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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Fri, 24 Feb 2012

Stock market watching

From an interview with the President of the European Central Bank, Mario Draghi in the Wall Street Journal (WSJ) yesterday:

WSJ: What’s the first statistic you look at in the morning?

Draghi: Stock markets.

WSJ: Do you look at the euro exchange rate?

Draghi: Not in the early morning.

I am surprised that he did not mention the TED Spread or some other interest rate spread. And even within the stock market, it would appear that he is looking at market levels and not something like VIX. Are inflation targeting central banks actually closet asset price targeters?

Interesting to compare the Draghi quote with a controversial statement in the Indian parliament by former central banker, then finance minister, and future prime minister, Manmohan Singh in 1992:

But that does not mean that I should lose my sleep simply because stock market goes up one day and falls next day.

This provoked a retort from a parliamentary committee a year later:

It is good to have a Finance Minister who does not lose his sleep easily, but one would wish that when such cataclysmic changes take place all around, some alarm would ring to disturb his slumber

Posted at 14:44 on Fri, 24 Feb 2012     View/Post Comments (0)     permanent link

Thu, 16 Feb 2012

Intra day exposures once again

No, I am not talking about my obsession with intra-day risks (see here and here), but about the New York Fed’s uncharacteristically blunt criticism of the big clearing banks on this issue:

... the amount of intraday credit provided by clearing banks has not yet been meaningfully reduced, and therefore, the systemic risk associated with this market remains unchanged.

These structural weaknesses are unacceptable and must be eliminated.

... the Task Force [of the clearing banks] ... has not proved to be an effective mechanism for managing individual firms’ implementation of process changes

The Fed’s response is to step in directly to ensure that practices change:

... the New York Fed will intensify its direct oversight of the infrastructure changes

Ideas that have surfaced and could be considered include restrictions on the types of collateral that can be financed in tri-party repo and the development of an industry-financed facility to foster the orderly liquidation of collateral in the event of a dealer's default.

Nor is the criticism restricted to the banks; the Fed is equally critical of the non bank participants in this market:

Ending tri-party repo market participants’ reliance on intraday credit from the tri-party clearing banks remains a critical financial stability policy goal.

The Federal Reserve and other regulators will be monitoring the actions of market participants to ensure that timely action is being taken to reduce sources of instability in this market.

The background to all this is the strange way in which the tri-party repo market operates in the US. Leveraged investors in various securities finance their positions using overnight repos which can be regarded as a form of secured borrowing. The securities in question are not however pledged directly to the lenders but with the clearing bank (hence the name tri-party). Next day morning, the lender gets the loan back, but the borrower does not repay the money. What happens is that the clearing bank lends the money intra-day. Over the course of the day, the borrower drums up a new set of borrowers to lend against its securities that night, and the bank again ends the day without any exposure to the borrower.

The weakness here is that the repo lenders are relying on the clearing bank to get their money back in the morning; the bank is relying on the repo lenders to get its money back in the evening; and both could become complacent about the risks involved. It is a little like two people passing a hot potato back and forth to each other, and pretending that there is no longer any hot potato to worry about. (It is actually worse than that because while the potato would cool in a few minutes, the securities underlying the repo may take years to mature – assuming that they do not default in between.) Of course, everybody wakes up at times of stress, and then the clearing bank is in the position of having to decide each day whether to throw the borrower into bankruptcy by refusing to clear its repos. This is hardly the way to organize such a large and systemically important market.

We should all be happy that, for once, the Federal Reserve seems to be taking things seriously instead of succumbing to regulatory capture.

Posted at 18:27 on Thu, 16 Feb 2012     View/Post Comments (0)     permanent link

Thu, 09 Feb 2012

Intra-day laxity: MF Global edition

I blogged two years back about the tendency in finance to be prudent at night but reckless during the day in the context of Lehman bankruptcy. A related phenomenon (compliant at night but trangressing during the day) is seen in the MF Global bankruptcy according to the preliminary trustee report released earlier this week:

The investigation to date has found that transactions regularly moved between accounts and that funds believed to be in excess of segregation requirements in the commodities segregated accounts were used to fund other daily activities of MF Global ... apparently with the assumption that funds would be restored by the end of the day. By Wednesday, October 26th, as the result of increasing demands for funds or collateral throughout MF Global, funds did not return as anticipated. As these withdrawals occurred, a lack of intraday accounting visibility existed, caused in part by the volume of transactions being executed ... (Paragraph 7, emphasis added)

Of course, I am not a lawyer, but it appears to me that such intra-day laxity is not consistent with the Commodity Exchange Act or the CFTC Regulations:

... all money, securities, and property received by such ... [futures commission merchant] to margin, guarantee, or secure the trades or contracts of any customer ... shall be separately accounted for and shall not be commingled with the funds of such commission merchant ... (Section 4d of the Commodity Exchange Act)

Each futures commission merchant shall treat and deal with the customer funds of a commodity customer or of an option customer as belonging to such commodity or option customer. All customer funds shall be separately accounted for, and shall not be commingled with the money, securities or property of a futures commission merchant or of any other person ... (CFTC Regulation 1.20)

... futures commission merchant ... [may add] to such segregated customer funds such amount or amounts of money, from its own funds or unencumbered securities from its own inventory, of the type set forth in §1.25, as it may deem necessary to ensure any and all commodity or option customers’ accounts from becoming undersegregated at any time. The books and records of a futures commission merchant shall at all times accurately reflect its interest in the segregated funds. (CFTC Regulation 1.23, emphasis added)

It would appear to me that the words “at any time” and “at all times” prohibit intra-day withdrawal “with the assumption that funds would be restored by the end of the day” as well as “lack of intraday accounting visibility”.

As an aside, it is interesting to note that after looking at 800 computer drives and 100 terabytes of data, the trustees still do not know where the money has gone

For three months the Trustee’s investigative team has worked to understand what happened during the final days of MF Global when cash and related securities movements were not always accurately and promptly recorded due to the chaotic situation and the complexity of the transactions. With these preliminary investigative conclusions in hand, the Trustee’s investigative team will analyze where the property wired out of bank accounts established to hold segregated and secured property ultimately ended up. (Paragraph 6)

The Trustee’s investigators, including the legal and forensic accounting teams, have conducted over 50 witness interviews, preserved secure access to thousands of boxes of hard copy documents, imaged over 800 computer drives, and are maintaining over 100 terabytes of data. (Paragraph 12)

Posted at 16:05 on Thu, 09 Feb 2012     View/Post Comments (0)     permanent link

Sun, 05 Feb 2012

Market microstructure: Limit orders and order flow

One of my favourite post crisis themes has been the idea that market microstructure has macro consequences. I touch upon this in my paper on post crisis finance (mentioned in my blog posts here and here). Two papers that I read last month are related to this theme.

Psy-Fi blog pointed me towards a paper by Linnainmaa showing that the under performance of individual investors’ portfolios can be attributed largely to their use of limit orders. When one looks at trades, it may appear that these investors were stupidly selling when the smart money was buying in response to good news. Linnainmaa’s point is that quite often, this apparent “selling” is not really active selling; their limit orders were simply being hit by the smart money. Looking at the totality of the orders of individual orders may show that these orders had no sell bias. What happens is that when the smart money is buying, the individual investors’ buy limit orders do not execute while their sell orders do.

If this is true, then one implication of this use of limit orders by uninformed traders is that the smart money is able to buy shares too cheap. The price does not move as much as it should have. This phenomenon may also be contributing to the well known momentum effect. This leads straight on to the second paper that I read recently (I do not recall to whom I owe a hat tip for this paper).

Beber, Brandt and Kavajecz published their paper “What Does Equity Sector Orderflow Tell Us About the Economy?” recently (the working paper version is available here). They not only show that the order flow into defensive sectors of the stock market forecasts recessions, but they go on to show that the order flow does a better job than prices or returns. One possible explanation of why order flow is more informative than prices is of course the phenomenon described by Linnainmaa – since uninformed limit orders absorb some of the impact of informed buying, the full information of these orders is not impounded in prices..

This is of course totally different from genuine equilibrium models with representative agents where prices are not only fully informative but also move with zero trading volume implying that order flows and trading volumes are totally uninformative (or rather totally irrelevant).

Posted at 21:49 on Sun, 05 Feb 2012     View/Post Comments (0)     permanent link