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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Sun, 29 Sep 2013

33 ways to control algorithmic trading

Earlier this month, the US Commodity Futures Trading Commission (CFTC) published a Concept Release on Risk Controls and System Safeguards for Automated Trading Environments. It seeks comments on a laundry list of 33 measures that could be adopted to control algorithmic and high frequency trading (I arrived at this count from the list on page 116-132, counting sub items in the first column also).

The proposals on this list range from the sensible to the problematic, and there does not seem to be much of an effort to analyse the economic consequences of these measures. The idea of the concept release appears to be to outsource this analysis to those who choose to submit comments on the concept release. There is nothing wrong with that. But with the current CFTC Chairman, Gary Gensler, set to step down soon, nothing much might come out of the concept release.

Posted at 12:32 on Sun, 29 Sep 2013     View/Post Comments (0)     permanent link

Wed, 25 Sep 2013

Systemic effects of the Merton model

David Merkel has posted on his The Aleph Blog a note that he wrote in 2004 about how widespread use of the Merton model to evaluate credit risk influences the corporate bond market itself. The Merton model regards risky debt as a combination of risk free debt and a short put option on the assets of the issuer. Credit risk assessment is then a question of valuing this put option – a process that relies largely on stock prices and implied volatilities. Merkel writes:

Over the last seven years, more and more managers of corporate credit risk use contingent claims models. Some use them exclusively, others use them in tandem with traditional models. They have a big enough influence on the corporate bond market that they often drive the level of spreads. Because of this, the decline in implied volatility for the indices and individual companies has been a major factor in the spread compression that has gone on. I would say that the decline in implied volatility, and deleveraging, has had a larger impact than improving profitability on spreads.

The Merton model is probably under-utilized in India and so I have not encountered this problem. But Merkel is saying that in some countries, it is over used and over reliance on it can be a problem. The global financial crisis highlighted the dangers of outsourcing credit evaluation to the rating agencies. The Merton model in some ways amounts to outsourcing credit evaluation to the equity markets, and this too could end badly. I have wondered for some time now as to why advanced country central banks act as if they have adopted equity price targeting. If the Merton model is so influential, then the primary channel of monetary transmission to the credit markets would lie via equity markets and targeting equity prices suddenly makes a lot of sense to the central banks themselves.

But those who buy poor credit risks on the basis of Merton model credit assessments that have been flattered by QE inflated stock prices (and QE dampened volatilities) might be in for a rude surprise if and when the central banks decide to let equity markets find their natural level and volatility.

Posted at 13:41 on Wed, 25 Sep 2013     View/Post Comments (0)     permanent link

Sun, 15 Sep 2013

Snowden disclosures and the cryptographic foundations of modern finance

I have always believed that the greatest tail risk in finance is a threat to its cryptographic foundations. Everything in modern finance is an electronic book entry that could suddenly evaporate if the cryptography protecting it could be subverted. Such a cryptographic catastrophe would make the Lehman bankruptcy five years ago look like a picnic.

Global finance should therefore be alarmed by the Snowden disclosures earlier this month that the large technology companies have been collaborating with the US government to actively subvert internet encryption. It is claimed that backdoors have been built into many commercial encryption software and that even the standards relating to encryption have been compromised.

I do not think this is about the US at all. It is very likely that large technology companies are extending similar cooperation to other governments that control large markets. A decade ago, Microsoft publicly announced that it had provided the Chinese government access to the Windows source code. Blackberry’s long resistance to the Indian government’s desire for access to its encryption suggest that the Indian market is not large enough to induce quick cooperation, but I would be surprised if the US and China were the only countries that are able to bend the large technology companies to their ends. Countries like Russia and Israel with proven cyber warfare capabilities would also have achieved some measure of success.

In this situation, financial firms around the world should consider themselves as potential targets of cyber warfare. Alternatively, they could just become collateral damage in the struggle between two or more cyber superpowers. In my view, this is an existential threat to the modern financial system.

The saving grace is that there is nothing to suggest that the mathematics of encryption has become less reliable. The problems are all in the implementation – commercial routers, commercial operating systems, commercial browsers and commercial encryption software may have been compromised but not the mathematics of encryption, at least not yet.

Perhaps, finance can still escape a cryptographic meltdown if it embraces open source software for all cryptography critical applications. As computer security expert Bruce Schneier explains: “Trust the math. Encryption is your friend. Use it well, and do your best to ensure that nothing can compromise it.”

Posted at 16:45 on Sun, 15 Sep 2013     View/Post Comments (1)     permanent link

Sun, 01 Sep 2013

Krugman on Asian Crisis as success story

Paul Krugman says so partly tongue in cheek, but still it is remarkable to read this from the world’s foremost authority on the Asian Crisis:

I will say, 15 years ago it would never have occurred to me that we would be looking back at Asia’s crisis as a success story.

My last blog post on the good that came out of the Asian Crisis looks a little less outrageous now. Also while I gave Malaysia of 1997-98 as an example of a bad response to a crisis, Krugman points to peripheral Europe. Now that is a truly atrocious response to a crisis – one in which the creditors are still in charge and are still thinking like creditors.

Posted at 11:03 on Sun, 01 Sep 2013     View/Post Comments (0)     permanent link