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, 27 Oct 2013

Greenspan: successful policy will always create a bubble

In an interview with Gillian Tett in the Financial Times of October 25, 2013 (behind paywall), Alan Greenspan says:

Beware of success in policy. A stable, moderately growing, non-inflationary environment will create a bubble 100 per cent of the time.

The first objection to this argument is that a bubble is by definition unstable and so the term “stable” should be changed to “apparently stable”. That apart, Greenspan seems to be making inferences from just one event – the Great Moderation. From a sample size of one, inferences can be drawn in many directions, and many permutations and combinations are possible. Some possible variants are:

Finally, not many would agree with Alan Greenspan’s self serving claim that bubble blowing can be regarded as a successful policy.

Posted at 14:28 on Sun, 27 Oct 2013     View/Post Comments (0)     permanent link

Sun, 20 Oct 2013

SEC order explains Knight Capital systems failure

More than a year ago, Knight Capital suffered a loss of nearly half a billion dollars and needed to sell itself after a defective software resulted in nearly $7 billion of wrong trades. A few days back, the US SEC issued an order against Knight Capital that described exactly what happened:

It appears to me that there were three failures:

  1. It could be argued that the first failure occurred in 2003 when Knight chose to let executable code lie dormant in the system after it was no longer needed. I would like such code to be commented out or disabled (through a conditional compilation flag) in the source code itself.
  2. I think the biggest failure was in 2005. While making changes to the cumulative order routine, Knight did not subject the Power Peg code to the full panoply of regression tests. Testing should be mandatory for any code that is left in the system even if it is in disuse.
  3. The third and perhaps least egregious failure was in 2012 when Knight did not have a second technician review the deployment of the RLP code. Furthermore, Knight did not have written procedures that required such a review.

I am thus in complete agreement with the SEC’s observation that:

Knight also violated the requirements of Rule 15c3-5(b) because Knight did not have technology governance controls and supervisory procedures sufficient to ensure the orderly deployment of new code or to prevent the activation of code no longer intended for use in Knight’s current operations but left on its servers that were accessing the market; and Knight did not have controls and supervisory procedures reasonably designed to guide employees’ responses to significant technological and compliance incidents; (para 9 D)

However, the SEC adopted Rule 15c3-5 only in November 2010. The two biggest failures occurred prior to this rule. Perhaps, the SEC found it awkward to levy a $12 million file for the failure of a technician to copy a file correctly to one out of eight servers. The SEC tries to get around this problem by providing a long litany of other alleged risk management failures at Knight many of which do not stand up under serious scrutiny.

For example, the SEC says: “Knight had a number of controls in place prior to the point that orders reached SMARS ... However, Knight did not have adequate controls in SMARS to prevent the entry of erroneous orders.” In well designed code, it is good practice to have a number of “asserts” that ensure that inputs are not logically inconsistent (for example, that price and quantity are not negative or that an order date is not in the future). But a piece of code that is called only from other code would not normally implement control checks.

For example, an authentication routine might verify a customer’s password (and other token in case of two factor authentication). Is every routine in the code required to check the password again before it does its work? This is surely absurd.

Posted at 21:45 on Sun, 20 Oct 2013     View/Post Comments (0)     permanent link

Wed, 16 Oct 2013

When solvent sovereigns default (aka technical default)

As the US approaches the deadline for resolving its debt ceiling stalemate, there has been much talk about the consequences of a “technical default”. Across the Curve has an acerbic comment about the utter inappropriateness of this terminology:

I guess a technical default is one in which you personally do not own any maturing debt or hold a coupon due an interest payment. If you hold one of those instruments it is a real default!

It is more appropriate to talk about defaults by a solvent sovereign where the ability of the sovereign to repay remains high even after the promise of timely repayment has been broken. This kind of default used to be pretty common in the past (till about a century ago). In the old days, defaults of this kind arose due to liquidity problems or due to some kind of fiscal dysfunction. However strange the US situation may look to us on the basis of our experience in recent decades, it is not at all unusual in the broad sweep of history.

Phillip II of Spain defaulted four times during his reign. Spain was a superpower when it defaulted and it remained a superpower after its initial couple of defaults. In a fascinating paper, Drelichman and Voth explain:

The king’s repeated bankruptcies were not signs of insolvency ... future primary surpluses were sufficient to repay Philip II’s debts ... In addition, lending was profitable ... (Drelichman and Voth (2011), “Lending to the Borrower from Hell: Debt and Default in the Age of Philip II”, The Economic Journal, 121, 1205-1227)

As long as Spain owned the largest silver mines in the world, its abilty to repay debts was not seriously in question (even when the debts reached 60% of GDP under Philip II). One can see a close parallel with the very high ability of the US to repay its debts if its politicians choose to do so.

In England, the default of Charles II (the notorious stop of the exchequer) was a result of fiscal dysfunction rather than any inability of England to repay its modest debts. Charles was not on the best of terms with his parliament and therefore could not levy new taxes to finance his expenses. The same parliament was of course willing to levy far greater taxes and support far greater debts to finance the wars of a monarch more to its liking (William of Orange) after the bloodless revolution. This episode also seems to have much in common with modern day US politics.

Another interesting phenomenon which appears counter intuitive to many people is that sovereign default often happens under very strong and competent rulers. If we look at England, Edward III, Henry VIII and Charles II were among its greatest kings. (In the case of Henry, I am counting the great debasement as a default. In the case of Charles, the chartering of the Royal Society cements his place as one of that country’s greatest monarchs in my view.). Turning to the US, one of its outstanding presidents (Franklin Roosevelt) presided over that country’s only default so far (the repudiation of the gold clause). Perhaps, only a strong ruler is confident enough to risk all the consequences of default. Lesser rulers prefer to muddle along rather than force the issue.

On another note, it may be that we are entering a new age where in at least some rich countries, sovereign default will no longer be as much of a taboo as it is today. Default may indeed be the least unpleasant of all choices that await a rich, over indebted and ageing society, but only truly heroic leaders may be willing to take the plunge.

Posted at 15:47 on Wed, 16 Oct 2013     View/Post Comments (1)     permanent link

Sun, 06 Oct 2013

Fama French and Momentum Factors: Data Library for Indian Market

My colleagues, Prof. Sobhesh K. Agarwalla, Prof. Joshy Jacob and I have created a publicly available data library providing the Fama-French and momentum factor returns for the Indian equity market using data from CMIE Prowess. We plan to keep updating the data on a regular basis. Because of data limitations, currently the data library starts in January 1993, but we are trying to extend it backward.

We differ from the previous studies in several significant ways. First, we cover a greater number of firms relative to the existing studies. Second, we exclude illiquid firms to ensure that the portfolios are investable. Third, we have classified firms into small and big using more appropriate cut-off considering the distribution of firm size. Fourth, as there are several instances of vanishing of public companies in India, we have computed the returns with a correction for survival bias.

The methodology is described in more detail in our Working Paper (also available at SSRN): Sobhesh K. Agarwalla, Joshy Jacob & Jayanth R. Varma (2013) “Four factor model in Indian equities market”, W.P. No. 2013-09-05, Indian Institute of Management, Ahmedabad.

Posted at 18:05 on Sun, 06 Oct 2013     View/Post Comments (0)     permanent link