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. This blog is currently suspended.

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Tue, 22 Jul 2008

Insider Trading by Underwriters

Robert Preston at BBC News reports about the extraordinary insider trading that took place after the HBOS rights issue flopped miserably and the underwriters were left holding the bulk of the issue:

On Friday, Dresdner and Morgan Stanley both knew that existing shareholders had shunned the rights issue, since they were organising the share sale. But the market was only given the information this morning.

That information was - in theory at least - highly price sensitive. You’d think therefore that both Dresdner and Morgan Stanley would be banned from dealing in HBOS on their own account till the market had been told the extent of the rights take-up.

But apparently no such prohibition applied.


Well after the rights closed at 11am on Friday, they were both allowed to take a short position in HBOS, to cover themselves against a future fall in the HBOS share price.

So they duly shorted HBOS in massive size. I understand Morgan Stanley took a 2.4 per cent short position in the mortgage bank - which is huge.

If this story is true, it means that the UK Financial Services Authority (FSA) has given up all pretence of being a referee rather than a market player itself. The FSA’s stand against what it called abusive short selling now sounds truly hollow.

Posted at 13:17 on Tue, 22 Jul 2008     View/Post Comments (2)     permanent link

Wed, 16 Jul 2008

US too turns against the shorts

The headline on FT Alphaville says “America suspends capitalism” while the Wall Street Journal’s Deal Journal suggests that the regulators would simply have put a bounty on a short seller’s head if only they knew that it could be done. They are both referring to the emergency order of the US SEC against naked short selling in 19 financial stocks including Lehman Brothers, Fannie Mae and Freddie Mac. These orders were issued under Section 12(k)(2) of the Securities Exchange Act which provides that the SEC “in an emergency, may by order summarily take such action ... as the Commission determines is necessary in the public interest and for the protection of investors ... to maintain or restore fair and orderly securities markets.”

I can well see that a ban shorting Fannie Mae and Freddie Mac might help the central banks of China, Russia and other countries which together hold close to a trillion dollars of these Agency bonds, but I fail to see how it protects the US investors whom the SEC was set up to protect.

It was only last month that I commended US regulators for not being as harsh on short sellers as the UK had been. My praise was clearly premature. In addition to the ban on naked shorting, the SEC was also talking loudly about “enforcement investigations into alleged intentional manipulation of securities prices through rumor-mongering and abusive short selling.”

Incidentally, Aleablog tells us that there is an ETF that allows one to short the US Financials Index without being naked short at all. That post also tells us June was the best month for short sellers since the dot com bust seven years ago.

Posted at 13:09 on Wed, 16 Jul 2008     View/Post Comments (3)     permanent link

Fri, 11 Jul 2008

Y V Reddy on Indian Financial Stability

Reserve Bank of India Governor, Dr. Y V Reddy in a speech at the Meeting of the Task Force on Financial Markets Regulation in the United Kingdom earlier this month talked about how “India has by-and-large been spared of global financial contagion due to the sub-prime turmoil”:

The credit derivatives market is in an embryonic stage; the originate-to-distribute model in India is not comparable to the ones prevailing in advanced markets; there are restrictions on investments by resident in such products issued abroad; and regulatory guidelines on securitisation do not permit immediate profit recognition. Financial stability in India has been achieved through perseverance of prudential policies which prevent institutions from excessive risk taking, and financial markets from becoming extremely volatile and turbulent. As a result, while there are orderly conditions in financial markets, the financial institutions, especially banks, reflect strength and resilience.

First of all, I would have liked the word “yet” to be added while talking about India being spared the turmoil because it is too early to say whether India will emerge unscathed out of all this. It has been my view that the global turmoil is first and foremost about the bursting of an asset price bubble in real estate and secondly about excessive leverage. The specifics of the financial products involved – credit derivatives, financial guarantees, securitization, CDOs and SIVs – are relatively less important. India has not yet had an equally severe correction in property prices though correction in the share prices of real estate companies suggests that such a correction is in progress. I also think that there is a high degree of leverage in Indian real estate and a fair degree of sub prime lending too. One part of the sub prime lending (unsecured personal loans) has already witnessed severe losses mainly for finance companies. A 20% nation wide fall in real estate prices in India is not inconceivable, and if that were to happen, the consequences would be ugly for the financial sector.

Second, the idea that institutions in India are prevented from excessive risk taking is quite incorrect. Indian banks can make bad loans as easily as banks elsewhere in the world, and there is little evidence that the culture of credit appraisal is particularly strong in large parts of the banking system. Low levels of non performing assets in an (until recently) booming economy prove nothing.

Third, the assertion that financial markets in India do not become extremely volatile is plainly wrong. I would recall January 16, 1998 in the fixed income markets, August 20, 1998 in the currency markets and January 21, 2008 in our equity markets as evidence of what can happen in a single day in three different financial markets. Low volatility during benign periods is irrelevant; what matters is the volatility when things go wrong.

The speech refers to several counter cyclical policies of the RBI:

The first and the third are valid points and highly creditable. The second is quite dubious as it only allowed banks to avoid mark to market losses.

Posted at 12:52 on Fri, 11 Jul 2008     View/Post Comments (2)     permanent link

Fri, 04 Jul 2008

Crude oil spot and futures markets

There appears to be a lot of confusion about the relationship between spot and futures markets for crude oil after Paul Krugman set the ball rolling with his remark: “Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price.” Krugman led up to this with an even more provocative example:

Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won’t. What direct effect does this have on the spot price of oil – the actual price people pay to have a barrel of black gunk delivered?

The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn’t make any difference.

Such provocation was bound to elicit an extreme response and Peak Oil Bebunked did just that with the oppposite claim:

Most crude oil is traded based on long-term contracts, and the prices in those contracts are set by ... adding a premium to, or subtracting a discount from, certain benchmark or marker crudes. ... Originally, the benchmark prices were spot prices, but over time ... many key oil exporters shifted away from the spot market, and began to use futures prices as the benchmark.

... Krugman and Birger are profoundly confused about the way the international oil markets actually function. Futures aren’t a paper bet on the direction of prices determined by some independent process. Futures themselves *determine* the price of most physical oil traded today. The futures price (+ or - the differential) literally *is* the price of oil.

Peak Oil Bebunked left many commentators on his blog thoroughly confused. One commentator for example wrote:

I always wondered about this. I figured the futures prices had to adjust to the spot price (which was driven by actual oil) as the contract expired. If they didn’t, a arbitrage opportunity would exist that would correct the imbalance.

But given this explanation, I guess not. I guess the “spot” prices adjusts to the futures price.

The downside to this approach is that supply/demand fundamentals don’t necessarily determine the price.

Crude oil markets are pretty complex and Peak Oil Bebunked’s description of this market is actually quite correct, but there is a sense in which Krugman’s textbook model is not totally wrong either. It is worthwhile understanding this market in some detail. For concreteness, I will focus on the Brent Crude market.

The term Brent crude today refers to crude coming out of any of four oilfields in the North Sea – Brent, Forties, Oseberg and Ekofisk – collectively referred to as BFOE.

The most important market for physical Brent crude is the cash BFOE market which is essentially a forward market. It is based on 21 days advance declaration (though 15 day and other periods are also in vogue). In July, a buyer and seller may conclude a transaction for delivery in August without fixing even the approximate date within the month. The buyer can choose the date later but has to give 21 days advance declaration to the seller. It is the price of this contract that most participants would regard as the price of physical Brent crude oil. Price discovery does happen in this market though it is heavily influenced by the futures price. Moreover, though this is a market for physical crude, it is a forward rather than a true spot market.

Let us then move to the closest that we get to a spot transaction – the dated Brent crude market. The terms are usually FOB – the buyer brings the vessel and the seller provides the berth at the terminal and loads the cargo. Dated Brent is a market for a specific cargo (typically 600,000 barrels) to be loaded at the terminal close to Brent during say July 23-25. The middle day (July 24) is the scheduled day of loading, but the buyer can usually bring the vessel to the terminal at any time within the three day period known as the laydays. Dated Brent contracts are actively traded between oil industry participants. Also, when a buyer gives an advance declaration in the cash BFOE contract, it effectively becomes a dated Brent contract.

Since the laydays span three days and the loading period itself could be close to two days, there is considerable deviation in the precise day of loading of the cargo even in the dated Brent market. Similarly, if the buyer of an August cash BFOE contract gives declaration for a date late in August, it is possible that loading takes place only on say the 2nd of September. Contracts often allow for further exceptions even beyond this if there is a curtailment of production in the oilfield or for other reasons beyond the control of the buyer or seller. These complications are natural in any genuine spot market for a non financial asset.

The dated Brent market probably has very little impact on price discovery for Brent crude. This is because these transactions are concluded on a differential to the (forward) cash BFOE price. The dated Brent for July 23-35 might for example be traded at August cash BFOE plus 10 cents.

Finally, we come to what is by far the most important price of Brent crude – the Brent crude futures at ICE. The ICE Brent Futures is a deliverable contract based on EFP delivery with an option to cash settle. Cash settlement is based on the cash BFOE market as explained in the contract specifications:

[T]he ICE Futures Brent Index ... is the weighted average of the prices of all confirmed 21 day BFOE deals throughout the previous trading day for the appropriate delivery months. These prices are published by the independent price reporting services used by the oil industry. The ICE Futures Brent Index is calculated as an average of the following elements:

  1. First month trades in the 21 day BFOE market.
  2. Second month trades in the 21 day BFOE market plus or minus a straight average of the spread trades between the first and second months.
  3. A straight average of all the assessments published in media reports.

Essentially, therefore, the underlying for the Brent futures is the cash (21 day) BFOE market. The standard textbook model of cash-futures arbitrage implies that the futures price cannot deviate too much from this underlying “spot” price. Even if we regard cash BFOE as a forward rather than spot contract, it is linked to its underlying which is dated Brent. The moment the buyer of cash BFOE gives declaration, he effectively turns his contract into dated Brent crude. Arbitrage would therefore tie cash BFOE down to dated Brent. At this level, Krugman’s argument that a futures contract is a bet about the future price is not without merit.

But things are much more complex than this because long term contracts for crude in regions far away from the North Sea are based on Brent futures price plus/minus a differential. ICE claims that the Brent contract “is used to price over 65% of the world's traded crude oil.” On the other hand, BFOE is only a miniscule part of the total crude oil production in the world. This is the point that Peak Oil Bebunked is making. Brent futures are far more important and influential than any of the markets for physical crude. Most price discovery actually happens in the futures market and the physical markets trade on this basis. In an important sense, the crude futures price is the price of crude.

Crude is a particularly nasty example, but similar phenomena exist even in financial assets. Much of the price discovery in stock markets happens in the index futures market. Individual stocks are priced taking the broader market index as given. If the index has fallen 5% on a day and a specific stock has not traded so far, a person contemplating placing a bid for this stock would implicitly price it off the index futures price taking into account the beta of the stock and any stock specific information. Yet the index futures contract is settled using the cash index value and is therefore itself tied down to the cash market through cash-futures arbitrage. This is not inconsistent with the fact that the major element of price discovery happens in the index futures market.

Posted at 10:02 on Fri, 04 Jul 2008     View/Post Comments (5)     permanent link

Wed, 02 Jul 2008

Non-use of ratings in SEC regulations

I am not fully satisfied with the 222 page proposal that the US SEC has put forward for eliminating the use of credit ratings in various regulations. It is certainly commendable that the SEC has done a comprehensive job of identifying all regulations that refer to ratings and then systematically eliminated every one of them. Moreover, in many cases, the SEC has also identified meaningful alternatives to the use of ratings. My disappointment is in relation to the two or three truly critical uses of rating in the SEC regulations.

The first is in capital requirements for broker dealers where the existing regulations specify different levels of haircuts for their proprietary positions in debt securities with different levels of credit rating. A good solution to this problem could have provided the template for eliminating the use of ratings in Basle 2 as well. Instead what the SEC proposes is:

We are proposing the substitution of two new subjective standards for the NRSRO ratings currently relied upon under the Net Capital Rule. For the purposes of determining the haircut on commercial paper, we propose to replace the current NRSRO ratings-based criterion -- being rated in one of the three highest rating categories by at least two NRSROs -- with a requirement that the instrument be subject to a minimal amount of credit risk and have sufficient liquidity such that it can be sold at or near its carrying value almost immediately. For the purposes of determining haircuts on nonconvertible debt securities as well as on preferred stock, we propose to replace the current NRSRO ratings-based criterion -- being rated in one of the four highest rating categories by at least two NRSROs with a requirement that the instrument be subject to no greater than moderate credit risk and have sufficient liquidity such that it can be sold at or near its carrying value within a reasonably short period of time.

We further believe that broker-dealers have the financial sophistication and the resources necessary to make the basic determinations of whether or not a security meets the requirements in the proposed amendments and to distinguish between securities subject to minimal credit risk and those subject to moderate credit risk. The broker-dealer would have to be able to explain how the securities it used for net capital purposes meet the standards set forth in the proposed amendments.

Notwithstanding our belief that broker-dealers have the financial sophistication and the resources to make these determinations, we believe it would be appropriate, as one means of complying with the proposed amendments, for broker-dealers to refer to NRSRO ratings for the purposes of determining haircuts under the Net Capital Rule.

The last paragraph above means that while technically the SEC gets ratings out of its rule book, for all practical purposes nothing really changes. Broker dealers would use ratings exactly as before with the full blessings of the SEC.

The SEC has a similar non solution in the second place where ratings play a critical role. Money market funds are allowed to value their holdings at amortized cost rather than fair value on the ground that regulations restrict their investments to short term debt securities in the two highest short-term rating categories. The proposal is to rely on a determination of “minimal credit risk” by the board of directors of the fund. In the context of the large losses that many money mutual funds have taken during the sub prime crisis, I would have thought that the logical thing to do would have been to mandate fair value accounting for money market funds and treat them like any other mutual fund.

The third critical use of rating and rating agencies is in the field of disclosure. Rating agencies are exempted from the prohibition of selective disclosure under Regulation FD. The SEC proposes to maintain this exemption. I think this exemption is inconsistent with the stand of the ratings agencies that their ratings are “editorials”. Similarly, the SEC permits but does not require issuers to disclose credit ratings in their offer documents. The SEC’s proposal leaves this substantially unchanged. My problem here is that if ratings are editorials, then they should be permitted to be disclosed in offer documents only in the same way and to the same extent that other editorials, research reports or expert opinions are permitted to be disclosed.

Posted at 11:39 on Wed, 02 Jul 2008     View/Post Comments (1)     permanent link