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

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Tue, 15 Apr 2014

The human rights of insider traders

The European Court of Human Rights (ECHR) has an interesting judgement (h/t June Rhee) upholding the human rights of those guilty of insider trading (The judgement itself is available only in French but the Press Release is available in English).

Though the fines and penalties imposed by the Italian Companies and Stock Exchange Commission (Consob) were formally defined as administrative in nature under Italian law, the ECHR ruled that “the severity of the fines imposed on the applicants meant that they were criminal in nature.”. As such, the ECHR found fault with the procedures followed by Consob. For example, the accused had not had an opportunity to question any individuals who could have been interviewed by Consob. Moreover, the functions of investigation and judgement were within the same institution reporting to the same president. The only thing that helped Consob was that the accused could and did challenge the Consob ruling in the Italian courts.

The ECHR ruling that the Consob fines were a criminal penalty brought into play the important principle that a person cannot be tried for the same offence twice. Under Italian law (based on the EC Market Abuse Directive), a criminal prosecution had taken place in addition to the Consob fines. ECHR ruled that this violated the human rights of the accused.

It is important to recognize that the ECHR is not objecting to the substance of the insider trading statutes and the need to penalize the alleged offences. The Court clearly states that the regulations are “intended to guarantee the integrity of the financial markets and to maintain public confidence in the security of transactions, which undeniably amounted to an aim that was in the public interest. ... Accordingly, the fines imposed on the applicants, while severe, did not appear disproportionate in view of the conduct with which they had been charged.” Rather, the Court’s concerns are about due process of law and the protection of the rights to fair trial.

I think the principles of human rights are broadly similar across the free world – US, Europe and India. The judgement therefore raises important issues that go far beyond Italy.

Posted at 11:03 on Tue, 15 Apr 2014     View/Post Comments (2)     permanent link

Sat, 12 Apr 2014

Heartbleed and the need for air-gapped backups in finance

Heartbleed is perhaps the most catastrophic computer security disaster ever (For those not technically inclined, this xkcd comic is perhaps the most readable explanation of the bug). Bruce Schneier says that “On the scale of 1 to 10, this is an 11.” Since the bug has been around for a few years and the exploit leaves no trace on the server, the assumption has to be that passwords and private keys have been stolen from every server that was ever vulnerable. If you have the private key, you can read everything that is being sent to or received from the server until the private key (SSL Certificate) is changed even if the vulnerability itself has been fixed.

Many popular email, social media and other popular sites are affected and we need to change our passwords everywhere. Over the next few weeks, I intend to change every single password that I am using on the web – more than a hundred of them.

Thankfully, only a few banking sites globally seem to be affected. When I check now, none of the Indian banking sites that I use regularly are being reported as vulnerable. However, the banks have not said anything officially and I am not sure whether they were never vulnerable or whether they fixed the vulnerability over the last few days after the bug was revealed. Even the RBI has been silent on this; if all Indian banks were safe, they should publicly say so, and if some were affected and have been fixed, they should say so too. Incidentally, many Indian banking sites do not seem to implement Perfect Forward Security and that is not good at all.

More importantly, I think it is only a matter of time before large financial institutions around the world suffer a catastrophic security breach. Even if the mathematics of cryptography is robust (P ≠ NP), all the mathematics is implemented in code that often goes through only flimsy code reviews. I think it is necessary to have offline repositories of critical financial data so that one disastrous hack does not destroy the entire financial system. For example, I think every large depository, bank, mutual fund and insurance company should create a monthly backup of the entire database in a secure air-gapped location. Just connect a huge storage rack to the server (or perhaps the disaster recovery backup server), dump everything (encrypted) on the rack, disconnect and remove the rack, and store the air-gapped rack in a secure facility. A few thousands of dollars or even a few tens of thousands of dollars a month is a price that each of these institutions should be willing to pay for partial protection against the tail risk of an irrecoverable security breach.

Posted at 13:34 on Sat, 12 Apr 2014     View/Post Comments (0)     permanent link

Sat, 05 Apr 2014

Campbell on 2013 Economics Nobel Prizes

While much has been written about the 2013 Economics Nobel Prizes, almost everybody has focused on the disagreements between Fama and Shiller, with Hansen mentioned (if at all) as an afterthought (Asness and Lieuw is a good example). By contrast, John Campbell has a paper (h/t Justin Fox) on the 2013 Nobels for the Scandinavian Journal of Economics, in which Hansen appears as the chief protagonist, while Fama and Shiller play supporting roles. The very title of the paper (“Empirical Asset Pricing”) indicates the difference in emphasis – market efficiency and irrational exuberance play second fiddle to Hansen’s GMM methodology.

To finance people like me, this comes as a shock; Fama and Shiller are people in “our field” while Hansen is an “outsider” (a mere economist, not even a financial economist). Yet on deeper reflection, it is hard to disagree with Campbell’s unstated but barely concealed assessment: while Fama and Shiller are story tellers par excellence, Hansen stands on a different pedestal when it comes to rigour and mathematical elegance.

And even if you have no interest in personalities, I would still strongly recommend Campbell’s paper – it is by far, the best 30 page introduction to Empirical Asset Pricing that I have seen.

Posted at 16:56 on Sat, 05 Apr 2014     View/Post Comments (2)     permanent link

Thu, 27 Mar 2014

Diversification, Skewness and Adverse Selection

When I first read about the fascinating ‘Star Wars’ deal between Steven Spielberg and George Lucas, my reaction was that this was a simple diversification story. But then I realized that it is more complex than that; the obstacles in the form of skewness preference, adverse selection and moral hazard are strong enough to make deals like this probably quite rare.

The story itself is very simple and Business Insider tells it well. Back in 1977, George Lucas was making his ‘Star Wars’ film, and Steven Spielberg was making ‘Close Encounters of the Third Kind’. Lucas was worried that his ‘Star Wars’ film might bomb and thought that ‘Close Encounters’ would be great hit. So he made an offer to his friend Spielberg:

All right, I’ll tell you what. I’ll trade some points with you. You want to trade some points? I’ll give you 2.5% of ‘Star Wars’ if you give me 2.5% of ‘Close Encounters’.

Spielberg’s response was:

Sure, I’ll gamble with that. Great.

Both films ended up as great classics, but ‘Star Wars’ was by far the greater commercial success and Lucas ended up paying millions of dollars to Spielberg.

At the time when neither knew whether either of the films would succeed, the exchange was a simple diversification trade that made both better off. So why are such trades not routine? One reason could be that many films are made by large companies that are already well diversified.

A more important factor is information asymmetry: normally, each director would know very little of the other’s film and then trades become impossible. The Lucas-Spielberg trade was possible because they were friends. It is telling that the trade was made after Lucas had spent a few days watching Spielberg make his film. It takes a lot of due diligence to overcome the information asymmetry.

The other problem is skewness preference. Nobody buys a large number of lottery tickets to “diversify the risk”, because that diversification would also remove the skewness that makes lottery tickets worthwhile. Probably both Lucas and Spielberg thought their films had risk adjusted returns that made them attractive even without the skewness characteristic.

It is also possible that Lucas simply did an irrational trade. Lucas is described as “a nervous wreck ... [who] felt he had just made this little kids’ movie”. Perhaps, Spielberg was simply at the right time at the right place to do a one-sided trade with an emotional disturbed counterparty. Maybe, we should all be looking out for friends who are sufficiently depressed to offer us a Lucas type trade.

Posted at 13:38 on Thu, 27 Mar 2014     View/Post Comments (0)     permanent link

Fri, 14 Mar 2014

China and Japan: Risk of Currency War

Over the last few months, the risks of such a currency war between China and Japan have increased substantially as pressing domestic economic problems in both countries could tempt them down this path.

In Japan, Abe came to power with a promise to revive the economy through drastic means. Though Abenomics has three “arrows”, the only arrow that is at all effective now is the monetary arrow that has worked by depreciating the yen. The risk is that Japan would seek to rely more and more on this arrow and try to push the yen down to 110 or even 120 against the US dollar. It is even possible that such a strategy might finally revive the Japanese economy.

China also faces a similar temptation. House of Debt has a fantastic blog post showing that since 2008, China has been forced to rely more and more on debt to keep its economy growing because its earlier strategy of export led growth is not working any more. The second graph in their blog post drives this point home very forcefully. Unfortunately, the debt led model is increasingly unsustainable. This month, China witnessed the first onshore corporate bond default. Earlier, a default on a popular wealth management product was avoided only by a bailout.

China’s leaders must now be sorely tempted to depreciate the currency to maintain economic growth without further exacerbating the country’s internal debt problem. Many observers believe that after many years of high inflation and gradual appreciation, the Chinese Renminbi is overvalued today. That would be another reason to attempt a weakening of the currency.

The high degree of intra-Asian economic integration means that a depreciation by either Asian giant would drive down many other Asian currencies (for example, the Korean Won) and make it difficult for the other Asian giant to refrain from depreciating its currency. A vicious cycle of competitive devaluations could rapidly become a currency war. And the already strained political relations between the two countries would clearly not help.

The yen and the yuan are in some ways like the yin and yang of Asian currency markets. A “beggar thy neighbour” currency war between Japan and China would of course have a dramatic impact on the whole of Asia.

Posted at 19:53 on Fri, 14 Mar 2014     View/Post Comments (0)     permanent link

Tue, 11 Mar 2014

Bitcoin as a retail RTGS without a central bank

Richard Gendal Brown has a very valuable blog post about bank payment systems that ends with a brief discussion about Bitcoin. His conclusion is very interesting:

My take is that the Bitcoin network most closely resembles a Real Time Gross Settlement system. There is no netting, there are (clearly) no correspondent banking relationships and we have settlement, gross, with finality.

I agree with this characterization, but would only add that Bitcoin is an RTGS (Real-Time Gross Settlement) without a central bank. To computer scientists, the core of Bitcoin is an elegant solution to the Byzantine Generals problem. To finance people, perhaps, the core of Bitcoin is an RTGS that (a) is open to all (and not just the privileged banks) and (b) functions without a central bank.

Posted at 18:42 on Tue, 11 Mar 2014     View/Post Comments (2)     permanent link

Fri, 07 Mar 2014

Why central banks should not regulate markets

The best reason for keeping central banks out of the regulation of markets is highlighted by the announcement a couple of days back by the Bank of England that it was suspending one of its employees and beginning an independent investigation into whether any of its staff were involved in or aware of any attempted manipulation of the foreign exchange market.

The simple fact of the matter is that the central bank is totally conflicted when it comes to market regulation. It is a big participant in financial markets – in fact its primary mandate is to legally manipulate these markets in the pursuit of the macroeconomic mandates entrusted to it. Monetary policy gives central banks a mandate to manipulate bond markets to fix interest rates at particular levels; in several countries, central banks are also mandated to manipulate foreign exchange markets; and occasionally (for example, Hong Kong and Japan at different points of time), they have even been mandated to manipulate the stock index market.

This completely legal manipulation mandate makes central banks unsuitable for enforcing conduct regulation of financial markets. There is too great a temptation for the central bank to condone or even encourage large banks to indulge in manipulation of markets in the same direction that the central bank desires. After all, this is just another very convenient “transmission mechanism” for the central bank.

In this light, the post crisis decision in the UK to move market regulation into a subsidiary of the central bank is a ghastly mistake.

Posted at 21:52 on Fri, 07 Mar 2014     View/Post Comments (2)     permanent link

Sat, 01 Mar 2014

Insider trading inside the regulator

Rajgopal and White have a paper euphemistically (or sarcastically) titled “Stock Picking Skills of SEC Employees”. The paper is actually about potential insider trading by the regulator’s employees. The empirical results show that sales (but not purchases) by SEC employees earned abnormal profits (as measured by the standard Fama-French four factor model). There is evidence that some of these sales were based on impending SEC enforcement actions or disclosures made to the SEC that have not yet been made public. This indicates that the measures introduced by the SEC after an earlier insider trading scandal in 2009 (see here, pages 40-43) are not sufficiently effective or are not properly enforced.

If my memory serves me right, back in 2000, when I was in SEBI (the Securities and Exchange Board of India), employees (from the Chairman down to all staff) were forbidden from investing in equities except through mutual funds. This is arguably too draconian, but clearly the SEC rules (and their enforcement) were not tight enough.

Posted at 13:29 on Sat, 01 Mar 2014     View/Post Comments (0)     permanent link

Tue, 25 Feb 2014

Edgar for Humans: Where individual effort trumps mighty organizations

Last week, Maris Jensen released her web site SEC Filings for Humans. (There is a nice interview with Maris Jensen at E Pluribus Unum.)

I use the SEC’s Edgar database quite often, but nowadays I never go there without first having identified the exact document that I need through other means. Searching for the document itself on Edgar is not for the faint hearted. I use Yahoo Finance and Google Finance quite extensively and find both quite disappointing. It is therefore truly amazing that one individual using a bunch of open source software (particularly D3.js and SQLAlchemy) can do something that none of these powerful organizations with vast resources have been able to accomplish.

For example, on Edgar, if you look for JPMorgan, you will find two registrants with the same name Jpmorgan Chase & Co. Only by trial and error would you be able to figure out which is the true JPMorgan. At Maris’ site, both registrants are listed, but the correct one is identified by the ticker symbol (JPM). Not rocket science, but saves a few minutes of searching for the wrong documents. Once you select JPM, you can view all its financial information (from the XBRL filings) in tabular form instead of wading through a huge text file. A lot of interesting information is displayed visually – for example, you can find a time series chart of all of the company’s subsidiaries. (For a company like JPM with hundreds of subsidiaries, this chart is quite intimidating, a similar chart for say Apple is more enjoyable). The influence chart of cross ownership is also truly impressive.

It is quite likely that in a few days as more and more users try out her website, it will become unresponsive and possibly even crash. One hopes that a large organization with more bandwidth and hardware takes over the site and keeps it running. But the prospects do not look very good – Maris tried to donate the whole thing to the SEC, but they did not even bother to respond. Meanwhile the SEC spends a lot of money buying back its own Edgar data from commercial vendors.

Finally, will something like this ever become available in India?

Posted at 17:39 on Tue, 25 Feb 2014     View/Post Comments (2)     permanent link

Sun, 23 Feb 2014

Looking for smuggled gold in the balance of payments

The World Gold Council (WGC) reported last week that despite import curbs imposed during 2013, Indian gold demand continued to grow with gold smuggling (what the WGC euphemistically calls unofficial gold imports) compensating for the fall in official imports. This is of course in line with a lot of anecdotal evidence.

In principle, gold smuggling should show up in the balance of payments (BOP) data in some form – after all the smuggled gold also has to be paid for in foreign exchange. For example, smugglers could collect foreign currency from migrant workers outside India and remit the money in Indian rupees to their families in India via the “hawala” channels. Corporate “hawala” could take the form of under/over invoicing of trade or inflating outbound foreign direct investment from India.

The Indian balance of payments data is available only for July-September 2013 while smuggling is likely to have picked up more in the subsequent quarter. Nevertheless, the data does show some tentative evidence for the financing of gold smuggling. For example, in item (Other capital transfers including migrants transfers), the gross inflows fell by nearly $1.0 billion and the net flow fell by $0.8 billion. Similarly, item 3.1.B (Direct Investment by India) rose by $1.2 billion on gross outflow basis and by $0.6 billion on a net outflow basis. I am grateful to my colleague Prof. Ravindra Dholakia for pointing out to me that the gross flows are possibly more important than the net flows.

The WGC data and the BOP data are consistent with the anecdotal evidence that smuggling is on the rise. Some economists tend to be dismissive of such anecdotal evidence – their standard refrain is that “the plural of anecdote is not data”. In finance, we tend to be much more respectful of anecdotal and suggestive evidence. Our standard reflex is to “buy the rumour and sell the fact”. Financial markets are forward looking and by the time conclusive statistical data becomes available, it is too late to be actionable.

In any case, it is dangerous to let smuggling take root. Smuggling of gold requires setting up a complex and sophisticated supply chain including financing, insurance, transportation, warehousing and distribution. Stringent import curbs create incentives to incur the large fixed costs required to set up such a supply chain. But once the supply chain has been set up, it may continue to operate even after the curbs are relaxed so long as the arbitrage differentials exceed the variable costs of the supply chain. In this sense, there are large hysteresis effects (path dependence) in these kinds of phenomena. More dangerously, the supply chain created to smuggle gold can be easily re-purposed for more nefarious activities. In the long run, the gold import curbs may turn out to be a very costly mistake.

Posted at 13:35 on Sun, 23 Feb 2014     View/Post Comments (1)     permanent link

Sun, 16 Feb 2014

High Frequency Manipulation at Futures Expiry

My colleagues, Prof. Sobhesh Kumar Agarwalla and Prof. Joshy Jacob and I have a working paper on “High Frequency Manipulation at Futures Expiry: The Case of Cash Settled Indian Single Stock Futures” (also available at SSRN).

Some extracts from the abstract and the conclusion:

In 2013, the Securities and Exchange Board of India identified a case of alleged manipulation (in September 2012) of the settlement price of cash settled single stock futures based on high frequency circular trading. This alleged manipulation exploited several interesting characteristics of the Indian single stock futures market: (a) the futures contract is cash settled, (b) the settlement price is not based on a call auction or special session, but is the volume weighted average price (VWAP) during the last half an hour of trading in the cash market on the expiry date, and (c) anecdotal evidence suggests that the Indian market is more vulnerable to circular trading in which different entities associated with the same person trade with each other to create a false market.

We demonstrate that the combination of cash settlement with the use of a volume weighted average price (VWAP) to determine the settlement price on expiry day makes the Indian single stock futures market vulnerable to a form of high frequency manipulation that targets price insensitive execution algorithms. This type of manipulation is hard to prevent using mechanisms like position limits, and therefore it is necessary to establish a robust program to detect and deter manipulation.

We develop an econometric technique that uses high frequency data and which can be integrated with the automated surveillance system to identify suspected cases of high frequency manipulation very close to the event. Human judgement then needs to be applied to identify cases which prima facie justify detailed investigation and possible prosecution. Our results suggest that high frequency manipulation of price insensitive execution algorithms may be taking place. However, successful manipulation of the settlement price is relatively rare with only one clear instance (the September 27, 2012 episode) and one (milder) parallel.

Finally, the use of the volume weighted average price (VWAP) to determine the cash settlement price of the futures contract might require reconsideration.

Posted at 21:02 on Sun, 16 Feb 2014     View/Post Comments (0)     permanent link

Thu, 13 Feb 2014

Does the market close at 4:00:00 pm or at 4:00:01 pm?

A few years ago, somebody asking this question would have been dismissed as a nit picking nerd, but today that question has become extremely important. Last week, the Wall Street Journal’s MoneyBeat blog carried an interesting story about how this difference cost a trader $100,000.

The official market close in the US is 4:00:00 pm, but the computers at Nasdaq keep humming for almost one second longer to reconcile all trades and determine the market closing price. About 150 milliseconds after 4:00 pm on December 5, the earnings announcement of Ulta Salon Cosmetics & Fragrance Inc. hit Business Wire and within 50 milliseconds after that a series of sale orders started hitting the market. When the market closed 700 milliseconds after 4:00 pm, the stock had fallen from $122 to $118.

The problem is that companies that want to release earnings after trading hours assume that trading stops at 4:00:00 pm, while smart traders know that the actual close is nearer to 4:00:01. That creates a profit opportunity for the fastest machine readable news feeds and the fastest trading algorithms. Traders are thinking in terms of milliseconds, but regulators are probably thinking in terms of minutes. Time for the regulators to catch up!

Posted at 17:51 on Thu, 13 Feb 2014     View/Post Comments (1)     permanent link

Tue, 11 Feb 2014

Flaws in EMV (Chip and Pin) Card Security

Steven J. Murdoch and Ross Anderson have a fascinating paper entitled “Security Protocols and Evidence: Where Many Payment Systems Fail” (h/t Bruce Schenier). The paper proposes five principles to guide the design of good security protocols:

Principle 1: Retention and disclosure. Protocols designed for evidence should allow all protocol data and the keys needed to authenticate them to be publicly disclosed, together with full documentation and a chain of custody.


Principle 2: Test and debug evidential functionality. When a protocol is designed for use in evidence, the designers should also specify, test and debug the procedures to be followed by police officers, defence lawyers and expert witnesses.


Principle 3: Open description of TCB [trusted computing base]. Systems designed to produce evidence must have an open specification, including a concept of operations, a threat model, a security policy, a reference implementation and protection profiles for the evaluation of other implementations.


Principle 4: Failure-evidentness. Transaction systems designed to produce evidence must be failure-evident. Thus they must not be designed so that any defeat of the system entails the defeat of the evidence mechanism.


Principle 5: Governance of forensic procedures. The forensic procedures for investigating disputed payments must be repeatable and be reviewed regu- larly by independent experts appointed by the regulator. They must have access to all security breach notifications and vulnerability disclosures.

EMV cards violate several of these principles and the authors propose several ideas to improve the evidential characteristics of the system. One idea is a cryptographic audit log of all transactions to be maintained by the card. A forward secure Message Authentication Code (MAC) would prevent a forger from inserting fake transactions in the past even with possession of the current audit key. Similarly, committing a hash chain over all past transactions would mean that a forger with knowledge of the audit key (but not the card itself) cannot insert fake transactions without inducing a discrepancy between the bank server log and the audit log on the genuine card. By putting the card into a forensic mode to retrieve the audit log, a customer would thus be able to demonstrate that the card was not present in a disputed transaction – presumably, the merchant and the bank will be left to figure out how to share the loss.

One of the comments (by mike~acke) on Bruce Schneier’s blog points out that in today’s system, the card holder has to trust the merchant completely: “when you use your card: you are NOT authorizing ONE transaction: you are giving the merchant INDEFINITE UNRESTRICTED access to your account.”. His solution is a very simple though radical idea which simply removes the merchant from the trusted chain. (mike~acke’s comment below is probably easier to understand if you interpret POST to mean merchant and PCI to mean bank though neither identification is completely correct.)

When the customer presents the card it DOES NOT send the customer’s card number to the POST. Instead, the POST will submit an INVOICE to the customer’s card. On customer approval the customer’s card will encrypt the invoice together with authorization for payment to the PCI (Payment Card Industry Card Service Center) for processing and forward the cipher text to the POST. Neither the POST nor the merchant’s computer can read the authorizing message because it is PGP encrypted for the PCI service. Therefore the merchant’s POST must forward the authorizing message cipher text to the PCI service center. On approval the PCI Service Center will return an approval note to the POST and an EFT from the customer’s account to the merchant’s account. The POST will then print the PAID invoice. The customer picks up the merchandise and the transaction is complete. The merchant never knows who the customer was: the merchant never has ANY of the customer’s PII data.

I like this idea and would like to extend the idea even to ATM cards. That way, we will never have to worry about inserting a card into a fake or compromised ATM, because our ATM card would not trust the ATM machine – it would talk directly to the bank server in encrypted messages that the ATM cannot understand. At the end of it all, the bank server would simply send a message to the ATM to dispense the cash.

Updated February 11, 2014 to insert block quotes and ellipses in quote from Murdoch-Anderson paper.

Posted at 10:47 on Tue, 11 Feb 2014     View/Post Comments (0)     permanent link

Tue, 28 Jan 2014

To short the rupee go to London and Singapore

Rajan Goyal, Rajeev Jain and Soumasree Tewari have an interesting paper in the RBI Working Paper series on the “Non Deliverable Forward and Onshore Indian Rupee Market: A Study on Inter-linkages” (WPS(DEPR):11/2013, December 2013).

They use a error correction model (ECM) to measure the linkages between the onshore and offshore rupee markets. The econometric model tells a very simple story: in normal times, much of the price discovery happens in the onshore market though there is a statistically significant information flow from the offshore market. But during a period of rupee depreciation, the price discovery shifts completely to the offshore market. (While the authors do not explicitly report Hasbrouk information shares or Granger-Gonzalo metrics, it seems pretty likely from the reported coefficients that the change in these measures from one regime to the other would be dramatic).

My interpretation of this result is that the exchange control system in India makes it very difficult to short the rupee onshore. The short interest emerges in the offshore market and is quickly transmitted to the onshore market via arbitrageurs who have the ability to operate in both markets:

  1. A hedge fund with a bearish view on the currency might short the rupee in the offshore market depressing the rupee in the offshore market.
  2. A foreign institutional investor with a relatively neutral view on the currency might buy the rupee (at a slightly lower price) in the offshore market from the bearish hedge fund
  3. This foreign institutional investor might then offset its offshore long position with a short position (at a slightly higher price) in the onshore market (clothed as a hedge of its existing Indian assets). This would transmit the price drop from the offshore market to the onshore market with a small lag.

On the other hand, during the stable or appreciation phase, there is no need to short the rupee and divergent views on the rupee can be accommodated in the onshore market in the form of differing hedge propensities of exporters, importers and foreign currency borrowers.

Short sale restrictions in the onshore market have two perverse effects:

  1. They contribute to the migration of the currency market from onshore to offshore.
  2. They make currency crashes more likely because they prevent rational bearish investors from contributing to price discovery in the build up to the crash. (This is a standard argument about short sale restrictions: see for example Harrison Hong and Jeremy Stein(2003) “Differences of opinion, short-sales constraints, and market crashes”, Review of financial studies, 16(2), 487-525.)

Posted at 17:11 on Tue, 28 Jan 2014     View/Post Comments (1)     permanent link

Sun, 19 Jan 2014

Rating Agencies: What changed in 2000s?

Consider three alternative descriptions of what happened to the big global rating agencies during the early 2000s:

  1. Kedia, Rajgopal and Zhou wrote a paper last year presenting evidence showing that the deterioration of Moody's credit rating was due to its going public and the consequent pressure for increasing profits.
  2. Bo Becker and Todd Milbourn wrote a paper three years ago arguing that increased competition from Fitch coincides with lower quality ratings from the incumbents (S&P and Moody's).
  3. Way back in 2005, Frank Partnoy wrote a highly prescient paper describing the transformation of the rating industry since the 1990s that turned “gate keepers” into “gate openers”. He attributed the very high profitability of the gate openers to three things: (a) the regulatory licences that made ratings valuable even if they were uninformative, (b) the “free speech” immunity from civil and criminal liability for malfeasance and (c) the rapid growth of CDOs and structured finance.

I find Partnoy’s paper the most convincing despite its total lack of econometrics. The sophisticated difference-in-difference econometrics of the other two papers is, in my view, vitiated by reverse causation. When rating becomes “a much more valuable franchise than other financial publishing” as Partnoy showed, there would be greater pressure to do an IPO and also greater willingness to disregard any adverse reputational effects on other publishing businesses of the group. Similarly, the structural changes in the industry would invite greater competition from previously peripheral players like Fitch who happen to hold the same regulatory licence.

Posted at 11:04 on Sun, 19 Jan 2014     View/Post Comments (1)     permanent link

Thu, 09 Jan 2014

Day dreaming about electronic money

Earlier this week, the Reserve Bank of India published the report of the Nachiket Mor Committee on financial inclusion (technically the Committee on Comprehensive Financial Services for Small Businesses and Low Income Households). Its first recommendation was that “By January 1, 2016 each Indian resident, above the age of eighteen years, would have an individual, full-service, safe, and secure electronic bank account.”

The Committee’s mandate was obviously to look at financial inclusion within the context of the current financial architecture and so it could not by any means have recommended a change in the core of that financial architecture itself. But for us sitting outside the Committee, there is no such constraint. We are entitled to day-dream about anything. So I would like to ask the question: if we were designing everything on a completely clean slate, what would we like to do?

Day dreaming begins here.

In my day dream, India would embrace electronic money and give every Indian an eWallet. Instead of linking India’s Unique ID (Aadhaar number) to a bank account, we would link it to an eWallet provided by the central bank. We would simultaneously move to abolish paper money by converting existing currency notes (with their famous “I promise to pay the bearer”) into genuine promissory notes redeemable in eRupees delivered into our eWallets. Financial inclusion would then have three ingredients: a Unique ID (Aadhaar) for everyone which is more or less in place now, the proposed eWallet for everyone, and a mobile phone for everyone. All eminently doable by 2016.

The costs of creating all the computing and communication infrastructure for a billion eWallets would be huge, but could be easily financed by a small cess on all paper money and bank money. The cess would also serve to incentivize a rapid shift to eRupees. (At some stage, we could even decide to make demand deposits illegal just like bearer demand promissory notes are illegal today, but I think that a ban would not be necessary at all.)

The operating costs of eRupees would be easily covered by the seigniorage income on the electronic money. Because of its greater convenience, safety and liquidity, eRupees should become at least as large as M2, and probably would grow to 25-30% of M3, making it about twice as large as paper money. The operating costs of eRupees should be significantly less than that of paper currency, and the seigniorage income much greater. The government would earn a fatter dividend from the Reserve Bank of India after covering all the cost of eRupees.

A huge chunk of the current banking infrastructure is now devoted to the useless paper shuffling activity that constitutes the current payment system. If this infrastructure is re-purposed to perform genuine financial intermediation, this would support much higher levels of economic growth. Divested of a payment system, the banks would be more like non bank finance companies and would pose far less systemic risk as well.

All this would allow India to leapfrog the rest of world and create the most advanced payment system on the planet (something like a Bitcoin backed by an army). In a world that struggles to ensure that systemically important settlement systems like clearing corporations settle in central bank money, we would have a system in which every individual could settle in central bank money. It is even possible that eRupees would find international adoption in the absence of any competition.

Day dreaming ends here.

Posted at 17:08 on Thu, 09 Jan 2014     View/Post Comments (5)     permanent link

Wed, 08 Jan 2014

Tapering Talk: Why was India hit so hard?

Barry Eichengreen and Poonam Gupta have written a paper on how the “Tapering Talk” by the US Federal Reserve in mid 2013 impacted emerging markets.

In order to determine which countries were affected more severely, Eichengreen and Gupta construct a “Pressure Index” based on changes in the exchange rate and foreign exchange reserves. They also construct a Pressure Index 2 that also includes the impact on the stock market. By both measures, they find that India was the worst affected within a peer group of seven countries. The peer group includes all the countries that Morgan Stanley have called the Fragile Five (Brazil, India, Indonesia, South Africa and Turkey); in addition, it includes China and Russia. The Pressure Index 1 for India was 7.15 compared to a median of 3.46 for the peer group. Since the Indian stock market did not do too badly, the Pressure Index 2 for India was slightly better at 6.57 compared to a median of 4.63 for the peer group.

Turning to why some countries were hit harder than others, the paper finds:

What mattered more was the size of their financial markets; investors seeking to rebalance their portfolios concentrated on emerging markets with relatively large and liquid financial systems; these were the markets where they could most easily sell without incurring losses and where there was the most scope for portfolio rebalancing. The obvious contrast is with so-called frontier markets with smaller and less liquid financial systems. This is a reminder that success at growing the financial sector can be a mixed blessing. Among other things, it can accentuate the impact on an economy of financial shocks emanating from outside

In addition, we find that the largest impact of tapering was felt by countries that allowed exchange rates to run up most dramatically in the earlier period of expectations of continued ease on the part of the Federal Reserve, when large amounts of capital were flowing into emerging markets. Similarly, we find the largest impact in countries that allowed the current account deficit to widen most dramatically in the earlier period when it was easily financed. Countries that used policy and in some cases, perhaps, enjoyed good luck that allowed them to limit the rise in the real exchange rate and the growth of the current account deficit in the boom period suffered the smallest reversals.

Clearly, India’s increasing integration with global financial markets imposes greater market discipline on our policy makers than they have been used to in the past.

Posted at 21:27 on Wed, 08 Jan 2014     View/Post Comments (2)     permanent link

Wed, 18 Dec 2013

Clearing of OTC Derivatives

Dr. David Murphy of the Deus ex Machiatto blog has published a comprehensive book on clearing of OTC derivatives (OTC Derivatives, Bilateral Trading and Central Clearing, Palgrave Macmillan, 2013). I was surprised that the author information on the book cover flap does not mention the blog at all but gives prominence to his having been head of risk at ISDA. Had I found this book at a book shop, the ISDA connection might have made me less likely to buy the book because of the obvious bias that the position entails. This was a book that I read only because of my respect for the blogger. Many publishers have obviously not received the memo on how the internet changes everything.

The book presents a balanced discussion of most issues while of course leaning towards the ISDA view of things. Many of the arguments in the book against the clearing mandate would be familiar to those who read the Streetwise Professor blog. Yet, I found the book quite informative and enjoyable.

In Figure 10.1 (page 261), Murphy summarizes the winners and losers from the clearing reforms. To summarize that highly interesting summary:

Obviously, the clearing mandate has not quite worked out the way its advocates expected. Clearing was originally expected to lead to greater competition and reduce the dominance of the big (G14) dealers. Murphy explains that the big dealers will actually benefit from the mandate as they can more easily cope with the compliance costs.

I am not disturbed to find corporate end users listed as losers. If Too Big to Fail (TBTF) banks were being subsidized by the taxpayer to write complex customized derivatives, these products would clearly have been under priced and over produced. When the subsidy is removed, supply will drop and prices will rise. This is a feature and not a bug.

If the price rises sufficiently, end users may shift to more standardized and simpler products. Of course, this will imply basis risks because the hedge no longer matches the exposure exactly. This matters less than one might think. The Modigliani Miller (MM) argument applied to hedging (which is actually very similar to a capital structure decision) implies that most hedging decisions are irrelevant. The only relevant hedging decisions are the ones that involve risks large enough to threaten bankruptcy or financial distress and therefore invalidate the MM assumptions. Basis risks are small enough to allow the MM arguments to be applied. Inability to hedge them has zero real costs for the corporate end user and for society as a whole.

One could visualize many ways in which the market may evolve:

  1. The reforms could lead to the futurization of OTC derivatives. That might be the best possible outcome – exchange trading has even more social benefits than clearing in terms of transparency and competition. The increased basis risk is a non issue because of the MM argument.
  2. Another possible outcome could be a reduction in end user hedging and consequently a smaller derivatives market. Under the MM assumptions, this need not be problematic either.
  3. The worst possible outcome would be an OTC market that is even more concentrated (G10 or even G5) and that uses clearing services provided by badly managed CCPs. This would be a nightmare scenario with a horrendous tail risk.

Posted at 16:21 on Wed, 18 Dec 2013     View/Post Comments (0)     permanent link

Tue, 17 Dec 2013

Electronic Trading

There was a time not so long ago when equities traded on electronic exchanges and everything else traded on OTC markets. We used to hear people argue vehemently that electronic trading would not work outside of the equities world. The belief was that the central order book could not handle large trade sizes. Algorithmic and high frequency trading changed all that. We learned that large trades could be sliced and diced into smaller orders that the central order book could handle easily. With exchanges offering lower and lower latency trading, a big order could be broken into pieces and fully executed faster than a block trade could be worked out upstairs in the old style.

Slowly the new paradigm is expanding into new asset classes. The 2013 triennial survey shows that electronic trading has virtually taken over spot foreign exchange trading and is dominant in other parts of the foreign exchange market as well (Dagfinn Rime and Andreas Schrimpf, “The anatomy of the global FX market through the lens of the 2013 Triennial Survey”, BIS Quarterly Review, December 2013). The foreign exchange market has ceased to be an inter bank market with hedge funds and other non bank financial entities becoming the biggest players in the market. As Rime and Schrimp explain:

Technological change has increased the connectivity of participants, bringing down search costs. A new form of “hot potato” trading has emerged where dealers no longer play an exclusive role.

The next battle ground is corporate bonds. Post Dodd Frank, the traditional market makers are less willing to provide liquidity and people are looking for alternatives including the previously maligned electronic trading idea. McKinsey and Greenwich Associates have produced a report on Corporate Bond E-Trading which discusses the emerging trends but is pessimistic about equities style electronic trading. I am not so pessimistic because in my view if you can get hedge funds and HFTs to trade something, then it will do fine on a central order book.

Posted at 18:03 on Tue, 17 Dec 2013     View/Post Comments (1)     permanent link

Fri, 13 Dec 2013

The Pharoah's funeral plans

Post crisis, there has been a lot of interest in ensuring that large banks prepare a living will or funeral plan describing how they will be resolved if they fail. Though this does look like a good idea, I think there is a catch which is best illustrated with an example.

Some of the most successful funeral plans in history were of the Egyptian Pharoahs who began their reigns with the construction of the pyramids in which they were to be entombed. If anything, this would have increased the cost of the funeral. It is very likely that left to their successors, the pyramids would have been less grandiose. Moreover, to a finance person it is obvious that the present value of the cost increased because the pyramids were built earlier than required.

Much the same thing may be true of the banks as well. Funeral plans may make regulators complacent about excessively large and complex banks; as a results, the costs would be higher when they do fail. Banks may also incur a lot of wasteful expenditure to prepare and defend funeral plans that may ultimately prove useless. The existence of these plans may lead to delays in taking prompt and corrective action for vulnerable banks. Why shut down a bank now when you believe (perhaps wrongly) that it can be shut down later without great difficulty? In short, the plans may allow mere words to substitute for real action.

Posted at 15:54 on Fri, 13 Dec 2013     View/Post Comments (1)     permanent link

Fri, 29 Nov 2013

Revisiting Fischer Black's deathbed paper

In 1995, Fischer Black submitted a paper on “Interest rates as options” when he was terminally ill with cancer. While publishing the paper (Journal of Finance, 1995, 50(5), 1371-1376), the Journal noted:

Note from the Managing Editor: Fischer Black submitted this paper on May 1, 1995. His submission letter stated: “I would like to publish this, though I may not be around to make any changes the referee may suggest. If I’m not, and if it seems roughly acceptable, could you publish it as is with a note explaining the circumstances?” Fischer received a revise and resubmit letter on May 22 with a detailed referee’s report. He worked on the paper during the Summer and had started to think about how to address the comments of the referee. He died on August 31 without completing the revision.

The paper contained an interesting idea to deal with the problem of negative interest rates – assume that the true or ‘shadow short rate’ can be negative, but the rate that we do observe is never negative because currency provides an option to earn a zero interest rate instead. Viewed this way, the interest rate can itself be viewed as an option (with a strike price of zero). What Black found attractive about this idea was that it made modelling easy: one could for example assume that the shadow rate follows a normal (Gaussian) distribution. Whenever the Gaussian distribution produces a negative interest rate, we simply replace it by zero. We do not need to assume a log normal or square root process just to avoid negative interest rates.

While interesting in theory, the model did not prove very popular in practice. But five years of zero interest rates in the US has changed this. Neither the lognormal nor the square root process can easily yield a persistent zero interest rate. Black’s shadow rate achieves this in a very easy and natural manner. More than the finance community, it the macroeconomics world that has rediscovered Black’s model. For example, Wu and Xia have a paper in which they show that macroeconomic models perform nicely even at the zero lower bound (ZLB) if the actual short rate is replaced by the shadow rate (h/t Econbrowser). The shadow rate has the same correlations with other macroeconomic variables at the ZLB as the actual rate has during normal times.

As I have mentioned previously on this blog, modelling interest rate risk at the ZLB is problematic and different clearing corporations have taken different approaches to the problem. Maybe, they should take Black’s shadow short rate more seriously.

Posted at 11:39 on Fri, 29 Nov 2013     View/Post Comments (0)     permanent link

Fri, 15 Nov 2013

Rakoff on financial crisis prosecutions

Judge Rakoff who is best known for rejecting SEC settlements against Bank of America and Citigroup for not going far enough, has come out with a devastating critique of the US failure to prosecute high level executives for frauds related to the financial crisis.

Rakoff points out that the frauds of the 1970s, 1980s and 1990s all resulted in successful prosecutions of even the highest level figures.

In striking contrast with these past prosecutions, not a single high level executive has been successfully prosecuted in connection with the recent financial crisis, and given the fact that most of the relevant criminal provisions are governed by a five-year statute of limitations, it appears very likely that none will be.

First of all, Rakoff dismisses the legal difficulties in prosecuting crisis crimes:

Rakoff thinks that there are three reasons why there have been no prosecutions:

  1. Prosecutors have other priorities –
    • the FBI’s resources were diverted to fighting terrorism;
    • the SEC was focused on Ponzi schemes and accounting frauds;
    • the Department of Justice was bogged down with the prosecution of insider trading based on the Rajaratnam tapes
  2. “[T]he Government’s own involvement in the underlying circumstances that led to the financial crisis ... [and] in the aftermath of the financial crisis ... would give a prudent prosecutor pause in deciding whether to indict a C.E.O. who might, with some justice, claim that he was only doing what he fairly believed the Government wanted him to do.”
  3. “The shift that has occurred over the past 30 years or more from focusing on prosecuting high-level individuals to focusing on prosecuting companies and other institutions.”

Rakoff is known for his strong views on the last point and he lays out the case brilliantly:

If you are a prosecutor attempting to discover the individuals responsible for an apparent financial fraud, you go about your business in much the same way you go after mobsters or drug kingpins: you start at the bottom and, over many months or years, slowly work your way up. Specifically, you start by “flipping” some lower or mid-level participant in the fraud ... With his help, and aided by the substantial prison penalties now available in white collar cases, you go up the ladder. ...

But if your priority is prosecuting the company, a different scenario takes place. Early in the investigation, you invite in counsel to the company and explain to him or her why you suspect fraud. He or she responds by assuring you that the company wants to cooperate and do the right thing, and to that end the company has hired a former Assistant U.S. Attorney, now a partner at a respected law firm, to do an internal investigation. ... Six months later the company’s counsel returns, with a detailed report showing that mistakes were made but that the company is now intent on correcting them. You and the company then agree that the company will enter into a deferred prosecution agreement that couples some immediate fines with the imposition of expensive but internal prophylactic measures. For all practical purposes the case is now over. You are happy ...; the company is happy ...; and perhaps the happiest of all are the executives, or former executives, who actually committed the underlying misconduct, for they are left untouched.

I suggest that this is not the best way to proceed. Although it is supposedly justified in terms of preventing future crimes, I suggest that the future deterrent value of successfully prosecuting individuals far outweighs the prophylactic benefits of imposing internal compliance measures that are often little more than window-dressing. Just going after the company is also both technically and morally suspect. It is technically suspect because, under the law, you should not indict or threaten to indict a company unless you can prove beyond a reasonable doubt that some managerial agent of the company committed the alleged crime; and if you can prove that, why not indict the manager? And from a moral standpoint, punishing a company and its many innocent employees and shareholders for the crimes committed by some unprosecuted individuals seems contrary to elementary notions of moral responsibility.

Rakoff concludes with a scathing criticism:

So you don’t go after the companies, at least not criminally, because they are too big to jail; and you don’t go after the individuals, because that would involve the kind of years-long investigations that you no longer have the experience or the resources to pursue.

After the series of frauds in the late 1990s and early 2000s in the US (Enron, Worldcom, Tyco and Adelphia), Europe (Lernout and Hauspie, Vivendi, ABB and KirchMedia) and India (Tata Finance), I wrote that: “ The US has shown that it can prosecute and punish wrong doers far more speedily than most other jurisdictions.”. I am not at all sure about this today.

Posted at 21:34 on Fri, 15 Nov 2013     View/Post Comments (1)     permanent link

Fri, 08 Nov 2013

Equity markets are different

Equity markets (specifically the market for large capitalization stocks) seem to be very different from other markets in that they are the only markets that are unconditionally liquid. The Basel Committee has officially recognized this – in their classification of 24 markets by liquidity horizons, the large cap equity market is the only market in the most liquid bucket. (Basel Committee on Banking Supervision, Fundamental review of the trading book: A revised market risk framework, Second Consultative Document, October 2013, Table 2, page 16)

There is abundant anecdotal evidence for the greater liquidity of large cap equity markets in stressed conditions – you may not like the price but you would not have any occasion to complain about the volume. For example, in India when the fraud in Satyam was revealed, the price of the stock dropped dramatically, but the market remained very liquid. In fact, the liquidity of the stock on that day was far greater than normal. During the global financial crisis, stock markets remained very liquid while liquidity in many other markets dried up. During the 2008 crisis, Societe General could unwind Kerviel’s unauthorized equity derivative position of € 50 billion in just two days.

There could be many reasons why large cap equity markets are indeed different:

At least some of these features can be replicated in other markets, and such replication should perhaps be a design goal.

Posted at 21:45 on Fri, 08 Nov 2013     View/Post Comments (0)     permanent link

Wed, 06 Nov 2013

Gorton defends opacity of the plutocrats

Gary Gorton has published a paper on “The development of opacity in U.S. banking” (NBER working paper 19540, October 2013). He writes that before the US Civil War:

... bank note markets functioned as “efficient” markets; the discounts were informative about bank risk. Banks at the same location competed, and the note market enforced common fundamental risk at these banks.

Then bank notes were replaced by checking accounts, the banks were taken over by rich men who kept the price per share high enough to keep it out of reach of most investors thereby effectively closing down the market for their stocks. Simultaneously,the clearing houses brought about a culture of secrecy so that depositors also knew little about the health of individual banks.

Gorton thinks that this shutdown of informative and efficient markets was a great thing for economic efficiency – a claim that I find difficult to believe.

On the other hand, the endogenous opacity that Gorton describes is completely analogous to the conclusion of another recent paper (“Shining a Light on the Mysteries of State: The Origins of Fiscal Transparency in Western Europe” by Timothy C. Irwin, IMF Working Paper, WP/13/219, October 2013) on the opacity of sovereign finances:

When power has been tightly held by a financially self-sufficient king, much information about government, including government finances, has remained secret. When power has been shared, either in democracies or sufficiently broad oligarchies, information on government finances has tended to become public.

Posted at 15:20 on Wed, 06 Nov 2013     View/Post Comments (0)     permanent link

Sun, 27 Oct 2013

Greenspan: successful policy will always create a bubble

In an interview with Gillian Tett in the Financial Times of October 25, 2013 (behind paywall), Alan Greenspan says:

Beware of success in policy. A stable, moderately growing, non-inflationary environment will create a bubble 100 per cent of the time.

The first objection to this argument is that a bubble is by definition unstable and so the term “stable” should be changed to “apparently stable”. That apart, Greenspan seems to be making inferences from just one event – the Great Moderation. From a sample size of one, inferences can be drawn in many directions, and many permutations and combinations are possible. Some possible variants are:

Finally, not many would agree with Alan Greenspan’s self serving claim that bubble blowing can be regarded as a successful policy.

Posted at 14:28 on Sun, 27 Oct 2013     View/Post Comments (0)     permanent link

Sun, 20 Oct 2013

SEC order explains Knight Capital systems failure

More than a year ago, Knight Capital suffered a loss of nearly half a billion dollars and needed to sell itself after a defective software resulted in nearly $7 billion of wrong trades. A few days back, the US SEC issued an order against Knight Capital that described exactly what happened:

It appears to me that there were three failures:

  1. It could be argued that the first failure occurred in 2003 when Knight chose to let executable code lie dormant in the system after it was no longer needed. I would like such code to be commented out or disabled (through a conditional compilation flag) in the source code itself.
  2. I think the biggest failure was in 2005. While making changes to the cumulative order routine, Knight did not subject the Power Peg code to the full panoply of regression tests. Testing should be mandatory for any code that is left in the system even if it is in disuse.
  3. The third and perhaps least egregious failure was in 2012 when Knight did not have a second technician review the deployment of the RLP code. Furthermore, Knight did not have written procedures that required such a review.

I am thus in complete agreement with the SEC’s observation that:

Knight also violated the requirements of Rule 15c3-5(b) because Knight did not have technology governance controls and supervisory procedures sufficient to ensure the orderly deployment of new code or to prevent the activation of code no longer intended for use in Knight’s current operations but left on its servers that were accessing the market; and Knight did not have controls and supervisory procedures reasonably designed to guide employees’ responses to significant technological and compliance incidents; (para 9 D)

However, the SEC adopted Rule 15c3-5 only in November 2010. The two biggest failures occurred prior to this rule. Perhaps, the SEC found it awkward to levy a $12 million file for the failure of a technician to copy a file correctly to one out of eight servers. The SEC tries to get around this problem by providing a long litany of other alleged risk management failures at Knight many of which do not stand up under serious scrutiny.

For example, the SEC says: “Knight had a number of controls in place prior to the point that orders reached SMARS ... However, Knight did not have adequate controls in SMARS to prevent the entry of erroneous orders.” In well designed code, it is good practice to have a number of “asserts” that ensure that inputs are not logically inconsistent (for example, that price and quantity are not negative or that an order date is not in the future). But a piece of code that is called only from other code would not normally implement control checks.

For example, an authentication routine might verify a customer’s password (and other token in case of two factor authentication). Is every routine in the code required to check the password again before it does its work? This is surely absurd.

Posted at 21:45 on Sun, 20 Oct 2013     View/Post Comments (0)     permanent link

Wed, 16 Oct 2013

When solvent sovereigns default (aka technical default)

As the US approaches the deadline for resolving its debt ceiling stalemate, there has been much talk about the consequences of a “technical default”. Across the Curve has an acerbic comment about the utter inappropriateness of this terminology:

I guess a technical default is one in which you personally do not own any maturing debt or hold a coupon due an interest payment. If you hold one of those instruments it is a real default!

It is more appropriate to talk about defaults by a solvent sovereign where the ability of the sovereign to repay remains high even after the promise of timely repayment has been broken. This kind of default used to be pretty common in the past (till about a century ago). In the old days, defaults of this kind arose due to liquidity problems or due to some kind of fiscal dysfunction. However strange the US situation may look to us on the basis of our experience in recent decades, it is not at all unusual in the broad sweep of history.

Phillip II of Spain defaulted four times during his reign. Spain was a superpower when it defaulted and it remained a superpower after its initial couple of defaults. In a fascinating paper, Drelichman and Voth explain:

The king’s repeated bankruptcies were not signs of insolvency ... future primary surpluses were sufficient to repay Philip II’s debts ... In addition, lending was profitable ... (Drelichman and Voth (2011), “Lending to the Borrower from Hell: Debt and Default in the Age of Philip II”, The Economic Journal, 121, 1205-1227)

As long as Spain owned the largest silver mines in the world, its abilty to repay debts was not seriously in question (even when the debts reached 60% of GDP under Philip II). One can see a close parallel with the very high ability of the US to repay its debts if its politicians choose to do so.

In England, the default of Charles II (the notorious stop of the exchequer) was a result of fiscal dysfunction rather than any inability of England to repay its modest debts. Charles was not on the best of terms with his parliament and therefore could not levy new taxes to finance his expenses. The same parliament was of course willing to levy far greater taxes and support far greater debts to finance the wars of a monarch more to its liking (William of Orange) after the bloodless revolution. This episode also seems to have much in common with modern day US politics.

Another interesting phenomenon which appears counter intuitive to many people is that sovereign default often happens under very strong and competent rulers. If we look at England, Edward III, Henry VIII and Charles II were among its greatest kings. (In the case of Henry, I am counting the great debasement as a default. In the case of Charles, the chartering of the Royal Society cements his place as one of that country’s greatest monarchs in my view.). Turning to the US, one of its outstanding presidents (Franklin Roosevelt) presided over that country’s only default so far (the repudiation of the gold clause). Perhaps, only a strong ruler is confident enough to risk all the consequences of default. Lesser rulers prefer to muddle along rather than force the issue.

On another note, it may be that we are entering a new age where in at least some rich countries, sovereign default will no longer be as much of a taboo as it is today. Default may indeed be the least unpleasant of all choices that await a rich, over indebted and ageing society, but only truly heroic leaders may be willing to take the plunge.

Posted at 15:47 on Wed, 16 Oct 2013     View/Post Comments (1)     permanent link

Sun, 06 Oct 2013

Fama French and Momentum Factors: Data Library for Indian Market

My colleagues, Prof. Sobhesh K. Agarwalla, Prof. Joshy Jacob and I have created a publicly available data library providing the Fama-French and momentum factor returns for the Indian equity market using data from CMIE Prowess. We plan to keep updating the data on a regular basis. Because of data limitations, currently the data library starts in January 1993, but we are trying to extend it backward.

We differ from the previous studies in several significant ways. First, we cover a greater number of firms relative to the existing studies. Second, we exclude illiquid firms to ensure that the portfolios are investable. Third, we have classified firms into small and big using more appropriate cut-off considering the distribution of firm size. Fourth, as there are several instances of vanishing of public companies in India, we have computed the returns with a correction for survival bias.

The methodology is described in more detail in our Working Paper (also available at SSRN): Sobhesh K. Agarwalla, Joshy Jacob & Jayanth R. Varma (2013) “Four factor model in Indian equities market”, W.P. No. 2013-09-05, Indian Institute of Management, Ahmedabad.

Posted at 18:05 on Sun, 06 Oct 2013     View/Post Comments (0)     permanent link

Sun, 29 Sep 2013

33 ways to control algorithmic trading

Earlier this month, the US Commodity Futures Trading Commission (CFTC) published a Concept Release on Risk Controls and System Safeguards for Automated Trading Environments. It seeks comments on a laundry list of 33 measures that could be adopted to control algorithmic and high frequency trading (I arrived at this count from the list on page 116-132, counting sub items in the first column also).

The proposals on this list range from the sensible to the problematic, and there does not seem to be much of an effort to analyse the economic consequences of these measures. The idea of the concept release appears to be to outsource this analysis to those who choose to submit comments on the concept release. There is nothing wrong with that. But with the current CFTC Chairman, Gary Gensler, set to step down soon, nothing much might come out of the concept release.

Posted at 12:32 on Sun, 29 Sep 2013     View/Post Comments (0)     permanent link

Wed, 25 Sep 2013

Systemic effects of the Merton model

David Merkel has posted on his The Aleph Blog a note that he wrote in 2004 about how widespread use of the Merton model to evaluate credit risk influences the corporate bond market itself. The Merton model regards risky debt as a combination of risk free debt and a short put option on the assets of the issuer. Credit risk assessment is then a question of valuing this put option – a process that relies largely on stock prices and implied volatilities. Merkel writes:

Over the last seven years, more and more managers of corporate credit risk use contingent claims models. Some use them exclusively, others use them in tandem with traditional models. They have a big enough influence on the corporate bond market that they often drive the level of spreads. Because of this, the decline in implied volatility for the indices and individual companies has been a major factor in the spread compression that has gone on. I would say that the decline in implied volatility, and deleveraging, has had a larger impact than improving profitability on spreads.

The Merton model is probably under-utilized in India and so I have not encountered this problem. But Merkel is saying that in some countries, it is over used and over reliance on it can be a problem. The global financial crisis highlighted the dangers of outsourcing credit evaluation to the rating agencies. The Merton model in some ways amounts to outsourcing credit evaluation to the equity markets, and this too could end badly. I have wondered for some time now as to why advanced country central banks act as if they have adopted equity price targeting. If the Merton model is so influential, then the primary channel of monetary transmission to the credit markets would lie via equity markets and targeting equity prices suddenly makes a lot of sense to the central banks themselves.

But those who buy poor credit risks on the basis of Merton model credit assessments that have been flattered by QE inflated stock prices (and QE dampened volatilities) might be in for a rude surprise if and when the central banks decide to let equity markets find their natural level and volatility.

Posted at 13:41 on Wed, 25 Sep 2013     View/Post Comments (0)     permanent link

Sun, 15 Sep 2013

Snowden disclosures and the cryptographic foundations of modern finance

I have always believed that the greatest tail risk in finance is a threat to its cryptographic foundations. Everything in modern finance is an electronic book entry that could suddenly evaporate if the cryptography protecting it could be subverted. Such a cryptographic catastrophe would make the Lehman bankruptcy five years ago look like a picnic.

Global finance should therefore be alarmed by the Snowden disclosures earlier this month that the large technology companies have been collaborating with the US government to actively subvert internet encryption. It is claimed that backdoors have been built into many commercial encryption software and that even the standards relating to encryption have been compromised.

I do not think this is about the US at all. It is very likely that large technology companies are extending similar cooperation to other governments that control large markets. A decade ago, Microsoft publicly announced that it had provided the Chinese government access to the Windows source code. Blackberry’s long resistance to the Indian government’s desire for access to its encryption suggest that the Indian market is not large enough to induce quick cooperation, but I would be surprised if the US and China were the only countries that are able to bend the large technology companies to their ends. Countries like Russia and Israel with proven cyber warfare capabilities would also have achieved some measure of success.

In this situation, financial firms around the world should consider themselves as potential targets of cyber warfare. Alternatively, they could just become collateral damage in the struggle between two or more cyber superpowers. In my view, this is an existential threat to the modern financial system.

The saving grace is that there is nothing to suggest that the mathematics of encryption has become less reliable. The problems are all in the implementation – commercial routers, commercial operating systems, commercial browsers and commercial encryption software may have been compromised but not the mathematics of encryption, at least not yet.

Perhaps, finance can still escape a cryptographic meltdown if it embraces open source software for all cryptography critical applications. As computer security expert Bruce Schneier explains: “Trust the math. Encryption is your friend. Use it well, and do your best to ensure that nothing can compromise it.”

Posted at 16:45 on Sun, 15 Sep 2013     View/Post Comments (1)     permanent link

Sun, 01 Sep 2013

Krugman on Asian Crisis as success story

Paul Krugman says so partly tongue in cheek, but still it is remarkable to read this from the world’s foremost authority on the Asian Crisis:

I will say, 15 years ago it would never have occurred to me that we would be looking back at Asia’s crisis as a success story.

My last blog post on the good that came out of the Asian Crisis looks a little less outrageous now. Also while I gave Malaysia of 1997-98 as an example of a bad response to a crisis, Krugman points to peripheral Europe. Now that is a truly atrocious response to a crisis – one in which the creditors are still in charge and are still thinking like creditors.

Posted at 11:03 on Sun, 01 Sep 2013     View/Post Comments (0)     permanent link

Thu, 29 Aug 2013

Why India's crisis could be a good thing

I recall telling some Indian policy makers in the late 1990s that it was unfortunate that India had not fallen victim to the Asian Crisis. I need hardly add that the rest of the conversation was not very pleasant. However, one of the great privileges of living in a democracy is that one get away with saying such things – policy makers do not have firing squads at their disposal (at least not yet).

Now we seem to be getting a crisis of the kind which I have been expecting for several months now (see my blog posts here, here and here). This is a good time to reflect on the aftermath of the Asian Crisis to understand how (under the right conditions) a lot of good can come out of our crisis.

Like in East Asia of 1997, the Indian corporate sector has come to be dominated by a rent seeking kleptocracy that resembles the Russian oligarchs. Unlike the businesses that came to prominence in the first decade after the 1991 reforms, many of the business group that have emerged in the last decade have been tainted by all kinds of unsavoury conduct. For the country to reestablish itself on the path of high growth and economic transformation, many of these unproductive businesses have to be swept away. In 1997, the bankruptcy of the Daewoo Group was important in reforming the Chaebol and getting Korea back on the track again. We need to see something similar happen in India. A useful analogy is that of a forest fire that clears all the deadwood and allows fresh shoots to grow and rejuvenate the forest.

One of the wonderful things about a financial crisis is that the capital allocation function shifts decisively from those who think like short term lenders to those who think like owners. In a debt restructuring for example, erstwhile lenders are forced to think like equity holders, and they end up allocating capital much better that they did when they were just chasing yields while floating on the high tide of liquidity. They have to stop worrying about sunk costs and focus more on future prospects.

A very good example is what the Asian Crisis did to Samsung. At the time of the crisis, Samsung was an also-ran Chaebol whose head was obsessed with building a car business like Daewoo or Hyundai. In the consumer electronics business, it was well behind Sony. The crisis forced Samsung to abandon its car making dreams under enormous pressure from the financial markets. As it focused on what it knew better, Samsung has created a world beating business while Sony ensconced in its cosy world in a country which largely escaped the Asian Crisis has simply gone downhill.

Even at the level of countries, one can see how a country like Malaysia that changed least in response to the crisis has been in relative decline as compared to its peers. I cannot help speculating that in the emerging crisis, China’s large reserves will allow that country the luxury of behaving like the Malaysia of 1997. If by chance, India responds like the Korea of 1997, Asia’s economic landscape in the next decade will be very interesting.

Another interesting parallel is that in 1997/1998, several of the crisis affected countries faced elections at the height of the crisis or had a change of government by other means (Indonesia). Far from leading to political confusion, these elections helped to legitimize decisive action at the political level. Nothing concentrates a politician’s mind more than a bankrupt treasury. We saw that in 1991 (another case of an election at the time of crisis). We could see that once again in 2014.

Of course, nothing is preordained. We can blow our chances. But to those who think that 1991 was the best thing that ever happened to this country, there is at last reason to hope that we will get another 1991. In these bleak times, all that one can do is to be optimistic in a pragmatic way.

Posted at 21:49 on Thu, 29 Aug 2013     View/Post Comments (5)     permanent link

Wed, 21 Aug 2013

Casualties of credit

I just finished reading Carl Wennerlind’s book Casualties of Credit about the English financial revolution in the late seventeenth century. Much has been written about this period including of course the seminal paper by Douglas North and Barry Weingast on “Constitutions and commitment” (Journal of Economic History, 1989). Yet, I found a lot of material in the book new and highly illuminating.

Especially interesting was the description of the crisis of 1710 – which I think was the first instance in history of the bond market trying to arm twist the government to change its policies. I was also fascinated by the discussion about how Isaac Newton used his vast talents to hunt down coin clippers and counterfeiters, and then ruthlessly sent them to the gallows. I knew that apart from inventing calculus and much of physics, Newton had time to dabble in alchemy, but I had thought that his position as Master of the Mint was a sinecure. Well Newton chose not to treat it as a sinecure.

Posted at 15:41 on Wed, 21 Aug 2013     View/Post Comments (1)     permanent link

Sun, 18 Aug 2013

Quadrillion mantle passes from Italy to Japan after a decade

In the 1990s, we used to joke that the word quadrillion was invented to measure the Italian pubic debt. The introduction of the euro put an end to this joke. Italy’s public debt is currently “only” around two trillion euros, but it would be around four quadrillion lire at 1999 exchange rates. After a gap of more than a decade, the mantle has passed to Japan whose public debt crossed the quadrillion yen mark recently.

The only other important monetary amount that I am aware of that could be in the quadrillion range is the total outstanding notional value of all financial derivatives in the world. The BIS estimate (which is perhaps conservative) for this is only around $600 trillion, but some other estimates (which are perhaps exaggerated) put it in the range of $1,200 – $1,500 trillion.

Posted at 13:38 on Sun, 18 Aug 2013     View/Post Comments (0)     permanent link

Sun, 04 Aug 2013

Do regulators understand countervailing power in markets?

Practitioners understand the importance of countervailing power in keeping markets clean. The biggest obstacle that a would-be manipulator faces is a big player on the opposite side with the incentives and ability to block the attempted manipulation. Without that countervailing power, the regulator would be stretched very thin trying to combat the myriad games that are being played out in the market at any point of time. But regulators seem to be oblivious of this completely and often step in to curb the countervailing power without realizing that they are allowing people on the other side a free run.

This was highlighted yet again by a recent order of the UK Financial Conduct Authority (FCA), the successor to the Financial Services Authority (FSA). The FCA fined Michael Coscia for a trading strategy that made money at the cost of high frequency traders (HFTs).

HFTs often try to trade in front of other people. When the HFT suspects that a large trader is trying to buy (sell), the HFT tries to buy (sell) immediately before the price has gone up (down), and then tries to turn around to sell to (buy from) the large trader at an inflated (depressed) price. Michael Coscia created a trading strategy designed to give the HFTs a taste of their own medicine in the crude oil market. He placed a set of large orders designed to fool the HFTs into thinking that he was trying to sell a big block. When the HFTs began front running his purported large sell order, Coscia turned around and bought some crude from them at below market prices. He then performed the whole operation in reverse, fooling the HFTs into thinking that there was a large buy order in the market. When they tried to front run that buy order, Coscia sold the crude (that he had bought in the previous cycle) back to the HFTs.

The FCA thinks that Corcia violated the exchange rules which provided that “it shall be an offence for a trader or Member to engage in disorderly trading whether by high or low ticking, aggressive bidding or offering or otherwise.” From a legal point of view, the FCA is probably quite correct. But the net effect of the action is to neutralize the kind of trading strategies that would have held the HFTs in check. The FCA of course thinks that they are acting against HFTs because Corcia’s trading strategy also involved high frequency trading.

Posted at 14:29 on Sun, 04 Aug 2013     View/Post Comments (4)     permanent link

Thu, 25 Jul 2013

Legal theory of finance

The Journal of Comparative Economics (subscription required) has a special issue on Law in Finance (The CLS Blue Sky Blog has a series of posts summarizing and commenting about this work – see here, here and here). The lead paper in the special issue by Katharina Pistor presents what she calls the Legal Theory of Finance (LTF); the other papers are case studies of different aspects of this research programme.

Most finance researchers are aware of the Law and Finance literature (La Porta, Shleifer, Vishny and a host of others), but Pistor argues that “Law & Finance is ... a theory for good times in finance, not one for bad times.” She argues that though finance contracts may appear to be clear and rigid, they are in reality in the nature of incomplete contracts because of imperfect knowledge and inherent uncertainty. When tail events materialize, it is desirable to rewrite the contracts ex post. This can be done in two ways: first by the taxpayer bailing out the losers, or by an elastic interpretation of the law.

One of the shrill claims of the LTF is that legal enforcement is much more elastic at the centre while being quite rigid at the periphery. Bail out is also more likely at the centre. I do not see anything novel in this observation which should be obvious to anybody who has not forgotten the first word of the phrase “political economy”. It should also be obvious to anybody who has read Shakespeare’s great play about finance (The Merchant of Venice), and noted how differently the law was applied to Jews and Gentiles. It has also been all too visible throughout the global financial crisis and now in the eurozone crisis.

Another persistent claim is that all finance requires the backstop of the sovereign state which is the sole issuer of paper money. This is in some sense true of most countries for the last hundred years or so though I must point out that the few financial markets that one finds in Somalia or Zimbabwe function only because they are not dependent on the state. The LTF claim on the primacy of the state was certainly not true historically. Until the financial revolution in the Holland and later England, merchants were historically more credit worthy than sovereigns. Bankers bailed out the state and not the other way around.

Most of the case studies in the special issue do not seem to be empirically grounded in the way that we have come to expect in modern finance. I was not expecting any fancy econometrics, but I did expect to see the kind of rich detail that I have seen in the sociology of finance literature. The only exception was the paper by Akos Rona-Tas and Alya Guseva on “Information and consumer credit in Central and Eastern Europe”. I learned a lot from this paper and will probably blog about it some day, but it seemed to be only tangentially about the LTF.

Posted at 13:40 on Thu, 25 Jul 2013     View/Post Comments (0)     permanent link

Sun, 14 Jul 2013

Dubious legal foundations of modern finance?

I have been reading a 2008 paper by Kenneth C. Kettering (“Securitization and Its Discontents: the Dynamics of Financial Product Development”) arguing that securitization is built on dubious legal foundations – specifically there are possible conflicts with aspects of fraudulent transfer law. Kettering argues that securitization is an example of a financial product that has become so widely used that it cannot be permitted to fail, notwithstanding its dubious legal foundations.

I am not a lawyer (and Kettering’s paper is over 150 pages long) and therefore I am unable to comment on the legal validity of his claims. But, I also recall reading Annelise Riles’s book Collateral Knowledge: Legal Reasoning in the Global Financial Markets (University of Chicago Press, 2011), which makes somewhat similar claims. But her ethnographic study was focused on Japan, and when I read that book, I had assumed that the problems were specific to that country.

Posted at 21:55 on Sun, 14 Jul 2013     View/Post Comments (1)     permanent link

Sun, 07 Jul 2013

Non discretionary portfolio management

Last month, the Reserve Bank of India (RBI) released draft guidelines on wealth management by banks. I have no quarrels with the steps that the RBI has taken to reduce mis-selling. My comments are related to something that they did not change:

4.3.2 PMS-Non-Discretionary The non-discretionary portfolio manager manages the funds in accordance with the directions of the client. Thus under Non-Discretionary PMS, the portfolio manager will provide advisory services enabling the client to take decisions with regards to the portfolio. The choice as well as the timings of the investment decisions rest solely with the investor. However the execution of the trade is done by the portfolio manager. Since in non-discretionary PMS, the portfolio manager manages client portfolio/funds in accordance with the specific directions of the client, the PMS Manager cannot act independently. Banks may offer non-discretionary portfolio management services.

... Portfolio Management Services (PMS)- Discretionary: The discretionary portfolio manager individually and independently manages the funds of each client in accordance with the needs of the client. Under discretionary PMS, independent charge is given by the client to the portfolio manager to manage the portfolio/funds. ... Banks are prohibited from offering discretionary portfolio management services. (emphasis added)

I am surprised that regulators have learnt nothing from the 2010 episode in which an employee of a large foreign bank was able to misappropriate billions of rupees from high net worth individuals including one of India’s leading business families. (see for example, here, here and here).

My takeaway from that episode was that discretionary PMS is actually safer and more customer friendly than non discretionary PMS. After talking to numerous people, I am convinced that the so called non-discretionary PMS is pure fiction. In reality, there are only two ways to run a large investment portfolio:

  1. The advisory model where the bank provides investment advice and the client takes investment decisions and also handles execution, custody and accounting separately.
  2. The de facto discretionary PMS where the bank takes charge of everything. The fiction of a non-discretionary PMS is maintained by the customer signing off on each transaction often by signing blank cheques and other documents.

When you think carefully about it, the bundling of advice, execution, custody and accounting without accountability is a serious operational risk. One could in fact argue that the RBI should ban non-discretionary PMS and allow only discretionary PMS. Discretionary PMS is relatively safe because the bank has unambiguous responsibility for the entire operational risk.

The only argument for non-discretionary PMS might be if the PMS provider is poorly capitalized or otherwise not very reliable. But in this case, the investor should be imposing strict segregation of functions and should never be entrusting advice, execution, custody and accounting to the same entity.

Posted at 13:59 on Sun, 07 Jul 2013     View/Post Comments (3)     permanent link

Tue, 02 Jul 2013

Consumer protection may be a bigger issue than systemic risk

Since the global financial crisis, policy makers and academics alike have focused attention on systemic risk, but consumer protection is an equally big if not bigger issue that has not received equal attention. John Lanchester has a long (6700 word) essay in the London Review of Books, arguing that the mis-sold PPI (payment protection insurance) scandal in the UK was bigger than all other banking scandals – the London Whale, UBS (Adoboli), HBOS, Libor rigging and several others.

Lanchester argues the case not only because the costs of the PPI scandal could go up to £16-25 billion ($24-37 billion), but also because it happened at the centre of the banks’ retail operations and involved a more basic breach of what banking is supposed to be about. Interestingly, the huge total cost of the scandal is the aggregation of small average payouts of only £2,750 to each affected customer indicating that the mis-selling was so pervasive as to become an integral part of the business model itself.

Posted at 12:40 on Tue, 02 Jul 2013     View/Post Comments (0)     permanent link

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