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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Mon, 26 Apr 2010

Principles versus rules: HSBC Mutual Fund in India

An order passed by the Securities and Exchange Board of India (SEBI) on Friday regarding a mutual fund run by HSBC in India provides a fascinating example of the advantages of principles based regulation.

Indian regulations require that before a mutual fund makes a “change in any fundamental attribute” of any mutual fund scheme it should not only inform all unit holders but also give them a costless exit option (Regulation 18(15A) of the Mutual Funds Regulations). The regulations do not define what is a fundamental attribute so that absent any further “clarifications” by the regulator, we would have a very sensible principles based regulation.

In 2009, the HSBC Mutual Fund made the following changes in one of its mutual fund schemes, the “HSBC Gilts – Short Term Plan.”

Under a principles based regulation, there is no question that this would be a change in the fundamental attribute of the scheme. In fact, it changes the nature of the scheme so drastically that it is conceivable that many investors in the original scheme might not wish to remain invested in the changed scheme.

Unfortunately, the SEBI regulations were not truly principles based. Way back in 1998, it issued clarifications that replaced the nice principles based regulation with a set of bright red lines by giving a laundry list of things that are fundamental attributes. Neither the change of name, nor the change in the modified duration, nor the change in the benchmark index figured in this list.

The regulator was forced to accept that HSBC was technically correct in claiming that it had not changed any fundamental attribute of its scheme.

The moral of the story is that while principles based regulation is genuinely hard both for regulator and regulatees, rules based regulation is often a farce.

Posted at 19:41 on Mon, 26 Apr 2010     View/Post Comments (6)     permanent link

Sat, 17 Apr 2010

Lehman and the Derivative Exchanges

The unredacted Volume 5 of the Lehman examiner’s report released earlier this week provides details about how CME handled the Lehman default by auctioning the positions of Lehman to other large dealers. The table below summarizes the data given in the report.

Asset ClassNegative Option ValueSpan Risk MarginTotal CollateralPrice paid by CME to buyerLoss to ExchangePercentage Loss to ExchangeLoss to Lehman
Energy Derivatives3722616337077412%335
FX Derivatives-41282-6-72%6
Interest Rate Derivatives9313022333311049%240
Equity Derivatives-5737732445-287-39%450
Agricultural Derivatives-555505224%57
Total auctioned by CME451119516461539-107-6%1088
Natural Gas Derivatives sold by Lehman itself482129611622112%140
Grand Total933132422572161-96-4%1228

The negative option value is as the close of business before the Lehman bankruptcy and the loss to Lehman is computed as the excess of the price paid by CME to the buyer over this negative option value. Futures positions are presumably assumed to have zero value after they have been marked to market. On the other hand, CME incurs a loss only if it pays a price in excess of the collateral provided by Lehman. For comparison purposes, the same computation is done for the positions sold by Lehman itself, though, in this case, the exchange does not make any profit or loss.

What I find puzzling here is that in the case of interest rate derivatives, CME had to pay the winning dealer a price of about 1.5 times the collateral available. Had it not been for excess collateral in other asset classes, the CME might have had to take a large loss. Was the CME seriously undermargined or was the volatility in the days after Lehman default so high or was this the result of a panic liquidation by the CME?

We do have an independent piece of information on this subject. LCH.Clearnet in London also had to liquidate Lehman’s swap positions amounting to $9 trillion of notional value. LCH has stated here and here that the Lehman “default was managed well within Lehman margin held and LCH.Clearnet will not be using the default fund in the management of the Lehman default.”

A number of questions arise in this context:

In the context of the ongoing debate about better counterparty risk management (including clearing) of OTC derivatives, I think the regulators should release much more detailed information about what happened. Unfortunately, in the aftermath of the crisis, it is only the courts that have been inclined to release information – regulators and governments like to regard all information as state secrets.

Posted at 14:26 on Sat, 17 Apr 2010     View/Post Comments (2)     permanent link

SEBI, IRDA and the courts

I wrote a column in the Financial Express today about letting the courts resolve disputes between two financial regulators.

When I wrote a month ago “At a crunch, I do not see anything wrong in a dispute between two regulators... being resolved in the courts,” (‘Fill the gaps with apex regulator’, FE, March 19); I did not imagine that my wish would be fulfilled so soon. The dispute between Sebi and Irda regarding Ulips seems to be headed to the courts for resolution. There is nothing unseemly or unfortunate about this development. On the contrary, I believe that this is the best possible outcome.

An independent regulator should be willing and able to carry out the mission laid down in its statute, without worrying about whether its actions would offend another regulator. Its primary loyalty should be to its regulatory mandate and not to any supposed comity of regulators. Equally, if a regulator intrudes on the mandate of another, the other regulator or its regulatees should have no compunctions in challenging it in a court of law.

In any case, the idea that regulators share cordial relationships with each other is a myth. Turf wars are the rule and not the exception. In the UK, for example, after Northern Rock, the Bank of England and the FSA began to talk to each other only through the press, it was obvious to all that the relationship was extremely bitter. In the US, during the crisis, severe strains were evident between the Fed and the FDIC. The relationship between the SEC and the CFTC has, of course, been strained for decades.

In the financial sector in particular, we want strong-willed regulators to act on the courage of their conviction. Since many of their regulatees probably have outsized egos, perhaps it does not hurt to have a regulator with an exaggerated sense of self-importance. We do not want regulators who are too nice to their regulatees. It follows then that we cannot wish that regulators be too nice to each other either.

What we need instead is a mechanism to deal with the problem of regulatory overreach—democracies thrive on checks and balances. Regulatory overreach is a problem, even when it does not involve another regulator at all. Instead of hoping that regulators will always exercise self-restraint, we need a process to deal with the consequences of regulators overstepping the line.

The best mechanism is a robust appellate process—appellate tribunals and beyond them, the regular judiciary. Regulators, too, must be accountable to the rule of law and an appellate process is the only way to ensure this. The judicial process is as capable of resolving disputes between two regulators as it is of resolving disputes between the regulator and its regulatees.

In the context of the dispute between Sebi and Irda, many people have argued that a bureaucratic process of resolving disputes is preferable to a judicial process. There is, however, little evidence for such a view from around the world. Bureaucratic processes are less likely to provide a lasting solution and more likely to produce unseemly compromises that paper over the problem.

The two-decade-long dispute in the US between the SEC and CFTC about equity futures provides an interesting case study to demonstrate this. In the early 1980s, the SEC and the CFTC came to an agreement (the Shad Johnson accord) dividing up the regulatory jurisdiction of stock index futures and index options, but they were unable to agree on the regulation of single stock futures. Futures on narrow indices were left somewhere in the middle, with the CFTC having regulatory jurisdiction but the SEC having a veto power on the introduction of the contract itself.

In the late 1990s, when the SEC barred the Chicago Board of Trade (CBOT) from trading futures on the Dow Jones Utilities and Transportation indices, CBOT took the SEC to court and won. The court sternly declared that, “SEC is not entitled to adopt a ‘my way or the highway’ view by using its approval power—as a lever.” With the Shad Johnson accord in tatters, the two regulators were finally forced to sort out the regulation of single stock futures—a matter that they had not been able to settle by bureaucratic processes for two decades.

It is evident that the resolution of the single stock futures dispute would not have happened without judicial intervention. For two decades, inter-regulatory coordination mechanisms in the US, like the President’s Working Group on Financial Markets were not able to resolve the matter—it was too convenient for both regulators to agree to disagree.

An important advantage of judicial resolution is that regulatory conflicts that have the most serious impact on the markets are more likely to be litigated than those that are less damaging. It is, therefore, more likely that the final outcome would be socially and economically efficient. There are no such incentives to guide a bureaucratic solution towards the social optimum.

Posted at 07:28 on Sat, 17 Apr 2010     View/Post Comments (2)     permanent link

Fri, 16 Apr 2010

The SEC and the Python

Last week, the SEC put out a 667 page proposal regarding disclosures for asset backed securities. What I found exciting was this:

We are proposing to require that most ABS issuers file a computer program that gives effect to the flow of funds, or “waterfall,” provisions of the transaction. We are proposing that the computer program be filed on EDGAR in the form of downloadable source code in Python. ... (page 205)

Under the proposed requirement, the filed source code, when downloaded and run by an investor, must provide the user with the ability to programmatically input the user’s own assumptions regarding the future performance and cash flows from the pool assets, including but not limited to assumptions about future interest rates, default rates, prepayment speeds, loss-given-default rates, and any other necessary assumptions ... (page 210)

The waterfall computer program must also allow the use of the proposed asset-level data file that will be filed at the time of the offering and on a periodic basis thereafter. (page 211)

This is absolutely the right way to go particularly when coupled with the other proposal that detailed asset level data be also provided in machine readable (XML) format. For a securitization of residential mortgages for example, the proposal requires disclosure of as many as 137 fields (page 135) on each of the possibly thousands of mortgages in the pool.

Waterfall provisions in modern securitizations and CDOs are horrendously complicated and even the trustees who are supposed to implement these provisions are known to make mistakes. A year ago, Expect[ed] Loss gave an example where approximately $4 million was paid to equity when that amount should have been used to pay down senior notes (hat tip Deus Ex Macchiato).

Even when the trustees do not make a mistake, the result is not always what investors had expected. A few months ago, FT Alphaville reported on two Abacus deals where the documentation allowed the issuer (Goldman Sachs) to use its “sole discretion” to redeem the notes without regard to seniority. People realized that this was possible only when Goldman Sachs actually paid off (at face value) some junior tranches of these CDOs at the expense of senior tranches.

When provisions become complex beyond a point, computer code is actually the simplest way to describe them and requiring the entire waterfall to be implemented in open source software is a very good idea. The SEC does not say so, but it would be useful to add that if there is a conflict between the software and textual description, the software should prevail.

Now to the inevitable question — Why Python? The SEC actually asks for comments on whether they should mandate Perl, Java or something else instead. I use Perl quite extensively, but the idea that Perl is a suitable language for implementing a transparency requirement is laughable. Perl is a model of powerful but unreadable and cryptic code. As for Java and C-Sharp, there is little point in having open source code if the interpreter is not also open source. I do not use Python myself, but it appears to be a good choice for the task at hand.

It is gratifying that the SEC continues the one good thing that Cox initiated when he was Chairman – the use of technology as a key regulatory tool.

Posted at 12:55 on Fri, 16 Apr 2010     View/Post Comments (2)     permanent link

Wed, 14 Apr 2010

Icesave: What is in a name?

The Special Investigation Committee set up by the Icelandic parliament (Althingi) to investigate and analyse the processes leading to the collapse of the three main banks in Iceland submitted its report this week. A portion of the report is available in English.

One of the interesting stories in the report (Chapter 18, page 5) is about the choice of the brandname Icesave for the deposit accounts offered by the Icelandic Bank, Landsbanki in the UK and in the Netherlands. The SIC states:

... Arnason [CEO of Landsbanki] also described how the brand name Icesave was created. He claimed that Landsbanki representatives had initially thought it was negative for an Icelandic bank to market deposit accounts in the UK. An advertising agency employed by the bank pointed out that it would never be possible to conceal the origin of the bank and, therefore, it would be better to simply advertise it especially. As a result, the brand name “Icesave” was created.

... Research indicated that a simple and clear message together with a strong link to Iceland would prove beneficial.

I think this has some implication for the literature about the relationship between geographical names on stock prices. For example, Kee-Hong Bae and Wei Wang show that during the China stock market boom in 2007, Chinese stocks listed in the US that had China or Chinese in their names significantly outperform US listed Chinese stocks that do not have China or Chinese in their names. (“What’s in a ‘China’ Name? A Test of Investor Sentiment Hypothesis”,

What the Icesave example shows is that the choice of the name is not independent of the advertising, pricing and other strategies of the company. Some of what appears to be the result of a name change might in fact be due to other changes in the company’s business and strategy.

This might be true even in case of other studies about the impact of name changes on the stock price. For example, Cooper, Dimitrov, and Rau (“A by Any Other Name”, Journal of Finance, 56 (2001), 2371–2387) found that stock prices rose 74% when they changed their names to dot com names in 1999. Similarly, Rau, Patel, Osobov, Khorana and Cooper (Journal of Corporate Finance, 11 (2005), 319-335) showed that stock prices rose when firms removed from their name after the bubble burst.

It is possible that these name changes were also accompanied by changes in business strategies.

Posted at 11:28 on Wed, 14 Apr 2010     View/Post Comments (0)     permanent link

Tue, 13 Apr 2010

IFRS in the Indian financial sector: Regulatory Capture?

A group constituted by the Ministry of Corporate Affairs with representation of all major financial sector regulators in India has approved a road map for the convergence to international accounting standards (IFRS) by insurance companies, banking companies and non-banking finance companies.

First of all, why should there be a different road map for the financial sector? Why not let financial entities be subject to the same road map as the rest of the corporate sector? The only plausible argument is that the most important change from Indian accounting standards to IFRS would be the treatment of financial instruments (IAS 39) and this impacts the financial sector more than any other sector.

But this argument is rather weak because there are other sectors which are disproportionately impacted by IFRS and there is no kid glove treatment for those sectors. The accounting treatment for agriculture for example changes quite substantially under IFRS. But agriculture does not have a powerful set of regulators protecting their regulatees while the financial sector does.

What I found even more interesting was the different treatment of insurance companies and banks within the financial sector itself. Insurance companies will adopt IFRS in 2012 while banks get an extra year. Is this because insurance companies do not stand to lose much from IFRS and might even stand to gain, while banks stand to lose a lot more?

If one looks only at the complexity of the transition to IFRS, it is not possible to argue that the transition is easier for insurance companies than for banks. Insurance companies too have large investment portfolios and they too will have to contend with all the complexities of IAS 39. In addition, there is an entire accounting standard (IFRS 4) for the insurance industry and IFRS 4 is by no means a model of simplicity. The insurance regulator (IRDA) has a 200 page report describing the implications of IFRS for Indian insurance companies.

Nor is it true that contemplated changes in IFRS will impact banks more and that therefore it makes sense for them to transition directly to the revised standards as and when they come out. IFRS 4 relating to insurance is explicitly described as Phase I of the IASB’s insurance project and Phase II promises drastic and fundamental changes in the accounting approach.

No, I do not see any strong argument why it is in the public interest for insurance companies to converge to IFRS a year ahead of banks. It is obvious however that it is in the interest of the banks themselves to postpone IFRS because of the stringent treatment of held to maturity investments. A cynic would say that regulators in every country and every sector are in danger of being captured by their regulatees.

I think this is a powerful reason for not mixing up regulatory capital and accounting capital. It would be nice if regulators could accept that accounting is for investors and agree to stay from interfering in this. Regulators are free to collect whatever data they want and define capital and profits in whatever way they want. They are free to ignore everything that the accountants put out. That would help make it easier for accounting standards to provide what is most relevant and useful for investors.

Posted at 14:02 on Tue, 13 Apr 2010     View/Post Comments (0)     permanent link

Thu, 01 Apr 2010

Prudent at night but reckless during the day

I have been thinking a lot about what the court examiner’s report on Lehman tells us about other banks. Looking at many things mentioned in the report, my conclusion is that even the banks that are prudent at night become quite reckless during the day. Banks that are careful about their end of day (overnight) exposures seem to be happy to assume very large exposures during the day provided they believe that the position will be unwound before close of the day.

My first example of this phenomenon is a repo transaction undertaken by Barclays after it bought a major part of the Lehman broker dealer business (LBI) in the bankruptcy court. The examiner describes this transaction and its consequences in detail in his report:

The parties then began to implement ... a repo transaction between LBI and Barclays under which Barclays would send $45 billion in cash to JPMorgan for the benefit of LBI, and Lehman would pledge securities to Barclays. Barclays planned to wire the $45 billion cash to JPMorgan in $5 billion components, and Barclays (actually, Barclays’ triparty custodian bank, BNYM) would receive collateral to secure each $5 billion cash transfer. (Page 2165, Volume 5)

Shortly after noon on Thursday, Barclays wired the initial $5 billion of cash to JPMorgan for the benefit of LBI. (Page 2166, Volume 5)

... a senior executive from JPMorgan then contacted Diamond, and asked Barclays to send the $40 billion in cash all at once to expedite the process. According to Ricci, the JPMorgan executive provided Diamond with assurances that, if Barclays sent the $40 billion in cash, JPMorgan would follow up promptly in delivering the remaining collateral. Early Thursday evening, Barclays wired the remaining $40 billion in cash. Barclays did not receive $49.6 billion in securities that evening. Although both the FRBNY and DTCC kept their securities transfer facilities open long after their usual closing times, by 11:00 p.m. on Thursday evening, September 18, Barclays had received collateral with a marked value of only approximately $42 billion. (Page 2167, Volume 5)

To put matters in perspective, $40 billion was roughly equal to the total shareholders’ equity of Barclays at that time (according to the June 30, 2008 balance sheet, shareholders’ equity was £ 22.3 billion or $40.5 billion at the exchange rate of 1.82 $/£ on September 18, 2008). In other words, Barclays was willing to take an unsecured intraday exposure to another bank equivalent to roughly its entire worth. I am sure that an overnight unsecured exposure of this magnitude would be regarded as reckless and irresponsible, but an intraday position was acceptable.

My second example is the triparty clearing bank services provided by JP Morgan Lehman and other broker-dealers. The examiner’s report provides a lucid explanation of the whole matter:

In a triparty repo, a triparty clearing bank such as JPMorgan acts as an agent, facilitating cash transactions from investors to broker- dealers, which, in turn, post securities as collateral. The broker-dealers and investors negotiate their own terms; JPMorgan acts only as an agent. Triparty repos typically mature overnight ... Each night collateral is allocated to investors ... The investors, in turn, provide overnight ... funding to the broker-dealer. The following morning, JPMorgan “unwinds” the triparty repos, returning cash to the triparty investors and retrieving the securities posted the night before by the broker-dealer. These securities then serve as collateral against the risk created by JPMorgan’s cash advance to investors. During the business day, broker-dealers arrange the funding that they will need at the close of business through new triparty-repo agreements. This new funding must repay the cash that JPMorgan advanced during the business day... (Page 1086-87, Volume 4)

The premise of a triparty repo is that it constitutes secured funding in which the lender (investor) has the opportunity to sell the collateral immediately upon a broker-dealer’s (borrower’s) failure to pay maturing principal. (Page 1092, Volume 4)

To guard against the possibility of the investor realizing less than the loan amount in a liquidation scenario, the borrower must pledge additional “margin” (i.e., additional collateral) to the lender – for example, $100 million of Treasury securities in exchange for $98 million in cash. (Page 1092, Volume 4)

As triparty-repo agent to broker-dealers, JPMorgan was effectively their intraday triparty lender. When JPMorgan paid cash to the triparty investors in the morning and received collateral into broker-dealer accounts (which secured its cash advance), it bore a similar risk for the duration of the business day that triparty lenders bore overnight. If a broker-dealer such as LBI defaulted during the day, JPMorgan would have to sell the securities it was holding as collateral to recoup its morning cash advance. (Page 1093, Volume 4)

Through February 2008, JPMorgan gave full value to the securities pledged by Lehman in the NFE calculation and did not require a haircut for its effective intraday triparty lending. Consequently, through February 2008, JPMorgan did not require that Lehman post the margin required by investors overnight to JPMorgan during the day. (Page 1094, Volume 4)

That last paragraph left me stunned. Why would the clearing bank not impose a haircut/margin on the intraday secured lending, while the repo lenders do require such a haircut on the overnight lending? It makes no sense to me. First, the clearing bank is taking a large concentrated exposure, while this exposure gets distributed over a large number of overnight lenders. If anything, the intraday lender should be more worried and should be charging a higher margin. Second, most financial asset prices instruments are more volatile when the markets are open than when they are closed. Since prices are expected to change more during the day than during the night, the intraday lender actually needs a higher margin. Yet, the intraday lender did not ask for any margins at all till February 2008!

For a moment, I thought that the clearing bank was not charging margins because it was willing to take some amount of unsecured exposure to the broker-dealer and it was willing to dispense with the margin under the assumption that the margin would be less than the unsecured exposure that it was willing to have. But no, the examiner’s report clearly states that the margin free secured lending was over and above the maximum unsecured lending that JPMorgan was willing to provide:

JPMorgan used a measurement for triparty and all other clearing exposure known as Net Free Equity (“NFE”). In its simplest form, NFE was the market value of Lehman securities pledged to JPMorgan plus any unsecured credit line JPMorgan extended to Lehman minus cash advanced by JPMorgan to Lehman. An NFE value greater than zero indicated that Lehman had not depleted its available credit with JPMorgan. (Page 1093, Volume 4)

Yet, on a reading of the entire examiner’s report, JPMorgan comes across as a bank with a very robust risk management culture. Again and again one sees that in the most turbulent of times, the bank is seen to be sensitive to various market risks and operational risks and appears to have taken corrective action very quickly. The only conclusion that I can come to is that even well run banks are complacent about intraday risks.

Why should banks be prudent at night but reckless during the day? Probably this has got to do with the fact that nobody prepares intraday balance sheets and so positions that are reversed before close of day do not appear in any external reports (and probably not in many internal reports either). Probably, it has to do with the primordial fear of darkness dating back to our evolutionary struggles in the African Savannah. As the biologists remind us, you can take the man out of the Savannah, but you can not take the Savannah out of the man.

Posted at 16:55 on Thu, 01 Apr 2010     View/Post Comments (2)     permanent link