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, 19 Apr 2012

US Department of Labour degrades BLS data releases

When I argued in my blog post a few days back that monopoly providers of official data are unlikely to innovate, I still did not imagine that lack of accountability could lead to their actually degrading their data releases. But that is exactly what the US Department of Labour is proposing to do as regards the BLS (Bureau of Labor Statistics) non farm payroll data release which is perhaps the most powerful market moving data release on the planet today. The proposed draft rules and a transcript of a conference call on the subject are available at the website of the Department of Labour (hat tip for the links and for the whole story to FT Alphaville).

I remember reading a couple of papers by Ederington and Lee two decades ago on the BLS data releases and marvelling both at the ingenuity of the data release system and the speed with which markets process the information. The two papers by Louis H. Ederington and Jae Ha Lee are “How Markets Process Information: News Releases and Volatility”, The Journal of Finance, 48(4),1993, 1161-1191 and “The Short-Run Dynamics of the Price Adjustment to New Information”, The Journal of Financial and Quantitative Analysis, 30(1), 1995, 117-134. The JFQA paper describes the release system as follows:

The release is distributed to reporters with a “need for timely access” about 30 minutes prior to the scheduled release time. While the reporters may type their reports, they cannot leave the room or use the phone. Approximately one minute before the scheduled release time, the reporters are allowed to plug in their modems or pick up the phones but the lines are dead until the scheduled time.

The same paper also describes the speed with which the eurodollar futures market processes the information as follows:

Using 10-second returns and tick-by-tick data, we find that prices adjust in a series of numerous small, but rapid, price changes that begin within 10 seconds of the news release and are basically completed within 40 seconds of the release.

We must remember that this was two decades ago when modern high frequency trading was practically absent and eurodollar futures trading was still on the trading pit.

The Department of Labour now plans to degrade the data release system. In the conference call, it described the proposed changes in the system as follows:

Currently, organizations that participate in our lock-ups use their own computer and phone equipment, which is installed in our facilities. The telephone and data lines they use belong to and have been maintained by them. That, too, is changing.

... all currently participating organizations should plan to have their equipment removed.

... The department’s main lock-up facility will be ... reconfigured with new computer equipment, and telephone and data lines. The Labor Department will own and maintain that equipment and those lines.

... Each work station will offer a telephone, monitor, mouse and keyboard. The server and network gear will be located in the lock-up room within a locked cage but separate from the workspace area. Users will be able to log onto their desktops at assigned work spaces. Those who want time to prepare notes or drafts can take advantage of the extra half hour to use Microsoft Word, which will be loaded on the computers.

... There will be a new rule that personal effects must be placed in lockers outside the lock-up facilities before entering the rooms. However, carrying in paper research notes and other paper materials will be allowed. Carrying in pens and pencils will not be permitted. The department will provide writing instruments as well as plain paper for notetaking inside the lock-up rooms.

... You can’t bring in discs or thumb drives or any type of electronic devices.

The Department of Labour will thus control what historical or background data is available to the reporters (they cannot bring anything in electronic form), and the Department of Labour will also control what software is available to the reporters (only Microsoft Word).

To understand how this degrades the information processing, let us go back to the market reacting to the release within 10 seconds in the age of human trading on the pit two decades ago. The only way this can happen is that a lot of analysis takes place prior to the data release and contingent trading strategies are worked out and well rehearsed in advance. The market thus waits not for the raw data, but for an interpreted news report that places the raw data in the context of all the consensus estimates, past trends and other background information and allows a pre-rehearsed trading strategy to be invoked. By reducing the quality of this analysis (by disallowing the tools required to do this), the Department of Labour is degrading the quality of its data release.

What is more, the Department of Labour has no real reasons for making these changes. Look at this exchange in the transcript:

Daniel Moss: Bloomberg News. I’m just wondering, why is the Labor Department choosing to do this now? What is the problem that you believe you are trying to fix given the master switch is already in place working effectively?

Carl Fillichio: [Department of Labour] It’s been, as I mentioned, 10 years since we took a holistic view of the lock- up, and times have certainly changed. ...

Daniel Moss: What is the problem that you imagine you’re trying to fix given there is an effective master switch there already that controls access out of the room for the information?

Carl Fillichio: There’s nothing we necessarily expect. I think we’re doing prudent business management of reviewing our systems and looking at the changes in technology and the way that the news is delivered and have decided that now is the correct time to institute these changes. ...

Daniel Moss: Do I interpret your response, Carl, as meaning there's no current problem?

Carl Fillichio: What I’m trying to do is prevent a problem, Daniel.

Daniel Moss: What is the problem you think, you imagine that this will prevent?

Carl Fillichio: I think we’re going to move on. Operator, we’ll take the next question.

What we see clearly in this exchange is the total lack of accountability. I am reminded of the famous lines in Shakespeare’s Julius Caesar (Act II, Scene II, 72-76):

   Most mighty Caesar, let me know some cause,
   Lest I be laugh'd at when I tell them so.
    The cause is in my will: I will not come
    That is enough to satisfy the Senate. 

As far as the governmental monopolist’s preference for a private sector monopoly (Microsoft Office), that is probably the subject of another post.

Posted at 21:54 on Thu, 19 Apr 2012     View/Post Comments (2)     permanent link

Tue, 17 Apr 2012

Exit policy for financial institutions

I wrote a piece in the Mint newspaper yesterday arguing that instead of worrying about granting licences, financial regulators need to focus on exit policies:

Rogues thrive most in regulatory regimes designed to keep them out. This paradox arises because regulations that try to keep them out also unintentionally keep out the good entrants. The few rogues who do get in are able to thrive because they are shielded from competitors who might otherwise have driven them out of the market. Therefore, an open entry policy coupled with a ruthless exit policy might be the best way to keep the system clean.

In India there are two areas regulators are struggling to arrive at the right entry policy—stock exchanges and banks. It is a fact that it is very hard to get a licence for a new stock exchange or a new bank, but it is also very hard to cancel the licence of an existing stock exchange or an existing bank. We have many existing licensed stock exchanges and many existing banks that are so poorly run that they would be unlikely to get a licence today if they were applying for the first time. Yet, it is not easy to kick them out.

If anything, there is a case for a complete reversal of this policy regime. It should be very easy to start a new stock exchange or a new bank, but it should be much harder to retain the licence. The rationale for this approach is that it is very difficult for any regulator to figure out whether a particular set of promoters will be able to run a proposed stock exchange or bank well enough. This question is completely hypothetical and speculative at the entry stage, and the regulators are forced to extrapolate from the promoters’ experience in other sectors or environments to make an assessment if the given licensees are able to do well in the new venture. In contrast, it is much easier to assess whether an existing bank or stock exchange is well run or not. It is easier because we are now dealing with a question of fact and not speculating about hypothetical future possibilities.

It is easier for rogues to get past stringent entry barriers because they can spend enough money to acquire all the trappings of respectability. They can easily meet minimum capital requirements. They do often succeed in hiring distinguished personalities to serve on their boards (or in senior management positions) and lobby on their behalf. They can engage expensive consultants to prepare impressive business plans. Of course, once they have got the licence, they can discard these ostensible plans, sideline the “distinguished” personalities, and get on with their real business plans.

For these reasons, tough entry barriers do not really keep out the rogues. For example, of the 10 new banks licensed in India in the first phase in the 1990s, the majority were failures in the broadest sense. There were serious and honest promoters who failed because of environmental changes or genuine management mistakes, but that cannot be said of all the banks that failed. A tiny number of those who did not deserve banking licences did manage to obtain them despite very tough entry standards set by a regulatory process that was widely regarded as free of corruption. At the same time, a large number of serious professionals with valuable ideas would have been denied a licence because of the tight entry norms.

The principal objection to the idea of relying on a strong exit policy to keep the rogues in check is the problem of “too big to fail”. This objection has, I think, lost its force after the global financial crisis. It is now accepted that a financial intermediary that is too big to fail is simply too big to exist. Current regulatory thinking is that big institutions should prepare “living wills” or “funeral plans” that ensure that they can die gracefully.

The idea of “funeral plans” applies with equal force to stock exchanges and clearing corporations as well. There is a high probability that a large clearing corporation in a Group of Twenty (G-20) country (or for that matter even in a G-7 country) will fail over the next five years or so. Rather than pretend that central counterparties can never fail, we should be working hard to ensure that they could fail without dragging the whole system down with them. This means multiple central counterparties, which in turn means higher margins and collateral requirements. In a post crisis world, a lower level of leverage is probably not a bad thing.

It is often argued that stock exchanges are a natural monopoly because liquidity begets more liquidity and trading gravitates towards the most liquid trading venue. In reality, however, liquidity has many dimensions. A dark pool can be the best source of liquidity for some investors, while being a terrible trading venue for others. Moreover smart order routing can aggregate liquidity across multiple venues.

A financial system with numerous small banks, many exchanges and multiple central counter parties would be more robust. It would also have fewer rogues, or at least fewer big rogues who can do great damage.

Posted at 11:51 on Tue, 17 Apr 2012     View/Post Comments (2)     permanent link

Fri, 13 Apr 2012

Crowd sourcing official statistics

Yesterday, the Indian government admitted a huge error in the Index of Industrial Production (IIP) data for January 2012 and corrected the growth rate from a healthy 6.8% to a dismal 1.1%:

... during the compilation of IIP for January, 2012, the sugar production was wrongly taken as 134.08 lakh tonnes in place of actual figure of 58.09 lakh tonnes. ... Immediately after detection of the error, the revised IIP numbers and growth rates for the month of January, 2012 have been compiled. ... the IIP for January 2012 has been revised from 187.9 to 177.9 and, therefore, growth rate over the corresponding period of previous year has been revised from 6.8% to 1.1%.

In my view, the fact that the government has a monopoly in the production of official statistics leads to poor quality, low accountability and lack of innovation. Perhaps, these problems are worse in an emerging economy and the costs of the public sector monopoly are less severe in developed countries. But the problem is not confined to emerging markets.

Even in the US, the seasonal adjustments being used for various official statistics has been called into question (see for example, here, and here). The whole process of seasonal adjustment is ripe for disruptive innovation. First of all, the reliance on a Gregorian calendar for seasonal adjustment is increasingly inappropriate in a world where some of the fastest growing economies with large populations base their principal holidays on a lunar calendar (China, India and the entire Islamic world). China’s influence on commodity prices is so great that it is possible that the commodity price component of seasonally adjusted prices even in the developed world are probably distorted by the incorrect use of Gregorian seasonality adjustment. Via inventories and collateralized commodity financing, this might be an issue for some financial data series as well. Who knows, some large global central banks may be getting their monetary policy wrong because of Gregorian seasonal adjustments!

Secondly, I would argue that the whole idea of seasonality adjustment is an abdication of responsibility by the econometrician. Wherever we use time as an independent variable, it is a proxy for omitted variables that are more fundamental. A time trend, for example, proxies for variables like population growth, technological progress, inflation and productivity improvements. A seasonality adjustment is also a proxy for more fundamental physical and economic variables like temperature, rainfall, holidays, advance tax payment due dates, government bond issuance calendars and the like. It is far better to model these variables directly so that the economic model is more robust and meaningful. The belief that economic variables have a different behaviour in different months solely because of the position of the sun in the zodiac is astrology and not economics. Seasonality adjustments need to move from the age of astrology to the age of econometrics.

Such radical changes are unlikely to happen so long as official data is provided by a monopolist (whether in the public or in the private sector). The time has come in my view to crowd source the creation of official statistics. The government should simply make the digitized raw data publicly available and should not publish anything else. There would be no official Index of Industrial Production, but the government website would have the raw production statistics submitted by various businesses. Yes, not the aggregate sugar production, but the sugar production of each sugar mill in the country. Every user would be free to choose what outlier tests to run, what aggregation algorithm (for example, mean, median or trimmed mean) to apply on this raw data, which base year and which base year weights to adopt, and which index computation methodology (Laspeyres or Paasche, arithmetic mean or geometric mean) to use in computing indices at whatever level of aggregation or disaggregation he or she wishes.

The lack of an authoritative index may also reduce systemic risk in the economy because different indices computed by different agencies may be giving a different picture of the economy. We would probably have less herding and more muted boom-bust cycles. Like the story of the six blind men and the elephant, each of the competing privately produced indices would be a partial and therefore incomplete view. That however is far superior to one blind man and the elephant – because the one blind man does not even know that his understanding is incomplete.

Posted at 06:18 on Fri, 13 Apr 2012     View/Post Comments (1)     permanent link

Wed, 11 Apr 2012

The social utility of hedging

I have been engaged in a stimulating email conversation with Vivek Oberoi on the social utility of hedging. The hedger is clearly better off by hedging and reducing risk, but Vivek’s question was whether society as a whole can be worse off? I found the discussion quite interesting and thought it worthwhile to widen the conversation by sharing it on this blog. Moreover, it is heartening to see people in the financial industry introspect about the social utility of their industry. Perhaps, this will encourage others in the financial industry to look at their own work more critically.

My position is that hedging has powerful redistributive effects but is socially useful so long as (a) the hedging is carried out in liquid derivative markets and (b) hedgers do not suffer too much from the Endowment Effect. Vivek of course is not convinced. Anyway here is the conversation so far

Vivek Oberoi writes:

If I buy tickets to travel for my vacation in December today, I am indifferent to any subsequent change in the price of oil. To be able to sell me the ticket forward, a risk averse airline will hedge their fuel for the sale. It too is now indifferent to the price of oil. The airline and I have made allocational choices based on forward price of oil today. If oil price on the day of the flight is different from what it is today, there will be an allocational loss. Both the airline and I may be better off (we are risk averse). But there will be dampening of the price signal. That will lead to an allocational loss (negative externality?) to society.

My response:

One key question is whether the forward contracts can be sold to a third party or can be unwound with the original party at market related prices. The ticket cannot, but the oil hedge can. Illiquid derivatives can be harmful for allocative efficiency. For example:

  1. You may be willing to accept $500 in return for postponing your vacation by a couple of days
  2. Somebody who needs to take that flight due to a personal emergency may be willing to pay $1000 premium to get on that flight.

The airline and the government would step in and say that you cannot do the trade. The wrong person gets on the plane and the outcome is inefficient.

But if you were allowed to do the trade then the Coase Theorem implies that allocative efficiency is achieved regardless of the initial allocation of property rights. In other words, it does not matter whether you owned the ticket or the other person owned the ticket in the beginning; after the bargaining and trading, the right person will get on the plane. The initial ownership will only determine who is richer/poorer at the end of the trade. The Coase Theorem requires low transaction costs which would be the case in liquid futures markets and in liquid OTC markets, but not in highly customized and illiquid bilateral forward contracts.

Behavioural finance will of course have a different take on this. The Endowment Effect could imply a loss of allocative efficiency due to derivative contracts. In the corporate context, you need some takeover threats from asset strippers (who would monetize the fuel hedges and then shut down the airline) to prevent the loss of allocative efficiency caused by managers suffering from the Endowment Effect.

Vivek Oberoi continues:

Imagine a risk-averse consumer of oil. He needs 1 unit of oil to drive to office. The price of oil is USD 100/unit. The consumer has USD 100. If the price of oil goes up to, say 150, he will have to take public transport. To keep things simple, assume the public transport ticket will cost 100. If the price goes down to 50 he will use the money saved to see a movie. The consumer is risk-averse. He dislikes the thought of using public transport more than the enjoyment of seeing a movie.

At time t0 the consumer gets into a fixed price contract for the purchase of 1 unit of oil at time t1. Assume oil prices spike to USD 150/bbl. Now the customer has a choice. He can either use the oil to drive to work. Or he can sell the oil for USD 150/unit. Use USD 100 of that for public transport and the remaining USD 50 for the movie. The essence of risk-aversion is that the combination of using public transport and seeing the movie will not be as good as driving to work.

My response:

I would interpret the situation a little differently. First of all, we can avoid expected values and risk aversion by just focusing on the case where the price of oil is 150. We must still take into account the non linearity (concavity) of the utility function which is what leads to risk aversion, but we can avoid probabilities and expectations.

In the $150 price scenario, the choices of the hedger are

  1. Spending $100 to drive to work and
  2. Spending $50 (net) to take the train leaving $50 surplus for the movie ticket.

The person who did not hedge also has two choices:

  1. Spending $150 to drive to work
  2. Spending $100 to take the train.

What is the difference? It is as if the hedger won a lottery ticket with a prize of $50. That is all. For the hedger, the car and the train are both cheaper by $50, but the relative cost of car versus train is the same for both hedger and non hedger (150-100=100-50=50).

You are right in saying that at the higher level of wealth induced by winning the lottery ticket, the consumer may be willing to pay $150 to drive to work and so he will not sell the forward contract while at the lower level of wealth, he would take the train. That is the result of the concavity of the utility function (risk aversion). Yet, allocative efficiency is achieved in both cases. The hedger taking the car is not allocative inefficiency – it is simply the redistributive effect of the lottery ticket. Exactly as the Coase theorem would say, the initial allocation of property rights (whether or not there is a forward contract) gives rise to windfall gains and losses (lottery prizes), but there is no loss of allocative efficiency.

Vivek Oberoi continues:

A similar case can be built for a risk-averse producer. Imagine a USD 50/unit drop in oil price will lead to a shutdown of his fields. He hedges to avoid that eventuality. An outcome in which he gets USD 50 in cash and shuts down his field is worse than him producing 1 unit.

My response:

Absolutely correct. The consumer wants to buy a lottery ticket that gives a $50 prize when oil is at $150. The producer wants to buy a lottery ticket that gives a $50 prize when oil is at $50. Each is willing to sell the lottery ticket that the other wants in order to pay for the lottery ticket that he wants. Risk aversion (concave utility functions) is what makes this trade possible. More generally, one party is a put buyer and the other is a call buyer. The combination of these two lotteries (options) is a forward contract. Again the Coase theorem says that the trade that they agree to do is allocatively efficient.

Your arguments do of course bring out some counter intuitive aspects of derivative markets:

Vivek Oberoi responds to my response:

  1. As you say, the redistributive effect of the lottery and the concavity of utility function ensures that the consumer of oil drives to work. That decision is allocationally inefficient. The consumer has no incentive to reduce his consumption of oil by taking public transport when the price of oil goes up to USD 150/bbl. Similarly the producer has no incentive (and no surplus funds with which) to increase his production of oil. The price signal is being damped.
  2. This transaction results in a net welfare gain for both the consumer and the producer. They are risk averse after all. But for society (i.e everyone besides the two principals) as a whole there is a welfare loss (negative externality). The price at which the derivative contract was struck and the ultimate price of oil are contractually unarbitragable. This reverses the gains from trade. The economic effect of the transaction *on society* is identical to that of price fixing by a government.

My response to his response to my response:

I do not agree that there is any inefficiency for the following reasons:

I think you are underestimating the power of the Coase theorem when markets are deep and liquid.

Posted at 12:39 on Wed, 11 Apr 2012     View/Post Comments (3)     permanent link