The CME futures contracts on the S&P 500 index comes in two flavours – the big or full-size (SP) contract is five times the E-Mini (ES) contract. For clearing purposes, SP and ES contracts are fungible with a five to one ratio. The daily settlement price of both contracts is obtained by taking a volume weighted average price of both contracts taken together weighted in the same ratio.

Yet, according to a recent SEC order against Latour Trading LLC and Nicolas Niquet, a broker-dealer is required to maintain a net-capital on the two contracts separately. In Para 28 of its order, the SEC says that in February 2010, Latour held 333,251 long ES contracts and 66,421 short SP contracts, and it netted these out to a long position of 1,146 ES contracts requiring a net capital of $14,325. According to the SEC, these should not have been netted out and Latour should have held a net capital of $8.32 million ($4.17 million for the ES and $4.15 million for the SP). This is surely absurd.

It is not as if the SEC does not allow netting anywhere. It allows index products to be offset by qualified stock baskets (para 10). In other words, an approximate hedge (index versus an approximate basket) can be netted but an exact hedge (ES versus SP) cannot be netted.

PS: I am not defending Latour at all. The rest of the order makes clear that there was a great deal of incompetence and deliberate under-estimation of net capital going on. It is only on the ES/SP netting claim that I think the SEC regulations are unreasonable.

It is well known that financial repression more or less disappeared in advanced economies during the 1980s and 1990s, but has been making a comeback recently. Is it possible that financial repression did not actually disappear, but was simply outsourced to China? And the comeback that we are seeing after the Global Financial Crisis is simply a case of insourcing the repression back?

This thought occurred to me after reading an IMF Working Paper on “Sovereign Debt Composition in Advanced Economies: A Historical Perspective”. What this paper shows is that many of the nice things that happened to sovereign debt in advanced economies prior to the Global Financial Crisis was facilitated by the robust demand for this debt by foreign central banks. In fact, the authors refer to this period not as the Great Moderation, but as the Great Accumulation. Though they do not mention China specifically, it is clear that the Great Accumulation is driven to a great extent by China. It is also clear that much of the Chinese reserve accumulation is made possible by the enormous financial repression within that country.

This leads me to my hypothesis that just as the advanced economies outsourced their manufacturing to more efficient manufacturers in China, they outsourced their financial repression to the most efficient manufacturer of financial repression – China. Now that China is becoming a less efficient and less willing provider of financial repression, advanced economies are insourcing this job back to their own central banks.

In this view of things, we overestimated the global reduction of financial repression in the 1990s and are overestimating the rise in financial repression since the crisis.

A year ago, my colleagues, Prof. Sobhesh K. Agarwalla, Prof. Joshy Jacob and I created a publicly available data library providing the Fama-French and momentum factor returns for the Indian equity market, and promised to keep updating the data on a regular basis. It has taken a while to deliver on that promise, but we have now updated the data library. More importantly, we believe that we have now set up a process to do this on a sustainable basis by working together with the Centre for Monitoring Indian Economy (CMIE) who were the source of the data anyway. CMIE agreed to implement our algorithms on their servers and give us the data files every month. That ensures more comprehensive coverage of the data and faster updates.

Andrew Verstein has an interesting paper on the Law and Economics of Benchmark Manipulation. One of the gems in that paper is the title of this blog post: “A benchmark is to price what a credit rating agency is to quality.” Verstein is saying that just as credit rating agencies became destructive when their ratings were hardwired into various legal requirements, benchmarks also become dangerous when they are hardwired into various legal documents.

Just as in the case of rating agencies, in the case of price benchmarks also, regulators have encouraged reliance on benchmarks. Even in the equity world where exchange trading eliminates the need for many kinds of benchmarks, the closing price is an important benchmark which derives its importance mainly from its regulatory use. Verstein points out that “Indeed, it is hard to find an example of stock price manipulation that does not target the closing (or opening) price.” So we have taken a liquid and transparent market and conjured an opaque and vulnerable benchmark out of it. Regulators surely take some of the blame for this unfortunate outcome.

Another of Verstein’s points is that governments use benchmarks even when they know that it is broken: “the United States Treasury used Libor to make TARP loans during the financial crisis, despite being on notice that Libor was a manipulated benchmark.” In this case, Libor was not only manipulated but had become completely dysfunctional – I remember that the popular definition of Libor at that time was that it was the rate at which banks do not lend to each other in London. That was well before Libor became Lie-bor. The US government could easily have taken a reference rate from the US Treasury market or repo markets and then set a fat enough spread over that reference rate (say 1000 basis points) to cover the TED spread, the CDS spread, and a Bagehotian penal spread. By choosing not to do so they lent legitimacy to what they knew very well was an illegitimate benchmark.

Yesterday, the Securities and Exchange Board of India (SEBI) issued regulations requiring all Research Analysts to be registered with SEBI. The problem is that the regulations use a very expansive definition of research analyst. This reminds me of my note of dissent to the report of the Financial Sector Legislative Reforms Commission (FSLRC) on the issue of definition of financial service. I wrote in that dissent that:

Many activities carried out by accountants, lawyers, actuaries, academics and other professionals as part of their normal profession could attract the regitration requirement because these activities could be construed as provision of a financial service … All this creates scope for needless harassment of innocent people without providing any worthwile benefits.

Much the same could be said about the definition of the definition of research analyst. Consider for example this blog post by Prof. Aswath Damodaran of the Stern School of Business at New York University on the valuation of Twitter during its IPO. It clearly meets the definition of a research report in Regulation 2(w):

any written or electronic communication that includes research analysis or research recommendation or an opinion concerning securities or public offer, providing a basis for investment decision

Regulation 2(w) has a long list of exclusions, but Damodaran’s post does not fall under any of them. Therefore, clearly Damodaran would be a research analyst under Regulation 2(u) under several of its prongs:

a person who is primarily responsible for:

  • preparation or publication of the content of the research report; or
  • providing research report; or
  • offering an opinion concerning public offer,

with respect to securities that are listed or to be listed in a stock exchange

Under Regulation 3(1), Prof. Damodaran would need a certificate of registration from SEBI if he were to write a similar blog post about an Indian company. Or, under Regulation 4, he would have to tie up with a research entity registered in India.

Regulations of this kind are a form of regulatory overreach that must be prevented by narrowly circumscribing the powers of regulators in the statute itself. To quote another sentence that I wrote in the FSLRC dissent note: “regulatory self restraint … is often a scarce commodity”.

A couple of weeks ago, Matt Levine at Bloomberg View described a curious incident of a company that was a public company for only six days before cancelling its public issue:

  1. On July 30, 2014, an Israeli company, Vascular Biogenics Ltd. (VBL) announced that it had priced its initial public offering (IPO) at $12 per share and that the shares would begin trading on Nasdaq the next day. The registration statement relating to these securities was filed with and was declared effective by the US Securities and Exchange Commission (SEC) on the same day.
  2. On August 8, VBL announced that it had cancelled its IPO.

What happened in between was that on July 31, the shares opened at $11.00 and sank further to close at $10.25 (a 15% discount to the IPO price) on a large volume of 1.5 million shares as compared to the total issue size of 5.4 million shares excluding the Greeshoe option (Source for price and volume data is Google Finance). This price drop was bad news for one of the large shareholders who had agreed to purchase almost 45% of the shares in the IPO. This insider was unwilling or unable to pay for the shares that he had agreed to buy. Technically, the underwriters were on the hook now, and the default could have triggered a spate of law suits. Instead, the company cancelled the IPO and the underwriting agreement. Nasdaq instituted a trading halt but the company appears to be still technically listed on Nasdaq.

Matt Levine does a fabulous job of dissecting the underwriting agreement to understand the legal issues involved. I am however more concerned about the relationship between the insider and the company. The VBL episode seems to suggest that if you are an insider in a company, a US IPO is a free call option. If the stock price goes up on listing, the insider pays the IPO price and buys the stock. If the price goes down, the insider refuses to pay and the company cancels the IPO.

Last month, the US Securities and Exchange Commission (SEC) adopted rules allowing money market funds (MMFs) to restrict (or “gate”) redemptions when there is a liquidity problem. These proposals have been severely criticized on the ground that they could lead to pre-emptive runs as investor rush to the exit before the gates are imposed.

I think the criticism is valid though I was among those who recommended the imposition of gates in Indian mutual funds during the crisis of 2008. The difference is that I see gates as a solution not to a liquidity problem, but to a valuation problem. The purpose of the gate in my view is to protect remaining investors from the risk that redeeming investors exit the fund at a valuation greater than the true value of the assets. An even better solution to this valuation problem is the minimum balance at risk proposal that I blogged about two years ago.


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