Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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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