Financial Sector Legislative Reforms Commission

The Financial Sector Legislative Reforms Commission submitted its report a few days ago. The Commission also submitted a draft law to replace many of the financial sector laws in India. Since I was a member of this Commission, I have no comments to add.

 

Big data crushes the regulators

I have repeatedly blogged (for example, here and here) about the urgent need for financial regulators to get their act together to deal with the big data generated by the financial markets that these regulators are supposed to regulate. The reality however is that the regulators are steadily falling behind.

Last week, Commissioner Scott D. O’Malia of the US Commodities and Futures Trading Commission delivered a speech in which he admitted that “Big Data Is the Commission’s Biggest Problem ”. This is what he had to say (emphasis added):

This brings me to the biggest issue with regard to data: the Commission’s ability to receive and use it. One of the foundational policy reforms of Dodd­Frank is the mandatory reporting of all OTC trades to a Swap Data Repository (SDR). The goal of data reporting is to provide the Commission with the ability to look into the market and identify large swap positions that could have a destabilizing effect on our markets. Since the beginning of 2013, certain market participants have been required to report their interest rate and credit index swap trades to an SDR.

Unfortunately, I must report that the Commission’s progress in understanding and utilizing the data in its current form and with its current technology is not going well. Specifically, the data submitted to SDRs and, in turn, to the Commission is not usable in its current form. The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files. Why is that? In a rush to promulgate the reporting rules, the Commission failed to specify the data format reporting parties must use when sending their swaps to SDRs. In other words, the Commission told the industry what information to report, but didn’t specify which language to use. This has become a serious problem. As it turned out, each reporting party has its own internal nomenclature that is used to compile its swap data.

The end result is that even when market participants submit the correct data to SDRs, the language received from each reporting party is different. In addition, data is being recorded inconsistently from one dealer to another. It means that for each category of swap identified by the 70+ reporting swap dealers, those swaps will be reported in 70+ different data formats because each swap dealer has its own proprietary data format it uses in its internal systems. Now multiply that number by the number of different fields the rules require market participants to report.

To make matters worse, that’s just the swap dealers; the same thing is going to happen when the Commission has major swap participants and end­users reporting. The permutations of data language are staggering. Doesn’t that sound like a reporting nightmare? Aside from the need to receive more uniform data, the Commission must significantly improve its own IT capability. The Commission now receives data on thousands of swaps each day. So far, however, none of our computer programs load this data without crashing. This would seem odd with such a seemingly small number of trades. The problem is that for each swap, the reporting rules require over one thousand data fields of information. This would be bad enough if we actually needed all of this data. We don’t. Many of the data fields we currently receive are not even populated.

Solving our data dilemma must be our priority and we must focus our attention to both better protect the data we have collected and develop a strategy to understand it. Until such time, nobody should be under the illusion that promulgation of the reporting rules will enhance the Commission’s surveillance capabilities. As Chairman of the Technology Advisory Committee, I am more than willing to leverage the expertise of this group to assist in any way I can.

The regulators have only themselves to blame for this predicament. As I pointed out in a blog post nearly two years ago, the SEC and the CFTC openly flouted the express provision in the Dodd Frank Act to move towards algorithmic descriptions of derivatives. I would simply repeat what I wrote then:

Clearly, the financial services industry does not like this kind of transparency and the regulators are so completely captured by the industry that they will openly flout the law to protect the regulatees.

 

JPMorgan London Whale and Macro Hedges

Last week, the US Senate Permanent Subcommittee on Investigations released a staff report on the London Whale trades in which JPMorgan Chase lost $6.2 billion last year. The 300 page report puts together a lot of data that was missing in the JPMorgan internal task force report which was published in January.

Unsurprisingly, the Senate staff report takes a very critical view of the JPMorgan trades which the bank’s chairman described in a conference call last May as a “bad strategy … badly executed … poorly monitored.” Where I think the staff report goes overboard is in describing even the original relatively simple hedging strategy that JPMorgan adopted during the global financial crisis (well before the complete corruption of the strategy in late 2011 and early 2012).

The staff report says:

A number of bank representatives told the Subcommittee that the SCP was intended to provide, not a dedicated hedge, but a macro-level hedge to offset the CIO’s $350 billion investment portfolio against credit risks during a stress event. In a letter to the OCC and other agencies, JPMorgan Chase even contended that taking away the bank’s ability to establish that type of hedge would undermine the bank’s ability to ride out a financial crisis as it did in 2009. The bank also contended that regulators should not require a macro or portfolio hedge to have even a “reasonable correlation” with the risks associated with the portfolio of assets being hedged. The counter to this argument is that the investment being described would not function as a hedge at all, since all hedges, by their nature, must offset a specified risk associated with a specified position. Without that type of specificity and a reasonable correlation between the hedge and the position being offset, the hedge could not be sized or tested for effectiveness. Rather than act as a hedge, it would simply function as an investment designed to take advantage of a negative credit environment. That the OCC was unable to identify any other bank engaging in this type of general, unanchored “hedge” suggests that this approach is neither commonplace nor useful

I think everything about this paragraph is wrong and indeed perverse.

1. What the crisis taught us is that tail risks are more important than any other risks and far from criticising tail hedges, policy makers should be doing everything possible to encourage them. That the US regulators could not find any other bank that implemented such tail hedges speaks volumes about the complacency of most bank managements. It is those banks that deserve to be criticized.
2. We do not need correlations to size or test the effectiveness of macro hedges. Consider for example hedging a diversified equity portfolio with deep out of the money puts. For a complete tail hedge, the notional value of the put would be equal to the value of the portfolio itself. A beta equal to one might be a perfectly reasonable assumption for a diversified portfolio since a precise estimate of the tail beta might not be very easy. There is no need to compute a correlation between the put value and the portfolio value to determine the effectiveness of the hedge. Even the correlation between the index and the equity portfolio is not too critical because in a crisis, correlations can be expected to go to one.
3. A put option of the kind described above is not an investment designed to take advantage of a stock market crash. Viewed as an investment, the most likely return on a deep out of the money put option is -100% (the put option expires worthless), just as the most likely return on a fire insurance policy is -100% because there are no fires and no insurance claims.

I think the problem with the JPMorgan hedges as they metamorphosed during 2011 was something totally different. The key is a statement that the JPMorgan Chairman made in the May 2012 conference call after the losses became clear:

It was there to deliver a positive result in a quite stressed environment and we feel we can do that and make some net income.

Sorry, tail hedges do not produce income, they cost money. Any alleged tail hedge that is expected to earn income under normal conditions is neither a hedge nor a speculative investment – it is just a disaster waiting to happen.

 

Is India experiencing incipient capital flight?

A number of phenomena we observe in India in the last few years can be interpreted as incipient capital flight:

1. Gold imports have risen sharply not only in value terms but also in terms of quantity. The nature of the gold demand has also changed. In recent years, we have been seeing a significant amount of gold being bought by the rich as an investment. A poor household buying gold jewelry could be interpreted as a form of social security, but a rich household buying gold bars and biscuits is a form of capital flight. Instead of converting INR into USD or CHF, many rich investors are converting INR into XAU.
2. Many Indian business groups are investing more outside India than in India. Many of them are openly justifying it on the ground that the investment climate in India is poor. This is of course a form of capital flight.
3. It is difficult to explain India’s large current account deficit and poor export growth solely on the basis of low growth in the developed world. First, many of our competitors in Asia and elsewhere are posting large trade surpluses in the same environment. Second, the depreciation of the Indian rupee has improved competitiveness of Indian companies in world markets. Indian companies used to complain loudly about their lack of competitiveness when the dollar was worth only 40 rupees, but with the dollar fetching 55 rupees, these complaints have disappeared. I fear that some of the current account deficit that we see today is actually disguised capital flight via under-invoicing of exports and over-invoicing of imports.

While economists have focused on the impossible trinity (open capital account, independent monetary policy and fixed exchange rates), I am more concerned about the unholy trinity that leads to full blown capital flight. This unholy trinity has three elements: (a) a de facto open capital account, (b) poor perceived economic fundamentals and (c) heightened political uncertainty. I believe that the first two elements of this unholy trinity are already in place; we can only hope that the 2014 elections do not deliver the third element.

While our policy makers keep up the pretence that India has a closed capital account, the reality is that during the last decade, the capital account has in fact become largely open. Outward capital flows were largely opened up by liberalizing outward FDI and allowing every person to remit $200,000 every year for investment outside India. This means that the first element of the unholy trinity (an open capital account) has been in place for sometime now. If the other two elements were also to materialize, a full blown capital flight is perfectly conceivable. India’s reserves may appear comfortable in terms of number of months of imports, but in an open capital account, this is not a relevant metric. What is relevant is that India’s reserves are about 20% of the money supply (M3), and in a full blown capital flight, a large part of M3 is at risk of fleeing the country.

 

More on 2014 as 1994 redux

Last week, I wrote a blog post on how 2014 may witness the same withdrawal of capital flows from emerging markets as was seen when the US Fed tightened interest rates in 1994. Over the weekend (India time), the Fed published a speech by Chairman Ben Bernanke which spells out the issues with surprising bluntness. The key points as I see it in this speech are:

• Long term US rates are likely to rise: “Overall, then, we anticipate that long-term rates will rise as the recovery progresses and expected short-term real rates and term premiums return to more normal levels. The precise timing and pace of the increase will depend importantly on how economic conditions develop, however, and is subject to considerable two-sided uncertainty. ”
• A repeat of 1994 cannot be ruled out: “… in 1994, 10-year Treasury yields rose about 220 basis points over the course of a year … A rise of more than 200 basis points in a year is at the upper end of what is implied by the mean paths and uncertainty measures shown in charts 4 and 5, but these measures still admit a substantial probability of higher–and lower–paths”. In fact, that last sentence is even more scary. Bernanke is saying that it could in fact be even worse than in 1994!
• The Fed is concerned about financial stability risks arising from a large rise in interest rates: “First, we have greatly increased our macroprudential oversight … Second, … we are using regulatory and supervisory tools to help ensure that financial institutions are sufficiently resilient to weather losses and periods of market turmoil … Third, … greater clarity concerning the likely course of the federal funds rate … should … reduce the risk that market misperceptions … would lead to unnecessary interest rate volatility.”

Bernanke is clearly warning US financial institutions to prepare for the coming bond market sell-off. It is not Bernanke’s job to warn emerging markets, but to those emerging market policy makers who read the speech, the message is loud and clear – it is time for serious preparation.

 

Looking at 2014 through the prism of 1994

Unless the United States shoots itself in the foot during the fiscal negotiations, it could conceivably be on the cusp of a recovery. There is a serious possibility that the unemployment rate starts falling towards 7%, and the US Fed begins to consider unwinding some of its unconventional monetary easing measures. Unconventional monetary policy is equivalent to a highly negative policy rate, and so a substantial monetary tightening can happen well before the Fed starts raising the Fed Funds rate.

The situation is reminiscent of 1994 when the US Fed tightened monetary policy as the economy recovered from the recession of the early 1990s. This monetary tightening is best known for the upheaval that it caused in the US bond markets, but the turbulence in US Treasuries lasted only a few months. The more lasting impact was on emerging markets as higher US yields dampened capital flows to emerging economies:

• The tightening phase lasted from early 1994 to early 1995 during which the Fed Funds rate was increased from 3% to 6%. In today’s situation the equivalent would be a unwinding of the Quantitative Easing (QE) programme beginning early 2014 possibly leading up to a nominal increase in the Fed Funds rate in late 2014 or early 2015.
• In 1994, 10-year US Treasury yields rose from around 6% to about 8% in less than a year, but during the later stages of the tightening, long term rates actually fell even as the policy rates were being raised. By late 1995, the 10-year yield had fallen back to 6%. The bond market upheaval was frightening to a levered investor in long term bonds, but immaterial for the buy and hold investor.
• The US stock market shrugged off the tightening completely. Moreover, in the late stages of the tightening, as people realized that the tightening was nearing its end, the US stock market took off. The S&P 500 rose by over a third during 1995.
• Even as US stocks were soaring, emerging market equities were hammered. The MSCI Emerging Markets Index lost about a third of its value in late 1994 and early 1995. In India, the Sensex fell from a peak of over 4,500 in late 1994 to below 3,000 in late 1996. The Sensex regained its 1994 peak only in the dot com boom of 1999.
• The Indian rupee also suffered during the period. After years of holding rock steady at 31.37 to the US dollar (with the RBI intervening only to prevent its appreciation), the rupee started falling in late 1995. This fall intensified in the late 1990s.
• The US tightening claimed its first emerging market victim in the Mexican peso crisis of late 1994 and early 1995.
• It is conceivable that the US tightening of 1994 set in motion forces that ultimately brought about the Asian Crisis of 1997.

History never repeats itself (though as Mark Twain remarked, it sometimes rhymes). Yet, there is reason to fear that a normalization of interest rates in the US in the coming year could be destabilizing to many emerging markets which are today bathed in the tide of liquidity unleashed by the US Fed and other global central banks. India, in particular, has become overly addicted to foreign capital flows to cover its large current account deficit, and any retrenchment of these flows in response to better opportunities in the US could be quite painful.

 

Indian Gold ETFs become Gold ETNs

Last week, the Securities and Exchange Board of India allowed Indian gold Exchange Traded Funds (ETFs) to deposit their gold with a bank under a Gold Deposit Scheme instead of holding the gold in physical form. In the Gold Deposit Scheme, the bank does not act as a custodian of the gold. Instead, the bank lends the gold out to jewellers (and others) and promises to repay the gold on maturity.

In my view, use of the Gold Deposit Scheme will convert the Gold ETF into an ETN (Exchange Traded Note) or an ETP (Exchange Traded Product). The ETF does not hold gold – it only holds an unsecured claim against a bank and is thus exposed to the credit risk of the bank. If the bank were to fail, the ETF would stand in the queue as an unsecured creditor of the bank. The ETF therefore does not hold gold; it holds a gold linked note.

So far, the ETFs in India have been honest-to-God ETFs instead of the synthetic ETNs and ETPs that have unfortunately become so popular in Europe and elsewhere. With the new scheme, India has also joined the bandwagon of synthetic ETNs and ETPs masquerading as ETFs.

Truth in labelling demands that any ETF that uses the Gold Deposit Scheme should immediately be rechristened as an ETN. I also think that this is a change in fundamental attribute of the ETF and should require unit holder approval.

From a systemic risk perspective, I fail to see why this concoction makes sense at all. It unnecessarily increases the inter-connectedness of the banking and mutual fund industries and aggravates systemic risk. A run on the bank could induce a run on the ETF and vice versa. All this is in addition to the maturity mismatch issues described by Kunal Pawaskar.

I can understand the desire to put idle gold to work, but that does not require the intermediation of the bank at all. The ETF can lend the gold directly against cash collateral with daily mark to market margins. Even if it were desired to use the services of a bank, there are better ways to do this than to treat the ETF just like any other retail depositor. For example, the bank could provide cash collateral to the ETF with daily mark to market margins. As is standard in such contracts, a portion of the interest that the ETF earns on the cash collateral would be rebated back to the bank to cover its hedging and custody costs.