Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Monthly Archives: January 2016

Does Regulation Crowd out Private Ordering and Reputational Capital?

The crowdfunding portal Kickstarter commissioned an investigative journalist to write a report on the failure of Zano which had raised $3.5 million on that platform, and the report has now been published on Medium. I loved reading this report for the quality of the information and the balance in the conclusions. It left me thinking why London’s AIM market never published something similar on many of the failures among the companies listed there, or why NASDAQ never commissioned something like this after the dotcom bust, or why the Indian exchanges never did anything like this about the vanishing companies of the mid 1990s.

Is it because these highly regulated exchanges are protected by a regulatory monopoly and they can safely leave this kind of thankless job to their regulators? Or are they worried that an honest investigative report might be used against them because of the regulatory burden that they face? Does regulation have the side effect of crowding out the private ordering that emerges in the absence of regulation? Does regulation weaken reputational incentives?

In the context of crowdfunding, the reputational incentives and private ordering are well described in Schwartz’ paper on “The Digital Shareholder”:

These intermediaries [funding portals] want investors to have a good experience so they will return to invest again on their website, making them sensitive to a reputation feedback system. A funding portal with lots of poorly rated companies will find it difficult to attract future users to its site. Importantly, this appears to be an effective constraint for existing reward crowdfunding sites, such as Indiegogo, which take care to avoid having their markets overrun by malfeasance.

It is true that regulation does have positive effects, but the challenge in framing regulations is to avoid weakening private ordering.


Whom do you bail out with your reserves?

Countries build up reserves in good times for many reasons including depressing the value of the exchange rate. The real proof of the pudding comes in bad times when the government needs to decide who should be bailed out, and who should be allowed to fail.

There have been two archetypes for this decision making. In the old Latin American model, the klepocratic elite was allowed to take its money out and everybody else was hung out to dry. The East Asian model (both in 1998 and 2008) was largely to bail out the banks (but not necessarily their owners) and to let the corporate sector go bust. Russia in 2008 followed a middle path: they bailed out the oligarchs till the reserves fell to uncomfortable levels, and then conserved the remaining reserves to protect the banking system.

The interesting question is which model is China following. The anti corruption campaign might suggest that China is following the East Asian path of forcing losses on the elite. But the scale of capital flight suggests a different interpretation: the anti corruption campaign is sending a signal to the klepocrats to take their money out of China before it is too late. Whatever the intentions might have been, China might end up in practice much closer to the Russian model. Maybe half the reserves will be used to allow the elite to unwind their carry trades and take their money out of the country. The remaining half would still be sufficient to stabilise the economy at a depreciated exchange rate.

CNBC Interview on Mutual Funds

I was interviewed on CNBC last week for their show The Firm on recent changes made by the Securities and Exchange Board of India (SEBI) in mutual fund regulations. SEBI tightened the norms relating to exposure of a mutual fund to a single issuer or industry. One of the issues that came up was whether the norms should be more generous for AAA rated debt. I referred to the subprime crisis where the losses came in AAA rated mortgage securities and argued that AAA debt is in some ways more dangerous because you do not even get a high coupon to compensate for the default losses. I have tweeted about this in the past quoting Asness: “the most dangerous things are those that you think protect you, but only mostly protect you”

There was also a discussion on the issue of gates and sidepockets that I have blogged about and tweeted about. I continued to maintain that fund managers have the responsibility to ensure that redemption does not take place at NAVs different from the realizable value of the underlying assets.

Easy to fix speculators, harder to fix problems

Looking at the turbulence in the Yuan HIBOR market, I was reminded of Thailand in 1997-98. I remember writing about the Thai episode at that time:

To speculate against the baht, a hedge fund has to sell baht, and to do so, it must directly or indirectly borrow baht. If the attack succeeds, the hedge fund would be able to buy back the baht at lower prices and repay the borrowing. The Bank of Thailand attempted to make this difficult by preventing residents from lending baht to non residents in any form including direct loans, overdrafts, currency swaps, interest rate swaps, forward rate agreements, currency options, interest rate options, outright forward transactions. It also preventing residents from selling baht to non residents against payment in foreign currencies. Simultaneously, the Bank of Thailand intervened heavily in the offshore market especially in the forward market. All this created an acute shortage of baht in the offshore market and drove up interest rates in that market to several hundred percent. In the process, several hedge funds reportedly made losses as they scrambled to buy or borrow baht to meet their obligations. When they tried to obtain baht by selling Thai stocks, the Bank of Thailand responded with a rule that the proceeds of all stock sales must be remitted in foreign currency and not in baht.

This policy was hugely successful in its immediate objective of punishing the hedge funds who had the temerity to short the Thai baht. Both the technocrats who engineered this and their political masters were immensely pleased with this result, and boasted about their success. But, all this did nothing to save the baht or fix Thailand’s economic problems back then. Unfortunately, neither the technocrats nor the politicians ever seem to learn the critical lesson that it is easy for a sovereign to fix the speculators, it is much harder to fix the underlying problems that cause the speculation in the first place.

Clearing Corporation Vulnerabilities

Last month, LCH published a White Paper entitled CCP Conundrums which raise a number of interesting issues, though I think that “conundrums” is a bit of a euphemism in this context. In my view, Central Counter Parties (CCPs) or Clearing Corporations globally face serious vulnerabilities arising out of a confluence of factors:

  1. After the Global Financial Crisis, regulators have pushed more and more products into clearing, even though they do not trade in liquid markets. The benefits of CCPs in exchange traded products flow as much from the price discovery in exchange trading as they do from clearing, netting and collateralization. In many of the products now being pushed into trading, price discovery is suspect because of poor liquidity or oligopolistic market structure.

  2. The opening up of several new products to clearing has created a once-in-a-lifetime opportunity for the top clearing corporations to expand into potentially large market segments. There is a temptation to gain market share through lower margins and less stringent risk management.

  3. There is no regulatorily imposed minimum margin that could prevent such a race to the bottom. In fact, there is a tendency for banking regulators to turn a blind eye to this risk because they have no desire to shore up the CCPs by draining liquidity and capital from the banks.

  4. Ultra loose monetary policy in the developed world is leading to yield chasing and suppression of risk aversion. This may be the intended “portfolio balance channel” of monetary policy transmission, but it creates an environment where risks are probably being ignored.

  5. This is what LCH refers to as the risk of pro-cyclicality of risk management at the CCPs. LCH is more or less openly saying that margins need to be increased before monetary conditions tighten as it would be too late to do so after tightening has already happened.

For all these reasons, I have been worrying for quite some time now that in the coming years, the failure of a large global CCP is more a matter of when rather than whether.