Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Why do economists ignore risk?

Cochrane writes on his Grumpy Economist blog:

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

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

  1. The US bank could default

  2. The European bank could default

  3. The forward contract counterparty could default

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

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

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

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

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

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

Indian financial history

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

Amol Agrawal January 27, 2017 at 5:44 pm

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

Jayanth Varma January 27, 2017 at 9:07 pm

There are some excellent books on Indian economic history. The Cambridge Economic History of India is absolutely invaluable. There are some books and other material on the history of the East India Company and the Dutch VOC which are also relevant. Adam Smith’s [discussion](, Ch.1, Of the Expences of the Sovereign or Commonwealth) of the English East India Company in the Wealth of Nations is also worth reading. Angus Maddison’s Asia in the World Economy 1500–2030 AD is also useful.

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

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

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

Amol Agrawal January 28, 2017 at 8:58 am

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

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

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

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

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

Jayanth Varma February 13, 2017 at 9:28 pm

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

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

Adding a few that have not been covered above:

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

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

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

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

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

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

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

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

  9. Some Books:

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

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

Towards bank cartelization in India?

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

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

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

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

Uberization or not of finance

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

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

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

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

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

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

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

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

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

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

  • Large investments that the big banks have made in blockchain technology in response to Bitcoin which was a highly anarchist innovation to begin with.

  • Integration of peer lending institutions into mainstream finance – extensive use of securitization, reintermediation by hedge funds and other financiers, collaboration with large banks and so on.

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

Making India less dependent on banks

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

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

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

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

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

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

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

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

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

Predicting human behaviour is legal, predicting machines is not?

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

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

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

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

  • A comparison of ambient casino sound and music: Effects on dissociation and on perceptions of elapsed time while playing slot machines
  • Casino decor effects on gambling emotions and intentions
  • Assessing the contribution of gambling venue design elements to problem gambling behaviour
  • The Influence of Casino Architecture and Structure on Problem Gambling Behaviour
  • Measuring the Effects of Pictorial and Text Messages on Memory and Gambling Intentions Within a Casino Environment
  • The Effect of Visual Stimuli in Casinos on Emotional Responses and Problem Gambling Behavior
  • The Effect of Match and Mismatch Between Trait and State Emotion on At-Risk Gambling
  • Effects of slot machine characteristics on problem gambling behaviour

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

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

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

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

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

Financial history books redux

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

  • A History of Interest Rates by Sidney Homer and Richard Sylla
  • The Early History of Financial Economics, 1478-1776: From Commercial Arithmetic to Life Annuities and Joint Stocks by Geoffrey Poitras.
  • The Origins of Value: The Financial Innovations that Created Modern Capital Markets edited by William N. Goetzmann and and K. Geert Rouwenhorst.
  • Manias, Panics and Crashes: a History of Financial Crises by Charles Kindleberger
  • The Origins and Development of Financial Markets and Institutions: From the Seventeenth Century to the Present edited by Jeremy Atack and Larry Neal.
  • This Time is Different: Eight Centuries of Financial Folly by Carmen Reinhart and Kenneth Rogoff

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

  • Larry Neal, A Concise History of International Finance. Cambridge Books (2015) is the most important book that I would add to my old list. In many ways, this is the perfect complement to Kindleberger:
    • Neal talks about the things that went right with finance: what economic functions were served by different financial innovations and reforms. Kindleberger is a litany of all that went wrong with finance.
    • Neal spends very little time taking about panics and crises and devotes most of the pages to the institutional reforms that came out of these crises and how these reforms enabled the financial sector to serve the needs of the economy.
    • Neal proceeds in chronological order while the endeavour of Kindleberger is to bring out the similarities between different crises.
  • David Hackett Fischer, The great wave: price revolutions and the rhythm of history. Oxford University Press, 1999 is more economic history (a history of inflation) than financial history, but it is a good complement to Homer and Sylla. Inflation is an important determinant of interest rates, and Fischer shows how over the past eight centuries, inflation has been concentrated in four very long waves of rising prices, punctuated by long periods of comparative price equilibrium. The developed world has been at the brink of deflation for a decade now after a century of inflation, and Fischer’s perspective is therefore hugely important. Fischer also demonstrates that these price revolutions are linked to cultural, economic, social, political, scientific, artistic and religious revolutions as well. If you want a quick overview of the book, I recommend Lynn Fichter’s slides.

  • William N. Goetzmann, Money changes everything: how finance made civilization possible. Princeton University Press, 2016 is in some ways a shorter and far less expensive version of his Origins of Value book that ranked high in my original list. If your budget or your library’s budget can absorb Origins of Value, I would still recommend that book.

  • If you want to explore the mutual relationships between power, politics, war and finance, there are a bunch of books worth reading:

    • Richard W. Carney, Contested capitalism: The political origins of financial institutions. Routledge, 2009. and Samuel Knafo, The making of modern finance: liberal governance and the gold standard. Routledge, 2013 are two books with a similar theme: financial institutions are a product of political power struggles. Knafo is a good antidote to the Douglas North thesis about the financial revolution in the UK being all about the state setting up property rights and withdrawing into the background. He argues that the Bank of England was the instrumentality through which the state asserted its dominance over financial markets.

    • David Graeber, Debt: the first 5,000 years. Brooklyn Melville House Publishing 2011 is a book that I regard as essential reading even (or especially) if you disagree with Graeber’s radical ideology. Graeber is an anthropologist and it is in the discussion of the ancient world and of pre-historic societies that his insights are most valuable.

    • Fritz Stern, Gold and Iron: Bismarck, Bleichroder, and the Building of the German Empire, Vintage, 1979. This is one of my favourite books. I still believe that the plural of biography is not history, but Stern’s book is less a biography of Bismarck and his financier (Bleichroder), and more a story of how the original German reunification was financed.

    • Ronald Findlay & Kevin H. O’Rourke, Power and Plenty: Trade, War, and the World Economy in the Second Millennium. Princeton University Press, 2009. More economic history than financial history, but it is among the best books out there, and there is little trade without finance and little finance without trade.

    • Sven Beckert, Empire of cotton: A global history. Vintage, 2015. This too is more economic history than financial history, but cotton was so important for the industrial revolution and for sovereign credit that it merits a place in a financial history list.

    • Kwasi Kwarteng, War and gold: a five-hundred-year history of empires, adventures and debt. Bloomsbury 2014

    • Carl Wennerlind, Casualties of credit. Harvard University Press, 2011.

  • Lodewijk Petram, The World’s First Stock Exchange. Columbia University Press, 2014 is a valuable book that goes well beyond Joseph de la Vega’s pioneering book Confusion de Confusiones of 1688 in describing the evolution and operation of the Amsterdam Stock Exchange.

  • Jonathan Barron Baskin, and Paul J. Miranti Jr., A history of corporate finance. Cambridge University Press, 1999 is different from most other books in that examines the evolution of financial markets and institutions from the perspective of corporate finance rather than public finance or economic growth.

The blockchain as an ERP for a whole industry

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

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

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

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

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

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

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

SEBI’s silly rule on celebrities

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

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

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

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

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

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

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

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

SEBI should be more proactive in disclosing regulatory information

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

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

  • SEBI received these complaints nearly two years ago

  • In response to a directive from SEBI, NSE submitted a report on this to SEBI more than a year ago.

  • A year ago, SEBI engaged a team headed by professors of the Indian Institute of Technology, Bombay to examine these complaints.

  • The report of this team was sent to NSE nine months ago. NSE in turn submitted a response disputing these findings.

  • Four months ago, SEBI sent an Observation Letter to NSE stating that “the architecture of [NSE] with respect to dissemination of TBT data … was prone to manipulation and market abuse” and advised NSE to appoint an independent agency to conduct an examination of all the concerns highlighted in the IIT Interim Report.

  • The report of the Independent Agency was filed with SEBI a fortnight ago.

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

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

  • Since some of the facts are disputed, both sides of the story should be disclosed with a clear disclaimer.

  • Since individuals ought not to be named without firm evidence, these names ought to be redacted before disclosing the documents.

  • Since some of the documents may contain proprietary confidential information, these too should be redacted before publication.