Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

In the sister blog and on Twitter during September-December 2016

The following posts appeared on the sister blog (on Computing) during September-December 2016.

Tweets during September-December 2016 (other than blog post tweets):

Financial crises prior to the typewriter

The Bank of England’s Bank Underground blog has a “Christmas Special” on financial crises in the UK in 1847, 1857 and 1866. The first commercially successful typewriter was invented only in 1868 and so all the letters from the Chancellor to the Governor of the Bank of England were handwritten. I was familiar with these letters from reading Andreades’ excellent History of the Bank of England, and several other sources, but unlike the Bank Underground blog posts, none of these sources contain any facsimile of the actual letters. What struck me was that these letters were written in rather poor handwriting. The blog posts take the pain of transcribing these letters, and without this, I would not have been able to decipher some of these words. This is all the more surprising since Andreades does state (at least in once case, page 336) that the official letter was sent two days after the Bank of England was unofficially informed about the decision.

Bank Underground also links to a newspaper article written by Karl Marx about the 1857 suspension of the Bank Act. I find it hard to disagree with the following observation of Marx about the report of the Select Committee of Parliament on the operation of the Bank Act:

The Committee, it would appear, had to decide on a very simple alternative. Either the periodical violation of the law by the Government was right, and then the law must be wrong, or the law was right, and then the Government ought to be interdicted from arbitrarily tampering with it. But will it be believed that the Committee has contrived to simultaneously vindicate the perpetuity of the law and the periodical recurrence of its infraction? Laws have usually been designed to circumscribe the discretionary power of Government. Here, on the contrary, the law seems only continued in order to continue to the Executive the discretionary power of overruling it.

More than a century and a half later, nowhere in the world have we been able to solve this dilemma of the excessive discretionary power of the government in times of crisis.

Euro Introduction as Demonetization

Peter Guy at Regulation Asia has an interesting piece describing the introduction of the euro as a process of demonetization:

Europeans practiced excessive cash-based tax avoidance for decades before the euro arrived. When forced to exchange their paper currencies, lira, francs, and pesetas, bundles of cash emerged in suitcases to buy other cash-generating assets like real estate.

The irony of it all is that today the €500 note is the currency note of choice for money launderers because of its large denomination (the 1000 Swiss franc note is more valuable but it is nowhere near as ubiquitous as the euro note). As Guy points out:

The euro was easier to launder with banks around the world than the individual currencies it replaced.

Guy also refers to the dangers of a cashless society, but that argument has been made far more eloquently and persuasively by Scott Garrett. The more I think about these issues, the more I think that cryptocurrencies must be a critical element of a modern monetary system in a democratic society.

A digital device for every Indian

It is my view that if India wants to replace cash with digital payments, it must be prepared to issue a digital device to every Indian and simply absorb the fiscal cost of doing so. The alternative is a tiered payment system with high quality payments for those with smartphones, a second tier solution for those with feature phones and a broken model for those with neither. Such a tiered payment system that makes some Indians second class citizens in their own country is fundamentally irreconcilable with our democratic values and with the constitutional guarantee of legal treatment.

Cash gives the poorest of the poor access to a retail payment system that meets the gold standard for payment systems: real time gross settlement in central bank money. It is unacceptable to give them anything less than this in a digital solution. Settlement in commercial bank money or other inferior forms of money can be a choice, it can never be a compulsion. I might voluntarily choose to adopt a paytm wallet or a bank wallet and take the credit risk that the wallet provider might fail; but I should not be forced to do so as the price for participating in digital payments. This means two things:

  1. The Reserve Bank of India should introduce electronic money on its own in the form of an official e-wallet because only an e-wallet filled with central bank money can replace cash. This would also solve the problem of interoperability between different wallets. A core function of the central bank is to be the “tender of the tender” – the issuer and maintainer of legal tender of the country. A central bank that abdicates this responsibility forfeits its raison d’être.

  2. Every Indian must be issued a digital device that allows first class access to the digital payment system. There is room for bringing the cost of this device down by careful design that pares it down to just its core functionality. I would think that a starting point for this might be something like the Raspberry Pi which is enough of a general purpose computer to run at least a bitcoin SPV client. The Raspberry Pi costs about $35, but a suitably pruned down device manufactured in truly large scale might cost only $20. Giving one such device to every Aadhar holder might cost about 1.5 trillion rupees.

In my view, this cost is affordable for a country at our stage of economic size and development, and is also quite reasonable in comparison to other big ticket fiscal expenditure (for example, large defence contracts, infrastructure projects or subsidy schemes). It is perfectly fine for you to take the opposite view that this cost is unacceptable. What you cannot do is to use that view as the justification for building a great payment system for the elite at the cost of taking away from the poor what they have today – a payment system (cash) that allows them to settle in real time in central bank money.

More on cash alternatives

In two recent blog posts, I argued that the post-demonetisation problems in India are not due so much to an absence of cash, but an environment that is implicitly or explicitly discouraging the emergence of cash alternatives. Free markets can solve these problems if we let them do so.

Here are three examples of cash alternatives from three continents that I came across post demonetisation:

  1. Tokens in Telengana in India (h/t Mostly Economics and Sonali Jain’s comments on my blog post)

  2. Bond notes in Zimbabwe: Though these notes are issued by a government, these count as cash substitutes because these bonds/notes are not issued by the government that issues the underlying currency.

  3. Bitcoin in Venezuela (h/t FT Alphaville): Only a year ago, I was thinking that Bitcoin had failed as a currency while succeeding enormously as a technology (the blockchain), but state failures around the world have been so great that now I think we can no longer rule out Bitcoin emerging as a major global currency.