Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Monthly Archives: January 2017

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):