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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Wed, 27 Feb 2019

Can a strong Gresham’s law make good money worthless?

Gresham’s law states that if good money and bad money are circulating simultaneously, everybody would hoard the good money and spend the bad money thereby driving the good money out of circulation. Essentially, the good money becomes a store of value, and the bad money becomes the medium of exchange. I am beginning to think that an even more perverse outcome is possible – the good money having ceased to be money can suddenly become nearly worthless (because the store of value function of the previously good money depended on its being money). This strong form of Gresham’s law came to my mind after reading Wiegand’s recent paper presenting a “prisoners’ dilemma” model of Germany’s adoption of the gold standard in the 1870s.

The story as Wiegand describes it is as follows. In the mid 19th century, a large bloc of countries led by France was on a bimetallic standard with both gold and silver being used as money at a fixed exchange rate. New discoveries in California and Australia brought new supplies of gold in the 1850s, leading to relative shortage of silver whose output grew slowly. While in 1849, annual production (by value) of gold was less than that of silver, in the 1850s and 1860s, gold output was 2-3 times that of silver. Gresham’s law operated as expected to cause hoarding of silver in the bimetallic world: the share of gold in the French currency in circulation rose from below 30% in 1849 to over 80% in the 1860s. As the proportion of gold in France approached 100%, the possibility emerged of silver simply ceasing to be money. But if silver was no longer money, its price would decline to its value in cutlery or jewellery (the first photographic rolls using silver halide came only in the 1880s). We know from 40-year old first generation currency crisis models (Krugman, P. (1979). A model of balance-of-payments crises. Journal of money, credit and banking, 11(3), 311-325.), that the transition from France being 90% on gold to 100% on gold would not be smooth, but would happen in a sudden speculative attack that demonitizes silver. My reading of Wiegand is that Germany acted like a mega George Soros in executing this speculative attack by shifting to a gold standard and dumping all its silver on world markets; soon everybody abandoned silver and its price collapsed. (In the French bimetallic standard, it took only 15.5 ounces of silver to buy an ounce of gold; currently it takes more than five times that many ounces of silver to buy an ounce of gold.) Wiegand’s “prisoners’ dilemma” model is that Germany was forced to act pre-emptively to prevent France from launching a similar speculative attack on Germany’s silver standard.

This is what I am calling the strong Gresham’s Law: in a world of competing monies, the good money would be destroyed by a sudden speculative attack if it undergoes excessive deflation. All successful moneys have been mildly inflationary over sufficiently long periods (Triffin’s dilemma also leads to the same insight).

On the other hand, it is well known that the bad (inflationary) money could also become worthless if inflation accelerates beyond a point (Bernolz has labelled this reverse of Gresham’s law as Thiers’ law). The two laws together imply that all moneys are likely to die over multi-century time frames because of the low probability of staying on the razor’s edge between being demonitized by (a) deflation (the strong Gresham’s Law) and (b) inflation (Thiers’ law) for such long periods of time. This is consistent with the historical evidence: the ultimate fate of every fiat money in human history beginning with 11th Century China seems to be to become worthless. Near worthlessness has also been the ultimate fate of every commodity money except gold (and who knows how long gold’s luck will last?).

This has implications for crypto currency money supply rules as well. Seared by an abundance of hyper inflationary episodes in the 20th Century, crypto currencies have been designed with a deflationary bias. Many of them have inbuilt rules that freeze the money supply after an initial period of gradual monetary emission. In the wake of the collapse of crypto currency prices in recent months, some are making their systems more deflationary. Commentators are interpreting the reduced rate of monetary emission under tomorrow’s Constantinople Upgrade in Ethereum as a move to increase its market price. The weak and strong Gresham’s Laws suggests that all this might be misguided. It appears to me that after the rapid appreciation of crypto currencies in 2017, the weak Gresham’s Law kicked in and crypto currencies ceased to be medium of exchange; they became mere stores of value as exemplified by the hodl meme. It remains to be seen whether the 2018 price collapse in crypto currencies is the beginning of the effect of the strong Gresham’s Law that could destroy these currencies. Counter intuitively, an increased rate of monetary emission might actually be the way to salvage these currencies. Models with multiple equilibria are indeed quite messy.

Posted at 21:51 on Wed, 27 Feb 2019     View/Post Comments (0)     permanent link

Sat, 23 Feb 2019

Convergence of insurance and derivatives

During the global financial crisis, it became fashionable to say that a CDS (Credit Default Swap) is insurance in disguise and should be regulated as such. My response used to be that (a) a lot of insurance is derivatives in disguise, (b) an LC (Letter of Credit) issued by a bank is a CDS in disguise, and (c) it might be better for both them to be regulated as derivatives with mark to market discipline and some pre/post trade transparency. Reinsurance for example is best thought of as put options on a portfolio of non traded or illiquid assets as I wrote in a blog post nearly 11 years ago.

More recently, I am beginning to think that a convergence of derivatives and insurance could happen as “parametric insurance” moves from a fringe idea to a mainstream insurance product. The common description of parametric insurance reads almost like a definition of a weather derivative:

Parametric insurance, …, provides coverage monies automatically upon the existence of certain objective weather-related parameters based upon a set formula. (Van Nostrand, J. M., & Nevius, J. G. (2011). Parametric insurance: using objective measures to address the impacts of natural disasters and climate change. Environmental Claims Journal, 23(3-4), 227-237.)

The parametric insurance literature talks a lot about “basis risk” which indicates convergence with derivatives not only in substance but also in terminology. More recently, proposals have emerged to move from digital call/put option payoffs (payout triggered by a variable such as rainfall amount, wind speed, or earthquake magnitude being observed to exceed a threshold) to more complex functional forms depending in non linear fashion on multiple indices (for example, Figueiredo, R., Martina, M. L., Stephenson, D. B., & Youngman, B. D. (2018). A Probabilistic Paradigm for the Parametric Insurance of Natural Hazards. Risk Analysis, 38(11), 2400-2414.) A traditional derivative structuring expert would be quite at home here.

Till now, parametric insurance has tended to be a niche product used for large transactions (often involving sovereigns or multilateral organizations). The derivatives analogy for this would be a transaction between two ISDA (International Swaps and Derivatives Association) counterparties. But that could change as well because FinTech (financial technology) players now see parametric insurance as an opportunity to break into the insurance space. They dream of using smart contracts and IOT (internet of things) to turn parametric insurance into a retail product. In some of these grandiose plans, a sensor in my home will inform the insurance company that it detected flood waters inside my home and the insurance company will automatically transfer the payout (or is it payoff?) to my bank account, and perhaps, all of this will happen on the blockchain. So we will have the equivalent of retail weather derivatives. I hope there will be a mark to market regulation somewhere.

Posted at 18:36 on Sat, 23 Feb 2019     View/Post Comments (2)     permanent link

Wed, 13 Feb 2019

Indian Bankruptcy Code: Morality play reaches a dead end

The Insolvency and Bankruptcy Code (IBC) introduced in India a couple of years ago was from the very beginning a morality play with a thin veneer of economic theory. With the passage of time, the veneer of economic theory has eroded, the morality play has become stronger and the functioning of the code has become progressively more divorced from economic reality.

Until the IBC came along, Indian businesses were well protected from their lenders by mechanisms like the BIFR which were the morality play of an earlier era that had become perverted over time. Originally designed to protect the interests of workers of distressed companies, these mechanisms ended up entrenching incumbent management, and leaving lenders helpless. Since a lot of the lenders were public sector banks, there was a strong political pressure to redress the balance. After a couple of attempts to empower the financial sector (Debt Recovery Tribunals and SARFAESI) proved inadequate, the IBC was introduced to redress the balance decisively.

In this morality play, the corporate sector were the villains, and the banks were the saints. The obvious solution was to hand over insolvent companies to the financial creditors. Of course, companies have operational creditors, but since these tend to be businesses which were classified as villains, a decision was taken to exclude operational creditors from the decision making. Morality was also the path of expediency as the new system also served as a backdoor bailout of the beleaguered financial sector.

Decades of studying finance have taught me that the world of finance is full of villains, but there are hardly any saints. In my first blog post on the Indian bankruptcy reform, I wrote that in the real world bankruptcy was “very much like the familiar scene in the Savannah where cheetahs, lions, hyenas and vultures can be seen fighting over the carcass”. There is no fairness in the jungle, and victory belongs neither to the one that hunted down the prey nor to the one in greatest need of food; victory typically goes to the most wicked of the lot. The story is the same when it comes to distressed debt around the world. Last month, Jared Ellias and Robert Stark wrote a fascinating paper entitled “Bankruptcy Hardball” which documented several episodes of such wickedness in the United States.

The sidelining of operational creditors was initially the most egregious morality play in the IBC and I wrote more than one blog post on this issue (here and here). Moreover, even the morality of this exclusion became suspect when it was realized that home buyers who had paid an advance to an insolvent builder would be operational creditors. Politically, it was impossible to club home buyers with other villainous operational creditors, and exceptions were made for them.

But there was more to come. Very soon, instances arose where the incumbent managements of the insolvent companies were potentially the highest bidders in the bankruptcy auction of their companies. Under the original IBC, they would have prevailed, and this might have been the best outcome from the point of view of maximizing the economic value of the lenders. But since the IBC was from inception a morality play, this could not be permitted. So the law was hurriedly amended to prevent them from bidding.

But this creates another problem. Originally, creditors were put in charge of the decision making because it was supposed to be a purely business decision. As the Bankruptcy Law Reforms Committee wrote in its report:

The evaluation of these proposals come under matters of business. The selection of the best proposal is therefore left to the creditors committee …

However, with the exclusion of tainted bidders, the choice of the best proposal is no longer one of economics, but one of theology. Some of the feverish debates in the courts on which bidders are tainted enough to be excluded reminds me of medieval scholastic debates about “How many angels can dance on the head of a pin?”. From an economic point of view, these debates are ridiculous. As the Roman emperor Vespasian said while imposing a tax on urine, Pecunia non olet (money does not stink). Morality plays tend to forget this principle.

By elevating morality above economics, the IBC is failing to live up to its promise. Instead, we see confusion reign paramount. We see distressed companies boasting of a respectable market capitalization while their debt trades at less than half of book value. We see bankruptcy remote vehicles delaying payment on their obligations after the parent group filed for insolvency. The time has come for us to deemphasize the morality play. It is time to hold our noses like emperor Vespasian, and get on with the ugly business of economics.

Posted at 22:16 on Wed, 13 Feb 2019     View/Post Comments (1)     permanent link

Thu, 07 Feb 2019

Covered Interest Parity yet again

I have blogged several times about how Covered Interest Parity (CIP) is not valid in the multi-curve discounting framework that is the standard in finance after the Global Financial Crisis. (My last post a couple of years ago argued that economists who still believe in CIP unreservedly are simply ignoring risk; earlier posts described the cross currency basis and the multi curve discounting framework).

Recently, I read a paper by Wong and Zhang that is perhaps the most lucid explanation that I have seen of the phenomenon of CIP violations and the emergence of a large cross currency basis. They are able to explain not only why the forward premium is not equal to the Libor differential, but also why the CIP violation persists when Libor is replaced by (near) risk free rates like OIS (Overnight Indexed Swaps) or repo.

Wong and Zhang point out that the Libor-OIS spread reflects two different things. First, Libor carries significant counterparty credit risk because it involves unsecured lending for a non trivial time period, while the overnight tenor of OIS reduces the credit risk to negligible levels. Second, Libor carries an exposure to funding liquidity risk because the lender has to fund the loan till maturity, while OIS involves only an exchange of interest cash flows without any principal funding.

The Cross Currency Basis Swap (CCBS) in its post-crisis form does not expose the counterparties to credit risk because of collateralization and variation margins. But it does involve funding liquidity risk (each party receives liquidity in one currency and gives up liquidity in another currency). Thus the CCBS spread reflects only one part of the Libor-OIS spread – the part that accounts for funding liquidity risk. The empirical results in the Wong and Zhang paper show that in some currencies, the Libor-OIS spread is dominated by credit risk while in other currencies (notably the US dollar) it is dominated by funding liquidity risk. As a result, a CIP violation is observed whether one measures the interest differential using Libor or OIS.

Of course, all this is consistent with the multi-curve discounting framework, but this analysis is probably a lot easier to understand.

Posted at 16:19 on Thu, 07 Feb 2019     View/Post Comments (0)     permanent link