Prof. Jayanth R. Varma's Financial Markets Blog

Photograph About
Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

Subscribe to a feed
RSS Feed
Atom Feed
RSS Feed (Comments)

Follow on:
twitter
Facebook
Wordpress

July
Sun Mon Tue Wed Thu Fri Sat
 
     
2019
Months
Jul
2018
Months

Powered by Blosxom

Fri, 26 Jul 2019

Big Tech 2019 = Big Finance 2005 = Big Risk?

That is the title of my post today in the sister blog on computing. In 2005, Big Finance was at the top of the world, but in 2008, it all came crashing down. It appears to me that Big Tech which enjoys a similar situation of dominance today also suffers from the same kind of hubris that destroyed Big Finance a decade ago. A change in fortunes could be as fast and as brutal as was the case with Big Finance a decade ago. Prudent risk management today demands that individuals and organizations take steps to protect themselves against the risk that one or more of the Big Tech companies would go bust or shutdown their services for other reasons.

Posted at 21:00 on Fri, 26 Jul 2019     View/Post Comments (0)     permanent link


Thu, 25 Jul 2019

A petty money dispute holds market to ransom

I am not a lawyer, and so it is with much trepidation that I write about a petty dispute that has been holding the Indian market to ransom. I venture to write only because I am convinced that the issue is not really about legal technicalities, and in any case the entire money dispute is quite petty and trivial compared to the broader issue of market integrity and the sanctity of key market infrastructure.

The facts of the dispute are well brought out in an order issued in May 2019 by the Securities Appellate Tribunal. The genesis of the dispute lies with a brokerage firm, Allied Financial Services, that allegedly stole about $50 million worth of its clients’ securities and pledged them as collateral with its Clearing Member, ILFS Securities, to support an options trade that they had done on the National Stock Exchange (NSE). On the strength of this collateral, ILFS Securities, deposited cash margins with NSE Clearing to support the trade done by Allied. After receiving complaints of fraud, the Economic Offences Wing (EOW) froze the collateral lying with ILFS Securities. When the time came to settle the trade, ILFS Securities asked for annulment of the trade. Even if the trade is annulled, ILFS would have to return the option premium and the benefit to them would be a only marginal reduction in the quantum of loss. ILFS Securities’ gain of probably $5-10 million would of course be the loss of the counter parties to the trade.

I deliberately call this a petty dispute because for some of the institutions involved, $5 million or even $50 million is quite likely a rounding error on their balance sheets. Even for the smaller entities, it is not by itself a bankruptcy threatening event. We are not talking about a poor investor whose lifetime savings could be wiped out by the dispute; we are talking about some big institutions which might be somewhat better off or somewhat worse off depending on which way the dispute is resolved. We are also not talking about recovering money from the alleged fraudster; the dispute is all about allocating the losses among different victims of the alleged fraud.

The tragedy is that as a result of this petty dispute, there has been a stay on the settlement of the trade. If not resolved soon, this settlement failure risks causing serious damage to the integrity and reputation of India’s largest stock exchange and its clearing corporation.

The core function of a stock exchange and its clearing corporation is to allow complete strangers to trade without doing any due diligence on each other. If you do an OTC trade or bilateral trade, you have to worry about whether your counter party is trustworthy. On the other hand, when you sell some shares on an exchange, you do not even bother to ask who was the buyer because it does not matter. The whole function of the exchange is to make that question (whom am I trading with) irrelevant and thereby create a national (or even global) market. OTC markets are a cosy club, while exchanges are open to one and all. At the centre of this magical transformation is the clearing corporation that becomes the counter party to all trades (novation) and thereby insulates buyer and seller from each other.

It is this core promise of the clearing corporation that has been called into question by the way this petty dispute has been allowed to fester and linger. A shadow has been allowed to fall on the sanctity of a key market infrastructure. I do not blame the judiciary for this tragedy because the judiciary adjudicates only issues that are brought before it. And it is the money dispute that has come before the judiciary because all the big and mighty entities involved have the wherewithal to hire the best lawyers to argue that this trivial dispute is the most important thing in the world.

The burden of preventing this tragedy lies primarily with the regulator who has the responsibility and mandate to draw the judiciary’s attention to the systemic issues and national interest involved in the smooth functioning of our market infrastructure. A $5 or even $50 million dispute should not be allowed to threaten the integrity of a $2 trillion stock market. As I said, I am not a lawyer, but I find it hard to believe that SEBI would not receive a patient hearing in the highest courts of the land if it made an earnest plea on its statutory duty to protect the investor interest and the public interest. Instead, it has confined itself to narrow legalistic arguments about who has the power to annul a trade and under what conditions. It has allowed the disputants to frame the debate instead of seeking to change the frame of the debate.

Posted at 16:06 on Thu, 25 Jul 2019     View/Post Comments (1)     permanent link


Thu, 11 Jul 2019

US wants to nurture single stock futures

Two decades ago, when India was trying to set up its equity derivatives market, the most contentious issue was that of single stock futures – market participants were keen on this product, while a large group of sceptics argued that the product did not exist in the US and was in fact confined to a handful of countries. It was also thought to be too similar to the indigenous system of rolling settlement known as badla which was somehow thought to be evil. The compromise was to begin with index futures and defer the launch of single stock futures. In reality, the single stock future was the first equity derivative to become successful in India, and then the earlier products picked up with a significant lag. India also became one of the largest single stock future markets in the world while also creating very liquid index futures, index options and single stock option markets. The Indian experience also demonstrated that each of these four markets catered to a different need. For example, my former doctoral student Sonali Jain in a recent paper, along with my colleagues, Sobhesh Agarwalla and Ajay Pandey and myself found that in India, single stock futures play the role that the options market plays in the US for informed trading around earnings announcements. This implies that single stock futures have some clear advantages over options in informed trading.

With this background, I found it quite amusing to read the joint proposal by the US Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) to reduce margins for retail investors in single stock futures (see press release and proposal). The US set up a single stock futures market a decade ago, but it remains tiny. The SEC is now very clear about its desire to promote the growth of this market:

The security futures market can provide a low-friction means of obtaining delta exposures, and relatively high margin requirements … may have played a role in restraining its development.

To the extent that the proposed reductions in margin requirements encourage significant growth in the security futures markets, it may, in time, improve price discovery for underlying securities. In particular, a more active security futures market can reduce the frictions associated with shorting equity exposures, making it easier for negative information about a firm’s fundamentals to be incorporated into security prices. This could promote more efficient capital allocations by facilitating the flow of financial resources to their most productive uses.

There is also a degree of anxiety about foreign markets that have stolen a march over the US in this product:

Lowering the minimum margin requirement also could enable the one U.S. security futures exchange to better compete in the global marketplace, where security futures traded on foreign exchanges are subject to risk-based margin requirements that are generally lower than those applied to security futures traded in the U.S.

To make things more interesting, there is also a public statement of dissent by one of the SEC Commissioners. I never thought that a day would come when it would be easier to obtain consensus between the SEC and the CFTC than to get consensus within the SEC. What is striking about this dissent is that it does not disagree with the goal of promoting single stock futures. Commissioner Jackson says:

So [stock futures] can provide a valuable price-discovery function in stock markets and give investors an important way to diversify.

But he is not convinced that reducing margins are the best way to accomplish this goal. He believes that there are many alternatives that could and should have been considered. As an example, he suggests that:

rather than asking us to lower margin requirements, an exchange could simply reduce the contract size for single-stock futures. … reducing contract size could also increase access to single-stock futures for the most popular securities and improve efficiency. … Indeed, one of the most liquid contracts in the world, the S&P E-mini Futures contract, is the product of cutting the classic S&P Futures contract in half.

To me, what is noteworthy is that, in two decades, the world has moved from frowning on single stock futures to trying to nurture them.

Posted at 12:23 on Thu, 11 Jul 2019     View/Post Comments (2)     permanent link


Tue, 02 Jul 2019

Deep fakes in finance?

For the last couple of years, I have been following the phenomenon of Deep Fakes with a mixture of cynicism and disinterest. It is only in the last few weeks that I have begun to worry that this is not something that concerns only a few celebrities, but could become a problem for the financial sector in general.

Last week, I read two things that brought the matter to focus. First was the news report about the fake French minister in a silicone mask who stole millions of euros from some of the richest men of Europe (h/t Bruce Schneier). The minister who was impersonated was quite impressed by the quality of the fake video: “They did a pretty good job. Unfortunately some people fell for it. They did a really good impression of my voice. But no-one can truly pass themselves off as me.”

The second was the following recommendation in the report of the Expert Committee on Micro, Small and Medium Enterprises set up by the Reserve Bank of India under the Chairmanship of Shri U K Sinha:

Presently the KYC process is manual and necessitates a physical presence, thus increasing costs and timelines in completing the required KYC processes. As an alternative to enabling e-KYC, the Committee recommends video KYC to be adopted as a part of digital financial architecture as a suitable alternative to performing a digital Aadhaar-based KYC process towards enabling non-physical customer onboarding. (Box XIV- Video Based KYC in Chapter 8)

It appears to me that we will see more of this: only a handful of Luddites will oppose the use of technology that saves cost and eliminates hassles. However, it is part of the folklore of digital security that you can pick any two of Secure, Usable and Affordable – you cannot get all three. Most market architectures would make the natural choice of Usable and Affordable and de-prioritize Security. Deep Fakes would thus emerge as a problem for mainstream finance over a course of time, but I guess it will (perhaps rightly) be treated as a cost of doing business.

Posted at 13:03 on Tue, 02 Jul 2019     View/Post Comments (0)     permanent link