To a Bayesian, almost everything is informative and therefore relevant. This means that the Independence of Irrelevant Alternatives axiom is rarely applicable.
A good illustration is provided by the Joint Staff Report on “The U.S. Treasury Market on October 15, 2014”. On that day, in the narrow window between 9:33 and 9:45 a.m. ET, the benchmark 10-year US Treasury yield experienced a 16-basis-point drop and then rebounded to return to its previous level. The impact of apparently irrelevant alternatives is described in the Staff Report as follows:
Around 9:39 ET, the sudden visibility of certain sell limit orders in the futures market seemed to have coincided with the reversal in prices. Recall that only 10 levels of order prices above and below the best bid and ask price are visible to futures market participants. Around 9:39 ET, with prices still moving higher, a number of previously posted large sell orders suddenly became visible in the order book above the current 30-year futures price (as well as in smaller size in 10-year futures). The sudden visibility of these sell orders significantly shifted the visible order imbalance in that contract, and it coincided with the beginning of the reversal of its price (the top of the price spike). Most of these limit orders were not executed, as the price did not rise to their levels.
In other words, traders (and trading algorithms) saw some sell orders which were apparently irrelevant (nobody bought from these sellers at those prices), but this irrelevant alternative caused the traders to change their choice between two other alternatives. Consider a purely illustrative example: just before 9:39 am, traders faced the choice between buying a modest quantity at a price of say 130.05 and selling a modest quantity at a price of 129.95. They were choosing to buy at 130.05. At 9:39, they find that there is a new alternative: they can buy a larger quantity at a price of say 130.25. They do not choose this new alternative, but they change their earlier choice from buying at 130.05 to selling at 129.95. This is the behaviour that is ruled out by the axiom of the Independence of Irrelevant Alternatives.
But if one thinks about the matter carefully, there is nothing irrational about this behaviour at all. At 8:30 am, the market had seen the release of somewhat weaker-than-expected US retail sales data. Many traders interpreted this as a memo that the US economy was weak and needed low interest rates for a longer period. Since low interest rates imply higher bond prices, traders started buying bonds. At 9:39, they see large sell orders for the first time. They realize that many large investors did not receive this memo, or may be received a different memo. They think that their interpretation of the retail sales data might have been wrong and that they had possibly over reacted. They reverse the buying that they had done in the last few minutes.
In fact,the behaviour of the US Treasury markets on October 15 appears to me to be an instance of reasonably rational behaviour. Much of the action in those critical minutes was driven by algorithms which appear to have behaved rationally. With no adrenalin and testosterone flowing through their silicon brains, they could evaluate the new information in a rational Bayesian manner and quickly reverse course. The Staff Report says that human market makers stopped making markets, but the algorithms continued to provide liquidity and maintained an orderly market.
I expected the Staff Report to recommend that in the futures markets, the entire order book (and not just the best 10 levels) should be visible to all participants at all times. Given current computing power and communication bandwidth, there is no justification for sticking to this anachronistic practice of providing only limited information to the market. Surprisingly, the US authorities do not make this sensible recommendation because they fail to see the highly rational market response to newly visible orders. Perhaps their minds have been so conditioned by the Independence of Irrelevant Alternatives axiom, that they are blind to any other interpretation of the data. Axioms of rationality are very powerful even when they are wrong.
Sun, 12 Jul 2015
In response to my blog post of a few days back on regulating crowd funding, my colleague Prof. Joshy Jacob writes in the comments:
I agree broadly with all the arguments in the blog post. I would like to add the following.
If tapping the crowd wisdom on the product potential is the essence of crowdfunding, substituting that substantially with equity crowdfunding may not be a very good idea. While the donation based crowdfunding generates a sense of the product potential by way of the backings, the equity crowdfunding by financiers would not give the same, as their judgments still need to be based on the crowd wisdom. Is it possible to create a sequential structure involving donation based crowdfunding and equity based crowdfunding?
Unlike most other forms of financing, the judgement in crowdfunding is often done sitting far away, without meeting the founders, devoid of financial numbers, and therefore almost entirely based on the campaign material posted. This intimately links the central role of the campaign success to the nature of the promotional material and endorsements by influential individuals. Evolving a role model for the multimedia campaigns would be appropriate, given the ample evidences on behavioral biases in retail investor decision making.
Both these are valid points that the regulator should take into account. However, I would worry a bit about people gaming the system. For example, if the regulator says that a successful donation crowdfunding is a prerequisite for equity crowdfunding, there is a risk that entrepreneurs will get their friends and relatives to back the project in a donation campaign. It is true that angels and venture capitalists rely on crowdfunding campaign success as a metric of project viability, but I presume that they would have a slightly greater ability to detect such gaming than the crowd.
Mon, 06 Jul 2015
Many jurisdictions are struggling with the problem of regulating crowd funding. In India also, the Securities and Exchange Board of India issued a consultation paper on the subject a year ago.
I believe that there are two key differences between crowd funding and other forms of capital raising that call for quite novel regulatory approaches.
Crowd funding is for the crowd and not for the Wall Street establishment. There is a danger that if the regulators listen too much to the Wall Street establishment, they will produce something like a second tier stock market with somewhat diluted versions of a normal public issue. The purpose of crowd funding is different – it is to tap the wisdom of crowds. Crowd funding should attract people who have a passion for (and possibly expertise in) the product. Any attempt to attract those with expertise in finance instead of the product market would make a mockery of crowd funding.
The biggest danger that the crowd funding investor faces is not exploitation by the promoter today, but exploitation by the Series A venture capitalist tomorrow. Most genuine entrepreneurs believe in doing well for their crowd fund backers. After all, they share the same passion. Everything changes when the venture capitalist steps in. We have plenty of experience with venture capitalists squeezing out even relatively sophisticated angel investors. The typical crowd funding investor is a sitting duck by comparison.
What do these two differences imply for the regulator?
A focus on accredited investors would be a big mistake when it comes to crowd funding. These accredited investors will look for all the paraphernalia that they are accustomed to in ordinary equity issues – prospectuses, financial data and the like.
The target investor in a technology related crowd funding in India might in fact be a young software professional in Bangalore who is an absolute nerd when it comes to the product, but has difficulty distinguishing an equity share from a convertible preference share.
Disclosure should be focused on the people and the product. Financial data is meaningless and irrelevant. As in donation crowd funding, the disclosure will not be textual in nature, but will use rich multimedia to communicate soft information more effectively.
Equity crowd funding should be more like donation crowd funding with equity securities being one of the rewards. This implies that the vast majority of investors should be investing tiny amounts of money – the sort of money that one may spend on a dinner at a good restaurant. It should be money that one can afford to lose. In fact, it should be money that one expects to lose. Close to half of all startups probably fail and one should expect similar failure rates here as well.
If such small amounts of money are involved, transaction costs have to be very low. No regulatory scheme is acceptable if it will not work for small investments of say USD 50-100 in developed markets and much lower in emerging markets (say INR 500-1000 in India).
Some regulatory mechanisms need to be created for protecting the crowd in future negotiations with angels, venture capitalists and strategic buyers. Apart from some basic anti dilution rights, we need some intermediary (similar to the debenture trustee in debt issues) who can act on behalf of all investors to prevent them from being short changed in these negotiations. Going even further, perhaps even something similar to appraisal rights could be considered.
Regulatory staff who work on crowd funding regulations should be required to spend several hours watching donation crowd funding campaigns on platforms like Kickstarter and Indiegogo to develop a better appreciation of the activity that they are trying to regulate.
In the spirit of crowd sourcing, I would like to hear in the comments on what a good equity crowd funding market should look like and how it should be regulated. Interesting comments may be hoisted out of the comments into a subsequent blog post.
Thu, 02 Jul 2015
The following posts appeared on the sister blog (on Computing) last month.
Wed, 01 Jul 2015
After careful thought, I now think that it is a bad idea to mandate that regulated entities should store and retain records of all digital communications by their employees. Juicy emails and instant messages have been the most interesting element in many prosecutions including those relating to the Libor scandal and to foreign exchange rigging. Surely it is a good thing to force companies to retain these records for the convenience of prosecutors.
The problem is that today we use things like instant messaging where we would earlier have had an oral conversation. And there was no requirement to record these oral conversations (unless they took place inside specified locations like the trading room). The power of digital communications is that they transcend geographical boundaries. The great benefit of these technologies is that an employee sitting in India is able (in a virtual sense) to take part in a conversation happening around a coffee machine in the New York or London office.
Electronic communications can potentially be a great leveller that equalizes opportunities for employees in the centre and in the periphery. In the past, many jobs had to be in London or New York so that the employees could be tuned in to the office gossip and absorb the soft information that did not flow through formal channels. If we allowed a virtual chat room that spans the whole world, then the jobs too could be spread around the world. This potential is destroyed by the requirement that conversations in virtual chat rooms should be stored and archived while conversations in physical chat rooms can remain ephemeral and unrecorded. Real gossip will remain in the physical chat rooms and the jobs will also remain within earshot of these rooms.
India as a member of the G20 now has a voice in global regulatory organizations like IOSCO and BIS. Perhaps it should raise its voice in these fora to provide regulatory space for ephemeral digital communications that securely destroy themselves periodically.