Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Bonds markets are not different

Institutional investors have long argued that bond markets are very different from equity markets and need OTC trading venues because of their peculiar characteristics. More than a decade ago, I remember receiving massive push back for suggesting that an exchange traded government bond market could be better for India than the recommendations of the RH Patil Committee.

In recent years, however, the structure of bond markets in the developed world has started moving closer to that of the equity market. Post crisis reforms like higher capital requirements and the Dodd Frank Act have led dealers to reduce their market making activities. Other players including hedge funds, algorithmic and high frequency traders as well as electronic trading platforms have stepped into the breach. The SEC study on Access to Capital and Market Liquidity submitted to the US Congress last month provides a great deal of evidence on the ability of the new market structure to deliver reasonable levels of liquidity.

Meanwhile, a recent study (Abudy and Wohl, “Corporate Bond Trading on a Limit Order Book Exchange”, July 2017) showed that the exchange traded corporate bond market in Tel Aviv Stock Exchange in Israel is more liquid than the OTC corporate bond market in the US (both in terms of narrower spreads and lower price dispersion). This is so despite the fact that the market for stocks in Israel is less liquid than in the US. An exchange traded corporate bond market in the US could therefore be expected to have even narrower spreads than in Israel.

We should stop doubting the ability of pre and post trade transparency to improve liquidity across asset classes.

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Should Equifax be shut down?

The US and India are among the few countries that still retain the death penalty for people, and they should have no qualms about imposing the death penalty on companies. Equifax might be a good candidate for this drastic action after the massive data hack that has been described as the worst leak of personal info ever.

There is probably no criminal activity involved, and so nobody can be sent to jail. Fines and penalties will doubtless be imposed, but companies like Equifax tend to think of any fines as simply the cost of doing business and do not find it a sufficient deterrent. They will continue to spend too little on cyber security. There is little that consumers can do to discipline them either. Adam Levetin at Credit Slips hits the nail on the hand:

Equifax didn’t lose customer records. It lost consumer records. That’s an important distinction, and it goes to the heart of the problem with the CRAs. Consumers can, in theory, avoid harm from a data security breach at a merchant by not doing business with the merchant.

It’s not possible for a consumer to withhold business from a CRA because the consumer does not have a business relationship with the CRA. And this is the key problem: we have a consumer financial services market in which consumers cannot vote with their pocketbooks.

A threat far bigger than fines and penalties is needed to force financial firms to take security of consumers seriously. The only credible threat is that of shutting down the company and simultaneously imposing a penalty large enough to ensure that neither shareholders nor creditors of the company receive anything in the liquidation.

The Jorda et al. estimate of the world Market Risk Premium

The Market Risk Premium (expected excess return of equities and other risky assets over risk free assets) is an important element in asset pricing models particularly the Capital Asset Pricing Model. Estimating the Market Risk Premium from historical data is very difficult because of high volatility – the sample mean over even many decades of data is subject to too large a sampling error. For example, reliable historical data on risk premiums in India goes back less than three decades, and we worry whether the realized risk premium over this period is representative of what premium will prevail in future. Data going back around a century is available for the United States, but use of this data raises serious issues of survivorship bias, as the US is clearly one of the best performing economies of the last century.

I think the NBER Conference paper by Jorda, Knoll, Schularick, Kuvshinov and Taylor “The Rate of Return on Everything, 1870–2015” is a valuable new estimate of the Market Risk Premium. First they have put together a large sample: 16 advanced economies over almost 150 years (the length of the sample varies from country to country). Second, they compute the Market Risk Premium using not merely equities, but also housing which is the most important risky asset outside of equities. In finance theory, the Market Portfolio in theory includes all risky assets, and including housing moves the empirical estimation closer to theory. Pooling data across all countries, they arrive at the following conclusion:

In most peacetime eras this premium has been stable at about 4% – 5%. But risk premiums stayed curiously and persistently high from the 1950s to the 1970s, despite the return to peacetime. However, there is no visible long-run trend, and mean reversion appears strong. The bursts of the risk premium in the wartime and interwar years were mostly a phenomena of collapsing safe rates rather than dramatic spikes in risky rates. In fact, the risky rate has often been smoother and more stable than safe rates, averaging about 7% – 8% across all eras.

It is interesting to observe that the Capital Asset Pricing Model was created during the period of high risk premiums in the 1960s, and its obituaries started being written in the 1980s and 1990s when the risk premium collapsed to very low levels (Figure 10 in the paper).

Jorda et al. also provide an estimate of another important risk premium using the same long period multi-currency sample: the term structure premium or the liquidity risk premium (bonds versus bills). This risk premium is around 1.5% for the full sample, but somewhat larger during the last quarter century (Figure 3 of the paper).

Operational creditors yet again

When the Bankruptcy Law Reforms Committee (BLRC) submitted its report nearly two years ago, one of my major concerns was the dubious and unwarranted distinction that it made between operational and financial creditors (see my blog posts here and here). This invidious distinction has come back to haunt us today as home buyers find themselves in the lurch when bankruptcy proceedings are initiated against the developer. Pratik Datta tells the full story of this mess in her blog post at Ajay Shah’s blog.

This is symptomatic of a deeper problem with how bankruptcy reform in India has developed as a bailout of the financial sector rather than as a reform of the real economy. From the Debt Recovery Tribunal to SARFAESI to the Bankruptcy Code, banks were privileged over other creditors and financial creditors over operational creditors. It would appear that the dominant goal has been to save the banks. Jason Kilborn articulates the problem very elegantly in his blog post at Credit Slips:

It seems to me a sign of serious regulatory dysfunction when a government expressly uses bankruptcy law as a means of collection, rather than rescue or at least collective redress, with an aim to treating economic stagnation.

It is particularly telling that there has been a profound unwillingness to apply bankruptcy principles to the financial sector itself: Global Trust Bank was merged instead of being left to die; Unit 64 was bailed out; even today, there is no willingness to liquidate even the worst public sector banks. One has to go back half a century to Palai Central Bank for an example of a bank of any significance being allowed to die (though only after a lot of dilly dallying).

Are bonds both a liability and an asset of the borrower?

I have a special interest in this question because that was the topic of the first post on my blog way back in 2005. Five centuries after Luca Pacioli wrote the first text book on double entry accounting, this issue remains unresolved, and smart litigants are still seeking to attach the bonds issued by the debtor to recover their claims. In 2005, it was Argentina; in 2017, it is Venezuela (hat tip Credit Slips).

Twelve years ago, Argentina was exchanging its old bonds for new bonds as part of its infamous debt restructuring. Some hedge funds moved to seize the old bonds that Argentina had accepted for the exchange on the ground that the surrendered bonds were assets of Argentina which could be sold in the market to satisfy the claims of the hedge funds. Argentina of course argued that the bonds belonged to the tendering holders, and that they could not be Argentina’s assets and liabilities at the same time. The federal appeals court in New York did not decide the legal question, but simply upheld the trial court’s ruling in favour of Argentina on the ground that the trial judge overseeing the overall debt exchange had broad discretion in the matter. Anna Gelpern provides more details in this paper (page 4).

If Argentina’s debt restructuring was a mess, Venezuela promises to be even messier if and when that country gets to that stage. What is happening now are merely some skirmishes before Venezuela defaults and the serious litigation begins. Buchheit and Gulati wrote in a recent paper:

Napoleon’s invasion of Russia in 1812 was a large undertaking. Restructuring Venezuela’s public sector debt will be a very large undertaking.

Early this year, Venezuela issued $5 billion in new bonds to a state owned entity to help raise cash needed for essential imports (“Venezuela issues $5bn in bonds as it seeks cash to ease shortages”, Financial Times, January 3, 2017). In June, Venezuela engaged a Chinese securities firm, Haitong, to resell these bonds reportedly at a steep discount of more than 70% (“Venezuela Discounts $5 Billion in Bonds”, Wall Street Journal, June 6, 2017). Soon, a Canadian firm, Crystallex, obtained a restraining order against Haitong, as a first step towards attaching the bonds. (“Crystallex Moves Closer To Collecting $1.2B Venezuela Award”, Law360, July 17, 2017). Perhaps, this time, the courts will actually decide this question as to whether a debtor’s bonds can be treated as its assets and attached by the creditors.

Markets that are Too Big To Fail (TBTF)

We hear a lot about TBTF banks, but I think in the post crisis world, policy makers are beginning to view some markets as being TBTF. The IMF published a working paper last month by Darryl King et al. on Central Bank Emergency Support to Securities Markets. This paper appears to me to formalize and legitimize this idea. My unease about this paper is that it not only endorse almost everything that the central banks did during the crisis, but also elevates these to the level of best practices. The paper ignores the fact that while these might have helped in the crisis, they would also have unintended effects on the functioning of markets during normal times.

Markets that are highly likely to be bailed out during a future crisis will be perceived as safer even during normal times. Bonds that trade in these markets will therefore command lower yields. The result is a subsidy to the borrowers issuing these bonds. The subsidy to TBTF banks is partially alleviated through more stringent regulation of these banks (SIFIs), but there is no such regulatory pressure on corporate borrowers benefiting from the subsidization of TBTF markets.

I am fond of Kindleberger’s statement that a lender of last resort must exist but his existence should be doubted. In their eagerness to legitimize whatever was done during the crisis, policy makers are removing this doubt and making the TBTF subsidy more certain and more significant. They are picking winners and losers, and since the winners that they choose are the mature companies, they are penalizing the more innovative dynamic firms that are crucial for long term economic growth.

In the sister blog and on Twitter during January-July 2017

The following posts appeared on the sister blog (on Computing) during January-July 2017.

Tweets during January-July 2017 (other than blog post tweets):

Equity Derivatives versus Cash Equities in India

The Securities and Exchange Board of India (SEBI), the Indian securities regulator, put out a discussion paper a couple of weeks ago on the Growth and Development of Equity Derivatives Market in India. The Indian Equity Derivatives Market is one of the success stories of financial market development in India and clearly, it makes sense to study this market to draw lessons that could help replicate this success in other segments (bond markets for example) that have remained under developed after 25 years of reforms.

Unfortunately, the SEBI discussion paper seems to prefer levelling down to levelling up. Rather than bring other markets up to the high standards set by the equity derivatives markets, it seeks to clamp down on this successful market to reduce it to the mediocrity of other lacklustre markets.

The discussion paper is worried about the high ratio of derivative market turnover to cash market turnover, and thinks that therefore there must be something wrong with the derivative market. The correct conclusion is quite the opposite: there is something grievously wrong about the cash market. Several policy makers have conspired to prevent a vibrant cash market from emerging in India:

  1. The Reserve Bank of India (RBI) places severe restrictions on capital market related lending and therefore starves the cash market of credit. Everybody who seeks leverage is therefore forced to move to the derivative market. SEBI has a margin trading scheme, but this scheme has been largely a failure.

  2. For a different set of reasons, the securities lending scheme has also failed to take off, and those desirous of taking a short position in stocks are also forced to turn to the derivative market.

  3. The government in its greed for tax revenue (with near zero collection cost) has pushed up the securities transaction tax to punitive levels in the cash market. Though the difference in price elasticity in the two markets could make the revenue maximizing rate of taxation unequal in the two markets, it is likely that the current rates are not actually optimal even from a revenue maximizing point. More importantly, the rate of transaction tax in the cash market is far too high from a social welfare point of view.

These factors have stunted the growth of the cash equities market in India. The liquid derivatives market has ameliorated this problem for the top 50-100 companies. But that leaves hundreds of other companies in the lurch. In my view, this is a serious problem because a vibrant equity market is important for economic growth. All policy makers (SEBI, RBI and the Finance Ministry) need to come together to fix the flaws in the cash equities market.

I believe that India can create a reasonably liquid market for the top 1000 companies in the country. Market participants laugh at me when I say this, but if the US can do this, I do not see why India cannot. We have all the institutional prerequisites for such a market – world class depositories, exchanges, and clearing corporations; a large ecosystem of intermediaries; a strong regulator; and above all a vast investor base. I hope that regulators will raise their sights and aim for this, rather than try to cripple the derivative market so that it is no longer obvious that the cash market is limping.

The SEC and The DAO

The US SEC has published an Investigation Report concluding that crpyto-currency tokens issued by The DAO constitute securities under US law. I am not a lawyer, and it is not my intention in this post to dispute the SEC’s conclusion which is, on balance, probably correct. What bothers me is that some vital facts seem to me to have been suppressed and misrepresented in the report. In particular, several passages look like the kind of suppresio veri suggestio falsi that one does not expect from a top notch regulator like the SEC which commands global respect:

DAO Token holders’ votes were limited to proposals whitelisted by the Curators, and, although any DAO Token holder could put forth a proposal, each proposal would follow the same protocol, which included vetting and control by the current Curators. While DAO Token holders could put forth proposals to replace a Curator, such proposals were subject to control by the current Curators, including whitelisting and approval of the new address to which the tokens would be directed for such a proposal.

This ignores the ability to split The DAO and create a new “child” DAO with a new curator. The hacking of The DAO (which the SEC refers to as the Attack below) involved exactly this splitting.

Second, the pseudonymity and dispersion of the DAO Token holders made it difficult for them to join together to effect change or to exercise meaningful control. … This was later demonstrated through the fact that DAO Token holders were unable to effectively address the Attack without the assistance of Slock.it and others.

In reality, it is the DAO Attack that constitutes the biggest obstacle to the theory that The DAO tokens were securities. The tokens looked much more like securities when they were issued than they do in retrospect after the Attack:

  1. The only important events (“investments” in some sense) in the entire life of the DAO were the Dark DAO (the Attacker) and the Robin Hood Group or the DAO White Hat Team. Since neither of these were initiated by Slock.it, this completely demolishes the idea that Slock.it was in a position to control The DAO.

  2. I could not help laughing out loud on reading the sentence: “DAO Token holders were unable to effectively address the Attack without the assistance of Slock.it and others”.
    • If the “others” refers to the Robin Hood Group (White Hat Team), this statement is factually incorrect: (a) the Robin Hood Group were also token holders (and not others) and (b) they were acting not on behalf of Slock.it, but in their individual capacity, struggling with “bad internet and family commitments”.

    • The major assistance that Slock.it provided in reversing the Attack was not in their role as developers of The DAO, but in their role as developers of Ethereum which was the platform on which The DAO ran. What the core developers did was to change the rules of Ethereum to undo the Attack.

      The right analogy is that of a company where the government has been outvoted in a shareholder’s meeting (because it has been reduced to a minority stake), and the government proceed to change the law and use its sovereign powers to get its way. This would establish not that the government still controls the company, but that it has lost control. The analogy is apt because Ethereum was the closest thing to the sovereign when it comes to The DAO.

    • Even this “assistance” (changing the rules of Ethereum) was well beyond the powers of Slock.it. Ethereum is far more decentralized than The DAO; even the SEC has not claimed that the Ethereum coin offering was a securities issue! The Ethereum community did not actually care much about the wishes of Slock.it. Whatever influence was there was the personal influence of Vitalik Buterin. (In much the same vein, the Ethereum community probably did not care much about Cornell University, but listened with respect to Emin Gun Sirer). Even Buterin’s enormous personal credibility could not prevent a split in Ethereum and the creation of the parallel coin, Ethereum Classic

In short, the Attack demonstrated that at truly important junctures, crypto communities are truly decentralized. The events in Bitcoin in the last few weeks provide additional corroboration of this.

These facts diminished the ability of DAO Token holders to exercise meaningful control over the enterprise through the voting process, rendering the voting rights of DAO Token holders akin to those of a corporate shareholder.

The SEC forgets that The DAO did not have a Board or a Chief Executive who run the company on a day to day basis. In the case of The DAO, the day to day administration of the organization was in the hands of the token holders.

By contract and in reality, DAO Token holders relied on the significant managerial efforts provided by Slock.it and its co-founders, and The DAO’s Curators, as described above.

The claim “By contract” is very rich. The DAO was very clear in all its communications that it was governed by its code and repeatedly emphasized that all English language descriptions were subordinate to the smart contract embedded in the code: code is law. And, I am sorry, the code did not contain any promises by Slock.it to provide managerial efforts.

Libor and Nash Equilibria

This week, I read two apparently unrelated things that on later reflection are deeply related:

  1. The FCA, the UK regulator, made a statement that the world’s most important interest rate benchmark, Libor, will be phased out in less than five years because of lack of liquidity. The problem discussed in this speech is very easy to understand: the underlying market is no longer sufficiently active. The reasons for this state of affairs are much harder to diagnose.

  2. A highly esoteric paper was published on the Computer Science and Game Theory section of arXiv more than six months ago, but I read it only recently after FT Alphaville linked to it at one remove a few days ago. This paper by Babichenko and
    Rubinstein proves that finding even an approximate Nash equilibrium of an n person binary-action games requires an exponential amount of communication, and therefore, it takes an exponential number of rounds of the game for the players to “learn” the approximate Nash equilibrium by playing the game repeatedly.

The link that I see from the esoteric paper to the Libor situation is that markets require very rich communication structures to be viable. One way to facilitate the required amount of multi-way communication is through the high degree of pre-trade and post-trade transparency that is created by trading on an exchange. The other method that was used in the past in various over the counter (OTC) markets was informal communication channels between traders in different firms. Some of these traders might have worked together in the past or might have other personal and social connections. Using various messaging and chat media, these traders used to accomplish an extremely rich communication structure. Of course, these informal communication networks were abused to allow key players to make greater profits (information is money in all markets). After the Global Financial Crisis, regulators shut down the informal communication channels in an attempt to clean up the markets. They succeeded beyond their wildest expectations – there is by definition no manipulation in a market that does not trade at all.

Post crisis, there was a move towards mandatory clearing, but not towards mandatory exchange based trading. This is clearly a huge mistake: the only real alternative to informal communication channels is formal information flows mediated by exchanges. So we see breakdown of previously highly liquid markets. On the other side, central clearing in a market without adequate liquidity and transparency is a prescription for disaster sooner or later. So far, most of the problems have been pushed under the carpet by the central banks that have become market makers of first and last resort in many markets. As they normalize their balance sheets, dysfunctional markets could become a progressively bigger problem.