Prof. Jayanth R. Varma's Financial Markets Blog

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

© Prof. Jayanth R. Varma

Subscribe to a feed
RSS Feed
Atom Feed
RSS Feed (Comments)

Follow on:

Sun Mon Tue Wed Thu Fri Sat

Powered by Blosxom

Thu, 27 Jan 2011

Barings, Rothschild and Morgan

During the last three centuries, four investment banks have dominated global finance at one point or the other:

After World War II, no investment bank has dominated global finance in a way even remotely comparable to these four. (No, not even the “great vampire squid”). I used Google’s Books Ngram Viewer to see how common were references to these banks in the books of different countries at different points of time. I dropped Hope & Co. because it hardly registered in the graphs.

There are some limitations in the results. I entered “Rothschilds” in the plural to avoid picking up references to other people with this not uncommon German surname. But this means that I am not catching references to Nathan Rothschild for example. Morgan is an even more common surname, and I had to use JP Morgan to avoid contaminating the results. On the flip side, I am losing references to Pierpont Morgan or the House of Morgan. Finally, despite using a three-year smoothing in the graphs, publication of books on any of these banks leads to spikes which should not be taken too seriously. Also, the scale of the vertical axis is not the same across the graphs.

With all these limitations, the graphs below tell an interesting story. First, the books lagged behind the financial reality often by several decades, particularly in the earlier years. Second, high-profile (and sometimes quasi-political) events like the Barings’ involvement in the Louisiana purchase of 1803, or JP Morgan’s involvement in the panic of 1907, or Nick Leeson’s fraud at Barings in 1995 are reflected in a disproportionate coverage in the books (often after a lag).

Third (and most puzzling), Rothschild dominates British and German literature while JP Morgan dominates the French. I would think that the Rothschild branch in Paris was at least as important as the branches in London and Vienna. I am baffled by the surge in the coverage of JP Morgan in the French books well before the panic of 1907, and well before the surge of this American bank in American books.

Barings, Rothschild and Morgan in British English books 1700-2000
Graph of Barings Rothschild and Morgan in British books

Barings, Rothschild and Morgan in American English books 1700-2000
Graph of Barings Rothschild and Morgan in American books

Barings, Rothschild and Morgan in English books 1700-2000
Graph of Barings Rothschild and Morgan in English books

Barings, Rothschild and Morgan in French books 1700-2000
Graph of Barings Rothschild and Morgan in French books

Barings, Rothschild and Morgan in German books 1700-2000
Graph of Barings Rothschild and Morgan in German books

Posted at 14:38 on Thu, 27 Jan 2011     View/Post Comments (1)     permanent link

Fri, 21 Jan 2011

Commodity bubbles or successful monetary policy?

The blogosphere has been discussing a Federal Reserve Board of St Louis paper by Richard Anderson arguing that what appears to be an asset price bubble may actually be the normal result of expansionary monetary policy.

Rapid increases in commodity and financial market prices by themselves, however, are not reliable indicators of potential bubbles because such increases also occur as part of normal monetary policy. ... Disappointingly low returns on short-term, low-risk investments prompt investors to move to longer-term, higher-risk investments in financial instruments, commodities, and durable goods.


One factor is the potential success of expansionary monetary policy: If economic activity expands, demand for commodities likely will increase, pushing futures prices upward, which, in turn, tends to increase current-period prices. ... A second factor is the decreased foreign exchange value of the dollar as a result of aggressive monetary policy.


As long as the FOMC’s pursuit of highly expansionary policy continues, households and businesses remain pessimistic, and demand is sluggish, the potential exists for asset prices to deviate from their long-run levels by large amounts and for long periods. Such increases per se are not bubbles but a commonplace reaction of the monetary transmission mechanism. ... Whether bubbles have been generated remains to be seen.

It is simplest to evaluate this argument for commodity prices because to a first approximation their “long-run levels” can be regarded as constant in real terms (real commodity prices are stationary to a first approximation absent secular supply or demand shocks).

A large increase above this long-run level implies a large negative expected real return on commodities. This is difficult to reconcile with positive yields on long-term inflation indexed bonds. Even at shorter maturities, inflation indexed yields are only mildly negative, and even a modest risk premium would lead to a positive required rate of return on commodities.

Moreover, if the price pressure on the spot prices is coming from elevated futures prices as Anderson argues, the implication is that nominal prices are expected to rise. That too does not appear consistent with falling real prices given modest inflation rates in the developed world.

It appears to me that one would have to assume severe supply constraints (of the peak oil variety) to provide a non-bubble explanation for a sharp rise in real commodity prices above their “long-run levels”.

Similar problems would arise in the case of other assets as well. If one assumes that prices are above their long-run levels, then expected risk adjusted returns would be negative which would be inconsistent with positive or even near zero yields on inflation indexed bonds.

Depressed expected rates of return can be attributed to “a commonplace reaction of the monetary transmission mechanism,” but it is difficult to see how highly negative expected rates of return (implied by large deviations from long-run levels) can be so explained.

Of course, one can argue that inflation indexed yields are only reflecting large risk premiums for sovereign default and that the true real risk-free rate is hugely negative. But that would be an even more scary story than an asset price bubble.

Posted at 12:17 on Fri, 21 Jan 2011     View/Post Comments (6)     permanent link

Wed, 19 Jan 2011

Complete that demat process

I have a column in today’s Financial Express on the need to complete the process of dematerialization of shares in India by abolishing physical share certificates completely.

The time has come to abolish physical share certificates completely and dematerialise all shares by eliminating the option that is currently given to the owner to hold shares either in physical form or in dematerialised form. Dematerialisation should be mandatory even if the owner has no immediate intention to trade the shares on the exchange.

When depositories were first created in India, it was well known that physical share certificates were prone to fraud and malpractices. However, since dematerialisation was a new concept in the country, it was thought that the ability to convert back and forth between paper and dematerialised form would give investors greater comfort and confidence. Today, after more than a decade, the depositories have established themselves as reliable and secure. There is now nothing to be lost and everything to be gained by eliminating paper completely.

Many of us believed that the risk of fraud and theft of physical certificates would induce a voluntary dematerialisation of large holdings, particularly after the exchanges shifted to trading exclusively in dematerialised mode. However, some large investors (including, unfortunately, some government entities) ignore these risks and hold on to paper certificates. More troublingly, one hears disconcerting (hopefully false) rumours of physical certificates being used to backdate or postdate transactions with the collusion of companies and their registrars.

Such alteration of dates may produce advantages under the takeover code and under the tax laws. For example, inter se transfer of shares between promoters is exempted from the requirements of the takeover code if the transferor and transferee have held the shares for at least three years. Similarly, purchases of shares during the previous six months are taken into account while deciding the open offer price. Under the tax laws, the lower tax rate on capital gains applies if the shares are held for a year.

All these could be facilitated by backdating or postdating transaction dates—something that would be impossible in the dematerialised environment. In fact, the more I think about it, the more I am convinced that some promoters and large operators hold on to paper certificates for unsavoury reasons.

Even if this were not so, there would still be reason to worry about these holdouts of paper certificates. As old timers retire, registrars are gradually losing the skill set required to verify the authenticity of physical certificates. I have seen airline check-in staff (and sometimes even their supervisors) fumble when they encounter the increasingly rare physical air tickets because they are all familiar only with e-tickets. Over a period of time, this lack of familiarity with the vestiges of a paper era will become a serious problem for registrars, and will provide a fertile opportunity for fraudsters.

It is, therefore, imperative to launch a time-bound action plan to achieve 100% dematerialisation. I think such a plan should have three elements.

First, we should stop creation of new paper certificates forthwith. The Depositories Act should be amended to prohibit rematerialisation of physical certificates. Furthermore, it must be mandatory to make all new allotments of shares in dematerialised form. Transfer or transmission of shares (even if it takes place outside the exchange) should be permitted only in dematerialised form.

Second, we must set a cutoff date (say, January 1, 2012), by which large and critical holdings must be dematerialised. This date should apply to:

An extended cutoff date (say, January 1, 2015) can be set for dematerialisation of other shares—small shareholdings by individual investors.

After the cutoff date (or the extended cutoff date for small holdings), physical shares that have not been dematerialised would become almost useless. However, in exceptional cases where genuine reasons can be demonstrated, dematerialisation of these shares may be permitted after issuing a public notice in a newspaper giving sufficient time for other claimants to dispute the claims of the holder. For tax purposes and for takeover code purposes, the date of dematerialisation would be deemed to be the date of acquisition of the shares.

Finally, we must set a cancellation date (say, January 1, 2020) on which all remaining physical share certificates would be deemed to be cancelled and forfeited, and the issuers would be required to record the forfeiture of shares in their books.

During this process of elimination of paper certificates, it would be useful to preserve samples of the old paper certificates for the historical record in an appropriate archive or museum. Regulations require dematerialised share certificates to be mutilated and cancelled, and in the absence of a conscious archival effort, these mutilated certificates are likely to be destroyed as a matter of course.

Posted at 05:22 on Wed, 19 Jan 2011     View/Post Comments (7)     permanent link

Sun, 16 Jan 2011

Watson and trading in financial markets

Much has been written about IBM’s Watson defeating top rated contestants in a practice round of the US TV quiz game Jeopardy. Modelled Behaviour says “AI and singularity suddenly feel near enough to care about.” Nemo says “simply an incredible achievement, far beyond beating Kasparov at chess.” What is also interesting is how much the machine has progressed from its dismal performance less than a year ago.

I have been thinking about what it means for finance especially financial markets. Could it make markets more resilient? Running on a supercomputer, Watson needs several seconds to come to its conclusions. By the standards of high frequency trading (HFT), this is an eternity, but we know that markets are more resilient when it is populated with a diversity of traders operating at totally different time scales. Could it also lead to more algorithmic trading based on a wide variety of news sources and fundamentals, instead of trading based only on order flow and machine readable news?

Posted at 10:09 on Sun, 16 Jan 2011     View/Post Comments (2)     permanent link

Sun, 09 Jan 2011

Citi fraud: a Madoff moment for wealthy Indians

India’s wealthy have encountered their Madoff moment with the fraud in the Gurgaon (New Delhi) branch of Citibank in which a relationship manager defrauded the wealth management clients of the bank of over Rs 3 billion (about $65 million). The relationship manager promised high rates of return and persuaded clients to sign blank cheques which were used to transfer the funds to bank accounts of the manager’s family members.

Why do wealthy people fall for such frauds? Why do they venture into such unregulated products where they have much lower levels of protection? I think this has a lot to do with people extrapolating their experiences of the pre reform era (prior to 1991) to the modern largely deregulated economy:

  1. Many people believe that one can earn higher rates of return in unregulated products without bearing higher risk. During the era of financial repression, it was true that interest rates in the formal market were artificially repressed below equilibrium levels (probably by as much as three percentage points). After the economic reforms of the early 1990s, this financial repression came to an end. However, those who grew up in the pre reform era still believe that there is an extra risk free return to be earned outside the formal regulated sector.
  2. During the days of the licence raj (prior to the reforms) political and business connections allowed people to get access to resources that were not available to ordinary people. Anything from train tickets to cement was easy to obtain for the privileged few. It is easy for people who grew up in that era to believe that their connections can give them access to investment opportunities not available to ordinary investors. Obviously, these opportunities would be in unregulated and opaque products.
  3. The experience of the pre reform era conditioned people to be relationship oriented rather than transaction oriented in financial matters. This makes them trust a wealth manager who comes home and collects the cheque (even blank cheques). The younger generation would probably rely on an online investment facility instead.
  4. The same distrust of formal systems leads people to ignore vital safeguards like independent custody as well as independent verification and audit of statements.

I do not believe that greater regulation is the answer to the problem. If the underlying investor attitude does not change, regulating one set of products would only drive investors to another set of unregulated products. The whole genesis of blank cheques probably lies in a misguided attempt to “empower” the investors by using a nondiscretionary portfolio management system.

In a nondiscretionary portfolio management system, the advisor only gives advice, and it is the investors that supposedly take all the decisions. By contrast, a discretionary portfolio management system is more like a mutual or a hedge fund where the client has little voice in investment decisions. A nondiscretionary system appears to give more power to the investors and is intended to protect investors from wrong investment decisions by the advisor. However, by getting investors to sign blank cheques and instruction forms, advisors are able to run what is effectively a discretionary portfolio management system while maintaining the documentary pretence of running a nondiscretionary system. Far from empowering the investor, the result is to leave investors vulnerable to fraud. In retrospect, investors might have been better off in a discretionary system.

Personally, I think financial regulators should not waste excessive amount of resources or time pursuing the Citi fraud for several reasons. First, the fraud involved unregulated products. Second, the fraud is well covered by normal criminal laws regarding theft and misappropriation. Third, the victims are very wealthy investors who are well capable of hiring the best lawyers and investigators to go after the bank. The regulators’ time and resources are much better spent on regulated products involving small investors who are less capable of looking after themselves.

Posted at 12:40 on Sun, 09 Jan 2011     View/Post Comments (5)     permanent link

Sat, 01 Jan 2011

Offshore rupee and renminbi markets

India and China appear to be responding in very different ways to the issue of their currencies trading offshore (the non deliverable forward or NDF market). The Reserve Bank of India says in its Financial Stability Report (page 29-30):

Prevalence of a large offshore market raises systemic concerns with regard to both monetary policy and financial stability as the offshore and onshore markets do not operate in silos.


In the Indian context, the major participants in the NDF markets are understood to be hedge funds and multinational firms (both domestic and foreign). Such participants tend to be guided more by international developments than domestic factors. Adding to the risks arising from NDF markets is the fact that information and flows going through in such markets are not available in a reliable and transparent manner. This opacity prevents the central bank from having an adequate early warning mechanism to tackle balance sheet adjustments and disorderly winding down of large one-way bets driven by market players.

China on the other hand has the advantage of an offshore centre (Hong Kong) which is under its own sovereignty but operates under a different economic regime. Mainland China and Hong Kong put together account for about half the global trading in the renminbi. This is roughly the same as the share of the global trading in the rupee that takes place in India (Table D.6 of the BIS data). China’s response to the growing offshore market is to make Hong Kong a more attractive centre for trading the renminbi. In a speech last month, the head of the Hong Kong Monetary Authority (HKMA) said:

With the strong support from the Central Government and the relevant Mainland authorities, the development of RMB business in Hong Kong has been encouraging this year.


I believe that next year will be a crucial year for the development of offshore RMB business in Hong Kong. ... Finally, to further promote the development of the RMB offshore business in Hong Kong, the HKMA is making preparations for overseas roadshows with the financial industry, focusing on locations which have growing trade and investment flows with the Mainland. We believe that with our joint efforts, Hong Kong will be able to play its role as an RMB offshore market to the fullest, thereby promoting and supporting the nation’s increasing cross-border trade and investment activities while enhancing and consolidating the status of Hong Kong as an international financial centre.

India still seems far away from this “if you can’t beat them, join them” approach. Actually, India already has a liquid non deliverable rupee market within India – it is called currency futures. Why can’t India use this market as strategically as China is using Hong Kong?

Posted at 16:29 on Sat, 01 Jan 2011     View/Post Comments (3)     permanent link

More self promotion

Last week, I posted about my blog being listed in’s 50 Best Business Professor Blogs. Around the same time, my blog also made it to’s list of Top 50 Blogs by Business Professors.

Posted at 11:07 on Sat, 01 Jan 2011     View/Post Comments (4)     permanent link