Posts this month
A blog on financial markets and their regulation
Update: While linking to Ajay Shah’s blog for a summary of global regulatory regimes on self trades, I failed to mention that the particular post that I was referring to was authored not by Ajay Shah, but by Nidhi Aggarwal, Chirag Anand, Shefali Malhotra, and Bhargavi Zaveri.
Imagine that you are bidding at an auction and after a few rounds, most bidders have dropped out and you are left bidding against one competing bidder who pushes you to a very high winning bid before giving up. Much later you find that the competing bidder who forced you to pay close to your reservation price was an accomplice of the seller. You would certainly regard that as fraudulent; and many well running auction houses have regulations preventing it. Observe that the seller did not actually sell to himself; in fact there would have been no fraud (and no profit to the seller) if he actually did so. The seller defrauded you not by an actual (disguised) self-trade but by a (disguised) potential self-trade that did not actually happen. In fact, the best of auction houses do not prohibit actual self-trades: when the auction does not achieve the seller’s (undisclosed) reserve price, they allow the item to be “bought in” (the seller effectively buys the item from himself). So the lesson from well run auction houses is that potential self-trades (which do not happen) are much more dangerous than actual self-trades.
In the financial markets, we have lost sight of this basic intuition and focused on preventing actual self-trades instead of limiting potential self-trades. India goes overboard on this by regarding all self-trades as per se abusive. Most other countries also frown on self-trades but do not penalize bona fide self-trades; they take action only against self-trades that are manipulative in nature. However, they too regard frequent self-trades as suggestive of manipulative intent (see Ajay Shah for a nice summary of these regulatory regimes). Many exchanges and commercial software around the world therefore now provide automated methods of preventing self-trades: when an incoming order by an entity would execute against a pre-existing order on the opposite side by the same entity, these automated procedures cancel either the incoming order or the resting order or both.
A little reflection on the auction example would show that the whole idea of automated self-trade prevention is an utterly misguided response to an even more misguided regulatory regime. Manipulation does not happen when the trade is executed: it happens when the order is entered into the system. The first sign that the regulators are understanding this truth is in the complaint that the US Commodity and Futures Trading Commission (CFTC) filed against Oystacher and others last month. Para 53 of the complaint states:
Oystacher.and 3 Red manually traded these futures markets, using a commercially available trading platform, which included a function called “avoid orders that cross.” The purpose of this function is to prevent a trader’s own orders from matching with one another. Defendants exploited this functionality to place orders which automatically and almost simultaneously canceled existing orders on the opposite side of the market (that would have matched with the new orders) and thereby effectuated their manipulative and deceptive spoofing scheme …
Far from preventing manipulation, automated self-trade prevention software is actually facilitating market manipulation. This might appear counter intuitive to many regulators, but is not at all surprising when one thinks through the auction example.
In India, for far too long, bankruptcy has been a battle between creditor and debtor with the dice loaded against the creditor. In its report submitted earlier this month, the Bankruptcy Law Reforms Committee (BLRC) proposes to change all this with a fast track process that puts creditors in charge. It appears to me however that the BLRC ignores the fact that in well functioning bankruptcy regimes, the fight is almost entirely creditor and creditor: it is very much like the familiar scene in the Savannah where cheetahs, lions, hyenas and vultures can be seen fighting over the carcass which has no say in the matter.
The BLRC ignores this inter-creditor conflict completely and treats unsecured financial creditors as a homogeneous group; it believes that everything can be decided by a 75% vote of the Creditors Committee. In practice, this is not the case. Unsecured financial creditors can be senior or junior and multiple levels of subordination are possible. Moreover, the bankruptcy of any large corporate entity involves several levels of holding companies and subsidiary companies which also creates an implicit subordination among different creditors made more complex by inter company guarantees.
Consider for example, the recommendation of the BLRC that:
The evaluation of these proposals come under matters of business. The selection of the best proposal is therefore left to the creditors committee which form the board of the erstwhile entity in liquidation. (p 100)
If the creditors are homogeneous, this makes eminent sense. The creditors are the players with skin in the game and they should take the business decisions. The situation is much more complex and messy with heterogeneous creditors. Suppose for example that a company has 60 of senior debt and 40 of junior debt and that the business is likely to be sold for something in the range of 40-50. In this situation, the junior creditors should not have any vote at all: like the equity shareholders, they too are part of the carcass in the Savannah which others are fighting over. On the other hand, if the expected sale proceeds are 70-80, then the senior creditors should not have a vote at all. The senior creditors have no skin in the game because it matters absolutely nothing to them whether the sale fetches 70 or 80; they get their money in any case. They are like the lion that has had its fill and leaves it to lesser mortals to fight over what is left of the carcass.
The situation is made more complex by the fact that in practice the value of the proposals is not certain, and the variance matters as much as the expected value. A junior creditor’s position is often similar to that of the holder of an out of the money option – it tends to prefer proposals that are highly risky. Much of the upside of a risky sale plan may flow to the junior creditor, while most of the downside may be to the detriment of the senior creditor.
Another recommendation of the BLRC that I am uneasy about is the stipulation that operational creditors should be excluded from the decision making:
The Committee concluded that, for the process to be rapid and efficient, the Code will provide that the creditors committee should be restricted to only the financial creditors. (p 84)
Suppose for example that Volkswagen’s liabilities to its cheated customers were so large as to push it into bankruptcy. Would it make sense not to give these “operational creditors” a seat at the table? What about the bankruptcy of a electric utility whose nuclear reactor has suffered a core meltdown?