Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

There are no irrelevant alternatives

To a Bayesian, almost everything is informative and therefore relevant. This means that the Independence of Irrelevant Alternatives axiom is rarely applicable.

A good illustration is provided by the Joint Staff Report on “The U.S. Treasury Market on October 15, 2014”. On that day, in the narrow window between 9:33 and 9:45 a.m. ET, the benchmark 10-year US Treasury yield experienced a 16-basis-point drop and then rebounded to return to its previous level. The impact of apparently irrelevant alternatives is described in the Staff Report as follows:

Around 9:39 ET, the sudden visibility of certain sell limit orders in the futures market seemed to have coincided with the reversal in prices. Recall that only 10 levels of order prices above and below the best bid and ask price are visible to futures market participants. Around 9:39 ET, with prices still moving higher, a number of previously posted large sell orders suddenly became visible in the order book above the current 30-year futures price (as well as in smaller size in 10-year futures). The sudden visibility of these sell orders significantly shifted the visible order imbalance in that contract, and it coincided with the beginning of the reversal of its price (the top of the price spike). Most of these limit orders were not executed, as the price did not rise to their levels.

In other words, traders (and trading algorithms) saw some sell orders which were apparently irrelevant (nobody bought from these sellers at those prices), but this irrelevant alternative caused the traders to change their choice between two other alternatives. Consider a purely illustrative example: just before 9:39 am, traders faced the choice between buying a modest quantity at a price of say 130.05 and selling a modest quantity at a price of 129.95. They were choosing to buy at 130.05. At 9:39, they find that there is a new alternative: they can buy a larger quantity at a price of say 130.25. They do not choose this new alternative, but they change their earlier choice from buying at 130.05 to selling at 129.95. This is the behaviour that is ruled out by the axiom of the Independence of Irrelevant Alternatives.

But if one thinks about the matter carefully, there is nothing irrational about this behaviour at all. At 8:30 am, the market had seen the release of somewhat weaker-than-expected US retail sales data. Many traders interpreted this as a memo that the US economy was weak and needed low interest rates for a longer period. Since low interest rates imply higher bond prices, traders started buying bonds. At 9:39, they see large sell orders for the first time. They realize that many large investors did not receive this memo, or may be received a different memo. They think that their interpretation of the retail sales data might have been wrong and that they had possibly over reacted. They reverse the buying that they had done in the last few minutes.

In fact,the behaviour of the US Treasury markets on October 15 appears to me to be an instance of reasonably rational behaviour. Much of the action in those critical minutes was driven by algorithms which appear to have behaved rationally. With no adrenalin and testosterone flowing through their silicon brains, they could evaluate the new information in a rational Bayesian manner and quickly reverse course. The Staff Report says that human market makers stopped making markets, but the algorithms continued to provide liquidity and maintained an orderly market.

I expected the Staff Report to recommend that in the futures markets, the entire order book (and not just the best 10 levels) should be visible to all participants at all times. Given current computing power and communication bandwidth, there is no justification for sticking to this anachronistic practice of providing only limited information to the market. Surprisingly, the US authorities do not make this sensible recommendation because they fail to see the highly rational market response to newly visible orders. Perhaps their minds have been so conditioned by the Independence of Irrelevant Alternatives axiom, that they are blind to any other interpretation of the data. Axioms of rationality are very powerful even when they are wrong.

Regulating Equity Crowdfunding Redux

In response to my blog post of a few days back on regulating crowd funding, my colleague Prof. Joshy Jacob writes in the comments:

I agree broadly with all the arguments in the blog post. I would like to add the following.

  1. If tapping the crowd wisdom on the product potential is the essence of crowdfunding, substituting that substantially with equity crowdfunding may not be a very good idea. While the donation based crowdfunding generates a sense of the product potential by way of the backings, the equity crowdfunding by financiers would not give the same, as their judgments still need to be based on the crowd wisdom. Is it possible to create a sequential structure involving donation based crowdfunding and equity based crowdfunding?

  2. Unlike most other forms of financing, the judgement in crowdfunding is often done sitting far away, without meeting the founders, devoid of financial numbers, and therefore almost entirely based on the campaign material posted. This intimately links the central role of the campaign success to the nature of the promotional material and endorsements by influential individuals. Evolving a role model for the multimedia campaigns would be appropriate, given the ample evidences on behavioral biases in retail investor decision making.

Both these are valid points that the regulator should take into account. However, I would worry a bit about people gaming the system. For example, if the regulator says that a successful donation crowdfunding is a prerequisite for equity crowdfunding, there is a risk that entrepreneurs will get their friends and relatives to back the project in a donation campaign. It is true that angels and venture capitalists rely on crowdfunding campaign success as a metric of project viability, but I presume that they would have a slightly greater ability to detect such gaming than the crowd.

Regulating Equity Crowdfunding

Many jurisdictions are struggling with the problem of regulating crowd funding. In India also, the Securities and Exchange Board of India issued a consultation paper on the subject a year ago.

I believe that there are two key differences between crowd funding and other forms of capital raising that call for quite novel regulatory approaches.

  1. Crowd funding is for the crowd and not for the Wall Street establishment. There is a danger that if the regulators listen too much to the Wall Street establishment, they will produce something like a second tier stock market with somewhat diluted versions of a normal public issue. The purpose of crowd funding is different – it is to tap the wisdom of crowds. Crowd funding should attract people who have a passion for (and possibly expertise in) the product. Any attempt to attract those with expertise in finance instead of the product market would make a mockery of crowd funding.

  2. The biggest danger that the crowd funding investor faces is not exploitation by the promoter today, but exploitation by the Series A venture capitalist tomorrow. Most genuine entrepreneurs believe in doing well for their crowd fund backers. After all, they share the same passion. Everything changes when the venture capitalist steps in. We have plenty of experience with venture capitalists squeezing out even relatively sophisticated angel investors. The typical crowd funding investor is a sitting duck by comparison.

What do these two differences imply for the regulator?

  • A focus on accredited investors would be a big mistake when it comes to crowd funding. These accredited investors will look for all the paraphernalia that they are accustomed to in ordinary equity issues – prospectuses, financial data and the like.

  • The target investor in a technology related crowd funding in India might in fact be a young software professional in Bangalore who is an absolute nerd when it comes to the product, but has difficulty distinguishing an equity share from a convertible preference share.

  • Disclosure should be focused on the people and the product. Financial data is meaningless and irrelevant. As in donation crowd funding, the disclosure will not be textual in nature, but will use rich multimedia to communicate soft information more effectively.

  • Equity crowd funding should be more like donation crowd funding with equity securities being one of the rewards. This implies that the vast majority of investors should be investing tiny amounts of money – the sort of money that one may spend on a dinner at a good restaurant. It should be money that one can afford to lose. In fact, it should be money that one expects to lose. Close to half of all startups probably fail and one should expect similar failure rates here as well.

  • If such small amounts of money are involved, transaction costs have to be very low. No regulatory scheme is acceptable if it will not work for small investments of say USD 50-100 in developed markets and much lower in emerging markets (say INR 500-1000 in India).

  • Some regulatory mechanisms need to be created for protecting the crowd in future negotiations with angels, venture capitalists and strategic buyers. Apart from some basic anti dilution rights, we need some intermediary (similar to the debenture trustee in debt issues) who can act on behalf of all investors to prevent them from being short changed in these negotiations. Going even further, perhaps even something similar to appraisal rights could be considered.

  • Regulatory staff who work on crowd funding regulations should be required to spend several hours watching donation crowd funding campaigns on platforms like Kickstarter and Indiegogo to develop a better appreciation of the activity that they are trying to regulate.

In the spirit of crowd sourcing, I would like to hear in the comments on what a good equity crowd funding market should look like and how it should be regulated. Interesting comments may be hoisted out of the comments into a subsequent blog post.

In the sister blog during June 2015

The following posts appeared on the sister blog (on Computing) last month.

Head in the clouds, feet on the ground: Part II (Feed Reader)

Head in the cloud, feet on the ground: Part I (email)

We must not mandate retention of all digital communications

After careful thought, I now think that it is a bad idea to mandate that regulated entities should store and retain records of all digital communications by their employees. Juicy emails and instant messages have been the most interesting element in many prosecutions including those relating to the Libor scandal and to foreign exchange rigging. Surely it is a good thing to force companies to retain these records for the convenience of prosecutors.

The problem is that today we use things like instant messaging where we would earlier have had an oral conversation. And there was no requirement to record these oral conversations (unless they took place inside specified locations like the trading room). The power of digital communications is that they transcend geographical boundaries. The great benefit of these technologies is that an employee sitting in India is able (in a virtual sense) to take part in a conversation happening around a coffee machine in the New York or London office.

Electronic communications can potentially be a great leveller that equalizes opportunities for employees in the centre and in the periphery. In the past, many jobs had to be in London or New York so that the employees could be tuned in to the office gossip and absorb the soft information that did not flow through formal channels. If we allowed a virtual chat room that spans the whole world, then the jobs too could be spread around the world. This potential is destroyed by the requirement that conversations in virtual chat rooms should be stored and archived while conversations in physical chat rooms can remain ephemeral and unrecorded. Real gossip will remain in the physical chat rooms and the jobs will also remain within earshot of these rooms.

India as a member of the G20 now has a voice in global regulatory organizations like IOSCO and BIS. Perhaps it should raise its voice in these fora to provide regulatory space for ephemeral digital communications that securely destroy themselves periodically.

Revolving door and favouring future employers

Canayaz, Martinez and Ozsoylev have a nice paper showing that the pernicious effect of the revolving door (at least in the US) is largely about government employees favouring their future private sector employers. It is not so much about government employees favouring their past private sector employers or about former government employees influencing their former colleagues in the government to favour their current private sector employers.

Their methodology relies largely on measuring the stock market performance of the private sector companies whose employees have gone through the revolving door (in either direction) and comparing these returns with a control group of companies which have not used the revolving door. The abnormal returns are computed using the Fama-French-Carhart four factor model.

The advantage of the methodology is that it avoids subjective judgements about whether for example, US Treasury Secretary Hank Paulson favoured his former employer, Goldman Sachs, during the financial crisis of 2008. It also avoids having to identify the specific favours that were done. The sample size also appears to be reasonably large – they have 23 years of data (1990-2012) and an average of 62 revolvers worked in publicly traded firms each year.

The negative findings in the paper are especially interesting, and if true could make it easy to police the revolving door. All that is required is a rule that when a (former) government employee joins the private sector, a special audit would be carried out of all decisions by the government employee during the past couple of years that might have provided favours to the prospective private sector employer. In particular, the resistance in India to hiring private sector professionals to important government positions (because they might favour their former employer) would appear to be misplaced.

One weakness in the methodology is that companies which anticipate financial distress in the immediate future might hire former government employees to help them lobby for some form of bail out. This might ensure that though their stock price declines due to the distress, it does not decline as much as it would otherwise have done. The excess return methodology would not however show any gain from hiring the revolver because the Fama French excess returns would be negative rather than positive. Similarly, companies which anticipate financial distress might make steps (for example, campaign contributions) that make it more likely that their employees are recruited into key government positions. Again, the excess return methodology would not pick up the resulting benefit.

Just in case you are wondering what all this has to do with a finance blog, the paper says that “[t]he financial industry, … is a substantial employer of revolvers, giving jobs to twice as many revolvers as any other industry.” (Incidentally, Table A1 in their paper shows that including or excluding financial industry in the sample makes no difference to their key findings). And of course, the methodology is pure finance, and shows how much information can be gleaned from a rigorous examination of asset prices.

On may versus must and suits versus geeks

On may versus must and suits versus geeks

On Monday, the Basel Committee on Banking Supervision published its Regulatory Consistency Assessment Programme (RCAP) Assessment of India’s implementation of Basel III risk-based capital regulations. While the RCAP Assessment Team assessed India as compliant with the minimum Basel capital standards, they had a problem with the Indian use of the word “may” where the rest of the world uses “must”:

The team identified an overarching issue regarding the use of the word “may” in India’s regulatory documents for implementing binding minimum requirements. The team considers linguistic clarity of overarching importance, and would recommend the Indian authorities to use the word “must” in line with international practice. More generally, authorities should seek to ensure that local regulatory documents can be unambiguously understood even in an international context, in particular where these apply to internationally active banks. The issue has been listed for further reflection by the Basel Committee. As implementation of Basel standards progresses, increased attention to linguistic clarity seems imperative for a consistent and harmonised transposition of Basel standards across the member jurisdiction.

Section 2.7 lists over a dozen instances of such usage of the word “may”. For example:

Basel III paragraph 149 states that banks “must” ensure that their CCCB requirements are calculated and publicly disclosed with at least the same frequency as their minimum capital requirements. The RBI guidelines state that CCCB requirements “may” be disclosed at table DF-11 of Annex 18 as indicated in the Basel III Master Circular.

Ultimately, the RCAP Assessment Team adopted a pragmatic approach of reporting this issue as an observation rather than a finding. They were no doubt swayed by the fact that:

Senior representatives of several Indian banks unequivocally confirmed to the team during the on-site discussions that there is no doubt that the intended meaning of “may” in Indian banking regulations is “shall” or “must” (except where qualified by the phrase “may, at the discretion of” or similar terms).

The Indian response to the RCAP Assessment argues that “may” is perfectly appropriate in the Indian context.

RBI strongly believes that communication, including regulatory communications, in order to be effective, must necessarily follow the linguistics and social characteristics of the language used in the region (Indian English in this case), which is rooted in the traditions and customs of the jurisdiction concerned. What therefore matters is how the regulatory communications have been understood and interpreted by the regulated entities. Specific to India, the use of word “may” in regulations is understood contextually and construed as binding where there is no qualifying text to convey optionality. We are happy that the Assessment Team has appreciated this point.

I tend to look at this whole linguistic analysis in terms of the suits versus geeks divide. It is true that in Indian banking, most of the suits would agree that when RBI says “may” it means “must”. But increasingly in modern finance, the suits do not matter as much as the geeks. In fact, humans matter less than the computers and the algorithms that they execute. I like to joke that in modern finance the humans get to decide the interesting things like when to have a tea break, while the computers decide the important things like when to buy and sell.

For any geek worth her salt, the bible on the subject of “may” and “must” is RFC 2119 which states that “must” means that the item is an absolute requirement; “should” means that there may exist valid reasons in particular circumstances to ignore a particular item; “may” means that an item is truly optional. I will let Arnold Kling have the last word: “Suits with low geek quotients are dangerous”.

Back from vacation

My long vacation provided the ideal opportunity to reflect on the large number of comments that I received on my last blog post about the tenth anniversary of my blog. These comments convinced me that I should not only keep my blog going but also try to engage more effectively with my readers. Over the next few weeks and months, I intend to implement many of the excellent suggestions that you have given me.

First of all, I have set up a Facebook page for this blog. This post and all future blog posts will appear on that page so that readers can follow the blog from there as well. My blog posts have been on twitter for over six years now and this will continue.

Second, I have started a new blog on computing with its own Facebook page which will over a period of time be backed up by a GitHub presence. I did not want to dilute the focus of this blog on financial markets and therefore decided that a separate blog was the best route to take. At the end of every month, I intend to post on each blog a list of posts on the sister blog, but otherwise this blog will not be contaminated by my meanderings in fields removed from financial markets.

Third, I will be experimenting with different kinds of posts that I have not done so far. This will be a slow process of learning and you might not observe any difference for many months.

Reflections on tenth anniversary

My blog reaches its tenth anniversary tomorrow: over ten years, I have published 572 blog posts at a frequency of approximately once a week.

My first genuine blog post (not counting a test post and a “coming soon” post) on March 29, 2005 was about an Argentine creditor (NML Capital) trying to persuade a US federal judge (Thomas Griesa) to attach some bonds issued by Argentina. The idea that a debtor’s liabilities (rather than its assets) could be attached struck me as funny. Ten years on, NML and Argentina are still battling it out before Judge Griesa, but things have moved from the comic to the tragic (at least from the Argentine point of view).

The most fruitful period for my blog (as for many other blogs) was the global financial crisis and its aftermath. The blog posts and the many insightful comments that my readers posted on the blog were the principal vehicle through which I tried to understand the crisis and to formulate my own views about it. During the last year or so, things have become less exciting. The blogosphere has also become a lot more crowded than it was when I began. Many times, I find myself abandoning a potential blog post because so many others have already blogged about it.

When I look back at the best bloggers that I followed in the mid and late 2000s, some have quit blogging because they found that they no longer had enough interesting things to say; a few have sold out to commercial organizations that turned these blogs into clickbaits; at least one blogger has died; some blogs have gradually declined in relevance and quality; and only a tiny fraction have remained worthwhile blogs to read.

The tenth anniversary is therefore less an occasion for celebration, and more a reminder of senescence and impending mortality for a blog. I am convinced that I must either reinvent my blog or quit blogging. April and May are the months during which I take a long vacation (both from my day job and from my blogging). That gives me enough time to think about it and decide.

If you have some thoughts and suggestions on what I should do with my blog, please use the comments page to let me know.

How does a bank say that its employees are a big security risk?

Very simple. Describe them as your greatest resource!

In my last blog post, I pointed out that the Carbanak/Anunak hack was mainly due to the recklessness of the banks’ own employees and system administrators. Now that they are aware of this, banks have to disclose this as another risk factor in their regulatory filings. Here is how one well known US bank made this disclosure in their Form 10K (page 39) last week (h/t the ever diligent

We are regularly the target of attempted cyber attacks, including denial-of-service attacks, and must continuously monitor and develop our systems to protect our technology infrastructure and data from misappropriation or corruption.

Notwithstanding the proliferation of technology and technology-based risk and control systems, our businesses ultimately rely on human beings as our greatest resource, and from time-to-time, they make mistakes that are not always caught immediately by our technological processes or by our other procedures which are intended to prevent and detect such errors. These can include calculation errors, mistakes in addressing emails, errors in software development or implementation, or simple errors in judgment. We strive to eliminate such human errors through training, supervision, technology and by redundant processes and controls. Human errors, even if promptly discovered and remediated, can result in material losses and liabilities for the firm.


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