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, 26 Sep 2010

BIS Confirms Huge Offshore Rupee Market

In my post early this month, I very tentatively argued that data from the BIS and the RBI could be put together to suggest that half the rupee-dollar market was outside India. Most people whom I talked to said that this was unlikely and that there was probably some error either in the data or in my analysis.

But now the BIS has published a paper on offshore foreign exchange markets which gives clearer data. According to Table 7 of this paper, 52% ($10.8 billion) of the total rupee forward and forex swap market ($20.8 billion) is offshore and only 48% ($10.0 billion) is onshore. We still need to wait for November for more detailed data on other segments of the rupee market, but $10.8 billion a day is much larger than most estimates that I have seen or heard of the offshore non deliverable forward market.

The same table provides data about 2007 as well – only 30% ($3.6 billion) of the rupee forward and forex swap market was offshore. In just three years, the offshore market has tripled in size! A footnote in the table cautions us that the mandatory reporting of trades in the rupee (and several other emerging market currencies) following its reclassification of these currencies as major currencies would have increased the reported size of the offshore markets.

According to the BIS Paper, the offshore markets are even bigger for the Chinese renminbi (63% is offshore but much of that is in Hong Kong) and the Brazilian real (82% is offshore). The paper argues that offshore non deliverable markets in the Brazilian real, Chinese renminbi and Indian rupee are now so large that “adding an offshore deliverable money and bond market may not represent a large change.”

Suddenly, we are waking up to a much more internationalized currency than any of us were aware of. I have long argued that Indian capital controls are more “sand in the wheels” than effective barriers to capital flows. The data points in the same direction – policy makers must recognize that India has a de facto open capital account.

Posted at 14:51 on Sun, 26 Sep 2010     View/Post Comments (2)     permanent link

Fri, 24 Sep 2010

Stock Exchange Regulation and Competition

This column of mine regarding stock exchange regulation and competition appeared in the Financial Express today. Coincidentally, yesterday evening, the Securities and Exchange Board of India released its order rejecting the application of MCX-SX to start trading equities in India. My column was written early this week well before SEBI passed its order. I am not yet masochistic enough to sit up all night to read a 68 page order and then write a column about it.

The ongoing dispute regarding the shareholding pattern of MCX-SX is an opportunity to rethink the current regulatory conception of the stock exchange as the extended regulatory arm of the state. Given this regulatory conception, the ownership structure (legal ownership, ownership of economic interests, and ownership of control rights) of the stock exchange becomes a matter of public policy. However, the requirement to have dispersed shareholding is likely to result in an unacceptably anti-competitive outcome.

There is a different way of looking at stock exchanges—not as frontline regulators, but as the equivalent of a shopping mall for securities. We do expect shopping malls to comply with the building safety code, but do not expect them to “regulate” the shop owners. If we treat stock exchanges the same way, we would expect them to comply with basic regulations regarding trading systems and infrastructure, but would not expect them to regulate either the listed companies or the stock brokers.

We could not have thought of stock exchanges like this a century ago because there were no securities regulators in those days and the central banks too did not bother to regulate the markets. For example, in the US a hundred years ago, it was left to the New York Stock Exchange to demand that companies publish their annual accounts (and delist even large companies like Proctor and Gamble for refusing to do so). Similarly, in those days, it was the London Stock Exchange that imposed free float requirements (67% free float!) because there was no other regulator to do so. Today, we expect the securities regulators, the company law departments and the accounting bodies to perform much of this regulatory role.

The time has come to ask whether the stock exchange should be a listing authority at all in an era of demutualised stock exchanges and alternate trading systems. There are stock exchanges elsewhere in the world that are listed on themselves; this appears to me to be as absurd as a snake swallowing its own tail. Of course, the alternative of a stock exchange listing on a rival exchange is only slightly less laughable. Some countries have shifted the listing function into an arm of the regulator itself and I think there is much to commend such a move.

Another problematic area is that of market surveillance. In an era of highly interconnected markets, the idea of each exchange performing surveillance on its own market is an anachronism. A stock exchange that sees only the trades happening on its own platform is no match for a market manipulator who trades in multiple cash and derivative exchanges (as well as the OTC markets) and shifts positions across these markets to avoid detection. The flash crash in the US markets on May 6, 2010, has highlighted the folly of relying on surveillance by the exchanges. Some of the best analyses of the events of that day have come not from the exchanges or the regulators but from data feed companies that specialise in processing high frequency data from multiple trading venues.

The final regulatory barrier to free competitive entry into the stock exchange industry comes from the extreme systemic importance of the clearing corporation of a major exchange. In the UK, the ability to outsource clearing to LCH.Clearnet has been very important in the emergence of alternate trading venues. Indian regulators should also explore such a solution.

Shorn of listing, surveillance and clearing, a stock exchange would be very much like a shopping mall and it would be possible to permit free entry without any significant regulatory barriers. The regulators should then be blithely unconcerned about who owns, controls or runs an exchange. By unleashing competition, this could help bring down costs and improve service levels.

In the interest of ensuring competitive outcomes, I think it would be useful to also dismantle the utterly dysfunctional “fit and proper” regime throughout the financial sector. The global financial crisis has shown that there is scarcely any bank or financial intermediary in the world that is “fit and proper” enough to be entrusted with any significant fiduciary responsibility without intrusive supervision and stringent regulation. The illusion of a “fit and proper” regime only serves to discourage private sector due diligence.

I believe that regulators worldwide should accept this reality and abandon the “fit and proper” requirement altogether. Resources devoted to screening applicants at the point of granting a licence are much better spent supervising those who are already licensed. Today, the position is the opposite. In India banks and stock exchanges have retained their licences long after they had deteriorated to the point where they would not get a licence if they were applying for it afresh. This is an intensely perverse anti-competitive situation.

In short, the problems relating to shareholding pattern of stock exchanges highlighted by the MCX-SX episode should be solved not through legal hair splitting but through more robust regulatory frameworks.

Posted at 05:20 on Fri, 24 Sep 2010     View/Post Comments (1)     permanent link

Sat, 11 Sep 2010

Teji-Mandi goes to Chicago

Options with one-day maturity (known as Teji and Mandi for call and put options) were popular in Indian equity markets during the 1970s and 1980s though they were prohibited under the Securities Contracts (Regulations) Act, 1956. With the equity market reforms of the 1990s, these contracts disappeared completely.

One-day options are now being proposed by the Chicago Board Options Exchange (hat tip FT Alphaville). In its regulatory filing, the CBOE says:

The Exchange believes that Daily Option Series will provide investors with a flexible and valuable tool to manage risk exposure, minimize capital outlays, and be more responsive to the timing of events affecting the securities that underlie option contracts. In particular, the Exchange seeks to introduce Daily Option Series to provide market participants with a tool to hedge overnight and weekend risk, as well as the risk of special events such as earnings announcements and economic reports, and pay a fraction of the premium of a standard or weekly option (due to the very small time value priced into the option premium). The Exchange believes that daily expirations would allow market participants to purchase an option based on a precise timeframe thereby allowing them to tailor their investment or hedging needs more effectively.

Regulatory fashions come and go – often, a financial innovation is only the reintroduction of something that existed decades or centuries ago. Much of what happens in modern equity markets (good or bad) can be traced back to early 17th Century Amsterdam. (See for example, Geoffrey Poitras, From Antwerp to Chicago: The History of Exchange Traded Derivative Security Contracts and Jose Luis Cardoso, “Confusion de confusiones: ethics and options on seventeenth-century stock exchange markets”, Financial History Review (2002), 9:109-123).

I have long believed that what was really wrong with things like Teji, Mandi or Badla in pre-reform Indian equity markets were not the instruments themselves but the absence of robust risk management and the lack of safeguards against market manipulation. There is nothing wrong with daily options – many high frequency trading strategies might effectively be replicating short maturity options. I would in fact wonder whether there is merit in options with even shorter maturity – hourly, if not even shorter.

Posted at 11:33 on Sat, 11 Sep 2010     View/Post Comments (4)     permanent link

Fri, 03 Sep 2010

Is half the rupee-dollar market outside India?

I do not know whether I am reading the data wrong, but the preliminary results of the BIS Triennial Survey on foreign exchange turnover (April 2010) appear to suggest that nearly half the rupee-dollar market is outside India.

For the first time, the 2010 BIS survey includes the rupee as a “main currency” and provides data about the USD/INR turnover. According to Table 4, the average daily turnover in USD/INR was $36 billion. Table 5 tells us that the average daily foreign exchange turnover in India was only $27.4 billion. That might suggest that India accounts for 75% of the USD/INR market.

However, not all the Indian market is USD/INR. According to the RBI data (Table 47 of the RBI bulletin of June 2010) in April 2010, INR versus all foreign currencies was only 71% of the market in India; almost 30% was trading of various foreign currencies against each other. In this computation, I have taken both sides of the merchant trades and only one side of the inter-bank trades as the BIS data is on net basis. Of course, BIS also does cross border netting which might change the numbers a bit, but I would think the percentages might not be impacted too much.

If we make the reasonable assumption that the entire INR versus foreign currency market in India is actually INR versus USD and take 71% of $27.4 billion as the USD/INR market in India, we get $19.5 billion which is only 54% of the $36 billion global USD/INR market. If these calculations are approximately correct, India is only a little more than half of the total global rupee-dollar market.

One other relevant data point is that according to the BIS Table 5, India’s share of the global foreign exchange market has dropped from 0.9% in 2007 to 0.5% in 2010.

Unfortunately, while the BIS links to various central banks that publish their national results at the same time as the BIS, the RBI is not among them. So we do not have more data to verify these computations.

Posted at 09:48 on Fri, 03 Sep 2010     View/Post Comments (8)     permanent link

Wed, 01 Sep 2010

How Fast Can Traders Add and Multiply?

I have written a paper entitled “When Index Dissemination Goes Wrong: How Fast Can Traders Add and Multiply?” It has also been uploaded at SSRN.

The abstract is as follows:

This paper studies an episode of dissemination of wrong stock index values in real time due to a software bug in the Indian Nifty index futures market on the morning of January 18, 2006.

The episode provides an opportunity to test various models of cognitive biases and bounded rationality highlighted in behavioural finance. The paper provides strong evidence against cognitive biases like “anchoring and adjustment” (Tversky and Kahneman, 1974) that one might expect under such situations even though the cognitive task involved is quite simple. The futures market tracked the true Nifty index which it could not see while completely ignoring the wrong Nifty index that it could see.

However, the paper demonstrates that market efficiency failed in more subtle ways. There is evidence of a partial breakdown of price discovery in the futures markets and a weakening of the bonds linking futures and cash markets.

This evidence is consistent with the centrality of “market devices” as argued in “actor network theory” in economic sociology (Muniesa, Millo and Callon, 2007 and Preda, 2006). Well functioning markets today depend critically on a whole set of information and communication technologies. Any failures in these material, socio-technical aspects of markets can make markets quite fragile even if behavioural biases are largely absent.

Posted at 04:28 on Wed, 01 Sep 2010     View/Post Comments (8)     permanent link