Prof. Jayanth R. Varma's Financial Markets Blog

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Yet more on Equifax data breach

I have written many times about the Equifax data breach arguing that the credit bureau business should be subject to the doctrine of strict liability, that society should not hesitate to impose punitive penalties on them (including shutting down errant entities), and that modern cryptography makes existing credit bureaus obsolete. My excuse for writing about them again is that I just finished reading the US Congress (Committee on Oversight and Government Reform) Majority Staff Report on The Equifax Data Breach.

This report makes it clear that things were even worse at Equifax than I thought. But what I found most interesting is that when the breach occurred, Equifax had initiated the process of making the hacked system compliant with PCI-DSS (Payment Card Industry Data Security Standard) and doing so “would have largely addressed the security concerns flagged”, and would have likely prevented the hack.

PCI DSS compliance requirements include: the use of file integrity monitoring; strong access control measures; retention of logs for at least one year, with the last three months of logs immediately available for analysis; installation of patches for all known vulnerabilities; and maintenance of an up-to-date inventory of system components.

None of this is rocket science and even tiny mom-and-pop stores are required to comply with them before they can accept credit card payments. Yet, one of the largest credit bureaus in the world did not comply with them. The reason is something that Bruce Schneier has been saying for a long time (Eliminating Externalities in Financial Security):

It’s an important security principle: ensure that the person who has the ability to mitigate the risk is responsible for the risk.

If you think this won’t work, look at credit cards. Credit card companies are liable for all but the first $50 of fraudulent transactions. They’re not hurting for business; and they’re not drowning in fraud, either. They’ve developed and fielded an array of security technologies designed to detect and prevent fraudulent transactions. They’ve pushed most of the actual costs onto the merchants. And almost no security centers around trying to authenticate the cardholder.

Equifax was so terrible at computer security because it had no incentives to do a better job: even after one of the worst breaches in history, Equifax faced only minor penalties.

Posted at 7:48 pm IST on Mon, 31 Dec 2018 permanent link

Categories: corporate governance, fraud, technology

Is index methodology a fundamental attribute of a mutual fund?

Adriana Robertson argues in a recent paper that index investing is not passive investing; it only delegates the active management to the index proviver. (Passive in Name Only: Delegated Management and ‘Index’ Investing (November 2018). Yale Journal on Regulation, Forthcoming. Available at SSRN). This is a problem because mutual funds are regulated, but index providers are not. The paper presents data showing that the vast majority of indices in the United States are used as a benchmark by only 1 or 2 mutual funds, and so it is hard to argue that these index providers are subject to strong market discipline.

She offers an ingenuous suggestion to solve this problem without new intrusive regulation.

While a mutual fund cannot deviate from its fundamental policies, as stated in its registration statement, without a shareholder vote, there is no restriction on an index’s ability to change its methodology.

Fortunately, there is a simple solution to this problem. Once we recognize that delegating to an index is no different from delegating to a fund manager, we can craft a solution based on the existing rules: Any time the underlying index makes a change that, if made by the fund manager in a comparable actively managed fund, would trigger a vote, the fund manager is required to hold a vote on retaining the index. This simple change would harmonize the protections offered to investors in the two types of funds.

I can think of at least two significant index changes that would qualify under this rule, and on both these, I think Adriana Robertson’s solution makes eminent sense:

Posted at 5:09 pm IST on Sun, 30 Dec 2018 permanent link

Categories: benchmarks, mutual funds

New Zealand shows the way again?

Three decades ago, New Zealand was the first country in the world to adopt a formal inflation target for its central bank. At around the same time, it also broke new ground in bank regulation with a focus on self-discipline and market-discipline with the regulator focusing mainly on systemic risks (a good summary is available here). Today, the Reserve Bank of New Zealand may be showing the way again with its proposal last week to almost double bank capital requirements.

More than the actual proposal itself, it is the approach that is interesting and likely to be influential. The fact that New Zealand is not a Basle Committee member gives it greater freedom to start from first principles. That is what they have done starting with their mandate to promote a sound and efficient financial system. First, they express the soundness goal in risk appetite terms: “a banking crisis in New Zealand shouldn’t happen more than once every two hundred years”. Second, they interpret the efficiency goal in terms of the literature on optimal capital requirements. This means that they begin by computing the capital requirements that would reduce the probability of a crisis to less than 0.5% per year, and then go on to ask if the optimal capital may be even higher. So the capital requirement is the higher of that determined from soundness and efficiency goals.

Another welcome thing about the proposal is that higher capital is seen as a way for the Reserve Bank of New Zealand to maintain its emphasis on self-discipline and market-discipline:

Capital requirements are the most important component of our overall regulatory arrangements. In the absence of stronger capital requirements, other rules and monitoring of bank’s activities would need to be much tougher.

They end up with Tier-1 capital of 16% as opposed to the existing 8.5% (6% + 2.5% conservation buffer). The 16% includes a countercyclical capital buffer, but unlike in other countries, this buffer would have a positive value at all times, except following a financial crisis. The 16% also includes a 1% D-SIB buffer for the large banks, but excludes the 2% Tier-2 capital requirement (which they are maintaining for the time being, though they would to have only Tier-1 capital).

What is interesting is that 16% is not the regulatory minimum (that remains at the current 6% level). Their idea seems to be that above 16%, it is all self-discipline and market-discipline, but as capital falls below that level, the regulator starts getting involved according to a “framework of escalating supervisory responses based on objective triggers that can provide clarity and much more certainty”. On the other side, when banks are operating above 16%, the Reserve Bank will impose relatively less of a regulatory burden on banks. They are even ready to consider allowing banks to change their internal risk models without regulatory approval at all. Below 16%, the supervisory responses escalate as follows:

Subject to increased monitoring
Capital plan must be submittted
Approval may be required for new business lines
A bank’s activities may be restricted
Additional capital must be raised

One of the dangers of international harmonization of financial sector regulation under the auspices of Basel, FSB and G20 has been the risk of a regulatory mono-culture. New Zealand located at the edge of the world and outside the Basel system is providing a good antidote to this.

Posted at 1:32 pm IST on Mon, 17 Dec 2018 permanent link

Categories: banks, leverage, risk management

Does better mathematics win in the markets?

Last week, the US District Court Southern District of New York issued a judgement dismissing the US CFTC’s complaint of market manipulation against Donald R. Wilson and DRW Investments (h/t Matt Levine). Describing the CFTC’s theories as little more than an “earth is flat” style conviction, the court wrote:

It is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented that product. In the summer and fall of 2010, Don Wilson believed that he comprehended the true value of the Three-Month Contract better than anyone else, including IDCH, MF Global, and Jeffries. He developed a trading strategy based on that conviction, and put his firm’s money at risk to test it. He didn’t need to manipulate the market to capitalize on that superior knowledge, and there is absolutely no evidence to suggest that he ever did so in the months that followed.

In August 2011, DRW unwound its swap futures trade at a profit of $20 million, and the CEO of the biggest firm on the other side Jeffries emailed Wilson: “You won big. We lost big.”. The mathematics behind this trade is well described in a paper by a well known academic quant and two quants who worked for DRW:

Rama Cont, Radu Mondescu and Yuhua Yu “Central Clearing of Interest Rate Swaps: A Comparison of Offerings” available on SSRN.

The purpose of this blog post is to ask a different question: how common is it for traders make money simply by better knowledge of the mathematics than other participants. My sense is that this is relatively rare; traders usually make money by having a better understanding of the facts.

Perhaps the best known mathematical formula in the financial markets is the Black-Scholes option pricing formula, and Black has described his attempts to make money using this formula:

The best buy of all seemed to be National General new warrants. Scholes, Merton, and I and others jumped right in and bought a bunch of these warrants. For a while, it looked as if we had done just the right thing. Then a company called American Financial announced a tender offer for National General shares. The original terms of the tender offer had the effect of sharply reducing the value of the warrants. In other words, the market knew something that our formula didn’t know.

Black, F., 1989. “How we came up with the option formula”. Journal of Portfolio Management, 15(2), pp.4-8.

Many years later, Black did make money with superior knowledge of the mathematics of option pricing. A well known finance academic Jay Ritter has described the sad story of being on the losing side of this trade:

I lost more in the futures market than I made from my academic salary. … Years later, I found out who was on the other side of the trades in the summer of 1986. It was Goldman Sachs, with Fischer Black advising the traders, that took me to the cleaners as the market moved from one pricing regime to another. In the first four years of the Value Line futures contract, the market priced the futures using the wrong formula. After the summer of 1986, the market priced the Value Line futures using the right formula. The September 1986 issue of the Journal of Finance published an article (Eytan and Harpaz, 1986) giving the correct formula for the pricing of the Value Line futures. In the transition from one pricing regime to the other, I was nearly wiped out.

Ritter, J.R., 1996. “How I helped to make Fischer Black wealthier”. Financial Management, 25(4), pp.104-107.

One person who did make money by understanding the mathematics of option pricing was Ed Thorp who kept his knowledge secret till Black and Scholes discovered their formula and published it. Decades later Thorp said in an interview:

… with blackjack, … I thought it was mathematically very interesting, so as an academic, I felt an obligation to publicize my findings so that people would begin to think differently about some of these games. … Moving on to the investment world, when I began Princeton/Newport Partners in 1969, I had this options formula, this tool that nobody else had, and I felt an obligation to the investors to basically be quiet about it. … I spent a lot of time and energy trying to stay ahead of the published academic frontier.

Consulting Submitter, Journal of Investment, “Putting the Cards on the Table: A Talk with Edward O. Thorp”, PhD (July 1, 2011). Journal of Investment Consulting, Vol. 12, No. 1, pp. 5-14, 2011. Available at SSRN

Academics in general have been content to publish their results even when they think it is worth a billion dollars:

Longstaff, F.A., Santa-Clara, P. and Schwartz, E.S., 2001. “Throwing away a billion dollars: The cost of suboptimal exercise strategies in the swaptions market”. Journal of Financial Economics, 62(1), pp.39-66.

Using unpublished mathematical results to make money often has the effect of destroying the underlying market. Nasdaq (which owned IDCH) delisted the swap futures contract within months of DRW unwinding its profitable trade. Similarly, Fischer Black effectively destroyed the Value Line index contract through his activities. Markets work best when the underlying mathematical knowledge is widely shared. It is very unlikely that the option markets would have grown to their current size and complexity if the option pricing formulas had remained the secret preserve of Ed Thorp. Mathematics is at its best when it is the market that wins and not individual traders.

PS: One of the things that has puzzled me about the DRW case is that DRW was a founding member of Eris which offered a competing Swap Futures product. Why didn’t anybody raise a concern that DRW and Eris were conspiring to destroy IDCH? Of course, DRW would have the compelling defence that with $20 million of profits to be made from the arbitrage, they did not need any other motive to do the trade. But still it bothers me that the matter does not seem to have come up at all.

Posted at 3:42 pm IST on Thu, 6 Dec 2018 permanent link

Categories: investment, manipulation, mathematics

Earnings related trading: Futures or Options

There is a large body of literature (mainly in the US) that a lot of the trading activity in response to earnings information happens in the options market. (The seminal paper in this field is Roll, R., Schwartz, E., & Subrahmanyam, A. (2010). O/S: The relative trading activity in options and stock. Journal of Financial Economics, 96(1), 1–17.) Unfortunately, the US and most other countries do not have a liquid single stock futures market, and so we do not know whether the options market was the preferred choice of the informed traders or it was the second best choice substituting for the missing first choice (the futures market). If what the informed trader wanted was leverage and short selling ability, the futures are a much better vehicle because there is no option premium and no delta rebalancing cost. On the other hand, if the trader believed for example that there was a high probability of a large upside surprise in the earnings, counterbalanced by a more modest risk of downside surprise, then the sensible way to express that view would be with a bull-biased strangle (buy a substantial number of out-of-the-money calls and a somewhat smaller number of out-of-the-money puts). It would be too risky to trade this view in the futures market without the downside protection provided by options.

India provides the perfect setting to resolve this issue because it has liquid single stock futures and single stock options markets (both of these markets are among the largest such markets in the world). In a recent paper, my doctoral student, Sonali Jain, my colleagues, Prof. Sobhesh Agarwalla and Prof. Ajay Pandey and I investigate this (Jain S, Agarwalla SK, Varma JR, Pandey A. Informed trading around earnings announcements – Spot, futures, or options?. J Futures Markets. 2018. https://doi.org/10.1002/fut.21983) We find that in India single stock futures play the role that the options market plays in the US implying that the informed traders are seeking leverage benefits of derivatives rather than the nonlinear payoffs of options. We also find patterns in the data that are best explained by information leakage. Though, Indian derivative markets are often disparaged as being gambling dens dominated by noise traders, our results suggest that the futures markets are also venues of trading based on fundamentals.

Posted at 6:16 pm IST on Wed, 28 Nov 2018 permanent link

Categories: accounting, derivatives

Spreads price constraints

Craig Pirrong writes on his Streetwise Professor blog that “Spreads price constraints.” Though Pirrong is talking about natural gas calendar spreads, I think this is an excellent way of thinking about many other spreads even for financial assets. In commodities, the constraints are obvious: for calendar spreads, the constraint is that you cannot move supply from the future to the present, for location spreads, the constraints are transportation bottlenecks, for quality spreads, technological constraints limit the elasticity of substitution between different grades (in case of intermediate goods), while inflexible tastes constrain the elasticity in case of final goods.

But the idea that “spreads price constraints” is also true for financial assets where the physical constraints of commodities are not applicable. The constraints here are more about limits to arbitrage – capital, funding, leverage and short-sale constraints, regulatory constraints on permissible investments, and constraints on the skilled human resources required to implement certain kinds of arbitrage.

Thinking of the spread as the shadow price of a constraint makes it much easier to understand the otherwise intractable statistical properties of the spread. Forget about normal distributions, even the popular fat tailed distributions (like the Student-t with 3-10 degrees of freedom) are completely inadequate to model these spreads. Modelling the two prices and computing the spread as their difference does not help because modelling the dependence relationship (the copula) is fiendishly difficult (see my blog post about Nordic power spreads). But thinking about the spread as the shadow price of a constraint, allows us to frame the problem in terms of standard optimization theory. Shadow prices can be highly non linear (even discontinuous) functions of the parameters of an optimization problem. For example, if the constraint is not binding, then the shadow price is zero, and changing the parameters makes no difference to the shadow price until the constraint becomes binding, at which point, the shadow price might jump to a large value and might also become very sensitive to changes in various parameters.

This is in fact quite often observed in derivative markets – a spread may be very small and stable for years, and then it can suddenly shoot up to very high levels (orders of magnitude greater than its normal value), and can also then become very volatile. If the risk managers had succumbed to the temptation to treat the spread as a very low risk position, they would now be staring at a catastrophic failure of the risk management system. Risk managers would do well to refresh their understanding about duality theory in linear (and non linear) programming.

Posted at 5:43 pm IST on Thu, 15 Nov 2018 permanent link

Categories: commodities, derivatives

Aadhaar and signing a blank sheet of paper redux

The Aadhaar abuse that I described a year ago as a hypothetical possibility a year ago has indeed happened in reality. In July 2017, I described the scenario in a blog post as follows:

That is when I realized that the error message that I saw on the employee’s screen was not coming from the Aadhaar system, but from the telecom company’s software. … Let us think about why this is a HUGE problem. Very few people would bother to go through the bodily contortion required to read a screen whose back is turned towards them. An unscrupulous employee could simply get me to authenticate the finger print once again though there was no error and use the second authentication to allot a second SIM card in my name. He could then give me the first SIM card and hand over the second SIM to a terrorist. When that terrorist is finally caught, the SIM that he was using would be traced back to me and my life would be utterly and completely ruined.

Last week, the newspapers carried a PTI report about a case going on in the Delhi High Court about exactly this vulnerability:

The Delhi High Court on Thursday suggested incorporating recommendations, like using OTP authentication instead of biometric, given by two amicus curiae to plug a ‘loophole’ in the Aadhaar verification system that had been misused by a mobile shop owner to issue fresh SIM cards in the name of unwary customers for use in fraudulent activities. The shop owner, during Aadhaar verification of a SIM, used to make the customer give his thumb impression twice by saying it was not properly obtained the first time and the second round of authentication was then used to issue a fresh connection which was handed over to some third party, the high court had earlier noted while initiating a PIL on the issue.

This vindicates what I wrote last year:

Using Aadhaar (India’s biometric authentication system) to verify a person’s identity is relatively secure, but using it to authenticate a transaction is extremely problematic. Every other form of authentication is bound to a specific transaction: I sign a document, I put my thumb impression to a document, I digitally sign a document (or message as the cryptographers prefer to call it). In Aadhaar, I put my thumb (or other finger) on a finger print reading device, and not on the document that I am authenticating. How can anybody establish what I intended to authenticate, and what the service provider intended me to authenticate? Aadhaar authentication ignores the fundamental tenet of authentication that a transaction authentication must be inseparably bound to the document or transaction that it is authenticating. Therefore using Aadhaar to authenticate a transaction is like signing a blank sheet of paper on which the other party can write whatever it wants.

Posted at 6:15 pm IST on Wed, 7 Nov 2018 permanent link

Categories: fraud, technology

Indian Single Stock Option Pricing

A recent paper by my doctoral student, Sonali Jain, my colleague, Prof. Sobhesh Agarwalla and myself (Jain S, Varma JR, Agarwalla SK. Indian equity options: Smile, risk premiums, and efficiency. J Futures Markets. 2018;1–14. https://doi.org/10.1002/fut.21971) studies the pricing of single stock options in India which is one of the world’s largest options markets.

Our findings are supportive of market efficiency: A parsimonious smile-adjusted Black model fits option prices well, and the implied volatility (IV) has incremental predictive power for future volatility. However, the risk premium embedded in IV for Single Stock Options appears to be higher than in other markets. The study suggests that even a very liquid market with substantial participation of global institutional investors can have structural features that lead to systematic departures from the behavior of a fully rational market while being “microefficient.”

The good news here is that (a) options with different strikes on the same stock are nicely consistent with each other (parsimonious smile), and (b) the option market predicts future volatility instead of blindly extrapolating past volatility. The troubling part is that the implied volatility of Indian single stock options consistently exceeds realized volatility by too large an amount to be easily explained as a rational risk premium. Globally, there is a substantial risk premium in index options but not so much in single stock options in accordance with the intuition that changes in index volatility are a non diversifiable risk, while fluctuations in the idiosyncratic volatility of individual stocks are probably diversifiable. The large gap between Indian implied and realized volatility is therefore problematic. However, the phenomenon cannot be attributed entirely to an irrational market: we find that the single stock implied volatility has a strong systematic component responding to changes in market wide risk aversion (the index option smile).

There is a puzzle here that demands further research. There is some anecdotal evidence that option writers demand a risk premium for expiry day manipulation by the promoters of the company. I also think that there is a shortage of capital devoted to option writing despite the emergence of a few alternative investment funds in this area. Perhaps there are other less well understood barriers to implementing a diversified option writing strategy in India.

Posted at 1:41 pm IST on Fri, 2 Nov 2018 permanent link

Categories: derivatives

Markets versus Institutions

I had the opportunity to engage in a conversation with Nobel Laureate Robert Merton after he delivered the R H Patil Memorial Lecture as part of the Silver Jubilee celebrations of the National Stock Exchange last week. The video is available here, and a large part of the conversation is about whether financial markets can be trusted more than financial institutions particularly in the Indian context.

Posted at 10:48 am IST on Sun, 21 Oct 2018 permanent link

Categories: miscellaneous

Lessons from the Nasdaq Clearing Default

Last month, the loss caused by the default of a single trader in a Nordic power spread contract cleared by Nasdaq Clearing consumed the entire €7 million contribution of Nasdaq to the default waterfall and then wiped out more than two thirds of the €168 million default fund of the Commodities Market segment of Nasdaq (the diagram on page 7 of this document shows the entire default waterfall for this episode).

Nasdaq explained its margin methodology as follows:

The margin model is set to cover stressed market conditions, covering at least 99.2% of all 2-day market movements over the recent 12 month period. In the final step of the margin curve estimation a pro-cyclicality buffer of 25% is applied.

The MPOR (Margin Period of Risk) for the relevant products is two days.

It also provided the following historical data:

Prior to the default, the largest daily change in spread since 2011 was €1.6.
99% of all observations during this period were below €1.
Nasdaq Clearing’s margin model for this particular spread was calibrated to cover changes in margin spread up to approximately €4
The change in the spread on the default date was €5.56.

There has been a lot of excellent commentary on this episode:

Craig Pirrong on his Streetwise Professor blog: here and here
Jo Burnham at OpenGamma
Amir Khwaja of Clarus

The episode highlights a number of important lessons about risk management that we knew even before this default happened:

Electricity is a nasty asset both for traders and for risk managers. Equities are of course the nicest asset class in terms of return distributions, but electricity is really messy compared to even quite ill behaved commodities like natural gas.
Spreads are a lot worse than the underlying assets from a risk modelling point of view. Over the last few decades, finance has figured out a lot about volatility, but we still do not know much about modelling correlation and dependence. (Ability to utter the magic word “copula” does not amount to knowledge).
It is very hard to get much beyond 99.9% risk coverage using margins alone – not even in equities. A decade ago, I computed that margins set at eight standard deviations would cover only 99.95% risk (in terms of expected shortfall) in the Indian index futures market.
To get to a AAA equivalent 99.99x% risk coverage would need other elements of the default waterfall like member and clearing house capital. Member contributions to CCP default funds are therefore at significant risk of loss.
There is always a risk that all this waterfall would not be enough. If one trader can blow away two-thirds of the default fund of one CCP, some day somebody is bound to blow away the entire default fund of some CCP somewhere. With the increasing clearing of toxic asset classes like credit and power, I think it is only a matter of time before that happens.
It is important to isolate different market segments with separate waterfalls and segregated default funds. In the Nordic power episode, even if there had been a delay or failure to replenish the default funds, it would have affected only the commodities segment, and Nasdaq would have continued to clear all other products. In India, I have always argued that this is extremely important since cash equities and derivatives trade on the same exchange: even if the derivatives clearing segment goes bust, cash equities must continue to trade.
Fire sale liquidation of defaulted positions appears to be a growing problem at the clearing houses. I remember when Nick Leeson almost brought down Symex, they chose to wind down the position over several days to reduce losses. The US exchanges seem to prefer a quick auction. When Lehman failed, CME did an immediate auction of the entire Lehman portfolio of positions at that exchange, while LCH used its well oiled machinery for trading down defaulted positions. (Lehman’s bankruptcy examiner complained bitterly about the losses suffered by the Lehman estate due to this auction, but ultimately concluded that the exchange action is protected by law and could not be challenged). In the Nordic episode also, Nasdaq has displayed the American penchant for quick auctions.The Streetwise Professor discusses another power spread related default in the United States where the clearing house abandoned the auction when it “resulted in liquidation prices that were more than six times higher than the actual portfolio losses”. I have long argued that Indian exchanges should build up the operational and technical capabilities to trade down large defaulted positions, but I fear that these capabilities are quite deficient. Regulators also seem to be insufficiently concerned about this problem.

Posted at 6:07 pm IST on Mon, 8 Oct 2018 permanent link

Categories: derivatives, exchanges, risk management

Mutual fund redemptions redux

Debt mutual funds are not banks: when mutual fund investors redeem their units at an inflated Net Asset Value (NAV) they simply steal money from their co-investors. This adjacency risk or co-investor risk comes to the fore every now and then, when heightened default risk makes bond prices volatile and unreliable. This happened in India in 2008 during the global financial crisis and is happening again today. Providing liquidity to solvent banks in a crisis makes sense, but providing liquidity to debt mutual funds is a bad idea because it simply allows rich, better informed investors to steal from less informed co-investors. The correct way to provide liquidity is to lend not to the mutual fund but to the unit holder (against units of debt mutual funds).

Unfortunately, I appear to be in a minority on this issue. Even the best analysts appear to support liquidity lines for the mutual fund; for example, the highly knowledgeable and respected Akash Prakash writes in today’s Business Standard (paywall):

Liquidity lines and repo facilities have to be set up for the debt mutual funds. We cannot allow forced selling at panic prices. Panic selling will force other funds to also mark down their bonds, showing paper losses, creating more redemptions, more selling and we will spiral into a negative feedback loop.

My position is the opposite: we must force mutual funds to mark down their bonds so that their NAVs are fair and correct. The way to stop panic selling is side pockets and gates as I have been saying for the last ten years: during the 2008 crisis in India (borrowing and gating), during the Amtek Auto episode, and in response to US money market mutual fund reforms (minimum balance at risk and gates).

Liquidity lines to the mutual funds are a bail out of rich corporations and high net worth individuals at the cost of the ordinary investor. Liquidity lines to unit holders (against the security of units of debt mutual funds) do not have this problem because then the bond price risk remains with the borrower and is not transferred to other co-investors.

Posted at 2:22 pm IST on Tue, 2 Oct 2018 permanent link

Categories: mutual funds

Indian banks: quiescent shareholders and activist regulators

The Indian central bank or other government agencies have been instrumental in effecting a change of management in three under-performing private sector banks (ICICI Bank, Axis Bank and Yes Bank) in recent months. While much has been written about the functioning of the boards and of the central bank, the more fascinating question is about the dog that did not bark: the quiescent shareholders of these banks. They have suffered in silence as these banks have surrendered the enviable position that they once had in India’s financial system. The void created by the wounded banking system in India is being filled by non bank finance companies. So much so that one of these non banks (Bajaj Finance) trades at a Price/Book ratio 3-4 times that of the above mentioned three banks and now boasts of a market capitalization roughly equal to the average of these three banks.

The question is why has this not attracted the attention of activist investors. One looks in vain for a Third Point, Elliott or TCI writing acerbic letters to the management seeking change. The Indian regulatory regime of voting right caps and fit and proper criteria has ensured that such players can never threaten the career of non performing incumbent management in Indian banks. The regulators have entrenched incumbent managements and so the regulators have to step in to remove them.

Incidentally, the securities regulator in India has been no better. It too has ensured that the big exchanges and other financial market infrastructure in India are immune to shareholder discipline, and over the last several years many of these too have performed far below their potential.

Indian regulators do not seem to understand that capitalism requires brutal investors and not just nice investors talking pleasantly to the management. Capitalism at its best is red in the tooth and claw.

Posted at 1:05 pm IST on Fri, 21 Sep 2018 permanent link

Categories: banks, corporate governance, regulation

The FED’s bite is worse than its bark

If any emerging market thought that the US Federal Reserve is a paper tiger whose bark is worse than its bite, the last few months have shattered that illusion. Already, the bite is hurting a lot more and the tiger still appears to be hungry and on the prowl.

The comparison below is actually biased in favour of a bigger effect for the bark because it focuses on the Fragile Five who were the worst sufferers during the barking phase. I have left out Argentina and China who have suffered only or mainly in the biting phase.

The FED’s bark (Taper Tantrum: April-July 2013)

The data is from Barry Eichengreen and Poonam Gupta, Tapering Talk: The Impact of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets. Following Eichengreen and Gupta, I have measured the exchange rate pressure by the percentage increase in the nominal exchange rate (units of domestic currency per US dollar), though ideally it should be the decline in the inverse of this number. Unlike Eichengreen and Gupta, I have simply added the percentage exchange rate change and the percentage reserve loss for a crude measure of the total effect. For a blog post, I am too lazy to weight the two measures by the inverse of their respective standard deviations (and I am also quite happy with improper linear models).

	Depreciation	Reserve Loss	Total
Brazil	12.52	1.69	14.21
India	9.98	4.77	14.75
Indonesia	3.58	13.61	17.19
South Africa	8.96	5.42	14.38
Turkey	7.61	8.20	15.81

The FED’s bite (Ongoing since April 2018)

The following data is what I have been able to put together from easily available sources on the internet. The currency depreciation is from Yahoo Finance and covers the period from April 16, 2018 to September 13, 2018. The reserve loss is from end March (or mid April where available) to the latest date for which I could get data clicking through to the data links on the National Summary Data Pages (NSDPs) of the IMF’s Dissemination Standards Bulletin Board (DSBB). Except for Turkey, the data for the rest of the countries is not hopelessly out of date, and for Turkey, the reserve loss is totally swamped by its currency depreciation.

If you have better data, please free to provide that in the comments section.

	Depreciation	Reserve Loss	Total
Brazil	22.22	0.26	22.48
India	10.46	5.90	16.36
Indonesia	8.02	6.35	14.37
South Africa	21.36	-0.00	21.36
Turkey	50.86	8.15	59.01

Posted at 4:14 pm IST on Mon, 17 Sep 2018 permanent link

Categories: international finance, monetary policy

Self-serving self-censorship in a crisis

In a crisis, the only thing that is not censored or self-censored is the market (provided it has not been regulated out of existence or into meek submission). That is the lesson that we can learn from a rare candid admission from a well known columnist at one of the most respected financial newspapers in the world. In his latest “The Long View” column (link behind paywall) in the Financial Times yesterday (September 9, 2018) John Authers writes:

It is time to admit that I once deliberately withheld important information from readers. It was 10 years ago, the financial crisis was at its worst, and I think I did the right thing.

…

There was a bank run happening, in New York’s financial district. The people panicking were the Wall Streeters who best understood what was going on.

All I needed was to get a photographer to take a few shots of the well-dressed bankers queueing for their money, and write a caption explaining it.

We did not do this. Such a story on the FT’s front page might have been enough to push the system over the edge. Our readers went unwarned, and the system went without that final prod into panic.

There are many things going on here that are worth pointing out:

If we go back to 2005 or 2006, the financial elite was as clueless as anybody else about the crisis that was round the corner.
However, during (or even just before) the crisis, the financial elite had a pretty good idea of the most vulnerable entities in the system. I remember when I discussed the matter with smart finance people back in 2007 and 2008, we could all agree on which banks (both in India and globally) were at grave risk and which were sound. In retrospect, those judgements were largely correct. At the same time, outside of finance, this understanding was often lacking.
This phenomenon was not peculiar to the global financial crisis of 2008, but was true in earlier crises like the Asian Crisis of 1997.
Self censorship is the main reason why the common knowledge of the financial elite does not percolate to the general public. Many factors play a role here:
- We all fear retribution from the state which can easily accuse the messenger of sedition or treason.
- There is the risk of defamation suits from the affected entities which might not have enough money to repay their debt, but are never short of money to pay their lawyers.
- Our views are often based on inferences rather than hard facts, and we shy away from making sweeping statements in public without objective data.
- Like John Authers, we might worry that what we write might become a self fulfilling prophecy.
But Authers’ story also points to a very uncomfortable fact, that our self censorship is self serving. We might hesitate to write about what we know, but we do not hesitate to act on that knowledge. Authers writes that he shuffled his money around so that he would not lose much if Citi failed. I recall that every company on whose board I served took preventive action to protect the company’s cash surpluses.

This means that, in a crisis, the general public cannot expect the elite (regulators, media, academics) to warn them or to tell them the truth. Meanwhile, the rich, powerful and well-connected are duly warned, and are able to protect themselves. Is it any wonder that the general public listens to wild rumours rather than to mainstream commentators?

There is one place where the public can learn the truth, and that is the financial markets. In the build up to the crisis, the markets are as complacent as everybody else. But during the crisis, the market is the fountain head of information. If I could make sensible judgements during 2008, it was only because I was tracking many different markets. Of course, one needs to know where to look: sometimes the most valuable information is in the spread between two arcane markets.

The governments and regulators know this very well and work overtime to ensure that the markets become uninformative. After Lehman failed, I had two blog posts on how successful government around the world had been in doing this (Towards a market only for buyers and More on market for buyers only).

Months before Lehman failed, I wrote this:

I believe that this crisis has shown the power and utility of financial markets. Policy makers have had at least a year of lead time to deal with the problems in the real economy. Without mark to market and without liquid ABX markets, the crisis would have become evident only when mortgages actually defaulted. By then it would have been too late to act.

It is difficult to persuade people about this in today’s context, but even today it is true that with all their imperfections and tendency to malfunction during crises, financial markets are the closest thing that we have to the crystal ball that reveals the future. Everything else is backward looking.

After reading Authers’ confession, I would add another clause to the last sentence: “Everything else is self-censored.”

Posted at 5:58 pm IST on Sun, 9 Sep 2018 permanent link

Categories: corporate governance, crisis

Why does the Indian Government mandate proprietary software?

One of my pet peeves has been about the Indian government forcing citizens to buy or use proprietary software to enable them to perform their statutory obligations. Things have got better in some government departments, but worse in others.

Income Tax is one place where things have become better: many years ago, the official tax preparation utility was in Microsoft Excel which compelled me to boot into Microsoft Windows and run Microsoft Excel. A few years ago, a Java utility became available, but initially, this ran only in Oracle Java, and I wrote unhappily about this two years ago. I was happy to find that I could run the latest version of the utility under OpenJDK 8 and OpenJFX. At last, I do not have to use proprietary software to file my income tax return. My only complaint is that the Income Tax department’s official website still says that the Java Runtime Environment (JRE) can be downloaded from http://www.oracle.com/technetwork/java/javase/downloads/index.html. Is it too much for a free citizen of a free country to demand that this link should instead point to http://openjdk.java.net/ which is the home of the open source project? (The OpenJDK site does provides a link to the Oracle site for those who prefer that.)
The Ministry of Company Affairs (MCA) has become a lot worse and it is now an absolute nightmare for proponents of open source software. Everything to do with Company Law now requires an e-filing. And the first thing that the MCA portal says is that you must have a computer with Windows 2000 or later installed, and you must also have Adobe Acrobat 11. As long as this portal affected only corporate filings, I did not care too much, because I know from bitter experience that the corporate world consists largely of unreformed Microsoft junkies who care two hoots about open source software. But now the government requires individual directors also to use this portal. Last month, like many other independent directors in India, I had to e-file a DIR-3 KYC. This uses a PDF Form that opens only in Adobe’s PDF reader and not in any of the numerous open source PDF readers that are installed on my Linux machine. Adobe discontinued support for Linux a few years ago. So the only thing to do was to fire up my licensed copy of Windows in a Virtual Machine and fill up the form.

In my opinion, it is a gross abuse of the sovereign powers of the state to compel a person to buy and use Windows in order to be a director of a company. Actually, I seriously considered resigning as Director rather than do this, but then that does not solve the problem as different departments of the government are moving in the same direction of e-filing with uncritical dependence on proprietary software.

No, we need to change incentives in the government to prevent the Indian state from becoming a marketing agent of powerful software companies. I think there are many arms of the government itself that can help bring about this change:

Central Vigilance Commission (CVC): The CVC could declare that going forward, it would regard a government action that forces unwilling citizens to buy software from private companies as an act of corruption (on the ground that it provides a benefit to a private party and is also against the public interest). The reality is that the government outsources software development to large software developers who also act as authorized resellers for a large number of software product companies, and have every incentive to push the sales of these products on to their clients. This is fine when all these costs are evaluated as part of the total cost of the project during the bid evaluation. But when the government official allows the vendor to sell software to ordinary citizens using the coercive power of the state, that should count as an act of corruption. The CVC could allow existing applications to be grandfathered with a sunset clause, but it should not permit any new projects.
Competition Commission: As explained in the previous point, the whole business of government software development involves giant software companies using their market dominance in the enterprise market to gain unfair and unlawful market power in the retail market using the coercive power of the state. The Competition Commission can and should investigate all authorized reseller agreements for such anti-competitive conduct.
National Security Advisory Board: Widespread use of proprietary software in critical government applications can pose a threat to national security, and with the increasing threat of cyber attacks on India from some of its neighbours and other countries, this is also a reason for reconsidering the design of government applications like the MCA Portal. For example, under the so called Government Security Program the Microsoft Windows source code has been shared with Russia and China which are both associated with large scale state sponsored hacking activities. This means that when you and I use Windows, the hackers can see the source code, but you and I cannot. With open source software like Linux, the hackers can read the source code, but so can you and I. It is important that the national security apparatus in India takes these risks seriously and start advising other arms of the government to move away from proprietary software in citizen facing applications.
Law Ministry: If rapid technological change and product obsolescence leads to Adobe going bankrupt and the Adobe Reader being discontinued, the government might find that it cannot read any of the PDF files that constitute the source documents for its entire database. Many people of my generation have old Wordstar files which are almost impossible to read because the Wordstar software is now defunct: truly desperate people do try to buy the old Wordstar diskettes on EBay and then try and find a disk drive that can read the diskettes. For those readers who are too young to remember, Wordstar was the undisputed market leader at its time, just as Adobe is today. The law ministry should recognize that storing critical source documents in a proprietary format is an unacceptable legal risk.

Until one or other of these branches of the government steps in and forces a redesign of citizen facing government applications, we will be doomed to pay money to rich multinationals to use insecure software to interact with our own governments.

Posted at 6:15 pm IST on Mon, 3 Sep 2018 permanent link

Categories: taxation, technology

Long hiatus ending soon

This blog has been on a hiatus for the last five months due to some disruptions on the personal front. This phase is now getting over and I hope to start blogging again soon, hopefully, early next month.

Posted at 3:40 pm IST on Mon, 20 Aug 2018 permanent link

Categories: miscellaneous

Corporate pivots and corporate ponzis

Companies that repeatedly pivot from one business to another (more glamorous) business could be indulging in a ponzi scheme designed to hide business failure and lead investors on a wild goose chase for an ever elusive pot of gold. There are some very large companies in India and in the United States about whom one could harbour such a suspicion.

The question is how can one distinguish these corporate ponzis from genuine pivots. After all it makes sense to change your business as situations change. Warren Buffet’s Berkshire Hathawy pivoted from the textiles business to insurance and finance and if its next elephant size deal is like its last one, it could pivot again to a non financial conglomerate. In India, Wipro became a software giant after a pivot from vegetable products.

One indicator of a ponzi is that the pivot typically chases a prevailing stock market fad rather than any particular competence or competitive advantage in the new business (unless one counts cheap capital as a competitive advantage). But even that is not determinative as the case of GE makes clear. As a Financial Times FT View pointed out a couple of months ago “In the dotcom bubble, GE was valued as a tech stock; in the credit bubble, it was valued like a leveraged debt vehicle (which, in large part, it was).” To which one could add that till recently it was trying to position itself as a leader in the industrial Internet of Things. That makes GE a stock market opportunist, but not a ponzi. Even after returning to its old industrial roots in the last few months, GE remains a valuable business.

The corporate ponzis that I worry about are something else altogether. This kind of company is a graveyard of serial failures, even though the future always looks rosy. In the heyday of each of these failed businesses, the market would not have bothered about current losses, because it would have valued the business on multiples of current or future revenues. After the company pivoted away from the business, the market would not bother about the losses (and revenue collapse) in the old business because the market is always “forward looking”. The corporate ponzi’s challenge is to find the next big thing (and make it bigger than the last big thing). When their luck runs out and the corporate ponzi finally fails, everybody wonders why nobody saw through the fraud earlier.

Posted at 6:41 pm IST on Wed, 21 Mar 2018 permanent link

Categories: corporate governance

Do we need banks?

More than a decade ago, in the days before the Global Financial Crisis, I asked a provocative question on this blog: “Had we invented CDOs first, would we have ever found it necessary to invent banks?” (I followed up in the early days of the crisis with a detailed comparison of banks with CDOs).

I am revisiting all this because I just finished reading a fascinating paper by Juliane Begenau and Erik Stafford demonstrating that, banks simply do not have a competitive edge in anything that they do. Specifically, the return on assets of the US banking system over the period 1960-2016 was less than that of a matched maturity portfolio of US Treasury bonds. This is a truly damning finding because banks are supposed to earn a return from two sources: maturity transformation (higher yielding long term assets funded by cheaper short term financing) and credit risk premium (investing in higher return risky debt). What Begenau and Stafford found is that their actual return does not match what you can get from maturity transformation without taking any credit risk at all.

That raises the question as to why banks have survived for so long. Another finding of Begenau and Stafford can be used to provide an answer: maturity transformation (even without any credit risk) with typical banking sector leverage is not viable in a mark-to-market regime. The banking regulators have acquiesced in the idea that the loan book of the banks need not be subject to mark to market. Making illiquid loans and taking credit risk is the price that banks have to pay to become eligible for hold-to-maturity accounting of their loan book. Banks are able to undertake maturity transformation with high levels of leverage without wiping out their equity because the loan book is not marked to market.

Hold-to-maturity accounting allows banks (and only banks and similar institutions) to carry out leveraged maturity transformation. This competitive advantage means that banks are able to make money on maturity transformation. However, they are so bad in their credit activities that they lose money on this side of their business. This offsets some of the returns from maturity transformation, and so they underperform a matched maturity portfolio of risk free bonds.

It is important to keep in mind that credit risk earns a reliable risk premium in the bond markets. Therefore, if banks manage to earn a negative reward for bearing credit risk, it is clear that either their credit risk assessment must be very poor or their intermediation costs must be very high. Interestingly, Begenau and Stafford do find that maturity transformation using risk free bonds has no exposure to systematic risk (CAPM beta), banks have CAPM betas close to one. The credit activity of the banks creates risks and loses money; in short, banks are really bad at this business.

I have always been of the view that banks are an obsolete financial technology. They made sense decades ago when financial markets were not developed enough to perform credit intermediation. That is no longer the case today.

This is particularly relevant in India where we have spent half a century creating an over-banked economy and stifled financial markets in a futile attempt to make banking viable. The crisis of bad loans in the banking system today is a reminder that this strategy has reached a dead end. As I wrote nearly a year ago:

India needs to move away from a bank dominated financial system, and some degree of downsizing of the banking system is acceptable if it is accompanied by an offsetting growth of the bond markets and non bank finance.

After the recent multi-billion dollar fraud at a leading Indian public sector bank, there has been a chorus of calls in India for privatizing state owned banks. We would do better to shut some of them down. Time and money are better spent on developing a bond market unshackled from the imperatives of supporting a weak banking system.

Posted at 4:06 pm IST on Sun, 18 Mar 2018 permanent link

Categories: banks

Is there a bank-sovereign feedback loop in India?

Between early October 2016 (shortly before demonetization) and today, the Reserve Bank of India (RBI) has cut its policy rate twice (October 4, 2016 and August 2, 2017) to bring the repo rate down by 50 basis points from 6.5% to 6.0%. But the ten year Government of India bond yield is roughly 100 basis points higher than it was in early October 2016. Apparent monetary easing has been accompanied by a substantial tightening of financial conditions. This looks like a reverse of Greenspan’s Conundrum of 2005 in which the concern was that 150 basis points of rise in the US policy rate was accompanied by a falling trend in the long term yield.

Is it possible that the Indian situation could be a mild form of the bank-sovereign feedback loop?

A deterioration of the health of the public sector banks (non performing assets) causes fiscal stress because the sovereign has to recapitalize the banks.
The enhanced borrowing requirement of government causes a rise in government bond yields.
Rising bond yields cause more stress in the public sector banks because they hold a large amount of long term government bonds (unlike the private and foreign banks who tend to hold shorter term bonds). Rising bond yields may also act as a drag on the economy and worsen the non performing assets of the banks. In either case, the deterioration of the health of the public sector banks takes us back to Step 1 and the cycle can begin all over again.

If this analysis is correct, what can be done to break the bank-sovereign feedback loop? Several possibilities come to mind:

The government could take duration risk out of the banks with a giant interest rate swap that immunizes the banking system from rising government bond yields. This turns a significant fraction of government debt into floating rate debt.
The RBI could take a leaf out of the Yield Curve Control policy of the Bank of Japan, and set monetary policy to prevent a rise in Indian government bond yields. In essence, the policy rate would no longer be the repo rate but the 10 year government bond yield.
The government could accomplish a massive pre-emptive recapitalization of the banking system that breaks the loop decisively.
The government could turn many of the public sector banks into narrow banks (or even shut them down) to eliminate the feedback loop.

The bank-sovereign feedback loop should not be a big problem for a currency issuing sovereign. This does not require any appeal to MMT, but is simply a reflection of the fact that banking sector liabilities are all nominal liabilities, and a currency issuing sovereign should not have any problem in backstopping these liabilities. If we still see evidence of such a loop, it should reflect some degree of mismatch between monetary policy, fiscal policy, and the bank recapitalization framework. And it should not be hard to fix the problem.

Posted at 4:54 pm IST on Mon, 26 Feb 2018 permanent link

Categories: banks, bond markets, sovereign risk

Can radical blockchain transparency decrease banking frauds?

During the last week, the Indian financial sector has been gripped by the $1.8 billion fraud at Punjab National Bank (PNB). Fingers have been pointed at bank management, at the auditors and at the regulators, but finger pointing and angry denunciations do not solve problems. We did not solve the problem of unfriendly bank tellers by shouting at them; we solved it using technology (Paul Volcker once remarked that the most important financial innovation that he had seen was the ATM). That is probably the route we must take again: we cannot change human nature, but we can change the technology.

The blockchain technology that underpins cryptocurrencies like Bitcoin has the potential to reduce large banking frauds drastically because it enables radical transparency. Every transaction on Bitcoin is public and you do not even need a Bitcoin wallet to see these transactions. Many websites like https://blockexplorer.com/, https://blockchain.info/, https://www.blocktrail.com/BTC, https://btc.com/, and https://live.blockcypher.com/btc/ allow anybody with a web browser anywhere in the world to see every single transaction as it happens. We can use the same technology to allow the whole world to see every large financing or guarantee transaction (above some threshold like a billion rupees).

The shibboleth of bank secrecy can be discarded for large financing transactions because many of them become public anyway:

Borrowers disclose a lot of information in their financial statements.
Many lenders (mutual funds for example) disclose large bond holdings as part of their portfolio disclosures.
All secured lending is entered in a public register of charges under company law.

We could extend this into a uniform requirement to make large loans public:

Any large lending (say above a billion rupees) by a financial intermediary.
Any lending (regardless of size) to a large borrower (say, with aggregate liabilities to the financial sector of over 10 billion rupees).

The natural medium for such a disclosure is the blockchain. The alternative idea of using a credit registry has been an unmitigated disaster (just think of Equifax), and these agencies create more opaqueness than transparency.

If the PNB fraud pushes us to use the blockchain to make finance more transparent and therefore safer, $1.8 billion may end up being a price well worth paying.

Posted at 8:34 pm IST on Tue, 20 Feb 2018 permanent link

Categories: blockchain and cryptocurrency

Are banks too opaque to manage?

Fabrizio Spargoli and Christian Upper have a BIS Working Paper with a different title: “Are Banks Opaque? Evidence from Insider Trading” with the following findings:

Our results do not support the conventional wisdom that banks are more opaque than other firms. Yes, purchases by bank insiders are followed by positive stock returns, indicating that banks are opaque. But banks are not special as we find the same effect for other firms. Where banks are special is when bad news arrive. We find that sales by bank insiders are not followed by negative stock returns. This suggests that bank insiders do not receive bad news earlier than outsiders. By contrast, insider sales at non-banks tend to be followed by a decline in stock prices.

My interpretation of the result is quite the opposite: banks are so opaque that even insiders cannot see through the opacity when bad things happen. Sometimes, as in the case of the London Whale, a market participant outside the bank has greater visibility to what is going on.

It appears to me that the findings of Spargoli and Upper are evidence that banks are too opaque to manage. Even a very competent chief executive can be clueless about some activities in a corner of the bank that have the potential to bring down the bank or at least cause severe losses. That would be an additional argument for moving from bank-dominated to market-dominated financial systems.

Posted at 3:47 pm IST on Tue, 13 Feb 2018 permanent link

Categories: banks, corporate governance

In the sister blog and on Twitter during December 2017 and January 2018

The following posts appeared on the sister blog (on Computing) during December 2017 and January 2018:

Turning an Android phone into a travelling desktop
Why Intel investors should subscribe to the Linux Kernel Mailing List or at least LWN (Cross-posted on this blog as well)
Peripheral vision and non Euclidean Geometry

Tweets during December 2017 and January 2018 (other than blog post tweets):

1 February 2018
- Matt Levine: “people will happily fund companies in non-traditional ways that are strictly worse for investors than the traditional ways, as long as they seem cool on the internet” https://www.bloomberg.com/view/articles/2018-02-01/was-chicken-libor-manipulated-too
24 January 2018
- Jihad Dagher discusses regulatory cycles over the last 300 years http://www.imf.org/en/Publications/WP/Issues/2018/01/15/Regulatory-Cycles-Revisiting-the-Political-Economy-of-Financial-Crises-45562
27 December 2017
- Just as there are stock market cycles, there are regulatory cycles also: of harsh and light regulation. See this story about Securities and Exchange Commission of Pakistan https://www.dawn.com/news/1378880/secp-seeks-to-lure-back-brokers-amidst-thin-volumes

Posted at 4:58 pm IST on Sun, 4 Feb 2018 permanent link

Categories: technology

Regulation as Pigouvian stealth taxation

“Regulation is stealth taxation,” said US President Donald Trump at Davos yesterday. Can this taxation be Pigouvian, and can this stealth taxation be a good idea? That is the claim in Turk’s thought provoking paper “Securitization Reform after the Crisis: Regulation by Rulemaking or Regulation by Settlement?”

Turk argues that:

The enforcement actions (and multi-billion dollar settlements) against large financial institutions relating to their securitization activities

can been seen as imposing a Pigouvian tax on the specific market externality associated with securitization, and therefore come surprisingly close to a first-best policy intervention.

The statutory rulemaking process established under the Dodd-Frank Act

missed the mark because it was premised on a flawed theory of the role that securitization played the crisis, which emphasized traditional notions of fraud rather than poor risk-management.

However, the more informal Regulation by Settlement was much more effective.

It appears to me that there is no convincing evidence that securitization imposes large negative externalities requiring a Pigouvian tax. On the other hand, there is somewhat more evidence that banking creates large negative externalities, and Basel 3 is a kind of Pigouvian tax on banking. This Pigouvian taxation has also happened by stealth in the name of risk reduction.

We should worry about the knowledge deficit and the governance deficit in these exercises in stealth taxation. Regulators probably think that they have calibrated the Pigouvian tax correctly; but this is more likely to reflect conceit than genuine expertise in this field. Even if the expertise is granted for the sake of argument, the governance issue remains: can taxation be delegated to unelected regulators?

Posted at 8:02 pm IST on Sat, 27 Jan 2018 permanent link

Categories: regulation

Financial Crisis and Response History

About a month ago, the US Federal Deposit Insurance Corporation (FDIC) published a 278 page document entitled “Crisis and Response: An FDIC History, 2008–2013.” It is a quite sanitized history compared to the excellent accounts of the crisis that came out many years ago (especially the books by Hank Paulson and Andrew Sorkin). Yet, I found that there was much of value in the FDIC book. There is of course a wealth of official and authoritative data, but there are also many interesting insights from the perspective of the regulators dealing with it in real time.

I wish Indian regulators could publish something similar about the various crises in Indian financial markets covering say 1990 to 2010 – the Harshad Mehta scam of 1992, the vanishing companies of 1995, the Ketan Parikh episode (especially the fate of the Calcutta Stock Exchange), the UTI Unit 64 bailout, Global Trust Bank, and Satyam. If the report of the Financial Crisis Inquiry Commission (FCIC) in the US did not affect the ability of the FDIC to publish their history, there is no reason why the reports of the Joint Parliamentary Committees (JPCs) should be an obstacle for the Indian authorities (RBI/SEBI/MOF/MCA) to publish their accounts of these episodes.

Posted at 6:37 pm IST on Fri, 26 Jan 2018 permanent link

Categories: crisis, financial history, post crisis finance

Why Intel investors should subscribe to the Linux Kernel Mailing List or at least LWN

On January 3 and 4, 2018 (Wednesday and Thursday), the Intel stock price dropped by about 5% amidst massive trading volumes after The Register revealed a major security vulnerability in Intel chips on Tuesday evening (the Meltdown and Spectre bugs were officially disclosed shortly thereafter). But a bombshell had landed on the Linux Kernel on Saturday, and a careful reader would have been able to short the stock when the market opened on Tuesday (after the extended weekend). So, -1 for semi-strong form market efficiency.

Saturday’s post on LWN was very cryptic:

Linus has merged the kernel page-table isolation patch set into the mainline just ahead of the 4.15-rc6 release. This is a fundamental change that was added quite late in the development cycle; it seems a fair guess that 4.15 will have to go to -rc8, at least, before it’s ready for release.

The reason this was a bombshell is that rc6 (release candidate 6) is very late in the release cycle where only minor bug fixes are usually made before release as version 4.15. As little as 10 days earlier, an article on LWN stated that Kernel Page-Table Isolation (KPTI) patch would be merged only into version 4.16 and even that was regarded as rushed. The article stated that many of the core kernel developers have clearly put a lot of time into this work and concluded that:

KPTI, in other words, has all the markings of a security patch being readied under pressure from a deadline.

If merging into 4.16 looked like racing against a deadline, pushing it into 4.15 clearly indicated an emergency. The public still did not know what the bug was that KPTI was guarding against, because security researchers follow a policy of responsible disclosure where public disclosure is delayed during an embargo period which gives time to the key developers (who are informed in advance) to patch their software. But, clearly the bug must be really scary for the core developers to merge the patch into the kernel in such a tearing hurry.

One more critical piece of information had landed on LWN two days before the bombshell. On December 27, a post described a small change that had been made in the KPTI patch:

AMD processors are not subject to the types of attacks that the kernel page table isolation feature protects against. The AMD microarchitecture does not allow memory references, including speculative references, that access higher privileged data when running in a lesser privileged mode when that access would result in a page fault.

Disable page table isolation by default on AMD processors by not setting the X86_BUG_CPU_INSECURE feature, which controls whether X86_FEATURE_PTI is set.

As Linus Torvalds put it a few days later: “not all CPU’s are crap.” Since it was already known that KPTI would degrade the performance of the processor by about 5%, the implication was clear: Intel chips would slow down by 5% relative to AMD after KPTI. In fact, one post on LWN on Monday evening (Note that Jan 2, 2018 0:00 UTC (Tue) would actually be late Monday evening in New York) did mention that trade idea:

Posted Jan 2, 2018 0:00 UTC (Tue) by Felix_the_Mac (guest, #32242)
In reply to: Kernel page-table isolation merged by GhePeU
Parent article: Kernel page-table isolation merged
I guess now would be a good time to buy AMD stock

The stock price chart shows that AMD did start rising on Tuesday, though the big volumes came only on Wednesday and Thursday. The interesting question is why was the smart money not reading the Linux Kernel Mailing List or at least LWN and getting ready for the short Intel, long AMD trade? Were they still recovering from the hangover of the New Year party?

Posted at 1:21 pm IST on Fri, 5 Jan 2018 permanent link

Categories: investment, market efficiency, technology

Madness on both sides

Forbes India has an article on Bitcoin in the January 5, 2018 issue. It has the following quote from me:

Which is more crazy: That bitcoin has a market capitalisation of a couple of hundred billion dollars, or that 11 trillion dollars of bonds are trading at a negative yield, which means that people are lending money with the full knowledge that they will not even receive the full principal back let alone earn any interest? After the global financial crisis of 2008, many feel that the actions of central bankers have been reckless, and it is no wonder that these people are attracted to a currency that is not subject to the whims and fancies of central bankers. There is madness on both sides (fiat currencies of advanced countries and cryptocurrencies) and it is best to view both with equal detachment.

This is not the first time that I have stated the view that virtual currencies are a response to bad things happening in the real world (see for example, this blog post from October 2017).

Posted at 12:17 pm IST on Mon, 1 Jan 2018 permanent link

Categories: blockchain and cryptocurrency, bond markets, sovereign risk