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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Tue, 25 Jun 2013

What is the worth of net worth?

The Securities and Exchange Board of India (SEBI) announced today:

Presently, mutual funds are not allowed to appoint a custodian belonging to the same group, if the sponsor of the mutual fund or its associates hold 50 per cent or more of the voting rights of the share capital of such a custodian or where 50 per cent or more of the directors of the custodian represent the interests of the sponsor or its associates.

The Board has decided that the custodian in which the sponsor of a mutual fund or its associates are holding 50 percent or more of the voting rights of the share capital of the custodian, would be allowed to act as custodian subject to fulfilling the following conditions i.e. (a) the sponsor should have net worth of atleast Rs.20,000 crore at all points of time, ...

To provide a perspective on this, the last reported net worth of Lehman was $19.283 billion which is about five times the Rs.20,000 crore stipulated in the above announcement. (The Lehman figure is from the quarterly 10-Q report filed by Lehman on July 10, 2008 about two months before it filed for bankruptcy.)

Even assuming that the reported net worth is reliable, what I fail to understand is the implicit assumption in the world of finance that wealthy people are somehow more honest than poor people. As far as I am aware, the evidence for this is zero. This widely prevalent view is simply the result of intellectual capture by the plutocracy.

Capital in finance has only function – to absorb losses. I would have understood if SEBI had proposed that a variety of sins of the custodian would be forgiven if it (the custodian and not its sponsor) had a ring fenced net worth of Rs.20,000 crore invested in high quality assets.

Posted at 21:37 on Tue, 25 Jun 2013     View/Post Comments (0)     permanent link

Sat, 15 Jun 2013

CBOE 2013 versus BSE 1993

Earlier this week, the US SEC imposed a fine on the Chicago Board Options Exchange (CBO) for conduct reminiscent of what used to happen in the Bombay Stock Exchange (BSE) two decades ago. In the early 1990s, the BSE board was dominated by broker members, and allegations of favouritism, conflict of interest and neglect of regulatory duties were very common. At that time, many of us believed that these were the kinds of problems that the US SEC had solved way back in the late 1930s under Chairman Douglas. India might have been six decades behind the US, but it is widely accepted that security market reforms in the 1990s solved this problem in India, though this solution might have created a different set of problems.

The SEC order reveals problems at the CBOE which are very similar to those that the BSE used to have in the early 1990s:

In financially regulation, no problems are permanently solved – potential problems just remain dormant ready to resurface under more favourable conditions.

Posted at 14:29 on Sat, 15 Jun 2013     View/Post Comments (0)     permanent link

Sun, 09 Jun 2013

The Baselization of CCPs

There was a time when central counter parties (CCPs) used robust and coherent risk measures. Way back in 1999, Artzner et al. could write that “We do not know of organized exchanges using value at risk as the basis of risk measurement for margin requirements” (Artzner, Delbaen, Eber and Heath (1999), “Coherent measures of risk”, Mathematical Finance, 9(3), 203-228, Remark 3.9 on page 217). During the global financial crisis, while Basel style risk management failed spectacularly, exchanges and their CCPs coped with the risks quite well. (I wrote about that here and here).

But things are changing as CCPs gear up to clear OTC derivatives. The robust risk management of CCPs is not percolating to the OTC world; instead, the model-risk infested risk measures of the OTC dealers are spreading to the CCPs. The OTC Space has a nice discussion of how the systems that CCP use to margin OTC derivatives are different from the systems that they use for exchange traded derivatives. No, the CCPs are sticking to expected shortfall and are not jumping into value at risk. But their systems are becoming more model dependent, more dynamic (and therefore procyclical) and more sensitive to recent market conditions. These are the characteristics of Basel (even with Basel’s proposed shift to expected shortfall), and these characteristics are gradually spreading to the CCP world.

I am not convinced that this is going to end well, but then CCPs are also rapidly becoming CDO-like (see my post here) and therefore their failure in some segments might not matter anymore.

Posted at 15:48 on Sun, 09 Jun 2013     View/Post Comments (0)     permanent link

Sat, 01 Jun 2013

The NASDAQ Facebook Fiasco and Open Sourcing Exchange Software

Last week, the US SEC issued an order imposing a $10 million fine on NASDAQ for the software errors that caused a series of problems during the Facebook IPO on May 18, 2012. I think the SEC has failed in its responsibilities because this order does nothing whatsoever to solve the problems that it has identified. The order reveals the complete cognitive capture of the SEC and other securities regulators worldwide by the exchanges that they regulate.

The entire litany of errors during the Facebook IPO demonstrates that critical financial market infrastructures like exchanges and depositories should be forced to publish the source code of the systems through which their rules and bylaws are implemented. Of course, the exchanges will complain about the dilution of their “intellectual property”. But the courts have whittled down the “intellectual property” embedded in standard-essential patents and this principle applies with even greater force to software which implements rules and bylaws that are effectively subordinate legislation. Financial regulators have simply fallen behind the times in this respect.

What is the point of an elaborate process of filing and approval for rule changes, if there is no equivalent process for the actual software that implements the rule? The SEC order shows several instances where the lack of disclosure or approval processes for software changes made a complete mockery of the disclosure or approval processes for the rules and regulations themselves:

The Facebook fiasco was itself the result of an infinite loop in the software. This infinite loop would almost certainly have been detected if the source code had been publicly released and discussed with the same attention to detail that characterizes rule changes.

The lack of well defined processes for software testing is revealed in this tidbit: “Given the heightened anticipation for the Facebook IPO, NASDAQ took steps during the week prior to the IPO to test its systems in both live trading and test environments. Among other things, NASDAQ conducted intraday test crosses in NASDAQ’s live trading environment, which allowed member firms to place dummy orders in a test security (symbol ZWZZT) during a specified quoting period. NASDAQ limited the total number of orders that could be received in the test security to 40,000 orders. On May 18, 2012, NASDAQ members entered over 496,000 orders into the Facebook IPO cross.” It should be obvious that the one thing that could have been anticipated prior to the Facebook IPO was the vastly greater volumes than in small time IPOs. Doing a test that excluded this predictable issue is laughable. Proper rules would have required the postponement of the IPO when the volume exceeded the tested capacity of the system.

It is my considered view that the SEC and other securities regulators worldwide are complicit in the fraud that exchanges perpetrate on investors in their greed to protect the alleged “intellectual property” embedded in their software. I have been writing about this for a dozen years now: (1, 2, 3, and 4). So the chances of anything changing any time soon are pretty remote.

Posted at 18:38 on Sat, 01 Jun 2013     View/Post Comments (2)     permanent link