I am off for seven weeks

I am on vacation for about seven weeks till mid June. I will not be posting on my blog during this period.

Posted at 8:40 pm IST on Sat, 14 Apr 2007         permanent link

Categories: miscellaneous

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Abel Prize for Varadhan and Large Deviations in Finance

The award of the Abel Prize (often described as the Mathematics Nobel Prize) to Indian born mathematician Srinivasa S. R. Varadhan for his work on the theory of large deviations reminded me of the applications of this theory in finance. Basically one starts with a large and well diversified portfolio of securities and considers the probability distribution of large losses. If the underlying distributions have exponentially declining tails, then the theory of large deviations applies. The conditional probabilty distributions (conditioning on a large loss) can be computed in terms of the cumulant generating function and its Legendre transform.

At one time, this looked liked a very promising approach for risk modelling. Unfortunately, around this time, the mainstream risk management literature embraced fat tailed distributions with a vengeance. Once you bring in fat tails (which do not decline exponentially), the large deviations theory loses much of its applicability. However, there is no denying the mathematical elegance of the whole theory and as the Abel prize citation mentions, the theory has a wide range of applications in other fields.

Posted at 6:12 pm IST on Thu, 29 Mar 2007         permanent link

Categories: mathematics, statistics

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The joys of Edgar full text search

In November of last year, I blogged about the benefits of being able to do a full text search of all filings with the US SEC. Paul Kedrosky’s infectious greed blog describes some innovative ways of using this feature that I had not thought of at all. Kedrosky says: “I have an ‘interesting word’ search that scans SEC filings and feeds ’em back to me. Out this one popped, much to my childish glee.”

In the filing that Kedrosky refers to, the “interesting word” is followed by the following sentence: “Mr. Chapman then forcefully informed Mr. Shahbazian that it was inappropriate and inadvisable for the Chief Financial Officer of a public company to utter such blasphemy to the advisor of a 9.3% ownership stakeholder in the Issuer.”. This leads Kedrovsky to propose “the 11th Commandment: Thou shalt not blaspheme >9% shareholders.” It also leads to an interesting comment on Kedrosky’s blog: “And nothing so clearly reveals the inner mind of the [venture capitalist]... Blasphemy is restricted to saying bad things about God ... We all know that most VCs view themselves as quasi-divine beings ... But it is invaluable to actually hear a VC claim godlike status publicly. One can only assume the word hubris will mean something to Chapman one day. ”

Posted at 1:58 pm IST on Wed, 21 Mar 2007         permanent link

Categories: accounting, technology

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Hacking online trading accounts

The SEC complaint against three Indians who hacked into online stock trading accounts in the United States illustrates an interesting strategy for using apparently legitimate stock exchange trades to take money out of hacked online trading accounts. Many people seem to have a belief that when shares are held in dematerialized form, the clear audit trail of securities transfers makes theft difficult. Some people connected with depositories in India appear to think that fraud can be reduced by applying stricter checks and controls to non market transfers as opposed to those made pursuant to settlement obligations on an exchange.

The procedure used by Jaisankar Marimuthu, Chockalingam Ramanathan and Thirugnanam Ramanathan illustrates the fallacy of this reasoning. Their method is described in the SEC complaint:

The Defendants first purchased thinly traded securities, at market prices, using their own online brokerage accounts. Shortly thereafter, the Defendants, using stolen usernames and passwords, intruded into the online brokerage accounts of unsuspecting individuals. The Defendants then used these intruded accounts to place a series of unauthorized buy orders, typically at prices well above the then-current market prices for those thinly traded securities. Immediately or shortly thereafter, the Defendants capitalized on the artificially inflated share price of the targeted securities by selling shares in their own accounts. In one instance, Defendant Marimuthu realized a 92% return on his investment in less than one hour.

It is easy to see how this process can be used in reverse to sell shares from the stolen online account and buy them in the fraudster’s account at artificially low prices only to sell them into the market at normal prices. This would be useful if the stolen account had a lot of shares but not much cash. The nice thing about this procedure is that it converts stolen shares into cash using what appears to be a very legitimate exchange transaction. This illustrates the fallacy of designing control systems based on subjective notions of what is suspicious and what is not. The fraudster gets to choose the method of defrauding the victim and the chosen method is likely to be one that is least likely to arouse suspicion.

Marimuthu and Ramanathan were arrested in Hong Kong but by then they had inflicted losses of $875,000 on their victims over a five month period.

Posted at 3:22 pm IST on Tue, 13 Mar 2007         permanent link

Categories: equity markets, fraud, technology

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SEC wants to hurt stock spammers

The SEC in the United States resorted to an interesting subterfuge while suspending trading in 35 stocks touted in email campaigns. Most of the SEC’s press release appears to suggest that this is merely intended to protect gullible investors who might fall for the spam. But the fag end of the press release coupled with the very different tone of its actual order tell us that the true intent of the SEC is something different – it wants to inflict heavy losses on the spammers.

If successful, this strategy of hurting the spammer rather than just protecting investors could very effectively deter future spam campaigns. The question is the legal and ethical justification for what the SEC is trying to do.

The core of a spam campaign is well described by Frieder and Zittrain in their January 2007 SSRN paper Spam Works: Evidence from Stock Touts and Corresponding Market Activity:

The evidence accords with a hypothesis that spammers “buy low and spam high,” purchasing penny stocks with comparatively low liquidity, then touting them – perhaps immediately after an independently occurring upward tick in price, or after having caused the uptick themselves by engaging in preparatory purchasing – in order to increase or maintain trading activity and price enough to unload their positions at a profit. We find that prolific spamming greatly affects the trading volume of a targeted stock, drumming up buyers to prevent the spammer’s initial selling from depressing the stock’s price. Subsequent selling by the spammer (or others) while this buying pressure subsides results in negative returns following touting. Before brokerage fees, the average investor who buys a stock on the day it is most heavily touted and sells it 2 days after the touting ends will lose approximately 5.5%. For the top half of most thoroughly touted stocks, a spammer who buys at the ask price on the day before unleashing touts and sells at the bid price on the day his or her touting is the heaviest will, on average, earn 5.79%.

The SEC’ action has the potential to inflict heavy losses on the touts by making his holding of the touted stock worthless. Not only can he not sell his holding for the 10 days for which the suspension is in force, but the SEC is making it more or less clear that it would not like these stocks to trade any time soon. As the SEC points out:

For stocks that trade in the OTC or the over-the-counter market, trading does not automatically resume when a suspension ends. (The OTC market includes the Bulletin Board and the Pink Sheets.) Before trading can resume for OTC stocks, SEC regulations require a broker-dealer to review information about a company before publishing a quote. If a broker-dealer does not have confidence that a company’s financial statements are current and accurate, especially in light of the questions raised by the SEC, then a broker-dealer may not publish a quote for the company’s stock.

In its press release, the SEC makes its intentions very clear on this point:

Further, broker-dealers should be alert to the fact that, pursuant to Rule 15c2-11 under the Exchange Act, at the termination of the trading suspensions, no quotation may be entered unless and until they have strictly complied with all of the provisions of the rule. If any broker-dealer enters any quotation that is in violation of the rule, the Commission will consider the need for prompt enforcement action.

The interesting point is that unlike the press release which talks at length of spamming, the actual order itself mentions nothing about spamming. For each company, the order states that “Questions have arisen regarding the adequacy and accuracy of press releases concerning the company’s operations and performance” or something similar. This is clearly designed to make it impossible for any broker or dealer to have the “reasonable basis under the circumstances for believing” that the information required under Rule 15c2-11 is “accurate in all material respects”. The statute itself does not require the SEC to raise questions about the accuracy of available information to suspend trading in the stock. Section 12(k) of the Securities Exchange Act allows the SEC to order suspension for 10 days “[i]f in its opinion the public interest and the protection of investors so require”.

Clearly the temporary suspension permitted by law might help protect investors, but an indefinite suspension does not do so – it hurts those genuine investors who were holding the stock. An indefinite suspension is needed to hurt the spammers by making their initial investment worthless. Unfortunately, the statute does not give the SEC the power to do this. Hence the subterfuge is needed. I find this action disturbing because (a) it turns the regulator into a stock price manipulator even if it is for a just cause and (b) it compromises the honesty and integrity of the regulator.

Posted at 2:43 pm IST on Fri, 9 Mar 2007         permanent link

Categories: equity markets, manipulation, regulation

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Tax-and-spend budget has good long-term initiatives for the capital market

The Indian government budget for 2007-08 presented yesterday was a tax-and-spend Budget, and neither the taxation nor the spending was capital market-friendly, but the budget contained some policy initiatives for the capital market that would enhance its vibrancy and efficiency in the long term. I wrote a piece on this in the Financial Express today. You can also read this here

1. I welcome the proposal to allow institutional short selling and create a proper securities lending and borrowing mechanism for this purpose.
2. I think exchangeable bonds are a good idea, both as an additional financial instrument in the marketplace and as a mechanism for unwinding interlocked corporate holdings.
3. The elimination of tax arbitrage on mutual funds is probably a good thing in the long run for the industry.
4. The promise to move forward on making Mumbai a regional financial hub is welcome. This initiative announced in the 2005 Budget has gone through a tortuous process, with delays in committee formation and rumours of dissent within the committee itself. The FM’s announcement hopefully means that we will see some real action backed by a strategic vision.
5. I read the Budget speech as signalling a willingness to improve access of Indian investors to foreign securities both directly and through mutual funds. Today it is much easier for Indians to use the $50,000 limit to invest in foreign currency bank deposits than to invest in foreign stocks and bonds.

All of this means that we will have a cleaner, stronger and deeper capital market in the years to come. That is little consolation to those nursing stock market losses on budget day, but it is hugely important for the future of India.

Posted at 1:25 pm IST on Thu, 1 Mar 2007         permanent link

Categories: miscellaneous

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Offshore rupee bond

Ajay Shah provides details of the first issuance of an offshore rupee bond: the bond issued by the Inter American Development Bank is denominated in Indian rupees but is cash settled in dollars using the prices in the non deliverable forward market for Indian rupees.

Ajay Shah is absolutely right in saying that India should promote greater international use of its currency and encourage the Indian corporate sector to borrow abroad in rupees rather than foreign currency. The global environment is today extremely congenial for these measures today and India is in serious danger of missing the bus altogether because of faulty regulatory policies. In the name of capital controls, we have created a regulatory regime that incentivizes Indian companies to accumulate billions of dollars of foreign currency debt. This must surely be considered one of the most irresponsible of India’s economic policies.

We need to move forward on this front rapidly. The December 2006 issue of the BIS Quarterly Review contains an excellent case study of how the Australians made their currency on of the most internationalized currencies in the world within just four years of opening up their market. The New Zealand dollar is an even more internationalized currency. This article in the Reserve Bank of New Zealand Bulletin two years ago described how Eurokiwi and Uridashi bonds have helped reduce cost of capital for New Zealand borrowers while also reducing risks in their banking system.

It is high time that we learned from these examples and changed our policies quickly

Posted at 4:35 pm IST on Sun, 25 Feb 2007         permanent link

Categories: international finance, risk management

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Reducing frauds in dematerialized share transfers

The Securities and Exchange Board of India (SEBI) issued a circular this week listing measures to reduce frauds in dematerialized share transfers. While these will create inconveniences for many investors, it is doubtful whether they would reduce fraud to any significant degree.

SEBI says that individual account holders should get only one Delivery Instruction Slip (DIS) booklet containing not more than 20 slips. They can get a subsequent DIS booklet when only 5 slips are left in the old booklet. All this is borrowed from the practices that banks follow while issuing cheque books. But there is a big difference between cheques and DIS. Cheques are only a small fraction of all payments that a person makes. In traditional payment systems, well over 90% of all payment transactions by number take place using cash and not cheques. In more modern systems, cash is being replaced by debit/credit/ATM cards, but cheques remain a small part of the payment system by number of transactions. In shares on the other hand, the situation is reversed: I would imagine that well over 90% of all transfer transactions by number take place using DIS. The proposed measure will create a huge inconvenience to active investors, but it is not clear how it will reduce fraud.

SEBI says that a new DIS booklet should be issued only on the strength of the DIS instruction request slip (contained in the previous booklet). This used to be the practice in case of cheque books in the past, but this is not the case anymore. Today, many of us apply for a cheque book using internet banking facilities and the request slip is hardly ever used. Why should DIS be any different?

On the critically important issues, however, SEBI does not follow the cheque book analogy to its logical conclusion. It talks of appropriate checks and balances with regard to verification of signatures of the owners while processing the DIS. Such exhortation is pointless without strict liability. The banker is supposed to know the constituent’s signature perfectly and cannot escape liability even if the signature has been forged skillfully. Can we demand the same from depositories?

Similarly, SEBI asks the depositories to educate investors to preserve DIS carefully and not to leave blank or signed DIS with anybody. People have learnt to treat cheque books with this degree of care. Why do they not treat DIS the same way? Perhaps, the physical appearance of the DIS does not give an impression that it is a valuable document while cheques contains security features that provide visual cues that they are valuable documents. Perhaps investor education would be easier if the DIS had better visual cues about the importance of safekeeping them. Moreover if a fraudster can easily forge a blank DIS using a scanner and a laser printer, then careful preservation of the genuine DIS does not deter fraud.

After the securities scam of 1992, I remember seeing a sample of a banker’s receipt for billions of rupees of government securities. The banker’s receipt was poorly printed on paper of ordinary quality with no security features at all. The absence of visual security cues perhaps made that fraud easier.

Another anti-fraud measure would be a (possibly paid) service whereby the investor gets email and SMS alerts about every debit into the depository accounts. The circular is completely silent about this and other ways in which technology can be leveraged to guard against fraud.

On the whole, the circular gives me the impression that it is quite happy to impose costs and inconveniences on investors but it is not ready to impose significant costs on the depositories and their participants.

Posted at 5:32 pm IST on Fri, 16 Feb 2007         permanent link

Categories: fraud, regulation, technology

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Principles based regulation and industry guidance

I do not agree at all with Ian Morley when he writes in the Financial Times (“Uphold the principles of financial services regulation”, February 7, 2007) that the Financial Services Authority in the UK is taking an unhelpful stand regarding Industry Guidance about its regulation. Morley’s complaint is about the FSA’s discussion paper of November 2006.

First of all, I found it puzzling that Morley publishes his piece about this discussion paper a few days after the comment period on this paper closed on February 1, 2007. If the purpose was to stimulate a debate, it would have been helpful to publish this a little earlier so that more people could respond to the FSA before the close of the response period.

Second, after reading the discussion paper carefully, I find nothing in it to complain about. Principles based regulation is a move away from the certainty of precise rules. Morley wishes to bring the certainty back and he seems to suggest that this could be done by industry bodies writing precise rules and the FSA granting them the force of law so that those who blindly follow these rules cannot be sued. Unfortunately, this is not a prescription for principles based regulation. It is a prescription for detailed rules with the rule making outsourced from the FSA to the industry bodies. Such a scenario would be the worst of all possible worlds. The FSA came into existence partly through a merger of several self regulatory bodies that made their own rules. It is pointless to turn the clock back.

The FSA has embarked on a tortuous journey towards principles based regulation that would take several years to complete. I hope that they succeed. Morley’s piece suggests that more than the regulator, it is the financial services industry that fears principles based regulation.

Posted at 11:58 am IST on Fri, 9 Feb 2007         permanent link

Categories: regulation

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Yen carry trade mechanics

The discussion and subsequent blog post on Brad Setzer’s blog about the yen carry trade shows how difficult it seems to be even for those economists specializing in international economics to understand the mechanics of the currency markets. Andrew Rozanov commented on Setzer’s blog that the actual mechanics of the trade is as follows:

Step 1. Buy US$ / Sell JPY in the spot market (say, at 120)
Step 2. Buy JPY/ Sell US$ in the spot market (again, at 120)
Step 3. Buy US$ at a discount / Sell JPY at a premium in the forward market (say, 3 months forward at 118.50)
Step 4. Buy UST in the spot market
Step 5. Borrow US$ against UST in the repo market

Most international finance people would regard this as a simple, matter-of-fact description of the mechanics except that they would club steps 2 and 3 together into “Swap spot dollars(yen) for dollars (yen) three months forward” (Romanov does mention this at a later stage). Most of the economists involved in this discussion however have difficulty understanding why the mechanics are as convoluted as this.

In any international finance course, this is among the first things that we teach – in the inter bank market, the way to do a forward transaction is to combine a spot transaction with a swap. Corporate finance people who deal with their banks and not directly in the inter bank market do not of course realize this because the bank synthesizes the forward contract for them out of these two components.

International economists think at an even higher level of synthesis – they collapse steps 2, 3 and 5 into a very simple step: “ borrow yen ”. The difficulty with that synthesis is that the cheapest way to borrow against UST collateral is the repo market in the US and not in the yen market. Moreover, since derivative markets are off balance sheet transactions, we would not see the carry trade at all until we break the transactions up into their pieces and start looking at the right places for evidence of the trades.

Posted at 7:57 pm IST on Mon, 5 Feb 2007         permanent link

Categories: derivatives, international finance

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SEC Approves Curious ESOP Securities

The US SEC issued a letter last week allowing Zions Bancorporation to value its employee stock options by auctioning a security which serves no economic purpose other than to price (or rather underprice) these options. Most ESOP valuations use a valuation model like Black Scholes or a binomial model. However, the accounting standards also allow a market based approach. What Zions proposed to do is to issue a security that offers to outside investors the actual cash flows obtained by its employees by exercising their options.

Logically, a company that seeks to hedge its ESOP costs should be on the other side of this transaction – it should be buying a security that reimburses the ESOP costs instead of selling the security which effectively magnifies the ESOP costs. When Zions sells this security, it is behaving like an importer who sells foreign currency forward and exacerbates the currency risk instead of buying foreign currency to hedge the risk.

If a company follows a stupid risk management policy, that should normally be a matter of concern to its investors and not to its regulator. But in this case, the design of the instrument has a completely perverse implication. As Floyd Norris put it very succintly in his column (“S.E.C. Approves New Method for Companies to Value Stock Options”, New York Times, February 2, 2007)

A major problem with such auctions, and the reason that the S.E.C. may have to watch over them, is that they are fundamentally unlike other security sales in that both the seller and the buyer would be happy to see a low price – the buyer to get something cheap and the seller to be able to minimize the reported expense of issuing options to employees.

The SEC’s letter does state that the size of the offering and the number of bidders (as well was their independence) would be factors that should be considered in determining whether an auction was an appropriate market pricing mechanism. It would have been helpful to state rather that the number of bidders, their independence and the size of the offering must be such as to overcome the presumption that the entire exercise is an Enronic accounting gimick. In my view, such a presumption would be justified because the security serves no other economic purpose for the issuer.

Posted at 1:39 pm IST on Fri, 2 Feb 2007         permanent link

Categories: accounting, derivatives, regulation

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Voting rights of hedged equity

US SEC Commissioner Paul Atkins in his talk at the Corporate Directors forum this week raised the issue of "empty voting" by those who have used derivatives to hedge the economic risk of their shareholding.

First of all, it is unfortunate that Atkins raised this issue in the context of the debate about giving shareholders more rights in the election in the directors. If “empty voting” is a problem at all, then it is a problem for all shareholder resolutions and not just the election of directors. By raising the issue in this context, Atkins sends an unfortunate and inappropriate signal to the investors about the SEC’s approach to the problem.

Second, the potential for the separation of voting rights and economic rights existed even without derivatives. Supervoting shares is one way in which separation occurs. For example, in the case of Google, each of the Class B shares held by the founders has ten times the voting rights of the Class A shares held by others. Google management controls a majority of the voting rights with a much smaller economic interest in the company.

Tracking shares are another way in which separation happens. Holders of tracking shares in a division of a company own the entire economic interest in the division, but the board has no obligation to them as opposed to their obligations to the company as a whole. This means that holders of the tracking stock own a division without controlling it and the holders of the regular stock control the division without owning it.

When all these mechanisms have been in existence for decades, it is strange that the SEC finds only the use of derivatives troubling. The nice thing about derivatives is that they are traded in an open market where everybody is welcome to play the game. You do not have to be the founder of a company to unbundle a share into economic rights and voting rights using total return swaps or other means. In an efficient market, the economic interests and the voting rights will both be valued in the market and anybody can buy or sell voting rights at this market price. Once everybody realizes that this can be done, both sides in any proxy battle or takeover struggle will use this method. It is then a level playing field.

Posted at 4:51 pm IST on Wed, 24 Jan 2007         permanent link

Categories: corporate governance, derivatives

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Risk Management at Exchanges

I gave a seminar this week at ICRIER (Indian Council for Research on International Economic Relations) where I argued that it is today computationally feasible to implement a risk management system for derivative exchanges that is (a) based on Expected Shortfall, (b) incorporates fat tailed distributions and (c) computes portfolio risk across multiple underlyings (securities or commodities) using non linear dependence models (copulas).

Risk measures like Value at Risk, SPAN and Risk Metrics have their intellectual roots in the early 1990s or earlier when the notion of coherent risk measures had not been developed and risk modelling had not yet embraced fat tailed distributions with non linear dependence structures. For example, current global best practice in handling exposure to multiple underlyings (“inter commodity spreads”) in exchange risk management can only be characterized as crude and ad hoc. Their continued popularity owes much to the inadequacies of correlation based dependency modelling. Similarly, the SPAN framework uses too few scenarios to meet the highly desirable “relevance axiom” for risk measures though computational advances allow us to come very close to fulfilling this axiom.

In India, the regulatory framework for risk management at Indian exchanges is still supposed to be based on the 99% value at risk mandated by the L C Gupta Committee a decade ago. In practice, however, Indian exchanges and their regulators have adopted several features of a fat tailed expected shortfall approach. Risk management practice has thus outgrown the regulatorily mandated value at risk to which it still pays lip service. The time has come to formally discard value at risk from the regulatory lexicon and adopt a more modern vocabulary. This would provide an opportunity to spur new research on improving exchange risk management systems.

My presentation made specific proposals for a modern risk management system and indicated directions for further research. The slides of this presentation are available here.

Posted at 2:13 pm IST on Thu, 11 Jan 2007         permanent link

Categories: derivatives, exchanges, risk management, statistics

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Alphabet Soup is not Innovation

Gillian Tett, the capital markets editor of the Financial Times writes (“Let us pass on the alphabet soup, SVP”, Financial Times, December 29, 2006) that bankers trained in science and mathematics are creating innovative debt instruments but giving them unimaginative names with unwieldy acronyms – the alphabet soup.

He talks about “the broader acceleration of the global financial innovation cycle” and says “banks are responding by inventing products at such a furious pace, they barely have time to think up names.” By contrast, he argues that “A couple of decades ago, when new financial products hit the markets, banks gave them names. A host of new words crept into the investment bible over the years, such as options, swaps or puts”.

I am unable to agree with this view. Much of the alphabet soup today does not represent really new products. Rather it consists of simple adaptations to the credit market of ideas and instruments well known in equity and other markets. Compared to true innovations like cash settled index futures, the credit market innovations that we are seeing are minor modifications and adaptations of well known dynamic portfolio strategies.

For decades, credit has been the preserve of the banking system. Today, as credit breaks out of that prison and moves into the hands of people accustomed to the joys and pleasures of vibrant financial markets, we are seeing a lot of changes. Even the simple idea of trading a portfolio of credits rather than a single credit appears revolutionary though this is what equity traders have been doing for decades now. However, all this is catch up and not innovation.

Posted at 12:22 pm IST on Tue, 2 Jan 2007         permanent link

Categories: banks, bond markets, derivatives

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Google Transferable Employee Stock Options

Google has introduced another financial innovation in relation to its own stock by allowing its employee stock options to be transferred after they have vested. Details on the transferable stock options (TSO) are available on its blog and several links in that blog entry. Google says:

When the options are sold to a bidder under the TSO program, three changes occur:

1. The remaining life is shortened to two years unless the remaining life is less than two years. If the remaining life is less than two years, then the transferable life is further reduced from two years in six-month increments (e.g., 18 months, 12 months, six months) until the remaining transferable life is zero. For example, an option with a remaining life of 23 months will, upon sale in the TSO program, have an 18-month life.
2. The forfeiture provisions related to the employee's employment with Google are removed.
3. We anticipate the anti-dilution provisions will be changed to conform to market-standard provisions.

Some conclusions are obvious. Any employee who is leaving Google should sell all long maturity options since that allows them to realize at least the value of two year options. If they do not sell, they would have to exercise the options within three months of quitting so as to avoid forfeiting the options. Employees should also sell options that have residual maturity of around two years or less to diversify their portfolios. They should ideally sell the options on dates when the residual life of the options is a few days more than an integral multiple of six months.

The hard part is those who do not intend to leave Google soon and who have options with much more than two years to maturity. Finance theory would suggest that they are better off delta hedging those options rather than shortening the lives of the options. If they are really sure that they will stay with Google for a long time they might also want to hedge the gamma and vega of their stock options with exchange traded options. But in practice, shorting stocks is not very easy for individuals and many might choose to sell the options rather than hold on to them. Probably, only the most financially sophisticated employees will hold on to the options and most others will sell. Incidentally, the possibly most sophisticated employees (the executive management group) is excluded from TSOs altogether.

All in all, Google has added value to its stock option programme and created a model that many other companies will try to emulate. There is an accounting charge as the existence of the TSO increases the expected life of the employee stock options and therefore their fair value. But this is I think a small price to pay for the added benefits. Perhaps, this effect might also be offset by issuing less number of options.

The most interesting question is whether this can be done with unlisted companies. I am sure some hedge funds would be quite willing to bid for even these options if there is reasonable assurance of a liquidity event in the not too distant future. That would add a lot of value to the employees.

Posted at 1:25 pm IST on Wed, 13 Dec 2006         permanent link

Categories: accounting, corporate governance, derivatives

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US court rules that IPO market is inherently inefficient

The ruling of the US Court of Appeal in Miles et al v Merrill Lynch et al (In Re: Initial Public Offering Securities Litigation is a sweeping judgement on the inherent inefficiency of the IPO market that effectively makes it impossible to use private litigation to deal with IPO fraud. The court not only tightened the legal standard for class action but then went on to decide the matter itself rather than remand it to the District Court. In the process it presented a dim view of the IPO market that effectively puts many kinds of wrong doing in this market beyond the purview of a class action law suit. This effectively rules out private litigation and makes the market dependent entirely on timely action by the regulator. This is extremely unfortunate.

The court’s views on the IPO market are as follows:

In the first place, the market for IPO shares is not efficient. As the late Judge Timbers of our Court has said, sitting with the Sixth Circuit, “[A] primary market for newly issued [securities] is not efficient or developed under any definition of these terms.” Freeman v. Laventhol & Horwath, 915 F.2d 193, 199 (6th Cir. 1990) (internal quotation marks omitted); accord Berwecky v. Bear, Stearns & Co., 197 F.R.D. 65, 68 n.5 (S.D.N.Y. 2000) (The fraud-on-the-market “presumption can not logically apply when plaintiffs allege fraud in connection with an IPO, because in an IPO there is no well-developed market in offered securities.”). As just one example of why an efficient market, necessary for the Basic presumption to apply, cannot be established with an IPO, we note that during the 25-day “quiet period,” analysts cannot report concerning securities in an IPO, see 17 C.F.R. 230.174(d), 242.101(b)(1), thereby precluding the contemporaneous “significant number of reports by securities analysts” that are a characteristic of an efficient market. See Freeman, 915 F.2d at 199.

Some good might still come out of it if these strong words induce the SEC to drop the unwarranted quiet period during IPOs.

Posted at 10:41 am IST on Sat, 9 Dec 2006         permanent link

Categories: equity markets, law

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US Capital Market Regulation

I was reading The Social Construction of Sarbanes Oxley by Langevoort when the Committee on Capital Markets Regulation published its interim report The interim report, the National Venture Capital Association Statement on this report, and the Statement of the Council of Institutional Investors on this report conform quite nicely to the social construction proposed by Langevoort.

Posted at 6:24 pm IST on Sun, 3 Dec 2006         permanent link

Categories: equity markets, regulation

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UK Bill about Light Touch Regulation of Exchanges

I have been reading the bill that the UK has introduced to ensure that a foreign acquisition of the London Stock Exchange does not endanger the “light touch regulation” of UK exchanges. When I blogged about this idea three months back, I was mildly in favour of it, but when I see the actual law, my reaction is quite negative.

First of all, the law is far too wide. It says

A requirement is excessive if –

1. it is not required under Community law or any enactment or rule of law in the United Kingdom, and
2. either–
   1. it is not justified as pursuing a reasonable regulatory objective, or
   2. it is disproportionate to the end to be achieved.

Second, the law requires any exchange that proposes to make any regulatory provision to give written notice of the proposal to the FSA. The provision can be introduced only if the FSA does not veto it during a 30 day period. The only saving grace is that the FSA has been empowered to limit the applicability of this clause to “specified descriptions of regulatory provision or in specified circumstances”.

It appears to me that in the name of preserving a light touch regulation, the law is introducing a whole new layer of regulation that is not light touch at all. The motivation for the law was to deal with certain extreme situations and it would have been better to limit the law to such situations. As it stands, the law only illustrates the general principle that knee jerk legislative responses end up as disasters.

Posted at 5:05 pm IST on Fri, 1 Dec 2006         permanent link

Categories: regulation

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Foreign Investment in Indian Exchanges

I wrote a piece in the Economic Times on Monday about permitting foreign investment in Indian exchanges. I wrote:

The ownership of exchanges should be largely left to market forces with minimal regulatory intervention. The regulatory goal should be to ensure that the securities trading industry is highly competitive. The death of the trading floor and the rise of electronic trading platforms have completely changed the nature of exchanges.

From being cosy clubs, they have become complex businesses that are technology driven. In the process, they have also become highly capital intensive. The ability to respond to the demands of a highly sophisticated and global user base has become paramount. SEs and derivative exchanges now require investors with deep pockets and willing to make the strategic investments required to grow the business.

Any attempt to exclude such investors tends to favour incumbent exchanges and perpetuate existing monopolies and duopolies. From the social point of view, this would lead to a less competitive and therefore less vibrant, less innovative and less investor-friendly capital market.

We must welcome foreign investment in our SEs and commodity derivative exchanges as well as the exchange-like entities that trade currency and fixed income products. SEs and derivative exchanges enjoy very attractive valuations in global markets today and we must allow our exchanges to tap these global markets to raise capital. Foreign exchanges and other strategic investors could also help revive and strengthen the less well performing exchanges and thereby foster greater competition.

India’s position on foreign ownership should be the same as that of the Financial Services Authority of the UK which has stated: “We will be indifferent to the nationality of the owners or the managers of the London Stock Exchange, and will be concerned to ensure that the future operation meets our regulatory standards.”

We too should focus on strengthening our regulatory framework so that ownership of the exchanges becomes irrelevant. We must not allow the incumbent exchanges to wrap themselves in the flag and appeal to our xenophobia to block much-needed competition.

Posted at 6:56 pm IST on Wed, 29 Nov 2006         permanent link

Categories: corporate governance, exchanges, international finance

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SEBI Disgorgement Order - Response to Comments

Some of the comments on my previous post have made me realize that I did a poor job of explaining why it is incorrect to simply make restitution to the genuine retail applicants in the so called IPO scam. As I started fleshing out the details, I found that it takes a rather long post to explain why I say this though issuers have the freedom to price their shares and the price paid by the retail segment is the same as that paid by others. There are two aspects to my argument.

The first point is that in equilibrium in an efficient market, a person who has not applied to an oversubscribed offering would not expect to make any gains by applying. The costs of applying (including the costs of analysis, costs of financing and the transaction costs of applying and bidding) offset the expected gains of a successful application (times the probability of success) after appropriate adjustment for the risk that during the period up to listing, the fundamental value of the share could drop below the issue price.

This equilibrium is achieved by a rise in the rate of over subscription and a concomitant fall in the probability of success falling until equality of costs and benefits is achieved. In the non retail segment this happens at high levels of over subscription because of the lower transaction costs and the ability to make large applications. In the retail segment, this equality is achieved at lower levels of over subscription because of higher search and analysis costs, higher financing costs and the higher transaction costs of applying in multiple names (legally or illegally).

The fictitious applications reduce the allotment rate and thus the expected benefits from applying. They thus reduce the gains to those who do apply. But they also deter many retail investors from applying at all because the reduced expected gains are now below their costs. Thus the fictitious applications inflict some losses on those who applied and some losses on people who did not apply at all. The key point is that in the absence of the fictitious applications, some genuine applicants (with high costs of applying) would have applied and reduced the success rate of the actual genuine applicants. It is thus a mistake to compute the losses suffered by the actual applicants by simply recomputing the allotment proportion after deleting the fictitious applications. True restitution would have to be to a much larger pool of potential applicants and not to the actual applicants. This is operationally very difficult. More importantly, even this analysis is flawed because of the analysis that follows next.

The second point is that the retail segment is permitted to bid at the cut off price. This has the potential to substantially reduce the contribution of this segment to price discovery. The under pricing of IPOs is a complex subject but at bottom under pricing can be regarded as a compensation for price discovery in the presence of asymmetric information. Succesful applicants normally earn their gains by contributing to price discovery. Those whose costs of analysis are lower earn more and those whose costs are higher earn less and the marginal investor earns nothing at all (this last statement simply rephrases my first point). But the retail segment has the ability to benefit from under pricing without contributing significantly to price discovery. The under pricing of the retail segment is then a dead weight loss to the company and its shareholders. The gains made by this segment are “rents” earned without doing anything economically useful and are thus “ill gotten”.

This argument can be made even without the ability to bid at cut off prices, but the argument then becomes more subtle. The point then would be that the retail segment crowds out more efficient investors whose information processing costs are lower and thereby forces the company to pay more (in the form of under pricing) to obtain price discovery. This again results in a dead weight cost on the company.

Therefore, I argue that the best way of achieving restitution of the ill gotten gains of the fictitious applicants is to pay this amount to the company and through it to its shareholders. Theoretically, the next best alternative is to pay it to all potential applicants to the issue. This is operationally infeasible. The naive alternative of restitution to those who happened to apply to the issue is simply wrong and indefensible.

Posted at 8:49 pm IST on Sat, 25 Nov 2006         permanent link

Categories: regulation

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SEBI Disgorgement Order

The Securities and Exchange Board of India has passed a bizarre “disgorgement” order for over rupees one billion (approximately $25 million) against both the depositories in India as well as a number of depository participants involved in the IPO scam that I blogged about last year. The most charitable explanation is that this is a penalty masquerading as a disgorgement. The less charitable explanation is that SEBI is merely behaving like class action lawyers who routinely proceed only against those with deep pockets because that increases the likelihood of recovering something if they succeed on the merits.

The IPO scam involved people submitting multiple applications in fictitious names to increase their allotment in a fixed price IPO. The disgorgement order does not target any of those who perpetrated the fraud but is directed against the depositories and the depository participants who opened the demat accounts used by the fraudsters. SEBI says in its order that “it stands to reason that the Depositories and Depository Participants who enabled the opening of numerous demat accounts (afferent accounts) in fictitious / benami names either by turning a Nelson’s eye to the compliance with KYC norms prescribed by SEBI or by actively participating in the scheme designed by the key operators and the financiers, should be held liable for the loss caused to innocent retail investors. Had each market participant played their respective roles diligently with a degree of real time sensitivity, the rampant cornering of IPO allotments, particularly on this scale would not have taken place. The failure of each intermediary in the hierarchy of intermediaries contributed cumulatively, (jointly and severally) to the market abuse.”

There are many problems with this theory. First of all, disgorgement is not about liability for loss caused to investors. In its own order, SEBI states the legal position regarding disgorgement as follows:

It is well established worldwide that the power to disgorge is an equitable remedy and is not a penal or even a quasi-penal action. Thus it differs from actions like forfeiture and impounding of assets or money. Unlike damages, it is a method of forcing a defendant to give up the amount by which he or she was unjustly enriched. Disgorgement is intended not to impose on defendants any demand not already imposed by law, but only to deprive them of the fruit of their illegal behavior. It is designed to undo what could have been prevented had the defendants not outdistanced the investors in their unlawful project. In short, disgorgement merely discontinues an illegal arrangement and restores the status quo ante (See 1986 (160) ITR 969). Disgorgement is a useful equitable remedy because it strips the perpetrator of the fruits of his unlawful activity and returns him to the position he was in before he broke the law. The order of disgorgement would not prejudice the right of the regulator to take such further administrative, civil and criminal action as the facts of the case may warrant.

Similarly a report prepared by the US Securities and Exchange Commission pursuant to the Sarbanes-Oxley Act describes the legal position regarding disgorgement:

Disgorgement is a well-established, equitable remedy applied by federal district courts and is designed to deprive defendants of “ill-gotten gains.” In contrast to actions for restitution or damages in private actions, which are brought to compensate fraud victims for losses, disgorgement orders require defendants to give up the amount by which they were unjustly enriched. Before exercising their discretion to order defendants to pay disgorgement, courts have required findings that a causal connection exists between the defendants’ wrongdoing and amounts to be disgorged. “[D]isgorgement extends only to the amount with interest by which the defendant profited from his wrongdoing.” To assist in determining the amount of disgorgement, the Commission often seeks, and courts require, that defendants provide an accounting of the funds and other assets they received in the course of their wrongdoing. In ordering disgorgement, courts have not required the Commission to determine the exact amount of the defendant’s ill-gotten gains. The Commission has the burden, though, of showing that the amount sought is a “reasonable approximation of profits causally connected to the violation.” Once the Commission has satisfied its burden, a defendant who asserts that the amount should be less has the burden of demonstrating that the amount should be reduced. As long as the measure of disgorgement is reasonable, courts have held that the wrongdoer should bear the risk of uncertainty regarding the precise amount. [footnotes omitted]

The only ill gotten gains for the depositories and their participants would be the account opening charges and transaction fees that they levied on the fraudulent demat accounts. This would be a miniscule fraction of the billion rupee disgorgement that has been ordered.

The second problem is that the deficiencies pointed out in the SEBI order against the depositories and their participants are largely in the nature of negligence or lack of diligence. The appropriate response to that is a penalty or a suit for damages.

Another problem is the joint and several liability that is imposed by this order. Joint and several liability is rooted in the principle that a wrongdoer is liable for the reasonably foreseeable acts of his fellow wrongdoers committed in furtherance of their joint undertaking. US courts have held that joint-and-several liability is appropriate in securities cases when two or more individuals or entities collaborate or have close relationships in engaging in the illegal conduct. It is difficult to see how this applies to several depository participants acting largely independently of each other.

Above all, it must be remembered that from a finance purist’s point of view, the notional gain made by even the genuine applicants in the retail quota of the IPO are in some sense “ill gotten gains” as they were given shares at less than their fair value. This gain really comes at the cost of the existing shareholders of the company and of those who bought shares under the non retail quota. Thus we should not get into the trap of believing that the IPO scamsters defrauded the genuine applicants in the retail quota. The correct way of looking at the situation is that the retail quota itself amounted to looting the company and the scamsters only changed the proportion in which this loot was shared. If the so called disgorgement were ever to be turned into a restitution, the recompense must go the company that did the IPO (and therefore to all its shareholders) and not to the genuine applicants in the retail quota.

Finally, the SEBI order raises serious questions about the capital adequacy of the depositories. If this is the kind of liability that SEBI intends to fasten on the depositories, they need to have a lot more capital than they currently have. The joint and several liability that the order imposes on the country’s largest depository, NSDL, represents 45% of its net worth as disclosed in the the 2005-06 annual report. It needs to have a lot more capital to protect against actual losses caused to investors by failures in its systems.

Posted at 3:08 pm IST on Wed, 22 Nov 2006         permanent link

Categories: regulation

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Edgar Full Text Search

The US SEC has at long last enabled full text searching of its Edgar database of corporate filings. The new search page is here. In the past, searching Edgar was quite painful and I usually went to Edgar only after identifying the form type and approximate filing date through other sources. Now it is much simpler. For example, I clicked on “advanced search” and typed in “pretexting” in the “text” field and “Hewlett Packard” in the “Company Name” field and I obtained links to the two 8-K filings on this issue that I have blogged about earlier.

Under Chairman Cox, the US SEC seems to be taking the internet quite seriously. Cox posted a comment on a blog recently in his official capacity. He is also pushing for adoption of XBRL in Edgar filings. Regulators elsewhere have a lot of catching up to do. I hope that the Securities and Exchange Board of India (SEBI) upgrades its Edifar database to include the full text of the financial statements (and not just the summary financial numbers) as also the material event disclosures that companies currently make only to the exchanges. Only after that can one start asking for search capabilities!

Posted at 1:34 pm IST on Wed, 15 Nov 2006         permanent link

Categories: accounting, technology

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XBRL and Financial Statement Preparation

I wrote an article for CFO Connect about the use of (eXtensible Business Reporting Language (XBRL) in the preparation of financial statements rather than just for their dissemination and analysis. Scanned image is available here.

Financial analysts have begun to love XBRL and the US SEC is also now pushing companies to use XBRL in their Edgar filings. Companies however tend to think of this as another investor relations expense rather than as a productivity tool for themselves as preparers of financial statements. I argue on the other hand that it is high time that we got rid of all those spreadsheets and word processor files and used XBRL to automate the process completely and integrate it completely with the corporate ERP systems. This would improve reliability, increase speed and reduce manual interventions.

Posted at 2:19 pm IST on Tue, 7 Nov 2006         permanent link

Categories: accounting, regulation, technology

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Ownership of Exchanges in India

I participated in a discussion on the CNBC TV channel last night on the ownership of Indian exchanges. This issue has become controversial because of the reported desire of the government and the regulators to discourage Indian companies and foreign entities from becoming strategic investors in Indian stock exchanges

My views on this are very simple. It is far more important to ensure that the securities trading industry is highly competitive than to regulate the ownership of exchanges. Stock exchanges are highly capital intensive technology driven businesses which require deep pocketed investors who are willing to make the strategic investments required to grow the business. Any attempt to exclude deep pocketed investors tends to favour incumbent exchanges and perpetuate existing monopolies and duopolies. From the social point of view, this would be a most unfortunate outcome as it would lead to a less competitive and therefore less vibrant, less innovative and less investor friendly capital market.

Much has been written about the alleged conflict of interest that would arise if certain categories of investors were to become controlling shareholders of exchanges. It has been suggested that ownership by financial institutions is the best solution. I do not agree with this view at all. Almost any potential owner of an exchange is conflicted because of the pervasive role of stock exchanges in a modern market economy. Financial investors are among the most highly conflicted of all potential owners. Some of them own broking subsidiaries and it is surely absurd to get rid of broker ownership only to reinstate it through the back door. All banks and term lending institutions live in mortal fear of the capital markets disintermediating them out of existence. Sixty years ago, the conflict of interest between banking and capital markets was taken so seriously that the US passed the Glass-Steagal Act prohibiting banks from owning securities firms. That was surely silly, but the idea that they are the best possible owners of stock exchanges is even more silly.

It is only an anti capital market mind set that can think of financial institutions as preferred investors in exchanges. Unfortunately, that mind set is in abundance in policy making circles in India.

Posted at 2:19 pm IST on Sat, 4 Nov 2006         permanent link

Categories: corporate governance, exchanges

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US CFTC Policy on Foreign Exchanges: Lessons for India

The US Commodities and Futures Trading Commission (CFTC) has issued a statement of policy regarding foreign exchanges offering their products in the United States. This issue had become controversial in the context of the UK based ICE Futures trading US energy contracts in the US that I blogged about here.

The CFTC has decided to maintain the existing policy framework of exempting exchanges like ICE from US regulation. In particular, the CFTC states that:

1. the trading volume originating in the US is not determinative of US location
2. the fact that the contract is based on a US produced or economically important commodity is not probative of location

These put to rest the two critical arguments that were raised against ICE Futures.

I think the CFTC has shown the way for regulators in India to allow foreign exchanges to offer their contracts directly in India through electronic trading platforms. The RBI now allows Indian citizens to remit up to $50,000 a year outside India for investment purposes. What better thing can we give these investors than the ability to buy foreign stocks or bonds or derivatives sitting in front of their computer screens in India? We must not let protectionist arguments prevail in denying Indian residents the best investment opportunities in the world and force them to park their money in foreign bank deposits.

What is more, acceptance of the CFTC principles would allow foreign exchanges to offer trading in India on ADRs of Indian companies provided the Indian investor pays for them in dollars. This would produce better price discovery in the ADR market and reduce the price gap between the Indian and offshore markets.

Posted at 1:29 pm IST on Thu, 2 Nov 2006         permanent link

Categories: exchanges, international finance, regulation

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Another electronic platform buys out another trading floor

The acquisition of CBOT (Chicago Board of Trade) by the CME (Chicago Mercantile Exchange) fits a now familiar pattern of an electronic platform buying out and gradually digesting a trading floor. One of the big benefits of the deal will be that CBOT products start trading on Globex. ICE (Intercontinental Exchange) buying NYBOT (New York Board of Trade) was also in the same mould. Viewed in this light, the deal between NYSE and Euronext will ultimately mean that Euronext’s electronic platform absorbs the NYSE trading floor though in financial terms, it is the NYSE that is buying Euronext. Of course, the NYSE deal with Archipelago was also similar, but Euronext would take the process much further.

Posted at 1:32 pm IST on Wed, 18 Oct 2006         permanent link

Categories: exchanges, technology

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UK Regulation of US Energy Markets

While I blogged about the potential regulation of the UK equity market by the SEC nearly two weeks ago, it took the collapse of Amaranth to draw my attention to the fact that a growing part of the US energy derivatives market is now regulated by the UK.

In January 2006, the Intercontinental Exchange (ICE) was permitted to use its trading terminals in the United States for the trading of US (WTI) crude oil futures on ICE Futures in London (formerly the International Petroleum Exchange or IPE). This was not a totally new contract because ICE simply took its electronically traded, standardized OTC contracts and offered them on ICE Futures. Therefore, these contracts have seen high initial adoption and rapid growth in the last few months. WTI volumes in ICE Futures are now about half of the NYMEX volumes. We now have a liquid contract on a US commodity that is predominantly traded by US participants using terminals in the US, but the contract is on an exchange (ICE Futures) which is located and regulated in the UK, though it is owned by a US entity (ICE).

More interesting is the fact that ICE also runs a large quasi futures market in energy derivatives. These are OTC contracts for regulatory purposes but are standardized, electronically traded and cleared through London’s LCH. LCH is UK regulated, but it is also a Designated Clearing Organization in the US. Amaranth served to remind us that when it comes to natural gas “futures”, ICE is today larger than NYMEX.

Even before Amaranth, the US political system was worried about this just as the UK is worried about potential regulation of UK equities by the US. The US Senate has prepared a report arguing for greater US (CFTC) regulation of the derivatives traded at ICE (“The role of market speculation in rising oil and gas prices: A need to put the cop back on the beat”, Staff Report prepared by the Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs, United States Senate, June 2006).

Incidentally, this week the US SEC met with Euronext regulators about the potential acquisition of Euronext by NYSE. The SEC’s press release states: “The regulators also affirmed that joint ownership or affiliation of markets alone would not lead to regulation from one jurisdiction becoming applicable in the other and stated their shared belief in the importance of local regulation of local markets.” That sounds categorical until one reads it again more carefully and realizes that it means nothing at all. Today there are no purely local markets. US investors do trade UK stocks at the LSE and the LSE is no longer a purely local market. All bets are then off.

Posted at 2:15 pm IST on Thu, 28 Sep 2006         permanent link

Categories: exchanges, international finance, regulation

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Nasdaq, LSE, Cadbury Schweppes and extra-territoriality

The UK has in the last week been involved in two tussles about extra territoriality but has been on opposite sides in the two tussles. In the case of the possible acquisition of the London Stock Exchange (LSE) by Nasdaq, the UK has been eager to ensure that the extra-territorial jurisdiction of US law (particularly Sarbanes Oxley) does not affect companies listed at LSE. In the case of Cadbury Schweppes, it is the UK that has been told to stop exerting territorial jurisdiction to impose a tax on the UK company’s Dublin subsidiary which is subject to low taxes there.

The fear of extra-territorial jurisdiction of US laws over a US owned LSE is quite well grounded. Way back in 1979, in the wake of the US hostage crisis, President Carter issued Executive Order 12710 under the International Emergency Economic Powers Act stating: “I hereby order blocked all property and interests in property of the Government of Iran, its instrumentalities and controlled entities and the Central Bank of Iran which are or become subject to the jurisdiction of the United States or which are in or come within the possession or control of persons subject to the jurisdiction of the United States.” Nearly half of the blocked money was in deposits outside the US (principally in London). While the Iranians did sue in London to release these funds, the courts and governments were slow in resisting the extra-territorial demands of the US order and since the entire hostage crisis lasted only 14 months, the legality of the US freeze was not adequately tested. A good account of this episode is provided by Robert Carswell’s article “Economic sanctions and the Iran experience”, in Foreign Affairs, Winter 1981/1982.

In later sanctions against other countries, the US was less successful. For example, “a U.S. bank in the United Kingdom was ordered by a British court to release a Libyan bank’s assets blocked under U.S. unilateral sanctions in 1986. The United States subsequently authorized the release of the assets.” (GAO-04-1006 “Foreign Regimes’ Assets: The United States Faces Challenges in Recovering Assets, but Has Mechanisms That Could Guide Future Efforts”, Government Accountability Office, 2004)

Extra-territorial reach over UK listed companies through a change in exchange regulations would be less vulnerable to judicial challenge. The UK government therefore wishes to have a statutory weapon against it. In a speech on September 13, 2006, Economic Secretary to the Treasury, Ed Balls stated “ the UK Government will now legislate to protect our regulatory approach. This legislation will confer a new and specific power on the FSA to veto rule changes proposed by exchanges that would be disproportionate in their impact on the pivotal economic role that exchanges play in the UK and EU economies. It will outlaw the imposition of any rules that might endanger the light touch, risk based regulatory regime that underpins London's success.”

The Financial Services Authority has made its view clear in February 2005 and again in June 2006.

[W]e will be indifferent to the nationality of the owners or the managers of any future combined operation, and will be concerned to ensure that the future operation meets our regulatory standards. If the LSE remains a UK exchange under a new parent it will continue to be subject to FSA regulation as a Recognised Investment Exchange (RIE).

The LSE, as a UK RIE, plays a key role as a focal point for the wider regulatory framework, including capital raising and corporate governance. The attractiveness of the UK financial markets, and ultimately the competitiveness of EU capital markets, depends, in part, on a system of corporate governance and of regulation which is of a high standard, but is proportionate and adaptable and attuned to the requirements of users. (“Potential longer term implications of a change of ownership of the London Stock exchange”, FSA/PN/015/2005, 4 February 2005)

However, we believe that there could be circumstances where a more complex regulatory position might arise. Theoretically, in the longer term, a new entity might seek to achieve further benefits from rationalisation of its regulatory structure. This could at the extreme involve the LSE no longer being subject to UK regulation as an RIE. Its services might be provided from outside the UK, either from the US, another EU member state or an alternative location, through the provision of trading screens in the UK and with securities admitted to trading on the market operated from elsewhere. Such a move, were it to occur, would potentially have significant implications for various aspects of the wider regulatory regime as indicated in our February 2005 statement. If such a market were to be operated from the US it would require member firms and issuers to be registered with the SEC and subject to its oversight. (“Implications of ownership of a UK Recognised Investment Exchange by a US entity”, FSA/PN/055/2006 12th June 2006).

It is ironic therefore that the UK had to be reminded this week about the extra-territoriality of its own tax laws by the European Court of Justice. Though the tax rate in Dublin’s International Financial Services Centre is only 10%, the UK claimed an additional 20% tax on the Dublin subsidiaries of Cadbury Schweppes on the ground that these were “controlled foreign companies”. The European Court ruled that if the foreign subsidiary has offices, staff and operations in the foreign country, then the fact that it was set up with an intention to obtain tax relief does not make it a wholly artificial arrangement that justifies levying UK tax rates. Ireland is a country that has built up a vibrant financial services industry on the strength of a sound regulatory and tax regime. The court ruling will hopefully allow this to survive.

In general, I like regulatory competition. I think of a regulator as being in the business of manufacturing and providing regulatory products and services. Consumers of these products and services (investors, issuers and others) benefit if this industry is competitive. Similarly, healthy competition in tax rates also helps put a bound on the rapacity of the nation state. A vigorous defence of the competitive structure of the market for regulatory services is therefore very much welcome.

Posted at 3:41 pm IST on Sat, 16 Sep 2006         permanent link

Categories: international finance, law, regulation

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Household Financial Leverage in India

Buried inside the Global Financial Stability Report of the IMF (September 2006) is a graph showing India and New Zealand as the outliers in terms of high financial leverage in the household sector, but the data does not seem right. Figure 2.10 on page 55 shows Indian household leverage (ratio of financial liabilities to financial assets) as about 60%, exceeded only by New Zealand’s 80%. India does not publish sectoral balance sheets, but the flow of funds data is grossly at variance with this number of 60%. If we cumulate the last several years’ change in financial assets, liabilities and physical assets from Tables 10 and 11 of the RBI’s Handbook of Statistics, 2005, the following picture emerges. Cumulative household financial savings are about 100% of GDP, cumulative household financial liabilities are about 20% of GDP and cumulative household physical savings are about 80% of GDP. This would imply household leverage of 20/180 or about 11%. This broad picture does not change whether I cumulate the last 35 years of data or just the last 10. I am struggling to understand how the IMF gets a number more than 5 times this estimate of about 11%. If one considers that most household assets (equities, real estate or gold) would have appreciated in value over the years while most liabilities would be fixed in nominal terms, the financial leverage evaluated at market prices must be even lower than the above estimate of 11%. Of course, the IMF says that it got the number from national authorities. So does the RBI/MOF/CSO see some household leverage out there that we are not seeing? Or is it all a mistake?

Posted at 1:28 pm IST on Wed, 13 Sep 2006         permanent link

Categories: miscellaneous

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HP Boardroom Leaks and Disclosure

While corporate disclosure in offer documents and to a lesser extent in annual reports is reasonably informative and neutral, material event disclosure still tends to consist of sanitized half truths. I have spent some time comparing:

• the Form 8-K filed with the US SEC by the Hewlett Packard Company on September 6, 2006 about its investigation of board room leaks, and
• the news report (“Leak, Inquiry and Resignation Rock a Boardroom” by Damon Darlin) about the same event in the New York Times of September 7, 2006

The New York Times reports that Thomas Perkins resigned from the HP Board in protest when he found that HP had used private detectives to monitor telephone calls by board members. It also reports that these detectives approached the phone company with the last four digits of Perkins’ social security number and tricked them into “revealing the multidigit code that would allow a person to set up an online account for access to billing statements ”. Using this the detectives viewed the list of his phone calls. According to the news report, Perkins regards this as “possible fraud, identity theft and misappropriation of personal records”

The same events are described in HP’s SEC filing as follows: “the Chairman of the Board, and ultimately an internal group within HP, working with a licensed outside firm specializing in investigations, conducted investigations into possible sources of the leaks of confidential information at HP. ... some form of ‘pretexting’ for phone record information, a technique used by investigators to obtain information by disguising their identity, had been used. ... The Committee was then advised by the Committee’s outside counsel that the use of pretexting at the time of the investigation was not generally unlawful (except with respect to financial institutions), but such counsel could not confirm that the techniques employed by the outside consulting firm and the party retained by that firm complied in all respects with applicable law.”

The SEC filing also asserts that the “Date of Earliest Event Reported” in the filing is August 31, 2006. Since the “pretexting” in question happened in May 2006 or earlier and had not previously been disclosed by HP, it would appear that this statement at least is false. Probably, HP wants to avoid an impression that it was tardy in filing the Form 8-K. Or perhaps, HP wants to claim that what is being disclosed is not all the sordid mess about the undercover investigation, but that as a result of the investigations, the Board decided on August 31, 2006 not to renominate George Keyworth who was reportedly the source of the leaks.

The Form 8-K filed by HP appears to me to be excessively sanitized to the extent of failing to communicate the gravity of the events. For example, “disguising their identity” is quite different from impersonating somebody else. It is evident that material event disclosure has a long way to go even in the US. In countries like India, the state of affairs is much worse.

Posted at 1:46 pm IST on Fri, 8 Sep 2006         permanent link

Categories: corporate governance

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More on Capital Account Convertibility 2.0

Sandeep Parekh tells me that my posting yesterday is not quite clear. So let me restate my views differently.

• I think we should move towards capital account convertibility much faster and much more boldly than the CAC 2.0 report suggests. A freely convertible currency by 2010 should be the goal.
• I believe that it is impossible to ban Participatory Notes (PNs) when portfolio investment is opened up to non institutional investors. This is because:
  • The PN is traded between foreigners outside India
  • If neither party to the PN is an FII, then the PN does not involve any party who is regulated by or registered with an Indian regulator. Compliance with a KYC norm is not the same as acceptance of regulatory jurisdiction.
  • The PN is a cash settled OTC derivative that does not require any money or securities to change hands in India.
  • Even if for a moment one can think up a legal theory that creates jurisdiction, it is infeasible to exercise such jurisdiction. It is one thing to threaten to prosecute 500 FIIs. It is another thing to do that with 50,000 non institutional investors who do not even have a home country regulator.
• In an FII oriented regime where only a select few can invest in India, the regulation of PNs serves to prevent others from getting a back door entry. In the proposed regime where any body can come in through the front door, I do not understand why the government should go to great lengths to prevent anybody trying the back door. The whole debate about PNs makes sense only if the FII regime continues. The moment that is diluted, the case against PNs vanishes.

Posted at 4:28 pm IST on Tue, 5 Sep 2006         permanent link

Categories: international finance

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Capital Account Convertibility 2.0

The Reserve Bank of India (RBI) has published the report of the Committee on Fuller Capital Account Convertibility chaired by S. S. Tarapore. A committee with the same chairman and almost the same set of members gave a report on Capital Account Convertibility to the RBI in 1998. Therefore, in line with phrases like Web 2.0 and Bretton Woods 2.0, I have chosen to call it CAC 2.0.

I resolved not to blog about CAC 2.0 until I had read the report fully. Since the report is over 200 pages long, it was only with great difficulty that I have managed to adhere to this resolve. My first set of comments are as follows:

• The dissent notes by Surjit Bhalla and A. V. Rajwade are more interesting and thought provoking than the main report itself.
• CAC 1.0 at 80 pages was less than half the length of CAC 2.0. It was also characterized by much greater conceptual clarity and internal consistency. In fact, CAC 1.0 could be summarized in two sentences: “Based on an assessment of macro economic conditions, the Committee is of the considered view that the time is now apposite to initiate a move towards CAC. ... Fiscal consolidation, a mandated inflation target and strengthening of the financial system should be regarded as crucial preconditions/signposts for CAC in India.” Everything in CAC 1.0 reflected this philosophy and while I disagreed with CAC 1.0 for being too cautious, I could not fault its internal consistency. One would struggle to find a similar succint philosophy for CAC 2.0
• CAC 1.0 took place in the backdrop of the Asian crisis. CAC 2.0 takes place in the backdrop of a much stronger external position and greater optimism about India. Yet a high degree of timidity permeates CAC 2.0.
• The most controversial recommendation of CAC 2.0 is about Participatory Notes (PNs). A PN is a cash settled OTC derivative sold by a registered foreign institutional investor (FII) to entities outside India. Though these instruments are traded between foreigners outside India, Indian regulators have exercised jurisdiction over them relying on the fact that the FII which issues these PNs is registered with Indian regulators. CAC 2.0 recommends a complete ban on new PNs and the liquidation of existing PNs within one year. The argument given is that “In the case of Participatory Notes (PNs), the nature of the beneficial ownership or the identity is not known unlike in the case of FIIs”. In the same breath, CAC 2.0 recommends that foreign corporate and individual investors should be allowed to invest in India through entities registered with the Indian regulators. On the face of it, therefore, a US hedge fund would be able to invest in India through an Indian stock broker who would be responsible for enforcing the Know Your Client norms. Or perhaps, the hedge fund would come through an Indian portfolio manager offering a non discretionary portfolio management service. In either case, the foreign entity is not now registered with the Indian regulator and not subject to its jurisdiction. How the Indian regulator would now enforce a ban on that unregulated entity selling cash settled OTC derivatives outside India is beyond my comprehension. Finally, if any foreign entity can invest in India directly, it is difficult to see what is gained by banning PNs. A foreign investor can easily hide behind several layers of special purpose vehicles and corporate entities that make it impossible to determine beneficial ownership even if all Know Your Client norms are adhered to. The recommendations lack internal consistency.

Posted at 4:22 pm IST on Mon, 4 Sep 2006         permanent link

Categories: international finance

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Quattrone and Regulating Initial Public Offerings

It is not often that I disagree vehemently with a Financial Times editorial, but that is what I found myself doing when I read “Quarter for Quattrone: A reminder that regulating is more efficient than prosecuting” Financial Times, August 25, 2006. Analysing the lessons from the prosecution’s failure to establish its charges against Frank Quattrone, the star technology analyst of the dot com era, the Financial Times writes:

In retrospect, and certainly in light of what happened this week, it would have been far better if regulators had stepped in earlier to impose some discipline, perhaps by insisting that companies show some record of profit before coming to market. Prevention could be far more effective than prosecutions have proved.

The big advantage of a capital market dominated financial system over a bank dominated system is its ability to provide risk capital to innovative enterprises that have not established any track record. The Financial Times appears to be saying that we must stop the capital market from performing this function. I am reminded of the old age that a ship is safest when it is in the harbour but that is not where it is intended to be. A capital market that does not allocate risk capital will be much safer and much less scandal prone, but it will not be a market worth having.

The Financial Times would have been on much stronger ground if it had asked why the regulators chose the easy path of focusing the Quattrone prosecution on his alleged role in destroying potentially incriminating emails rather than on the substantive wrongs that he is alleged to have committed in the IPO process.

Posted at 9:16 pm IST on Sun, 27 Aug 2006         permanent link

Categories: banks, exchanges, regulation

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Alleged Manipulation of CME Cash Cheese Market

The cash cheese market at the Chicago Mercantile Exchange (CME) has been in the news recently for alleged price manipulation. (For example, "CME in cheese price fix investigation", Financial Times, August 17, 2006.). Six senators including Hillary Clinton have demanded an investigation.

A decade ago, the cash cheese market used to be at the National Cheese Market and one reason for moving the market to the CME was the hope that oversight by the Commodities Futures Trading Commission (CFTC) would clean up the market. It appears that the political establishment is still not satisfied about the integrity of the market.

On closer analysis, it is difficult to see how the integrity of this market can ever be ensured as long as the US government manipulates the US milk market with the Federal Milk Marketing Order (FMMO). FMMO sets minimum prices paid to farmers for liquid milk based partly on cheese prices. Essentially, FMO regards liquid milk as a combination of butterfat, proteins and other solids. The weighted average price of hard (cheddar) cheese, dry whey and butterfat determines the price of what FMMO calls Class III milk. It then adds a price differential (varying across regions) to this to get the price of liquid milk (Class I milk).

The FMMO relies on cheese prices reported from surveys by the National Agricultural Statistical Service (NASS), but since practically all large cheese transactions are based on CME prices, NASS reflects CME prices with a lag. Thus by manipulating CME prices, the big diary companies can affect prices determined under the FMMO.

This means that the big diary companies have every incentive to manipulate CME cash cheese prices. Milkweed reported in May 2006 that “A major focus of CFTC’s investigation centers on Cheddar cash market activities by Dairy Farmers of America – the nation’ largest dairy farmers’ cooperative” over the last five years. Complaints have also been made against Kraft.

The best that the US senate can do to clean up the market is to get rid of the depression era legislation that mandates government intervention in the milk market.

Posted at 3:19 pm IST on Sat, 19 Aug 2006         permanent link

Categories: commodities, derivatives

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Global Diversification and Indian Mutual Funds

Ajay Shah has a detailed analysis of the regulations governing international investment by Indian mutual funds. His conclusion: “Small pieces of progress on economic policy in India seem to take a long time.” I entirely agree. There is a need to move much faster. Moreover the first thing that needs to be liberalized is access to global index products. The actual regulations appear to reflect not only the fear of a more open capital account, but also some degree of regulatory capture. Obstacles in the path of exchange traded funds serve to protect management fees in the fund management industry.

Posted at 12:42 pm IST on Wed, 16 Aug 2006         permanent link

Categories: international finance, mutual funds

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Financial Regulators and the Media

Nouriel Roubini’s Global Economics Blog has an aside on the interaction of Fed Chairmen with the media.

In 1987, the relatively inexperienced Greenspan did not know how to properly communicate his message and he rattled markets. He presented his views in the wrong forum by giving an interview to a Sunday television news show where he expressed his concerns about inflation; the next day stock markets sharply wobbled. He learned his lesson, realized the risks to his reputation, made a mea culpa, never again gave a TV interview for the following 20 years and became altogether Delphic in his public pronunciations. Ditto for Bernanke: after a congressional testimony on April 27th that was read by investors as dovish, he made the famous flap with CNBC anchor Maria Bartimoro telling her that he had been misunderstood and was more hawkish than the market perceived him. The next day – when Bartimoro reported this – equity markets sharply contracted and Bernanke’s reputation was shaken. Bernanke then made his own public mea culpa and you can be sure that – like Greenspan – he will never speak again to any TV reporter, either in private or in public.

This set me thinking about the issue of financial regulators interacting with the media. Should the selective disclosure regulations that apply to corporate managements apply to financial regulators? In principle, I think the answer is yes. The ideal solution would be for every financial regulator to maintain a blog and use that as the primary means of communicating with the outside world. If the regulator wants to respond to a reporter’s query, the response should be on the blog with due credit to the reporter who raised the query. If the media wants sound bytes and visuals that is fine so long as the regulator does not go beyond what is there on the blog. If there is any deviation, that should hit the blog very rapidly.

Transparency is imperative and a blog is today the most transparent medium available.

Posted at 12:31 pm IST on Wed, 16 Aug 2006         permanent link

Categories: corporate governance, insider trading, regulation

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Hedge funds are not unregulated!

The Chairman of the US Securities and Exchange Commission declares boldly that hedge funds are not unregulated. Announcing the SEC’s decision not to appeal a court verdict invalidating the hedge fund registration rules, Chairman Cox states:

Finally, notwithstanding the Goldstein decision, it is important to point out that hedge funds today remain subject to SEC regulations and enforcement under the antifraud, civil liability, and other provisions of the federal securities laws. The SEC will continue to vigorously enforce the federal securities laws against hedge funds and hedge fund advisers who violate those laws. Hedge funds are not, should not be, and will not be unregulated.

One can well imagine an excerpts from this paragraph adorning the publicity material of a hedge fund to reassure its investors that a hedge fund is a well regulated entity not too different from a mutual fund!

I understand the feeling of “sour grapes” that underlies the statement of Cox. But one expects a little more care and circumspection from the top securities regulator in the world. A good deal of anti fraud and civil liability exists even under contract law. Push the logic a little further and one could argue that the SEC does not need to exist. Ha! Ha! Perhaps we should all re-read Stigler’s classic paper on that subject once again (Journal of Business, Volume 37, 1964, page 117-142 and 382-422).

Posted at 2:15 pm IST on Wed, 9 Aug 2006         permanent link

Categories: regulation

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Binary options on the Fed Funds Target Rate

Many exotic options leave one wondering whether they serve any real purpose other than producing fat margins for the investment banks that manufacture them. Binary options on the Fed funds target are an interesting exception where there is a clear rationale for a binary rather than a vanilla option.

Every six weeks, the US Federal Reserve (Fed) meets to decide on changes to its monetary policy. The key instrument that the Fed uses is the Fed Funds target. This is essentially a target that the Fed sets for the overnight inter bank interest rate. The Fed supplies or withdraws liquidity from the market so as to ensure that the interest rate on Fed funds does not deviate by more than a few basis points from the target set by it. In the bad old days, the Fed did not announce this target but left it to be inferred by market participants from the behaviour of the Fed. However, for several years now, the Fed annnouces this target explicitly at the end of each meeting.

Most hedging activity related to the Fed funds target happens in the Fed Funds Futures market which trades monthly contracts that settle using the average Fed funds rate in that month. The difficulty is that since the Fed Comitttee meets once in six weeks, this meeting will often happen in the middle of the month. Fed funds target changes will also happen mid way through the month. Ignoring the differences between the actual Fed funds rate and its target, the settlement rate for the monthly Fed funds contract will then be close to the weighted average of the old target rate and the new target rate. It will not be exactly equal to this weighted average because of the slight deviation of a few basis points between actual and target rates.

All this is very messy compared to the CBOT’s Binary Options on the Target Federal Funds Rate. These binary call and put options are available for the next four Fed Comitttee meetings at strikes ranging from 250 basis points below the current target to 250 basis points above the target at intervals of 12.5 basis points. The payout is $1,000 if the option expires in-the-money, and $0 if it does not.

Though this contract was launched only a month ago, it has picked up a tiny but fast growing open interest (less than 3,000 contracts compared to over 0.5 million contracts on vanilla Fed fund options). The Financial Times has an interesting report.

For those who use Fed Fund derivatives to hedge Fed fund interest rate risk itself, the binary offers nothing truly exciting, but for those who treat changes in the Fed Fund target as a driver of risk appetite in other markets, the binary clearly makes a lot of sense. For example, if you believe that a change in the target rate impacts emerging market bonds or equities, then the binary is the right hedging tool.

The usual arguments about discontinuous and unhedgeable Greeks of binary options do not apply in this case because the discontinuity is characteristic of the risk being hedged.

Posted at 6:31 pm IST on Tue, 8 Aug 2006         permanent link

Categories: derivatives, monetary policy

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Does it take three years to register securities?

Yesterday, the US SEC issued an exemption order allowing NASDAQ members to continue to trade (till August 2009) a handful of securities that have not been registered with the SEC nor are deemed to be registered with it. The vast majority of NASDAQ listed stocks are covered by a separate order under which the SEC treats them as registered securities on the basis of the information that they have already filed with the SEC under different statutory provisions. The exemption order that I am focusing on covers only four insurance companies and nine private foreign issuers. Even for these issuers, I can well understand the need for a transitional provision as the NASDAQ converts itself into an exchange, but I am amazed that this exemption lasts for as long as three years. An SEC registration is an expensive and time consuming process, but to the best of my knowledge the time involved is measured in months and not in years. A one year exemption would have been much more appropriate especially when the number of issuers involved is so small.

By granting a three year exemption, the SEC is signaling that it regards the conversion of NASDAQ into an exchange to be a mere change of nomenclature in which nothing substantive changes.

Posted at 4:10 pm IST on Tue, 1 Aug 2006         permanent link

Categories: exchanges, regulation

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IPO Quiet Periods

There has been a lot of discussion in the press about the reported move by the Securities and Exchange Board of India to introduce a “quiet period” prior to public offering of securities. Ajay Shah blogged in support of this idea here. The financial press in India also seems to have been largely supportive. Sandeep Parikh provides links to several press reports in his blog. Sandeep Parikh himself has been supportive of the quiet period.

The quiet period is a long established practice in the United States though as Sandeep Parikh points out, US regulations have been dramatically liberalized this year. The purpose is clearly to ensure that securities are sold using a carefully written prospectus and not on the basis of advertisements and other marketing material.

While the goal may be laudable, I think that the quiet period is basically a bad idea. First of all, I am very sceptical about any restraints on the freedom of speech. To my mind, free speech comes much higher in the hierarchy of rights than the right to property. Therefore, if somebody’s free speech conflicts with somebody else’s property rights, I would think that normally it is the free speech that must prevail. I can understand the desire to ensure that any advertising is not misleading, but I cannot understand a ban on general corporate advertising.

Secondly, in practice, the ban extends only to written material. The SEC has now clarified that written material includes videos placed on a website but it excludes communications that are carried live and in real-time to a live audience. This is immensely anti competitive and benefits only a cosy club of investment banks and other financial intermediaries. What it means that an issuer can carry a “soft” advertising message to the investor only through road shows to investor groups. Typically, it is only an investment bank that can organize these road shows. All that the SEC is doing is helping these banks collect their rents. To understand the implications of this, let us take this out of the securities setting. Imagine a rule that said that soft drinks cannot be advertised but live road shows to live audiences are allowed. The Cokes of the world would then have to pay the Walmarts to do road shows in their various retail stores and the Walmarts would surely lobby vigorously for such a rule to be kept in place. Or imagine a rule that said that election meetings and door to door campaigns are allowed but no election related advertising is allowed. Cadre based parties would love this because it increases the entry barrier for new political formations.

These general principles applies to the securities industry as to any other industry. Restrictions on advertising are anti competitive. They favour incumbents. They allow intermediaries to earn rents. Unfortunately regulators are captured by these intermediaries and it is often this regulatory capture that leads to such anti competitive regulations. Sadly, all this is done in the name of consumer protection or investor protection.

Posted at 6:05 pm IST on Wed, 26 Jul 2006         permanent link

Categories: equity markets, regulation

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FSA as a Regulatory Role Model

Ajay Shah discusses the regulatory successes of the UK’s Financial Services Authority (FSA) in an article in the Financial Express and on his blog. The discussion is related to the common law versus civil law orientation that I blogged about a few days ago.

So is the FSA more common law oriented than other securities regulators? That depends on whom you compare it with. I would imagine that Ajay Shah was comparing the FSA with the Indian regulators (the Securities and Exchange Board of India and more importantly the Reserve Bank of India) and perhaps also with the US Securities and Exchange Commission. If these were his benchmarks, then Ajay Shah is undoubtedly right. The conclusion would also remain valid if the comparison is with the other super regulator that all UK institutions have to contend with - the European Commission. By these benchmarks, the FSA has been a success story that other regulators could seek to emulate.

However, these reference points set the bar too low. I would put forward three other reference points against which the FSA’s performance looks much less impressive.

1. The first and most obvious comparison would be with the regulator across the border in Ireland which has established itself as a global centre of excellence for hedge funds and other alternative investment vehicles. Most people that I have talked to agree that the IFSRA is one of the smartest and most flexible securities regulators in the world. Before the formation of the IFSRA, the Central Bank of Ireland also had a similar well deserved reputation. In comparison to the IFSRA, the FSA comes across as much more of a check-box or civil law oriented regulator.
2. Another comparator is the plethora of self regulatory organizations that existed prior to the formation of the FSA. Most observers think that the formation of the FSA saw the emergence of a more rule oriented regulation than what existed earlier. A large part of the staff of the FSA came from the Bank of England and brought with them a more heavy handed regulatory style. The FSA of course had to operate within the limits of its statute and this prevented an excessive civil law orientation.
3. The last point of reference is the US SEC in its heyday. All regulators are more flexible and competent in their youth. As they age, they tend to ossify and lose their brilliance. Since the FSA is in its early days of existence, a comparison with the Douglas or Landis SEC would be appropriate. A comparison across such a long time gap is problematic. Markets have become more complex and therefore there is a case to be made for more complex regulations. Yet, as I read the situation, the SEC of those days was probably smarter and more flexible than the FSA of today. Though the SEC was a product of a civil law era in US administration (the New Deal), Douglas made the SEC the most successful and least civil law oriented of all the New Deal agencies.

I do have an uneasy feeling that both Ajay Shah and I are relying on anecdotal evidence and an intuitive understanding of how the FSA and other regulators function. There is a need for a more rigorous academic evaluation based on measurable and quantifiable parameters.

Posted at 1:45 pm IST on Thu, 20 Jul 2006         permanent link

Categories: law, regulation

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Legal Origins and Modern Stock Markets

Mark Roe has written a fascinating paper at SSRN challenging many of the conclusions of La Porta, Shleifer and others that a common law regime favours the development of stock markets and a civil law regime impedes it.

Roe’s first line of attack is to show empirically that the intensity of labour regulation is a better predictor of financial market development than legal origin. Roe goes on to link this with the devastation that the core civil law countries suffered in the world wars. “Early twentieth century ruin strongly predicts late 20th century financial markets’ strength. It may explain both post-World War II strong labor policy in the devastated nations and the weaknesses of securities markets in the same nations.” Roe has a nice theoretical argument to provide the linkage: “If a nation’s middle class’ financial savings were devastated first by inter-war hyper-inflation and depression and then by war-time destruction of the underlying physical assets, then voters for decades after 1945 could have cared little about financial capital because their well-being was tied more to their human capital. ”

The second line of attack is to deny that modern securities regulation in common law countries has any common law characteristics left anymore. I think Roe is on strong ground here when he says that SEC regulations are more in the civil law tradition than in the common law tradition. People like me who thought that was merit in the common law approach would then have to conclude that the direction in which the SEC has taken securities regulation in the last few decades is a big mistake.

All said, Roe has written a very thought provoking paper

Posted at 8:32 pm IST on Tue, 18 Jul 2006         permanent link

Categories: law

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Accounting Standard Setters Capitulate to Financial Economics

The International Accounting Standards Board and the US Financial Accounting Standards Board have issued preliminary drafts of the first two chapters of their proposed joint Conceptual Framework for Financial Reporting. This available at the FASB web site.

The draft document appears to me to represent the triumph of financial economics over traditional accounting. For example:

• The document describes the principal objective of financial reporting as follows “To help achieve its objective, financial reporting should provide information to help present and potential investors and creditors and others to assess the amounts, timing, and uncertainty of the entity’s future cash inflows and outflows (the entity’s future cash flows). That information is essential in assessing an entity’s ability to generate net cash inflows and thus to provide returns to investors and creditors.” In its subsequent discussion of this issue, the document goes on to say “The Boards’ eventual consideration of those matters might result in a conclusion that adding a discussion of forecasts to the framework would be consistent with the focus on users’ interest in the amounts, timing, and uncertainty of an entity’s future cash flows” This is in sharp contrast to the existing framework document of the IASB which places primacy on “information about the financial position, performance and changes in financial position of an enterprise.”
• The document strengthens the importance of neutrality and completely does away with the notions of ‘conservatism’ and ‘prudence’ in a hard hitting paragraph: “Neutrality is incompatible with conservatism, which implies a bias in financial reporting information. Neutral information does not color the image it communicates to influence behavior in a particular direction. For example, automobiles might be produced with speedometers that indicate a higher speed than the automobile actually is traveling at to influence drivers to obey the speed limit. But those ‘conservative’ speedometers would be unacceptable to drivers who expect them to faithfully represent the speed of the automobile. Conservative or otherwise biased financial reporting information is equally unacceptable.”

Posted at 3:55 pm IST on Mon, 10 Jul 2006         permanent link

Categories: accounting, derivatives

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A First Cut Estimate of the Equity Risk Premium in India

Prof S K Barua and I wrote a paper estimating the equity risk premium in India using data for the last 25 years. We address the shortcomings of existing indices by constructing our own total return index for the 1980s and early 1990s. We use our estimates of the extent of financial repression during this period to construct a series of the risk free rate in India going back to the early 1980s. We find that the equity risk premium is about 8.75% on a geometric mean basis and about 12.50% on an arithmetic mean basis. There is no significant difference between the pre reform and post reform period: the premium has declined marginally on a geometric mean basis and has risen slightly on an arithmetic mean basis. The reason for this divergence between the sub period behaviour of the two means is the increase in the annualized standard deviation of stock market returns from less than 20% in the pre reform period to about 25% in the post reform period. The higher standard deviation depresses the geometric mean in the post reform period.

Posted at 3:14 pm IST on Thu, 29 Jun 2006         permanent link

Categories: CAPM

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Volatility so far has been benign

Yesterday, I wrote an article in the Financial Express saying that volatility in the Indian stock market so far has been benign and there is no need for regulatory intervention. You can also read the story here. The article concludes by saying that:

The volatility that we have witnessed so far has been benign. While there have been large losses, there have been no major defaults or bankruptcies. Risk management systems at the exchanges have held up well. The volatility has been large enough to grab headlines but not large enough to cripple the markets. Volatility on this scale serves to focus attention on the huge fundamental uncertainty that exists. Several years of booming economies and rising asset prices have led to a reduction of risk premiums to the point where risk is probably under priced in many markets. A period of heightened volatility serves as a gentle reminder that prices can go down as well as go up. If this reminder leads to a re-pricing of risk in domestic and global markets, that is also welcome.

Posted at 2:27 pm IST on Tue, 27 Jun 2006         permanent link

Categories: exchanges, risk management

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Partnoy on Rating Agencies

Frank Partnoy has an interesting paper entitled “How And Why Credit Rating Agencies Are Not Like Other Gatekeepers”. I have talked about rating agencies on this blog here and here. Partnoy brings several new insights into this discussion.

• “Before the 1970s, when the Securities and Exchange Commission created the NRSRO designation and various regulations began to depend on NRSRO ratings, credit rating agencies made money by charging subscription fees to investors, not ratings fees to issuers. In contrast, today roughly 90 percent of credit rating agencies’ revenues are from issuer fees.”
• “As of early September 2005, Moody’s market capitalization was more than $15 billion ... Moody’s share price trades at a significantly higher multiple than the typical publicly traded gatekeeper, such as an investment bank.”
• “Although Moody’s might say that it is in the financial publishing business, market participants do not believe it. Moody’s is substantially smaller than the other major financial publishers and generates less revenue than they do, but it has a much higher market capitalization. ... Investors will pay five times more for a dollar of Moody’s revenue than for a dollar of the revenues of Dow Jones or Reuters. Each Moody’s employee is associated with ten times more market value than each Dow Jones or Reuters employee. By virtually any financial measure, Moody’s has a much more valuable franchise than other financial publishing firms and is much too profitable to be considered a financial publisher. If Moody’s were in the same business as financial publishing firms, one would expect these ratios to be close.”

Partnoy also has an extended discussion criticizing the way ratings agencies rate CDOs and argues that CDOs are there only because of rating arbitrage: “Put another way, credit rating agencies are providing the markets with an opportunity to arbitrage the credit rating agencies’ mistakes”. I would not agree with this part of Partnoy’s analysis. The intense competition between the two major rating agencies to produce better CDO rating models would rather suggest that rating arbitrage is a passing phase in a maturing market.

But Partnoy has written a very informative and thought provoking paper on rating agencies. I entirely agree that the time has come to eliminate the regulatory use of ratings completely.

Posted at 6:40 pm IST on Fri, 23 Jun 2006         permanent link

Categories: credit rating, regulation

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Governance of Investment Institutions

Just before my long vacation, I wrote an article for CFO-Connect arguing that the corporate governance problems of the twentieth century are essentially problems of governance at the big investment institutions. These problems meant that shareholder empowerment ceased to be an effective corporate governance weapon. I also argue that I expect this century to be different because of the rise of hedge funds and also improvements in governance at other institutions. If shareholder empowerment works, empowerment and reform of the Board becomes less important than reconnecting the Board to the company. That leads to a different way of looking at Sarbanes-Oxley.

The text of this article as I wrote it is available here. The scanned image of the article as it appeared in print is also available.

This is my first post after a long vacation.

Posted at 11:01 am IST on Thu, 22 Jun 2006         permanent link

Categories: corporate governance, mutual funds

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I am off for six weeks

I am on vacation for about six weeks till early June. I will not be posting on my blog during this period.

Posted at 6:46 pm IST on Mon, 24 Apr 2006         permanent link

Categories: miscellaneous

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Have risk premiums declined?

The IMF’s Global Financial Stability Report, April 2006 has a discussion about risk premiums (Box 1.2) which states

There is a widely held view that investors’ appetite for risk has increased over the past few years, leading to higher prices for risky assets and narrower spreads on credit and other risky products. ... However, the analysis here suggests that investors’ overall attitude toward risk appears not to have changed appreciably

Basically, the IMF says that that while the credit risk premium seems to have declined, there is little change in the equity risk premium. Therefore, on balance, the IMF seems to say there is no evidence of under pricing of risk.

This conclusion is problematic for several reasons. First the evidence on falling risk premium is not based only on a declining credit spread. The term structure spread also has a large risk premium component and this component appears to have declined sharply. Similarly, there is surely some evidence that currency risk premiums have declined. Some observers are even talking of the end of ‘original sin’. So even if we accept the claim regarding stable equity premium, I would think that the score is 3-1 in favour of a decline in premium rather than the 1-1 draw that the IMF seems to portray.

But even the claim regarding the equity risk premium has to be taken with more than a pinch of salt. First, equity risk premiums declined sharply in the late 1990s and even an unchanged premium is still quite low by longer historical standards. Second, the estimate of risk premium is based on the earnings yield without any adjustment for growth. Most discussions on over pricing of equity today emphasize the apparent disconnect between the high growth expectation embedded in current valuation and the low long term interest rate. Thus any discussion of equity risk premium that treats the earnings yield as the return on equity simply misses the point.

Posted at 3:26 pm IST on Thu, 13 Apr 2006         permanent link

Categories: CAPM

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Foreign investment in rupee debt

Ajay Shah has written an interesting piece about what is wrong with India’s policy on foreign debt. His most important point is that India restricts foreign investment in rupee debt while being much more liberal about Indian companies borrowing in foreign currency internationally. I agree with Ajay Shah that this is truly absurd but it is fully explained by the political economy of the situation. The corporate sector usually gets what it wants through intensive lobbying. This happened in East Asia before the crisis and it is happening in India now.

We should work towards getting rid of ‘original sin’ and replacing foreign currency debt with rupee debt. There are though two caveats. First if foreign investors are allowed to hedge currency risk, then the true national exposure may still be that of foreign currency debt if it is an Indian entity that stands on the other side of the hedge. In fact, the effective position of the nation can be that of short term foreign currency debt. This problem is not insurmountable but some thought needs to be given to it.

Second, as Martin Wolf points out, many countries have been able to overcome ‘original sin’ and borrow in their own currencies “once they have persuaded their own citizens to lend to them”. We need a proper government debt market instead of the captive market that we have now.

Posted at 1:55 pm IST on Wed, 5 Apr 2006         permanent link

Categories: bond markets, international finance

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