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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Thu, 24 Feb 2011

Using options to evade futures position limits

What happens when a Briton, a Frenchman and an Australian in Hong Kong conspire with an American in New York and a Korean in Seoul to make money for the German financial giant for whom they all work? The answer according to the Financial Services Commission (FSC) of Korea is that the Korea Stock market index drops 2.79% in the last ten minutes of trading and Deutsche Bank’s Korean securities unit makes $40 million of profit.

According to the press release put out by the FSC yesterday, Deutsche Securities Korea created a large short position in the index derivatives market and then sent massive ($2.2 billion) sell orders into the cash market in the last 10 minutes of trading on expiry day (November 11, 2010). Position limits in the index futures market would have prevented them from establishing such a large short position, but for some strange reason, the Koreans did not have any position limit in the options market.

Deutsche Securities Korea therefore created synthetic short futures positions by simultaneously buying put options and selling call auctions. By put call parity, this combination is economically equivalent to a short futures position. In addition, they also bought put options, but unlike the synthetic futures, these options would have incurred a cost in terms of the upfront premium.

Belatedly, the FSC has realised that position limits are required as much in options as in futures. Last month, the FSC announced new rules establishing a position limit in index options roughly equal to a quarter of the position that Deutsche Securities Korea held on November 11, 2010. Hedging and arbitrage activities are exempted from this position limit, but this exemption is not available on expiry day.

FSC also banned Deutsche Securities Korea from trading shares and derivatives for its own account for six months. The individuals concerned will be prosecuted separately.

Compared to other investigative orders that I have read (from the US, UK, India and Australia), the Korean order appears to me to be short on detail. I think that in matters like this, it is important for the regulators to provide detailed information not only to increase their own credibility, but also to strengthen private sector surveillance and discipline.

For example, the FSC says the stocks that were sold in the cash market in those 10 minutes had been purchased through index arbitrage trading. Since there were position limits in the futures market, stocks purchased through index arbitrage could have accounted for only a small fraction of the total sales. Where did the remaining sales come from? If these were sold short, how was the short covered? Moving the market with a large trade is easy; making money out of this after getting rid of the resulting position (“burying the corpse” as we often call it) is harder. The FSC does not explain how this was done.

Posted at 13:47 on Thu, 24 Feb 2011     View/Post Comments (2)     permanent link

Wed, 23 Feb 2011

Indian exchanges must go regional and then global

Indian stock exchanges are now confronted with an urgent need to look beyond the borders of India and formulate a vision for their role in the Asian stock exchange business. When I wrote about this last year (FE, November 30, 2010), I thought that Indian exchanges might have a year or so to get their act together. Global consolidation in the exchange space has moved much faster in the last few weeks and this timeframe has shrunk dramatically.

Last year, the Singapore exchange (SGX) initiated the process of consolidation in Asia with a bid for the Australian exchange (ASX). Though this bid appeared to have stalled, it is now receiving an uplift from a wave of global consolidation. The London Stock Exchange (LSE) wants to merge with the Canadian exchange (TMX) to create a transatlantic platform for listing and trading equities. This plan is dwarfed by an even more ambitious proposal by the German exchange Deutsche Börse (DB) to merge with NYSE Euronext to create a behemoth in equities and derivatives trading.

It is now clear that exchange consolidation is not going to be on a regional scale. Increasingly, the goal will be to create exchanges that span several continents and provide a single platform for trading stocks and derivatives from all over the world round-the-clock. In a year or two, when the LSE-TMX and DB-NYSE combines have completed the integration of their respective mergers, they will be looking at acquiring Asian exchanges to complete their global reach. Many analysts now believe that 5-10 years from now, there will probably be 4-5 global exchanges, each of which spans Asia, Europe and the Americas.

At that point, the Indian exchanges will have the choice between splendid isolation (and irrelevance) in a globalised world and becoming a relatively minor piece in a global exchange. To avoid this fate, Indian exchanges need to act now to spearhead the formation of pan-Asian exchanges that would have much greater bargaining power during the final round of consolidation.

There are two reasons for optimism that Indian exchanges can play a key role in the first phase of Asian consolidation. First, India is a large and fast growing emerging market. Second, Indian exchanges are world-class in terms of market design, range of derivative products, large and varied investor base, sound regulation and high liquidity.

If we exclude developed markets like Japan, Australia and Singapore, and if we regard China, Hong Kong and possibly Taiwan as being in a class of their own, then India and Korea are the emerging markets of the Asia-Pacific region, with large and vibrant equity and derivative markets. Korea has the world’s largest index derivative market while India is the premier market for single stock futures.

The accompanying table compares Indian and Korean exchanges with the aggregate of other Asia-Pacific emerging markets to demonstrate how large these two countries loom over the rest.

Comparison of Asian Exchanges

A partnership of some form (an alliance, if not a merger) between the Korean and Indian exchanges would clearly be a formidable Asian exchange that could, over time, absorb other smaller Asian exchanges and introduce derivative markets in those countries. Just as Euronext (a merger of European exchanges) subsequently became a major part of a transatlantic merger, it is easy to visualise this pan-Asian exchange becoming a significant part of a global exchange in the final phase of global consolidation towards the end of this decade.

Of course, any such alliance would involve tricky issues of valuation.

For instance, the Indian market capitalisation is 1½ times that of Korea; Korean traded value is nearly 4 times that of India; the exchange profit numbers are comparable; and the long-run growth prospects are probably better in India.

When it comes to regulation, nothing much will change because each exchange as a separate operating subsidiary could continue to be regulated by its current national regulator. Any merger would, however, require changes in national regulation on foreign shareholding and other related matters.

Needless to say, the purpose of this article is not to campaign for a specific merger or alliance. The purpose rather is to illustrate, with sufficient particularity, the thought processes that Indian exchanges need to go through in identifying potential partners and working out various permutations and combinations in order to derive the maximum possible advantage for themselves and for India.

Posted at 05:46 on Wed, 23 Feb 2011     View/Post Comments (4)     permanent link

Mon, 21 Feb 2011

Bernanke pontificates about political systems

After the crisis, it is common for regulators to hold forth about the relative merits of different regulatory systems, but I was surprised to find Bernanke expound his thoughts about presidential and parliamentary systems of government. The Financial Crisis Inquiry Commission has released transcripts of a closed door session on November 17, 2009 with Ben Bernanke.

The problem was – well, to give you a broad perspective, around the world, the United States was the only country to lose a major firm. Everywhere else, countries were able to come in, intervene, prevent these failures.

And I think, politically speaking, this is one place where the parliamentary system probably worked better because the prime ministers and the parliamentary leadership were able to get together over the weekend, make decisions, and on Monday morning, able to take those choices. And, generally speaking, the central banks, although they were involved in Switzerland and other places, in finding solutions, were not leading the efforts to prevent the collapse of these institutions.

But in the United States, as you know – of course, we don’t have the political flexibility for the government – quote, unquote – to come together and make a fiscal commitment to prevent the collapse of a firm. And so basically, we had only one tool, and that tool was the ability of the Federal Reserve under 13(3) authority to lend money against collateral. Not to put capital into a company but only to lend against collateral. That, plus our ingenuity in trying to find merger partners, et cetera, was essentially all -- that was our tool-kit. That’s all we had.

Bernanke is absolutely right that the parliamentary governments of Europe were able to act faster than the US. Where I would disagree is whether this was a good thing or not. The failure of the US Congress to pass the first version of TARP (assuming for a minute that it was a failure) was relatively minor compared to the hasty and catastrophic decision of Ireland to guarantee all the liabilities of its insolvent banks. All Irish citizens must be wishing that they had a US like system of checks and balances to prevent such a stupid decision being made so quickly and secretly.

The world’s oldest democracy, Iceland, was saved from Ireland’s disastrous fate only by the action of its president to allow the people to vote directly on the whether the government should assume the Icesave liabilities. The President’s declaration on that occasion is worth recalling:

Following the passing by the Althingi of the new Act on 30 December, the President has received a petition, signed by about a quarter of the electorate, calling for the Act to be subjected to a referendum.


It is the cornerstone of the constitutional structure of the Republic of Iceland that the people are the supreme judge of the validity of the law. Under the Constitution, which was passed on the foundation of the Republic in 1944, and which over 90% of the nation approved in a referendum, the power which formerly rested with the Althingi and the King was transferred to the people. It is then the responsibility of the President of the Republic to ensure that the nation can exercise this right.


It has steadily become more apparent that the people must be convinced that they themselves determine the future course. The involvement of the whole nation in the final decision is therefore the prerequisite for a successful solution, reconciliation and recovery.

In the light of all the aforesaid, I have decided, according to Article 26 of the Constitution, to refer this new Act to the people.


Now the people have the power and the responsibility in their hands.

What Bernanke seems to gloss over is that a decision to bail out a large bank is not a technocratic decision with an objectively optimal answer; it is an inherently political decision with massive redistributive consequences. It takes money away from one group of taxpayers to protect a group of bank depositors and creditors. This is not a decision to be made behind closed doors.

On the other hand, where the decision is essentially technocratic in nature, normal checks and balances do not stand in the way of a government that confronts a crisis. In nineteenth century England, the amount of notes that the Bank of England could issue was laid down by statute and the government did not have the powers to waive this requirement. That did not prevent governments from “suspending the Bank Act” in emergencies. For example during the crisis of 1857, the Prime Minister and Chancellor of the Exchequer wrote to the Bank of England as follows:

The discredit and distrust which have resulted from these events, and the withdrawal of a large amount of the paper circulation authorised by the existing Bank Acts, appear to Her Majesty’s Government to render it necessary for them to inform the directors of the Bank of England that if they should be unable in the present emergency to meet the demands for discounts and advances upon approved securities without exceeding the limits of their circulation prescribed by the Act of 1844, the Government will be prepared to propose to Parliament, upon its meeting, a Bill of Indemnity for any excess so issued.


Her Majesty’s Government are fully impressed with the importance of maintaining the letter of the law, even in a time of considerable mercantile difficulty; but they believe that, for the removal of apprehensions which have checked the course of monetary transactions, such a measure as is now contemplated has become necessary, and they rely upon the discretion and prudence of the directors for confining its operation within the strict limits of the exigencies of the case.

The British parliament passed the Act of Indemnity a month later and the suspension lasted for another 11 days. Most of the period of suspension was therefore without any statutory authority at all and depended entirely on the confidence of officials that parliament would act as promised. Such confidence in turn follows from the belief that the suspension of the Act was something that most reasonable people would agree with.

I believe that there is merit in constraining the ability of a handful of people to act secretly and hastily to bail out the financial elite. The checks and balances of the US constitution should be seen as a strength and not as a weakness. For the same reason, it is a good idea to separate bank supervision from the central bank. It makes it harder to cover up supervisory failures by using the vast resources of the central bank to bail out a failed bank.

Posted at 16:38 on Mon, 21 Feb 2011     View/Post Comments (0)     permanent link

Tue, 15 Feb 2011

Does the loser get to keep the name?

There have been reports that after the proposed “merger of equals” of NYSE Euronext and Deutsche Börse, the combined entity would be called “DB NYSE Group.” The politicians are up in arms about this with the senior Senator from New York, Charles E. Schumer stating:

... a sticking point that could emerge, even after a deal is announced, is the name of the new entity.

Some may say what’s in a name, but I say a lot. The New York Stock Exchange is a symbol of national prestige, and its brand must not suffer under this merger.

It is totally logical to keep the N.Y.S.E. name first. If for some reason, the Germans sought an alternative option, it could be an indication that they are trying to wield an upper hand in the new company and would seek to make other business decisions that could go against New York. The name is an important bellwether of whether this deal is regarded as a merger of equals.

In banking mergers, we have a rule of thumb that says that the loser gets to keep the name. Travelers bought Citi and named the combined entity as Citigroup. NationsBank bought Bank of America and became Bank of America. In the long chain of mergers that produced JP Morgan Chase, at every stage the loser got to keep the name – Chemical bought Chase and adopted the Chase name; Chase bought JP Morgan and put the loser’s name first to become JP Morgan Chase; finally, Dimon’s Bank One bought JP Morgan Chase and retained the loser’s name.

In exchange mergers, the winner has not bothered to keep the loser’s brands simply because the brands of exchanges are not really worth anything. So long as an exchange has the contracts and the liquidity, nobody cares what it is called. Long ago, the London Stock Exchange rechristened itself as the “International Stock Exchange of the United Kingdom and Ireland”and then went back to being the London Stock Exchange again without anybody bothering about it.

Acquirers have therefore been quite happy to drop or demote the names of the exchanges that they buy. This is what happened when the LSE bought Borsa Italiana or when NYSE bought Euronext or when Nasdaq bought OMX.

Another complication is that equity trading (particularly in the US) is a cut throat business and much of the profit (and valuation) is in derivative trading. In the case of the proposed DB NYSE, it is Deutsche Börse that has the most valuable derivative contracts. The most important derivative contract at NYSE Euronext is the Euribor futures which trades on Euronext and not on NYSE. One could argue that the merged entity should be called DB Euronext.

Posted at 16:10 on Tue, 15 Feb 2011     View/Post Comments (1)     permanent link

Thu, 10 Feb 2011

Global mergers and Indian exchanges

Last year, I wrote about the role that Indian exchanges should be playing in the emerging period of regional and global consolidation:

... the stock exchange business in Asia is entering a period of regional, if not global, competition. The abortive bid by the Singapore Stock Exchange to buy the Australian Stock Exchange marked the first warning shot in this process. Asia is going to be one of the fastest growing equity markets in the world, and India’s world-class exchanges and depositories have a wonderful opportunity to occupy a pole position in this space.

After that, however, it appeared that the process had stalled with regulatory obstacles emerging for the SGX-ASX deal. In the last few days, the picture has changed again with the announcement of the LSE-TMX merger (that brings together the British and Canadian exchanges) and the merger talks between Deutsche Boerse AG and NYSE Euronext (that brings together the largest European and US exchanges). It is almost as if the Atlantic Ocean no longer exists. The SGX-ASX deal also now looks more likely to receive approval.

The Points and Figures blog argues that “Eventually, when all the M+A is finished, there will be 3-4 worldwide exchanges. It will look like the credit card industry. But, because of money, regulation, and government borders it takes time.” Points and Figures blog also suggests that down the road, LSE+TMX would seek some sort of combination with an Indian exchange, possibly the BSE.

It is tragic that at this point of great opportunities and strategic challenges, the energies of Indian exchanges and their regulators are entirely consumed by the debate about whether exchanges should be regulated like public utilities.

While discussing about exchanges, I would like to point to a fascinating post at the Unreasonable Response blog (hat tip Deus Ex Macchiato) arguing that the central bank should become the sole exchange for all OTC derivatives. Unreasonable Response thinks that the Bank of England would do a very good job at this. On the other hand, I do recall that in its early years, the Bank of England did try to run an exchange in its famed rotunda to compete against the London stock exchange. That attempt was a dismal failure.

Posted at 17:17 on Thu, 10 Feb 2011     View/Post Comments (2)     permanent link

Fri, 04 Feb 2011

Of percentages, decimals, SEC and Rosenberg

Whether interest rates, volatilities and other similar numbers are expressed as percentages (say 6%) or as decimals (say 0.06) is a trivial yet vexed issue in finance. I always remind students that when they use an online option pricing calculator, this is one common source of error (the other common source of error is to use an annually compounded interest rate where the software expects a continuously compounded rate).

But even I never thought that confusion between percentages and decimals could cause $216 million of losses and an enforcement action by the US SEC. And that too at Axa Rosenberg Group – the firm that (under its original name Barr Rosenberg Associates or BARRA) pioneered quantitative portfolio management and risk measurement for institutional investors.

The SEC described the coding error as follows. (BRRC stands for Barr Rosenberg Research Centre, a subsidiary of ARG which stands for Axa Rosenberg Group):

In April 2007, BRRC put into production a new version of the Risk Model. BRRC had assigned the task of writing the computer code that would link this new Risk Model with the Optimizer primarily to two programmers. Although BRRC tested the new Risk Model, it did not conduct independent quality control over the programmers’ work on the code. When these two programmers linked the Risk Model to the Optimizer, they made an error in the Optimizer’s computer code. ...

Starting in 2009, a BRRC employee began work as part of BRRC’s effort to implement a new version of the Risk Model. In June 2009, this employee noticed certain unexpected results when comparing the new Risk Model to the existing one that was rolled out in April 2007. He learned that the Optimizer was not reading the Risk Model’s assessment of common factor risks correctly because an error in the code caused a failure to perform the required scaling of information received from the Risk Model. Some Risk Model components sent information to the Optimizer in decimals while other components reported information in percentages; therefore the Optimizer had to convert the decimal information to percentages in order to effectively consider all the information on an equal footing. Because proper scaling did not occur, the Optimizer did not give the intended weight to common factor risks.

The SEC goes on to describe the cover-up as follows:

The Senior Official and other BRRC employees met around the end of June 2009 to further discuss the error. The BRRC employee who discovered the error advocated that the error be fixed immediately. The Senior Official, however, disagreed and stated that the error should be corrected when the new Risk Model would be implemented. The Senior Official directed BRRC employees with knowledge of the error to keep quiet about the discovery of the error and to not inform others about it. The BRRC employee who discovered the error asked the Senior Official whether ARG’s Global Chief Investment Officer (“CIO”) should be informed, and the Senior Official instructed that he should not be told.

The SEC does not identify the “Senior Official” who tried to cover up the error, but last year Axa Rosenberg stated that Dr. Barr Rosenberg himself was involved in the cover-up and had resigned.

More than the trivial error itself, what is so tragic is that such a distinguished academic (whose papers I have been reading and enjoying for over 25 years) should try to cover up the error.

As an aside, in a case which is all about scaling errors, the SEC order itself contains a ridiculous scaling error – it states that the losses were $216,806,864 million. That would be $216 trillion which is well in excess of the total stock of financial assets in the world. I presume that the true losses were $216,806,864 or $216 million. I suppose this is fine unless the SEC tries to cover up this error.

Posted at 14:17 on Fri, 04 Feb 2011     View/Post Comments (1)     permanent link

Tue, 01 Feb 2011

Why does the US government write a financial crisis book?

During the financial crisis, as many parts of the financial sector broke down, the government stepped in to perform the function normally performed by banks, markets or other private players. But there is no market failure at all in the business of publishing books on the financial crisis. As I noted in a blog post four months ago, this business is booming and there is no shortage of well-written books on the crisis.

But, writing a book on the financial crisis is exactly what the US government or rather the Financial Crisis Inquiry Commission (FCIC) has done in its report published last week. By sheer coincidence, when the report came out, I had just finished reading All the Devils are Here by Bethany McLean and Joe Nocera. It struck me that the FCIC report was quite similar to this book in terms of narrative, racy style, reliance on interesting anecdotes and juicy quotes.

I was looking forward to the FCIC producing an investigative report comparable to the outstanding reports produced for example by the Special Investigative Commission set up by the parliament of Iceland or the Examiner appointed by the bankruptcy court for Lehman Brothers. Unfortunately, that has not happened. Indeed, I found very little that is new in the FCIC report except for this interesting excerpt from a closed-door interview with Fed Chairman Ben Bernanke:

As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression. If you look at the firms that came under pressure in that period ... only one ... was not at serious risk of failure. So out of maybe the 13, 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two. (page 354)

Another quote from the same closed-door session suggests that the one exception was JP Morgan Chase:

[Like JP Morgan,] Goldman Sachs I would say also protected themselves quite well on the whole. They had a lot of capital, a lot of liquidity. But being in the investment banking category rather than the commercial banking category, when that huge funding crisis hit all the investment banks, even Goldman Sachs, we thought there was a real chance that they would go under. (page 362)

Another bit of self-promotion: has listed my blog in the Top 50 Blogs By Accounting Professors, Students and Professionals. It looks like 50 is becoming my lucky number.

Posted at 15:09 on Tue, 01 Feb 2011     View/Post Comments (2)     permanent link