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

© Prof. Jayanth R. Varma

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Wed, 27 Feb 2013

Looking at 2014 through the prism of 1994

Unless the United States shoots itself in the foot during the fiscal negotiations, it could conceivably be on the cusp of a recovery. There is a serious possibility that the unemployment rate starts falling towards 7%, and the US Fed begins to consider unwinding some of its unconventional monetary easing measures. Unconventional monetary policy is equivalent to a highly negative policy rate, and so a substantial monetary tightening can happen well before the Fed starts raising the Fed Funds rate.

The situation is reminiscent of 1994 when the US Fed tightened monetary policy as the economy recovered from the recession of the early 1990s. This monetary tightening is best known for the upheaval that it caused in the US bond markets, but the turbulence in US Treasuries lasted only a few months. The more lasting impact was on emerging markets as higher US yields dampened capital flows to emerging economies:

History never repeats itself (though as Mark Twain remarked, it sometimes rhymes). Yet, there is reason to fear that a normalization of interest rates in the US in the coming year could be destabilizing to many emerging markets which are today bathed in the tide of liquidity unleashed by the US Fed and other global central banks. India, in particular, has become overly addicted to foreign capital flows to cover its large current account deficit, and any retrenchment of these flows in response to better opportunities in the US could be quite painful.

Posted at 16:31 on Wed, 27 Feb 2013     View/Post Comments (3)     permanent link

Fri, 22 Feb 2013

Indian Gold ETFs become Gold ETNs

Last week, the Securities and Exchange Board of India allowed Indian gold Exchange Traded Funds (ETFs) to deposit their gold with a bank under a Gold Deposit Scheme instead of holding the gold in physical form. In the Gold Deposit Scheme, the bank does not act as a custodian of the gold. Instead, the bank lends the gold out to jewellers (and others) and promises to repay the gold on maturity.

In my view, use of the Gold Deposit Scheme will convert the Gold ETF into an ETN (Exchange Traded Note) or an ETP (Exchange Traded Product). The ETF does not hold gold – it only holds an unsecured claim against a bank and is thus exposed to the credit risk of the bank. If the bank were to fail, the ETF would stand in the queue as an unsecured creditor of the bank. The ETF therefore does not hold gold; it holds a gold linked note.

So far, the ETFs in India have been honest-to-God ETFs instead of the synthetic ETNs and ETPs that have unfortunately become so popular in Europe and elsewhere. With the new scheme, India has also joined the bandwagon of synthetic ETNs and ETPs masquerading as ETFs.

Truth in labelling demands that any ETF that uses the Gold Deposit Scheme should immediately be rechristened as an ETN. I also think that this is a change in fundamental attribute of the ETF and should require unit holder approval.

From a systemic risk perspective, I fail to see why this concoction makes sense at all. It unnecessarily increases the inter-connectedness of the banking and mutual fund industries and aggravates systemic risk. A run on the bank could induce a run on the ETF and vice versa. All this is in addition to the maturity mismatch issues described by Kunal Pawaskar.

I can understand the desire to put idle gold to work, but that does not require the intermediation of the bank at all. The ETF can lend the gold directly against cash collateral with daily mark to market margins. Even if it were desired to use the services of a bank, there are better ways to do this than to treat the ETF just like any other retail depositor. For example, the bank could provide cash collateral to the ETF with daily mark to market margins. As is standard in such contracts, a portion of the interest that the ETF earns on the cash collateral would be rebated back to the bank to cover its hedging and custody costs.

Posted at 07:59 on Fri, 22 Feb 2013     View/Post Comments (1)     permanent link

Fri, 08 Feb 2013

Disincentivising Cheques

More than a year ago, I blogged about how banks in India were perversely incentivising retail customers to use cheques instead of electronic transfers though the cost to the whole system of processing a cheque is much higher. I also hypothesized that it may well be rational for an individual bank to follow this perverse pricing under certain assumptions about price elasticity of demand.

Now the Reserve Bank of India has put out a discussion paper on Disincentivising Issuance and Usage of Cheques. It discusses at length ways to disincentivize individuals, institutions and government departments from using cheques. I was surprised to find however that there was no proposal to disincentivize the banks themselves. I think it makes a lot more sense to impose a significant charge on the paying bank for every cheque that is presented for clearing. It can be left to the banks to decide on whether (and how) to pass on the charge itself to some or all their customers. The more important purpose of the charge would be to incentivize the banks to educate and incentivize their customers and also to make their payment gateways more user friendly. Why should the charge be on the paying banks? Because, they own the customer who writes the cheque and also because they sit on the float when cheques are used.

Posted at 14:59 on Fri, 08 Feb 2013     View/Post Comments (2)     permanent link

Sun, 03 Feb 2013

Financial Risk: Perspectives from psychology and biology

During the last week, I found myself reading two different perspectives on financial risk:

  1. A fascinating paper by Anat Bracha and Elke Weber entitled “A Psychological Perspective of Financial Panic” (h/t Mostly Economics).
  2. A marvellous book by John Coates called The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust.

The main thesis of Bracha and Weber is that:

... perceived control is a key concept in understanding mania and panic, as the need for control is a basic human need that contributes to optimism bias and affects risk perception more generally. Lack of control is therefore a violation of a basic need and will trigger episodes of panic and retreat to the safe and known.

The illusion of control refers to the human tendency to believe we can control or at least influence outcomes, even when these outcomes are the results of chance events.

The book by Coates is much more complex. The title itself requires a whole paragraph of explanation – it translates a French phrase that refers to the time around dusk when it is difficult to determine whether a shadow that one is seeing is that of a dog or a wolf, implying that the one could metamorphose into the other at any time.

From a biological perspective, it appears that:

... researchers have found that three types of situations signal threat and elicit a massive physiological stress response – those characterized by novelty, uncertainty and uncontrollability


Novelty, uncertainty and uncontrollability – the three conditions are similar in that when subjected to them we have no downtime, but are in a constant state of preparedness.

The uncontrollability that the psychologists emphasize is present in the biologist's description as well, but it does not seem to have a privileged position compared to other forms of risk – novelty and uncertainty. The biological response to all these forms of risk is the same – the body is flooded with stress hormones (mainly cortisol) which command the body to “shut down long term functions of the body and marshal all available resources, mainly glucose, for immediate use.”

More interesting is that the biological (unconscious) stress response closely mirrors the objective reality unlike the self reported (conscious) risk perception that is elicited by questionnaires. In his research with a groups of bond market traders, Coates asked the traders to report their level of stress at the end of each day. This self reported stress was totally unrelated either to their losing money or swings in their P&L or the volatility in the market. At the same time, their cortisol level faithfully measured the volatility that the individual traders were experiencing. That is not all – the average cortisol level of this group of traders very closely tracked the implied volatility of options related to the bonds that they were trading.

Coates links this finding to what biologists had found with rats. After several days of being placed in an objectively dangerous situation, the rats got habituated to the situation and became outwardly calm. However, their stress hormones reflected the stress that existed. Again, the unconscious biology reflected the objective reality while the conscious behaviour did not.

This seems to suggest that the “illusion of control” that Bracha and Weber talk about may be an illusion that afflicts only the conscious mind and not the unconscious mind that governs actual risk taking. Biology teaches us to assume that millions of years of evolution have perfected the more primitive (unconscious) parts of the brain to achieve near optimal behaviour (at least relative to the original environment). The more recent (conscious) parts of the brain perhaps have still some way to go before reaching evolutionary perfection.

Posted at 05:28 on Sun, 03 Feb 2013     View/Post Comments (1)     permanent link

Fri, 01 Feb 2013

Sociology of the evolution of electronic trading

Donald MacKenzie has a couple of papers recently analyzing the evolution of electronic trading from a sociology of finance point of view. The first paper describes the emergence of ETNs in the United States beginning with the Island system which became Instinet and was ultimately acquired by Nasdaq. The second paper describes the rise of electronic trading at the Chicago Mercantile Exchange.

I have in the past blogged about MacKenzie's previous works (here, and here) and find his approach useful. Others have been less impressed – one critic dismissed some of MacKenzie's previous works as “remarkable close-up studies ... without context ... all cogs and no car”. MacKenzie gets back at this criticism brilliantly at the end of the Island paper:

... historical change can involve shift in scale. In this paper, we have focussed on a small actor becoming big ... However, we could equally have told a story of big actors becoming small ... NYSE was a car, and has become a cog. Island was a cog that became a car ... Scales are indeed not stable, and cogs – and their histories – matter.

I knew most of the facts about Island from Scott Patterson's fascinating book on Dark Pools (subtitled “High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System”). Still, I learned a lot from MacKenzie's paper – the theoretical framework (particularly the idea of bricolage in the process of financial innovation) is quite valuable. I learned less from the paper on the CME, though, in this case, many of the facts were new to me.

Posted at 10:55 on Fri, 01 Feb 2013     View/Post Comments (0)     permanent link