While I blogged about the potential regulation of the UK equity market by the SEC nearly two weeks ago, it took the collapse of Amaranth to draw my attention to the fact that a growing part of the US energy derivatives market is now regulated by the UK.
In January 2006, the Intercontinental Exchange (ICE) was permitted to use its trading terminals in the United States for the trading of US (WTI) crude oil futures on ICE Futures in London (formerly the International Petroleum Exchange or IPE). This was not a totally new contract because ICE simply took its electronically traded, standardized OTC contracts and offered them on ICE Futures. Therefore, these contracts have seen high initial adoption and rapid growth in the last few months. WTI volumes in ICE Futures are now about half of the NYMEX volumes. We now have a liquid contract on a US commodity that is predominantly traded by US participants using terminals in the US, but the contract is on an exchange (ICE Futures) which is located and regulated in the UK, though it is owned by a US entity (ICE).
More interesting is the fact that ICE also runs a large quasi futures market in energy derivatives. These are OTC contracts for regulatory purposes but are standardized, electronically traded and cleared through London’s LCH. LCH is UK regulated, but it is also a Designated Clearing Organization in the US. Amaranth served to remind us that when it comes to natural gas “futures”, ICE is today larger than NYMEX.
Even before Amaranth, the US political system was worried about this just as the UK is worried about potential regulation of UK equities by the US. The US Senate has prepared a report arguing for greater US (CFTC) regulation of the derivatives traded at ICE (“The role of market speculation in rising oil and gas prices: A need to put the cop back on the beat”, Staff Report prepared by the Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs, United States Senate, June 2006).
Incidentally, this week the US SEC met with Euronext regulators about the potential acquisition of Euronext by NYSE. The SEC’s press release states: “The regulators also affirmed that joint ownership or affiliation of markets alone would not lead to regulation from one jurisdiction becoming applicable in the other and stated their shared belief in the importance of local regulation of local markets.” That sounds categorical until one reads it again more carefully and realizes that it means nothing at all. Today there are no purely local markets. US investors do trade UK stocks at the LSE and the LSE is no longer a purely local market. All bets are then off.
Sat, 16 Sep 2006
The UK has in the last week been involved in two tussles about extra territoriality but has been on opposite sides in the two tussles. In the case of the possible acquisition of the London Stock Exchange (LSE) by Nasdaq, the UK has been eager to ensure that the extra-territorial jurisdiction of US law (particularly Sarbanes Oxley) does not affect companies listed at LSE. In the case of Cadbury Schweppes, it is the UK that has been told to stop exerting territorial jurisdiction to impose a tax on the UK company’s Dublin subsidiary which is subject to low taxes there.
The fear of extra-territorial jurisdiction of US laws over a US owned LSE is quite well grounded. Way back in 1979, in the wake of the US hostage crisis, President Carter issued Executive Order 12710 under the International Emergency Economic Powers Act stating: “I hereby order blocked all property and interests in property of the Government of Iran, its instrumentalities and controlled entities and the Central Bank of Iran which are or become subject to the jurisdiction of the United States or which are in or come within the possession or control of persons subject to the jurisdiction of the United States.” Nearly half of the blocked money was in deposits outside the US (principally in London). While the Iranians did sue in London to release these funds, the courts and governments were slow in resisting the extra-territorial demands of the US order and since the entire hostage crisis lasted only 14 months, the legality of the US freeze was not adequately tested. A good account of this episode is provided by Robert Carswell’s article “Economic sanctions and the Iran experience”, in Foreign Affairs, Winter 1981/1982.
In later sanctions against other countries, the US was less successful. For example, “a U.S. bank in the United Kingdom was ordered by a British court to release a Libyan bank’s assets blocked under U.S. unilateral sanctions in 1986. The United States subsequently authorized the release of the assets.” (GAO-04-1006 “Foreign Regimes’ Assets: The United States Faces Challenges in Recovering Assets, but Has Mechanisms That Could Guide Future Efforts”, Government Accountability Office, 2004)
Extra-territorial reach over UK listed companies through a change in exchange regulations would be less vulnerable to judicial challenge. The UK government therefore wishes to have a statutory weapon against it. In a speech on September 13, 2006, Economic Secretary to the Treasury, Ed Balls stated “ the UK Government will now legislate to protect our regulatory approach. This legislation will confer a new and specific power on the FSA to veto rule changes proposed by exchanges that would be disproportionate in their impact on the pivotal economic role that exchanges play in the UK and EU economies. It will outlaw the imposition of any rules that might endanger the light touch, risk based regulatory regime that underpins London's success.”
The Financial Services Authority has made its view clear in February 2005 and again in June 2006.
[W]e will be indifferent to the nationality of the owners or the managers of any future combined operation, and will be concerned to ensure that the future operation meets our regulatory standards. If the LSE remains a UK exchange under a new parent it will continue to be subject to FSA regulation as a Recognised Investment Exchange (RIE).
The LSE, as a UK RIE, plays a key role as a focal point for the wider regulatory framework, including capital raising and corporate governance. The attractiveness of the UK financial markets, and ultimately the competitiveness of EU capital markets, depends, in part, on a system of corporate governance and of regulation which is of a high standard, but is proportionate and adaptable and attuned to the requirements of users. (“Potential longer term implications of a change of ownership of the London Stock exchange”, FSA/PN/015/2005, 4 February 2005)
However, we believe that there could be circumstances where a more complex regulatory position might arise. Theoretically, in the longer term, a new entity might seek to achieve further benefits from rationalisation of its regulatory structure. This could at the extreme involve the LSE no longer being subject to UK regulation as an RIE. Its services might be provided from outside the UK, either from the US, another EU member state or an alternative location, through the provision of trading screens in the UK and with securities admitted to trading on the market operated from elsewhere. Such a move, were it to occur, would potentially have significant implications for various aspects of the wider regulatory regime as indicated in our February 2005 statement. If such a market were to be operated from the US it would require member firms and issuers to be registered with the SEC and subject to its oversight. (“Implications of ownership of a UK Recognised Investment Exchange by a US entity”, FSA/PN/055/2006 12th June 2006).
It is ironic therefore that the UK had to be reminded this week about the extra-territoriality of its own tax laws by the European Court of Justice. Though the tax rate in Dublin’s International Financial Services Centre is only 10%, the UK claimed an additional 20% tax on the Dublin subsidiaries of Cadbury Schweppes on the ground that these were “controlled foreign companies”. The European Court ruled that if the foreign subsidiary has offices, staff and operations in the foreign country, then the fact that it was set up with an intention to obtain tax relief does not make it a wholly artificial arrangement that justifies levying UK tax rates. Ireland is a country that has built up a vibrant financial services industry on the strength of a sound regulatory and tax regime. The court ruling will hopefully allow this to survive.
In general, I like regulatory competition. I think of a regulator as being in the business of manufacturing and providing regulatory products and services. Consumers of these products and services (investors, issuers and others) benefit if this industry is competitive. Similarly, healthy competition in tax rates also helps put a bound on the rapacity of the nation state. A vigorous defence of the competitive structure of the market for regulatory services is therefore very much welcome.
Wed, 13 Sep 2006
Buried inside the Global Financial Stability Report of the IMF (September 2006) is a graph showing India and New Zealand as the outliers in terms of high financial leverage in the household sector, but the data does not seem right. Figure 2.10 on page 55 shows Indian household leverage (ratio of financial liabilities to financial assets) as about 60%, exceeded only by New Zealand’s 80%. India does not publish sectoral balance sheets, but the flow of funds data is grossly at variance with this number of 60%. If we cumulate the last several years’ change in financial assets, liabilities and physical assets from Tables 10 and 11 of the RBI’s Handbook of Statistics, 2005, the following picture emerges. Cumulative household financial savings are about 100% of GDP, cumulative household financial liabilities are about 20% of GDP and cumulative household physical savings are about 80% of GDP. This would imply household leverage of 20/180 or about 11%. This broad picture does not change whether I cumulate the last 35 years of data or just the last 10. I am struggling to understand how the IMF gets a number more than 5 times this estimate of about 11%. If one considers that most household assets (equities, real estate or gold) would have appreciated in value over the years while most liabilities would be fixed in nominal terms, the financial leverage evaluated at market prices must be even lower than the above estimate of 11%. Of course, the IMF says that it got the number from national authorities. So does the RBI/MOF/CSO see some household leverage out there that we are not seeing? Or is it all a mistake?
Fri, 08 Sep 2006
While corporate disclosure in offer documents and to a lesser extent in annual reports is reasonably informative and neutral, material event disclosure still tends to consist of sanitized half truths. I have spent some time comparing:
- the Form 8-K filed with the US SEC by the Hewlett Packard Company on September 6, 2006 about its investigation of board room leaks, and
- the news report (“Leak, Inquiry and Resignation Rock a Boardroom” by Damon Darlin) about the same event in the New York Times of September 7, 2006
The New York Times reports that Thomas Perkins resigned from the HP Board in protest when he found that HP had used private detectives to monitor telephone calls by board members. It also reports that these detectives approached the phone company with the last four digits of Perkins’ social security number and tricked them into “revealing the multidigit code that would allow a person to set up an online account for access to billing statements ”. Using this the detectives viewed the list of his phone calls. According to the news report, Perkins regards this as “possible fraud, identity theft and misappropriation of personal records”
The same events are described in HP’s SEC filing as follows: “the Chairman of the Board, and ultimately an internal group within HP, working with a licensed outside firm specializing in investigations, conducted investigations into possible sources of the leaks of confidential information at HP. ... some form of ‘pretexting’ for phone record information, a technique used by investigators to obtain information by disguising their identity, had been used. ... The Committee was then advised by the Committee’s outside counsel that the use of pretexting at the time of the investigation was not generally unlawful (except with respect to financial institutions), but such counsel could not confirm that the techniques employed by the outside consulting firm and the party retained by that firm complied in all respects with applicable law.”
The SEC filing also asserts that the “Date of Earliest Event Reported” in the filing is August 31, 2006. Since the “pretexting” in question happened in May 2006 or earlier and had not previously been disclosed by HP, it would appear that this statement at least is false. Probably, HP wants to avoid an impression that it was tardy in filing the Form 8-K. Or perhaps, HP wants to claim that what is being disclosed is not all the sordid mess about the undercover investigation, but that as a result of the investigations, the Board decided on August 31, 2006 not to renominate George Keyworth who was reportedly the source of the leaks.
The Form 8-K filed by HP appears to me to be excessively sanitized to the extent of failing to communicate the gravity of the events. For example, “disguising their identity” is quite different from impersonating somebody else. It is evident that material event disclosure has a long way to go even in the US. In countries like India, the state of affairs is much worse.
Tue, 05 Sep 2006
Sandeep Parekh tells me that my posting yesterday is not quite clear. So let me restate my views differently.
- I think we should move towards capital account convertibility much faster and much more boldly than the CAC 2.0 report suggests. A freely convertible currency by 2010 should be the goal.
- I believe that it is impossible to ban Participatory Notes (PNs)
when portfolio investment is opened up to non institutional
investors. This is because:
- The PN is traded between foreigners outside India
- If neither party to the PN is an FII, then the PN does not involve any party who is regulated by or registered with an Indian regulator. Compliance with a KYC norm is not the same as acceptance of regulatory jurisdiction.
- The PN is a cash settled OTC derivative that does not require any money or securities to change hands in India.
- Even if for a moment one can think up a legal theory that creates jurisdiction, it is infeasible to exercise such jurisdiction. It is one thing to threaten to prosecute 500 FIIs. It is another thing to do that with 50,000 non institutional investors who do not even have a home country regulator.
- In an FII oriented regime where only a select few can invest in India, the regulation of PNs serves to prevent others from getting a back door entry. In the proposed regime where any body can come in through the front door, I do not understand why the government should go to great lengths to prevent anybody trying the back door. The whole debate about PNs makes sense only if the FII regime continues. The moment that is diluted, the case against PNs vanishes.
Mon, 04 Sep 2006
The Reserve Bank of India (RBI) has published the report of the Committee on Fuller Capital Account Convertibility chaired by S. S. Tarapore. A committee with the same chairman and almost the same set of members gave a report on Capital Account Convertibility to the RBI in 1998. Therefore, in line with phrases like Web 2.0 and Bretton Woods 2.0, I have chosen to call it CAC 2.0.
I resolved not to blog about CAC 2.0 until I had read the report fully. Since the report is over 200 pages long, it was only with great difficulty that I have managed to adhere to this resolve. My first set of comments are as follows:
- The dissent notes by Surjit Bhalla and A. V. Rajwade are more interesting and thought provoking than the main report itself.
- CAC 1.0 at 80 pages was less than half the length of CAC 2.0. It was also characterized by much greater conceptual clarity and internal consistency. In fact, CAC 1.0 could be summarized in two sentences: “Based on an assessment of macro economic conditions, the Committee is of the considered view that the time is now apposite to initiate a move towards CAC. ... Fiscal consolidation, a mandated inflation target and strengthening of the financial system should be regarded as crucial preconditions/signposts for CAC in India.” Everything in CAC 1.0 reflected this philosophy and while I disagreed with CAC 1.0 for being too cautious, I could not fault its internal consistency. One would struggle to find a similar succint philosophy for CAC 2.0
- CAC 1.0 took place in the backdrop of the Asian crisis. CAC 2.0 takes place in the backdrop of a much stronger external position and greater optimism about India. Yet a high degree of timidity permeates CAC 2.0.
- The most controversial recommendation of CAC 2.0 is about Participatory Notes (PNs). A PN is a cash settled OTC derivative sold by a registered foreign institutional investor (FII) to entities outside India. Though these instruments are traded between foreigners outside India, Indian regulators have exercised jurisdiction over them relying on the fact that the FII which issues these PNs is registered with Indian regulators. CAC 2.0 recommends a complete ban on new PNs and the liquidation of existing PNs within one year. The argument given is that “In the case of Participatory Notes (PNs), the nature of the beneficial ownership or the identity is not known unlike in the case of FIIs”. In the same breath, CAC 2.0 recommends that foreign corporate and individual investors should be allowed to invest in India through entities registered with the Indian regulators. On the face of it, therefore, a US hedge fund would be able to invest in India through an Indian stock broker who would be responsible for enforcing the Know Your Client norms. Or perhaps, the hedge fund would come through an Indian portfolio manager offering a non discretionary portfolio management service. In either case, the foreign entity is not now registered with the Indian regulator and not subject to its jurisdiction. How the Indian regulator would now enforce a ban on that unregulated entity selling cash settled OTC derivatives outside India is beyond my comprehension. Finally, if any foreign entity can invest in India directly, it is difficult to see what is gained by banning PNs. A foreign investor can easily hide behind several layers of special purpose vehicles and corporate entities that make it impossible to determine beneficial ownership even if all Know Your Client norms are adhered to. The recommendations lack internal consistency.