Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

HBOS: An old fashioned bank failure

Most of the bank failures of the Global Financial Crisis involved complex products or an excessive reliance on markets rather than good old banking relationships. The HBOS failure as described in last month’s 400 page report by the UK regulators (PRA and FCA) is quite different. One could almost say that this was a German or Japanese style relationship bank.

The report describes the approach of the Corporate Division where most of the losses arose:

The often-quoted approach of the division was to be a relationship bank that would ‘lend through the cycle’. Elsewhere the division’s approach had been called ‘counter-cyclical’. This was described as standing by and supporting existing customers through difficult times, while continuing to lend to those good opportunities that could be found. The division claimed it had a deep knowledge of the customers and markets in which it operated, which would enable it to pursue this approach with minimal threat to the Group. It was an approach that was felt to have served BoS well in the early 1990s downturn. (Para 274)

What could go wrong with such old fashioned banking? The answer is very simple:

Taking into account renting, hotels and construction, the firm’s overall exposure to property and related assets increases to £68 billion or 56% of the portfolio. (para 285)

And in some ways, relationship banking made things worse:

The top 30 exposures included a number of individual high-profile businessmen. Many of these had been customers of the division for many years, some going back to the BoS pre-merger. True to the division’s banking philosophy, it had supported these customers as they grew and expanded their businesses. However, business growth and expansion sometimes meant a change in business model to become significant property investors; not necessarily the original core business and expertise of the borrower. In the crisis, a number of these businessmen, though not all, incurred losses on their property investments. (Para 318)

When you as a bank lend a big chunk of your balance sheet into a bubble, it does not matter whether you are a transaction bank or a relationship bank: you are well on your way to failure. (If you do not want to jump to conclusions based on one bank, a recent BIS Working Paper on US commercial banks studies all bank failures in the US during the Great Recession and comes to a very similar conclusion).

In the sister blog and on Twitter during October and November 2015

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

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

Potential self-trades are worse than actual self-trades

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.

Creditor versus Creditor and Creditor versus Debtor

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?

Distrust and cross-check

I have piece in today’s Mint arguing that the Volkswagen emission scandal is a wake-up call for all financial regulators worldwide:

The implications of big firms such as Volkswagen using software to cheat their customers go far beyond a few million diesel cars

The Volkswagen emissions scandal challenges us to move beyond Ronald Reagan’s favourite Russian proverb “trust but verify” to a more sceptical attitude: “distrust and cross-check”.

A modern car is reported to contain a hundred million lines of code to deliver optimised performance. But we learned last month that all this software can also be used to cheat. Volkswagen had a cheating software in its diesel cars so that the car appeared to meet emission standards in the lab while switching off the emission controls to deliver fuel economy on the road.

The shocking thing about Volkswagen is that (unlike, say Enron), it is not perceived to be a significantly more unethical company than its peers. Perhaps, the interposition of software makes the cheating impersonal, and allows managers to psychologically distance themselves from the crime. Individuals who might hesitate to cheat personally might have less compunctions in authorizing the creation of software that cheats.

The implications of big corporations using software to cheat their customers go far beyond a few million diesel cars. We are forced to ask whether, after Volkswagen, any corporate software can be trusted. In this article, I explore the implications of distrusting the software used by big corporations in the financial sector:

Can you trust your bank’s software to calculate the interest on your checking account correctly? Or might the software be programmed to check your Facebook and LinkedIn profiles to deduce that you are not the kind of person who checks bank statements meticulously, and then switch on a module that computes the interest due to you at a lower rate?

Can you be sure that the stock exchange is implementing price-time priority rules correctly or might the software in the order matching engine be programmed to favour particular clients?

Can you trust your mutual funds’ software to calculate Net Asset Value (NAV) correctly? Or might the software be programmed to understate the NAV on days where there are lots of redemption (and the mutual fund is paying out the NAV) while overstating the NAV on days of large inflows when the mutual fund is receiving the NAV?

Can you be sure that your credit card issuer has not programmed the software to deliberately add surcharges to your purchases. Perhaps, if you complain, the surcharges will be promptly reversed, but the issuer makes a profit from those who do not complain.

Can you trust the financials of a large corporation? Or could the accounting software be smart enough to figure out that it is the auditor who has logged in, and accordingly display a set of numbers different from what the management sees?

After Volkswagen, these fears can no longer be dismissed as mere paranoia. The question today is how can we, as individuals, protect ourselves against software-enabled corporate cheating? The answer lies in open source software and open data. Computing is cheap, and these days each of us walks around with a computer in our pocket (though, we choose to call it a smartphone instead of a computer). Each individual can, therefore, well afford to cross-check every computation if (a) the requisite data is accessible in machine-readable form, and (b) the applicable rules of computation are available in the form of open source software.

Financial sector regulations today require both the data and the rules to be disclosed to the consumers. What the rules do not do is to require the disclosures to be computer friendly. I often receive PDF files from which it is very hard to extract data for further processing. Even where a bank allows me to download data as a text or CSV (comma-separated value) file, the column order and format changes often and the processing code needs to be modified every time this happens. This must change. It must be mandatory to provide data in a standard format or in an extensible format like XML. Since data anyway comes from a computer database, the bank or financial firm can provide machine-readable data to the consumer at negligible cost.

When it comes to rules, disclosure is in the form of several pages of fine print legalese. Since the financial firm anyway has to implement rules in computer code, there is little cost to requiring that computer code be freely made available to the consumer. It could be Python code as the US SEC proposed five years ago in the context of mortgage-backed securities (, or it could be in any other open source language that does not require the consumer to buy an expensive compiler to run the code.

In the battle between the consumer and the corporation, the computer is the consumer’s best friend. Of course, the big corporation has far more powerful computers than you and I do, but it needs to process data of millions of consumers in real time. You and I need to process only one person’s data and that too at some leisure and so the scales are roughly balanced if only the regulators mandate that corporate computers start talking to consumers’ computers.

Volkswagen is a wake-up call for all financial regulators worldwide. I hope they heed the call.

Twitter or Newswires: Are regulators behind the curve?

Last week, I read two stories that made me wonder how regulators are far behind the curve when it comes to new media.

First, Business Insider reported that after the newswire hacking scandal (which I blogged about last month), Goldman Sachs was considering announcing its earnings on Twitter instead of on the newswires. Of course, such reports are often speculative and nothing may come of it, but it indicates that at least some organizations are taking the new media seriously.

Second, was an amendment to the New York Stock Exchange (NYSE) rules on how companies should release news to the public (h/t CLS Blue Sky Blog):

Currently, section 202.06(C) … on the best way to release material news … is outdated as it refers to, among other things, the release of news by telephone, facsimile or hand delivery. Instead, the Exchange proposes … that listed companies releasing material news should either (i) include the news in a Form 8-K or other Commission filing, or (ii) issue the news in a press release to the major news wire services.

The regulators have finally decided to shift from obsolete media to the old media; the new media is not even on the horizon.

Interview in Bloomberg TV

Bloomberg TV carried an interview with me last week. The video is available at the channel’s website. Among several other things, the interview also covered the Amtek Auto episode that I have blogged about in the past. I argued that Amtek Auto is unlikely to be the last episode of distressed corporate bonds in mutual fund portfolios, and we need to be more proactive in future.

Are large fund managers problematic?

Last month, I read four seemingly unrelated papers which all point towards problems posed by large fund managers.

  1. Ben-David, Franzoni, Moussawi and Sedunov (The Granular Nature of Large Institutional Investors) show that the stocks owned by large institutions exhibit stronger price inefficiency and are also more volatile. They also study the impact of Blackrock’s acquisition of Barclays Global Investors (which the authors for some strange reason choose to identify only as “a mega-merger between two large institutional investors that took place at the end of 2009”). Post merger, the ownership of stocks which was spread across two fund managers became concentrated in one fund manager. The interaction term in their regression results show that this concentration increased the volatility of the stocks concerned. On the mispricing front, they show that the autocorrelation of returns is higher for stocks that are held by large institutional investors; and that stocks with common ownership by large institutions display abnormal co-movement. They also show that negative news about the fund manager (increase in the CDS spread) lead to an increase in volatility of stocks owned by that fund.

  2. Israeli, Lee and Sridharan (Is There a Dark Side to Exchange Traded Funds (ETFs)? An Information Perspective) find that stocks that are owned by Exchange Traded Funds (ETFs) suffer a decline in pricing efficiency: higher trading costs (measured as bid-ask spreads and price impact of trades), higher co-movement with general market and industry returns; a decline in the predictive power of current returns for future earnings); and a decline in the number of analysts covering the firm. They hypothesize that ETF ownership reduces the supply of securities available for trade, as well as the number of uninformed traders willing to trade these securities. Much the same factors may be behind the results found by Ben-David, Franzoni, Moussawi and Sedunov.

  3. Clare, Nitzsche and Motson (Are Investors Better Off with Small Hedge Funds in Times of Crisis?) argue that on average investors were better off investing with a small hedge fund instead of a large one in times of crisis (the dot com bust and the global financial crisis). They speculate that bigger hedge funds might attract more hot money (fund of funds) which might lead to large redemptions during crises. Smaller hedge funds might have less flighty investors and more stringent gating arrangements. Smaller hedge funds might also have lower beta portfolios.

  4. Elhauge (Horizontal Shareholding as an Antitrust Violation) focuses on problems in the real economy rather than in the financial markets. The argument is that when a common set of large institutions own significant shares in firms that are horizontal competitors in a concentrated product market, these firms are likely to behave anticompetitively. Elhauge discusses the DuPont-Monsanta situation to illustrate his argument. The top four shareholders of DuPont are also four of the top five shareholders in Monsanto, and they own nearly 20% of both companies. The fifth largest shareholder of DuPont, the Trian Fund, which did not own significant shares in Monsanto, launched a proxy contest criticizing DuPont management for failing to maximize DuPont profits. In particular, Trian complained that DuPont entered into a reverse payment patent settlement with Monsanto whereby, instead of competing, DuPont paid Monsanto for a license to use Monsanto’s patent. Trian’s proxy contest failed because it was not supported by the four top shareholders of DuPont who stood to gain from maximizing the joint profits of DuPont and Monsanto. I thought it might be useful for the author to compare this situation with the cartelization promoted by the big investment banks in 19th century US or by the big banks in early 20th century Germany or Japan.

Negative interest rates wreak havoc with finance textbooks

By assuming non negative interest rates, finance textbooks arrive at many results that are false in a negative rates world. Finance theory does not rule out negative rates – theory requires only bond prices to be non negative, and this only prevents interest rates from dropping below −100%. In practice also, early 2015 saw interest rates go negative in many countries. The BIS 2015 Annual Report (Graph II.6, page 32) shows negative ten-year yields in Switzerland, and negative five year yields in Germany, France, Denmark and Sweden in April 2015.

Let us take a look at how many textbook results are no longer valid in this world:

  • The formula for the present value of a perpetuity PV=1/r yields the absurd result that the present value is negative when r is negative. In fact, the present value is infinite (the geometric series diverges for negative r).

  • Interestingly, the formula for a growing perpetuity PV=1/(r−g) is still valid under the text book assumption that r>g. But this requires negative g in a negative rates world. That is why the 1/r formula for the zero growth case fails.

  • It is no longer true as the textbooks claim that an American call option on a non dividend paying stock would never be exercised prematurely and is therefore the same as a European call. If the call is sufficiently deeply in the money, the holder would want to pay the exercise price as early as possible to avoid the tax (of negative rates) on cash holdings.

  • The opposite text book claim about puts is now false. The textbook result is that a deep out of the money put could be exercised early to realize the cash flow early. In a negative rates world, we want to postpone the realization of cash (and avoid paying negative rates on that cash). Consequently, in a negative rates world, American puts would never be exercised early. Even the non dividend paying assumption is not needed for this result.

  • It is no longer true that the modified duration of a bond is slightly less than the duration; with negative rates, the modified duration of a bond is slightly more than the duration. Modified duration is given by MD=D/(1+r); if r is negative, the denominator is less than unity and the ratio is therefore more than the numerator.

  • Negative rates have not so far generally translated into negative coupons. For example, the Swiss Government and German Government have sold bonds with non negative coupons at a premium to par to achieve negative yields. If this trend continues, then in a negative rates world, there will be no par bonds and no discount bonds, and the concept of a par bond yield curve becomes problematic.

  • Over a period of time, probably negative coupon bonds will emerge. Warren Buffet’s Berkshire Hathaway sold a convertible bond with a negative coupon way back in 2002. With negative coupons, it is no longer true that the duration of a bond cannot exceed its maturity. It is also not true that for the same maturity, the zero coupon bond has the longest duration. For example, a simple calculation shows that a ten year par bond with a −1% coupon and a −1% yield has a duration of 10.47 years.

US corporate disclosure delays

Corporate disclosures rules in the US still permit long delays more appropriate to a bygone age before technology speeded up everything from stock trading to instant messaging. Cohen, Jackson and Mitts wrote a paper earlier this month arguing that substantial insider trading occurs during the four business day window available to companies to disclose material events. The paper studied over forty thousand trades by insiders that occurred on or after the event date and before the filing date; the analysis demonstrates that these trades (which may be quite legal) were highly profitable.

Cohen, Jackson and Mitts also document that companies do usually disclose information much earlier than the legal deadline: about half of the disclosures are made on the same day; and large firms are even more prompt in their filing. But nearly 15% of all filings use the full four day delay that is available. In the early 2000s, after the Enron scandal, the US SEC tried to reduce the window to two days, but gave up in the face of intense opposition. I think the SEC should require each company to monitor the median delay between the event and the filing, and provide an explanation if this median delay exceeds one day. Since there are on average about four filings per company per year, it should be feasible to monitor the timeliness over a rolling three year period.

Another troubling thing about the US system is the use of press releases as the primary means of disclosure. Last month, the SEC filed a complaint against a group of traders and hackers who stole corporate press releases from the web site of the newswire agencies before their public release. What I found most disturbing about this case was that the SEC went out of its way to emphasize that the newswire agencies were not at fault; in fact, the SEC redacted the names of the agencies (though it was not at all hard for the media to identify them). Companies disclose material events to a newswire several hours before the scheduled time of public release of this information by the newswire; the newswire agencies are not regulated by the SEC; they are not required to encrypt market sensitive data during this interregnum; there are no standards on the computer security measures that the newswires are required to take during this period; a group of relatively unsophisticated hackers had no difficulty hacking the newswire websites repeatedly over a period of five years. And the SEC thinks that no changes are required in this anachronistic system.


Get every new post delivered to your Inbox.

Join 2,205 other followers