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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Wed, 28 Oct 2009

Indian overnight interbank market in October 2008

The Reserve Bank of India’s Report on Trend and Progress of Banking in India 2008-09 has a series of charts (Chart VII.3 on page 250) comparing the volatility of the overnight interbank interest rate in India with that of several other (mature and emerging) economies.

India and Russia stand out in the charts for the ridiculously high volatility in October 2008. The inability to keep the overnight rate close to the policy rate in these two countries is so glaring that one is forced to conclude that central banking was virtually suspended in India and Russia for a few weeks in that period.

It is not that the mature economies were doing a great job of liquidity management in those days. Only in August 2008, Willem Buiter had gone to the Jackson Hole symposium to tell the assembled central bankers that “The deviations between the official policy rate and the overnight interbank rate that we observe for the Fed, the ECB and the Bank of England are the result of bizarre operating procedures ...” (Page 531). If the mild volatility in the US and Europe appeared bizarre to Buiter, I wonder what he would say if confronted with the Indian data.

Posted at 16:28 on Wed, 28 Oct 2009     View/Post Comments (1)     permanent link

Wed, 21 Oct 2009

Galleon Insider Trading Charges

The US Justice Department and the US SEC filed insider trading complaints against the billionaire Raj Rajaratnam, his Galleon hedge fund and several other friends and associates a few days ago. All the interesting stuff (for example, the transcripts of telephone conversations) are in the criminal complaints filed by the Justice Department. If one reads only the SEC complaint, one would not realize that there are several smoking guns here.

The fact that the whole thing was made possible by the FBI’s use of informants and wiretaps appears to provide some support for a controversial paper by Peter Henning posted at SSRN last month. In this paper, titled “Should the SEC spin off the enforcement division?,” Henning argued that “To allow the SEC to regulate Wall Street properly, splitting off at least a portion of the enforcement function to an agency with expertise in prosecutions – the United States Department of Justice – is at least worthy of consideration as the government looks to increase regulation.”

One reason why the Department of Justice had all the advantages here is that insider trading is very simple to understand. There is no need for a PhD in finance to recognize insider trading if the prosecutors have access to all the communications that are taking place. But absent such access, insider trading is notoriously difficult to prove. So here, wiretapping expertise beats finance expertise hollow.

At another level, it was interesting to find that with all the insider information that they had from multiple sources, the defendants lost money trading AMD shares prior to its announcement of the spin off of the fabrication facilities and a capital infusion by Abu Dhabi. The complaint attributes it to a general decline in stock prices due to the global financial crisis. The defendants bought AMD stock beginning August 15, 2008, the Lehman collapse occurred in mid September, the AMD announcement happened on October 7, 2008 and the defendants sold stocks around October 20, 2008.

But the global financial crisis is not the whole story as seen from the graph below. Even if the defendants had hedged their AMD long position with a short position in the Nasdaq Composite index, they would not have made money. Yes, AMD does outperform Intel over the period, but not by a huge amount.

AMD versus Nasdaq price graph

It appears from the graph that around the time that the defendants were buying AMD on inside information, many others were also buying. They could also have been buying on inside information or on pure rumours. The graph reminds me of the old adage: “buy the rumour, sell the fact.” It is also possible that the Abu Dhabi deal was not as attractive as people initially thought and the prices reacted to this reassessment. In other words, if Galleon had the advantage of superior information, other traders might have had the advantage of superior analysis. The complaint contains the transcript of a telephone conversation where two defendants agree on a division of labour: one of them is to collect the information and the other is to analyze it. The second person probably was not up to the task.

Posted at 11:15 on Wed, 21 Oct 2009     View/Post Comments (1)     permanent link

Tue, 20 Oct 2009

SEC response to Madoff failure

I have a column in the Financial Express yesterday about the SEC response to its failure to detect the Madoff fraud and what this means for other securities regulators worldwide. Some of my related blog posts can be found here, here and here.

After its dismal failure to detect the Madoff fraud despite plenty of warnings, the US SEC conducted a review by its own Inspector General of what went wrong. This report published in August was uninteresting as it explained it all away as incompetence and inexperience of the staff concerned.

This explanation was not completely convincing given the detailed information that people like Markopolos provided to the SEC over several years. In any case, there is little point in a 450 page report that reaches a conclusion that could be arrived at simply by applying Hanlon’s Razor: “Never attribute to malice what can be adequately explained by stupidity.”

At the end of September, however, the Inspector General released two more reports (totalling 130 pages) indicating that incompetence might not be the whole story. A survey carried out by the Inspector General found that 24 percent of the SEC enforcement staff felt that cases were improperly influenced or directed by management and 13% stated that they had observed lack of impartiality in performance of official duties.

In this article, however, I will focus on the Inspector General’s recommendations (which the SEC has already accepted) for improving the enforcement and inspections processes at the SEC. These recommendations represent very significant changes in the mindset of how to run these divisions not only at the SEC but at other regulators worldwide.

The report recommends that 50% of the staff and management associated with examination activities should have qualifications like the Certified Fraud Examiner and Certified in Financial Forensics. This recommendation is a sanitised version of what Markopolos recommended when he testified to the US Congress in February about the SEC failure to uncover Madoff despite his detailed complaints.

Markoplos argued that talented CPAs, CFAs, CFPs, CFEs, CIAs, CAIAs, MBAs, finance PhDs and others with finance backgrounds need to be recruited to replace current SEC staffers. He also claimed that SEC staffers with credentials like CPA and CFA are not allowed to have their designations printed on their business cards presumably because if the SEC allowed its few credentialled staff to do so, it would expose the overall lack of talent within the SEC.

The Inspector General recommends that all examiners should have access to relevant industry publications and third-party database subscriptions sufficient to develop examination leads and stay current with industry trends. It also talks about establishing a system for searching and screening news articles and information from relevant industry sources for potential securities law violations.

This recommendation responds at least partially to Markopolos’s testimony that most of the time all the SEC uses is Google and Wikipedia because both are free and the SEC regional offices do not have access to industry publications and academic journals.

The SEC estimates that it would cost $300,000-$400,000 annually to provide data access in one room in each office; providing access to each examiner will cost a lot more. It also estimates that it would cost $3-4 million to implement the system for searching news reports and other media, but this appears to be a one time cost rather than an annual cost.

The Inspector General wants examiners to have direct access to the databases of the exchanges, depositories, clearing corporations and various self-regulatory organisations rather than having to get data from these agencies as and when required. This is a huge change of mindset because it blurs the distinction between the self-regulatory organisations as first line regulators and the SEC as the apex regulator. It moves the SEC into the regulatory frontline.

In line with this change, the SEC proposes to train its examiners in the mechanics of securities settlement (both in the US and in major foreign markets), in the trading databases maintained by the various exchanges as well as in the methods to access the expertise of foreign regulators, exchanges, and clearing/settlement agencies.

Turning to investigation, the Inspector General wants all investigation teams to have at least one individual on the team with specific and sufficient knowledge of the subject matter (like Ponzi schemes or options trading) as well as access to at least one additional individual who also has such expertise or knowledge.

During the last quarter century, many regulators elsewhere in the world have looked upon the SEC as the gold standard in securities regulation enforcement and have consciously or unconsciously fashioned themselves on the SEC.

The lesson from Madoff is that the role model should not be the SEC of recent decades but the SEC of the 1930s and 1940s under chairmen like Douglas who believed that the management of the SEC was a higher form of business management. Or perhaps, the role model should be the modern New York Attorney General’s Office.

For regulators who are far behind even the current SEC in terms of talent and resources, the SEC experience should be a wake-up call to put their houses in order.

Posted at 07:02 on Tue, 20 Oct 2009     View/Post Comments (1)     permanent link

Tue, 13 Oct 2009

Mumbai elections: Do machines need a holiday?

India’s national stock markets are closed today because of elections in Mumbai where the main exchanges are headquartered. It is true that Mumbai accounts for more than half of the trading in the pan India stock markets, but still the question does arise – do machines need a holiday on election day?

It is surely possible for the stock exchange servers to keep running so that the rest of India can trade. Alternatively, the lower trading volumes on a day on which Mumbai is closed provides a wonderful opportunity to test the exchanges’ business continuity plan by running the trading engine off the back up servers outside of Mumbai.

For a variety of legal reasons, it is desirable for the disaster recovery site of the exchanges to be located in a state different from the one where the main site is located. This would provide a safeguard against any one city or state imposing exorbitant taxes and other levies on what is really a national market.

It is interesting to note that when it comes to the payment system, the nearly universal global practice is to close the system only on days which are holidays for the entire country or region. In the Eurozone for example, the Target system closes only on days which are holidays in every participating country. The Indian RTGS also closes only on national holidays though the number of holidays is larger than that of Target.

Stock markets (and more importantly, their regulators) globally have been much more willing to close the markets. The worst manifestation of this was after 9/11 when the US stock market remained closed even after the US Treasury market re-opened though the loss of lives in the Treasury market was more severe (I had a post on this subject way back in 2005).

Posted at 07:12 on Tue, 13 Oct 2009     View/Post Comments (2)     permanent link

Thu, 08 Oct 2009

SEC formalizes bail out of fat fingers

Exchanges world wide have often bailed out fat fingered traders who punch in wrong buy or sell orders. I have blogged about this here, and also about a rare contrary example here and here. Such bail outs create a moral hazard problem because traders have insufficient incentives to install internal controls and processes to prevent erroneous orders.

Instead of stopping this practice, the SEC has now stepped in to formalize the moral hazard and has also set exceptionally low thresholds for such bail outs:

In general, the new rules allow an exchange to consider breaking a trade only if the price exceeds the consolidated last sale price by more than a specified percentage amount: 10% for stocks priced under $25; 5% for stocks priced between $25 and $50; and 3% for stocks priced over $50.

I believe this move by the SEC reflects regulatory capture: those who are harmed by trade cancellation are typically day traders and other small traders who have little voice in the regulatory system, while those benefited by the bail out tend to be large trading firms. (The very term day trading is always used pejoratively – when a large firm does it, the terminology changes to high frequency trading which suddenly sounds a lot more respectable).

Three years ago, I wrote: “Clearly exchanges can not be trusted with the discretion that is vested in them. The rule should be very simple. Traders should bear the responsibility (and the losses) of their erroneous trades.” I wonder now whether the regulators can be trusted with the discretion that is vested in them.

Posted at 04:07 on Thu, 08 Oct 2009     View/Post Comments (5)     permanent link

Sun, 04 Oct 2009

Bank Losses: Securities versus loans

I have been arguing for some time now (for example, here) that the financial crisis in the US is looking more and more like an old fashioned banking crisis rather than a problem in the securities markets. The IMF Global Financial Stability Report released earlier this week provides strong evidence for this.

Table 1.2 in Chapter 1 shows that out of the trillion dollar losses projected for US banks, 64% would come from loans and only 36% from securities. The losses on loans are estimated as 8.1% of the total loans held by the banks while the losses on securities are 8.2% of the securities holding. These practically identical loss rates demolish the idea that we would not have had a crisis if the US had boring banks which just took deposits and made loans.

For the world as a whole, the loss rate on securities (5.9%) is significantly higher than loans (4.7%). Despite that, 67% of the $2.8 trillion losses come from loans and only 33% from securities.

Posted at 08:26 on Sun, 04 Oct 2009     View/Post Comments (0)     permanent link