SEBI trading curbs when promoter fail to dematerialize their holdings

I was interviewed on CNBC TV18 today on the implications of the trading curbs imposed by the Securities and Exchange Board of India (SEBI) on companies whose promoters do not dematerialize all their shares. Even though the deadline is now only 10 days away, many of the largest companies in India including several state owned companies are not in compliance and could therefore face these curbs.

The principal points that I made in the interview were as follows:

• It is necessary to eliminate physical shares completely to deal with the risks of fraud. I argued this point at length in an article that I wrote in January.
• However, the measure introduced by the regulator is highly problematic because it penalizes the company and all its shareholders for a failure on the part of its promoters. The trading curbs reduce the liquidity of shares for innocent shareholders who have already dematerialized their shares.
• The logic of the SEBI measure is presumably that the trading curbs hurt the promoters so much that they would comply with it. I argued that this is incorrect. In a rising market, the trading curbs slow down the rise in the share price of the affected company by slowing down price discovery and making it harder for speculators to buy the stock. This presumably hurts the promoters. But this effect is completely symmetric – in a falling market, the slowing of price discovery supports the stock price. The stock price does not fall as much as it otherwise would because speculators find it difficult to short sell the stock. It is conceivable that some promoters will delay dematerialization precisely to activate the trading curbs.
• It is distressing that the government is not dematerializing its shares in state owned companies. I argue that the Comptroller and Auditor General (CAG) should be worried about the potential for fraud and theft and should insist on dematerialization.
• If neither the regulators nor the promoters blink in this game of chicken, the Indian stock market could be severely affected. Impeding price discovery in a large number of index stocks would create serious problems for the index derivative market as well.
• If the regulator really wants the promoters to fall in line, it is much better to say that physical shares will not be entitled to voting rights or to dividends until they are dematerialized.

The transcript of the interview as well as the video are available at the CNBC web site.

Posted at 10:21 pm IST on Tue, 20 Sep 2011         permanent link

Categories: equity markets

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The UK Finish versus the Swiss Finish

The United Kingdom and Switzerland are the two large economies with global banking systems that are far larger than their own economies. Both of them have been worried about the risks that these outsized banking systems pose to their national solvency. They realize that if their banks were to behave as stupidly as the Icelandic banks did, they could face the same fate as Iceland.

A year ago, a Commission of Experts appointed by the Swiss government produced a report on dealing with “too big to fail” banks. A few days ago, an Independent Commission on Banking appointed by the UK government produced its report on improving stability and competition in UK banking.

Both reports have adopted a similar approach in terms of additional capital requirements. For their largest banks, the Swiss report recommended 19% capital consisting of 10% common equity and 9% contingent capital (CoCos). The UK report asks for 17% capital for a large ring-fenced retail banks and 20% for a large investment bank. Again 10% is equity but the balance can be in any form of debt that has “Primary Loss Absorbing Capacity” (PLAC). It is likely that a big part of the PLAC will be CoCos.

The Swiss finish for large banks kicks in for banks with assets of about 50% of Swiss GDP and the 19% capital level mentioned above is reached for their largest banks which have assets of about 300% of Swiss GDP. The UK requirements kick in for banks with Risk Weighted Assets (RWA) equal to 1% of UK GDP and reach the stated level of 17% for RWA of 3% of UK GDP. If we assume that RWA is about a third of total assets, then the 3% level for RWA would correspond to about 9% of UK GDP for total assets. Since UK GDP is about 4 times Swiss GDP, this would correspond to about 35% of Swiss GDP. In other words, the Swiss proposals are calibrated to catch just their two largest banks (UBS and CS), but the UK proposals are much broader. For universal banks which are essentially investment banks, the capital level of 20% is also marginally higher than the Swiss level of 19%. On balance, the UK is going a little beyond Switzerland.

The UK report would allow foreign owned investment banks to operate in London without being subject to the higher capital requirements applicable to UK banks on the assumption that the UK taxpayer would not have any significant exposure to such institutions. The report is really saying that the UK should make money by renting out office space in London to investment banks that may wreck the taxpayers of their home countries so long as the UK taxpayer is spared. “The fact that some other countries may implicitly subsidise their wholesale/investment banks does not make it sensible for the UK to do so.”

I personally believe that capital levels close to 20% are the right levels. The Rothschilds survived and prospered over two centuries of war and revolution in Europe because they had capital of this level or more (and that too as percentage of total assets and not risk weighted assets). High level of capital did not prevent the Rothschilds from becoming bankers to the world. The Modigliani Miller theorem in capital structure theory assures us that debt is cheaper than equity only because of the tax deductibility of interest. The tax advantage of debt essentially means that levered banks get a subsidy as a percentage of their total debt. If we do want to give tax breaks to the banks, it is better to give it to them as a percentage of assets so that it does not distort capital structure decisions.

The UK proposal goes far beyond the Swiss in another respect – the ring fencing of retail banks. In some respects, it goes beyond even the Glass Steagall Act let alone the Volcker Rule. Ring fenced retail banks are to be prohibited from providing any of the following services:

• any service which is not provided to customers within the European Union (EEA);
• any service which results in an exposure to a non-ring-fenced bank or a non-bank financial organisation, except those associated with the provision of payments services where the regulator has deemed this appropriate;
• any service which would result in a trading book asset;
• any service which would result in a requirement to hold regulatory capital against market risk;
• the purchase or origination of derivatives or other contracts which would result in a requirement to hold regulatory capital against counterparty credit risk; and
• services relating to secondary markets activity including the purchase of loans or securities.

In another sense, the UK proposal is much milder than Glass Steagall. A ring fenced retail bank and an investment bank can be part of the same group provided the retail bank is independently capitalized and can continue to operate normally even if the investment bank fails and is put into liquidation.

I see some merit in this proposal, but I think it is less important than the requirement for higher capital.

Posted at 10:00 pm IST on Thu, 15 Sep 2011         permanent link

Categories: banks, leverage, regulation

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Credit, money and sociopaths

Early in my career, I read Homer and Sylla’s A History of Interest Rates and learned that credit predates money and probably predates barter. As a finance professor I was thrilled to read a top notch economic historian like Richard Sylla say that finance predates economics: barter is economics, even money is economics, but credit is quintessential finance. No wonder that decades later I still love this book. In a blog post last year, I recommended Homer and Sylla as the one book on financial history that we should all read.

Of course, I did worry whether Homer and Sylla were right or were merely making a casual remark, but the other books that I read (for example, Polanyi, Trade and Markets in the Early Empires) confirmed the primacy of credit over money and barter. In the anthropological and sociological literature, there appeared to be a consensus on this issue.

So long as this account was confined to obscure books read only by a technical audience, there was no great controversy about it. But then, David Graeber wrote a book entitled Debt: The First 5,000 Years and more importantly talked about it in the widely followed economics blog Naked Capitalism. Austrian economists in particular were very upset with him and criticized him only to climb down subsequently. In his latest post at Naked Capitalism, Graeber provides a detailed description of how credit was transformed into money.

The post is worth reading in full especially the passage where Graeber writes that “Homo Oeconomicus ... is ... an almost impossibly boring person—basically, a monomaniacal sociopath who can wander through an orgy thinking only about marginal rates of return”. I entirely agree with this but in a way very different from what Graeber intends. The only way to succeed in finance is to assume that the other person is a monomaniacal sociopath; and that is true whether you are doing high frequency trading or negotiating with the people who borrowed your money years ago but are unwilling to repay it now. As for orgies, anybody who has seen a trading room (or read about it in books like Liar’s Poker) knows that such minor distractions do not impede the true sociopath’s ability to concentrate on making as much money as possible off the other person.

Posted at 7:37 pm IST on Tue, 13 Sep 2011         permanent link

Categories: behavioural finance, interesting books

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Importance of Financial Markets

After the global financial crisis, many people started thinking that financial markets are evil. So it is nice to see several papers in quick succession arguing that financial markets are more important than banks.

Asli Demirguc-Kunt, Erik Feyen, and Ross Levine presented a paper at a World Bank conference in June entitled “Optimal Financial Structures and Development: The Evolving Importance of Banks and Markets”. They present strong empirical evidence to show that as countries grow richer and become more sophisticated, they need markets more than banks. The optimal financial structure becomes more market based at higher levels of income. Deviations from this optimal structure lead to slower growth.

This month, Julien Allard and Rodolphe Blavy published an IMF working paper entitled “Market Phoenixes and Banking Ducks: Are Recoveries Faster in Market-Based Economies?” in which they argue that “market-based economies experience significantly and durably stronger rebounds than the bank-based ones” They go on to state that “because the financial structure of economies matters, structural policies to deepen financial markets so that they can effectively complement banking sectors are useful. This suggests that policies that would stifle the development of financial markets after the crisis would be misguided.” Of course, Allard and Blavy also emphasize that policy makers must enhance the stability of financial markets as well as reduce rigidities in the real economy.

Closed related is a paper by Stephen Cecchetti, M S Mohanty and Fabrizio Zampolli presented at the Jackson Hole Symposium late last month entitled “The real effects of debt”. Cechetti et al argue that “At moderate levels, debt improves welfare and can enhance growth. But high levels can be damaging.” For example, when corporate debt goes beyond 90% of GDP, it becomes a drag on growth. This appears to me to suggest that deepening of equity markets is more important than the development of banks beyond a certain stage of development.

Posted at 9:21 pm IST on Tue, 6 Sep 2011         permanent link

Categories: banks

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Can too much capital be risky?

An IMF working paper by Perotti, Ratnovski and Vlahu (PRV) published earlier this month argues that higher bank capital may not only fail to reduce risk taking, but may have an unintended effect of enabling banks to take more tail risk without the fear of breaching the minimal capital ratio in non-tail risky project realizations. PRV argue that the traditional minimum capital requirement must be supplemented with a maximum capital requirement (realistically, in the form of special attention devoted to banks with particularly high capital) in order to assure that they are not taking tail risk.

The key driver of this result is that, in the PRV model, banks choose between a relatively safe investment and a risky project which has both tail risk and non tail risk. Even though tail risk can be passed on to the government through explicit and implicit bail out, the non tail risk is borne by the bank. Banks facing high levels of non tail risk would rationally hold higher capital to protect themselves from the corrective actions imposed by the regulators when minimum capital levels are breached. In the PRV model, this high level of capital tells the regulator that the bank is bearing a large amount of tail risk as well.

In reality, banks can choose not only between safe assets and risky assets, but also between tail risk and non tail risk. For example, a bank which lends against a residential mortgage bears a significant amount of non tail risk and experiences volatility in earnings requiring capital even in normal situations. As against that, consider a bank that provides liquidity support to a special investment vehicle (SIV) that borrows short term and invests in senior and super senior tranches of a mortgage securitization. In normal times, the SIV earns a nice carry with virtually no risk because the senior tranches are unlikely to default except in systemic crisis events. However, the SIV faces catastrophic tail risk because of the high leverage. The liquidity support provided by the bank to the SIV transfers this tail risk to the bank. In normal times, the SIV produces no losses at all, and the bank produces smooth and predictable earnings with negligible losses. In times of systemic distress, the bank would take large losses, but the bank would rely on a tax payer bail out for coping with this tail risk. A rational bank would therefore set aside negligible capital for its SIV exposure because its non tail risk is low.

By setting up a model in which tail risk and non tail risk are embedded in the same project, the PRV paper does not capture the true risk profile of too big to fail (TBTF) banks that manufacture tail risk to monetize their TBTF status.

Posted at 5:21 pm IST on Wed, 31 Aug 2011         permanent link

Categories: leverage, risk management

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Safe assets as Giffen goods

Updated: corrected reference to absolute risk aversion instead of relative risk aversion and added a reference for the usage of the term return free risk.

The increased demand for US Treasuries after their credit rating was downgraded led some analysts to ask whether these assets are Giffen goods. The classic example of Giffen goods are staple foods like bread or potatoes where a rise in price depletes the spending power of the poor so much that they are no longer able to afford meat or other expensive food and are forced to consume more of the cheaper food. This means that the demand rises as the price rises – the income effect increases the demand of the inferior good so much that it outweighs the substitution effect of the higher price.

Can this happen with investment assets? For an investor trying to protect her capital, a rise in risk (without any change in the rate of return) of the safest asset is effectively an increase in the price of capital preservation. The idea is that a rise in risk of the safe asset consumes so much of the risk budget of the investor that she can no longer afford too much of the riskier asset. She therefore is forced to shift more of her portfolio into the safer asset. At a qualitative level, the story sounds plausible.

For a more rigorous analysis consider a portfolio choice model with two uncorrelated assets which we shall call the safer asset and the riskier asset. The following results can then be proved:

1. In a pure mean-variance optimization framework, the safer asset can never be a Giffen good. An investor who had a positive allocation to the safer asset will reduce his allocation if its risk rises.
2. In a more general expected utility setting, the safer asset can be a Giffen good. An investor who had a positive allocation to the safer asset could under certain conditions allocate even more to that asset when its risk rises.

I have written up a complete mathematical demonstration of the mean variance result for those who are interested. The intuitive reason for this result is actually quite simple. In a mean variance framework, the optimal portfolio consists of two components (a) the minimum variance portfolio which minimizes risk without any regard for return, and (b) a zero investment purely speculative portfolio of long positions in high return assets financed by short positions in low return assets. The allocation to the speculative portfolio is proportional to the risk tolerance (reciprocal of the Arrow Pratt measure of relative risk aversion) of the investor. An investor with zero risk tolerance holds only the minimum variance portfolio. As the risk tolerance increases, the investor blends the minimum variance portfolio with more and more of the speculative portfolio.

Now if the risk of the safer asset rises, its weight in the minimum variance portfolio necessarily declines. The weights of the two uncorrelated assets in the minimum variance portfolio are proportional to the reciprocals of the variances of the two assets and so a rise in variances reduces the weight.

So an investor with zero risk tolerance will necessarily reduce his holding of the safer asset when its risk increases. What about other investors? What will happen to the short positions that they hold in the safer assets through the speculative portfolio? Increasing the risk of the safer asset makes this short position riskier and all risk averse investors will therefore reduce this position by buying the safer asset. The question is whether this can outweigh the sale of the safer asset via the minimum variance portfolio?

Clearly this can happen if and only if the risk tolerance is very high. We can show that at such high levels of risk tolerance, the initial total position in the asset would have been short. Such an investor is not increasing his long position; he is only reducing his short position. This is not a Giffen good situation at all. Moreover, with short sale restrictions, the initial position in the safer asset would have been zero and it would just remain zero.

So in a mean variance framework, the safe asset is never a Giffen good. As one thinks about it, this result is being driven by the fact that in this framework, the risk aversion is being held constant in the form of a fixed tradeoff between risk and return. This does not allow the income effect to play itself out fully. The principal mechanism for a Giffen phenomenon is likely to be a rapid rise in risk aversion as wealth declines.

So I shift to an explicit expected utility framework using a logarithmic utility function with a fixed subsistence level: U(x) = log(x – s). This functional form is characterized by rapidly increasing risk aversion as the subsistence level s is approached. I consider an up state and a down state for the terminal value of the safe asset u₁ and d₁ with probabilities p₁ and q₁=1 – p₁ respectively. Independently of this, the riskier asset also has two states u₂ and d₂ with probabilities p₂ and q₂=1 – p₂ respectively. The investor invests w₁ in the safer asset and w₂ = 1 – w₁ in the riskier asset. Expected utility is therefore given by:

p₁p₂ log(w₁u₁+ w₂u₂ – s) +p₁q₂ log(w₁u₁+ w₂d₂ – s) +q₁p₂ log(w₁d₁ +w₂u₁ – s) +q₁q₂ log(w₁d₁+ w₂d₂ – s)

The optimal asset allocation is determined by maximizing this expression with respect to w₁. I did this numerically using this R script for specific numerical values of the various parameters. Specifically, I set:

s = 0.8, u₁ = 1.01, d₁ = 0.99, u₂ = 5.00, d₂ = 0.70, p₁ = p₂ = 0.50.

In keeping with the spirit of the times, the expected return on the safer asset is zero – instead of a risk free return, it represents return free risk. For these parameters, the weight in the safer asset is 81%. If we now reduce d₁ to 0.90 (increasing the risk and reducing the return of the safer asset), the weight in the safer asset rises to 82%. Alternatively, if we change d₁ to 0.85 and u₁ to 1.15 (increasing the risk and leaving the return unchanged), the weight in the safer asset rises to 85%. The absolute risk aversion in the low wealth scenario rises from 7.4 when d₁ = 0.99 to 15.7 when d₁ = 0.90 and even further to 37.3 when d₁ = 0.85. This is what drives the higher allocation to the safe asset. The safer asset is truly a Giffen good.

Posted at 9:01 am IST on Mon, 29 Aug 2011         permanent link

Categories: bond markets

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More on Law, Madoff, Fairness and Interest Rates

Last year, I blogged about a US bankruptcy court ruling which said that the net claim that a Madoff investor could make in court was for the total of all amounts invested less all amounts withdrawn. Somebody who invested $10 million in 1988 and withdrew $10 million in 2007 would be deemed to have got back his investment and would have no claims in the bankruptcy court. This ruling completely ignores the time value of money.

Grant Christensen, has written a detailed paper explaining the legal position regarding allocating losses in securities frauds, particularly Ponzi schemes like Madoff. Apparently, the bankruptcy courts “have a great deal of leeway when it comes to ratifying different methods to determine loss and allocate assets.” While the net investment method used by the court in the Madoff case is the most popular method, it is not the only method that is legally sustainable. The rescission and restitution method subtracts only the withdrawal of principal and does not subtract any interest or dividend that was withdrawn. Apparently, “appellate courts have expressed a clear preference for the rescission and restitution method over the net investment approach.”

Quite frankly, I have not been able to understand the mechanics of the various methods discussed in the Christensen paper. The economic difference, if any, between the rescission and restitution method (from civil law) and the loss to the losing victim method (based on criminal law) is not explained at all. The paper focuses on the legal foundations for various methods. I do know that some of the readers of my blog are lawyers and if they can throw light on this in the comments, that would be most helpful.

From what I have been able to understand, the alternative methods are based on accounting definitions of interest and principal. These would then be based on the promised rate of return which would be unrealistically high. Finance theory would suggest that the rate of return on a risk free asset (or a low risk asset) might be more appropriate. Alternatively, the average return earned by the Ponzi operator on the actual invested assets could be considered. For a successful Ponzi scheme, the cash inflows from new investors would exceed the cash outflows to withdrawing investors. This surplus cash would hopefully earn some return and this realized rate of return could be used as the discount rate.

Posted at 3:51 pm IST on Mon, 22 Aug 2011         permanent link

Categories: bankruptcy, fraud, law

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HKEx Clearing House Risk Management Reforms

Last month, the Hong Kong Exchanges and Clearing Limited (HKEx) released a 73 page consultation paper on risk management reforms at the clearing house. Now, HKEx is nobody’s idea of best practices in risk management – this was after all the clearing house that needed a government bail out after the crash of 1987. Even today, the cash equities market of HKEx collects only mark to market margins and not initial margins – only the futures market collects initial margins. But, the HKEx consultation paper goes far beyond what most other exchanges have done and provides much needed transparency on the issue of clearing corporation risk management.

I have long argued that the international standards (the CPSS-IOSCO Recommendations for Central Counterparties, 2004) issued jointly by the BIS Committee on Payment Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) are woefully inadequate. They only allow even the worst run clearing houses to claim to be compliant with global standards. Even the consultative report issued by CPSS-IOSCO earlier this year still falls well short of what is needed for such a systemically important entity as a clearing house.

What HKEx has done is to (a) explain (and strengthen) its stress testing procedures, (b) publicly admit that its guarantee fund is inadequate and (c) set out the process by which this guarantee fund will be built up to acceptable levels.

HKEx also states clearly that while some exchanges treat “margins” as a pooled resource, HKEx does not want to go down that path. It wants only the contributions to the guarantee fund to operate as a pooled resource. In other words, in case of a default, the exchange will have access to the margins of the defaulting member and the guarantee fund contributions of both defaulting and non defaulting members, but not the margins of the non defaulting members. Some exchanges are permitted under their bylaws to use even the margins of the non defaulting members. I believe that the HKEx is right in taking this “non-pooled upfront margin + pooled default fund” approach. In practice, if an exchange taps the margins of the non defaulting members, the market place would regard it as a default by the clearing house regardless of what the bylaws might say.

In conformity with Hong Kong’s well known plutocratic traditions, HKEx proposes:

To ensure long term sustainability and scalability of funding to support these changes and to mitigate any higher funding requirements for CPs that may detract from the markets’ competitiveness, we are keen to work with the HKSAR Government and the regulator in establishing a RMF which is funded by the SFC, HKEx and the market in equal proportion. The model is based on the principle that all key stakeholders, including the market players, the CCP and the regulator will support the stability of the securities and derivatives markets.

While reformers are struggling to avoid having to bail out the finance industry when things go badly wrong, HKEx is seeking a bailout in advance. We can see very clearly the moral hazard created by the 1987 bail out of HKEx.

Posted at 6:19 pm IST on Sun, 7 Aug 2011         permanent link

Categories: derivatives, exchanges, risk management

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Two curves and non deliverable interest rate swaps

I have blogged about the importance of two curve discounting in valuation of swaps (here and here), and I have separately blogged (here, here, here and here) about the growing offshore market in rupees and other emerging Asian currencies. But it was an alert reader of the blog who pointed out to me a very interesting connection between the two. The instrument that lies at this intersection is the non deliverable interest rate swap (NDIRS). This is like the non deliverable forward (NDF) market in that it is cash settled in US dollars and operates out of reach of the local regulators. But the underlying product is an interest rate swap rather than a forward contract. The two parties agree to exchange a floating interest rate for a fixed interest rate in rupees or renminbi or other emerging market currency. However, the contract is non deliverable and is therefore cash settled in US dollars without any cash flows in the underlying currency.

The issue is about valuation of the swap and the complexity arises because in India and in many other emerging markets, the OTC derivative market runs without collateralisation. As I explained in my earlier blog post, this means that the valuation depends on the funding cost of the counter parties involved. The problem affects the valuation of the swap even at inception (particularly when the yield curves are quite steep), but the problem is most acute and clearly understood for a swap which has moved into or out of the money some time after inception.

For example, consider a hedge fund that entered into a five year swap agreeing to pay a fixed rate of 5.25% and received floating. After some time, suppose that the swap rate has moved to 5.75%. The hedge fund can now lock in a risk free profit of 0.50% per year for the next five years by entering into another swap in which it receives fixed at today’s rate (5.75%) and pays floating. The net effect of the old swap and the new swap is that the floating legs cancel and the hedge fund simply receives 0.5% fixed for the next five years. The question that arises is what should the hedge fund receive if it wants to unwind the two offsetting swaps and simply pocket the entire profit upfront instead of letting the profit trickle in over five years.

The simple and obvious answer of course is that the hedge fund should receive the present value of the annuity of 0.50% a year. The tricky part is to agree on the discount rate for determining this present value. If the hedge fund goes to a local bank that funds itself largely in the onshore market, the answer would clearly be a discount rate based on the onshore interest rates. On the other hand, if the hedge fund goes to a foreign bank that funds itself largely in the offshore market (borrowing US dollars and swapping into rupees or renminbi), then the discount rate would be based on the all-in (swapped) cost of the offshore borrowing. This latter cost of funds is given by the cross currency swap rates (where a US dollar floating rate is swapped for fixed rate in rupees or renminbi).

In countries with capital account convertibility, there is not too much of a difference between the onshore swap yield curve and the cross currency swap curve because of covered interest parity (CIP). But CIP is clearly not applicable to rupees and renminbi! The cross currency swap rate for currencies like renminbi can actually be negative because of the wall of money wanting to speculate on the appreciation of the currency. Even if things do not get that bad, the gap between the two curves can be several percentage points. Swap valuation using the cross currency swap rate is a form of two curve discounting – the forward rates come from the onshore swap market and the discount rates come from the cross currency swap market.

Smart hedge funds know all about this and choose the banks carefully when unwinding trades. It would clearly like a low discount rate when unwinding a winning trade and a high discount rate when unwinding a losing trade. A bank that watches the hedge fund do this probably feels frustrated, but in fact, the bank is not being cheated at all as the unwind is done at the rate offered by the bank. What the hedge fund is doing is to arbitrage between the onshore and offshore markets with their different interest rates.

All this assumes that the banks are smart and know what their funding costs are. While this may be true of the most sophisticated banks, it is certainly not true for all banks. Some banks may also not be fully clear about the difference between average cost of funds and marginal cost of funds. A foreign bank that funds 90% of its rupee balance sheet in local currency deposits and borrowing may think that its cost of funds is the onshore rate. But if it depends on offshore borrowing for the incremental growth of the balance sheet, it may still be true that its marginal cost of funds (which is all that is relevant for valuation and pricing) is actually the offshore rate. Some banks surely get this wrong.

The lesson in all of this is that the non deliverable market is quite a big mess and there is plenty of scope for supplanting this to a great extent with an onshore cash settled exchange traded currency derivative and interest rate derivative market. Without compromising on capital controls, these exchange traded markets would improve transparency and would move the market (and associated high paying jobs) onshore.

Posted at 7:55 pm IST on Sun, 24 Jul 2011         permanent link

Categories: bond markets, derivatives, post crisis finance, risk management

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Indian uncollateralised derivative markets

An article by Christopher Whittall in the International Financing Review (IFR) about the difficulties in valuing uncollateralised derivatives is of great relevance to Indian OTC swap markets. Christopher Whittall explains in his article that “Unsecured trades now present a serious valuation headache”. FT Alphaville follows up on this story and highlights the problem: “... pricing even the most basic (uncollateralised) swaps is now very complex. ... traders just flat refuse to enter into any detail about how they price uncollateralised derivatives nowadays — hardly a positive thing for a market that is regularly accused of being like a black box. ”.

Over the last few years, the two curve discounting model which discounts cash flows using the OIS curve (see my blog post of last year) has emerged as the market standard for valuing collateralised swaps. This technique is not applicable for uncollateralised swaps, and in fact there is no “market” valuation for these swaps because the value depends on the cost of funds of the two parties via the Credit Value Adjustment (CVA) and Debt Value Adjustment (DVA).

Deus ex Machiatto puts the matter succinctly:

A vanilla derivative is a collateralized one under the standard CSA these days (cash collateral in the same currency, daily MTM, daily margin). Anything else is exotic, because it involves an exotic collateral option.

All this is important for Indian OTC swap markets because the market runs largely without collateralisation. While these swap deals are governed by the standard ISDA (International Swaps and Derivatives Association) documentation, most Indian banks do not sign the Credit Support Annex (CSA) that deals with collateralisation. We have tended not to worry too much about the Indian OTC swap market because it is dominated by plain vanilla interest rate swaps. What Whittal and Deus ex Machiatto are saying is that this view is incorrect. Effectively, these are all exotic derivatives because of the lack of collateralisation. I believe that this is correct and the matter needs urgent regulatory attention.

There are three main ways to set things right:

• Indian OTC markets can move towards collateralised swaps. This is simple as it only requires Indian banks to sign the CSA under standard ISDA documentation.
• We can move one step further towards the post crisis global regulatory consensus and adopt central clearing of the OTC swaps. The Clearing Corporation of India (CCIL) already has the ability to clear OTC derivatives. Of course, moving more risks into CCIL would make it even more systemically important than it already is, and regulators would need to be extra vigilant about this concentrated risk.
• The most radical solution is to move more of the markets towards exchange trading and clearing. There is a great deal of experience with this both in the equity markets and in currency futures and there is the added benefit of price and trade transparency.

I believe that it is necessary to move quickly along one or more of these alternative paths to mitigate the risks in this market.

Posted at 1:31 pm IST on Fri, 15 Jul 2011         permanent link

Categories: bond markets, derivatives, risk management

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The Formula That Killed Wall Street is Alive and Well

The Gaussian Copula which used to be the standard model for valuing CDOs has been described as the The Formula That Killed Wall Street. After the crisis, several alternatives to the Gaussian copula have become popular for CDO valuation.

But there are many other areas where Gaussian copulas still hold sway. Last month, the Basle Committee on Banking Supervision published Operational Risk Supervisory Guidelines for the Advanced Measurement Approaches. The paper notes that the most common method of dealing with dependence in modelling operational risk is by use of copulas; and “Of the banks using Copulas, most (83%) use a Gaussian copula.” In addition about 17% of banks, used a correlation matrix which is even worse than a Gaussian copula.

Faced with this clearly unsatisfactory situation, the BCBS pushes back against this in the mildest possible way:

Assumptions regarding dependence should be conservative given the uncertainties surrounding dependence modelling for operational risk. Consequently, the dependence structures considered should not be limited to those based on Normal or Normal-like (eg T- Student distributions with many degrees of freedom) distributions, as normality may underestimate the amount of dependence between tail events. (para 229)

Not only is the Gaussian copula alive and well, the regulators do not seem to feel any sense of urgency in changing this state of affairs.

Posted at 10:26 pm IST on Sat, 9 Jul 2011         permanent link

Categories: derivatives, mathematics, risk management, statistics

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The political economy of selling gold reserves

For those of us in India who lived through the economic crisis of 1991, one of the images seared into our memory is that of the plane taking off from Mumbai to London filled with gold to be pledged for an emergency loan. This helped create a broad consensus among politicians and bureaucrats to do whatever it takes to solve the crisis and bring back the gold. Almost two decades later, that episode still influences the thinking of policymakers. I believe that it played some role in the government's decision last year to buy some gold in the IMF gold auction.

Similarly, one of the enduring images of the Asian crisis of 1997 is that of Korean citizens depositing their gold with the government so that the country could pledge this gold for badly needed loans. The Korean people took ownership of the problem and became determined to overcome the crisis.

I was reminded of all this when I read an article in Time (originally published in Die Welt) pointing out that both Greece and Portugal are sitting on billions of dollars of gold reserves even while they are being bailed out by the EU and the IMF.

It appears to me that when countries receive help before they have exhausted their own resources, the moral hazard is exacerbated. Moreover, commitment to painful reforms is likely to be very weak. During the Asian crisis, the IMF was accused of being too harsh. The reality is that while the IMF medicine was bitter (in a few cases, unnecessarily so), it was successful in creating dynamic economies that could put the crisis behind them.

Responding to the criticism that it was subjected to after the Asian crisis, the IMF seems to have turned from a purveyor of bitter medicine to a dispenser of sugar coated placebos. The EU is even less willing to take any harsh action. This is most unfortunate, and I believe years from now, peripheral Europe would wish that they had a sterner taskmaster.

Posted at 1:07 pm IST on Thu, 7 Jul 2011         permanent link

Categories: gold, risk management

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Banking index option spreads during the crisis

Kelly, Lustig and Nieuwerburgh have written an NBER Working Paper (Bryan T. Kelly, Hanno Lustig, Stijn Van Nieuwerburgh, “Too-Systemic-To-Fail: What Option Markets Imply About Sector-wide Government Guarantees”, NBER Working Paper No. 17149, June 2011) explaining banking index option spreads during the global financial crisis in terms of the effect of sector-wide government guarantees:

Investors in option markets price in a collective government bailout guarantee in the financial sector, which puts a floor on the equity value of the financial sector as a whole, but not on the value of the individual firms. The guarantee makes put options on the financial sector index cheap relative to put options on its member banks. The basket-index put spread rises fourfold from 0.8 cents per dollar insured before the financial crisis to 3.8 cents during the crisis for deep out-of-the-money options. The spread peaks at 12.5 cents per dollar, or 70% of the value of the index put. The rise in the put spread cannot be attributed to an increase in idiosyncratic risk because the correlation of stock returns increased during the crisis.

I am not convinced about this because the “No more Lehmans” policy implied a guarantee on individual firms and not merely on the sector as a whole. I propose an alternative explanation for the counter intuitive movement of the index spread based on the idea that the market knew the approximate scale of subprime losses but did not know which banks would take those losses. What securitization had done was to spread the risk across the whole world and nobody knew where the risk had ultimately come to rest. However, the total amount of the toxic securities could be estimated and the ABX index provided a market price for what the average losses would be on these securities. In the macabre language that was popular then, the market knew how many murders had taken place, but did not know where the bodies were buried. The interesting implication of this model is that when a “body” (large loss) turns up in one place (bank X), that immediately reduces the chance that a “body” would turn up elsewhere (bank Y) because there were only a fixed number of “bodies” to discover. The fact that bank X has a huge loss reduces the losses that other banks are likely to suffer because the total scale of losses is known.

A simple numerical example using the Black Scholes model would illustrate the application of this idea to the basket-index put spread. I consider a banking sector with only two stocks A and B each of which is trading at 100. Assuming equal number of shares outstanding, the index is also 100. Consider a put option with a strike of 85 with a volatility of 20% and for simplicity an interest rate of 0 (we are in a ZIRP world!). The put option on each of the two stocks is priced at 2.16 by the Black Scholes formula. Since the two stocks are identical the price of a basket of options (half an option each on each of the two stocks) is also 2.16. To value the index put at the same strike, assume that the correlation between the two stocks is 0.50. The standard formula for the variance of a sum implies an index volatility of 17.32% and using a lognormal approximation and the Black Scholes model, the index option is priced at 1.49. The basket-index put spread is 2.16 - 1.49 = 0.67.

Consider now the crisis situation and assume that the correlation rises to 0.60 but nothing else changes. The stock option prices are unchanged, but the higher correlation raises the index volatility to 17.89% and the index put is now worth 1.63. The basket-index put spread declines to 0.53. During the crisis the actual data shows that the spread rose instead of declining as correlations rose. This is the puzzle that Kelly et al are trying to solve.

I now solve the same puzzle using the “where are the bodies buried” model. In this framework, the simple Black Scholes diffusion is supplemented by a jump risk representing the risk that a “body” would be discovered in one of the banks. Assume for simplicity that there is only “body” to be discovered and that the discovery of that “body” would reduce the value of the affected stock by 25%. As far as the index is concerned, there is no uncertainty at all. One of the stocks goes to 75 and the other remains at 100 (though we do not know which stock would be at which price) and so the index drops to 0.50 x 75 + 0.50 x 100 = 87.50. Assuming the same correlation (0.6) and volatility as before the index put option price rises from 1.63 to 4.98 because the put option is now much closer to the money.

As far as either of the two stocks is concerned, the position is more complicated. There is a 50% chance that a “body” turns up at that bank in which case the stock would trade at 75; there is also a 50% chance that there is no “body” in that bank in which case its stock should trade at 100. Let us make the reasonable assumption that the 50% objective probability is also the risk neutral probability. Before we know where the “body” is buried, the stock price of either bank would be 0.50 x 75 + 0.50 x 100 = 87.50. Note the interesting negative dependence in the tail, if a “body” is discovered in one bank, its price would fall from 87.50 to 75, but the price of the other bank would rise from 87.50 to 100.00 because it is now clear that there is no “body” there.

Option valuation in this situation can no longer use Black Scholes because of the jump risk. Adapting the basic idea of the Merton jump model, we can value this put as follows. If the stock price jumps to 100, the Black Scholes put option price would be 2.16 as computed earlier. But if the price jumps to 75, the Black Scholes put price rises dramatically to 12.58 (the put is now actually in the money). Since the risk neutral probabilities of these two events are 50%, the value of the stock option (before we know where the “body” is buried) is 0.50 x 2.61 + 0.50 x 12.58 = 7.37. The basket-index put spread is now 7.37 - 4.98 = 2.39.

The “where are the bodies buried” model produces a rise in the basket-index put spread from 0.67 to 2.39 without any government guarantees at all. At the same time, the basket-index call option spread shows very little change – this is what Kelly et al found in the actual data as well.

We can elaborate and complicate this basic model in many ways. Of course, there can be more than two banks, they may be of different sizes, there may be more than one “body” to be discovered, the number of “bodies” may be uncertain, the effect of a “body” on the stock price may also be uncertain (random jump size). None of this would change the essential feature of the model – a negative tail dependence between the various bank stock prices.

The key purpose of the model is to demonstrate the pitfalls of using correlation to measure dependence relationships when it comes to tail risk. The dependence in the middle of the distribution (the diffusion process) can be large, positive and rising while the dependence in the left tail is becoming sharply negative. This is the phenomenon that Kelly et al seem to be ignoring completely.

Posted at 7:32 pm IST on Tue, 28 Jun 2011         permanent link

Categories: derivatives, regulation

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Sending internet banking passwords by mail

I have observed banks in India use several different ways to send internet banking passwords to their customers, but from a security point of view all these methods are totally unsatisfactory:

• Some banks send the username and password in two separate envelopes by ordinary mail usually with a time gap of a couple of days. The mailer is so designed that the password cannot be read (at least by the naked eye) without tearing it open. The only security here is that even if one of the envelopes is stolen or tampered with, the account is not compromised. Customers love this method because it is the most hassle free and simple mechanism. Banks like this because it allows them to centralize password issuance at a central location where it is easier to control operational risk. Moreover, because of centralization, it is possible to generate and print passwords only as needed. Since printed passwords do not have to be stored for long periods, the risk of their being compromised by insiders is reduced. However, this method of password dissemination also poses the biggest security risk at the customer end. Any person staying in the same house has the opportunity to take possession of both the username and the password; the account is then completely compromised.
• A less common variant of the above method is one where the bank requires the customer to send a signed acknowledgement of having received the password before activating the internet banking facility. This is a powerful security measure, but to make the process more convenient, these banks typically allow the acknowledgement to be sent by fax or email (scanned image). This makes the method useless because it is quite trivial to scan a signature from some other document and superimpose it on the scanned image of the acknowledgement form.
• Some banks (particularly public sector banks) require the customer to come to the bank in person to collect the username and password. Customers (especially the younger generation to whom a bank means an ATM and not a branch) hate this because they are today accustomed to getting everything sitting at home. The direct security risk is low in this method, but there are severe operational risks. Thousands of envelopes containing usernames and passwords are stored for long periods of time in hundreds of branches across the country. If even one pair (of usernames and passwords) is compromised, a rogue employee might be able to arrange matters in such a way as to assign this pair to a vulnerable account (an account with a large balance that is monitored infrequently). Moreover general bank staff in the branches are not particularly sensitive to password security. Sharing of password between different staff members is quite rampant in many branches and there is often a culture of not taking security precautions seriously. Some bank staff are themselves not aware of the nuances of internet banking and often give wrong instructions to customers. All of these increase security risks.

Many people think that these security risks are trivial and unavoidable. Subconsciously, they think that the bank must anyway store the password somewhere to verify the password that the user types in. But this is wrong. Computers never store user passwords at all – at least they are not supposed to do so. What is stored is a secure cryptographic hash of the password from which the password cannot be recovered with any reasonable amount of computational effort. When a user tries to log in, what happens is that the computer applies the same secure cryptographic hash to the password that the user typed in. If this hash matches the stored password hash, the computer accepts the password as correct and carefully erases (from its own memory) the password that it just read in from the user. Good software programmers are so paranoid about this that before they read the password that a user is typing in, they take care to lock the memory location into RAM (for example, by using mlock in unix) so that during the few milliseconds that the plain text password exists in the computer’s memory, this password is not accidentally written to the hard disk when the operating system manages its virtual memory.

Looking at things with this background, it appears to me that any system in which a password exists in plain text printed form even for a few minutes (let alone several days) is an unacceptable and intolerable level of security risk.

There is also a very simple solution to the problem. The most secure way of sending a password to the customer is not to send the password at all! This requires that the bank should not generate the password in the first place. If the user generates the password, then there is no need to send the password to him at all. This thought occurred to me when I was examining the process of applying for a PAN number online (A similar process is used for online filing of income tax returns also.). This process addresses the same problem that the bank faces – a PAN number cannot be allotted without receiving signed documents in physical form:

1. The applicant fills the form online and submits the form.
2. The system displays an acknowledgement which contains a unique 15-digit acknowledgement number.
3. The applicant prints the acknowledgement, affixes the photograph, signs it, attaches relevant documents and mails it to the PAN Service Unit.
4. At the PAN Service Unit, the 15-digit acknowledgement number provides the link between the physical records and the online application to enable processing of the application.

This process can be adapted to the internet banking password problem as follows. The customer applies for internet banking online and chooses a password. As usual, the system stores a a secure cryptographic hash of the password but does not enable the online banking facility at this stage. The system generates an acknowledgement number and lets the customer print out an application form which includes this acknowledgement number. The customer mails this form duly signed to the bank. After the bank verifies the signature and other documents, it simply enables the password that the user has already generated. At all times, this password is known only to the user; neither does the bank records this password on paper nor does it store the password electronically in plain text.

Posted at 2:23 pm IST on Fri, 24 Jun 2011         permanent link

Categories: fraud, technology

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Cryptic RBI announcement on banknote numbering

The Reserve Bank of India issued a cryptic press release yesterday saying:

With a view to enhancing operational efficiency and cost effectiveness in banknote printing at banknote presses, it has been decided to issue, to begin with, fresh banknotes of Rs 500 denomination in packets, which may not necessarily all be sequentially numbered. This is consistent with international best practices. Packets of Banknotes in non-sequential number will, as usual, have 100 notes. The bands of the packets containing the banknotes in non-sequential number will clearly be superscribed with the legend, “The packet contains 100 notes not numbered sequentially.”

The confusion comes from the three phrases “enhancing operational efficiency and cost effectiveness in banknote printing”, “to begin with”, and “international best practices” each of which gives a different idea of what this is all about. My very limited understanding of the subject is that there are three reasons for non sequential numbering of currency notes:

1. The most important and best known is the checksum or security reason seen principally in euro banknotes. The euro banknote contains a checksum and therefore every packet of freshly printed notes is non sequentially numbered – ignoring the factors below, consecutive notes in a packet are nine numbers apart: Z10708476264 would be followed by Z10708476273. This would truly be consistent with “international best practices”, but this can be ruled out because the press release clearly says that only some packets will have non sequential numbers.
2. The second is the replacement note reason which arises when there are defects while printing a sheet of notes. The defective note is removed and is replaced with a replacement note which usually has a different number in a totally separate replacement note series (for example, star series in India). This is ruled out because it would not be consistent with the phrase “to begin with”. Star series notes were introduced in India five years ago. The annual policy statement for 2006-07 stated:

   Currently, all fresh banknote packets issued by the Reserve Bank contain one hundred serially numbered banknotes. In a serially numbered packet, banknotes with any defect detected at the printing stage are replaced at the presses by banknotes carrying the same number in order to maintain the sequence. As part of the Reserve Bank’s ongoing efforts to benchmark its procedures against international best practices, as also for greater efficiency and cost effectiveness, it is proposed to adopt the STAR series numbering system for replacement of defectively printed banknotes. A ‘star series’ banknote will have an additional character, viz., a star symbol * in the number panel and will be similar in every other respect to a normal bank note and would be legal tender. Any new note packet carrying a star series note will have a band on which it will be indicated that the packet contains a star note(s). The packet will contain one hundred notes, though not in serial order. To begin with, star series notes would be issued in lower denominations, i.e., Rs.10, Rs.20 and Rs.50 in the Mahatma Gandhi series. Wide publicity through issue of press advertisements is being undertaken and banks are urged to keep their branches well informed so as to guide their customers.

3. The third reason that I am aware of is the column sort. This too arises from defective sheets. The defective sheets are first cut into columns and the “good” columns are cut into notes and packed into bundles which will not be sequentially numbered because of the missing “bad” columns. It does enhance “operational efficiency and cost effectiveness in banknote printing”. It is of course internationally common simply because DeLaRue uses it, and they print notes for many countries around the world. But in light of the developments last year, DeLaRue is not exactly a paragon of “international best practices”.

So what exactly does the RBI mean in its cryptic press release? I fail to see the need for “constructive ambiguity” when it comes to the numbering of banknotes. Any comments that would clarify my understanding of this would be welcome.

Posted at 4:16 pm IST on Tue, 14 Jun 2011         permanent link

Categories: currency

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Levin-Coburn Report and Goldman Risk Management

The Levin-Coburn report (prepared by the staff of the US Senate Permanent Subcommittee on Investigations) came out while I was on vacation and I finished reading it (nearly 650 pages) only now. In the meantime, the findings of the report have been discussed and analyzed extensively in the press and in the blogs. I will therefore focus on what the report tells us about risk management in a large well run investment bank.

Even as the crisis unfolded, we knew that Goldman was among the few firms that sold and hedged their mortgage portfolio and limited their losses. The Levin-Coburn report gives us a ringside view of how this process actually works. Of course, it is ugly, but it is also fascinating. Three examples stand out:

• Even before one starts selling off problematic assets or hedging them, the first step would obviously be to shut down the purchase of more such assets. In reality, this is very difficult to do. When Goldman is half way through putting together a pool of assets to be put into a CDO, it has two choices – (a) it can abort the process and try and sell the underlying mortgages or securities, or (b) it can complete the pool and sell the CDO (securities). Which works better for Goldman depends on how quickly the situation is expected to deteriorate as well as the comparative liquidity and depth of the two markets. The report (pages 535-36) describes a decision taken late night on a Saturday to choose alternative (a) for the Anderson CDO, but this is reversed and alternative (b) is finally chosen. There is also an interesting discussion about the mark to market/model accounting under the two alternatives.
• A tail risk hedge has very little VaR (value at risk) until the tail risk materializes; at this point when it becomes profitable, it also becomes highly risky. For example, the report (page 419-24) describes Goldman’s $9 billion short position in AAA rated tranche of an ABX index. When the short was put on, the index was trading close to par and the volatility was negligible. The tail risk if the index were to rise even further was also small – $80 million if the tranche traded at zero spread to Treasuries. The VaR was so small that nobody bothered too much about it even while monitoring the VaR of the mortgage portfolio very closely. But in mid 2007 as the index started falling, the highly profitable short position also became increasingly risky and began contributing a large VaR. Goldman had to unwind this profitable trade to bring down the VaR. This illustrates the power of the mark to market framework – since past profits are already embedded in the carrying value of the assets, any reversal in market direction shows up as a loss for the day and not as a reduction of past profits.
• When you analyze a portfolio of short and long positions in closely related assets some of which (say on the long side) are highly illiquid while some others (say on the short side) are reasonably liquid, it is awfully difficult to measure the risk of the position. It is even more difficult to decide the optimal amount of the short position (hedge). Reading the report, one finds that Goldman did a tolerable job of this in a very turbulent environment only by cutting across organizational boundaries (vertically and horizontally) and involving top management in what would under normal conditions be regarded as operational decisions.

In short, implementing a risk mitigation strategy was extremely hard even though (a) Goldman had the right view on the market, and (b) it was willing to place its self interest far above that of its “customers” in executing its desired trades.

Finally, anybody who thinks that investment banks like Goldman would give them a fair deal should read the gory details of how Goldman dumped toxic securities (Hudson, Anderson and Timberwolf) on investors around the world to protect/further its own interests. There have been many press reports about these shady deals, but the wealth of detail in the report (page 517-560) is much more than what I have seen elsewhere. The Abacus deal which led to the record $550 million settlement with the SEC appears much less sinister in comparison.

Posted at 5:40 pm IST on Mon, 13 Jun 2011         permanent link

Categories: crisis, risk management

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RBI Report on Financial Holding Companies

I participated in a panel discussion on CNBC-TV18 about the recent report of an RBI Working Group on Financial Holding Companies (FHCs). The transcript and video are available at the CNBC-TV18 web site. I made four points:

1. The global financial crisis has shown that we need a funeral plan for our largest financial conglomerates. The FHC model makes it easier to deal with the failure of a part of a conglomerate. The failing subsidiary can be wound up leaving the rest of the conglomerate intact. In the current model, the failing business unit may own other healthy business and they all go down if the parent unit is resolved.
2. It is natural that a report by the Reserve Bank would recommend that the FHC should be regulated by the RBI in line with the central bank’s mandate regarding financial stability. I am sure there will be a lot of debate on that. It is perfectly possible that this could move up to the financial stability development council or something like that. The competencies required to regulate FHCs probably does not exist in the Indian regulatory space today, and if we are going to build those capabilities, then it it probably make sense to create them in a regulatory collegium like the FSDC.
3. A big advantage of the FHC model does is that the FHC does not have any operations on its own – it does nothing other than own share in each of the operating subsidiaries. Each operating subsidiary can be independently regulated by its own sectoral regulator. The only thing that you need to do at the FHC is consolidated prudential supervision of the conglomerate. That is a lot easier to do than consolidated supervision of an entity, which is also an operating financial company.
4. Businesses houses that set up banks should be subject to the FHC regime. If a manufacturing company chooses to own a bank or a systemically important insurance company or asset manager then the financial regulators have interest in the solvency and in the governance of the parent manufacturing company itself. The regulation of the corporate holding company will essentially be in terms of how much leverage it can have and in terms of what are the minimum governance standards. If a manufacturing company does not like that then it should not get into the financial sector.

Posted at 5:36 pm IST on Sat, 4 Jun 2011         permanent link

Categories: bankruptcy, corporate governance, regulation

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When is an algorithm not an algorithm?

An algorithmic description becomes a mere description and not an algorithm when you ask the US SEC and CFTC to interpret the term. Section 719(b) of the Dodd-Frank Act mandated a study on algorithmic description of derivative contracts in the following terms:

The Securities and Exchange Commission and the Commodity Futures Trading Commission shall conduct a joint study of the feasibility of requiring the derivatives industry to adopt standardized computer-readable algorithmic descriptions which may be used to describe complex and standardized financial derivatives.

The algorithmic descriptions defined in the study shall be designed to facilitate computerized analysis of individual derivative contracts and to calculate net exposures to complex derivatives. The algorithmic descriptions shall be optimized for simultaneous use by— (A) commercial users and traders of derivatives; (B) derivative clearing houses, exchanges and electronic trading platforms; (C) trade repositories and regulator investigations of market activities; and (D) systemic risk regulators.

When the SEC and CFTC published their joint study in April, they redefined the mandate of the study completely as follows:

Section 719(b) of the Dodd-Frank Act requires that the Commissions consider “algorithmic descriptions” of derivatives for the purposes of calculating “net exposures.” An algorithm is a step-by-step procedure for solving a problem, especially by a computer, which frequently involves repetition of an operation. Algorithmic descriptions, therefore, would refer to a computer representation of derivatives contracts that is precise and standardized, allowing for calculations of net exposures. While it is conceivable to represent derivatives as algorithms – by reflecting the steps necessary to calculate net exposures and other analysis as computer code – such an approach would be very difficult given the divergence of assumptions and complex modeling needed to calculate net exposures. Accordingly, the staff have interpreted “algorithmic descriptions” to mean the representation of the material terms of derivatives in a computer language that is capable of being interpreted by a computer program.

This is truly astounding. The Commissions clearly understood that they were flagrantly violating the express provisions of the law. They are brazenly telling the lawmakers that they will do not what the law asks them to do, but what they find it convenient to do. If only the entities that the SEC regulates could do the same thing! Imagine the SEC telling companies that they need shareholder approval for certain matters, and the companies brazenly saying that since calling shareholder meetings is very difficult, we will “interpret” shareholder approval to mean board approval. What the two commissions have done is no less absurd than this.

The Dodd-Frank Act explicitly states “The study shall be limited to ... derivative contract descriptions and will not contemplate disclosure of proprietary valuation models.” This is important because for many complex derivatives, there are no good valuation algorithms. Dodd-Frank is not bothered about valuation, it is talking about the payoffs of the derivatives. I do not understand what is so difficult about describing derivative payoffs algorithmically. The Church Turing thesis states (loosely speaking) that everything that is at all computable is computable using a computer algorithm (Turing machine). Since derivative payoffs are clearly computable, algorithmic descriptions are clearly possible.

A year ago, I blogged about an SEC proposal to require algorithmic description for complex asset backed securities:

We are proposing to require that most ABS issuers file a computer program that gives effect to the flow of funds, or “waterfall,” provisions of the transaction. We are proposing that the computer program be filed on EDGAR in the form of downloadable source code in Python. ... (page 205)

Under the proposed requirement, the filed source code, when downloaded and run by an investor, must provide the user with the ability to programmatically input the user’s own assumptions regarding the future performance and cash flows from the pool assets, including but not limited to assumptions about future interest rates, default rates, prepayment speeds, loss-given-default rates, and any other necessary assumptions ... (page 210)

The waterfall computer program must also allow the use of the proposed asset-level data file that will be filed at the time of the offering and on a periodic basis thereafter. (page 211)

The joint study does not reference this proposal at all. Nor does it give any clear rationale for dropping the algorithmic requirement. Interestingly, last week, the Economist described a typo in a prospectus that could cost $45 million:

On February 11th Goldman issued four warrants tied to Japan’s Nikkei index which were described in three separate filings amounting to several hundred pages. Buried in the instructions to determine the settlement price was a formula that read “(Closing Level – Strike Level) x Index Currency Amount x Exchange Rate”. It is Goldman’s contention that rather than multiplying the currency amount by the exchange rate, it should have divided by the exchange rate. Oops.

It is exactly to prevent situations like this that algorithmic descriptions are needed. By running a test suite on each such description, errors can be spotted before the documentation is finalized. Clearly, the financial services industry does not like this kind of transparency and the regulators are so completely captured by the industry that they will openly flout the law to protect the regulatees.

Posted at 9:31 pm IST on Wed, 1 Jun 2011         permanent link

Categories: law, regulation, technology

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Am on vacation

I am on vacation during most of April and May 2011. There will be no posts during this period. I shall try to moderate comments during this period, but there are bound to be delays.

Posted at 12:31 pm IST on Fri, 1 Apr 2011         permanent link

Categories: miscellaneous

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Finance teaching and research after the global financial crisis

I have a paper on “Finance teaching and research after the global financial crisis” (the paper is also available here). The abstract is as follows:

Finance has come in for a great deal of criticism after the global financial crisis of 2007 and 2008. Clearly there were serious problems with finance as it was practiced in the years before the crisis. To the extent that this was only a gap between theory and practice, there is a need for finance practice to go back to its theoretical roots. But there is a need to re-examine finance theory itself.

The paper begins with an analysis of what the crisis taught us about preferences, probabilities and prices, and then goes on to discuss the implications for the models that are used in modern finance.

The paper concludes that the finance curriculum in a typical MBA programme has not kept pace with the developments in finance theories in the last decade or more. While a lot needs to change in finance teaching, finance theory also needs to change though to a lesser extent. Many ideas that are well understood within certain subfields in finance need to be better assimilated into mainstream models. For example, many concepts in market microstructure must become part of the core toolkit of finance. The paper also argues that finance theory needs to integrate insights from sociology, evolutionary biology, neurosciences, financial history and the multidisciplinary field of network theory. Above all, finance needs more sophisticated mathematical models and statistical tools.

Posted at 9:41 pm IST on Wed, 23 Mar 2011         permanent link

Categories: Bayesian probability, post crisis finance

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BCG Report on Organizational Reform of SEC

As required by Section 967 of the Dodd-Frank Act, the SEC engaged an independent consultant (Boston Consulting Group) to examine the internal operations, structure, and the need for reform at the SEC. The BCG report released last week covers four matters: organization structure, personnel and resources, technology and resources, and relationships with self-regulatory organizations.

The strength of the report is that it focuses on SEC as an organization rather than on regulatory philosophy or politics. We have known from several sources that there are serious organizational problems at the SEC. For example, Selling America Short by former SEC official, Richard Sauer, provides an insider’s perspective of the bureaucratic hurdles facing a committed SEC official. Markopolos of Madoff fame provides an even more riveting outsider’s perspective (see my blog post of two years ago).

I therefore looked forward to the BCG report which is based on nearly six months of work and more than 425 discussions with various people inside and outside the SEC. My main complaint against the report is that BCG appears to have accepted the views of the SEC senior management uncritically. This is quite normal in consulting assignments – a consultancy firm that does not align itself with the perspective of the client is unlikely to have many clients. In this case, however, it is not clear that the SEC is the client; arguably, the client is the US Congress if not the people of the US.

Consider for example, the excellent work that BCG has done in putting together Exhibit 4.1.1 on page 49. Essentially, BCG says that the SEC has too many layers and that many experienced and highly qualified professionals sit in the lower layers (layers six through eight of the organization. Equally disturbing is the finding (page 210-11) on the level of engagement of the workforce (the degree to which employees feel a bond to the organization and are motivated to give their best). Using data from a survey conducted by the US Government as well as their own data, BCG finds that SEC’s level of engagement is low compared to other private and public sector organizations.

If one combines this analysis with the insights from Markopolos and Sauer, the natural remedy is clearly a brutal delayering of the SEC that prunes out a lot of the dead wood at the upper managerial layers of the SEC and empowers the professionals who actually do the work. Unfortunately, a management consultant’s loyalties are to the senior managers and not to the professionals in layer eight.

The key conclusion of the BCG report is that the SEC needs a bigger budget and less interference from the Congress and the Government. The SEC Chairman of course welcomed the report enthusiastically.

Posted at 5:09 pm IST on Tue, 15 Mar 2011         permanent link

Categories: regulation

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Incredibly lax regulation of central counterparties

Regulators of central counterparties (CCPs) seem to have learned a very tiny lesson from the crisis – their standards for CCPs has moved from the laughable to the incredibly lax. The old standard (CPSS-IOSCO Recommendations for Central Counterparties, November 2004) said:

If a CCP relies on margin requirements to limit its credit exposures to participants, those requirements should be sufficient to cover potential exposures in normal market conditions. (Recommendation 4)

In a paper last year, I wrote:

This is like telling a car manufacturer that if a car has brakes, then the brakes should be sufficient to stop the car under normal driving conditions. The implication being that a car need not have brakes and even if they do, the brakes need not be designed to work on a slippery road.

The new standard (CPSS IOSCO Principles for financial market infrastructures: Consultative report, March 2011 ) is a tiny improvement:

A CCP should cover its credit exposures to its participants for all products through an effective margin system that is risk-based and regularly reviewed. ... Initial margin should meet an established single-tailed confidence level of at least 99 percent ... (Principle 6)

So, now the regulators have gotten around to accepting that the car should have brakes, but the regulation on the effectiveness of the brakes is still incredibly lax.

A confidence level of 99% implies that there would be a margin shortfall every six months. Even if we take into account other resources of the CCP, this is an unacceptably high failure rate for an institution as systemically important as a CCP. In banking regulation, 99% was the accepted level in 1996 (Market Risk Amendment), but this increased to 99.9% in Basel II (2004). For derivative exchanges, I have argued that the margin coverage should be set at 99.95%, so that margins coupled with other CCP resources would allow the CCP to reach an acceptable level of safety.

Posted at 9:37 pm IST on Thu, 10 Mar 2011         permanent link

Categories: exchanges, risk management

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Ajay Shah on cross-border exchange mergers

Ajay Shah has written an elegant analytical blog post on the illusory cost savings from cross-border exchange mergers. In my view however, these mergers are as much about integration of capital markets as they are about cost savings.

Twenty years ago, India had around twenty exchanges spread across maybe twenty different states. Each exchange had its own clientele of listed companies and investors; India was divided into several regional capital markets. Then we witnessed a rapid integration of the Indian capital market in which two exchanges in Mumbai became national markets and the other exchanges became defunct.

I believe we are on the cusp of a similar integration of capital markets on a global scale. We will probably go from a hundred different exchanges in a hundred different countries to maybe ten (maybe fewer) global exchanges. The question is whether in this new game the Indian exchanges will end up like the BSE and the NSE that survived the consolidation or whether they will end up like the CSE and DSE that became defunct.

The MIFC report had a bold and wonderful vision of India being among the winners in the globalization of financial services. I fear that we are now abandoning this vision. Meanwhile globalization is picking up speed – this year’s budget has pulled down a couple of the few remaining barriers to de facto capital account convertibility.

Posted at 2:05 pm IST on Wed, 2 Mar 2011         permanent link

Categories: exchanges

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Libya assets freeze: will other sovereigns start hiding assets?

I have been thinking about whether the moves by many countries to freeze Libyan assets could cause many sovereigns to start hiding their foreign assets (including assets held by foreign exchange reserves as well as sovereign wealth funds). First of all the asset freezes:

1. The action began in Switzerland on Thursday (February 24). The text of the ordinance is in German, but the media release says:

   In order to avoid any misuse of state monies, the Federal Council decided today to block with immediate effect all assets in Switzerland of Moammar Gaddafi and those associated with him. The sale and any disposal of goods – in particular real estate – belonging to these persons are also prohibited with immediate effect. The Federal Council thus intends to take all the necessary steps to avoid any embezzlement of Libyan state assets that may still be in Switzerland. The corresponding ordinance will take effect today and will remain valid for three years.

   Apparently, most Libyan government assets were pulled out of Switzerland a couple of years ago because of a dispute between the two countries. So the impact of this freeze is minimal but it is of huge symbolic significance.

2. The next day (Friday), the US followed up with a freeze very similar to the order used against Iran in 1979. The US order covers deposits with US banks outside the US, but in the case of similar sanctions back in 1986 (coincidentally against Libya itself) a UK court ordered the London branch of a US bank to release the assets and the US accepted this verdict.

   Some reports have suggested that the US was waiting to close down its embassy in Libya and bring most of its citizens back before doing the asset freeze on Friday. Similarly, it has been suggested that the UK had delayed action on a similar freeze while it tried to get its citizens back. This is important because the majority of Libyan foreign assets are probably in the UK.

3. On Saturday, the UN Security Council passed Resolution 1970 requiring all UN member countries to freeze Libyan assets:

   [The UN Security Council] Decides that all Member States shall freeze without delay all funds, other financial assets and economic resources which are on their territories, which are owned or controlled, directly or indirectly, by the individuals or entities listed in Annex II ..., and decides further that all Member States shall ensure that any funds, financial assets or economic resources are prevented from being made available by their nationals or by any individuals or entities within their territories, to or for the benefit of the individuals or entities listed in Annex II ...

I recall that the 1979 US asset freeze against Iran had a dramatic and lasting impact on the investment of sovereign assets in the Arab world. Most Arab dollar deposits are today placed in non US banks in London or elsewhere out of reach of a US asset freeze. This is true though many of these nations are on friendly terms with the US and have no love lost for Iran. A significant part of Chinese holdings of US Treasury is also routed via London for possibly similar reasons.

The Libyan asset freeze poses far more serious challenges for sovereign asset managers, and could I think lead to even more dramatic changes. Most importantly, since countries other than the US (and in particular, Switzerland) are acting on this, it is hard to see where to park the money safely.

China did vote for the UN resolution: “Taking into account the special circumstances in Libya, the Chinese delegation had voted in favour of the resolution.” Yet it is arguable that in a post “Resolution 1970” world, Tiananmen Square might have led to much stronger action by many other countries. Surely, China has a veto in the UN Security Council, but I must point out that the Security Council records “Resolution 1970” as being welcomed by Libya:

IBRAHIM DABBASHI ( Libya) expressed his condolences to the martyrs who had fallen under the repression of the Libyan regime, and thanked Council Members for their unanimous action, which represented moral support for his people, who were resisting the attacks. The resolution would be a signal that an end must be put to the fascist regime in Tripoli.

Under this precedent, the veto is potentially useless during a period of intense internal turmoil when the country’s representative in the UN might have defected to the rebel regime.

Many countries other than China must also be wondering whether their assets are safe. Even India would remember the international sanctions that came after Pokhran II. Can India be absolutely confident that its assets outside India would be safe under all conditions?

It appears to me that the Westphalian sovereignty of the nation state is really dead. All sovereigns will have to start acting on this assumption, and trying to safeguard their foreign assets as best as they can. I suspect that this means that at least some part of sovereign wealth will have to be invested in assets whose ownership is opaque if not untraceable.

What might these assets be?

• First is of course currency notes. All governments do have the facilities to store large amounts of their own currency, and storing billions of dollars or euros would not pose a serious logistical problem even if it is thought safer not to use the notorious 500 euro note. Over a period of time, it should be easy to accumulate large quantities of used notes whose ownership would be impossible to trace. It should even be possible to accumulate notes of nonconvertible emerging market currencies like the real, rupee and yuan. I believe that it would be another couple of decades before currency notes become obsolete as they are progressively replaced by electronic money.
• Next would be gold and other precious metals. Though gold bars do have serial numbers, I do not believe that it is practical to trace their ownership and in any case, it is trivial to melt the bar.
• Other commodities like base metals, crude oil and agriculturals would also have merit not only as a store of value but also as a safeguard against temporary trade sanctions.
• Bearer shares certificates and bearer bonds are rapidly becoming extinct and it is increasingly common to require some form of identification at the time of encashing. The only exception might be the eurobonds that are issued in bearer form.
• It might not be difficult to hide the ownership of a diversified portfolio of corporate securities behind a chain of multiple shell companies and trusts whose ownership is extremely opaque. Similar structures applied to government bonds are perhaps more likely to be uncovered.

In short, sovereign fund managers who have been putting all their money in safe government bonds might have been focusing on the wrong risk. Assets with greater market risk and credit risk might have lower political risk particularly tail risk.

Posted at 1:37 pm IST on Tue, 1 Mar 2011         permanent link

Categories: currency, gold, international finance, law

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Using options to evade futures position limits

What happens when a Briton, a Frenchman and an Australian in Hong Kong conspire with an American in New York and a Korean in Seoul to make money for the German financial giant for whom they all work? The answer according to the Financial Services Commission (FSC) of Korea is that the Korea Stock market index drops 2.79% in the last ten minutes of trading and Deutsche Bank’s Korean securities unit makes $40 million of profit.

According to the press release put out by the FSC yesterday, Deutsche Securities Korea created a large short position in the index derivatives market and then sent massive ($2.2 billion) sell orders into the cash market in the last 10 minutes of trading on expiry day (November 11, 2010). Position limits in the index futures market would have prevented them from establishing such a large short position, but for some strange reason, the Koreans did not have any position limit in the options market.

Deutsche Securities Korea therefore created synthetic short futures positions by simultaneously buying put options and selling call auctions. By put call parity, this combination is economically equivalent to a short futures position. In addition, they also bought put options, but unlike the synthetic futures, these options would have incurred a cost in terms of the upfront premium.

Belatedly, the FSC has realised that position limits are required as much in options as in futures. Last month, the FSC announced new rules establishing a position limit in index options roughly equal to a quarter of the position that Deutsche Securities Korea held on November 11, 2010. Hedging and arbitrage activities are exempted from this position limit, but this exemption is not available on expiry day.

FSC also banned Deutsche Securities Korea from trading shares and derivatives for its own account for six months. The individuals concerned will be prosecuted separately.

Compared to other investigative orders that I have read (from the US, UK, India and Australia), the Korean order appears to me to be short on detail. I think that in matters like this, it is important for the regulators to provide detailed information not only to increase their own credibility, but also to strengthen private sector surveillance and discipline.

For example, the FSC says the stocks that were sold in the cash market in those 10 minutes had been purchased through index arbitrage trading. Since there were position limits in the futures market, stocks purchased through index arbitrage could have accounted for only a small fraction of the total sales. Where did the remaining sales come from? If these were sold short, how was the short covered? Moving the market with a large trade is easy; making money out of this after getting rid of the resulting position (“burying the corpse” as we often call it) is harder. The FSC does not explain how this was done.

Posted at 1:47 pm IST on Thu, 24 Feb 2011         permanent link

Categories: derivatives, exchanges, manipulation, regulation

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Indian exchanges must go regional and then global

Indian stock exchanges are now confronted with an urgent need to look beyond the borders of India and formulate a vision for their role in the Asian stock exchange business. When I wrote about this last year (FE, November 30, 2010), I thought that Indian exchanges might have a year or so to get their act together. Global consolidation in the exchange space has moved much faster in the last few weeks and this timeframe has shrunk dramatically.

Last year, the Singapore exchange (SGX) initiated the process of consolidation in Asia with a bid for the Australian exchange (ASX). Though this bid appeared to have stalled, it is now receiving an uplift from a wave of global consolidation. The London Stock Exchange (LSE) wants to merge with the Canadian exchange (TMX) to create a transatlantic platform for listing and trading equities. This plan is dwarfed by an even more ambitious proposal by the German exchange Deutsche Börse (DB) to merge with NYSE Euronext to create a behemoth in equities and derivatives trading.

It is now clear that exchange consolidation is not going to be on a regional scale. Increasingly, the goal will be to create exchanges that span several continents and provide a single platform for trading stocks and derivatives from all over the world round-the-clock. In a year or two, when the LSE-TMX and DB-NYSE combines have completed the integration of their respective mergers, they will be looking at acquiring Asian exchanges to complete their global reach. Many analysts now believe that 5-10 years from now, there will probably be 4-5 global exchanges, each of which spans Asia, Europe and the Americas.

At that point, the Indian exchanges will have the choice between splendid isolation (and irrelevance) in a globalised world and becoming a relatively minor piece in a global exchange. To avoid this fate, Indian exchanges need to act now to spearhead the formation of pan-Asian exchanges that would have much greater bargaining power during the final round of consolidation.

There are two reasons for optimism that Indian exchanges can play a key role in the first phase of Asian consolidation. First, India is a large and fast growing emerging market. Second, Indian exchanges are world-class in terms of market design, range of derivative products, large and varied investor base, sound regulation and high liquidity.

If we exclude developed markets like Japan, Australia and Singapore, and if we regard China, Hong Kong and possibly Taiwan as being in a class of their own, then India and Korea are the emerging markets of the Asia-Pacific region, with large and vibrant equity and derivative markets. Korea has the world’s largest index derivative market while India is the premier market for single stock futures.

The accompanying table compares Indian and Korean exchanges with the aggregate of other Asia-Pacific emerging markets to demonstrate how large these two countries loom over the rest.

A partnership of some form (an alliance, if not a merger) between the Korean and Indian exchanges would clearly be a formidable Asian exchange that could, over time, absorb other smaller Asian exchanges and introduce derivative markets in those countries. Just as Euronext (a merger of European exchanges) subsequently became a major part of a transatlantic merger, it is easy to visualise this pan-Asian exchange becoming a significant part of a global exchange in the final phase of global consolidation towards the end of this decade.

Of course, any such alliance would involve tricky issues of valuation.

For instance, the Indian market capitalisation is 1½ times that of Korea; Korean traded value is nearly 4 times that of India; the exchange profit numbers are comparable; and the long-run growth prospects are probably better in India.

When it comes to regulation, nothing much will change because each exchange as a separate operating subsidiary could continue to be regulated by its current national regulator. Any merger would, however, require changes in national regulation on foreign shareholding and other related matters.

Needless to say, the purpose of this article is not to campaign for a specific merger or alliance. The purpose rather is to illustrate, with sufficient particularity, the thought processes that Indian exchanges need to go through in identifying potential partners and working out various permutations and combinations in order to derive the maximum possible advantage for themselves and for India.

Posted at 11:16 am IST on Wed, 23 Feb 2011         permanent link

Categories: exchanges

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Bernanke pontificates about political systems

After the crisis, it is common for regulators to hold forth about the relative merits of different regulatory systems, but I was surprised to find Bernanke expound his thoughts about presidential and parliamentary systems of government. The Financial Crisis Inquiry Commission has released transcripts of a closed door session on November 17, 2009 with Ben Bernanke.

The problem was – well, to give you a broad perspective, around the world, the United States was the only country to lose a major firm. Everywhere else, countries were able to come in, intervene, prevent these failures.

And I think, politically speaking, this is one place where the parliamentary system probably worked better because the prime ministers and the parliamentary leadership were able to get together over the weekend, make decisions, and on Monday morning, able to take those choices. And, generally speaking, the central banks, although they were involved in Switzerland and other places, in finding solutions, were not leading the efforts to prevent the collapse of these institutions.

But in the United States, as you know – of course, we don’t have the political flexibility for the government – quote, unquote – to come together and make a fiscal commitment to prevent the collapse of a firm. And so basically, we had only one tool, and that tool was the ability of the Federal Reserve under 13(3) authority to lend money against collateral. Not to put capital into a company but only to lend against collateral. That, plus our ingenuity in trying to find merger partners, et cetera, was essentially all -- that was our tool-kit. That’s all we had.

Bernanke is absolutely right that the parliamentary governments of Europe were able to act faster than the US. Where I would disagree is whether this was a good thing or not. The failure of the US Congress to pass the first version of TARP (assuming for a minute that it was a failure) was relatively minor compared to the hasty and catastrophic decision of Ireland to guarantee all the liabilities of its insolvent banks. All Irish citizens must be wishing that they had a US like system of checks and balances to prevent such a stupid decision being made so quickly and secretly.

The world’s oldest democracy, Iceland, was saved from Ireland’s disastrous fate only by the action of its president to allow the people to vote directly on the whether the government should assume the Icesave liabilities. The President’s declaration on that occasion is worth recalling:

Following the passing by the Althingi of the new Act on 30 December, the President has received a petition, signed by about a quarter of the electorate, calling for the Act to be subjected to a referendum.

...

It is the cornerstone of the constitutional structure of the Republic of Iceland that the people are the supreme judge of the validity of the law. Under the Constitution, which was passed on the foundation of the Republic in 1944, and which over 90% of the nation approved in a referendum, the power which formerly rested with the Althingi and the King was transferred to the people. It is then the responsibility of the President of the Republic to ensure that the nation can exercise this right.

...

It has steadily become more apparent that the people must be convinced that they themselves determine the future course. The involvement of the whole nation in the final decision is therefore the prerequisite for a successful solution, reconciliation and recovery.

In the light of all the aforesaid, I have decided, according to Article 26 of the Constitution, to refer this new Act to the people.

...

Now the people have the power and the responsibility in their hands.

What Bernanke seems to gloss over is that a decision to bail out a large bank is not a technocratic decision with an objectively optimal answer; it is an inherently political decision with massive redistributive consequences. It takes money away from one group of taxpayers to protect a group of bank depositors and creditors. This is not a decision to be made behind closed doors.

On the other hand, where the decision is essentially technocratic in nature, normal checks and balances do not stand in the way of a government that confronts a crisis. In nineteenth century England, the amount of notes that the Bank of England could issue was laid down by statute and the government did not have the powers to waive this requirement. That did not prevent governments from “suspending the Bank Act” in emergencies. For example during the crisis of 1857, the Prime Minister and Chancellor of the Exchequer wrote to the Bank of England as follows:

The discredit and distrust which have resulted from these events, and the withdrawal of a large amount of the paper circulation authorised by the existing Bank Acts, appear to Her Majesty’s Government to render it necessary for them to inform the directors of the Bank of England that if they should be unable in the present emergency to meet the demands for discounts and advances upon approved securities without exceeding the limits of their circulation prescribed by the Act of 1844, the Government will be prepared to propose to Parliament, upon its meeting, a Bill of Indemnity for any excess so issued.

...

Her Majesty’s Government are fully impressed with the importance of maintaining the letter of the law, even in a time of considerable mercantile difficulty; but they believe that, for the removal of apprehensions which have checked the course of monetary transactions, such a measure as is now contemplated has become necessary, and they rely upon the discretion and prudence of the directors for confining its operation within the strict limits of the exigencies of the case.

The British parliament passed the Act of Indemnity a month later and the suspension lasted for another 11 days. Most of the period of suspension was therefore without any statutory authority at all and depended entirely on the confidence of officials that parliament would act as promised. Such confidence in turn follows from the belief that the suspension of the Act was something that most reasonable people would agree with.

I believe that there is merit in constraining the ability of a handful of people to act secretly and hastily to bail out the financial elite. The checks and balances of the US constitution should be seen as a strength and not as a weakness. For the same reason, it is a good idea to separate bank supervision from the central bank. It makes it harder to cover up supervisory failures by using the vast resources of the central bank to bail out a failed bank.

Posted at 10:08 pm IST on Mon, 21 Feb 2011         permanent link

Categories: crisis, law, regulation

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Does the loser get to keep the name?

There have been reports that after the proposed “merger of equals” of NYSE Euronext and Deutsche Börse, the combined entity would be called “DB NYSE Group.” The politicians are up in arms about this with the senior Senator from New York, Charles E. Schumer stating:

... a sticking point that could emerge, even after a deal is announced, is the name of the new entity.

Some may say what’s in a name, but I say a lot. The New York Stock Exchange is a symbol of national prestige, and its brand must not suffer under this merger.

It is totally logical to keep the N.Y.S.E. name first. If for some reason, the Germans sought an alternative option, it could be an indication that they are trying to wield an upper hand in the new company and would seek to make other business decisions that could go against New York. The name is an important bellwether of whether this deal is regarded as a merger of equals.

In banking mergers, we have a rule of thumb that says that the loser gets to keep the name. Travelers bought Citi and named the combined entity as Citigroup. NationsBank bought Bank of America and became Bank of America. In the long chain of mergers that produced JP Morgan Chase, at every stage the loser got to keep the name – Chemical bought Chase and adopted the Chase name; Chase bought JP Morgan and put the loser’s name first to become JP Morgan Chase; finally, Dimon’s Bank One bought JP Morgan Chase and retained the loser’s name.

In exchange mergers, the winner has not bothered to keep the loser’s brands simply because the brands of exchanges are not really worth anything. So long as an exchange has the contracts and the liquidity, nobody cares what it is called. Long ago, the London Stock Exchange rechristened itself as the “International Stock Exchange of the United Kingdom and Ireland”and then went back to being the London Stock Exchange again without anybody bothering about it.

Acquirers have therefore been quite happy to drop or demote the names of the exchanges that they buy. This is what happened when the LSE bought Borsa Italiana or when NYSE bought Euronext or when Nasdaq bought OMX.

Another complication is that equity trading (particularly in the US) is a cut throat business and much of the profit (and valuation) is in derivative trading. In the case of the proposed DB NYSE, it is Deutsche Börse that has the most valuable derivative contracts. The most important derivative contract at NYSE Euronext is the Euribor futures which trades on Euronext and not on NYSE. One could argue that the merged entity should be called DB Euronext.

Posted at 4:10 pm IST on Tue, 15 Feb 2011         permanent link

Categories: derivatives, exchanges, international finance

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Global mergers and Indian exchanges

Last year, I wrote about the role that Indian exchanges should be playing in the emerging period of regional and global consolidation:

... the stock exchange business in Asia is entering a period of regional, if not global, competition. The abortive bid by the Singapore Stock Exchange to buy the Australian Stock Exchange marked the first warning shot in this process. Asia is going to be one of the fastest growing equity markets in the world, and India’s world-class exchanges and depositories have a wonderful opportunity to occupy a pole position in this space.

After that, however, it appeared that the process had stalled with regulatory obstacles emerging for the SGX-ASX deal. In the last few days, the picture has changed again with the announcement of the LSE-TMX merger (that brings together the British and Canadian exchanges) and the merger talks between Deutsche Boerse AG and NYSE Euronext (that brings together the largest European and US exchanges). It is almost as if the Atlantic Ocean no longer exists. The SGX-ASX deal also now looks more likely to receive approval.

The Points and Figures blog argues that “Eventually, when all the M+A is finished, there will be 3-4 worldwide exchanges. It will look like the credit card industry. But, because of money, regulation, and government borders it takes time.” Points and Figures blog also suggests that down the road, LSE+TMX would seek some sort of combination with an Indian exchange, possibly the BSE.

It is tragic that at this point of great opportunities and strategic challenges, the energies of Indian exchanges and their regulators are entirely consumed by the debate about whether exchanges should be regulated like public utilities.

---

While discussing about exchanges, I would like to point to a fascinating post at the Unreasonable Response blog (hat tip Deus Ex Macchiato) arguing that the central bank should become the sole exchange for all OTC derivatives. Unreasonable Response thinks that the Bank of England would do a very good job at this. On the other hand, I do recall that in its early years, the Bank of England did try to run an exchange in its famed rotunda to compete against the London stock exchange. That attempt was a dismal failure.

Posted at 5:17 pm IST on Thu, 10 Feb 2011         permanent link

Categories: exchanges

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Of percentages, decimals, SEC and Rosenberg

Whether interest rates, volatilities and other similar numbers are expressed as percentages (say 6%) or as decimals (say 0.06) is a trivial yet vexed issue in finance. I always remind students that when they use an online option pricing calculator, this is one common source of error (the other common source of error is to use an annually compounded interest rate where the software expects a continuously compounded rate).

But even I never thought that confusion between percentages and decimals could cause $216 million of losses and an enforcement action by the US SEC. And that too at Axa Rosenberg Group – the firm that (under its original name Barr Rosenberg Associates or BARRA) pioneered quantitative portfolio management and risk measurement for institutional investors.

The SEC described the coding error as follows. (BRRC stands for Barr Rosenberg Research Centre, a subsidiary of ARG which stands for Axa Rosenberg Group):

In April 2007, BRRC put into production a new version of the Risk Model. BRRC had assigned the task of writing the computer code that would link this new Risk Model with the Optimizer primarily to two programmers. Although BRRC tested the new Risk Model, it did not conduct independent quality control over the programmers’ work on the code. When these two programmers linked the Risk Model to the Optimizer, they made an error in the Optimizer’s computer code. ...

Starting in 2009, a BRRC employee began work as part of BRRC’s effort to implement a new version of the Risk Model. In June 2009, this employee noticed certain unexpected results when comparing the new Risk Model to the existing one that was rolled out in April 2007. He learned that the Optimizer was not reading the Risk Model’s assessment of common factor risks correctly because an error in the code caused a failure to perform the required scaling of information received from the Risk Model. Some Risk Model components sent information to the Optimizer in decimals while other components reported information in percentages; therefore the Optimizer had to convert the decimal information to percentages in order to effectively consider all the information on an equal footing. Because proper scaling did not occur, the Optimizer did not give the intended weight to common factor risks.

The SEC goes on to describe the cover-up as follows:

The Senior Official and other BRRC employees met around the end of June 2009 to further discuss the error. The BRRC employee who discovered the error advocated that the error be fixed immediately. The Senior Official, however, disagreed and stated that the error should be corrected when the new Risk Model would be implemented. The Senior Official directed BRRC employees with knowledge of the error to keep quiet about the discovery of the error and to not inform others about it. The BRRC employee who discovered the error asked the Senior Official whether ARG’s Global Chief Investment Officer (“CIO”) should be informed, and the Senior Official instructed that he should not be told.

The SEC does not identify the “Senior Official” who tried to cover up the error, but last year Axa Rosenberg stated that Dr. Barr Rosenberg himself was involved in the cover-up and had resigned.

More than the trivial error itself, what is so tragic is that such a distinguished academic (whose papers I have been reading and enjoying for over 25 years) should try to cover up the error.

As an aside, in a case which is all about scaling errors, the SEC order itself contains a ridiculous scaling error – it states that the losses were $216,806,864 million. That would be $216 trillion which is well in excess of the total stock of financial assets in the world. I presume that the true losses were $216,806,864 or $216 million. I suppose this is fine unless the SEC tries to cover up this error.

Posted at 2:17 pm IST on Fri, 4 Feb 2011         permanent link

Categories: mathematics, risk management

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Why does the US government write a financial crisis book?

During the financial crisis, as many parts of the financial sector broke down, the government stepped in to perform the function normally performed by banks, markets or other private players. But there is no market failure at all in the business of publishing books on the financial crisis. As I noted in a blog post four months ago, this business is booming and there is no shortage of well-written books on the crisis.

But, writing a book on the financial crisis is exactly what the US government or rather the Financial Crisis Inquiry Commission (FCIC) has done in its report published last week. By sheer coincidence, when the report came out, I had just finished reading All the Devils are Here by Bethany McLean and Joe Nocera. It struck me that the FCIC report was quite similar to this book in terms of narrative, racy style, reliance on interesting anecdotes and juicy quotes.

I was looking forward to the FCIC producing an investigative report comparable to the outstanding reports produced for example by the Special Investigative Commission set up by the parliament of Iceland or the Examiner appointed by the bankruptcy court for Lehman Brothers. Unfortunately, that has not happened. Indeed, I found very little that is new in the FCIC report except for this interesting excerpt from a closed-door interview with Fed Chairman Ben Bernanke:

As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression. If you look at the firms that came under pressure in that period ... only one ... was not at serious risk of failure. So out of maybe the 13, 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two. (page 354)

Another quote from the same closed-door session suggests that the one exception was JP Morgan Chase:

[Like JP Morgan,] Goldman Sachs I would say also protected themselves quite well on the whole. They had a lot of capital, a lot of liquidity. But being in the investment banking category rather than the commercial banking category, when that huge funding crisis hit all the investment banks, even Goldman Sachs, we thought there was a real chance that they would go under. (page 362)

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Another bit of self-promotion: onlineaccountingcolleges.com has listed my blog in the Top 50 Blogs By Accounting Professors, Students and Professionals. It looks like 50 is becoming my lucky number.

Posted at 3:09 pm IST on Tue, 1 Feb 2011         permanent link

Categories: crisis, financial history, investigation

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Barings, Rothschild and Morgan

During the last three centuries, four investment banks have dominated global finance at one point or the other:

• Hope & Co. (the Hopes of Amsterdam/Rotterdam) during the 18th century and early 19th century;
• Barings in the late 18th and early 19th centuries;
• Rothschilds in the 19th century; and
• JP Morgan in the first half of the 20th century.

After World War II, no investment bank has dominated global finance in a way even remotely comparable to these four. (No, not even the “great vampire squid”). I used Google’s Books Ngram Viewer to see how common were references to these banks in the books of different countries at different points of time. I dropped Hope & Co. because it hardly registered in the graphs.

There are some limitations in the results. I entered “Rothschilds” in the plural to avoid picking up references to other people with this not uncommon German surname. But this means that I am not catching references to Nathan Rothschild for example. Morgan is an even more common surname, and I had to use JP Morgan to avoid contaminating the results. On the flip side, I am losing references to Pierpont Morgan or the House of Morgan. Finally, despite using a three-year smoothing in the graphs, publication of books on any of these banks leads to spikes which should not be taken too seriously. Also, the scale of the vertical axis is not the same across the graphs.

With all these limitations, the graphs below tell an interesting story. First, the books lagged behind the financial reality often by several decades, particularly in the earlier years. Second, high-profile (and sometimes quasi-political) events like the Barings’ involvement in the Louisiana purchase of 1803, or JP Morgan’s involvement in the panic of 1907, or Nick Leeson’s fraud at Barings in 1995 are reflected in a disproportionate coverage in the books (often after a lag).

Third (and most puzzling), Rothschild dominates British and German literature while JP Morgan dominates the French. I would think that the Rothschild branch in Paris was at least as important as the branches in London and Vienna. I am baffled by the surge in the coverage of JP Morgan in the French books well before the panic of 1907, and well before the surge of this American bank in American books.

Barings, Rothschild and Morgan in British English books 1700-2000

Barings, Rothschild and Morgan in American English books 1700-2000

Barings, Rothschild and Morgan in English books 1700-2000

Barings, Rothschild and Morgan in French books 1700-2000

Barings, Rothschild and Morgan in German books 1700-2000

Posted at 2:38 pm IST on Thu, 27 Jan 2011         permanent link

Categories: financial history

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Commodity bubbles or successful monetary policy?

The blogosphere has been discussing a Federal Reserve Board of St Louis paper by Richard Anderson arguing that what appears to be an asset price bubble may actually be the normal result of expansionary monetary policy.

Rapid increases in commodity and financial market prices by themselves, however, are not reliable indicators of potential bubbles because such increases also occur as part of normal monetary policy. ... Disappointingly low returns on short-term, low-risk investments prompt investors to move to longer-term, higher-risk investments in financial instruments, commodities, and durable goods.

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One factor is the potential success of expansionary monetary policy: If economic activity expands, demand for commodities likely will increase, pushing futures prices upward, which, in turn, tends to increase current-period prices. ... A second factor is the decreased foreign exchange value of the dollar as a result of aggressive monetary policy.

...

As long as the FOMC’s pursuit of highly expansionary policy continues, households and businesses remain pessimistic, and demand is sluggish, the potential exists for asset prices to deviate from their long-run levels by large amounts and for long periods. Such increases per se are not bubbles but a commonplace reaction of the monetary transmission mechanism. ... Whether bubbles have been generated remains to be seen.

It is simplest to evaluate this argument for commodity prices because to a first approximation their “long-run levels” can be regarded as constant in real terms (real commodity prices are stationary to a first approximation absent secular supply or demand shocks).

A large increase above this long-run level implies a large negative expected real return on commodities. This is difficult to reconcile with positive yields on long-term inflation indexed bonds. Even at shorter maturities, inflation indexed yields are only mildly negative, and even a modest risk premium would lead to a positive required rate of return on commodities.

Moreover, if the price pressure on the spot prices is coming from elevated futures prices as Anderson argues, the implication is that nominal prices are expected to rise. That too does not appear consistent with falling real prices given modest inflation rates in the developed world.

It appears to me that one would have to assume severe supply constraints (of the peak oil variety) to provide a non-bubble explanation for a sharp rise in real commodity prices above their “long-run levels”.

Similar problems would arise in the case of other assets as well. If one assumes that prices are above their long-run levels, then expected risk adjusted returns would be negative which would be inconsistent with positive or even near zero yields on inflation indexed bonds.

Depressed expected rates of return can be attributed to “a commonplace reaction of the monetary transmission mechanism,” but it is difficult to see how highly negative expected rates of return (implied by large deviations from long-run levels) can be so explained.

Of course, one can argue that inflation indexed yields are only reflecting large risk premiums for sovereign default and that the true real risk-free rate is hugely negative. But that would be an even more scary story than an asset price bubble.

Posted at 5:47 pm IST on Fri, 21 Jan 2011         permanent link

Categories: bubbles, commodities

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Complete that demat process

I have a column in today’s Financial Express on the need to complete the process of dematerialization of shares in India by abolishing physical share certificates completely.

The time has come to abolish physical share certificates completely and dematerialise all shares by eliminating the option that is currently given to the owner to hold shares either in physical form or in dematerialised form. Dematerialisation should be mandatory even if the owner has no immediate intention to trade the shares on the exchange.

When depositories were first created in India, it was well known that physical share certificates were prone to fraud and malpractices. However, since dematerialisation was a new concept in the country, it was thought that the ability to convert back and forth between paper and dematerialised form would give investors greater comfort and confidence. Today, after more than a decade, the depositories have established themselves as reliable and secure. There is now nothing to be lost and everything to be gained by eliminating paper completely.

Many of us believed that the risk of fraud and theft of physical certificates would induce a voluntary dematerialisation of large holdings, particularly after the exchanges shifted to trading exclusively in dematerialised mode. However, some large investors (including, unfortunately, some government entities) ignore these risks and hold on to paper certificates. More troublingly, one hears disconcerting (hopefully false) rumours of physical certificates being used to backdate or postdate transactions with the collusion of companies and their registrars.

Such alteration of dates may produce advantages under the takeover code and under the tax laws. For example, inter se transfer of shares between promoters is exempted from the requirements of the takeover code if the transferor and transferee have held the shares for at least three years. Similarly, purchases of shares during the previous six months are taken into account while deciding the open offer price. Under the tax laws, the lower tax rate on capital gains applies if the shares are held for a year.

All these could be facilitated by backdating or postdating transaction dates—something that would be impossible in the dematerialised environment. In fact, the more I think about it, the more I am convinced that some promoters and large operators hold on to paper certificates for unsavoury reasons.

Even if this were not so, there would still be reason to worry about these holdouts of paper certificates. As old timers retire, registrars are gradually losing the skill set required to verify the authenticity of physical certificates. I have seen airline check-in staff (and sometimes even their supervisors) fumble when they encounter the increasingly rare physical air tickets because they are all familiar only with e-tickets. Over a period of time, this lack of familiarity with the vestiges of a paper era will become a serious problem for registrars, and will provide a fertile opportunity for fraudsters.

It is, therefore, imperative to launch a time-bound action plan to achieve 100% dematerialisation. I think such a plan should have three elements.

First, we should stop creation of new paper certificates forthwith. The Depositories Act should be amended to prohibit rematerialisation of physical certificates. Furthermore, it must be mandatory to make all new allotments of shares in dematerialised form. Transfer or transmission of shares (even if it takes place outside the exchange) should be permitted only in dematerialised form.

Second, we must set a cutoff date (say, January 1, 2012), by which large and critical holdings must be dematerialised. This date should apply to:

• Holdings of shares by all bodies-corporate, governments and other artificial persons
• Holdings of shares by promo-ters, directors and key managerial personnel
• Holdings of shares by a single individual in a single stock exceeding, say, Rs 1 million by face value as well as, say, Rs 25 million by market value.

An extended cutoff date (say, January 1, 2015) can be set for dematerialisation of other shares—small shareholdings by individual investors.

After the cutoff date (or the extended cutoff date for small holdings), physical shares that have not been dematerialised would become almost useless. However, in exceptional cases where genuine reasons can be demonstrated, dematerialisation of these shares may be permitted after issuing a public notice in a newspaper giving sufficient time for other claimants to dispute the claims of the holder. For tax purposes and for takeover code purposes, the date of dematerialisation would be deemed to be the date of acquisition of the shares.

Finally, we must set a cancellation date (say, January 1, 2020) on which all remaining physical share certificates would be deemed to be cancelled and forfeited, and the issuers would be required to record the forfeiture of shares in their books.

During this process of elimination of paper certificates, it would be useful to preserve samples of the old paper certificates for the historical record in an appropriate archive or museum. Regulations require dematerialised share certificates to be mutilated and cancelled, and in the absence of a conscious archival effort, these mutilated certificates are likely to be destroyed as a matter of course.

Posted at 10:52 am IST on Wed, 19 Jan 2011         permanent link

Categories: equity markets, technology

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Watson and trading in financial markets

Much has been written about IBM’s Watson defeating top rated contestants in a practice round of the US TV quiz game Jeopardy. Modelled Behaviour says “AI and singularity suddenly feel near enough to care about.” Nemo says “simply an incredible achievement, far beyond beating Kasparov at chess.” What is also interesting is how much the machine has progressed from its dismal performance less than a year ago.

I have been thinking about what it means for finance especially financial markets. Could it make markets more resilient? Running on a supercomputer, Watson needs several seconds to come to its conclusions. By the standards of high frequency trading (HFT), this is an eternity, but we know that markets are more resilient when it is populated with a diversity of traders operating at totally different time scales. Could it also lead to more algorithmic trading based on a wide variety of news sources and fundamentals, instead of trading based only on order flow and machine readable news?

Posted at 3:39 pm IST on Sun, 16 Jan 2011         permanent link

Categories: technology

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Citi fraud: a Madoff moment for wealthy Indians

India’s wealthy have encountered their Madoff moment with the fraud in the Gurgaon (New Delhi) branch of Citibank in which a relationship manager defrauded the wealth management clients of the bank of over Rs 3 billion (about $65 million). The relationship manager promised high rates of return and persuaded clients to sign blank cheques which were used to transfer the funds to bank accounts of the manager’s family members.

Why do wealthy people fall for such frauds? Why do they venture into such unregulated products where they have much lower levels of protection? I think this has a lot to do with people extrapolating their experiences of the pre reform era (prior to 1991) to the modern largely deregulated economy:

1. Many people believe that one can earn higher rates of return in unregulated products without bearing higher risk. During the era of financial repression, it was true that interest rates in the formal market were artificially repressed below equilibrium levels (probably by as much as three percentage points). After the economic reforms of the early 1990s, this financial repression came to an end. However, those who grew up in the pre reform era still believe that there is an extra risk free return to be earned outside the formal regulated sector.
2. During the days of the licence raj (prior to the reforms) political and business connections allowed people to get access to resources that were not available to ordinary people. Anything from train tickets to cement was easy to obtain for the privileged few. It is easy for people who grew up in that era to believe that their connections can give them access to investment opportunities not available to ordinary investors. Obviously, these opportunities would be in unregulated and opaque products.
3. The experience of the pre reform era conditioned people to be relationship oriented rather than transaction oriented in financial matters. This makes them trust a wealth manager who comes home and collects the cheque (even blank cheques). The younger generation would probably rely on an online investment facility instead.
4. The same distrust of formal systems leads people to ignore vital safeguards like independent custody as well as independent verification and audit of statements.

I do not believe that greater regulation is the answer to the problem. If the underlying investor attitude does not change, regulating one set of products would only drive investors to another set of unregulated products. The whole genesis of blank cheques probably lies in a misguided attempt to “empower” the investors by using a nondiscretionary portfolio management system.

In a nondiscretionary portfolio management system, the advisor only gives advice, and it is the investors that supposedly take all the decisions. By contrast, a discretionary portfolio management system is more like a mutual or a hedge fund where the client has little voice in investment decisions. A nondiscretionary system appears to give more power to the investors and is intended to protect investors from wrong investment decisions by the advisor. However, by getting investors to sign blank cheques and instruction forms, advisors are able to run what is effectively a discretionary portfolio management system while maintaining the documentary pretence of running a nondiscretionary system. Far from empowering the investor, the result is to leave investors vulnerable to fraud. In retrospect, investors might have been better off in a discretionary system.

Personally, I think financial regulators should not waste excessive amount of resources or time pursuing the Citi fraud for several reasons. First, the fraud involved unregulated products. Second, the fraud is well covered by normal criminal laws regarding theft and misappropriation. Third, the victims are very wealthy investors who are well capable of hiring the best lawyers and investigators to go after the bank. The regulators’ time and resources are much better spent on regulated products involving small investors who are less capable of looking after themselves.

Posted at 6:10 pm IST on Sun, 9 Jan 2011         permanent link

Categories: fraud, investment

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Offshore rupee and renminbi markets

India and China appear to be responding in very different ways to the issue of their currencies trading offshore (the non deliverable forward or NDF market). The Reserve Bank of India says in its Financial Stability Report (page 29-30):

Prevalence of a large offshore market raises systemic concerns with regard to both monetary policy and financial stability as the offshore and onshore markets do not operate in silos.

...

In the Indian context, the major participants in the NDF markets are understood to be hedge funds and multinational firms (both domestic and foreign). Such participants tend to be guided more by international developments than domestic factors. Adding to the risks arising from NDF markets is the fact that information and flows going through in such markets are not available in a reliable and transparent manner. This opacity prevents the central bank from having an adequate early warning mechanism to tackle balance sheet adjustments and disorderly winding down of large one-way bets driven by market players.

China on the other hand has the advantage of an offshore centre (Hong Kong) which is under its own sovereignty but operates under a different economic regime. Mainland China and Hong Kong put together account for about half the global trading in the renminbi. This is roughly the same as the share of the global trading in the rupee that takes place in India (Table D.6 of the BIS data). China’s response to the growing offshore market is to make Hong Kong a more attractive centre for trading the renminbi. In a speech last month, the head of the Hong Kong Monetary Authority (HKMA) said:

With the strong support from the Central Government and the relevant Mainland authorities, the development of RMB business in Hong Kong has been encouraging this year.

...

I believe that next year will be a crucial year for the development of offshore RMB business in Hong Kong. ... Finally, to further promote the development of the RMB offshore business in Hong Kong, the HKMA is making preparations for overseas roadshows with the financial industry, focusing on locations which have growing trade and investment flows with the Mainland. We believe that with our joint efforts, Hong Kong will be able to play its role as an RMB offshore market to the fullest, thereby promoting and supporting the nation’s increasing cross-border trade and investment activities while enhancing and consolidating the status of Hong Kong as an international financial centre.

India still seems far away from this “if you can’t beat them, join them” approach. Actually, India already has a liquid non deliverable rupee market within India – it is called currency futures. Why can’t India use this market as strategically as China is using Hong Kong?

Posted at 9:59 pm IST on Sat, 1 Jan 2011         permanent link

Categories: international finance

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More self promotion

Last week, I posted about my blog being listed in bschool.com’s 50 Best Business Professor Blogs. Around the same time, my blog also made it to PhDinManagement.org’s list of Top 50 Blogs by Business Professors.

Posted at 4:37 pm IST on Sat, 1 Jan 2011         permanent link

Categories: miscellaneous

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Einstein Nobel futures contract

Last week FiveBooks carried an interview with well-known Einstein biographer, Walter Isaacson, reviewing his favourite five books on Einstein. Isaacson discusses a very interesting futures contract related to Einstein’s Nobel Prize:

This is a great piece of writing and of research about Einstein’s relationship with his first wife who served as his sounding-board in the miracle year of 1905 when he discovers special relativity and lays the groundwork for quantum theory. Mileva Maric was a physics student at Zurich Polytechnic, and when she and Einstein met they fell madly in love.

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When the passionate relationship exploded and Einstein wanted a divorce he couldn’t afford the money Maric wanted to raise their two boys. So Einstein says to her that one day he’ll win the Nobel Prize for his 1905 work and if she gives him a divorce he’ll give her the prize money when he wins. She takes a week to calculate the odds and consult other scientists, but she is a good scientist herself and she takes the bet. He didn’t win until 1921 but he did give her the money and she bought three apartment buildings in Zurich.

I was aware that Einstein gave the prize money to his first wife, but did not know that there was actually a futures contract (or more precisely a forward contract). Wikipedia has more details about the transaction. As I think carefully about it, this futures contract is actually quite hard to value:

• First of all, we need the risk neutral probability (as of 1919) that Einstein’s work would win the Nobel Prize at all. This is a nontrivial task – those who think that this probability was close to one must keep in mind the fact that no Nobel Prize was ever awarded for relativity theory (Einstein’s prize was for his work on the photon).
• There is a significant information asymmetry in assessing this probability because Einstein obviously knew more about his own work than anybody else.
• To value the futures contract it is also necessary to estimate the expected time at which the prize would be awarded. Coase received the economics Nobel Prize six decades after his original work. Physicists do not usually have to wait that long, but in 1919, Einstein had already waited 14 years.
• Mileva Maric would also have to worry about mortality risk because the Nobel Prize is not given posthumously. Her own mortality is less important because the money would probably have gone to a trust for the benefit of her children.
• There is also the vexed issue of counterparty risk – during and after the First World War, it could not be taken for granted that the endowment of the Nobel Foundation would be preserved sufficiently well in real terms to ensure that the expected prize money could be paid out.
• Finally, since the futures contract was clearly non-tradable, a significant liquidity discount would also have to be applied while doing the valuation.

Despite all these difficulties, the fact is that Mileva Maric was able to arrive at a reasonable valuation and conclude the negotiations. It is interesting to read that the information asymmetry was resolved not only by her own competence as a physicist, but also by consulting other scientists. This is similar to the use of rating agencies in debt markets.

In the real world, instruments do end up getting valued despite the theoretical difficulties involved. One of Einstein’s famous quotes is probably relevant here with suitable modifications: “God does not care about mathematical difficulties, he integrates empirically.”

Posted at 6:02 pm IST on Mon, 27 Dec 2010         permanent link

Categories: derivatives

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Self promotion

My blog has been listed among 50 Best Business Professor Blogs by bschool.com. The list includes 15 blogs on finance and accounting. If one excludes the accounting and personal finance blogs, the list is even shorter. Perhaps too few finance professors are blogging.

Posted at 10:40 am IST on Sat, 25 Dec 2010         permanent link

Categories: miscellaneous

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Hard to act against systemic risk

Richard Bookstaber says in an interview yesterday that it is not difficult to detect systemic risk – the hard part is to take useful action against it:

But I don’t think systemic risk is hard; at least monitoring systemic risk is not difficult. Nobody can hide risk of that magnitude. It’s there to be seen. As I already mentioned, it is taking action that is difficult.

I entirely agree with this assessment. For example, in Indian banking (and many other parts of the financial sector), it is not at all difficult to see that infrastructure finance is a big systemic risk:

• There is a large amount of it.
• There are huge maturity mismatches.
• Infrastructure as the ultimate non tradeable is a bet on the growth of the Indian economy.
• Many of the instruments and techniques are new and many lenders have little prior experience with the sector.
• The central bank has been willing to bend the rules to facilitate expansion of credit to this sector.
• Infrastructure in India is closely bound up with real estate which is implicated in most banking crises.
• No individual bank has any incentive to worry about it because it can count on a bail out – infrastructure is too large and strategically important to be allowed to fail.

In short, it is the classic tail risk mitigated by the high likelihood of a sovereign bailout. It is simply not in the interest of anybody (lender, borrower, regulator or government) to do anything about it.

Posted at 9:29 pm IST on Fri, 24 Dec 2010         permanent link

Categories: regulation

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Financial history books

In my blog post more than a month ago on books related to the global financial crisis, I promised to post a list of books related to financial history. One of the lessons from the crisis was that practitioners, regulators and academics in the field of finance need to have a good understanding of financial history.

If you wish to read only one book on financial history, I would recommend A History of Interest Rates by Sidney Homer and Richard Sylla. This book covers the evolution of credit markets over 5,000 years and is packed with charts and tables about interest rates across space and time. It was from this book that I learned for example that credit predates money and probably predates barter.

Another important book is The Early History of Financial Economics, 1478-1776: From Commercial Arithmetic to Life Annuities and Joint Stocks by Geoffrey Poitras. I found it surprising that so much of financial economics including net present value and expected utility had been developed prior to Adam Smith and the Wealth of Nations. Poitras also covers the early development of the stock market in Amsterdam and has extensive extracts from Joseph de la Vega’s pioneering book Confusion de Confusiones of 1688.

I was fascinated by The Origins of Value: The Financial Innovations that Created Modern Capital Markets edited by William N. Goetzmann. This wonderfully illustrated book covers financial innovations from ancient Mesopotamia and China to the modern world. For example, it describes how Benjamin Franklin printed United States government bonds at home introducing technical innovations designed to make counterfeiting difficult.

Manias, Panics and Crashes: a History of Financial Crises by Charles Kindleberger would probably be the favourite financial history book for many academics. It is also one of my favourite books – I have been fond of saying that one must approach the study of finance with Ito’s lemma in one hand and Kindleberger in the other. In this list, I have ranked it lower for two reasons. First, it is more a theory of financial crises than a history. Second, it covers only the period since modern financial markets developed in Holland in the late 16th and early 17th centuries.

For an institutional perspective of financial history, I enjoyed The Origins and Development of Financial Markets and Institutions: From the Seventeenth Century to the Present edited by Jeremy Atack and Larry Neal. I also learned a lot from Meir Kohn’s forthcoming books on commerce and finance in preindustrial Europe (draft chapters are available on his website)

In my post on crisis related books, I mentioned This Time is Different: Eight Centuries of Financial Folly by Carmen Reinhart and Kenneth Rogoff but I must mention it again here. This book is more of a macroeconomist’s view of financial crises than a financial economist’s view but the wealth of data and analysis in this book make it indispensable.

Among the books that I read but did not enjoy as much as the above books are:

• Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor
• The Ascent of Money: A Financial History of the World by Niall Ferguson
• False Economy: A Surprising Economic History of the World by Alan Beattie

Turning to the financial history of the 19th and 20th centuries, there is a wealth of material that is available on each country and each period. Among the books that provide an interesting multicountry perspective, I would like to mention:

• Financial Development of India, Japan and the United States: A Trilateral Institutional, Statistical and Analytic Comparison by Raymond Goldsmith
• Evolving Financial Markets and International Capital Flows: Britain, the Americas, and Australia, 1865-1914 by Lance Davis and Robert Gallman.

I believe that the plural of biography is not history and have therefore not included the numerous books that have been written about individual banks and bankers. For example, Niall Ferguson is absolutely outstanding in his two-volume book on The House of Rothschild. There are also many good books on the House of Morgan and on the Medici, but I have not seen any on the Hopes of Rotterdam/Amsterdam.

Posted at 4:44 pm IST on Fri, 10 Dec 2010         permanent link

Categories: crisis, financial history, interesting books

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Where is the rupee-dollar market?

In two blog posts three months ago, I put together data from the BIS and the RBI to suggest that half of the rupee-dollar market is outside India. Now we have the data from the BIS. Table D.6 gives the location wise break up of the rupee-dollar market: 50% is in India, 16% is in Singapore, 12% in UK, 11% in Hong Kong, and 9% in the US with the balance scattered across four countries (Switzerland, Australia, Japan and Canada) each with less than 0.5%. The offshore market exceeds $20 billion a day.

One of the reasons most people underestimated the size of this market is that they were looking only at Singapore, while the market is spread across several locations.

Posted at 9:09 pm IST on Thu, 2 Dec 2010         permanent link

Categories: derivatives, international finance

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Stock Exchange Ownership and Competition

I have a column in today’s Financial Express about a key committee report on ownership and competition in India’s stock exchanges.

The Jalan Committee appointed by Sebi has effectively recommended the back-door nationalisation of stock exchanges, clearing corporations and depositories (market infrastructure institutions or MIIs). If these recommendations are accepted, we will extinguish the essential spark of dynamism that has given India a world class equity market.

The Jalan report is permeated from beginning to end with the ideology of socialism and the command economy, but instead of overt nationalisation, it seeks to destroy private sector exchanges and other MIIs through a thousand small cuts. Let me list out just a few key elements of this strategy:

1. The maximum profit that an exchange (or MII) can earn would be capped at a certain percentage of annual return on net worth of the previous year. Any excess over this would be transferred to the investor protection fund (IPF) or similar fund. The economic result of this would be that the existing equity capital of all exchanges would effectively become non-cumulative preference shares with a fixed rate of dividend, and the government (in the form of the IPF) would own the economic equity of the exchange.
2. In keeping with the back-door nationalisation of the exchanges, it is proposed that their key executives should also be remunerated like bureaucrats—fixed salary with fixed annual increments, no variable pay and no form of stock options.
3. The users of the market infrastructure (the members of the exchanges and clearing corporation) are prohibited from sitting on the board.
4. Only public financial institutions and banks are allowed to become anchor investors in exchanges and other MIIs attenuating any residual chance of shareholder control.

The Jalan report also takes an essentially anti-competitive position in the field of exchanges and MIIs. The view taken is that there is sufficient competition already and that it would be undesirable to have more competition: “Sebi should have the discretion to limit the number of MIIs operating in the market, in the interest of the market and in public interest.”

There are two problems with this. First, the Indian MII industry (exchanges and depositories) is a near monopoly where the dominant players have been disciplined not by actual competition but by the threat of competition. In the jargon of the economists, it is a contestable market but not a competitive market. In this context, an attempt to limit new entrants will entrench the existing near-monopoly and remove the disciplining force of potential competition.

Historical experience tells us that we have got far better and cheaper telecommunications from competitive profit-seeking companies than from a monopoly state-run public utility. Competitive private players have given us cheaper and more convenient air travel than monopoly state players. It is the same story in industry after industry. The Jalan report is ignoring this overwhelming evidence from India and elsewhere, and propounding the belief that a cosy government-controlled monopoly or oligopoly would serve the market and the public interest better than a competitive industry structure.

The Jalan report seeks to limit competition by several means quite apart from the explicit limit on the number of exchanges and depositories. The regulated public utility model ensures that it is very unattractive for new entrants. Anybody seeking to challenge an entrenched incumbent faces a high chance of failure and the only incentive for entry is the prospect of large profit in case of success. The ceiling on profitability rules this out. Moreover, the new entrant would not be able to attract talented managers because of the inability to offer performance-based compensation.

As if all this were not enough, the proposed ownership norms rule out most strong strategic investors with deep pockets who have an incentive to enter the business. If only public financial institutions and banks are allowed to become anchor investors, the current incumbents are unlikely to be seriously challenged.

India, therefore, runs the risk of losing the competitive dynamism of the Indian equity markets. What is more tragic is that this is happening at a time when the stock exchange business in Asia is entering a period of regional, if not global, competition. The abortive bid by the Singapore Stock Exchange to buy the Australian Stock Exchange marked the first warning shot in this process. Asia is going to be one of the fastest growing equity markets in the world, and India’s world-class exchanges and depositories have a wonderful opportunity to occupy a pole position in this space.

At this critical juncture, when each exchange in Asia is deciding whether to be predator or prey in the emerging pan-Asian competition, the Jalan Committee is pushing India in the wrong direction. The recommendations, if implemented, would ensure that Indian exchanges never become pan-Asian institutions. Worse, Indian exchanges could even become completely unviable, if the business moves to exchanges outside India that may offer better service at more competitive prices.

Posted at 10:59 am IST on Tue, 30 Nov 2010         permanent link

Categories: corporate governance, exchanges

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Bailouts and thanksgiving

I wrote a column in Wednesday’s Financial Express arguing that bailout recipients seem to regard the bailout as an entitlement and are therefore unwilling to say ‘thank you’ let alone ‘sorry.’ This sense of entitlement aggravates the risk of moral hazard.

Warren Buffet’s open letter last week (NYT, November 17, 2010) thanking ‘Uncle Sam’ for bailing him out in 2008 serves to remind us that very few corporate leaders in the US or in India have been willing to say ‘thank you’ let alone ‘sorry’ after the global financial crisis and the ensuing bailout. Warren Buffet proudly says that “My own company, Berkshire Hathaway, might have been the last to fall,” but at least he admits that he too needed help.

By contrast, many corporate leaders around the world are busy creating a revisionist history of the crisis in which they can pretend that there was no serious problem with their companies at all. I do not think of the willingness to say ‘thank you’ or ‘sorry’ as a matter of politeness and courtesy. I view it instead as a measure of whether the recipient thinks of the bailout as an entitlement that he can look forward to in future or as a piece of good fortune that may or may not be repeated in future.

Warren Buffet’s letter describes the bailout as a correct policy but makes it clear that the bailout required a confluence of ideological disposition and technical competence in key decision makers. When recipients have this perspective, the moral hazard created by the bailout is attenuated.

While I disagree with the pro-bailout ideology of the Indian government (including RBI and other regulators) at the time, there is little doubt that the Indian crisis response was well thought-out, coordinated and implemented smoothly. Key recipients of this government bailout should be thankful to the government for this but, unfortunately, they seem to see the bailout as their right. Let us look at some examples of how this is leading to moral hazard.

Many debt-oriented mutual funds in India would have had to suspend redemptions but for the support provided by the government through the banking system. More than the mutual funds themselves, the corporate sector that had parked cash surpluses with these funds owe a big thank you to the government. For years, the corporate sector used these mutual funds as a tax sheltered vehicle to earn a high post-tax return on their cash surpluses.

Without the government bailout, these cash surpluses would have become illiquid and inaccessible at the time of the corporate sector’s greatest need. Moreover, the corporate sector would have taken large losses on their investments as the mutual funds tried to liquidate troubled assets into a risk-averse market.

This bailout encouraged moral hazard and within months corporate investors were pouring money back into liquid mutual funds believing that they would be protected if things go wrong. It is very disappointing that the government did not take the opportunity provided by the crisis to end the tax sheltered status of short-term mutual fund investments. Similarly, it is very unfortunate that the government did not impose a hair cut on impatient investors trying to redeem out of these funds at the height of the liquidity crisis.

Many Indian banks benefited from foreign exchange swaps extended by RBI during the crisis. When they were unable to roll over the foreign borrowing after the Lehman failure, and when their credit default swap spreads were trading at around 10% per annum, the RBI swaps were very attractively priced. Indian banks have therefore been in no hurry to subsidiarise their foreign branches.

Non-bank financial companies (NBFCs) owe a large debt of gratitude to the government for the lender of last resort (LOLR) support that they received at the peak of the crisis. Despite the fig leaf of providing the LOLR support through the banking system, the dividing line between banks and NBFCs was largely obliterated in those months.

The entire real estate sector owes a big thank you to the government for encouraging the banking system to restructure real estate loans during the crisis. More importantly, the sector benefited from the bailout of mutual funds and NBFCs, which were important sources of finance for them. Again the moral hazard engendered by this bailout is the main reason we have to worry about a real estate bubble so soon after the crisis.

The Indian corporate sector should also be grateful to the US Fed for unleashing a flood of dollar liquidity into the world after the Lehman failure. The resulting revival of capital flows into India in mid-2009 was instrumental in repairing damaged corporate balance sheets. There is no guarantee that conditions would be the same in the next crisis.

All these bailouts contributed to the relative mildness of the 2008 crisis in India, which has made the Indian private sector complacent. As a result, Indian managers are behaving less prudently than they ought to. That itself is a source of systemic risk. It would be far better if Indian corporate leaders emulated Buffet’s sense of humility and gratitude.

Posted at 9:40 pm IST on Fri, 26 Nov 2010         permanent link

Categories: crisis

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Why do Indian mutual funds intermediate inter-bank lending?

The Reserve Bank of India’s Report on Trends and Progress in Banking in India 2009-10 contains an interesting discussion on the inter-linkages between banks and debt mutual funds (Box IV.1 on page 64). As of November 2009, banks had invested Rs 1.3 trillion in debt mutual funds, but had also borrowed Rs 2.8 trillion from these funds – banks were thus net borrowers to the extent of over Rs 1.5 trillion. It appears that debt mutual funds are intermediating two kinds of flows in the debt market.

1. Debt mutual funds were intermediating Rs 1.5 trillion of debt flows to the banks largely from the corporate sector.
2. More interestingly, debt mutual funds were also intermediating Rs 1.3 trillion of interbank lending.

The RBI report describes the intermediation of interbank lending as follows:

When banks were arranged in a descending order by the amount of their net borrowings from MFs, public sector banks figured prominently at the upper end as major borrowers, while the new private sector banks along with SBI could be seen as major lenders to MFs.

The interbank money market is one of the oldest and most liquid markets in India. The repo market for secured lending is also well established with a central counterparty for risk mitigation, and has worked smoothly even during the turbulent periods of 2008. Why would there be a need for mutual funds to intermediate this market? Two possible reasons come to mind.

1. The intermediation may be happening largely due to the tax advantages of mutual funds.
2. The mutual funds may be intermediating the interest rate risk involved in investing in certificates of deposit issued by banks with several months of residual maturity, while allowing their own investors to redeem at any time. In the ultimate analysis however, this is an illusion because a mutual fund does not absorb risks, it only passes these risks on to its investors. Since the primary non-bank investors in a debt mutual fund come from the corporate sector, the question is whether the corporate sector has superior ability or willingness to assume this risk. I think the answer is no; in times of stress the corporate sector has been desperate to bail out of mutual funds. In 2008, it was left to the government to bail out the mutual funds themselves.

It appears to me that the whole system of artificial tax breaks to mutual funds has created economically useless layers of intermediation while also adding to systemic risk and fragility.

Posted at 1:52 pm IST on Mon, 15 Nov 2010         permanent link

Categories: banks, mutual funds

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Mutual funds supporting their parents

Nearly three years ago, Ajay Shah sent out an email to a few of us about how the regulatory framework of a “first world country” would deal with possible conflicts of interest between a mutual fund and its parent company. At that time, it was too early in the global financial crisis for me to give the flippant answer that there are no first world countries any more – we are all third world countries.

The example that I gave then was that of UBS allegedly stuffing its own shares into its mutual fund and into the portfolios of wealth management clients and then voting them to win a proxy war against Martin Ebner way back in 1994. Holders of class N shares voting in favour of the UBS share unification proposal in that meeting were effectively voting to destroy the value of their own shares as Loderer and Zgraggen explained in an interesting paper (“When Shareholders Choose Not to Maximize Value: The Union Bank of Switzerland’s 1994 Proxy Fight”, Journal of Applied Corporate Finance, Fall 1999). Ideally therefore, portfolio investors should have sold all their class N shares ahead of the meeting.

But now there is an academic paper showing that Spanish mutual funds buy shares in their parent banks to prop up the share price after a significant fall (Golezyand and Marinz, “Price Support in the Stock Market”, SSRN, June 2010). The paper finds compelling evidence for such price support with careful econometrics that rules out alternative explanations like portfolio rebalancing into the banking sector, contrarian trading, timing skills or information-driven trading.

The authors point out that “Strictly speaking, price support activities by mutual funds are illegal, as the trades are not necessarily placed in the interest of the fund investors.” However they also believe that Spain is a country in which such crimes are not closely monitored and are not severely prosecuted.

Posted at 2:45 pm IST on Tue, 9 Nov 2010         permanent link

Categories: banks, corporate governance, mutual funds

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Goodhart's law and leverage ratios

I am a strong believer in Goodhart’s Law which says that any measure begins to lose its usefulness when it is used as a regulatory target. The Basel Committee paper on “Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach” released last week shows that this is quite true of the leverage ratio.

Table 2 on page 17 shows that if we exclude countries which had a leverage ratio requirement before the financial crisis, the leverage ratio does predict financial distress of banks. There is a large and statistically significant difference in the 2006 leverage ratios for banks that were stressed in the crisis of 2007/2008 and those that were not. However when these countries are included, the difference is smaller and is not statistically significant in most cases.

The Basle committee, which is now wedded to the idea of a leverage ratio, does not draw the conclusion that Goodhart’s Law is in operation. It refuses to even provide the only data which is truly relevant – the data for the countries which had a leverage ratio requirement pre-crisis. It is very likely that for these countries the leverage ratio would have been seen to be practically useless.

Posted at 2:07 pm IST on Mon, 1 Nov 2010         permanent link

Categories: leverage, post crisis finance, regulation, risk management

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Crisis related books

My favourite crisis related book, Raghuram Rajan’s Fault Lines won the Financial Times and Goldman Sachs Business Book of the Year award last week. That gives me an excuse to write about the various crisis related books that I have read. There are clearly many important books on the crisis I have not read, and so I cannot comment on them. My list is not therefore intended to be comprehensive.

First of all are the books that provide a theoretical analysis of the crisis in its entirety and not just a few aspects of it.

• Of the books that I have read in this genre, the one that I liked the most was Raghuram Rajan’s Fault Lines. It provides a comprehensive analysis of the crisis covering both the domestic factors in the US and the global factors.
• A close second was Nouriel Roubini’s Crisis Economics. Roubini’s writings during the depths of the crisis were perhaps the most insightful discussions that one could get in real time. (I remember that Roubini was also the most insightful commentator on the Argentine crisis of 2001 in real time and next only to Krugman in real time analysis of the Asian Crisis in 1997-98). Perhaps it was because I read Roubini’s book with such high expectations that I found his book a little rushed. That pushed the book to second place in my ranking. Yet, I think that Roubini is also a book that anybody who wants an analytical understanding of the whole crisis must read.

Then there are books that provide important but partial theoretical perspectives on the crisis.

• Simon Johnson’s 13 Bankers is a wonderful book. We know a lot about emerging market crises because there have been so many of them; and Simon Johnson applies that knowledge to the crisis in the United States. The idea that the US has behaved like an third world country during the crisis is an important idea to which I am very sympathetic. I talked about Mahathirism in the US and UK in a blog post in April 2008. Yet I somehow found his May 2009 article The Quiet Coup in the Atlantic more powerful and satisfying than the book itself.
• Animal Spirits by George Akerlof and Robert Shiller, is a book length analysis of what Keynes discussed in a single paragraph in the General Theory. It appears to me that “Animal Spirits” needs more than a paragraph, but less than a book.
• Martin Wolf, Fixing Global Finance is a book that I liked very much, despite its heavy focus on global imbalances.
• Robert Shiller’s The Subprime Solution is a masterly analysis of the housing bubble by an economist who did warn about the bubble long before it burst. Similarly, Andrew Smithers’s Wall Street Revalued comes from an economist who made his name by warning about the dot com bubble.
• Are the Golden Years of Central Banking Over? by Stefan Gerlach and others deals at length with the monetary policy and financial regulation implications of the crisis. Richard Koo’s The Holy Grail of Macroeconomics about balance sheet recessions and the lessons from Japan is also an interesting book.
• Among the books in this genre that I read but did not enjoy to the same extent were ECONned by Yves Smith, How markets fail by John Cassidy, The origin of financial crises by George Cooper and POP: why bubbles are great for the economy by Daniel Gross.

The third category is books that provide a detailed factual narrative of the entire crisis.

• By far the best book here is the magnum opus by Andrew Sorkin – Too Big to Fail. He has been able to put together eye witness accounts from so many sources that the book makes it appear that Sorkin was a fly on the wall watching and listening as the momentous events unfolded.
• Another must read book is Henry Paulson’s On the Brink. Despite being written so soon after Paulson stepped down as Treasury Secretary, the book is surprisingly frank and detailed. He does seek to justify what he did, but manages to do so without becoming jarring. I am tempted to say that Paulson has done a far better job as an author than he did as Treasury Secretary.
• I am waiting eagerly for Bernanke’s long promised book Before Asia Opens. If Bernanke serves as Fed Chairman for as long as Greenspan did, we might have forgotten about the crisis by the time we get that book.

Another important category of crisis books look at specific actors or groups of actors that made or lost a fortune in the crisis.

• The Big Short by Michael Lewis and the Confidence Game by Christene Richard are among the most enjoyable crisis related books that I have read. (I have yet to read Gregory Zuckerman’s Greatest Trade Ever).
• William Cohan chronicles the demise of Bear Stearns in House of Cards, while Roger Lowenstein has a broader sweep covering Bear, Lehman, AIG and the rest of the infamous cast in his End of Wall Street. I believe however that no book on Lehman is likely to match the dull prose of the 2,200 page report produced by the court examiner Anton Valukas.
• Several great books about hedge funds, quants and nerds helped me understand the crisis much better though they are only partly (or in some cases, only peripherally) about the crisis. Sebastian Mullaby’s More Money than God, Scott Patterson’s The Quants, David Leinweber’s Nerds on Wall Street, and Richard Bookstaber’s Demon of Our Own Design are all books from which I learned a lot. They are also well written and immensely enjoyable. Lecturing Birds on Flying by Pablo Triana gives an extreme anti-quant view, but I found the book unconvincing. Gillian Tett’s fabulous book on the origin and growth of credit default swaps – Fool’s Gold – is another must read. Selling America Short by Richard Sauer is also a very good book; all regulators should definitely read this.

I now turn to official reports related to the crisis.

• On the crisis as a whole, the IMF’s Global Financial Stability Report, the BIS Quarterly Review and Annual Report were indispensable in making sense of the crisis as it unfolded. But if I ask myself which of these would one like to re-read years later, it would be the BIS Annual Report for 2007-08, particularly its first chapter, “The unsustainable has run its course”. The Financial Crisis Inquiry Commission in the US is due to submit its report at the end of the year, but expectations are rather muted about this.
• On individual firms, I have already mentioned the Valukas report on Lehman. The Shareholder Report on UBS’s writedowns, and the subsequent Transparency Report are good sources of information on UBS. The report of the Special Investigation Commission in Iceland provides detailed information about the failure of the big Icelandic banks. Some information is available about AIG in the reports of the Congressional Oversight Panel, but we still know too little about that company.

I have not mentioned the books on financial history without which one cannot make sense of the crisis at all. This however is a subject for a separate blog post that I hope to compose in the next few days. So in this post, I will confine myself to only one book in this genre – This Time is Different – by Carmen Reinhart and Kenneth Rogoff. This is a book that simply cannot be dropped from any reading list on the crisis

Postscript: I have cheated a little. Many of the books that I have mentioned have a long subtitle in addition to the main title that I have mentioned here. I was too lazy to type these subtitles; moreover, the title is usually much more pithy without the subtitle. I have also consciously avoided giving links to Amazon or any other book site for any of these books in the belief that any half decent search engine will make up for this omission.

Posted at 4:44 pm IST on Sun, 31 Oct 2010         permanent link

Categories: crisis, financial history, interesting books

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Some more thoughts on the flash crash

I have written a number of times about the flash crash during the last five months (here, here, here, here, here, and here.) This post tries to put together the key issues as I see them.

• The flash crash happened towards the end of the day in the US when Asia and Europe were both closed and therefore nothing happened in those markets. The rest of the world has therefore been able to think of this as America’s problem. Had this happened when other markets were open, it would have been every body else’s problem.

  Quite apart from that, I think the flash crash is a serious issue for regulators in all countries. Large market orders interacting with a thin order book can cause a flash crash in any market anywhere in the world.

• The crash happened on a relatively calm and benign day. Yes, there were some protests in Greece, but that hardly counts as a crisis situation. Things would have been much worse if the crash had happened when a big bank was tottering or when a serious terrorist attack or a grave natural calamity was in progress.

  In this sense, the flash crash episode can even be regarded as a good thing to have happened. Without causing much damage, it provided a wake up call to regulators to analyze market designs and make them more robust. If we do not take corrective action, we will probably end up facing a much bigger market disturbance on a bad day.

• It is a mistake to think that the flash crash can happen only with automated high frequency trading. With a sufficiently thin order book, a flash crash can be triggered by a cascade of stop loss orders (at one level, a stop loss order is also an algorithm). Indeed, even a cascade of market orders is sufficient.

• It is time to reconsider the whole issue of internalization that allows brokers to execute proprietary trades against customer order flow without routing everything to a transparent execution venue.

  The SEC report discusses internalization at length, but its cognitive capture is so complete that it does not see anything wrong in what happened. What are the fiduciary responsibility of a market maker who thinks that the market is too risky to trade in on its own account but merrily routes customer orders into that same market? Is it acceptable to argue that this is fine because the trades would be cancelled anyway?

• The CFTC/SEC report has not provided confidence to the retail investors about the integrity of the market structure. It has failed to provide a convincing and conclusive answer to whether any market abuses happened during the flash crash.

• There is need to examine whether the SEC’s implementation of the National Market System is fundamentally flawed.

  The technology underlying the dissemination of the National Best Bid and Offer (NBBO) is so antiquated compared to the rest of the modern market infrastructure that the professionals seem to be relying only on proprietary price feeds.

  At the same time, as trading gets fragmented across multiple execution venues, the need for best execution is only becoming more and more pressing.

• As trading has moved to ever shorter latencies, the surveillance capability of the regulators has fallen far behind. Regulators do not seem to have the capabilities to analyze high frequency data at all and I think this is a serious problem.

• There is a major problem with the accuracy of time stamps of major market infrastructure providers. Today using GPS time synchronization and PTP instead of NTP, it is possible to achieve accuracy of a few microseconds, and regulators need to mandate this for systemically important entities.

• We should consider eliminating the ability of exchanges to cancel wrong trades completely.

  The SEC has moved to make the cancellation process a little more objective and transparent than before. But today’s information technology makes it possible to get rid of trade cancellation completely. If an objective algorithm exists to determine the trades to be cancelled, the same algorithm can be used to prevent those trades from happening at all. Unlike in a manual system, the reaction time of a computer can be fast enough to “cancel” the trade in real time by not matching the trade at all.

• The evidence seems to suggest that the market structure has become so fragile that it is an accident waiting to happen. I am reminded of the old nursery rhyme:

  For want of a nail the shoe was lost.
  For want of a shoe the horse was lost.
  For want of a horse the rider was lost.
  For want of a rider the battle was lost.
  For want of a battle the kingdom was lost.
  And all for the want of a horseshoe nail.

  When this kind of a thing happens, the solution is not to go in search of the blacksmith who lost the nail (or the mutual fund that did a large futures trade), but to build more buffers and make the system more robust so that a few nails and horses can be lost without catastrophic consequences. Just as we stress test individual banks, it is also necessary to stress test the entire market structure.

  The best way to do that is to build simulated computer models of the entire market structure including the most popular trading algorithms and then stress test the whole edifice.

Posted at 8:23 pm IST on Wed, 20 Oct 2010         permanent link

Categories: exchanges, investigation

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