Prof. Jayanth R. Varma's Financial Markets Blog

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

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

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Mon, 16 Oct 2017

Credit bureaus as fundamentally dangerous businesses

I received a lot of push back against my suggestion that Equifax should be shutdown in response to the massive data hack that has been described as the worst leak of personal info ever. Many people thought that this was too drastic: one comment was that it “would shake the ground under capitalism.” Some thought that all computers can get hacked and we cannot keep shutting down a company whenever this happens.

I think of this in terms of the standard legal maxim of “strict liability” which is described for example here:

A strict liability tort holds a person or entity responsible for unintended consequences of his actions. In other words, some circumstances or activities are known to be fundamentally dangerous, so when something goes wrong, the perpetrator is held legally responsible.

I regard credit bureaus as fundamentally dangerous businesses that ought not to exist in their current form. When something goes wrong in these businesses, the liability should be absolute and punitive. What has happened in Equifax is so bad that imposition of a reasonable liability would simply put them out of business. Simultaneously, we start building modern, safer alternatives to this fundamentally dangerous business.

I see the past, present and future of credit bureaus as follows:

  1. Past: Credit bureaus were first formed more than a century ago in the age of paper records and manual systems, and the business was relatively safe at that time. Society therefore encouraged the growth and development of these institutions.

  2. Present: With the emergence of the internet, the business has rapidly become a systemic risk to the entire financial system, but till now we have tolerated them because there seemed to be no viable alternatives.

  3. Future: Recent advances in cryptography today provide much safer alternatives to the credit bureaus in their current form.

We are today at the cusp of the transition from the second to the third stage:

I plan to write a separate blog post on how homomorphic encryption can solve the problems that plague current credit bureaus.

Posted at 16:47 on Mon, 16 Oct 2017     View/Post Comments (0)     permanent link


Fri, 29 Sep 2017

How insider trading laws became the crooks' best friend

Andrew Verstein’s blog post on “Insider Tainting: Strategic Tipping of Material Non-Public Information” at the CLS Blue Sky Blog made me think about the numerous ways in which insider trading laws have become the crooks’ best friend. Verstein gives an example based on a controversial real life episode, but I would prefer to rephrase it as a purely hypothetical situation:

Consider a small company (let us call it SmallCo) which has not been doing too well. The company plans to issue new shares to shore up its capital though this would dilute the existing shareholders. At this point of time, SmallCo's CEO comes to know that the largest shareholder in the company (let us call him John) is on the verge of selling his shares. If John sells his block, that would send a negative signal to the market about SmallCo's prospects and would frustrate its plans to raise new capital. More menacingly, if John’s stake ends up in the hands of an activist investor, that would lead to a lot of pressure on the existing management and even a change of management – SmallCo's CEO could end up losing his job. The CEO comes up with a brilliant plan to stop John from selling his stake (and save his job): he simply calls up John and informs him of the confidential plan to sell new shares. John is now “tainted” with insider information, and may not be able to sell his stake without attracting insider trading laws.

While this is a shocking illustration of how a crooked CEO may be able to recruit the securities regulator itself as his partner in market manipulation, the more important question to ask is why did the securities regulator choose to frame laws that end up having this perverse effect. In my opinion, the true reason for this is the regulatory capture of securities regulators worldwide by the intermediaries that they regulate.

As part of this argument, I would like to draw on a brilliant blog post by Judge Rakoff in 2013 on “Why Have No High Level Executives Been Prosecuted In Connection With The Financial Crisis?” (I blogged about this piece at that time). Rakoff quickly dismisses the argument that no fraud was committed, and that the Global Financial Crisis was simply a result of negligence, of the kind of inordinate risk-taking commonly called a ‘bubble.’ The judge cites various official reports to demonstrate that “in the aftermath of the financial crisis, the prevailing view of many government officials (as well as others) was that the crisis was in material respects the product of intentional fraud.” He then articulates what he regards as the most important reason why no such prosecutions happened:

First, the prosecutors had other priorities.

...

Alternative priorities, in short, is, I submit, one of the reasons the financial fraud cases were not brought, especially cases against high level individuals that would take many years, many investigators, and a great deal of expertise to investigate.

Insider trading prosecutions (Martha Stewart, Raj Rajaratnam and Rajat Gupta) and Ponzi scheme prosecutions (Bernie Madoff) in my view played an important role here. The public’s anger was assuaged by prosecuting some high profile individuals, and this served to deflect attention from the fact that the executives running the large institutions escaped scot-free.

What is interesting about insider trading prosecution is that it allows financial sector regulators to target people who are outside (or at the periphery of) the financial system. It is therefore extremely attractive to regulators who have been captured by its regulatees. It is able to project an image of being a very tough regulator without causing much harm to its own regulatees.

This perspective explains several puzzling facts about the evolution of insider trading law:

  1. Insider trading law and enforcement has expanded though there has been a strong academic argument going back half a century for legalizing insider trading (see for example, Henry Manne and Hu and Noe). Even if one does not go that far, there is a strong argument for decriminalizing insider trading and making it purely a civil liability. I have been making this argument for nearly 15 years now (see for example here).

  2. Regulators have progressively sought to enlarge the definition of insider trading to cover many legitimate activities on the ground that without such an expansive definition, insider trading becomes hard to prove. I often joke that the prohibition of “insider trading” has gradually morphed into the prohibition of “informed trading.”

  3. Regulators have rarely used their powers judiciously and have typically tended to pursue specific high-profile cases for extraneous reasons.

Posted at 16:45 on Fri, 29 Sep 2017     View/Post Comments (0)     permanent link


Sat, 23 Sep 2017

Norway and the tail risk of bonds

I have long been an admirer of the transparent and sound investment policies of Norway’s sovereign wealth fund (Government Pension Fund Global). However, I was perplexed by their recent proposals regarding the bond portfolio of this fund.

In the long term, the gains from broad international diversification are considerable for equities but moderate for bonds. For an investor with 70 percent of his investments in an internationally diversified equity portfolio, there is little reduction in risk to be obtained by also diversifying his bond investments across a large number of currencies.

The benchmark index for bonds currently consists of 23 currencies. Our recommendation is that the number of currencies in the bond index is reduced. This will have little impact on risk in the overall benchmark index.

An index consisting of bonds issued in dollars, euros and pounds alone will be sufficiently liquid and investable for the fund.

I tend to think of the risk of the high grade bonds (of the kind that Norway invests in) as consisting predominantly of tail risk. This is well described by Adam Fergusson’s When Money Dies about the German hyperinflation of the 1920s. A long term investor like the Norway sovereign fund needs to worry about this tail risk. A policy of concentrating the bond portfolio in just three currencies does not appear prudent to me.

The other possibility is that the Norway fund is ceasing to be the long term investor it used to be. As the accumulation phase comes to an end, and the fund enters its draw down phase, it may be prioritizing liquidity over everything else. (In 2016, Norway drew down from the sovereign fund for the first time in its history.) The management of the bond portfolio of the fund then begins to resemble normal foreign exchange reserve management which tends to concentrate holdings in a handful of highly liquid reserve currencies.

Posted at 15:13 on Sat, 23 Sep 2017     View/Post Comments (0)     permanent link


Sun, 17 Sep 2017

Bonds markets are not different

Institutional investors have long argued that bond markets are very different from equity markets and need OTC trading venues because of their peculiar characteristics. More than a decade ago, I remember receiving massive push back for suggesting that an exchange traded government bond market could be better for India than the recommendations of the RH Patil Committee.

In recent years, however, the structure of bond markets in the developed world has started moving closer to that of the equity market. Post crisis reforms like higher capital requirements and the Dodd Frank Act have led dealers to reduce their market making activities. Other players including hedge funds, algorithmic and high frequency traders as well as electronic trading platforms have stepped into the breach. The SEC study on Access to Capital and Market Liquidity submitted to the US Congress last month provides a great deal of evidence on the ability of the new market structure to deliver reasonable levels of liquidity.

Meanwhile, a recent study (Abudy and Wohl, “Corporate Bond Trading on a Limit Order Book Exchange”, July 2017) showed that the exchange traded corporate bond market in Tel Aviv Stock Exchange in Israel is more liquid than the OTC corporate bond market in the US (both in terms of narrower spreads and lower price dispersion). This is so despite the fact that the market for stocks in Israel is less liquid than in the US. An exchange traded corporate bond market in the US could therefore be expected to have even narrower spreads than in Israel.

We should stop doubting the ability of pre and post trade transparency to improve liquidity across asset classes.

Posted at 17:31 on Sun, 17 Sep 2017     View/Post Comments (0)     permanent link


Wed, 13 Sep 2017

Should Equifax be shut down?

The US and India are among the few countries that still retain the death penalty for people, and they should have no qualms about imposing the death penalty on companies. Equifax might be a good candidate for this drastic action after the massive data hack that has been described as the worst leak of personal info ever.

There is probably no criminal activity involved, and so nobody can be sent to jail. Fines and penalties will doubtless be imposed, but companies like Equifax tend to think of any fines as simply the cost of doing business and do not find it a sufficient deterrent. They will continue to spend too little on cyber security. There is little that consumers can do to discipline them either. Adam Levetin at Credit Slips hits the nail on the hand:

Equifax didn’t lose customer records. It lost consumer records. That’s an important distinction, and it goes to the heart of the problem with the CRAs. Consumers can, in theory, avoid harm from a data security breach at a merchant by not doing business with the merchant.

...

It’s not possible for a consumer to withhold business from a CRA because the consumer does not have a business relationship with the CRA. And this is the key problem: we have a consumer financial services market in which consumers cannot vote with their pocketbooks.

A threat far bigger than fines and penalties is needed to force financial firms to take security of consumers seriously. The only credible threat is that of shutting down the company and simultaneously imposing a penalty large enough to ensure that neither shareholders nor creditors of the company receive anything in the liquidation.

Posted at 21:33 on Wed, 13 Sep 2017     View/Post Comments (2)     permanent link


Mon, 04 Sep 2017

The Jorda et al. estimate of the world Market Risk Premium

The Market Risk Premium (expected excess return of equities and other risky assets over risk free assets) is an important element in asset pricing models particularly the Capital Asset Pricing Model. Estimating the Market Risk Premium from historical data is very difficult because of high volatility – the sample mean over even many decades of data is subject to too large a sampling error. For example, reliable historical data on risk premiums in India goes back less than three decades, and we worry whether the realized risk premium over this period is representative of what premium will prevail in future. Data going back around a century is available for the United States, but use of this data raises serious issues of survivorship bias, as the US is clearly one of the best performing economies of the last century.

I think the NBER Conference paper by Jorda, Knoll, Schularick, Kuvshinov and Taylor “The Rate of Return on Everything, 1870–2015” is a valuable new estimate of the Market Risk Premium. First they have put together a large sample: 16 advanced economies over almost 150 years (the length of the sample varies from country to country). Second, they compute the Market Risk Premium using not merely equities, but also housing which is the most important risky asset outside of equities. In finance theory, the Market Portfolio in theory includes all risky assets, and including housing moves the empirical estimation closer to theory. Pooling data across all countries, they arrive at the following conclusion:

In most peacetime eras this premium has been stable at about 4% – 5%. But risk premiums stayed curiously and persistently high from the 1950s to the 1970s, despite the return to peacetime. However, there is no visible long-run trend, and mean reversion appears strong. The bursts of the risk premium in the wartime and interwar years were mostly a phenomena of collapsing safe rates rather than dramatic spikes in risky rates. In fact, the risky rate has often been smoother and more stable than safe rates, averaging about 7% – 8% across all eras.

It is interesting to observe that the Capital Asset Pricing Model was created during the period of high risk premiums in the 1960s, and its obituaries started being written in the 1980s and 1990s when the risk premium collapsed to very low levels (Figure 10 in the paper).

Jorda et al. also provide an estimate of another important risk premium using the same long period multi-currency sample: the term structure premium or the liquidity risk premium (bonds versus bills). This risk premium is around 1.5% for the full sample, but somewhat larger during the last quarter century (Figure 3 of the paper).

Posted at 17:02 on Mon, 04 Sep 2017     View/Post Comments (0)     permanent link


Tue, 29 Aug 2017

Operational creditors yet again

When the Bankruptcy Law Reforms Committee (BLRC) submitted its report nearly two years ago, one of my major concerns was the dubious and unwarranted distinction that it made between operational and financial creditors (see my blog posts here and here). This invidious distinction has come back to haunt us today as home buyers find themselves in the lurch when bankruptcy proceedings are initiated against the developer. Pratik Datta tells the full story of this mess in her blog post at Ajay Shah’s blog.

This is symptomatic of a deeper problem with how bankruptcy reform in India has developed as a bailout of the financial sector rather than as a reform of the real economy. From the Debt Recovery Tribunal to SARFAESI to the Bankruptcy Code, banks were privileged over other creditors and financial creditors over operational creditors. It would appear that the dominant goal has been to save the banks. Jason Kilborn articulates the problem very elegantly in his blog post at Credit Slips:

It seems to me a sign of serious regulatory dysfunction when a government expressly uses bankruptcy law as a means of collection, rather than rescue or at least collective redress, with an aim to treating economic stagnation.

It is particularly telling that there has been a profound unwillingness to apply bankruptcy principles to the financial sector itself: Global Trust Bank was merged instead of being left to die; Unit 64 was bailed out; even today, there is no willingness to liquidate even the worst public sector banks. One has to go back half a century to Palai Central Bank for an example of a bank of any significance being allowed to die (though only after a lot of dilly dallying).

Posted at 14:08 on Tue, 29 Aug 2017     View/Post Comments (0)     permanent link


Mon, 07 Aug 2017

Are bonds both a liability and an asset of the borrower?

I have a special interest in this question because that was the topic of the first post on my blog way back in 2005. Five centuries after Luca Pacioli wrote the first text book on double entry accounting, this issue remains unresolved, and smart litigants are still seeking to attach the bonds issued by the debtor to recover their claims. In 2005, it was Argentina; in 2017, it is Venezuela (hat tip Credit Slips).

Twelve years ago, Argentina was exchanging its old bonds for new bonds as part of its infamous debt restructuring. Some hedge funds moved to seize the old bonds that Argentina had accepted for the exchange on the ground that the surrendered bonds were assets of Argentina which could be sold in the market to satisfy the claims of the hedge funds. Argentina of course argued that the bonds belonged to the tendering holders, and that they could not be Argentina’s assets and liabilities at the same time. The federal appeals court in New York did not decide the legal question, but simply upheld the trial court’s ruling in favour of Argentina on the ground that the trial judge overseeing the overall debt exchange had broad discretion in the matter. Anna Gelpern provides more details in this paper (page 4).

If Argentina’s debt restructuring was a mess, Venezuela promises to be even messier if and when that country gets to that stage. What is happening now are merely some skirmishes before Venezuela defaults and the serious litigation begins. Buchheit and Gulati wrote in a recent paper:

Napoleon’s invasion of Russia in 1812 was a large undertaking. Restructuring Venezuela’s public sector debt will be a very large undertaking.

Early this year, Venezuela issued $5 billion in new bonds to a state owned entity to help raise cash needed for essential imports (“Venezuela issues $5bn in bonds as it seeks cash to ease shortages”, Financial Times, January 3, 2017). In June, Venezuela engaged a Chinese securities firm, Haitong, to resell these bonds reportedly at a steep discount of more than 70% (“Venezuela Discounts $5 Billion in Bonds”, Wall Street Journal, June 6, 2017). Soon, a Canadian firm, Crystallex, obtained a restraining order against Haitong, as a first step towards attaching the bonds. (“Crystallex Moves Closer To Collecting $1.2B Venezuela Award”, Law360, July 17, 2017). Perhaps, this time, the courts will actually decide this question as to whether a debtor’s bonds can be treated as its assets and attached by the creditors.

Posted at 19:06 on Mon, 07 Aug 2017     View/Post Comments (0)     permanent link


Sat, 05 Aug 2017

Markets that are Too Big To Fail (TBTF)

We hear a lot about TBTF banks, but I think in the post crisis world, policy makers are beginning to view some markets as being TBTF. The IMF published a working paper last month by Darryl King et al. on Central Bank Emergency Support to Securities Markets. This paper appears to me to formalize and legitimize this idea. My unease about this paper is that it not only endorse almost everything that the central banks did during the crisis, but also elevates these to the level of best practices. The paper ignores the fact that while these might have helped in the crisis, they would also have unintended effects on the functioning of markets during normal times.

Markets that are highly likely to be bailed out during a future crisis will be perceived as safer even during normal times. Bonds that trade in these markets will therefore command lower yields. The result is a subsidy to the borrowers issuing these bonds. The subsidy to TBTF banks is partially alleviated through more stringent regulation of these banks (SIFIs), but there is no such regulatory pressure on corporate borrowers benefiting from the subsidization of TBTF markets.

I am fond of Kindleberger’s statement that a lender of last resort must exist but his existence should be doubted. In their eagerness to legitimize whatever was done during the crisis, policy makers are removing this doubt and making the TBTF subsidy more certain and more significant. They are picking winners and losers, and since the winners that they choose are the mature companies, they are penalizing the more innovative dynamic firms that are crucial for long term economic growth.

Posted at 21:36 on Sat, 05 Aug 2017     View/Post Comments (0)     permanent link


Wed, 02 Aug 2017

In the sister blog and on Twitter during January-July 2017

The following posts appeared on the sister blog (on Computing) during January-July 2017.

Tweets during January-July 2017 (other than blog post tweets):

Posted at 14:16 on Wed, 02 Aug 2017     View/Post Comments (2)     permanent link


Mon, 31 Jul 2017

Equity Derivatives versus Cash Equities in India

The Securities and Exchange Board of India (SEBI), the Indian securities regulator, put out a discussion paper a couple of weeks ago on the Growth and Development of Equity Derivatives Market in India. The Indian Equity Derivatives Market is one of the success stories of financial market development in India and clearly, it makes sense to study this market to draw lessons that could help replicate this success in other segments (bond markets for example) that have remained under developed after 25 years of reforms.

Unfortunately, the SEBI discussion paper seems to prefer levelling down to levelling up. Rather than bring other markets up to the high standards set by the equity derivatives markets, it seeks to clamp down on this successful market to reduce it to the mediocrity of other lacklustre markets.

The discussion paper is worried about the high ratio of derivative market turnover to cash market turnover, and thinks that therefore there must be something wrong with the derivative market. The correct conclusion is quite the opposite: there is something grievously wrong about the cash market. Several policy makers have conspired to prevent a vibrant cash market from emerging in India:

  1. The Reserve Bank of India (RBI) places severe restrictions on capital market related lending and therefore starves the cash market of credit. Everybody who seeks leverage is therefore forced to move to the derivative market. SEBI has a margin trading scheme, but this scheme has been largely a failure.

  2. For a different set of reasons, the securities lending scheme has also failed to take off, and those desirous of taking a short position in stocks are also forced to turn to the derivative market.

  3. The government in its greed for tax revenue (with near zero collection cost) has pushed up the securities transaction tax to punitive levels in the cash market. Though the difference in price elasticity in the two markets could make the revenue maximizing rate of taxation unequal in the two markets, it is likely that the current rates are not actually optimal even from a revenue maximizing point. More importantly, the rate of transaction tax in the cash market is far too high from a social welfare point of view.

These factors have stunted the growth of the cash equities market in India. The liquid derivatives market has ameliorated this problem for the top 50-100 companies. But that leaves hundreds of other companies in the lurch. In my view, this is a serious problem because a vibrant equity market is important for economic growth. All policy makers (SEBI, RBI and the Finance Ministry) need to come together to fix the flaws in the cash equities market.

I believe that India can create a reasonably liquid market for the top 1000 companies in the country. Market participants laugh at me when I say this, but if the US can do this, I do not see why India cannot. We have all the institutional prerequisites for such a market – world class depositories, exchanges, and clearing corporations; a large ecosystem of intermediaries; a strong regulator; and above all a vast investor base. I hope that regulators will raise their sights and aim for this, rather than try to cripple the derivative market so that it is no longer obvious that the cash market is limping.

Posted at 21:23 on Mon, 31 Jul 2017     View/Post Comments (1)     permanent link


Sun, 30 Jul 2017

The SEC and The DAO

The US SEC has published an Investigation Report concluding that crpyto-currency tokens issued by The DAO constitute securities under US law. I am not a lawyer, and it is not my intention in this post to dispute the SEC’s conclusion which is, on balance, probably correct. What bothers me is that some vital facts seem to me to have been suppressed and misrepresented in the report. In particular, several passages look like the kind of suppresio veri suggestio falsi that one does not expect from a top notch regulator like the SEC which commands global respect:

DAO Token holders’ votes were limited to proposals whitelisted by the Curators, and, although any DAO Token holder could put forth a proposal, each proposal would follow the same protocol, which included vetting and control by the current Curators. While DAO Token holders could put forth proposals to replace a Curator, such proposals were subject to control by the current Curators, including whitelisting and approval of the new address to which the tokens would be directed for such a proposal.

This ignores the ability to split The DAO and create a new “child” DAO with a new curator. The hacking of The DAO (which the SEC refers to as the Attack below) involved exactly this splitting.

Second, the pseudonymity and dispersion of the DAO Token holders made it difficult for them to join together to effect change or to exercise meaningful control. ... This was later demonstrated through the fact that DAO Token holders were unable to effectively address the Attack without the assistance of Slock.it and others.

In reality, it is the DAO Attack that constitutes the biggest obstacle to the theory that The DAO tokens were securities. The tokens looked much more like securities when they were issued than they do in retrospect after the Attack:

  1. The only important events (“investments” in some sense) in the entire life of the DAO were the Dark DAO (the Attacker) and the Robin Hood Group or the DAO White Hat Team. Since neither of these were initiated by Slock.it, this completely demolishes the idea that Slock.it was in a position to control The DAO.

  2. I could not help laughing out loud on reading the sentence: “DAO Token holders were unable to effectively address the Attack without the assistance of Slock.it and others”.

    • If the “others” refers to the Robin Hood Group (White Hat Team), this statement is factually incorrect: (a) the Robin Hood Group were also token holders (and not others) and (b) they were acting not on behalf of Slock.it, but in their individual capacity, struggling with “bad internet and family commitments”.

    • The major assistance that Slock.it provided in reversing the Attack was not in their role as developers of The DAO, but in their role as developers of Ethereum which was the platform on which The DAO ran. What the core developers did was to change the rules of Ethereum to undo the Attack.

      The right analogy is that of a company where the government has been outvoted in a shareholder’s meeting (because it has been reduced to a minority stake), and the government proceed to change the law and use its sovereign powers to get its way. This would establish not that the government still controls the company, but that it has lost control. The analogy is apt because Ethereum was the closest thing to the sovereign when it comes to The DAO.

    • Even this “assistance” (changing the rules of Ethereum) was well beyond the powers of Slock.it. Ethereum is far more decentralized than The DAO; even the SEC has not claimed that the Ethereum coin offering was a securities issue! The Ethereum community did not actually care much about the wishes of Slock.it. Whatever influence was there was the personal influence of Vitalik Buterin. (In much the same vein, the Ethereum community probably did not care much about Cornell University, but listened with respect to Emin Gun Sirer). Even Buterin’s enormous personal credibility could not prevent a split in Ethereum and the creation of the parallel coin, Ethereum Classic

In short, the Attack demonstrated that at truly important junctures, crypto communities are truly decentralized. The events in Bitcoin in the last few weeks provide additional corroboration of this.

These facts diminished the ability of DAO Token holders to exercise meaningful control over the enterprise through the voting process, rendering the voting rights of DAO Token holders akin to those of a corporate shareholder.

The SEC forgets that The DAO did not have a Board or a Chief Executive who run the company on a day to day basis. In the case of The DAO, the day to day administration of the organization was in the hands of the token holders.

By contract and in reality, DAO Token holders relied on the significant managerial efforts provided by Slock.it and its co-founders, and The DAO’s Curators, as described above.

The claim “By contract” is very rich. The DAO was very clear in all its communications that it was governed by its code and repeatedly emphasized that all English language descriptions were subordinate to the smart contract embedded in the code: code is law. And, I am sorry, the code did not contain any promises by Slock.it to provide managerial efforts.

Posted at 20:54 on Sun, 30 Jul 2017     View/Post Comments (0)     permanent link


Sat, 29 Jul 2017

Libor and Nash Equilibria

This week, I read two apparently unrelated things that on later reflection are deeply related:

  1. The FCA, the UK regulator, made a statement that the world’s most important interest rate benchmark, Libor, will be phased out in less than five years because of lack of liquidity. The problem discussed in this speech is very easy to understand: the underlying market is no longer sufficiently active. The reasons for this state of affairs are much harder to diagnose.

  2. A highly esoteric paper was published on the Computer Science and Game Theory section of arXiv more than six months ago, but I read it only recently after FT Alphaville linked to it at one remove a few days ago. This paper by Babichenko and Rubinstein proves that finding even an approximate Nash equilibrium of an n person binary-action games requires an exponential amount of communication, and therefore, it takes an exponential number of rounds of the game for the players to “learn” the approximate Nash equilibrium by playing the game repeatedly.

The link that I see from the esoteric paper to the Libor situation is that markets require very rich communication structures to be viable. One way to facilitate the required amount of multi-way communication is through the high degree of pre-trade and post-trade transparency that is created by trading on an exchange. The other method that was used in the past in various over the counter (OTC) markets was informal communication channels between traders in different firms. Some of these traders might have worked together in the past or might have other personal and social connections. Using various messaging and chat media, these traders used to accomplish an extremely rich communication structure. Of course, these informal communication networks were abused to allow key players to make greater profits (information is money in all markets). After the Global Financial Crisis, regulators shut down the informal communication channels in an attempt to clean up the markets. They succeeded beyond their wildest expectations – there is by definition no manipulation in a market that does not trade at all.

Post crisis, there was a move towards mandatory clearing, but not towards mandatory exchange based trading. This is clearly a huge mistake: the only real alternative to informal communication channels is formal information flows mediated by exchanges. So we see breakdown of previously highly liquid markets. On the other side, central clearing in a market without adequate liquidity and transparency is a prescription for disaster sooner or later. So far, most of the problems have been pushed under the carpet by the central banks that have become market makers of first and last resort in many markets. As they normalize their balance sheets, dysfunctional markets could become a progressively bigger problem.

Posted at 14:45 on Sat, 29 Jul 2017     View/Post Comments (0)     permanent link


Wed, 19 Jul 2017

Why Aadhaar transaction authentication is like signing a blank paper

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

All this was brought home to me when I bought a new SIM card recently and was asked to authenticate myself with a finger print. The employee of the telecom company told me that there was a problem and I needed to try again. Being a little suspicious, I stretched forward and twisted my neck to peep at the computer screen in front of the employee (this screen would otherwise not have been visible to me). My suspicion was allayed on seeing an error message on the screen and I tried again only to get the same error message. After three attempts, the employee suggested that I come again the next day. Back home, I saw three emails from UIDAI (Unique Identification Authority of India) stating “Your Aadhaar number ___ was used successfully to carry out e-KYC Authentication using ‘Fingerprint’ on ___ at ___ Hrs at a device deployed by ___.” Note the word successfully.

That is when I realized that the error message that I saw on the employee’s screen was not coming from the Aadhaar system, but from the telecom company’s software. That is a huge problem. This conclusion was corroborated the next day when after one more error message, I found that the employee had left one field in the form partially filled and the error message disappeared when that was corrected.

Let us think about why this is a HUGE problem. Very few people would bother to go through the bodily contortion required to read a screen whose back is turned towards them. An unscrupulous employee could simply get me to authenticate the finger print once again though there was no error and use the second authentication to allot a second SIM card in my name. He could then give me the first SIM card and had over the second SIM to a terrorist. When that terrorist is finally caught, the SIM that he was using would be traced back to me and my life would be utterly and completely ruined.

Actually, even my precaution of trying to read the employee’s screen is completely pointless. The screen is not an inseparable part of the finger print reader. On the contrary. the fingerprint reader is attached by a flimsy cable to a computer (which is out of view) and the screen is purportedly attached to the same computer. It is very easy to attach the fingerprint reader to one computer (from which a malicious transaction is carried out) and attach the screen on the counter to another computer which displays the information that I expect to see.

Another way of looking at the same thing is that a rogue employee of the telecom company could effortlessly execute what is known in computer security as an MitM (Man in the Middle) attack on the communication between me and the Aadhaar system. In fact, I see some analogies between the problem that I am discussing and the MitM attack described by Nethanel Gelerntor, Senia Kalma, Bar Magnezi, and Hen Porcilan in their recent paper (h/t Bruce Schneier). Neither I nor the Aadhaar system has any way of detecting or foiling this MitM attack.

I think the whole model is fundamentally broken, and Aadhaar should be used only to verify identities, and not to authenticate transactions. Transaction authentication must happen with a thumb impression, a physical signature, a digital signature or something similar that is inseparably bound to a document.

Posted at 21:36 on Wed, 19 Jul 2017     View/Post Comments (2)     permanent link


Sat, 15 Jul 2017

Secret deals between exchanges and traders: securities fraud implications

Dolgopolov has a nice paper on the conditions under which secret arrangements between exchanges and high frequency traders might or might not constitute securities fraud. Modern exchanges use complex order types and intricate order hiding and matching rules, and they could claim that any bugs or flaws in their trading protocols are honest implementation mistakes. Smart traders who exploit these trading imperfections and frictions could simply claim to be skillful beneficiaries who discovered the bugs by their own effort. In many cases, there appears to be collusion between the exchange and the HFT firms (the exchanges often disclose undocumented features and bugs privately to their best customers in return for getting more business from these firms), but this is not easy to prove. Dolgopolov proposes legal theories under which securities fraud liability could be imposed on the HFT firms themselves.

For over a decade now, I have been arguing for a different solution: regulators should mandate that critical exchange software be open source (here, here, here and here). At the risk of sounding like a broken record, I would like to reiterate my view that “regulators and self regulatory organizations have not yet understood the full power of the open source methodology in furthering the key regulatory goals of market integrity.”

Posted at 12:58 on Sat, 15 Jul 2017     View/Post Comments (0)     permanent link


Sun, 09 Jul 2017

Global Capital Flows: VIX versus US Fed

Historically, the VIX (the volatility of the US stock market implied by option prices) has been an important barometer of global risk aversion that has a strong influence on global capital flows. A BIS Working Paper published last month (Avdjiev, Gambacorta, Goldberg and Schiaffi, “The Shifting Drivers of Global Liquidity”) demonstrate that this changed in the aftermath of the Global Financial Crisis with US monetary policy becoming the dominant driver of capital flows while the VIX declined in importance. They also point out that this phenomenon peaked in 2013 and there has been a partial return to pre-crisis patterns since then.

The results make intuitive sense: as global central banks pursued unconventional monetary policy, a large amount of duration risk ended up on the ever expanding balance sheets of these central banks. They thus became the marginal risk taker in the economy. (The authors use the Wu-Xia shadow rate as their measure of US monetary policy to take account of the impact of unconventional monetary policy). Since 2013, the central banks have been in tapering mode and they are no longer the marginal risk taker in the economy.

Though the authors do not venture down this path, I think their results explain well why the 2013 taper talk had such a drastic impact on emerging markets while the coordinated tightening by global central banks during the last year has had such a muted impact. The marginal risk taker is now the private investor and the low level of VIX currently indicates that the marginal risk taker is in “risk on” mode. This suggests that we should be looking at the VIX rather than at global monetary policy for the early warning signs of the next wave of turbulence in emerging markets.

Posted at 13:51 on Sun, 09 Jul 2017     View/Post Comments (0)     permanent link


Sat, 08 Jul 2017

Electronic banking liability allocation

A couple of days back, the Reserve Bank of India (RBI) issued new guidelines regarding who bears the loss from online banking frauds. The effect is to limit the liability of the customer and thereby transfer the loss to the banks. This measure has been seen as a customer friendly one. Basic economics teaches us to be careful about coming to such a conclusion. In equilibrium, banks would probably recover all expenses incurred by them from their customers. In fact, today, bank customers in India are probably paying higher fees as banks try to recover their bad loan losses from their customers. Unless banking becomes more competitive, the effect of the RBI regulation would more likely be a transfer from one group of customers (those who do not use online banking or have not been defrauded) to those who have lost money.

I think that the RBI regulation is a very good move for a very different reason: incentive compatibility. The important thing is that the regulation places losses on the party that can do something to reduce frauds. A customer cannot improve the bank’s computer security, she cannot ensure that the bank patches all its software, follows a good password policy, and so on. Only the bank can do all this. Unfortunately, computer security does not receive adequate attention from the top management of banks in India. If the new policy helps concentrate the minds of top management, that would be a good thing. If that does not happen, maybe the bank will wake up when the losses materialize. That is the true benefit of the new regulation – it has the potential to reduce online frauds.

Posted at 21:54 on Sat, 08 Jul 2017     View/Post Comments (0)     permanent link


Sun, 25 Jun 2017

Enterprise without entities

In recent months, a significant amount of money has been raised using smart contracts and initial coin offerings. In May 2016, The DAO raised about $150 million with an “objective to provide a new decentralized business model for organizing both commercial and non-profit enterprises”. It did not have a formal organizational structure or legal entity and consisted only of open source computer code. A bug in this code allowed a hacker to siphon off about $50 million of this money, but this was reversed by a hard fork of the Ethereum blockchain (see here for the details). A few days ago, Bancor raised even more money than the DAO amidst criticism that its business model is seriously flawed.

These smart contracts create business enterprises without creating any legal entity. You cannot sue a piece of code, nor send it to jail, but when this piece of code creates a self enforcing contract, it becomes an enterprise. This seems to create a challenge for the legal system.

It was in this context that I read “Enterprise without Entities” by Andrew Verstein (Michigan Law Review, 2017).

This Article challenges conventional wisdom by showing that vast enterprises – with millions of customers paying trillions of dollars – often operate without any meaningful use of an entity.

This Article introduces the reciprocal exchange, a type of insurance company that operates without any meaningful use of a legal entity. Instead of obtaining their insurance from a common nexus of contract, customers directly insure one another through a web of countless bilateral agreements. While often overlooked or conflated with mutual insurance companies, reciprocal exchanges include some of America’s largest and best known insurance enterprises.

This Article explores how it is possible to run an international conglomerate with essentially no recourse to organizational law as it is normally conceived.

The whole paper is worth reading for the wealth of detail and careful legal analysis. It tells us that enterprise without entities is not some radical new innovation made possible by smart contracts, but is something that has been successfully practised since the early twentieth century.

More importantly, it also tells us that the challenge in making smart contracts work is not going to be legal. The real challenge is the more mundane and much harder task of writing software without nasty bugs.

Posted at 20:31 on Sun, 25 Jun 2017     View/Post Comments (0)     permanent link


Fri, 16 Jun 2017

How to bury zombie companies quickly

Earlier this week I posted about the bankruptcy literature of the 1990s that sought to rely less on judges, administrators and experts and more on contracts and markets. As promised in that post, I now explore the implications of that framework for the widespread corporate distress in India today.

While much of the discussion on the Indian situation emphasizes the problem of bad loans in the banking system, the government’s Economic Survey rightly described it as a twin balance sheet problem encompassing problems in the balance sheets of the banking system and of the corporate sector. Of the two, I would argue that the problem in the banking system is the less serious one for many reasons.

  1. The overt problem is largely confined to the public sector banks and from past experience we know that these banks can run smoothly (without any run on the banks) regardless of how little capital they have. Indian Bank in the mid 1990s is a classic example of the depositors retaining their faith in the bank even after reporting a large loss that resulted in a negative net worth. These days, there is the issue of Basel norms, but strictly speaking, they apply only to internationally active banks. If the overseas operations of the unhealthy public sector banks are shut down or transferred to healthier ones, there is no technical bar on letting them operate with low levels of capital adequacy. By placing restrictions on their fresh lending, any moral hazard problems can be alleviated.

  2. Many observers believe that bad loans are not confined to the public sector banks, and that at least some private sector banks have a large but covert problem. But this issue can probably be addressed by imposing a large preemptive recapitalization on them.

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

In my view, the problem of zombie companies is far more serious than the problem of zombie banks. There is overwhelming anecdotal evidence that these zombie companies are a major drag on the economy. For those who are not swayed by anecdotal evidence, an IMF working paper published this month demonstrates that the decline in private investment in India is linked to over-leveraged companies being unable to start new projects or complete ongoing projects. For India to achieve high growth, it is necessary to sort out these zombie companies.

Bankruptcy is the most effective way of putting an end to the zombie companies, and recycling their assets for more efficient use. Bankruptcy breaks the vicious cycle through which past debt acts as a brake on future growth. As Heidt put it: “Bankruptcy separates the past from the future ... it takes the debtor’s past assets to pay its past creditors.”

Traditional bankruptcy processes may not provide an adequate solution to this problem because the number of companies involved is quite high and because India does not yet have enough trained bankruptcy professionals and judges to do bankruptcy on a massive scale. This is where I am fascinated by the idea in the bankruptcy literature of the 1990s of using markets instead of courts. This is much more scaleable in the Indian context because some Indian financial markets are reasonably deep, and the supply of funds in these markets is quite elastic because they are open to foreign investors.

My preferred solution is basically the same as the AHM procedure that I mentioned in my last blog post. In this approach, the government forces the banks to converts all their loans into equity, and also forces the banks to sell the resulting equity in the stock market within a tight time frame. The new shareholders decide whether to sell the assets or to run the business. In any case, with the debt completely removed, the company is no longer a zombie company, and even a partial or total liquidation would be a voluntary liquidation by the shareholders that does not require significant court intervention. The difficulties with this method are easy to surmount:

  1. It assumes a well functioning equity market, but I think this is more reasonable assumption to make than that banks can suddenly figure out how to restructure all this debt, or that rating agencies can be trusted to provide useful guidance on this (Partnoy’s scathing piece last month should remove all doubts on the matter) or that an omniscient central bank can tell the banks how to restructure all the debt.

  2. One “discretionary” question still appears to remain: how much of the old equity should be wiped before the conversion of the loans. In the original AMH procedure, this problem is solved using Bebchuk options: old shareholders are given the option to buy out the creditors pro rata. In most of the zombie companies, the Bebchuk options are unlikely to be exercised, and the old shareholders would be completely wiped out. Allowing the old shareholders to retain 5-10% of the expanded equity might be another possibility to make it politically more palatable.

  3. The banks would take large losses in this process that could leave them poorly capitalized. I have already discussed this above. For public sector banks, the capital does not really matter, and for the private sector banks, the problem can be solved by imposing a preemptive recapitalization. The important thing is to downsize the banking system so that we do not get into this mess again.

Posted at 18:52 on Fri, 16 Jun 2017     View/Post Comments (0)     permanent link


Sun, 11 Jun 2017

Bankruptcy ideas from the 1990s

During the last few weeks, I had the opportunity to read (and in some cases re-read) the large stream of literature about bankruptcy that emerged in the United States in the early 1990s. (That is one of the benefits of taking a serious vacation). There are a lot of original ideas in this literature because a serious application of the law and economics paradigm to this field probably began around this time. As Aghion, Hart and Moore wrote, prior to the 1990s, “economic analysis – which has been applied with such great success to other aspects of law in the last thirty years – has, with a few notable exceptions, not been used to shed light on optimal bankruptcy procedure”. The radical thinking in the 1990s literature can probably be attributed to the backlash against corporate abuses during the late 1980s and early 1990s. The savings and loan crisis of the 1980s in the United States somehow managed to provoke a greater outrage against financial fraud than the much bigger global financial crisis of the last decade.

Probably the best compilation of the 1990s bankruptcy literature is the proceedings of the Interdisciplinary Conference on Bankruptcy and Insolvency Theory of 1994 published in the Washington University Law Review. This features provocative articles like Adler’s “A World Without Debt” and Heidt’s article that begins with the line “The Bankruptcy Code is fifteen years old and fourteen years out of date”. Above all, there is the famous paper by Aghion-Hart-Moore describing one of the most radical bankruptcy procedures ever proposed – the AHM procedure.

In keeping with the law and economics paradigm, most proposals of that era are based on a greater reliance on contracts and markets rather than on judges, administrators and experts. The complication is that the problem of bankruptcy arises only under imperfect capital markets and there are obvious difficulties in relying too strongly on imperfect capital markets. Yet this 1990s idea underlies a number of the post crisis innovations in reorganization of distressed financial enterprises – contingent equity, contingent convertible bonds (CoCos), and hair cutting of claims against clearing corporations.

My motivation for studying this literature stems from the problem of corporate distress in India today. It is hard to see how India’s zombie companies can be efficiently and speedily resolved without relying much more on markets than on so called experts. That is the subject of a future blog post.

Posted at 19:54 on Sun, 11 Jun 2017     View/Post Comments (0)     permanent link


Wed, 07 Jun 2017

Are markets efficient if you are a particle physicist?

Among the thousands of pages that I read during my two month long vacation were two papers that show that many of the large number of published asset pricing anomalies (Cochrane’s “zoo”) have withered away over time. The papers are Hou, Xue and Zhang (2017), Replicating Anomalies, NBER Working Paper 23394 and Mclean and Pontiff (2016) Does Academic Research Destroy Stock Return Predictability?, Journal of Finance.

Hou, Xue and Zhang show that out of the 447 anomalies that they study as many as 286 (64%) are insignificant at the conventional 5% level. Increasing the cutoff t-value to 3.0 raises the number of insignificance to 380 (85%). Clearly, there are a lot of Type M errors in the anomalies literature and a few Type S errors as well.

I started wondering what would happen if we imposed an even higher standard of statistical significance. This is where particle physics comes in. While the social sciences are quite happy with significance levels of 5% and 1% (implying cutoffs of around 2 or 3 standard deviations), the significance level required for the discovery of a new particle in physics is 0.0001% or one in a million (implying a cutoff of around 5 standard deviations). For example, when the Higgs particle was discovered in July 2012, the official press release from CERN stated: “Today, both the ATLAS and CMS experiments are beyond the level of around one per million that’s required to claim a discovery.” For more discussion on the 5 sigma standard, see here, here and here.

Asset prices exhibit significantly fatter tails than the Gaussian distribution and that would require raising the cutoff even higher. The statistical quality control world uses a shift of 1.5 standard deviations so that 6 standard deviations (six sigma) are required to achieve quality standards that would otherwise require only 4.5 standard deviations.

I pored over Table 4 of Hou, Xue and Zhang that lists the t-values for all the anomalies that are significant at the 5% level. Not one of these is above 6.0 and only two (Abr1 and dRoe1) are above 5.0. Adjusted for fat tails, there is no anomaly that meets a one in a million standard of significance. By this standard, therefore, markets can be assumed to be efficient. More prosaically, finance is still at the Tycho_Brahe stage of assembling enough high quality data to discriminate between competing theories.

Posted at 13:26 on Wed, 07 Jun 2017     View/Post Comments (0)     permanent link


Sun, 26 Mar 2017

Why do economists ignore risk?

Cochrane writes on his Grumpy Economist blog:

Here’s how covered interest parity works. Think of two ways to invest money, risklessly, for a year. Option 1: buy a one-year CD (conceptually. If you are a bank, or large corporation you do this by a repurchase agreement). Option 2: Buy euros, buy a one-year European CD, and enter a forward contract by which you get dollars back for your euros one year from now, at a predetermined rate. Both are entirely risk free.

It is only an economist who today thinks of this trade as risk free. Before the global financial crisis many finance people would have thought so too, but not today. After the crisis, any serious finance professional would immediately think of the multiple risks in these trades:

  1. The US bank could default

  2. The European bank could default

  3. The forward contract counterparty could default

  4. There is euro redenomination risk. In that terrifying state of the world, depending on the nationality of the bank and the forward contract counterparty, one or both of these could be redenominated into some other currency – new francs, marks, liras or drachmas . Theoretically, you could end up being long new French francs (on the euro CD) and short new German marks (on the forward contract).

During the last decade, finance has moved on from simplistic notions of risk. I like to believe that in many top banks today, those who espouse Cochrane’s view of risk would be at risk of losing their job. Or at least they would be asked to enrol in a course on two curve (or multi curve) discounting. In today’s finance, there is return free risk, but no risk free return. Covered interest parity is today only an approximation that you may use for a back of the envelope calculation, but not for actually quoting a price. I wrote about this in a wonky blog post last year, and I have discussed two curve discounting in another wonky post half a dozen years ago.

The wonderful thing about finance is that it provides an opportunity to get rid of bad ideas by marking them to market. The problem comes when we distrust the market and start thinking of model errors as market inefficiencies. Cochrane writes about the violations of covered interest parity:

... this makes no sense at all. Banks are leaving pure arbitrage opportunities on the table, for years at a time. ... But this is arbitrage! It’s an infinite Sharpe ratio!

Rather than accept that the covered interest parity model is wrong in a two curve world, Cochrane thinks that post crisis regulations are preventing the banks from doing this “arbitrage” and bringing the markets back to the old world. It is true that a Too Big to Fail (TBTF) can still do covered interest “arbitrage”. But what that tells us is that a TBTF bank can pocket the gains from the covered interest trade and palm off the risks to the tax payer. A TBTF bank can do the trade, because it is closer to being risk neutral (anybody can be risk neutral with other people’s money). Yes, the covered interest trade has a positive Sharpe ratio but not an infinite one, and perhaps not even a very large one. We need less TBTF banks doing low Sharpe ratio trades, keeping the gains and shoving the losses to the taxpayers.

And both economists and policy makers need to take risk more seriously than they do today.

Posted at 13:36 on Sun, 26 Mar 2017     View/Post Comments (0)     permanent link


Wed, 22 Mar 2017

Indian financial history

My blog post a couple of months ago on financial history books led to a lively discussion in the comments on a similar list for Indian financial history. There was so much useful material in these comments that I thought it useful to hoist it from the comments to a blog post in its own right. As you can see, very little of this post is my contribution. Most of the material is from my colleague at IIM Ahmedabad, Prof. Chinmay Tumbe who is deeply interested in business, economic and demographic history. All that I have done is to add hyperlinks wherever possible, and must in fact confess that I have not yet read most of the material listed here.

Amol Agrawal January 27, 2017 at 5:44 pm

I was also wondering whether you could recommend some books on India’s financial history as well. I guess you might say there are hardly any. But I guess history of RBI (Volume I), History of SBI, Indigenous Banking by LC Jain etc could be a part of the list. But these are just on banking, We have very little ideas on equity markets, insurance, funds etc. Could you please help me with a few titles?

Jayanth Varma January 27, 2017 at 9:07 pm

There are some excellent books on Indian economic history. The Cambridge Economic History of India is absolutely invaluable. There are some books and other material on the history of the East India Company and the Dutch VOC which are also relevant. Adam Smith’s discussion of the English East India Company in the Wealth of Nations is also worth reading. Angus Maddison’s Asia in the World Economy 1500–2030 AD is also useful.

But there is too little of financial history in all this. I would like to know more about the financial transactions of Jagat Seth for example though there is some material here.

Indian monetary history in the nineteenth century is absolutely fascinating: I think at one time or the other, India had every kind of exchange rate regime known at the time. Oscar Wilde famously advised a student to omit this chapter because it is too sensational. If you have access to JSTOR, I recommend: Laughlin, J. Laurence. “Indian Monetary History.” Journal of Political Economy, vol. 1, no. 4, 1893, pp. 593–596.

Way back in 2010, SEBI set up an Advisory Panel on History of Indian Securities Market of which I was a member and some material was collected and made available on the SEBI web site. I do not think that much progress has taken place after that.

Amol Agrawal January 28, 2017 at 8:58 am

I fully agree we have nothing much in financial history which is a puzzle. I have read the Lodewijk Petram work on World’s oldest Stock exchange. We need similar accounts for BSE and other Regional SEs which were important earlier. I have seen SEBI’s links but most are unreadable. Like RBI and SBI have commissioned their history, we need SEBI/IRDA etc to do the same for other markets. From these, students like me can pick up and build.

Likewise Sylla and Homer’s History of Interest Rates could be developed into History of interest rates in India using several RBI publications. There is some data which has to be all put together.

Having said this, I think following books do give some perspective on history of finance in India: 1) Industrial Organisation (1934) by PS Lokanathan 2) Organisation and Finance of Industries in India (1937) by D R Samant and M A Mulky 3) Financial Chapter in History of Bombay (1910) by DE Wacha

There are some others which are mainly on banking. I can add them but I think if one reads History of RBI and History of SBI (by Prof AK Bagchi), banking is pretty much covered.

We clearly need to expand this list and have more works on India’s financial history. I will try and add as and when I find more readings.

Jayanth Varma February 13, 2017 at 9:28 pm

Another useful book is Raymond W. Goldsmith The financial development of India, Japan, and the United States : a trilateral institutional, statistical and analytic comparison, Yale University Press 1983.

Prof. Chinmay Tumbe March 1, 2017 5:10 pm

Adding a few that have not been covered above:

  1. Goldsmith has one book just on India called Financial Development of India, 1860-1977, which is a truly monumental work.

  2. A 2017 book by a friend of mine attempts to synthesise monetary history in India

  3. I have a paper in the Indian Economic and Social History Review on the history of the Post Office as a financial institution; not too many associate that with finance though it is the largest financial institution of India in terms of network and personal deposits.

  4. Tirthankar Roy has a recent paper on seasonality of interest rates in the money market of colonial India.

  5. Dwijendra Tripathi of IIMA wrote the biography of Bank of Baroda in the 1980s and updated that in the late 2000s.

  6. Amiya Bagchi’s edited volume on Money and Credit in Indian History in 2002 has wide ranging contributions to it

  7. P R Brahmananda’s Money, Income, Prices in 19th century India: A Historical, Quantitative and Theoretical Study.

  8. On the 1860-65 Bombay episode, see Wacha’s Financial Chapter; or any biography of Premchand Roychand as in Lakshmi Subramanian’s Three Merchants of Bombay

  9. Some Books:

    Of course, several other banking histories can be added to this list.

The Financial History Review does not have a single piece on India, which goes to show the huge scope for research in this field. Amol’s thesis on south Indian banking history will add to our knowledge.

Posted at 16:41 on Wed, 22 Mar 2017     View/Post Comments (0)     permanent link


Fri, 17 Mar 2017

Towards bank cartelization in India?

I have begun to wonder whether Indian banks have stopped competing aggressively with each other and have started forming an implicit cartel. Rising non performing assets have reduced the appetite for bank lending to a level even lower than the severely depressed demand for bank credit. Obviously, banks do not need to raise much deposits if they are not lending much. It is easier (at least in the short run) to try and charge higher fees from a smaller depositor base than to spend time and money acquiring and retaining customers. And that is what we are seeing. More ominously, some of the attempts to raise fees and user charges seem to a casual observer to be coordinated across banks. If that is the case, then of course these are serious issues for the Competition Commission.

I think demonetization has played some role in this for multiple reasons. First, it boosted the liquidity of the banks virtually overnight and accelerated trends that had been building up slowly over several months. Second, demonetization turned banks into an extended arm of the state: bank officers became quasi government officials with substantial powers. Long after that stage passed, many banks have not gone back to being service organizations again. Anecdotal evidence suggests that this transformation from customer service to bureaucratic conduct has happened in the private sector banks to the same if not a greater extent.

In the long run, this change in the behaviour of the management and employees of the banks would be disastrous for the banking system. On the deposit side, payment banks and mutual funds might find a once in a lifetime opportunity to disrupt banking. On the advances side, non bank finance companies have gained valuable customers turned away by the banks. In the long run, the bond markets could also take business away from the banks.

The first 25 years of economic reforms saw the banking system grow to dominate the financial system previously dominated by the development financial institutions. Shortsighted management and staff could erode this dominance very quickly.

Posted at 18:10 on Fri, 17 Mar 2017     View/Post Comments (0)     permanent link


Mon, 27 Feb 2017

Uberization or not of finance

Two years ago, Mike Carney (Chairman of the Financial Stability Board apart from being Governor of the Bank of England) warned financial regulators that they should:

not be in this position where we’re filling in with prudential regulation after the fact. In other words, facing an Uber-type situation in financial services, which many jurisdictions are struggling with.

(This discussion can be found around 59 minutes into the video from the World Economic Forum Annual Summit at Davos in 2015).

The Uberization of finance does appear to be a probable outcome, and many fintech startups are predicated on this possibility. But then I read the paper by Pollman and Barry on Regulatory Entrepreneurship which they define as:

pursuing a line of business in which changing the law is a significant part of the business plan

Uber and Airbnb are among the prominent examples of regulatory entrepreneurship that they discuss in their paper. Pollman and Barry enumerate several business-related factors, law-related factors and startup-related factors that facilitate regulatory entrepreneurship. Among these are two that appear to pour cold water on the Uberization of finance:

One important factor is the penalty that the law imposes on violators. For example, if the only penalty is a civil fine imposed on the corporation, pushing the boundaries of the law may be an attractive prospect. ... On the other hand, if a law provides for the incarceration of the executives of a company that violates it, that may deter the guerrilla growth strategies that some modern regulatory entrepreneurs employ.

Relatedly, another key element is whether the law in question is determined at the local, state, or national level. Change at the state and local level is often possible more quickly than at the national level.

The authors refer to the shutting down of Napster to highlight the difficulties of regulatory entrepreneurship in the face of national level laws that carry significant criminal penalties. This lesson is clearly quite relevant to much of finance.

Another aspect that Pollman and Barry do not mention is that much of regulatory entrepreneurship has succeeded against incumbents who are not very technology savvy. The finance industry on the other hand is technologically quite sophisticated, and is quite capable of adopting and co-opting any successful innovations that the regulatory entrepreneurs may come up with. Examples of such behaviour include:

A counterpoint to this is that historically some of the truly radical innovations in finance have come from criminal enterprises. Three centuries ago, central banking was created largely by criminals. Johan Palmstruch, the founder of the world’s oldest central bank, the Sveriges Riksbank of Sweden, was sentenced to death before a royal pardon reduced the death sentence to imprisonment. Another great pioneer of central banking was John Law, who escaped from the English prison where he was held on charges of murder, and went on to preside over the French experiment with central banking in the early eighteenth century. John Law was probably the greatest central banker of his generation, but he spent most of his life roaming across Europe as a fugitive from the law. The founder of the Bank of England, William Paterson was an exception in this regard (he was certainly of high integrity), but he was a reckless adventurer who would probably not be acceptable to any modern central bank. A lot of modern finance is actually re-purposed criminality – negotiable instruments (bills of exchange) were originally created to evade usury laws, fractional reserve banking is alleged to have evolved out of goldsmiths fraudulently lending out customer gold which was not theirs to lend (though this has been disputed), and so on. If there is money to be made in fintech, even the threat of a death penalty will not deter would-be entrepreneurs, and it is at this edge of criminality, that we must look for future radical innovations in finance.

Posted at 14:11 on Mon, 27 Feb 2017     View/Post Comments (0)     permanent link


Thu, 23 Feb 2017

Making India less dependent on banks

In the quarter century since economic reforms, India has created a reasonably well functioning equity market, but has failed to create a well functioning banking system. We began the reforms process with a broken banking system, and have come full circle to a broken banking system once again. And no, the mess is not confined to just the public sector banks.

I am reminded of Albert Einstein’s apocryphal remark that insanity consists in doing the same thing over and over again and expecting different results. That leads to the question: what can we do differently. I can think of several things:

  1. We can reduce dependence on debt and rely more on equity. An easy way to do that would be to abolish the tax deduction of interest and reduce the tax rate. A lower tax rate calculated on PBIT (Profit before Interest and Taxes) would raise the same revenue as a much higher tax rate applied to PBT (Profit before Taxes). This would incentivize firms to issue more equity than debt allowing the economy to benefit from the relatively better developed equity market. This would have the added benefit of reducing systemic risk in the economy. The banking system can be downsized by winding up the most inefficient banks. Incidentally, the tax reforms being formulated in the United States today do contemplate abolishing tax deduction for interest expense.

  2. We can try to forcibly create a bond market by either (a) starving the banking system of capital, or (b) imposing a differential tax on bank borrowing. If bank borrowing is rationed or taxed, companies will be forced to borrow from the bond markets. It is not often realized that one reason for the lack of a bond market is that the banking system is subsidized by repeated bailouts and Too Big to Fail (TBTF) subsidies. An unsubsidized bond market cannot compete against a subsidized banking system. The way to level the playing field and enable a vibrant bond market is to neutralize the banking subsidy through an offsetting tax or to limit the subsidy by rationing.

  3. We can leverage the equity market to improve the functioning of the bond market. More than a decade ago, I wrote:

    Let me end with a provocative question. Having invented banks first, humanity found it necessary to invent CDOs because they are far more efficient and transparent ways of bundling and trading credit risk. Had we invented CDOs first, would we have ever found it necessary to invent banks?

    For a short time in 2007, when the CDOs had started failing, but the bank failures had not yet begun, I did experience some degree of doubt about this statement. But now I am convinced that banks are simply badly designed CDOs. The global banking regulators seem to agree – much of the post crisis banking reforms (for example, contingent capital, total loss absorbing capital and funeral plans) are simply adapting the best design features of CDOs to banks. The question is why should we make banks more like CDOs when we can simply have real CDOs. In India, the lower tranches of the CDO could trade in our well functioning equity markets, because they offer equity like returns for equity like risks. The senior most tranche would be very much like bank deposits except that they would be backed by much more capital (supporting tranches).

  4. We could encourage the growth of non bank finance companies. Prior to the Global Financial Crisis, GE Capital was perhaps the sixth largest US financial institution by total assets. Even during the crisis, GE Capital perhaps fared better than the banks – it had only a liquidity problem and not a solvency problem. India too could try and create large non deposit taking non bank finance companies (NBFC) with large equity capital. Again NBFCs find it hard to compete against banks with their TBTF bailout subsidies. Neutralizing or rationing these subsidies is one way to let NBFCs grow larger.

I think the time has come to seriously think out of the box to make India less dependent on its non performing banks.

Posted at 14:59 on Thu, 23 Feb 2017     View/Post Comments (0)     permanent link


Wed, 08 Feb 2017

Predicting human behaviour is legal, predicting machines is not?

I read this Wired story about some hackers being sent to jail for “hacking” slot machines in US casinos. “Hacking” is probably the wrong word to use for this: they made money by predicting what the slot machine would do by observing it carefully, and using their knowledge of the insecure random number generator used in the software of the slot machines. It appears therefore that it is illegal to predict what a machine would do by figuring out its vulnerabilities and observing its behaviour.

The irony of the matter is that the entire business model of the casinos is built on figuring out the vulnerabilities of the human customers, predicting how they would bet under different situations and designing every minute detail of the casino to exploit these vulnerabilities. The New Yorker had a story five years ago about how a casino was redesigned completely when the customer profile changed from predominantly older male customers to more women:

So Thomas redesigned the room. He created a wall of windows to flood the slot machines with natural light. He threw out the old furniture, replacing it with a palette that he called “garden conservatory” ... There are Italian marbles ... Bowls of floating orchids are set on tables; stone mosaics frame the walkway; the ceiling is a quilt of gold mirrors. Thomas even bought a collection of antique lotus-flower sculptures

Casinos “monitor the earnings of the gaming machines and tables. If a space isn’t bringing in the expected revenue, then Thomas is often put to work.” The design is optimized using a massive amount of research which can justifiably be called “hacking” the human brain. If you look at the Google Scholar search results for the papers of just one top academic (Karen Finlay) in the field of casino design, you will see that she has studied every conceivable design element to determine what can cause people to bet more:

The more recent studies on human behaviour are done using a panoscope which:

features networked immersive displays where individuals are absorbed in an environment (12 feet in diameter) that surrounds them on a 360-degree basis. ... Use of these panels creates a totally immersive life-like experience and facilitates the delivery of these manipulations. (Finlay-Gough, Karen, et al. “The Influence of Casino Architecture and Structure on Problem Gambling Behaviour: An Examination Using Virtual Reality Technology.” ECRM2015-Proceedings of the 14th European Conference on Research Methods 2015: ECRM 2015. Academic Conferences Limited, 2015.)

I do not see how this kind of attempt to fathom the workings of the human mind is much different from the hackers buying scrapped slot machines and figuring out how they work.

The better way to think about what is going on is to view it as a bad case of regulatory capture. The Wired story says that “Government regulators, such as the Missouri Gaming Commission, vet the integrity of each algorithm before casinos can deploy it.” The sensible thing to do is for the regulators to decertify these algorithms because the random number generators are not secure and force the casinos to use cryptographically secure random number generators. The casinos do not want to spend the money to change these slot machines and the captured regulators let them run these machines, while taxpayer money is expended chasing the hackers.

Perhaps, we should be less worried about what the hackers have done than about what the casinos are doing. Unlike the vulnerabilities in the slot machines, the vulnerabilities in the human brain cannot be fixed by a software update. Yet hacking the human brain is apparently completely legal, and it is not only the casinos which are doing this. Probably half of the finance industry is based on the same principles.

Posted at 17:42 on Wed, 08 Feb 2017     View/Post Comments (0)     permanent link


Tue, 24 Jan 2017

Financial history books redux

More than six years ago, I wrote a blog post with a list of books related to financial history that I had found useful (especially in the aftermath of the global financial crisis). The most important books in my list of 2010 were:

I read several more important books in the last few years and I would therefore like to expand my original list:

Posted at 18:40 on Tue, 24 Jan 2017     View/Post Comments (0)     permanent link


Fri, 20 Jan 2017

The blockchain as an ERP for a whole industry

In the eight years since Satoshi Nakomoto created Bitcoin, there has been a lot of interest in applying the underlying technology, the blockchain, to other problems in finance. The blockchain or the Distributed Ledger Technology (DLT) as it is often called brings benefits like Byzantine fault tolerance, disintermediation of trusted third parties and resilience to cyber threats.

Gradually, however, the technology has moved from the geeks to the suits. In the crypto-currency world itself, this evolution is evident: Bitcoin was and is highly geek heavy; Etherium is an (unstable?) balance of geeks and suits; Ripple is quite suit heavy. History suggests that the suits will ultimately succeed in repurposing any technology to serve establishment needs however anarchist its its original goals might have been. One establishment need that the blockchain can serve very well is the growing need for an industry-wide ERP.

ERP (enterprise resource planning) software tries to integrate the management of all major business processes in an enterprise. At its core is a common database that provides a single version of the truth in real time throughout the organization cutting across departmental boundaries. The ERP system uses a DBMS (database management system) to manage this single version of the truth. The blockchain is very similar: it is a real time common database that provides a single version of the truth to all participants in an industry cutting across organizational boundaries.

To understand why and how the blockchain may gain adoption, it is therefore useful to understand why many large organizations end up adopting an ERP system despite its high cost and complexity. The ERP typically replaces a bunch of much cheaper department level software, and my guess is that an ERP deployment would struggle to meet a ROI (return on investment) criterion because of its huge investment of effort, money and top management time. The logical question is why not harmonize the pre-existing pieces of software instead? For example, if marketing is using an invoicing software and accounting needs this data to account for the sales, all that is really needed is for the accounting software to accept data from the marketing software and use it. The reason this solution does not work boils down to organizational politics. In the first place, the accounting and marketing departments do not typically trust each other. Second, marketing would insist on providing the data in their preferred format and argue that accounting can surely read this and convert it into their internal format. Accounting would of course argue that marketing should instead give the data in the accountant’s preferred format which is so obviously superior. Faced with the task of arbitrating between them, the natural response of top management is to adopt a “plague on both houses” solution and ask both departments to scrap their existing software and adopt a new ERP system.

It is easy to see this dynamic playing out with the blockchain as well. There is a need for a single version of the truth across all organizations involved in many complex processes. Clearly, organizations do not trust each other and no organization would like to accept the formats, standards and processes of another organization. It is a lot easier for everybody to adopt a neutral solution like the blockchain.

A key insight from this analysis is that for widespread adoption of blockchain to happen, it is not at all necessary that the blockchain be cheaper, faster or more efficient. It will not be subjected to an ROI test, but will be justified on strategic grounds like resilience to cyber threats and Byzantine actors.

The only thing that worries me is that the suits are now increasingly in charge, and cryptography is genuinely hard. As Arnold Kling says: “Suits with low geek quotients are dangerous”.

Posted at 17:34 on Fri, 20 Jan 2017     View/Post Comments (1)     permanent link


Sun, 15 Jan 2017

SEBI's silly rule on celebrities

I have for very long been bitterly opposed to the rule of the Securities and Exchange Board of India (SEBI) that mutual funds cannot use celebrities in their advertisements. In fact, I have been against it for so long that I have stopped talking about it. But yesterday, the SEBI Board approved a silly tweak to this rule, and that gives me the perfect excuse to attack the rule itself one more time.

The first point is of course that celebrities are allowed to endorse so many other things even in the world of finance – banks and insurance companies do use celebrities because they do not come under SEBI and their regulators do not share SEBI’s celebrity phobia. Outside of finance, celebrities endorse all kinds of products, and even governments use them to spread awareness of issues of national importance. What makes one think that the buyers of mutual funds are of such abysmally low intelligence that celebrity endorsement would be detrimental to their interests, while bank depositors are so smart and savvy that they would not be swayed by the presence of celebrities?

The second point is that the logo of one large mutual fund operating in India contains the image of one of the greatest celebrities that one can think of. The visage of Benjamin Franklin himself graces the Franklin Templeton Mutual Fund. I remember asking a senior SEBI official about this many years ago. The response that I got was that Benjamin Franklin was a foreign celebrity and most Indians would not know about him. I thought then that this response was an affront to the intelligence of the Indian mutual fund investor. Forget the fact that Benjamin Franklin was one of the founding fathers of the United States, and easily the greatest US diplomat ever (it was his diplomacy that ensured US independence by getting the support of France). Benjamin was simply one of the greatest intellectuals of his time anywhere in the world (the man who brought lightning down from the clouds). His face adorns the largest denomination US dollar note (the $100 bill, which is popularly called the Benjamin), and his book Poor Richard’s Almanac and the essay The Way to Wealth are recommended readings in personal finance. This example itself serves to demonstrate how thoughtless the rule is.

I am well aware of the genesis of this whole regulation (it goes back to a celebrity gracing an IPO so long ago that everybody has forgotten about it). But regulators are supposed to have the common sense not to react to such isolated instances with sweeping general rules disproportionate to the situation at hand. Above all, any regulation needs something more than the mere whim of a regulator to justify it.

So did the SEBI Board have the good sense to jettison this silly rule yesterday? No, not at all. It merely said that:

Celebrity endorsements of Mutual Funds shall be permitted at industry level; however, not for endorsing a particular scheme of a Mutual Fund or as a branding exercise of a Mutual Fund house. Further, prior approval of SEBI shall be required for issuance of such advertisements which feature celebrities.

I do not even know where to begin about the silliness of this. Globally, we know that the mutual fund industry makes money with high cost actively managed funds rather than low cost ETFs, and that the industry has launched some very toxic products (leverage inverse ETFs for example). So it is not as if the industry cannot hire a top notch celebrity to endorse the most profitable products that the industry produces today without any concern for their suitability to the average investor. As far as prior approval is concerned, this takes the regulator into an area where it should not tread for reputational considerations. Moreover, if such prior approval can solve the celebrity problem, why would that magic not work for individual funds?

Even now, it is not too late for the regulator to accept that it has had a silly rule in the rule book for too long, and that when it comes to scrapping silly rules, it is better late than never.

Posted at 22:22 on Sun, 15 Jan 2017     View/Post Comments (0)     permanent link


Tue, 03 Jan 2017

SEBI should be more proactive in disclosing regulatory information

The Securities and Exchange Board of India (SEBI) seems to be more aggressive in requiring listed companies to disclose material information than it is in disclosing important regulatory information itself or requiring regulated entities to disclose it. That is the only conclusion that can be drawn from the Draft Red Herring Prospectus (DRHP) filed by the National Stock Exchange (NSE) last week. The NSE is an important Financial Market Infrastructure (FMI) and yet critical information about market integrity at this FMI is becoming available only now in the context of its listing!

The third risk factor in this DRHP discloses the following information regarding complaints about unfair access being provided to some trading members at NSE:

All this information is becoming public only as a result of the NSE filing for a public issue. SEBI seems to have taken the narrow and untenable view that the operations of a large Financial Market Infrastructure are of concern only to its shareholders and so disclosure is required only when the FMI goes public. It is surely absurd to claim that listed companies should be held to higher disclosure standards than key regulated entities. If this absurdity is really the regulator’s view, then it should forthwith require that all depositories, exchanges and clearing corporations become listed companies so that they conform to higher disclosure standards.

In my view, all the documents whose existence has now been disclosed represent material information about the operation of one of India’s most critical Financial Market Infrastructure. These documents ought to have been disclosed long ago, but it is still not too late for the regulator to release suitably redacted versions of all these documents:

Posted at 21:08 on Tue, 03 Jan 2017     View/Post Comments (0)     permanent link


Mon, 02 Jan 2017

In the sister blog and on Twitter during September-December 2016

The following posts appeared on the sister blog (on Computing) during September-December 2016.

Tweets during September-December 2016 (other than blog post tweets):

Posted at 15:54 on Mon, 02 Jan 2017     View/Post Comments (0)     permanent link


Tue, 27 Dec 2016

Financial crises prior to the typewriter

The Bank of England’s Bank Underground blog has a “Christmas Special” on financial crises in the UK in 1847, 1857 and 1866. The first commercially successful typewriter was invented only in 1868 and so all the letters from the Chancellor to the Governor of the Bank of England were handwritten. I was familiar with these letters from reading Andreades’ excellent History of the Bank of England, and several other sources, but unlike the Bank Underground blog posts, none of these sources contain any facsimile of the actual letters. What struck me was that these letters were written in rather poor handwriting. The blog posts take the pain of transcribing these letters, and without this, I would not have been able to decipher some of these words. This is all the more surprising since Andreades does state (at least in once case, page 336) that the official letter was sent two days after the Bank of England was unofficially informed about the decision.

Bank Underground also links to a newspaper article written by Karl Marx about the 1857 suspension of the Bank Act. I find it hard to disagree with the following observation of Marx about the report of the Select Committee of Parliament on the operation of the Bank Act:

The Committee, it would appear, had to decide on a very simple alternative. Either the periodical violation of the law by the Government was right, and then the law must be wrong, or the law was right, and then the Government ought to be interdicted from arbitrarily tampering with it. But will it be believed that the Committee has contrived to simultaneously vindicate the perpetuity of the law and the periodical recurrence of its infraction? Laws have usually been designed to circumscribe the discretionary power of Government. Here, on the contrary, the law seems only continued in order to continue to the Executive the discretionary power of overruling it.

More than a century and a half later, nowhere in the world have we been able to solve this dilemma of the excessive discretionary power of the government in times of crisis.

Posted at 17:55 on Tue, 27 Dec 2016     View/Post Comments (0)     permanent link


Mon, 19 Dec 2016

Euro Introduction as Demonetization

Peter Guy at Regulation Asia has an interesting piece describing the introduction of the euro as a process of demonetization:

Europeans practiced excessive cash-based tax avoidance for decades before the euro arrived. When forced to exchange their paper currencies, lira, francs, and pesetas, bundles of cash emerged in suitcases to buy other cash-generating assets like real estate.

The irony of it all is that today the €500 note is the currency note of choice for money launderers because of its large denomination (the 1000 Swiss franc note is more valuable but it is nowhere near as ubiquitous as the euro note). As Guy points out:

The euro was easier to launder with banks around the world than the individual currencies it replaced.

Guy also refers to the dangers of a cashless society, but that argument has been made far more eloquently and persuasively by Scott Garrett. The more I think about these issues, the more I think that cryptocurrencies must be a critical element of a modern monetary system in a democratic society.

Posted at 17:32 on Mon, 19 Dec 2016     View/Post Comments (2)     permanent link


Fri, 09 Dec 2016

A digital device for every Indian

It is my view that if India wants to replace cash with digital payments, it must be prepared to issue a digital device to every Indian and simply absorb the fiscal cost of doing so. The alternative is a tiered payment system with high quality payments for those with smartphones, a second tier solution for those with feature phones and a broken model for those with neither. Such a tiered payment system that makes some Indians second class citizens in their own country is fundamentally irreconcilable with our democratic values and with the constitutional guarantee of legal treatment.

Cash gives the poorest of the poor access to a retail payment system that meets the gold standard for payment systems: real time gross settlement in central bank money. It is unacceptable to give them anything less than this in a digital solution. Settlement in commercial bank money or other inferior forms of money can be a choice, it can never be a compulsion. I might voluntarily choose to adopt a paytm wallet or a bank wallet and take the credit risk that the wallet provider might fail; but I should not be forced to do so as the price for participating in digital payments. This means two things:

  1. The Reserve Bank of India should introduce electronic money on its own in the form of an official e-wallet because only an e-wallet filled with central bank money can replace cash. This would also solve the problem of interoperability between different wallets. A core function of the central bank is to be the “tender of the tender” – the issuer and maintainer of legal tender of the country. A central bank that abdicates this responsibility forfeits its raison d'être.

  2. Every Indian must be issued a digital device that allows first class access to the digital payment system. There is room for bringing the cost of this device down by careful design that pares it down to just its core functionality. I would think that a starting point for this might be something like the Raspberry Pi which is enough of a general purpose computer to run at least a bitcoin SPV client. The Raspberry Pi costs about $35, but a suitably pruned down device manufactured in truly large scale might cost only $20. Giving one such device to every Aadhar holder might cost about 1.5 trillion rupees.

In my view, this cost is affordable for a country at our stage of economic size and development, and is also quite reasonable in comparison to other big ticket fiscal expenditure (for example, large defence contracts, infrastructure projects or subsidy schemes). It is perfectly fine for you to take the opposite view that this cost is unacceptable. What you cannot do is to use that view as the justification for building a great payment system for the elite at the cost of taking away from the poor what they have today – a payment system (cash) that allows them to settle in real time in central bank money.

Posted at 11:34 on Fri, 09 Dec 2016     View/Post Comments (3)     permanent link


Tue, 29 Nov 2016

More on cash alternatives

In two recent blog posts, I argued that the post-demonetisation problems in India are not due so much to an absence of cash, but an environment that is implicitly or explicitly discouraging the emergence of cash alternatives. Free markets can solve these problems if we let them do so.

Here are three examples of cash alternatives from three continents that I came across post demonetisation:

  1. Tokens in Telengana in India (h/t Mostly Economics and Sonali Jain’s comments on my blog post)

  2. Bond notes in Zimbabwe: Though these notes are issued by a government, these count as cash substitutes because these bonds/notes are not issued by the government that issues the underlying currency.

  3. Bitcoin in Venezuela (h/t FT Alphaville): Only a year ago, I was thinking that Bitcoin had failed as a currency while succeeding enormously as a technology (the blockchain), but state failures around the world have been so great that now I think we can no longer rule out Bitcoin emerging as a major global currency.

Posted at 16:31 on Tue, 29 Nov 2016     View/Post Comments (1)     permanent link


Fri, 18 Nov 2016

Cash and credit redux

I have received a lot of push back against my blog post about cash being less important than credit. I would also freely admit that the evidence on the ground during this week does not suggest a smoothly functioning credit economy. But the reason for this unfortunate situation is not that cash is essential for a functioning economy. The true reason for the difficulties that we are seeing now is something more alarming – a partial disruption of credit expansion.

Cash substitutes are not emerging because there is a legitimate fear that the creation of such substitutes could be misconstrued as facilitating money laundering. For example, based on local and global historical experience, I am quite confident that if my Institute were to issue 500 rupee tokens or IOUs, it would circulate freely as money not only among the couple of thousand people on campus but also outside the campus (within a radius of a kilometre or so). A decade or two ago, during a period of shortage of small coins, many shops and institutions did issue coupons to substitute for the coins and these circulated quite freely. Today, however, probably no institution would want to tread that path for lack of clarity on how the government would react to such a move. Employers who have not been able to pay salaries in cash are not issuing IOUs which could ameliorate the cash shortage.

I firmly believe that the government should immediately step in with a public announcement that it would not frown upon the creation of temporary cash substitutes. In times like this, cash substitutes are essential because shortages lead to hoarding and much of the cash being paid out from the banks is not entering circulation, but is being locked away for future contingencies (cash could be even scarcer tomorrow than it is today). Almost everybody that I have talked to is today targeting a cash balance that is at least twice what they were holding two weeks ago. This has been the case historically as well as described very well in, for example, Andrew, A. Piatt. “Hoarding in the Panic of 1907.” The Quarterly Journal of Economics (1908): 290-299 (sorry that is behind a paywall).

As regards the feasibility of cash substitutes, I would once again link to the Irish experience that I linked to in my previous blog post. I would in addition describe the US experience of 1907. My source for this is unfortunately behind a paywall and I can only quote some material from there. The paper that I am referring to was published in the Quarterly Journal of Economics in 1908 shortly after the crisis of 1907 (Andrew, A. Piatt. “Substitutes for Cash in the Panic of 1907.” The Quarterly Journal of Economics 22.4 (1908): 497-516) and was based on extensive primary and secondary data collection. The author states that he wrote letters “addressed to banks in all cities of 25,000 or more inhabitants” and reports having got responses from 145 out of 147 such cities (response rates to mail surveys were much higher in those days than they are now!).

... we may safely place an estimate of the total issue of substitutes for cash above 500 millions. For two months or more these devices furnished the principal means of payment for the greater part of the country, passing almost as freely as greenbacks or bank-notes from hand to hand and from one locality to another. The San Francisco certificates, for instance, circulated, not only in California, but in Nevada and in south-eastern Oregon, some reaching as far east as Philadelphia, some as far west as the Hawaiian Islands. The banks of Pittsburg, on the other hand, reported remittances of certificates and checks, in denominations ranging from $1 up, from as scattered localities as Cleveland, Cincinnati, St. Louis, Chicago, Milwaukee, Duluth, Philadelphia, Danville, Va., and Spokane.

To put that $500 million number in perspective, the total coin and paper currency in circulation in the US was only about $2,800 million and the total gold coins was only $560 million (this data is from the Federal Reserve of St. Louis). In other words, cash substitutes were almost equal to the total gold coins in circulation and almost 20% of the entire gold and paper currency.

Andrew describes many different cash substitutes, but I would quote only one: bearer cheques “payable only through the clearing house,” (this clause meant they could not be redeemed for cash but could only be converted into other cash substitutes).

Last of all among the emergency devices were the pay checks payable to bearer drawn by bank customers upon their banks in currency denominations and used in all parts of the country in payment of wages and in settlement of other commercial obligations. These checks were generally “payable only through the clearing house,” ... they were not a liability of the clearing- house association or of the bank on which they were drawn, but of the firm or corporation for whose benefit they were issued.

The pay-check system reached its largest development in Pittsburg, where during the panic some $47,000,000 were issued, much of which was in denominations of $1 and $2.

Pay checks were also issued by railroads, mining companies, manufacturers, and store-keepers in a large number of other cities. Shops and stores and places of amusement in the neighborhood of their issue generally accepted them, and it is, indeed, surprising, considering their variety, their liability to counterfeit, and their general lack of security, how little real difficulty was experienced in getting them to circulate in lieu of cash

The last paragraph in the paper about cash substitutes in general is worth quoting in full:

Most of this currency was illegal, but no one thought of prosecuting or interfering with its issuers. Much of it was subject to a 10 per cent. tax, but no one thought of collecting the tax. As practically all of it bore the words “payable only through the clearing house,” its holders could not demand payment for it in cash. In plain language it was an inconvertible paper money issued without the sanction of law, an anachronism in our time, yet necessitated by conditions for which our banking laws did not provide. During the period of apprehension, when banks were being run upon and legal money had disappeared in hoards, in default of any legal means of relief, it worked effectively and doubtless prevented multitudes of bankruptcies which otherwise would have occurred.

Markets will find solutions to most problems if the government steps out of the way. In 1907, governments in the US were willing to do precisely that. Andrew quotes several official announcements during the panic of 1907 that allowed the creation of cash substitutes. For example, the following was a letter from the Government of Indiana of October 28, 1907:

To THE INDIANA BANKS AND TRUST COMPANIES:

Gentlemen,-Your bank being solvent, should it adopt the same rule that has been adopted by the banks of Indianapolis and refuse to pay to any depositor or holder of a check only a limited amount of money in cash and settle the balance due by issuing certified checks, or drafts on correspondents, such act, in this emergency, will not be considered an act of insolvency by this department.

The same rule will apply to trust companies.

P.S.-The question of your solvency is to be determined by yourselves upon an examination of your present condition.

The question today is whether the Indian government is willing to be bold and imaginative, and allow the market to find solutions to the current problems that are beyond the power of governments to solve.

Posted at 13:11 on Fri, 18 Nov 2016     View/Post Comments (2)     permanent link


Wed, 16 Nov 2016

Why not a helicopter drop of new rupee notes?

A helicopter drop of new currency notes might be the perfect solution to the logistic problems arising out of last week’s demonetization of most of the Indian currency. The pressing logistical problems are about getting the new notes to the remote and under banked rural areas of the country. There is also a concern about solving the problems of the poor who were more reliant on currency than the rich, and have less access to credit which can substitute for cash. The simplest solution is to simply drop currency notes from the sky across the length and breadth of the country so that every Indian receives some money to carry on their daily activities without worry.

There is a strong fiscal justification for this free gift of money to every Indian. The whole purpose of the demonetization exercise is to destroy the stock of unaccounted holdings of currency in India. If we assume that 40% of the 14 trillion rupees of the old notes represent untaxed income and will not therefore be exchanged for new notes, there is a gain of over 5 trillion rupees which amounts to about 4,000 rupees for every man, woman and child in India. A helicopter drop of this magnitude would simply be a way distributing this windfall gain equally to the people of India in a kind of negative poll tax. The alternative to this equal distribution would be a reduction in the income tax rate or the GST rate which would distribute the benefits more to the rich than to the poor. In fact, the costs of demonetization are falling equally on the rich and the poor. The poor man stands in the queue for the same few hours to get his 1,000 rupees as the rich man does to get his 24,000. There is therefore every reason to spread the benefits also equally among all.

In addition, there are huge logistic benefits from a helicopter drop. It gets money directly in the hands of those who need it most without wasting their time. Farmers can spend their time harvesting the crop instead of standing in queues in a far away branch. Urban poor do not have to forsake their daily wages to go to the bank. This also ensures minimal disruption to economic activities. In fact, demonetization could become so popular among the common people that we would be able to demonetize our currency every 5-10 years instead of doing it only once in 30-40 years.

Helicopter drops of money are a well established tool in economic theory. The Nobel laureate, Milton Friedman was perhaps the first person to discuss the idea his 1969 paper on The Optimal Quantity of Money. The greatest living exponent of helicopter drops is former Fed Chairman, Ben Bernanke who endorsed the idea in his 2002 speech on deflation and has apparently been advising Japanese Prime Minister Shinzo Abe to try it. It is quite likely that apart from solving the logistics problems of demonetization, the helicopter money drop would also stimulate the economy at a time when it is facing several headwinds. It would certainly do more to increase rural spending than rate cuts by the central bank which seem to get lost in monetary transmission.

Economists are more willing to contemplate bold ideas, while politicians and bureaucrats tend to be cowardly in their approach. In India, today, we have the perfect constellation of factors that make a helicopter drop economically sensible and politically feasible. If a bill were to be moved in parliament to provide statutory basis for a helicopter drop, I am confident that almost all MPs who want to be reelected in 2019 will support the bill and it would be passed by an overwhelming majority.

In my dreams, the Indian government invites Ben Bernanke to advise it on the helicopter drop and also lets him ride the chopper on its first flight and drop the first wad of new notes with his own hands. It also invites Japanese prime minister Shinzo Abe to witness the inauguration of this programme. Today, Japanese tourists come to India to visit the holy sites of Buddhism. Perhaps, future generations of Japanese will come to India to visit the parliament which pioneered the first helicopter drop that was emulated in Japan and eventually lifted that country out of deflation. It is all a dream, but it could well become reality if the Indian government is willing to be bold and imaginative.

Posted at 11:31 on Wed, 16 Nov 2016     View/Post Comments (7)     permanent link


Wed, 09 Nov 2016

It is not money but credit that makes the world go round

After the Indian government withdrew most of the Indian currency notes from circulation last night, there has been a fear that this would be so disruptive that the economy would just go off the cliff. I think this fear is totally misplaced. Contrary to what some economists might tell us, money does not make the world go round. We finance people know that the world actually runs on credit. Economists tend to think that credit is what you use when you run out of money. Nothing could be further from the truth. In reality, money is what you use when your credit has run out. I work for my employer on credit, my newspaper vendor sells me newspaper on credit, companies buy raw material on credit and sell their products on credit. If you find somebody having difficulty doing any of these transactions on credit, you can be sure that that somebody is a whisker away from bankruptcy.

Yes, today you will not be able to go to your neighbourhood grocery store and buy anything with the 500 rupee note in your wallet. But if you cannot buy whatever you like on credit from the same neighbourhood grocery store, then you have a very serious problem on your hand; a problem that will not go away when the banks reopen tomorrow. If you really find yourself in that position, you should be very worried and you should drop everything that you are doing, and work slowly and painstakingly on rebuilding your credit. For in a capitalist society, if you have lost your credit, you have lost everything.

So, yes, the Indian economy will be fine even though it is denuded of most of its currency for the next few days. Apart from the few people who are travelling (other than your credit card, you have no credit amidst strangers), it will not even be too inconvenient for the vast majority of people. I have no first hand knowledge of the black economy and would be reluctant to comment on that, but I suspect that this too runs more on credit than on cash. It might be premature to conclude that the economy would suffer from a fall in demand due to disruption of the black economy.

If you want historical evidence on how the world copes with disruptions to money supply, I would recommend an excellent article early this year by the Bank of England on how Ireland coped with a six month long bank strike in the 1970s. Or you could look at the experience from 19th century US in the wake of frequent bank failures and how cities and towns rebuilt their economy on alternative credit networks. Or you could read Niklas Blanchard on complementary currencies.

Posted at 11:24 on Wed, 09 Nov 2016     View/Post Comments (4)     permanent link


Sun, 30 Oct 2016

How to make the banks paranoid about security?

All online businesses are highly vulnerable to hacking, but the business response to this threat ranges from paranoia to complacency. Banks are among those that are most complacent, and there is a lot that regulators can and should do to change that.

Let me start with an example of a paranoid online business – online pornography. A few days ago a distributed denial of service attack on a large DNS server took down several major websites including Twitter, Spotify, Reddit, Etsy, Wired, and PayPal. While these giants tottered, adult entertainment sites like pornhub.com withstood the attack. The secret was DNS redundancy; to bring pornhub.com down, you would have to take down several DNS servers, not just one. Or consider another example: Wikileaks whose total security budget might be a rounding error for many large banks. Wikileaks has angered some of the most powerful nation states in the world, but the only disruption that Wikileaks has suffered is Ecuador cutting off the internet lines to its founder Julian Assange who is holed up in the Ecuadorian embassy for several years now. Wikileaks claims to have activated contingency plans and its twitter feed has continued to be very active.

Compared to these organizations that run their websites as a serious activity, banks come across as utterly complacent and casual about computer security. Let me give a few examples:

  1. My internet banking passwords are among my weaker passwords not because I am careless, but because most banks do not allow me to use high quality passwords. To combat Moore’s law, I have been increasing my default password length every year or so, and now this default length exceeds the maximum allowed by most banking sites in India. Most banks also disallow various special characters that my random password generator produces by default.

  2. A few days ago it was reported that over three million Indian debit cards had been compromised but the breach was not detected for several weeks. Many banks have tried to turn this into a business opportunity by discouraging their customers from using ATMs of other banks. If some banks are running vulnerable ATMs, they must be publicly identified and their ATMs must be shut down promptly and ruthlessly. A general discouragement of other bank ATMs only helps each bank to save on interconnect charges.

  3. Anecdotal evidence suggests that banks are extremely reluctant to disclose or correct vulnerabilities detected by their own security audits due to fear that it might hurt their business. They find it cheaper to compensate the few customers who do complain loudly enough. Most customers are neither knowledgeable enough to complain, or vociferous enough to succeed.

In banking regulation, there has been a progressive shift towards considering systemic (also called macro-prudential) risks rather than the idiosyncratic risk of failure of a single bank. This lesson has to be applied to cyber risks as well. A breach in any bank opens up a threat surface for the entire interconnected financial system. The regulatory response to the breach must not be based on the loss to the bank in question; it must consider the risks posed to the entire system.

This means that failure to disclose breaches must be punished a lot more severely than the actual breach itself. Undisclosed breaches pose huge systemic risks because of the difficulty of defending against the unknown enemy. For India, I would think that an appropriate calibration of the penalty would require that the fine for unreasonable delay in disclosing a breach affecting a million customers should amount to approximately one year’s cyclically adjusted profits of the entire banking system.

A couple of such large fines would shake the banks out of their complacency and induce a healthy dose of paranoia in the banks. It would also shift the cost benefit analysis towards investing more in security. Perhaps they will hire some personnel from organizations like pornhub.com who are demonstrably better at running an online business. As Andy Gove wrote in Only the Paranoid Survive:

You need to plan the way a fire department plans: It cannot anticipate where the next fire will be, so it has to shape an energetic and efficient team that is capable of responding to the unanticipated as well as to any ordinary event.

Posted at 17:46 on Sun, 30 Oct 2016     View/Post Comments (1)     permanent link