Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Are bonds the new equities, and equities the new bonds?

A year and a half ago, I wrote a blog post about loss aversion and negative interest rates. That post argued that if prospect theory is true, then the most loss averse investors who traditionally invest in bonds would now become risk seeking when confronted with certain loss of principal induced by negative interest rates. I also raised the possibility that the most loss averse investors would switch to equities and the less loss averse investors would stay in bonds. As we look around at investor behaviour under negative rates, we can see evidence of loss aversion at work though perhaps not quite in the way that I hypothesized earlier.

The most loss averse investors have become risk seeking by taking on duration risk rather than equity risk. If you buy a bond maturing beyond your investment horizon, then there is a possibility of a capital appreciation if interest rates become even more negative in the meantime. For example, suppose your investment horizon is 4 years and you put your money in a 10-year zero coupon bond yielding -0.1%. You would have to pay 100 × 0.999-10 = 101.0055 for such a bond with a face value of 100. At the end of 4 years, when you sell your bond, suppose the 6-year yield is -0.17%. the price of the bond would be 100 × 0.9983-6 = 101.0261, and you would have sold the bond at a profit! (You would break even if the 6-year yield is -0.1666%). You may think that there is a good chance that the 6-year yield will be more negative than -0.1666% for two reasons. First, since the yield curve is usually upward sloping, the yield is likely to drop as the residual maturity shortens from 10 years today to 6 years at the time of sale. Second, you may hope that central banks would become more aggressive with ultra loose monetary policy and push the entire yield curve deeper into negative territory.

In some sense, this is similar to the flight to equity markets that I postulated in my 2015 blog post. Equity investors traditionally tended to chase capital gains and tended to be relatively unconcerned about yields. Now it is bond market investors who are behaving in this way. There is no coupon anymore and they are hoping for redemption through capital gains by selling the bond before maturity. That is the best explanation that I can think of for bond yields turning negative at very long maturities – for example, the Swiss 50 year bond has been trading at negative yields.

On the other hand, there is a sizeable group of equity market investors who are today enamoured of the high dividend yield on some “safe” value stocks. Some of them are actually crossover investors from the bond market who see these dividends as the replacement for the coupons that they used to get on their bonds. These investors are buying equities for their yield rather than their capital appreciation.

In this sense, my original blog post may have got things upside down – bonds are the new equities (home to risk seeking investors hoping for capital appreciation) and at least some equities are the new bonds (home to risk averse investors hoping for a steady yield). If this is so, prospect theory is critical for understanding the effectiveness of unconventional monetary policy.

200 pages on why they let Lehman fail

When I first saw Laurence Ball’s 218 page NBER paper “The Fed and Lehman Brothers”, my first reaction was that this was too long to read. During the crisis, I had waded through 2200 pages (not counting appendices totalling close to 2000 pages) of the report of bankruptcy examiner Anton Valukas. But so many years after the crisis, Lehman fatigue sets in even for persistent readers like me. I am glad however that I overcame my initial reluctance and read this paper. Incidentally, NBER found the paper too long and so they relegated it to a “supplemental file” and posted an 18 page summary as the main paper. I think this is stupid – if you wish to read it at all, I would suggest you read the full paper (the 18 page summary is a waste of time). If you do not have access to NBER, you can read the full paper at the author’s website.

Ball puts together evidence scattered over many different sources to demolish the claim by the Fed that they lacked legal authority to rescue Lehman. The legal requirement was only that any loan should be secured by adequate collateral. Since Lehman had a large amount of unsecured long term debt, its assets (even at very pessimistic valuations) exceeded its short term debt by a wide margin. Therefore Lehman could have provided adequate collateral to the Fed to support a loan large enough to replace its entire short term debt. Lehman would then have been able to remain open for several weeks or months (until the long term debt fell due). This could have enabled Barclays to buy Lehman – the stumbling block to that deal was that Barclays needed a shareholder vote to complete the transaction and without a Fed loan, Lehman could not have survived that long. Even if that deal did not happen, an orderly liquidation of Lehman would have been possible. Ball’s point about long term debt is a valuable contribution to the Lehman literature. In credit risk modelling, it is well known that long term debt is less problematic than short term debt. In the famous KMV model, default risk measurement uses the sum of short term debt and half long term debt. But I have not previously seen this insight applied to Lehman.

Ball is also able to establish that the decision not to lend to Lehman was taken by Treasury Secretary Hank Paulson, though legally Paulson had no role in this decision which was the exclusive province of the Fed. This is of course evidence that the powers to lend to distressed institutions should be moved out of the central bank to a separate resolution corporation in order to safeguard the independence of the central bank.

Let me add that I am firmly of the view that the decision to let Lehman fail was the correct one. If today the US seems to be the only country to have put the crisis behind it and to be on the recovery path, much of the credit should go to the bold decision to let Lehman fail. Countries which spent years in denial and tried to muddle along have fared much worse. It is unfortunate that those who took this correct decision have not had the courage to admit this, but have chosen to hide behind the fig leaf of a non existent legal barrier. Ball’s paper set the record straight on this and ensures that future historians will know the truth.

Finally, a more responsible 2-hour recovery mandate

Nearly two years ago, I wrote a blog post in which I strongly criticized the insistence of the Basel Committee on Payments and Market Infrastructures (CPMI, previously known as CPSS) that payment and settlement systems should be able to resume operations within 2 hours from a cyber attack and should be able to complete the settlement by end of day. I described this demand as reckless and irresponsible because it ignored Principle 16 which requires an FMI to “safeguard its participants’ assets and minimise the risk of loss on and delay in access to these assets.” I argued that in a cyber attack, the primary focus should be on protecting participants’ assets by mitigating the risk of data loss and fraudulent transfer of assets. In the case of a serious cyber attack, this principle would argue for a more cautious approach which would resume operations only after ensuring that the risk of loss of participants’ assets has been dealt with. Shortly thereafter, I was glad to find the Reserve Bank of India echoing these sentiments (in less colourful language) in its Financial Stability Report.

Almost two years later, the Basel Committee (CPMI) has issued new guidance that reflects a much more responsible approach to 2-hour recovery. The Guidance on cyber resilience for financial market infrastructures published late last month states:

An FMI should design and test its systems and processes to enable the safe resumption of critical operations within two hours of a disruption and to enable itself to complete settlement by the end of the day of the disruption, even in the case of extreme but plausible scenarios. Notwithstanding this capability to resume critical operations within two hours, when dealing with a disruption FMIs should exercise judgment in effecting resumption so that risks to itself or its ecosystem do not thereby escalate, whilst taking into account that completion of settlement by the end of day is crucial. FMIs should also plan for scenarios in which the resumption objective is not achieved.

This is a welcome sign that regulators are more pragmatic and are not allowing market participants to form unrealistic expectations. As Regulation Asia wrote about last week’s outage at the Singapore Exchange (SGX):

Trying to lead the public to think a resumption is possible, without knowing if it is really possible only degrades credibility with each successive retraction and announcement.

Is US Treasury becoming a hot money playground?

During the Great Moderation, the US Treasury market came to be dominated by official investors – Asian central banks and the reserve funds of oil producing countries. During the last couple of years, these flows have gone into reverse. With oil around $50 a barrel, most oil producers are liquidating their reserves rather than adding to them. In Asia too, reserve accumulation has slowed down if not reversed with China in particular depleting its reserves as it deals with capital flight.

The massive selling by official investors has been more than balanced by large scale buying by private investors. Some of this is clearly visible in the official data (see for example, slide 10 in Torsten Slok’s presentation at the Brookings event last month on “Negative interest rates: Lessons learned…so far”). I suspect that the official figures understate the true extent of this shift because at least a part of the official selling would be from offshore vehicles that are not clearly identifiable as official holdings.

If this trend continues, I believe this could have serious implications for the volatility in US Treasury yields. As long as the net buying was dominated by price insensitive reserve managers whose mandates restrict them to very safe assets anyway, the volatility of yields would have been quite muted. But the private buyers are much more unconstrained in their portfolio choices and are also much more sensitive to risk-return opportunities in the market. For example, a large part of Chinese capital flight amounts to Chinese external assets moving from the government (PBoC/SAFE) to private investors. Unlike the PBoC or even SAFE, private investors can invest in corporate bonds, equities and real assets anywhere in the world, and have no special preference for US Treasury.

In today’s environment of flight to safety, US Treasury is well bid on the basis of risk-return expectations. But that could easily change and then long term UST yields might have to move a lot to equilibriate supply and demand. At that point, we will see the true consequences of UST becoming a playground of hot money instead of a long term store of value.

In the sister blog and on Twitter during February-June 2016

The following posts appeared on the sister blog (on Computing) during the last few months.

Tweets during the last few months (other than blog post tweets):

The 3 Cs of Clearing

After the global financial crisis, clearing corporations or Central Counter Parties (CCPs) have become the focal point of systemic risk. I think that globally banks have become stronger as a result of Basel 3, but clearing corporations have become weaker as they have started clearing OTC contracts where there is poor liquidity and price transparency. Competition among CCPs has led to a race to the bottom where the CCP with the worst risk management grabs market share in the newly opened up markets.

Regulators have been slow in addressing the problems of CCP regulation. Much of the discussion has focused on margins and capital, but this is too narrow a view of what a CCP needs to manage defaults without creating systemic risk. This is where I keep coming back to what I call the 3 Cs – cash, capital and (operational) capability.

  1. Cash: A CCP first of all needs cash to meet its settlement obligations to the non defaulting side when it faces a default by a large counter party. Given the rigid times lines of the clearing process, this liquidity is needed at very short notice. In my view, the only credible provider of liquidity in that time frame is the central bank. I have argued for years (probably decades) that a CCP needs discount window access at the central bank, but this solution presumes that the CCP has an abundance of discount window eligible collateral.

  2. Capital: The moment a CCP takes over a defaulted position, it is exposed to market risk on the position until it is able to unwind the position and restore a matched book position. In periods of market stress, orderly liquidation would happen over time frame of several days if not weeks. I recall the long liquidation period involved when LCH unwound the interest rate positions of Lehman after the latter’s bankruptcy or Singapore liquidated the Barings Bank position after the Nick Leson episode. During this period, the CCP needs capital to absorb the market risk and to credibly continue its business as a CCP.

  3. Capability: In my view, many CCPs and their regulators underestimate the importance of operational capability to liquidate positions. It requires access to talented traders with the skill required to trade large positions at times of market stress. It could require access to related markets to lay on proxy hedges; depending on the contract involved, access may be required to index futures, currency futures, foreign derivative markets, spot commodity markets, OTC derivative markets and so on. All this would require pre-existing brokerage relationships and ISDA documentations (in case of OTC derivatives). LCH solves the problem by imposing a legal requirement on its members to provide highly capable traders on secondment to manage a default. During the Lehman default, CME dealt with the problem by conducting an auction of defaulted positions, but this may not always be possible. In my experience, many large CCPs have not even conducted mock drills of managing very large defaults. They tend to believe that their success in managing small defaults proves their operational readiness. I think this is a mistake.

It is my belief that regulators have not taken an integrated view of the 3 Cs and have focused excessively on margins and CCP resolution as the solution. The problem with this approach is that it creates the risk that the CCP would take steps that create massive systemic risk in its efforts to protect itself. A CCP with inadequate cash, capital or capability gets so scared of a potential default that it takes recourse to pre-emptive margin calls or market distorting regulatory measures to ward off a threat to its own solvency. At a time of market stress, these actions are destabilizing and can become a source of systemic risk.

Would the Swiss someday demonitize the 1000 franc note?

I wonder whether someday the Swiss would be tempted to simply demonitize the 1000 franc note and earn a windfall gain. After falling for decades, Swiss currency in circulation started rising after the global financial crisis and is now higher than at any time in the last 35 years. Notes in circulation are now well above 10% of GDP and the 1000 franc note accounts for 62% of this or over 6% of GDP. The Swiss central bank publishes a nice set of tables and graphs about all this. Even the US whose currency circulates so widely all over the world (half of all US currency is estimated to circulate outside the US) has a currency to GDP ratio of only about 8% (currency data from the FED and GDP data from the BEA).

As Swiss interest rates remain in highly negative territory (-0.75% at the short end and negative all the way to 30 years), the extremely high denomination 1000 franc note has become very attractive to investors. It is conceivable that if this environment persists Swiss currency might approach 15% of GDP and the 1000 franc note might by itself edge close to 10% of GDP. In a regime of negative interest rates, currency is not a source of seigniorage, but is a costly form of borrowing. At some point, the Swiss may well start thinking about just extinguishing this liability and earning a windfall gain of more than 5% of GDP.

I am not talking about an outright default. The Swiss could start by citing the decision of the European Central Bank (ECB) last month to “permanently stop producing the €500 banknote … taking into account concerns that this banknote could facilitate illicit activities”. They could say that in accordance with global best practices, they too are abolishing the 1000 franc note. Unlike the ECB which retained the existing notes as legal tender, the Swiss could require holders of the 1000 franc note to exchange them for lower denomination notes or bank deposits. The sting in the tail would be a statement that the exchange would be carried out in accordance with the Financial Action Task Force (FATF) recommendations that require member states to seize and confiscate proceeds of money laundering and property involved in financing of terrorism. Therefore, holders of 1000 franc notes would be required to establish their identity as well as the source of the funds.

It is a fair assumption that a significant fraction of the 1000 franc notes will not be tendered for exchange under these conditions, and the Swiss would have made a profit of several percentage points of GDP. The question to my mind is how large that number would need to be for the Swiss to be tempted.

Funding Value Adjustments

The global financial crisis led to a lot of turmoil in derivative markets and large players introduced a number of changes in their valuation models. Acronyms like CVA (Credit Value Adjustment), DVA (Debit Value Adjustment) and FVA (Funding Value Adjustment) became quite commonplace. Of these, CVA and DVA have strong theoretical foundations and have gained wide ranging acceptance. But FVA remains controversial as it contradicts long standing financial theories. Hull and White wrote an incisive article The FVA Debate explaining why it is a mistake to use FVA either for valuing derivative positions on the balance sheet or for trading decisions. But four years later, FVA shows no signs of just going away.

Three months back, Andersen, Duffie and Song wrote a more nuanced piece on Funding Value Adjustments arguing that FVA will influence traded prices, but not balance sheet valuations. I have written a simplified note explaining the Andersen-Duffie-Song model, but at bottom it is a capital structure (debt overhang) issue than a derivative valuation issue.

Consider therefore a very simple capital structure problem of borrowing a small amount (say 1 unit) to invest in the risk free asset. The qualifier “small” is used to ensure that this borrowing itself does not change the company’s (risk neutral) Probability of Default (PD), Loss Given Default (LGD) or credit spread (s). From standard finance theory we get s=DL/(1DL) where the expected Default Loss (DL) is given by DL=PD×LGD. For simplicity, we assume that the interest rate is zero (which is probably not too far from the median interest rate in the world today).

  • At default (which happens with probability PD), the pre-existing creditors pay only (1LGD)(1+s) to the new lender and receive 1 from the risk free asset for a net gain of LGDs+s×LGD. The expected gain to the unsecured creditors is therefore: PD(LGDs+s×LGD) which after some tedious algebra reduces to (1PD)s

  • If there is no default (which happens with probability 1PD), the shareholders pay 1+s to the new lender but collect only 1 from the risk free asset. The expected loss to them is (1PD)s which is the same as the expected gain to the pre-existing creditors.

The transaction does not change the value of the firm, but there would be a transfer of wealth from shareholders to pre-existing creditors. Somebody who owns a vertical slice of the company (say 10% of the equity and 10% of the pre-existing debt) would be quite happy to buy the risk free asset at its fair value of 1, but if the shareholders are running the company, they would refuse to do so. (This is of course the standard corporate finance result that a debt overhang causes the firm to reject low-risk low-return positive NPV projects because they transfer wealth to creditors). The shareholders would be ready to buy the risk free asset only if it is available at a price of 1/(1+s). At this price, the shareholders are indifferent, the pre-existing creditors gain a benefit and the counterparty (seller of the risk free asset) suffers a loss equal to s/(1+s). The price of 1/(1+s) includes a FVA because it is obtained by discounting the cash flows of the risk free asset not at the risk free rate of 0, but at the company’s funding cost of s.

Now consider a derivative dealer doing a trade with a risk free counterparty in which it has to make an upfront payment (for example, a prepaid forward contract or an off-market forward contract at a price lower than the market forward price). If the derivative is fairly valued, the counterparty would be expected to make a payment to the dealer at maturity. From the perspective of the dealer, the situation is very much like investing in a risk free asset (note that we assume that the counterparty is risk free). The shareholders of the derivative dealer would not agree to this deal unless there were a funding value adjustment so that the expected payment from the counterparty were discounted at s instead of 0.

Now consider the opposite scenario where the dealer receives an upfront payment and is expected to have to make payments to the counterparty at maturity. This is very much like the dealer taking a new loan to repay existing borrowing (Andersen-Duffie-Song assume that the dealer uses all cash inflows to retire existing debt and finances all outflows with fresh borrowings). There is no transfer of wealth between shareholders and creditors and no funding value adjustment.

The result is the standard FVA model: all expected future inflows from the derivative are discounted at the funding cost and all expected outflows are discounted at the risk free rate. This is because the future inflows require an upfront payment by the dealer (which requires FVA) and future outflows require upfront receipts by the dealer (which do not require FVA).

Andersen, Duffie and Song correctly argue that (unlike CVA and DVA) the FVA is purely a transfer of wealth from shareholders to pre-existing creditors and is not an adjustment that should be made to the carrying value of the derivative in the books of the firm. This part of their paper therefore agrees with Hull and White. However, Andersen, Duffie and Song argue that in the real world where shareholders are running the company, the FVA would be reflected in traded prices. Dealers would buy only at fair value less FVA. They argue that this is quite similar to a bid-ask spread in market making. The market maker buys assets only below their fair value (bid price is usually below fair value). Just as for liquidity or other reasons, counterparties are willing to pay the bid ask spread, they would be willing to pay the FVA also as a transaction cost for doing the trade.

I wonder whether this provides an alternative explanation for the declining liquidity in many markets post crisis. Much of this has been attributed to enhanced regulatory costs (Basel 3, Dodd-Frank, Volcker Rule and so on). Perhaps some of it is due to (a) the higher post crisis credit spread s and (b) greater adoption of FVA. The increasing market share of HFT and other alternative liquidity providers may also be due to their lower leverage and therefore lower debt overhang costs.

SWIFT hacking threatens to erode confidence in financial sector

I had a short blog post on the Bangladesh-Bank SWIFT hacking shortly before I went on a two month long vacation. Since then, the story has become more and more frightening. It is no longer about Bangladesh Bank and its cheap routers: the hacking now appears to be global in scope and sophisticated in approach:

  • BAE Systems have identified parts of the malware that was used in the Bangladesh-Bank hacking. This malware “contains sophisticated functionality” and “appears to be just part of a wider attack toolkit”.

The tools are highly configurable and given the correct access could feasibly be used for similar attacks in the future.

The wider lesson learned here may be that criminals are conducting more and more sophisticated attacks against victim organisations, particularly in the area of network intrusions (which has traditionally been the domain of the ‘APT’ actor).

  • More than a year before the Bangladesh-Bank hacking, a total of $12 million was stolen from Banco del Austro (BDA) in Ecuador through SWIFT instructions to Wells Fargo in the US to transfer funds to a number of accounts around the world. The matter came to light only when BDA sued Well Fargo to recover the money.

Neither bank reported the theft to SWIFT, which said it first learned about the cyber attack from a Reuters inquiry.

  • In 2015, there had been an attempt to steal more than 1 million euros from Vietnam’s Tien Phong Bank through fraudulent SWIFT messages using infrastructure of an outside vendor hired to connect it to the SWIFT bank messaging system. TP Bank did not suffer losses because it detected the fraud quickly enough to stop the transfers.

  • SWIFT now admits that there were “a number of fraudulent payment cases where affected customers suffered a breach in their local payment infrastructure”. The whole set of press releases issued by SWIFT on this issue is worth reading.

The picture that emerges out of this is that on the one side there are well organized criminals who are building sophisticated tools to attack the banks. They may or may not be linked to each other, but they are certainly borrowing and building on each others’ tools. Their arsenal is gradually beginning to rival that of the APT (Advanced Persistent Threat) actors (who are traditionally focused on espionage or strategic benefits rather than financial gains). Very soon global finance could be attacked by criminals wielding Stuxnet-like APT tools re-purposed for stealing money.

On the other side is a banking industry that is unable to get its act together. Instead of hiring computer security professionals to shore up their defences, they are busy hiring lawyers to try and deflect the losses on to each other. It is evident that the banks are not sharing information with each other. Worse, my experience is that information is not even being shared within the banks. I have heard horror stories in India of security firms who have detected vulnerabilities in the IT systems of banks being told by the IT departments not to mention these to the top management. These IT people think that everything is fine so long as top management does not know about the problems. The top management in turn thinks that things are fine so long as the regulator does not know that there is a problem. I hear reports of banks quietly reimbursing a customer’s losses without either fixing the problem or reporting it to the regulators or other authorities. Most of the stories that I hear are from India, but the evidence suggests that the situation is not any different elsewhere in the world.

This state of denial and discord in the banking industry provides the hackers the perfect opportunity to learn the vulnerabilities of the banks, improve their hacking tools, and increase the scale and scope of their attacks. At some point, of course, the losses to the banking system would become too big to sweep under the carpet. That is when the confidence in the financial sector would begin to erode.

Another problem for the banks is that in their lawsuits against the paying banker, the victim bank is raising the issue of “red flags” and “suspicious transactions” to argue that the paying banker should have halted the payment. With large amounts of money at stake, this argument would be made by skilled lawyers and may even be successful in court. If that happens, it would set up a dangerous precedent against the banks themselves. So far, banks have taken the stand that their customers are responsible for the transactions so long as the valid authentication was provided. Bank customers typically do not have the resources and inside knowledge to challenge this stand. The inter-bank litigation is very different and has the potential to overturn the established distribution of liability.

I have not so far talked about nation state actors getting into the attack. Any nation state would love to hack the banks of an enemy country. Some rogue states that are excluded from global finance might even want to try and disrupt the global financial system. India is one of the countries at serious risk of an attack from a resourceful nation state, but as I look around, I see only complacency and no sense of concern let alone paranoia.

Regulatory priority: punish, deter or protect?

When a serious breach of market integrity is suspected, what should the regulators’ priorities be: should it try to punish the guilty, or should it seek to deter other wrong doers or should it focus on protecting the victims? Both bureaucratic and political incentives may be tilted towards the first and perhaps the second, but in fact it is the last that is most important. I have been thinking about these issues in the context of the order of the Securities and Exchange Board of India in the matter of Sharepro Services, a Registrar and Share Transfer Agent regulated by SEBI. The order which is based on six months of investigation and runs into 98 pages finds that:

  • Shares and dividends have been transferred from the accounts of the genuine investors to entities linked with the top management of Sharepro without any supporting documents

  • Records have been deliberately falsified avoid the audit trails.

  • Sharepro and its top management have authorized issuances of new certificates without any
    request or authorisation from shareholders.

  • The management of Sharepro has not cooperated with the investigation which being carried
    out by SEBI and on several occasions, it has attempted to mislead the investigation in the
    matter.

If one assumes that these findings are correct, then the key regulatory priority must be to take operational control of Sharepro and thereby protect the interests of investors who might have been harmed. A Registrar and Share Transfer Agent is a critical intermediary whose honest functioning is essential to ensure market integrity and maintain the faith of investors in the capital markets. I think that SEBI’s powers under section 11B of the SEBI Act would be adequate to achieve this objective, but in case of need, resort could also be had to section 242 of the Companies Act 2013.

The SEBI order does take some steps to punish the top management of Sharepro but does too little to protect the investors who appear to have lost money. It does not even cancel or suspend the registration of Sharepro as a Registrar and Share Transfer Agent, but merely advises companies who are clients of Sharepro switchover to another Registrar and Share Transfer Agent or to carry out these activities in-house. The only investor protection step in the order is the direction to companies who are clients of Sharepro to audit the records and systems of Sharepro. But if the records have been falsified, then only a regulator or other agency with statutory powers can carry out a meaningful audit by obtaining third party records.

A decade ago, when the Satyam fraud occurred, I was among the earliest to write that the government should simply take control of the company. I would argue the same in the case of Sharepro as well assuming that the SEBI findings are correct.

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