(Economic Times, October 3, 2005)

But I think the battle is not over yet. All of us who have a stake in clean and vibrant capital markets must therefore keep up the vigil to ensure that unscrupulous corporate managements do not succeed in delaying this reform any further.

It is equally important to move quickly beyond the broad framework that has been published now. First, short selling needs to be quickly expanded beyond the derivative stocks to at least the top 1,000 or 2,000 stocks as I discussed in my blog post two years ago. Second, the position limits need to be increased substantially. Third, mechanisms for borrowing stocks for much longer periods than seven days need to be created. The proposed framework requires gross settlement at client level so that even a roll over of the seven day contract into the next contract would be cumbersome. Global experience suggests that when short positions are established in stocks on the suspicion of fraud or misreporting by the company, the position has to be maintained for several months for the short sellers to expose the fraud and make a profit on the position.

But all these problems should not hold up progress. The better should not become the enemy of the good. SEBI, RBI and the exchanges must work hard to make short selling and securities lending a reality in January 2008.

Posted at 15:09 on Wed, 26 Dec 2007     View/Post Comments (2)     permanent link


Mon, 10 Dec 2007

FASB tries to define equity and liability

The Financial Accounting Standards Board (FASB) in the United States has put out a very interesting document outlining its preliminary views on a consistent definition of equity and liabilities. As highlighted in Table 2 at the end of the document, the FASB proposals would involve substantial changes in current accounting practice. In particular, it would allow gains or losses to be recognized when a company enters into derivative transactions on its own stock.

Years ago, while writing a paper on Enron, I came across instances where current accounting treatment for such transactions is not in line with economic realities, but thought that the changes required to bring them in alignment would be too drastic for accountants to countenance. It is fascinating to find that FASB is prepared to contemplate making these drastic changes and it is likely that the International Accounting Standards Board (IASB) would move in the same direction as well.

Posted at 08:09 on Mon, 10 Dec 2007     View/Post Comments (0)     permanent link


Sun, 09 Dec 2007

SEC Admits that it Rigged Share Prices!

I find it hard to believe this, but the SEC press release explicitly says that as part of its sting operation, it and the FBI did actually manipulate the share market – the SEC/FBI “bought the stock defendants were promoting. Every buy transaction had a material effect on the stock trading volume of the companies in question”. Will the SEC/FBI compensate genuine investors who traded on the basis of the false volumes or prices? The SEC says “Our office worked closely with the criminal authorities and provided information and technical assistance throughout the FBI sting operation in order to minimize harm to innocent investors.” But minimize is not the same as prevent.

Another puzzling thing in the press release is that after saying that “In fact, there was no hedge fund”, it goes on to say that “the hedge fund bought the stock”. Perhaps, it was a drafting error in the press release.

Posted at 16:35 on Sun, 09 Dec 2007     View/Post Comments (2)     permanent link


Fri, 07 Dec 2007

Financial markets and financial information

There is a chicken and egg relation between financial markets and financial information: the markets need data to function well but the data is generated only when the markets become vibrant. This was my response to Peeyush Mishra who emailed me this week with a comparison of the richness of data that is available about the US housing market (OFHEO, Case-Shiller, NAR, NAHB and Commerce Department) with the paucity of such data for India. Peeyush asked me whether we should make a sustained push to collect and organize more of this data and put it in the national domain.

My argument was that we have already traveled down this top-down route with the National Statistical Commission that submitted its report in 2001 and the National Statistical Commission that was established in 2006 following the recommendations of that report.

The alternative (bottom-up) approach is to rely on the demand pull that emerges from well developed financial markets. These markets not only create demand for financial data, but this demand is backed by willingness to pay for the data – it is as the economists like to say “effective demand”. Both private sector and public sector providers respond to this demand. It may appear surprising but it is a fact that even Indian public sector providers respond to private sector demand for data particularly when this demand starts being met by private sector providers. Once they get into the game, public providers also sometimes try to shut out the private providers on vague grounds related to the integrity of the data. Viewed in this light, the main reason why the US has such rich data on housing is the huge mortgage and mortgage derivative market in that country.

It is also true that data providers (both private and public) are more reliable when the data they generate is used by financial markets than when it used primarily by academics. This is because while academics are content to run some outlier tests and get rid of the worst errors in the data, market participants have less tolerance for mistakes in the data. The private sector can also help in scrutinizing the validity of the methodology. For example, in 2003, Statistics South Africa was forced to correct flaws in the estimation of the housing rentals component of the consumer price index in response to complaints by analysts.

Posted at 15:55 on Fri, 07 Dec 2007     View/Post Comments (0)     permanent link


Wed, 28 Nov 2007

Can governments be trusted with financial data?

When the UK government loses CDs containing name, addresses, date of birth, child benefit and national insurance numbers and bank details relating to 25 million people (40% of the population), we must ask the question whether governments can be trusted with financial information on a large scale.

A comment by a reader of the Times Online underscored the gravity of the problem:

Given the large number of government employees that clearly have access to these databases, if the administration and security systems in place allow for this kind of data to be burned onto an external removable disc, then it is inevitable that such data already has been (or will be) deliberately taken and sold to identity theft fraudsters by a modestly paid, unscrupulous civil servant (it is unfortunately naive to assume everyone is honest).

This is an issue that has largely been addressed in banks and other financial institutions who have historically held our private data, and who have measures in place to prevent such extraction of confidential data.

The idea of a “momentary blunder” or accidental loss seems to miss the real risk.

It is true that the private sector is a little better at handling data, but then the US telecom operators have shown that they are more than happy to part with data to the government even when the government requests the data illegally.

In the Indian context, I am worried about the huge amount of data that is being collected under the tax information network. Moreover, as India makes hesitant moves towards electronic payment systems, there seems to be a great deal of eagerness on the part of everybody including the tax authorities to collect and preserve all the transaction data. If somebody wants to do data mining on a few petabytes of data, that is fine, but who will ensure the safety of all the data? Whom can we sue if the data is lost or stolen?

Posted at 17:43 on Wed, 28 Nov 2007     View/Post Comments (1)     permanent link


Sat, 24 Nov 2007

New Derivative Products in India

Yesterday, the Financial Express published an interview with me on the proposal by SEBI earlier this month to launch new derivative products. I made two main points:

Posted at 17:06 on Sat, 24 Nov 2007     View/Post Comments (1)     permanent link


Sun, 18 Nov 2007

Deposit Insurance and Northern Rock

The flurry of comments and discussion that followed Mervyn King’s interview to the BBC on November 6, 2007 have led me to the conclusion that the true lessons from Northern Rock are largely about deposit insurance and not about bank supervision.

Mervyn King’s interview about the handling of Northern Rock prompted a series of comments last week in the Financial Times by Philip Stevens, Willem Buiter and Martin Wolf. This has prompted me to revisit Northern Rock which I blogged about last month here and here. I am even more convinced than before that the Northern Rock episode does not reveal fundamental flaws with the model of unified regulation and separation of monetary policy from bank supervision. I also think that King’s decision to provide liquidity only at penal rates and against top class collateral was quite correct. Mervyn King said in his interview:

If you look at what the European Central Bank lent to banks through their auctions that they conducted, relative to the size of the banking system they lent an average of 230 million pounds per bank participating in their auctions. Northern Rock needed something closer to 25 billion, 100 times larger than the average amount which the European Central Bank was lending to banks through their auctions. The scale of the funding that was needed was staggeringly large.

...

So could we have had an auction that was sufficiently large that all the banks would have got 20 to 30 billion and Northern Rock wouldn’t have been noticed in that process? Well, that would have been an auction on a scale 50 odd times that which any other Central Bank had engaged in. And I’m absolutely convinced that the first question you would have asked on that day is: “What on earth must have happened to the entire British banking system to have merited an auction of that size?” We were doing this not to bail out the British banking system, which didn’t need bailing out, but actually to get money into one institution that needed it.

In my view, the lessons from Northern Rock are:

Posted at 17:44 on Sun, 18 Nov 2007     View/Post Comments (0)     permanent link


Wed, 14 Nov 2007

OTC Equity Derivatives in India

I wrote an article in the Business Standard today arguing for the creation of an OTC equity derivative market in India.

I made the following points

Posted at 15:55 on Wed, 14 Nov 2007     View/Post Comments (1)     permanent link


Tue, 13 Nov 2007

Quiet Period in US Public Offerings

Earlier this year, I blogged about the problems created by the quiet period during public offerings of shares in the United States. The Lex column on “Quiet Periods” in the Financial Times yesterday raises the same issues and refers to the Blackstone example that I mentioned in my blog posting. Lex concludes by saying that the US Securities and Exchange Commission (SEC) should put the “onus on companies to talk rather than hide”. This is a very elegant way of putting it. Regulations must always impose a duty to disclose rather than a duty to keep quiet.

Posted at 16:41 on Tue, 13 Nov 2007     View/Post Comments (0)     permanent link


Sun, 28 Oct 2007

Northern Rock and Unified Regulators

In my previous post today, I described what I had learnt about managing liquidity risk from studying Northern Rock; in this post, I shall discuss the implications for the regulatory architecture (separation of bank supervision from the monetary authority).

Many observers appear to think that Northern Rock has revealed the dangers of the UK system of separating bank supervision from the central bank. In my view, it has on the contrary, revealed the strengths of this system. It is clear from the evidence, that the banking supervisor (Financial Services Authority) was keen to solve the problem of Northern Rock by making changes in monetary policy while the monetary authority (Bank of England) was unwilling to do this. If the central bank were in charge of both monetary policy and bank supervision, there is little doubt that monetary policy would have been changed to save Northern Rock. The deficiences if any in banking supervision would then have never come to light at all. This is a form of regulatory moral hazard – regulators will tweak the regulatory system to hide their failures. The UK system where the central bank is not the bank supervisor is less vulnerable to this kind of moral hazard.

That the UK had not had a bank run for 140 years prior to Northern Rock is to me a troubling thing. Banks are highly fragile institutions. If in 140 years including two world wars, a great depression, the loss of a vast empire and over three decades of chronic exchange rate difficulties, the UK did not have any bank runs, then it tells us not that banks were well regulated but that they were saved covertly. In these covert operations, doubtless the reputations of bank regulators (and perhaps bank managers) were also protected at the tax payers expense. That Northern Rock has dented many reputations is not such a bad thing by comparison.

Posted at 19:20 on Sun, 28 Oct 2007     View/Post Comments (0)     permanent link


Liquidity Risk and Northern Rock

I have spent a fair amount of time trying to understand the collapse of Northern Rock in the United Kingdom by poring through the transcripts of the Treasury Committee hearings that took evidence from the Bank of England, the Financial Services Authority and the directors of Northern Rock as well as the financial statements of Northern Rock itself.

In a separate post, I shall discuss the implications for the regulatory architecture (separation of bank supervision from the monetary authority. In this posting, I shall focus on what I have learnt from all this about managing liquidity risk:

Posted at 19:17 on Sun, 28 Oct 2007     View/Post Comments (1)     permanent link


Wed, 24 Oct 2007

Can SEBI be more transparent?

The Securities and Exchange Board of India provided critical clarifications on its policies regarding offshore derivative instruments (participatory notes) issued by Foreign Institutional Investors (FIIs) through a video conference on Monday, but their website still has no video recordings, no transcripts, no press releases on what was revealed during this conference. (I have looked in the “What is New”, “Press Releases”, “From the Chairman” and “News Clarifications” sections of the web site and also searched the site for “video conference”. I hope it is not hidden somewhere else in the site.)

SEBI’s policy announcements on this subject have caused intra-day movements in the market index of several percent in recent days and the potential for insider trading is immense whenever SEBI issues even the smallest clarification on the subject. That a video conference on such an important subject was done without it being webcast live is regrettable; that it was not even followed up with recordings and transcripts is unacceptable.

Posted at 14:57 on Wed, 24 Oct 2007     View/Post Comments (3)     permanent link


Fri, 19 Oct 2007

SEBI Proposal on Participatory Notes

I wrote an article in the Business Standard today on the Discussion Paper put out by the Securities and Exchange Board of India (SEBI) proposing to limit the issuance of Offshore Derivative Instruments (participatory notes) by Foreign Institutional Investors (FIIs) in India.

This discussion paper produced a wide range of commentary in the financial press. An excellent summary of this discussion has been put together by Ajay Shah in his blog. The key points that emerge from this analysis are:

My Business Standard article did not dwell much on any of these but focused on some of the details of the SEBI proposal.

SEBI’s first proposal is to ban participatory notes that have a derivative as the underlying. This is a very confusing statement. The intention appears to be to ensure that a participatory note is backed by a cash market position and not a derivative position. If this is what SEBI indeed wishes to do, it should explicitly ban the use of derivatives to hedge participatory notes.

SEBI should recognize that the term “underlying” is a technical term with a well defined meaning in the world of finance. The underlying of a participatory note is the instrument from which the participatory note derives its value; it is the instrument which is delivered on settlement of the participatory note or with reference to whose price the participatory note is cash settled. The “underlying” in this technical sense has nothing to do with the portfolio that the FII uses to hedge the participatory note. A participatory note that is cash settled using the Nifty index futures price has the future as the underlying even if the FII hedges it using cash equities. Similarly, if the participatory note is cash settled using the cash price of the Nifty index, its underlying is the cash index and not the index future even if the FII hedges the note using index futures.

A financial regulator should respect the semantic integrity of well defined technical terms and not abuse the term “underlying” to mean what it does not and cannot mean. In this context, the use of the word “against” before the word “underlying” in regulation 15A of the FII regulation is also unfortunate as that word is perhaps the source of this confusion.

Enough of semantics. I now turn to the substance of the proposal. If SEBI bans the use of derivatives to hedge participatory notes, it would have three implications.

  1. Since cash equities are less liquid than the futures, the hedging costs would increase. The increase would be even greater if the underlying is an index where hedging using the constituent shares is far more difficult than using the index future. If the participatory note contains some option-like features (non linear payoffs), the hedging risks could also increase as the volatility risk of options cannot be hedged using only the cash market. The FII would therefore have to charge a wider spread to its clients. OTC derivatives tend to be carry large spreads anyway (annualized costs of 4% to 8% of the notional principal are not uncommon). A mere increase in transaction costs would not probably kill the participatory note market.
  2. SEBI’s proposal would prevent participatory notes that involve a short position in Indian equities (for example by a long-short hedge fund) since short selling is not feasible in the cash market today. Since short selling is essential for a well functioning market, this is clearly an undesirable consequence of the SEBI proposal.
  3. SEBI’s proposal would also prevent issuance of participatory notes that are essentially synthetic rupee money market instruments because these synthetics can be created only by offsetting positions in cash and futures markets. It is doubtful whether any significant amount of participatory notes are of this kind.

The second major proposal of SEBI is to ban participatory notes issued by sub accounts of FIIs. In my view, this is largely an administrative measure which would not have a significant long run impact. An FII which is active enough to issue participatory notes should be willing to register as a full fledged FII.

SEBI’s third proposal is to limit participatory notes issuance by any FII to 40% of the assets under custody of that FII. Today, issuance of participatory notes is concentrated in the hands of a few FIIs. This is a very natural phenomenon. Running a derivative hedge book is a very complex activity and those with superior skills in doing this will get more business because of their lower costs and their ability to offer a wider range of products. There are also significant economies of scale in running a derivatives book because if an FII sells a long position to one offshore client and a short position to another offshore client, it needs to hedge only the net position in the Indian market. When the efficient hedgers have exhausted their 40% limits, buyers of participatory notes would have to buy from less efficient hedgers who have not reached the 40% limit. This would increase the costs and would amount to more “sand in the wheels” whose long term impact would be modest.

I also believe that the 40% limit can be circumvented by an FII buying cash equities and selling stock futures or index futures. This synthetic rupee money market position would not increase the FII’s exposure to the Indian equity market but it would increase assets under custody and allow the FII to issue more participatory notes. In the context of a strong rupee and a positive interest rate differential, this synthetic money market position may also be a profitable low risk investment for the FII. It would indeed be a delicious irony if a proposal designed partly to reduce capital inflows leads to more capital inflows.

Posted at 18:19 on Fri, 19 Oct 2007     View/Post Comments (1)     permanent link


Tue, 09 Oct 2007

Similarities and Differences between Banks and CDOs

In February 2006, I posted a blog entry about how banks and CDOs are very similar in their economic function. I received a couple of comments on that entry and then in August 2007, Francisco Casanova from Madrid began a long email conversation with me on the subject. All this forced to me think carefully about the issues and helped clarify my thoughts on the similarities and differences between banks and CDOs. So I decided to pull the comments and my responses into one long blog entry.

Comment Response

A CDO is a leveraged play on the underlying, banks forget that the ‘deltas’ of the underlying portfolio can be quite large and mean substantial MtM volatility.

I think a good test of the market is around the corner when the credit cycle turns and we see a number of downgrades on existing tranches making them economically unviable. (Mrinal Sharma)

A bank is also a leveraged play on the underlying loan book. But banks do not M2M their loan book and when the credit cycle turns, the impact is gradual. When there is no M2M, downgrades do not matter only defaults do.

‘Correlation risk’ and how it affects pricing is also a term misunderstood by banks and frequently ignored. (Mrinal Sharma)

Most of the risk of a bank’s loan book is also correlation risk though it is more commonly called concentration risk.

Tranching creates a slicing of risk whereby the 0-3% (in 5 years CDOs) is labeled as an equity investor. By receiving this name it would equate to the equity investor in any business, i.e., a bank. Nevertheless the actual risk/return characteristics of a non tranched equity stakeholder (i.e., a bank equity holder) are very different to those of a 0-3% holder in a CDO, aren’t they? (Francisco Casanova)

In a bank also, there are actually many tranches – demand deposits, time deposits, subordinated debt, hybrid capital and equity. If there were no central bank to bail out the bank, this would behave much like a CDO. When things start getting bad, the demand deposits will pull out quickly and will be paid out in full – this is like the AAA tranche. Time deposits might involve some loss if pulled out but the loss might be very small – an A or AA tranche. Some of the subordinated debt and hybrid capital would be like the BB tranche. Equity would be like the equity tranche.

The precise attachment points of the tranches in the CDO reflect three things – the quality of the underlying pool, the lack of central bank bail out and the rating errors of the rating agencies.

The big difference between banks and CDOs is the lender of last resort (the central bank)

Also, this permanent presence of the idiosyncratic vs systemic signals debate arising from the correlation movements in trading (which I do not know how accurately could be extrapolated to a bank), or the fact that, ceteris paribus (collateral spreads unchanged), a change in correlation reallocate expected losses among tranches in a zero sum game (i.e., an increase in default correlation expectations shifts risk allocation from junior to senior CDO tranche holders)... Or the mere fact that you can trade pure correlation views if you take delta hedged positions... (I guess you could do the same if all stakeholdings in a bank were securities form...). (Francisco Casanova)

It is interesting to note that the Basle II formula for corporate exposures is based on the same one-factor Gaussian copula models that are often used to price CDS index tranches. It is also useful to look at the following paragraphs from the second consultative package (Jan 2001) on Basle II that introduced the formula:

424. Credit risk in a portfolio arises from two sources, systematic and idiosyncratic. Systematic risk represents the effect of unexpected changes in macroeconomic and financial market conditions on the performance of borrowers. Borrowers may differ in their degree of sensitivity to systematic risk, but few firms are completely indifferent to the wider economic conditions in which they operate. Therefore, the systematic component of portfolio risk is unavoidable and undiversifiable. Idiosyncratic risk represents the effects of risks that are peculiar to individual firms, such as uncertain investments in R&D, new marketing strategies, or managerial changes. Decomposition of risk into systematic and idiosyncratic sources is useful because of the large-portfolio properties of idiosyncratic risk. As a portfolio becomes more and more fine-grained, in the sense that the largest individual exposures account for a smaller and smaller share of total portfolio exposure, idiosyncratic risk is diversified away at the portfolio level. In the limit, when a portfolio becomes “infinitely fine-grained,” idiosyncratic risk vanishes at the portfolio level, and only systematic risk remains.

425. The design and calibration of the IRB approach to regulatory capital relies on decomposing risk in this manner. Under an IRB system, the risk weight on an exposure does not depend on the bank portfolio in which the exposure is held. That is, while capital charged on a given loan reflects its own risk characteristics, such as the credit rating of the obligor and the strength of the collateral, it is not permitted to depend on the characteristics of the rest of the bank’s portfolio. To get this property of portfolio-independence, we must calibrate risk weights under the assumption of infinite granularity. Without this assumption, the appropriate capital charge for a facility would depend partly on its contribution to the aggregate idiosyncratic risk in the portfolio, and therefore would depend on what else was in the portfolio. With the assumption of infinite granularity, idiosyncratic risk can be ignored, so the appropriate capital charge for a facility depends only on the systematic component of its credit risk.

426. Of course, no real-world portfolio is infinitely fine-grained. Thus, there is always some idiosyncratic risk that has not been fully diversified away. If this residual risk is ignored, then a bank just satisfying IRB capital requirements will in fact be undercapitalised with respect to the intended regulatory soundness standard. To avoid such under-capitalisation, IRB risk weights have been scale upwards by a constant factor from the infinite granularity standard. The constant factor was chosen to approximate the effect of granularity on economic capital for a typical large bank. In order to capture variation across banks in granularity, we furthermore introduce a portfolio-level “granularity adjustment.” This additive adjustment to risk-weighted assets is negative for banks with relatively fine-grained portfolios, and positive for banks with more coarse-grained portfolios.

If the concepts of CDO and Bank are so fundamentally close, why are CDOs facing this acute lack of consensus in the valuation methodologies which is not present in the valuation of banks by equity and debt analysts? (Francisco Casanova)

  1. Banks are well diversified as compared to many CDOs. The few banks like Northern Rock that are not so diversified have seen huge valuation volatilities similar to CDOs. In the past, banks that have faced deterioration of a major part of their portfolio have seen values go down to zero very quickly. For example, think of what happened to some of the largest East Asian banks during the Asian Crisis. In the late 80s/early 90s, some analysts had a target price of zero for Citi stock before it clawed its way back from the brink.
  2. This leads to the interesting question as to why CDO investors did not apply the lessons of centuries of bank management and regulation to CDOs. Why did they accept sector concentrations that would have raised eyebrows in banking?
    • One possible answer is that this was a new field and investors were learning the lessons the hard way.
    • The other answer is that the investors were diversifying across CDOs and so risk concentration in any one CDO did not matter. If this is so, then big value changes in individual CDOs do not matter; what matter is value changes of diversified portfolios of CDOs. These latter changes have been much less dramatic.
  3. The attachment points for AAA and AA tranches in many CDOs seem to have been badly off. A well run AA rated bank probably has a capital of 10% and a price to book ratio of 1.5 implying a cushion of 15% on a globally diversified asset pool with very little sector concentration. If we apply this benchmark to a CDO, the AA attachment point was I think badly off the mark. If the rating agencies had thought of CDOs as mini banks, would they have given these ratings? I think the answer is clearly no.
  4. Bank valuations have not suffered much because they had huge liquidity support. If the central banks had gone to sleep, what would have been the volatility in the valuations of the big banks? The CDOs have had no liquidity support.
  5. It would be interesting to compare the actual default rate in investment grade CDO tranches during this crisis with the default rate of banks during the days before central banking became so widespread. I suspect the default rates have actually been lower so far, but it will take a year or so to find out.
  6. If CDOs can survive this crisis without any central bank bailout, they may emerge stronger with better risk management, better valuation models, better rating practices, greater transparency and less moral hazard. In the long run, this crisis might be the best thing that ever happened to CDOs!

Posted at 21:48 on Tue, 09 Oct 2007     View/Post Comments (1)     permanent link


Tue, 25 Sep 2007

Bank of England U-Turn

Last week, I blogged admiringly about the Bank of England paper on inter bank liquidity and moral hazard and it was embarassing to find the Bank do a U-turn within days of that paper. Mervyn King faced a hostile Treasury Committee and the transcripts of this oral testimony are quite disturbing.

King stated that he wants to carry out lender of last resort operations covertly and wants disclosure laws to be changed to make this possible. To my mind, this is totally unacceptable. The disclosure requirements of modern securities market are sacrosanct and central banks must simply learn to live with them.

The transcripts also show that King had difficulty providing a convincing explanation for his U-turn on moral hazard:

Q2 Chairman: ... In that letter of 12 September you told us that providing extra liquidity at longer maturities - in your words - undermines the efficient pricing of risk by providing ex post insurance for risky behaviour and that you would conduct such operations only if there were strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in the future. However, yesterday you conducted such operations. What has changed in the past seven days?

Mr King: ... the balance of judgment between how far you extend liquidity against a wider range of collateral on the one hand and being concerned to limit the moral hazard on the other, to limit the ex post insurance, is a judgment that we are making almost daily in the febrile circumstances of the time. The operation yesterday was carefully designed and judged. It does not give ex post insurance, it is limited in size, it is limited in amount to each individual bank, and that provides a strict limit on the extent to which there is some ex post insurance, so we have balanced the concerns about moral hazard against the concerns that arose at the beginning of this week about the strains on the banking system more generally.

Q18 Chairman: When you talk about everybody knows their own job, Governor, I have to ask you this question because it has been in the public press: are you your own man? Were you lent on in this situation? Is that why you did the U-turn in the past seven days?

Mr King: No, I can assure you that the operation we carried out was designed in the Bank. Of course in these circumstances I want to discuss it with Callum McCarthy and the Chancellor. It would be very odd if they were to have woken up and found we had done this and they did not know anything about it, so of course we discussed it, but I give you my personal assurance that I would never do anything unless I thought it was the right thing to do. The independence of a central bank is not just about legislation; it is about having people in the central bank who will do what is right for the country in their job and not do what people ask them to do, whether it is the banks or whether it is politicians.

Q46 Mr Fallon: Governor, you have spoken on moral hazard and you have written us an eloquent essay on moral hazard, but is not the criticism that you have passed the theory but when it came to dealing with Northern Rock and when it came to dealing with three-month funding actually you failed the practical?

Mr King: No, I do not think that is true at all. I am happy to explain a bit later if you like why I think moral hazard is such an important issue. Can I just answer this point. I have tried to set out a sequence of events in which Northern Rock required ultimately a lender of last resort, the way in which we would have preferred to do it was not open to us, and at that point we did it in an overt way. I do not think it was at all obvious what impact that would have. It might or might not have led to people wanting to take their money out. In the event it did and once that run had started people were not behaving illogically by joining it and at that point the only solution was the Government guarantee. I think this is a very clear chain of events.

Q86 Peter Viggers: How severely do you think the principle of moral hazard has been compromised since you wrote us your rigorous and lucid letter?

Mr King: I hope that it has not and I do not believe that it has but, as I said, this is a balancing judgment. When I listened to the banks I do not believe that they felt that offering them an ability to bid for liquidity at a 100 basis point premium over bank rate was something that they regarded as entirely generous, so I think there is still a fair chunk of restriction against moral hazard in what we have done.

Posted at 21:32 on Tue, 25 Sep 2007     View/Post Comments (1)     permanent link


Thu, 13 Sep 2007

Bank of England analysis of turbulence in inter bank liquidity

The paper that the Bank of England submitted yesterday to the Treasury Committee of parliament is an unusually lucid analysis of the recent turbulence in inter bank liquidity; surprisingly, it reads more like a thoughtful blog than a ponderous official pronouncement. This certainly cements Mervyn King’s reputation as the foremost academic among central bankers. Ben Bernanke is of course not far behind – his speech day before yesterday on global imbalances was also very insightful.

King’s paper contains a careful analysis of what has happened since the beginning of August:

In summary, the turmoil in financial markets since the beginning of August stems from a reluctance by investors to purchase financial instruments backed by loans. Liquidity in asset­backed markets has dried up and a process of re­intermediation has begun, in which banks move some way back towards their traditional role taking deposits and lending them. That process is likely to be temporary but it may not be smooth. During that process, demand for liquidity by the banking system has increased, leading to a substantial rise in inter­bank rates.

King then argues (a) that monetary policy should continue to be fixated on inflation targeting and (b) the provision of liquidity in the automatic window at penal rates against high quality collateral is sufficient for the smooth functioning of the payment system.

The concluding part of the paper is sharp and brutal:

So, third, is there a case for the provision of additional central bank liquidity against a wider range of collateral and over longer periods in order to reduce market interest rates at longer maturities? This is the most difficult issue facing central banks at present and requires a balancing act between two different considerations. On the one hand, the provision of greater short­term liquidity against illiquid collateral might ease the process of taking the assets of vehicles back onto bank balance sheets and so reduce term market interest rates. But, on the other hand, the provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behaviour. That encourages excessive risk­taking, and sows the seeds of a future financial crisis. So central banks cannot sensibly entertain such operations merely to restore the status quo ante. Rather, there must be strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in the future. In this event, such operations would seek to ensure that the financial system continues to function effectively.

As we move along a difficult adjustment path there are three reasons for being careful about where to tread. First, the hoarding of liquidity is a finite process ... [T]he banking system as a whole is strong enough to withstand the impact of taking onto the balance sheet the assets of conduits and other vehicles.

Second, the private sector will gradually re­establish valuations of most asset backed securities, thus allowing liquidity in those markets to build up ...

Third, the moral hazard inherent in the provision of ex post insurance to institutions that have engaged in risky or reckless lending is no abstract concept. The risks of the potential maturity transformation undertaken by off­balance sheet vehicles were not fully priced. The increase in maturity transformation implied by a change in the effective liquidity in the markets for asset­backed securities was identified as a risk by a wide range of official publications, including the Bank of England’s Financial Stability Report, over several years. If central banks underwrite any maturity transformation that threatens to damage the economy as a whole, it encourages the view that as long as a bank takes the same sort of risks that other banks are taking then it is more likely that their liquidity problems will be insured ex post by the central bank. The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises.

In addition, central banks, in their traditional lender of last resort (LOLR) role, can lend “against good collateral at a penalty rate” to an individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent ... LOLR operations remain in the armoury of all central banks ...

...Injections of liquidity in normal money market operations against high quality collateral are unlikely by themselves to bring down the LIBOR spreads that reflect a need for banks collectively to finance the expansion of their balance sheets. To do that, general injections of liquidity against a wider range of collateral would be necessary. But unless they were made available at an appropriate penalty rate, they would encourage in future the very risk­taking that has led us to where we are ...

The key objectives remain, first, the continuous pursuit of the inflation target to maintain economic stability and, second, ensuring that the financial system continues to function effectively, including the proper pricing of risk. If risk continues to be under­priced, the next period of turmoil will be on an even bigger scale. The current turmoil, which has at its heart the earlier under­pricing of risk, has disturbed the unusual serenity of recent years, but, managed properly, it should not threaten our long­run economic stability.

Posted at 13:35 on Thu, 13 Sep 2007     View/Post Comments (0)     permanent link


Sat, 08 Sep 2007

Carry trades and hedging

Stephen Jen and Luca Bindelli argue in a post at the Morgan Stanley Global Economic Forum that currency hedging produces much of the effects that are commonly attributed to carry trades. Jen and Luca Bindelli are absolutely right in arguing that:

However, to replicate the carry trade effect, Jen and Bindelli need to make the further assumption that the hedge ratio depends on the cost of hedging as measured by interest rate differentials. I would argue that the part of the hedge that depends on interest rate differentials is a speculative position masquerading as a hedge. In Black’s universal hedging model (“Equilibrium Exchange Rate Hedging”, Journal of Finance, 45(3), 899-907) the hedge ratio is a constant across all currency pairs and the primary reason for the hedge ratio to differ from unity is Siegel’s paradox. Even if one employs more general models, it is difficult to see a role for interest rate differentials in determining the optimal hedge ratio if one assumes that the forward rates are equilibrium rates.

The assumption that forward rates are incorrect and therefore (via interest rate parity) that interest rate differentials are irrational, is a speculative position which is the core of the carry trade phenomenon. It is difficult to regard this as hedging.

Posted at 12:18 on Sat, 08 Sep 2007     View/Post Comments (0)     permanent link


Sun, 26 Aug 2007

SEBI proposes fast track issuance of securities

The Securities and Exchange Board of India has announced its intention to allow fast track issuance of securities under certain conditions. It is nice to see SEBI doing something constructive to make the primary market smoother and more efficient.

A spate of investor complaints after the IPOs of 1995-96 led to a regulatory clampdown that has had a chilling effect on the primary market. In 1995-96, the capital raised through the primary market was more than 6.5% of gross domestic capital formation. Despite a revival in the primary market in 2005-06 and 2006-07, the capital raised in these years is less than 2.5% of gross domestic capital formation.

The regulatory clampdown has also led to the partial exporting of our primary market. In 2006-07, the capital raised in the foreign (ADR/GDR) market was about half of that raised in the domestic primary market. In 1995-96, the corresponding figure was only 11% and until 1996-97, this figure had never crossed 25%.

A lot needs to be done to make the primary market vibrant once again. The fast track issuance scheme addresses some of the needs of well established companies trying to do a follow-on issue. The needs of the IPO market also need to be addressed in course of time.

Posted at 19:57 on Sun, 26 Aug 2007     View/Post Comments (0)     permanent link


Mon, 20 Aug 2007

US regulatory framework and light touch regulation

An IMF working paper published this month forced me to rethink the often repeated contrast between the heavy handed rule based US regulatory framework and the light touch principles based system in the UK. The paper New Landscape, New Challenges: Structural Change and Regulation in the U.S. Financial Sector by Ashok Vir Bhatia argues that the US financial sector is divided into a tightly regulated core and a loosely regulated periphery. The tightly regulated core consisting of the banks and depository institutions, the housing sector federal agencies and the big five investment banks today account only for a third of the US financial assets. The remaining two-thirds of the assets are in the periphery which is subject to Bernanke’s “regulation by the invisible hand” of market discipline.

Bhatia argues in particular that “the Fed [serves] a singular role as guardian against more dirigiste temptations.” I think this is an important point – there is little doubt that the US Fed has a significantly lighter touch regulatory mindset than the US SEC. This is also an aspect that is often missed in the simple US versus UK dichotomy of rules versus principles based regulation.

Where the rules based approach is most dominant in the United States is in the area of consumer protection which is of course dominated by the SEC. The UK has shown the way in applying principles based regulation even here and this is a model that is worth emulating. However, the US model shows how great the benefits are of a light touch regulation applied only to the periphery. The vibrancy of the US financial sector is due doubtless to this light touch. For countries like India whose financial sector is repressed by heavy handed regulation, applying light touch to the periphery is a low hanging fruit that can be plucked quite easily and with low risk.

Posted at 16:44 on Mon, 20 Aug 2007     View/Post Comments (1)     permanent link


Thu, 09 Aug 2007

Regulating External Commercial Borrowings

Dr. Shankar Acharya and I participated in a discussion on the business news channel CNBC about the move by the Indian government to restrict external commercial borrowings. Both of us agreed that the ECB window was a very selective opening up of the capital account. My concern was that ECBs allowed the corporate sector to obtain cheap foreign debt while preventing individuals from tapping foreign markets to get cheap home loans. Dr. Acharya’s concern was that even within the corporate sector, the ECB window was being used largely by a handful of companies.

Both of us also agreed that in the long term, India needs a vibrant domestic financial system that is well integrated into the global capital markets. We disagreed about the timing and sequencing of these reforms. Dr. Acharya argued that the weaknesses of the domestic financial system (particularly the state owned banking system) need to be addressed first and that capital account opening must be gradual. My argument was that the best way to strengthen the domestic financial sector is to open it up to foreign competition and that we need to move rapidly on capital account convertibility.

Posted at 21:52 on Thu, 09 Aug 2007     View/Post Comments (2)     permanent link


Tue, 07 Aug 2007

SEBI Report on Dedicated Infrastructure Funds

The Securities and Exchange Board of India has published the Report and Recommendations of the Committee on Launch of Dedicated Infrastructure Funds by Mutual Funds

I have been a firm supporter of allowing domestic hedge funds, private equity funds, real estate funds and other alternative investment vehicles. I would also welcome retail access to these products with appropriate risk disclosures. Thus in principle, I have no problem with the proposed Dedicated Infrastructure Funds. My difficulty is that the report does not justify why an exception should be made only for infrastructure funds while keeping the lid shut on all other alternative investment vehicles.

From the perspective of a securities regulator, the justification for a retail product has to be in terms of the risk-reward profile that the product provides to the investor. The report is silent on this and talks only about the need for infrastructure for the economy. The most depressing statement in the report is the statement in the report that:

The nature of infrastructure projects ... will include a gestation period where the project could be loss making. Thus, the NAV performance of the [Dedicated Infrastructure Funds] may suffer during the initial periods. This could have a negative impact on the listed price and generate adverse reactions from investors who exit early. Hence providing a listing window of 24 months will help the [Dedicated Infrastructure Fund] to deploy a substantial portion of the funds as well as some investments might move beyond the initial construction / build-out period.

To my mind, this amounts to cheating the investors by deliberately concealing information from them. In a rational market, investors should be trusted to understand that there will be losses in the gestation period. If they do not, then they are not appropriate investors for the fund.

I strongly believe that permitting retail access to a financial products should be based primarily on whether the product fulfills an investor need and only secondarily (if at all) not on whether it fulfills the need of the issuer (infrastructure developer in this case) or the intermediary (the mutual fund in this case).

I also think that it is far better to liberalize regulations across the board to provide investors access to a wide range of financial products than to make an exception for one special interest group. The regulatory goal has to be to increase innovation, competition and market completeness. That calls for a wide range of alternate investment vehicles.

Posted at 17:43 on Tue, 07 Aug 2007     View/Post Comments (3)     permanent link


Tue, 31 Jul 2007

Manipulating Closing Prices: The randomization antidote

Manipulation of closing pricing appears to be happening in some of the most liquid markets in the world, and randomization might be the most effective antidote to the problem. I blogged about Amaranth’s manipulation of Nymex natural gas closing prices last week. Dealbook talks about an episode in Blackstone’ shares:

Units of Blackstone ... nosedived for much of the day, dipping as low as $23.27, down 8.8 percent from Wednesday’s close of $25.51, by mid-afternoon. But a mysterious frenzy of trades just before the market’s close helped erase the entire day’s losses and push the stock up to $25.70.

Starting in the last 10 minutes, a series of rapid-fire buy orders helped push up the stock’s price. Among them was a block trade of 114,000 units, which was one of the biggest trade of the day. The time? It was executed at 3:59:55 p.m.

Averaging the last few minutes of trading helps but not completely because the manipulator knows the averaging algorithm used by the exchange. The key insight in my view is to think of this as a game between the exchange and the manipulator in which the exchange moves first and the manipulator can decide his response accordingly.

Game theory would suggest that the exchange use a mixed strategy involving randomization of the time slots over which averaging is done. This neutralizes the advantage that the manipulator has in the current system of moving second. The random time slots could be chosen by sampling from say a beta distribution with shape parameters alpha>1 and beta=1 that produces an increasing probability density function. This would ensure that most time slots would be from the final minutes of trading, but occasionally, there would be a time slot from earlier in the day.

Using public key encryption technology, it is possible for the exchange to announce the actual time slots resulting from the random sampling in advance in a manner which is verifiable ex post but not readable ex ante. This ensures that the exchange cannot manipulate the sample either.

Posted at 14:24 on Tue, 31 Jul 2007     View/Post Comments (3)     permanent link


Thu, 26 Jul 2007

Amaranth Natural Gas Manipulation

The civil complaint filed by CFTC against Amaranth has a fascinating description of how Amaranth allegedly manipulated the settlement price of natural gas futures. The most interesting part is Exhibit C which contains the letter that Amaranth wrote to the exchange explaining its unusual trading in the final minutes of trading on expiry day. It tells a story of Amaranth trying to reduce its calendar spread position by first reducing the far month position and then reducing the near month position by the same amount. Amaranth argued that the near (expiring) month trades took place in the last few minutes because that was when the extent of reduction in the far month position became clear.

The CFTC complaint contains a whole set of instant messages (IM) exchanged by Amaranth’s traders about the manipulation that they were attempting. What is interesting about many of these instant messages is that they also show the IM Administrator sending messages to all participants stating “Note: This session is recorded and this recording is the sole property of Amaranth”. This does not appear to have deterred the traders from talking of their manipulation quite explicitly.

Posted at 21:56 on Thu, 26 Jul 2007     View/Post Comments (1)     permanent link


Thu, 19 Jul 2007

Regulation of Clearing Corporations

Last month, the Ministry of Finance in India put out a discussion paper on the regulatory framework for clearing corporations, but I got around to reading this only now.

The discussion paper says that the exchanges should have only trading members and the clearing corporation should have only clearing members. This seems to imply that the clearing members should all be professional trading members that clear for others but not for themselves. I do not see the logic for such a requirement. The large trading members would normally want to clear their own trades.

The regulatory framework is perhaps hobbled by the enabling legislation itself, but I think there is a clear need for clearing corporations to provide clearing services for a wide range of contracts including not only equities and bonds but also derivatives on equities, interest rates, currencies and commodities. The discussion paper seems to have a different take on this:

Since CCs need to have dedicated resources to meet the exigencies of settlement, it would not ordinarily undertake any other activity which can have contagion effect on the adequacy of its resources. However, it may be allowed to take up other activities not related to securities settlement with prior approval of SEBI.

Finally, the rationale for the clearing corporation to be 51% owned by exchanges is not clear. First of all, exchanges in the context of SCRA probably means only stock exchanges and thus the proposal rules out major participation by commodity exchanges. Secondly, this legislates the “silo” model of clearing and trading that is quite controversial today. It appears to rule out user owned clearing corporations. This provision could also impede competition among exchanges by not allowing an upstart exchange to gain ground by using the services of an established clearing corporation.

Posted at 12:23 on Thu, 19 Jul 2007     View/Post Comments (0)     permanent link


Wed, 04 Jul 2007

SEC and IFRS - Embrace, extend and extinguish?

The US SEC yesterday released the proposed rules allowing foreign issuers to file their financial statements using the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board. This proposal is certainly welcome, but one consequence of this is likely to be the emergence of a US flavour of IFRS.

Many countries that have adopted IFRS as their national accounting standard have effected some carve-outs or made some modifications in the interpretation of these standards. When foreign issuers file under IFRS, the US SEC reviews the financial standards for conformity with the original IFRS and not with the jurisdictional variant followed in the issuer’s home country.

Moreover, IAS 8 “Accounting Policies, Changes in Accounting Estimates and Errors,” suggests that when the IASB’s standard or interpretations do not address a matter, issuers should look to the most recent pronouncements of other standard-setting bodies. The SEC’s proposal states (page 61-62):

An issuer using IFRS as published by the IASB, although not required to follow U.S. GAAP guidance, may find reference to FRRs, ASRs, SABs, and Industry Guides and other forms of U.S. GAAP guidance useful in the application of IAS 8.

In addition, the SEC states (page 61):

We believe that a company that would no longer be required to reconcile its IFRS financial statements to U.S. GAAP under the proposed amendments, and its auditor, would continue to be required to follow any Commission guidance that relates to auditing issues.

In addition, foreign private issuers are required to have audits conducted in accordance with the Standards of the PCAOB (U.S.)/U.S. Generally Accepted Audit Standards regardless of the comprehensive basis of accounting they use to prepare their financial statements.

The SEC also points out (page 79) that under current PCAOB standards when SEC filings are audited by foreign audit firms, these audit firms must have policies that provide for review of these filings by persons knowledgeable in accounting, auditing and independence standards generally accepted in the United States.

What all of this means is that the US which has not adopted IFRS at all might still be able to create a US variant of the IFRS. Over time, this variant (more rule based than principles based) may become highly influential and could even become the dominant flavour of IFRS. If this happens, the SEC’s stance could begin to resemble the “Embrace, extend and extinguish” strategy long associated with Microsoft.

Posted at 13:36 on Wed, 04 Jul 2007     View/Post Comments (0)     permanent link


Thu, 28 Jun 2007

Australian court rules that Chinese walls need not be perfect

I am not a lawyer and the judgement of the Federal Court of Australia dismissing insider trading and conflict of interest charges against Citigroup is 120 pages long, but the sum and substance of the judgement seems to be that absolute perfection is not required in Chinese wall arrangements. The judgement says:

But what the unscripted actions of Mr Sinclair and Mr Darwell show is the practical impossibility of ensuring that every conceivable risk is covered by written procedures and followed by employees.

However, the arrangements required to satisfy s 1043F(b) of the Corporations Act do not require a standard of absolute perfection. The test stated in the section is an objective one. It is, “arrangements that could reasonably be expected to ensure that the information was not communicated”.

In my view, the arrangements referred to by Mr Monaci in his written statement were sufficient to meet the requirements of s 1043F(b). They did not, in express terms, anticipate the situation which arose on 19 August 2005 but they laid down general procedures which could reasonably be expected to ensure that legal or compliance officers of Citigroup vetted any communication of potentially price sensitive information to prevent it crossing the Chinese wall.

The other important part of the judgement is that parties can contract out of a fiduciary relationship. The acquirer’s mandate letter stated that Citigroup was engaged “as an independent contractor and not in any other capacity including as a fiduciary”. With the court holding that this clause absolved Citigroup of all fiduciary (conflict of interest) responsibilities, language of this kind will probably become even more commonplace than it is now.

Posted at 14:10 on Thu, 28 Jun 2007     View/Post Comments (1)     permanent link


Fri, 22 Jun 2007

Problems in US regulation of public offerings

Two events this week have highlighted the persistent problems in US regulation of public offerings: first was the unacceptable effect that the quiet period regulation had on the Blackstone IPO and the other was the decision by the SEC to further tighten short selling activities during a public offering.

While the Blackstone IPO was in progress, a bill was introduced in the US Congress to increase the tax rates applicable to listed private equity firms. Since this proposal came with a five year breather, the market would have benefited from an analysis by the company explaining the tax incidence in the light of anticipated profit realization during the next five years. Unfortunately, as the Lex column in the Financial Times pointed out (“Blackstone’s tax bill”, June 18, 2007), the quiet period regulation prevented Blackstone from commenting on the situation at all. This is a totally unacceptable outcome. Clearly, the regulations that were framed long ago in a much slower paced era need to change to keep up with the times.

Sometimes, however, when regulations are changed, they are changed for the worse. The SEC’s proposal to tighten short selling restrictions during public offerings of securities is an example of this kind. The SEC states:

When a trader expects to receive shares in an offering, there is an incentive to sell short prior to pricing an offering and then cover that short position with shares bought at the reduced offering price. By doing so, the trader can cover the short sale with minimal risk, and generally lock in a guaranteed profit – to the detriment of the issuer and the other shareholders.

The amendments change the way the rule works to prevent this from happening. They replace the rule's current limitation on covering the short sales in the offering with a prohibition on purchasing in the offering after a short sale in the securities. This change was triggered by persistent non-compliance with the rule and a string of strategies to conceal the prohibited covering. Under the amended rule, if a person sells short during the restricted period prior to pricing, that person is prohibited from purchasing the offered security. Thus, the amended rule changes the prohibited activity from covering to purchasing the offered security.

Accurate price discovery is as important (if not more important) during a public offering as at other times and short selling is a critical element of good price discovery. In the absence of this process, there is a risk that companies and their underwriters would be able to manipulate the market and overprice their issues. In this light, the rule proposed by the SEC is a step in the wrong direction.

Posted at 15:16 on Fri, 22 Jun 2007     View/Post Comments (0)     permanent link


Tue, 19 Jun 2007

Equities drive Mumbai into global list on financial flows

The Indian financial press has widely reported the Mastercard Centres of Commerce 2007 study that listed Mumbai among the top 10 cities in the world in terms of financial flows ahead of Hong Kong and Shanghai. Many of these reports did not mention that despite faring so well on this sub index, Mumbai ranks 45th out of 50 in the overall index of global centres while Hong Kong ranks 5th.

Mumbai ranks high only in the financial flows sub index while ranking near the bottom (below 40) on all other components. Even within the financial flows sub index, Mumbai owes its place primarily to the vibrant equities market. (Measuring derivative activity in terms of number of contracts also helps since the single stock futures contracts popular in India have small contract sizes.) Even then, the gap separating Mumbai (38.71) from Shanghai (38.30) and Hong Kong (38.06) is quite low compared to the gap that separates Mumbai from Seoul (53.00) or Tokyo (53.39).

The Mastercard study serves to remind us that the equity markets are the real success story in Indian financial sector reform. We do need to replicate this success in other sectors.

Posted at 15:29 on Tue, 19 Jun 2007     View/Post Comments (0)     permanent link


Thu, 14 Jun 2007

US SEC abolishes the uptick rule

The US SEC has finally decided to abolish the rule that prohibited shares being shorted except on an uptick. The surprising thing is that it has taken 70 years (almost three generations) to get rid of a stupid idea that entered the statute book in 1938.

Of course, in a balancing act, the SEC also tightened rules on “naked short selling”. There is a genuine problem that these rules are trying to address, but this problem is not short selling, it is failed settlement. Though the US has a three day settlement cycle, an unacceptably large proportion of trades fail to settle for several days beyond that date.

It is really fortunate that India avoided importing the system of “continuous net settlement” which is the root of the settlement problem in the US. The Indian approach of ruthless penalties for settlement failures is the right solution to this problem. Instead the SEC wants to look at the whether the failure was intentional or unintentional. It uses silly notions like “abusive short selling” to decide which settlement failures ought to be penalized. It is much better to focus on consequences and penalize all failures regardless of intention. The Indian system has the additional advantage of using a civil liability to deal with a contractual violation. The US system tries to elevate a contractual violation to the level of a fraud.

At a deeper level, the problem of naked short selling is a failure of the securities lending system. The US has a highly developed system for this, but even this system does not work well for all stocks. India faces the challenge of building a securities lending system from scratch, but without any past baggage, it has the potential to build a system with universal access.

Posted at 14:27 on Thu, 14 Jun 2007     View/Post Comments (0)     permanent link


Wed, 13 Jun 2007

PIPE deals as regulatory arbitrage

Sjostrom has an excellent paper on SSRN about how PIPE (Private Investment in Public Equity) deals can be regarded as a form of regulatory arbitrage. Sjostrom’s argument is that the hedge fund that invests in a PIPE deal is performing the same economic function as an underwriter without being subject to either the NASD’s cap on maximum underwriting fees or the due diligence liability that the SEC imposes on underwriters. The paper also argues against the harsh posture that the SEC has adopted against PIPE deals.

I agree with much of this analysis but this line of thinking raises a few other broader issues that Sjostrom does not touch upon:

In an earlier blog entry, I argued that “Regulators however continue to act as if anything unfamiliar is worse than the status quo even when it is potentially better.” The SEC’s response to PIPE deals seems to fit this description. PIPE deals which are not of the death spiral variety appear to me to be a very legitimate financing vehicle

Posted at 14:57 on Wed, 13 Jun 2007     View/Post Comments (1)     permanent link


Thu, 07 Jun 2007

Spitzer Commission on Financial Regulation

Last week, Eliot Spitzer, Governor of New York created the New York State Commission to Modernize the Regulation of Financial Services. Among the reasons for setting up the Commission, Spitzer’s order refers to:

The mandate of the Commission is to suggest regulatory changes needed to:

This mandate appears to me to be well balanced and sound. I like the pro competitive and pro market approach to regulation. As Attorney General of New York, Spitzer earned a reputation for tough enforcement of laws. Tough enforcement makes sense only when the laws themselves are sound as Stigler taught us in his classic paper 35 years ago (Stigler, J. “The optimum enforcement of laws”, Journal of Political Economy, 1970, 526-536). As Governor, Spitzer now has a chance to work on that side of the equation as well.

Frank Partnoy has an article in the Financial Times of June 6, 2007 (“A gamekeeper turns to the poachers”) defending Spitzer’s decision to appoint senior executives from financial services firms on this Commission.

Posted at 15:38 on Thu, 07 Jun 2007     View/Post Comments (0)     permanent link


Sat, 14 Apr 2007

I am off for seven weeks

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

Posted at 20:40 on Sat, 14 Apr 2007     View/Post Comments (0)     permanent link


Thu, 29 Mar 2007

Abel Prize for Varadhan and Large Deviations in Finance

The award of the Abel Prize (often described as the Mathematics Nobel Prize) to Indian born mathematician Srinivasa S. R. Varadhan for his work on the theory of large deviations reminded me of the applications of this theory in finance. Basically one starts with a large and well diversified portfolio of securities and considers the probability distribution of large losses. If the underlying distributions have exponentially declining tails, then the theory of large deviations applies. The conditional probabilty distributions (conditioning on a large loss) can be computed in terms of the cumulant generating function and its Legendre transform.

At one time, this looked liked a very promising approach for risk modelling. Unfortunately, around this time, the mainstream risk management literature embraced fat tailed distributions with a vengeance. Once you bring in fat tails (which do not decline exponentially), the large deviations theory loses much of its applicability. However, there is no denying the mathematical elegance of the whole theory and as the Abel prize citation mentions, the theory has a wide range of applications in other fields.

Posted at 18:12 on Thu, 29 Mar 2007     View/Post Comments (1)     permanent link


Wed, 21 Mar 2007

The joys of Edgar full text search

In November of last year, I blogged about the benefits of being able to do a full text search of all filings with the US SEC. Paul Kedrosky’s infectious greed blog describes some innovative ways of using this feature that I had not thought of at all. Kedrosky says: “I have an ‘interesting word’ search that scans SEC filings and feeds ’em back to me. Out this one popped, much to my childish glee.”

In the filing that Kedrosky refers to, the “interesting word” is followed by the following sentence: “Mr. Chapman then forcefully informed Mr. Shahbazian that it was inappropriate and inadvisable for the Chief Financial Officer of a public company to utter such blasphemy to the advisor of a 9.3% ownership stakeholder in the Issuer.”. This leads Kedrovsky to propose “the 11th Commandment: Thou shalt not blaspheme >9% shareholders.” It also leads to an interesting comment on Kedrosky’s blog: “And nothing so clearly reveals the inner mind of the [venture capitalist]... Blasphemy is restricted to saying bad things about God ... We all know that most VCs view themselves as quasi-divine beings ... But it is invaluable to actually hear a VC claim godlike status publicly. One can only assume the word hubris will mean something to Chapman one day. ”

Posted at 13:58 on Wed, 21 Mar 2007     View/Post Comments (2)     permanent link


Tue, 13 Mar 2007

Hacking online trading accounts

The SEC complaint against three Indians who hacked into online stock trading accounts in the United States illustrates an interesting strategy for using apparently legitimate stock exchange trades to take money out of hacked online trading accounts. Many people seem to have a belief that when shares are held in dematerialized form, the clear audit trail of securities transfers makes theft difficult. Some people connected with depositories in India appear to think that fraud can be reduced by applying stricter checks and controls to non market transfers as opposed to those made pursuant to settlement obligations on an exchange.

The procedure used by Jaisankar Marimuthu, Chockalingam Ramanathan and Thirugnanam Ramanathan illustrates the fallacy of this reasoning. Their method is described in the SEC complaint:

The Defendants first purchased thinly traded securities, at market prices, using their own online brokerage accounts. Shortly thereafter, the Defendants, using stolen usernames and passwords, intruded into the online brokerage accounts of unsuspecting individuals. The Defendants then used these intruded accounts to place a series of unauthorized buy orders, typically at prices well above the then-current market prices for those thinly traded securities. Immediately or shortly thereafter, the Defendants capitalized on the artificially inflated share price of the targeted securities by selling shares in their own accounts. In one instance, Defendant Marimuthu realized a 92% return on his investment in less than one hour.

It is easy to see how this process can be used in reverse to sell shares from the stolen online account and buy them in the fraudster’s account at artificially low prices only to sell them into the market at normal prices. This would be useful if the stolen account had a lot of shares but not much cash. The nice thing about this procedure is that it converts stolen shares into cash using what appears to be a very legitimate exchange transaction. This illustrates the fallacy of designing control systems based on subjective notions of what is suspicious and what is not. The fraudster gets to choose the method of defrauding the victim and the chosen method is likely to be one that is least likely to arouse suspicion.

Marimuthu and Ramanathan were arrested in Hong Kong but by then they had inflicted losses of $875,000 on their victims over a five month period.

Posted at 15:22 on Tue, 13 Mar 2007     View/Post Comments (3)     permanent link


Fri, 09 Mar 2007

SEC wants to hurt stock spammers

The SEC in the United States resorted to an interesting subterfuge while suspending trading in 35 stocks touted in email campaigns. Most of the SEC’s press release appears to suggest that this is merely intended to protect gullible investors who might fall for the spam. But the fag end of the press release coupled with the very different tone of its actual order tell us that the true intent of the SEC is something different – it wants to inflict heavy losses on the spammers.

If successful, this strategy of hurting the spammer rather than just protecting investors could very effectively deter future spam campaigns. The question is the legal and ethical justification for what the SEC is trying to do.

The core of a spam campaign is well described by Frieder and Zittrain in their January 2007 SSRN paper Spam Works: Evidence from Stock Touts and Corresponding Market Activity:

The evidence accords with a hypothesis that spammers “buy low and spam high,” purchasing penny stocks with comparatively low liquidity, then touting them – perhaps immediately after an independently occurring upward tick in price, or after having caused the uptick themselves by engaging in preparatory purchasing – in order to increase or maintain trading activity and price enough to unload their positions at a profit. We find that prolific spamming greatly affects the trading volume of a targeted stock, drumming up buyers to prevent the spammer’s initial selling from depressing the stock’s price. Subsequent selling by the spammer (or others) while this buying pressure subsides results in negative returns following touting. Before brokerage fees, the average investor who buys a stock on the day it is most heavily touted and sells it 2 days after the touting ends will lose approximately 5.5%. For the top half of most thoroughly touted stocks, a spammer who buys at the ask price on the day before unleashing touts and sells at the bid price on the day his or her touting is the heaviest will, on average, earn 5.79%.

The SEC’ action has the potential to inflict heavy losses on the touts by making his holding of the touted stock worthless. Not only can he not sell his holding for the 10 days for which the suspension is in force, but the SEC is making it more or less clear that it would not like these stocks to trade any time soon. As the SEC points out:

For stocks that trade in the OTC or the over-the-counter market, trading does not automatically resume when a suspension ends. (The OTC market includes the Bulletin Board and the Pink Sheets.) Before trading can resume for OTC stocks, SEC regulations require a broker-dealer to review information about a company before publishing a quote. If a broker-dealer does not have confidence that a company’s financial statements are current and accurate, especially in light of the questions raised by the SEC, then a broker-dealer may not publish a quote for the company’s stock.

In its press release, the SEC makes its intentions very clear on this point:

Further, broker-dealers should be alert to the fact that, pursuant to Rule 15c2-11 under the Exchange Act, at the termination of the trading suspensions, no quotation may be entered unless and until they have strictly complied with all of the provisions of the rule. If any broker-dealer enters any quotation that is in violation of the rule, the Commission will consider the need for prompt enforcement action.

The interesting point is that unlike the press release which talks at length of spamming, the actual order itself mentions nothing about spamming. For each company, the order states that “Questions have arisen regarding the adequacy and accuracy of press releases concerning the company’s operations and performance” or something similar. This is clearly designed to make it impossible for any broker or dealer to have the “reasonable basis under the circumstances for believing” that the information required under Rule 15c2-11 is “accurate in all material respects”. The statute itself does not require the SEC to raise questions about the accuracy of available information to suspend trading in the stock. Section 12(k) of the Securities Exchange Act allows the SEC to order suspension for 10 days “[i]f in its opinion the public interest and the protection of investors so require”.

Clearly the temporary suspension permitted by law might help protect investors, but an indefinite suspension does not do so – it hurts those genuine investors who were holding the stock. An indefinite suspension is needed to hurt the spammers by making their initial investment worthless. Unfortunately, the statute does not give the SEC the power to do this. Hence the subterfuge is needed. I find this action disturbing because (a) it turns the regulator into a stock price manipulator even if it is for a just cause and (b) it compromises the honesty and integrity of the regulator.

Posted at 14:43 on Fri, 09 Mar 2007     View/Post Comments (0)     permanent link


Thu, 01 Mar 2007

Tax-and-spend budget has good long-term initiatives for the capital market

The Indian government budget for 2007-08 presented yesterday was a tax-and-spend Budget, and neither the taxation nor the spending was capital market-friendly, but the budget contained some policy initiatives for the capital market that would enhance its vibrancy and efficiency in the long term. I wrote a piece on this in the Financial Express today. You can also read this here

  1. I welcome the proposal to allow institutional short selling and create a proper securities lending and borrowing mechanism for this purpose.
  2. I think exchangeable bonds are a good idea, both as an additional financial instrument in the marketplace and as a mechanism for unwinding interlocked corporate holdings.
  3. The elimination of tax arbitrage on mutual funds is probably a good thing in the long run for the industry.
  4. The promise to move forward on making Mumbai a regional financial hub is welcome. This initiative announced in the 2005 Budget has gone through a tortuous process, with delays in committee formation and rumours of dissent within the committee itself. The FM’s announcement hopefully means that we will see some real action backed by a strategic vision.
  5. I read the Budget speech as signalling a willingness to improve access of Indian investors to foreign securities both directly and through mutual funds. Today it is much easier for Indians to use the $50,000 limit to invest in foreign currency bank deposits than to invest in foreign stocks and bonds.

All of this means that we will have a cleaner, stronger and deeper capital market in the years to come. That is little consolation to those nursing stock market losses on budget day, but it is hugely important for the future of India.

Posted at 13:25 on Thu, 01 Mar 2007     View/Post Comments (3)     permanent link


Sun, 25 Feb 2007

Offshore rupee bond

Ajay Shah provides details of the first issuance of an offshore rupee bond: the bond issued by the Inter American Development Bank is denominated in Indian rupees but is cash settled in dollars using the prices in the non deliverable forward market for Indian rupees.

Ajay Shah is absolutely right in saying that India should promote greater international use of its currency and encourage the Indian corporate sector to borrow abroad in rupees rather than foreign currency. The global environment is today extremely congenial for these measures today and India is in serious danger of missing the bus altogether because of faulty regulatory policies. In the name of capital controls, we have created a regulatory regime that incentivizes Indian companies to accumulate billions of dollars of foreign currency debt. This must surely be considered one of the most irresponsible of India’s economic policies.

We need to move forward on this front rapidly. The December 2006 issue of the BIS Quarterly Review contains an excellent case study of how the Australians made their currency on of the most internationalized currencies in the world within just four years of opening up their market. The New Zealand dollar is an even more internationalized currency. This article in the Reserve Bank of New Zealand Bulletin two years ago described how Eurokiwi and Uridashi bonds have helped reduce cost of capital for New Zealand borrowers while also reducing risks in their banking system.

It is high time that we learned from these examples and changed our policies quickly

Posted at 16:35 on Sun, 25 Feb 2007     View/Post Comments (0)     permanent link


Fri, 16 Feb 2007

Reducing frauds in dematerialized share transfers

The Securities and Exchange Board of India (SEBI) issued a circular this week listing measures to reduce frauds in dematerialized share transfers. While these will create inconveniences for many investors, it is doubtful whether they would reduce fraud to any significant degree.

SEBI says that individual account holders should get only one Delivery Instruction Slip (DIS) booklet containing not more than 20 slips. They can get a subsequent DIS booklet when only 5 slips are left in the old booklet. All this is borrowed from the practices that banks follow while issuing cheque books. But there is a big difference between cheques and DIS. Cheques are only a small fraction of all payments that a person makes. In traditional payment systems, well over 90% of all payment transactions by number take place using cash and not cheques. In more modern systems, cash is being replaced by debit/credit/ATM cards, but cheques remain a small part of the payment system by number of transactions. In shares on the other hand, the situation is reversed: I would imagine that well over 90% of all transfer transactions by number take place using DIS. The proposed measure will create a huge inconvenience to active investors, but it is not clear how it will reduce fraud.

SEBI says that a new DIS booklet should be issued only on the strength of the DIS instruction request slip (contained in the previous booklet). This used to be the practice in case of cheque books in the past, but this is not the case anymore. Today, many of us apply for a cheque book using internet banking facilities and the request slip is hardly ever used. Why should DIS be any different?

On the critically important issues, however, SEBI does not follow the cheque book analogy to its logical conclusion. It talks of appropriate checks and balances with regard to verification of signatures of the owners while processing the DIS. Such exhortation is pointless without strict liability. The banker is supposed to know the constituent’s signature perfectly and cannot escape liability even if the signature has been forged skillfully. Can we demand the same from depositories?

Similarly, SEBI asks the depositories to educate investors to preserve DIS carefully and not to leave blank or signed DIS with anybody. People have learnt to treat cheque books with this degree of care. Why do they not treat DIS the same way? Perhaps, the physical appearance of the DIS does not give an impression that it is a valuable document while cheques contains security features that provide visual cues that they are valuable documents. Perhaps investor education would be easier if the DIS had better visual cues about the importance of safekeeping them. Moreover if a fraudster can easily forge a blank DIS using a scanner and a laser printer, then careful preservation of the genuine DIS does not deter fraud.

After the securities scam of 1992, I remember seeing a sample of a banker’s receipt for billions of rupees of government securities. The banker’s receipt was poorly printed on paper of ordinary quality with no security features at all. The absence of visual security cues perhaps made that fraud easier.

Another anti-fraud measure would be a (possibly paid) service whereby the investor gets email and SMS alerts about every debit into the depository accounts. The circular is completely silent about this and other ways in which technology can be leveraged to guard against fraud.

On the whole, the circular gives me the impression that it is quite happy to impose costs and inconveniences on investors but it is not ready to impose significant costs on the depositories and their participants.

Posted at 17:32 on Fri, 16 Feb 2007     View/Post Comments (0)     permanent link


Fri, 09 Feb 2007

Principles based regulation and industry guidance

I do not agree at all with Ian Morley when he writes in the Financial Times (“Uphold the principles of financial services regulation”, February 7, 2007) that the Financial Services Authority in the UK is taking an unhelpful stand regarding Industry Guidance about its regulation. Morley’s complaint is about the FSA’s discussion paper of November 2006.

First of all, I found it puzzling that Morley publishes his piece about this discussion paper a few days after the comment period on this paper closed on February 1, 2007. If the purpose was to stimulate a debate, it would have been helpful to publish this a little earlier so that more people could respond to the FSA before the close of the response period.

Second, after reading the discussion paper carefully, I find nothing in it to complain about. Principles based regulation is a move away from the certainty of precise rules. Morley wishes to bring the certainty back and he seems to suggest that this could be done by industry bodies writing precise rules and the FSA granting them the force of law so that those who blindly follow these rules cannot be sued. Unfortunately, this is not a prescription for principles based regulation. It is a prescription for detailed rules with the rule making outsourced from the FSA to the industry bodies. Such a scenario would be the worst of all possible worlds. The FSA came into existence partly through a merger of several self regulatory bodies that made their own rules. It is pointless to turn the clock back.

The FSA has embarked on a tortuous journey towards principles based regulation that would take several years to complete. I hope that they succeed. Morley’s piece suggests that more than the regulator, it is the financial services industry that fears principles based regulation.

Posted at 11:58 on Fri, 09 Feb 2007     View/Post Comments (1)     permanent link


Mon, 05 Feb 2007

Yen carry trade mechanics

The discussion and subsequent blog post on Brad Setzer’s blog about the yen carry trade shows how difficult it seems to be even for those economists specializing in international economics to understand the mechanics of the currency markets. Andrew Rozanov commented on Setzer’s blog that the actual mechanics of the trade is as follows:

Step 1. Buy US$ / Sell JPY in the spot market (say, at 120)
Step 2. Buy JPY/ Sell US$ in the spot market (again, at 120)
Step 3. Buy US$ at a discount / Sell JPY at a premium in the forward market (say, 3 months forward at 118.50)
Step 4. Buy UST in the spot market
Step 5. Borrow US$ against UST in the repo market

Most international finance people would regard this as a simple, matter-of-fact description of the mechanics except that they would club steps 2 and 3 together into “Swap spot dollars(yen) for dollars (yen) three months forward” (Romanov does mention this at a later stage). Most of the economists involved in this discussion however have difficulty understanding why the mechanics are as convoluted as this.

In any international finance course, this is among the first things that we teach – in the inter bank market, the way to do a forward transaction is to combine a spot transaction with a swap. Corporate finance people who deal with their banks and not directly in the inter bank market do not of course realize this because the bank synthesizes the forward contract for them out of these two components.

International economists think at an even higher level of synthesis – they collapse steps 2, 3 and 5 into a very simple step: “ borrow yen ”. The difficulty with that synthesis is that the cheapest way to borrow against UST collateral is the repo market in the US and not in the yen market. Moreover, since derivative markets are off balance sheet transactions, we would not see the carry trade at all until we break the transactions up into their pieces and start looking at the right places for evidence of the trades.

Posted at 19:57 on Mon, 05 Feb 2007     View/Post Comments (7)     permanent link


Fri, 02 Feb 2007

SEC Approves Curious ESOP Securities

The US SEC issued a letter last week allowing Zions Bancorporation to value its employee stock options by auctioning a security which serves no economic purpose other than to price (or rather underprice) these options. Most ESOP valuations use a valuation model like Black Scholes or a binomial model. However, the accounting standards also allow a market based approach. What Zions proposed to do is to issue a security that offers to outside investors the actual cash flows obtained by its employees by exercising their options.

Logically, a company that seeks to hedge its ESOP costs should be on the other side of this transaction – it should be buying a security that reimburses the ESOP costs instead of selling the security which effectively magnifies the ESOP costs. When Zions sells this security, it is behaving like an importer who sells foreign currency forward and exacerbates the currency risk instead of buying foreign currency to hedge the risk.

If a company follows a stupid risk management policy, that should normally be a matter of concern to its investors and not to its regulator. But in this case, the design of the instrument has a completely perverse implication. As Floyd Norris put it very succintly in his column (“S.E.C. Approves New Method for Companies to Value Stock Options”, New York Times, February 2, 2007)

A major problem with such auctions, and the reason that the S.E.C. may have to watch over them, is that they are fundamentally unlike other security sales in that both the seller and the buyer would be happy to see a low price – the buyer to get something cheap and the seller to be able to minimize the reported expense of issuing options to employees.

The SEC’s letter does state that the size of the offering and the number of bidders (as well was their independence) would be factors that should be considered in determining whether an auction was an appropriate market pricing mechanism. It would have been helpful to state rather that the number of bidders, their independence and the size of the offering must be such as to overcome the presumption that the entire exercise is an Enronic accounting gimick. In my view, such a presumption would be justified because the security serves no other economic purpose for the issuer.

Posted at 13:39 on Fri, 02 Feb 2007     View/Post Comments (0)     permanent link


Wed, 24 Jan 2007

Voting rights of hedged equity

US SEC Commissioner Paul Atkins in his talk at the Corporate Directors forum this week raised the issue of "empty voting" by those who have used derivatives to hedge the economic risk of their shareholding.

First of all, it is unfortunate that Atkins raised this issue in the context of the debate about giving shareholders more rights in the election in the directors. If “empty voting” is a problem at all, then it is a problem for all shareholder resolutions and not just the election of directors. By raising the issue in this context, Atkins sends an unfortunate and inappropriate signal to the investors about the SEC’s approach to the problem.

Second, the potential for the separation of voting rights and economic rights existed even without derivatives. Supervoting shares is one way in which separation occurs. For example, in the case of Google, each of the Class B shares held by the founders has ten times the voting rights of the Class A shares held by others. Google management controls a majority of the voting rights with a much smaller economic interest in the company.

Tracking shares are another way in which separation happens. Holders of tracking shares in a division of a company own the entire economic interest in the division, but the board has no obligation to them as opposed to their obligations to the company as a whole. This means that holders of the tracking stock own a division without controlling it and the holders of the regular stock control the division without owning it.

When all these mechanisms have been in existence for decades, it is strange that the SEC finds only the use of derivatives troubling. The nice thing about derivatives is that they are traded in an open market where everybody is welcome to play the game. You do not have to be the founder of a company to unbundle a share into economic rights and voting rights using total return swaps or other means. In an efficient market, the economic interests and the voting rights will both be valued in the market and anybody can buy or sell voting rights at this market price. Once everybody realizes that this can be done, both sides in any proxy battle or takeover struggle will use this method. It is then a level playing field.

Posted at 16:51 on Wed, 24 Jan 2007     View/Post Comments (0)     permanent link


Thu, 11 Jan 2007

Risk Management at Exchanges

I gave a seminar this week at ICRIER (Indian Council for Research on International Economic Relations) where I argued that it is today computationally feasible to implement a risk management system for derivative exchanges that is (a) based on Expected Shortfall, (b) incorporates fat tailed distributions and (c) computes portfolio risk across multiple underlyings (securities or commodities) using non linear dependence models (copulas).

Risk measures like Value at Risk, SPAN and Risk Metrics have their intellectual roots in the early 1990s or earlier when the notion of coherent risk measures had not been developed and risk modelling had not yet embraced fat tailed distributions with non linear dependence structures. For example, current global best practice in handling exposure to multiple underlyings (“inter commodity spreads”) in exchange risk management can only be characterized as crude and ad hoc. Their continued popularity owes much to the inadequacies of correlation based dependency modelling. Similarly, the SPAN framework uses too few scenarios to meet the highly desirable “relevance axiom” for risk measures though computational advances allow us to come very close to fulfilling this axiom.

In India, the regulatory framework for risk management at Indian exchanges is still supposed to be based on the 99% value at risk mandated by the L C Gupta Committee a decade ago. In practice, however, Indian exchanges and their regulators have adopted several features of a fat tailed expected shortfall approach. Risk management practice has thus outgrown the regulatorily mandated value at risk to which it still pays lip service. The time has come to formally discard value at risk from the regulatory lexicon and adopt a more modern vocabulary. This would provide an opportunity to spur new research on improving exchange risk management systems.

My presentation made specific proposals for a modern risk management system and indicated directions for further research. The slides of this presentation are available here.

Posted at 14:13 on Thu, 11 Jan 2007     View/Post Comments (2)     permanent link


Tue, 02 Jan 2007

Alphabet Soup is not Innovation

Gillian Tett, the capital markets editor of the Financial Times writes (“Let us pass on the alphabet soup, SVP”, Financial Times, December 29, 2006) that bankers trained in science and mathematics are creating innovative debt instruments but giving them unimaginative names with unwieldy acronyms – the alphabet soup.

He talks about “the broader acceleration of the global financial innovation cycle” and says “banks are responding by inventing products at such a furious pace, they barely have time to think up names.” By contrast, he argues that “A couple of decades ago, when new financial products hit the markets, banks gave them names. A host of new words crept into the investment bible over the years, such as options, swaps or puts”.

I am unable to agree with this view. Much of the alphabet soup today does not represent really new products. Rather it consists of simple adaptations to the credit market of ideas and instruments well known in equity and other markets. Compared to true innovations like cash settled index futures, the credit market innovations that we are seeing are minor modifications and adaptations of well known dynamic portfolio strategies.

For decades, credit has been the preserve of the banking system. Today, as credit breaks out of that prison and moves into the hands of people accustomed to the joys and pleasures of vibrant financial markets, we are seeing a lot of changes. Even the simple idea of trading a portfolio of credits rather than a single credit appears revolutionary though this is what equity traders have been doing for decades now. However, all this is catch up and not innovation.

Posted at 12:22 on Tue, 02 Jan 2007     View/Post Comments (2)     permanent link