What is gained from cross-border exchange mergers?

by Ajay Shah.

Cross-border exchange mergers are in the news. See Indian exchanges must go regional and then global and Global mergers and Indian exchanges, by Jayanth Varma, who points us to LSE and TMX merge by Jeff Carter on Points and Figures. Also see Stock exchange mergers: the fight for global dominance in the Telegraph, and Big bourse mergers are back but hold the hyperbole by Benn Steil.

An article in the Economist, Back for more: Has the global exchange industry lost its marbles again?, is skeptical about various stories that are being told about exchange mergers, but holds forth the possibility that there might be cost savings:

Joining forces does not in itself realise revenue gains or alter this decline. But it may make it possible to combine the technology and back-office platforms being used by different exchanges, cutting costs. Efficiency savings are the one element of the last round of consolidation that did arrive as promised.

Cost savings are being emphasised again now. The Deutsche Borse and NYSE-Euronext combination should yield annual savings of  \$412m, the two firms say, equivalent to about a fifth of the combined entity's pre-tax profits, while the LSE-TMX deal should produce savings of about 7%.

In this article, I focus on the question: Is there a big opportunity for reducing cost through exchange mergers?

Getting a sense of the magnitudes

An exchange is an IT system that matches orders. The computational complexity of an exchange is all about taking in a lot of orders per second and computing a lot of trades per second. The output of the IT facility is purely measured by the number of orders that were produced. In the public domain, we see the number of trades, and not the number of orders. Hence, the number of trades is the best public domain source of the size of each exchange, from the viewpoint of cost.

To illustrate the magnitudes involved, last Friday, BSE got 34.1 million orders and did 1.94 million trades. This is an orders-to-trades ratio of 17.6:1 -- for each trade that BSE produces, they have to have the IT capacity to process 17 orders. The only way to get up to these kinds of values is by having a good deal of algorithmic trading.

The revenue per trade is, of course, very different across countries. In India, the average trade size on the equity spot market is \$500 and the tariff for the exchange is hence tiny: NSE or BSE earn Rs.0.65 or \$0.014 per trade. Using the above numbers, BSE's earning Rs.0.04 or \$0.000795 per order on average. These low low tariffs imply that the revenue, profit and valuation of an exchange in India is tiny when compared with what's seen abroad. But on the question of cost, there is direct comparability: it costs as much to produce a billion trades in India as it does anywhere else.

From this perspective, let's look at the biggest factories in the world that produce trades. This is data from the World Federation of Exchanges, for equity trades on the limit order book, in January 2011:

Rank	Exchange	'000 trades
1	NYSE Euronext	1,52,922
2	NSE	1,18,200
3	NASDAQ OMX	1,13,753
4	Shanghai SE	1,04,965
5	Korea Exchange	1,00,221
6	Shenzhen SE	76,268
7	BSE	35,157
8	Tokyo SE	27,557
9	Taiwan SE	20,313
10	London SE	19,132

Saving money through unification of data centres?

I do believe that in this business, there are economies of scale. To build a factory that produces twice the trades costs less than twice the money.

Does this mean that exchange mergers can create value? Not necessarily.

Let's take one plausible merger from the above. The London SE is a small exchange: they did 19.1 million trades in January. The BSE did 35.1 million trades.

Can one save money by producing 55 million trades in a single data centre? Yes.

Will a BSE+LSE merged entity drop down to one data centre? Of course not! The problem is the speed of light. Today, the conversations between securities firms and exchanges are reckoned in milliseconds. And in one millisecond, light only travels 300 km. So even without reckoning for switching overheads (which are huge!) it is not feasible to unify data centres apart from local mergers such as CME and CBOT.

Since light moves at a glacial pace, it is simply not feasible to beam orders from London to a data centre in Bombay. So even if BSE merged with London SE, there would be two data centres. This limits the cost saving. Until we find a way to speed up light, there is going to be no data centre consolidation in this business, other than within small geographical areas (e.g. within Chicago or within New York).

Saving money on software development?

Okay, let's look further. Could there be cost saving by building one software system and deploying it twice? We'd still spend money to run two data centres, but we'd have only one expense of building software. Could this work?

It's much harder than it sounds. It is not often that one gets to fully transplant an exchange software system in a new location: all too often, the systems have to be significantly different. Regulatory differences, local preferences, history, what users prefer and are used to: all these shape immense diversity in exchange systems. There can actually be diseconomies of scale, with engineering and political problems of handling multiple versions.

Another key problem lies in the sizing of the software system. An exchange system that works for BSE will generally involve a different set of engineering tradeoffs when compared with the LSE setting. So ground-up implementations could be more efficient. By this logic, there may be a useful role for cooperation between similar-sized exchanges (e.g. NSE and Shanghai), but not across divergent sizes which are more than 2x apart.

When decision makers think `a system' can be readily transported across highly diverse order intensities, without regard for the inefficiencies introduced in this process, I think this has something to do with the lack of engineering backgrounds among these decision makers. On a related note, there isn't much of a role for exchange software as a software product, other than in the zone of tiny exchanges where an android phone will suffice for order matching. By the time you get to anything in the top 20 exchanges of the world, an efficient implementation will involve large amounts of ground-up development.

A skeptical perspective

NYSE merged with Euronext. Did we see cost reductions? A lot was said about cost reduction at the time of the merger, but I haven't particularly seen evidence of this filtering out post-merger.

ASX-SGX: Will they drop down to one data centre? Of course not. Will they unify systems? What will be the cost of system unification? Does it make any sense to unify systems? It helps that both are similar-sized small exchanges, but the institutional settings are highly different.

NSE and NASDAQ produce a similar number of equity spot trades. In the latest year, NSE spends roughly \$150 million a year doing this, while NASDAQ spent \$850 million. (NSE produces derivatives trades also, and the NSE number includes the cost of the clearing corporation, so the cost-per-trade edge at NSE is probably of the order of 10x when compared with NASDAQ). The two exchanges are similar in size in terms of the trades per second. Yet, this is not an easy merger opportunity. There will certainly be no data centre unification. NSE's knowledge can be used to run the NASDAQ data centre more cheaply, but complex organisational dynamics would have to be navigated in achieving the transition, and this could take decades to pull off. It is hard to get management teams that are able to play for such long-term gains.

Also see Are exchange mergers always good? by Mobis Philipose in Mint.

There is one kind of exchange merger which I have become increasingly skeptical about: one in which a parent foists computer systems upon the recipient. I have started worrying that this is a bit of a con, a method to generate revenues from system sales under the garb of partnership or strategic alliances. This is done to some extent by firms that are primarily in the business of selling software and not in the business of running exchanges. Or, to the extent that high-cost exchanges are able to do this, the systems/software revenues are able to mask the deeper problem of a high cost structure.

I have watched the grand global deal-making between exchanges for a long time. In my reckoning, most of it has been a waste of time and money. As one specific example, in my observation in India, some foreign investments into Indian exchanges has been irrelevant, others have directly done damage. None has as yet helped improve product offerings or cost efficiency.

One contract that comes to my mind as one that really worked was Mutual Offset (MOS) between CME and SIMEX, which was done way back in 1984. This was one deal that really mattered and was a good idea. But it was useful in the age before capital account openness - such connections are less important today when capital flows freely anyway. And, remember that it was a mere contract, it involved no complications of ownership and management. So I do think there will be value if the Nifty futures on SGX, CME and NSE are all unified through a mutual offset system: but this does not require anything more complex than signing a contract.

Jayanth Varma says:

It is tragic that at this point of great opportunities and strategic challenges, the energies of Indian exchanges and their regulators are entirely consumed by the debate about whether exchanges should be regulated like public utilities

I disagree. The global exchange M&A story seems to be overrated, apart from the extent to which systems like MOS which can alleviate home bias (and only require contracts). There isn't much to gain there. On the other hand, the problem of sound regulation and supervision of exchanges in India is a GDP-scale issue. Indian experience and evidence does not support a complacent approach that the regulation and supervision will work out.

Acknowledgements

My thinking on this was improved through conversations with Ravi Apte and Ashish Chauhan.

Rapid buildup of currency options open interest

Today, on NSE, derivatives trading showed the following numbers:

Product class	Turnover (Billion rupees)
Index futures	353
Index options	1981
Stock futures	391
Stock options	48
Currency futures	178
Currency options	30
Total	2981

This is really something: Rs.2.98 trillion notional rupees in a day. It's starting to sound like a real market.

This data shows an incredible domination of Nifty futures and options. It also shows the massive success of Nifty options.

One element of the options to futures ratio with equities lies in the securities transactions tax, which has distorted the market in favour of options. In the case of currencies, this distortion is absent. Hence, the ratio of options to futures that we see there should reflect the undistorted applications of the products by the market.

Now that the NSE trading community has skills on options, the question arises: Do these skills readily port over into currency options? I believe they should: every good Nifty options trader is a good INRUSD options trader. The same options knowledge should pretty much carry over from equity stock or equity index options to currency options. In fact, with small modifications, the algorithmic trading that is being done on the equity options should readily deploy into the currency options.

So what does the evidence show? Currency options trading (INR/USD only, says the RBI) started on 29 October 2010. I have 117 trading days of data for the open interest of INRUSD options. Let's compare the rise of open interest starting from contract launch:

The early days of currency futures trading was hard work: the open interest got up to $0.2 billion and stopped growing. In contrast, open interest with currency options has grown very fast in these 117 days. At each contract expiration, it has been much bigger than the previous one.

As a consequence, INRUSD options open interest is now bigger than INRUSD futures open interest, even though the latter has been a market that has been around for much longer:

This is consistent with the story that the Nifty options brainpower would yield a rapid establishment of the currency options market. This also tells us that not all of the domination of equity options is a distortion caused by the differential securities transaction tax.

This rise of the options and futures open interest has done a great deal for the viability of enterprise-scale economic risk management using the currency futures and options, given that the position limit is linked to the overall open interest. The limit is now looking big enough to be of interest to even the biggest Indian companies.

Some older materials that you might like to see:

• Evolution of exchange traded derivatives, 1 June 2009.
  
• URLs for the two option chains.
  
• Who will make the exchange-traded currency options market, 5 December 2010.
  
• Currency futures: An example of how India changes, 22 April 2010.
  
• A book.

Jittery regimes fix prices

The puzzle

All of us are now curiously thinking about the abrupt phase transition that seems to sometimes occur in the endgame of an authoritarian regime. The traditional script was: The people rise up to rebel and the strongman murders them.

When the USSR collapsed, we thought it was special: it was a defunct regime that had just lost the will to live. But for the rest, the basic rulebook stood: the people get mowed down. And sure enough, that happened in Tiananmen Square.

But now, there are an increasing number of success stories with `velvet revolutions', and one has to think more carefully about what goes in an authoritarian regime.

Conflicts beneath the surface

What appears like a monolithic regime from the outside can actually often reflect a diverse array of interests tugging in different directions. In this beautiful article by Laurence Wright on Saudi Arabia, he says:

I had begun to look at Saudi society as a collection of opposing forces: the liberals against the religious conservatives, the royal family versus democratic reformers, the unemployed against the expats, the old against the young, men against women.

On that same thread, Why do protests bring down regimes? A follow up by Graeme Robertson says:

While the news media focus on "the dictator", almost all authoritarian regimes are really coalitions involving a range of players with different resources, including incumbent politicians but also other elites like businessmen, bureaucrats, leaders of mass organizations like labor unions and political parties, and, of course, specialists in coercion like the military or the security forces. These elites are pivotal in deciding the fate of the regime and as long as they continue to ally themselves with the incumbent leadership, the regime is likely to remain stable. By contrast, when these elites split and some defect and decide to throw in their lot with the opposition, then the incumbents are in danger.
So where do protests come in? The problem is that in authoritarian regimes there are few sources of reliable information that can help these pivotal elites decide whom to back. Restrictions on media freedom and civil and political rights limit the amount and quality of information that is available on both the incumbents and the opposition. Moreover, the powerful incentives to pay lip service to incumbent rulers make it hard to know what to make of what information there is.

I have also read others write similarly about China (but sadly, I do not have the reference): That in the absence of freedom of speech, the regime actually has no idea about where the problems lie, and is hence hypersensitive about criticism, and about solving the problems that it thinks do matter.

The behaviour of a jittery regime

Democracy matters in two ways. First, the regime has legitimacy. It is not worrying about a sudden upheaval that will destroy the regime. And, freedom of speech carries a steady flow of information to the regime. The UPA leadership does live in a bubble, but even they know that 8% inflation is a serious problem.

When a regime lacks legitimacy, and does not know what is going on, it is constantly fearful. It does not know what is going wrong and it can go off into extremes in trying to stave off some problems that it believes are first order. One area where this shows up is inflexible prices. To an external observer, it may be obvious that allowing price flexibility is better, but the regime is terrified about what will happen, so the price stays fixed.

Three examples

Egypt

In a blog post titled Garam Masala: Bread And The Life Of Egypt, Vikram Doctor writes:

I first realised how different Egypt was when I saw the bread in the street in Cairo. It was piled on low charpoy-like tables, thick rounds of freshlybaked bread, slightly scorched from the oven, a bit like tandoori rotis, but heavier.... Someone would replenish them from the bakery close by, and collect the money that people left, but nothing seemed to stop them just taking it away... the other reason why no one took the bread free was that it was so ridiculously cheap that they might as well just leave the few coins needed (in fact, buying bread seemed to be pretty much all that the piastre coins were used for). I calculated that, at that time (over 12 years back), the cost of a round of bread converted to something like three paise : something I could not imagine anything costing in any large Indian city. But this was the point: the price was unreal because a massive bread subsidy was one of the basic ways the Mubarak regime stayed in place.

Iran

From The regime tightens its belt and its first, in the Economist:

From top ayatollahs to the IMF, everyone agrees that spending $100 billion each year to pin down petrol, gas and electricity prices, besides the cost of staples such as flour and cooking oil, is a bad way to dispose of Iran's hydrocarbon revenues, accounting for more than 10% of GDP and encouraging waste on an epic scale. The symptoms of the malaise are legion: tea kettles simmer all day; the streets clog with recreational drivers out for a spin; lights glare because no one can be bothered to turn them off. `We can do it because we have oil,' Iranians used to tell incredulous visitors.

China

The outstanding price inflexibility of China is that of the exchange rate. Consider the Chinese and the Indian exchange rates of recent years:

There is a dramatic difference in the exchange rate flexibility. The Chinese authorities are extremely loath to allow the exchange rate to fluctuate, even though it induces massive distortions in the economy. Why? I would venture to guess that once a large export reprocessing sector has built up, the regime is just scared to rock the boat, to displease many workers.

The exchange rate is the most important price in any economy. A country that can handle a floating exchange rate is a flexible economy, one in which firms are born and die, workers move across locations and industries, and prices fluctuate. Deep and liquid markets are shock absorbers. Firms have ample equity capital, i.e. low leverage, so that they are able to absorb shocks. There is a whole configuration of institutional arrangements which are conducive to price flexibility. By and large, India fares well on these counts, particularly in the vast informal sector where there is extreme flexibility. And most of all, when things do hurt, individuals are able to express their discontent through democratic politics.

If India did not have these long-standing strengths, Governors Reddy and Subbarao would not have been able to move to a flexible exchange rate. And this exchange rate flexibility, in turn, enables an array of other economic reforms in favour of a market-based system.

Also see: The message for China from Tahrir Square by Minxin Pei in the Financial Times and The Secret Politburo Meeting Behind China's New Democracy Crackdown by Perry Link, on the New York Review of Books Blog.

Stability that is illusory

The regime change of recent years should make us think afresh about the notion of `political stability'. Democracy is always messy: demonstrations, machinations of party politics out in the open, colourful and often intemperate figures on television, elections, change in the ruling arrangement. But at a deeper level, this can be a more stable arrangement; there is no revolution at the end of the tunnel.

Similar reasoning applies in economics. Economists have always known that when prices appear to be stable, they often mask real trouble underneath. It is far better to have a small fluctuation every day, i.e. a steady flow of vol. The alternative -- of clamping down on price movements on most ordinary days -- merely yields big price movements on some days, which are far more difficult to handle.

Economic agents are not fooled by this stability on the surface. As Mark Roe says on Project Syndicate:

Even if all of the rules for finance are right, few will part with their money if they fear that an unfavorable regime change might occur during the lifetime of their investment.
More importantly, the grim stability of the type displayed by Hosni Mubarak's Egypt is oftentimes insufficient for genuine financial development. Authoritarian regimes, especially those with severe income and wealth inequality, inherently create a risk of arbitrariness, unpredictability, and instability. They are themselves arbitrary. And everyone knows that beneath the stability of the moment lurk explosive forces that can change the regime and devalue huge investments. Because financiers and savers have limited confidence in the future, such regimes can't readily build and maintain strong foundations for financial development.

Implications

This is a `capitalism and freedom' style argument: that democracy and markets interact in the double helix of modern civilisation.

Price flexibility works best when there is price flexibility in a lot of markets. If all prices were fixed, and you only freed up one, then it could easily make things worse. It is hard, crossing the hump, and reaching over to the other side where all prices are flexible. And, price flexibility goes well with democracy. Flexible prices are constantly disruptive. Every day, there are a few pockets of the economy that are really getting hurt in the creative destruction. It requires a confident regime to take these fluctuations in its stride. A jittery and illegitimate regime may be more likely to clamp down on price fluctuations since it fears these could destabilise it.

Interesting readings

My collection of links on the transition at SEBI from C. B. Bhave to U. K. Sinha.

How India's banks killed the future of commerce on the Cleartrip blog.

The defining problem of the Indian State is the tension between spending on program that benefit the few (e.g. the typical UPA welfare program) versus programs that benefit all (i.e. public goods). This problem even extends to skimping on resources for the judiciary. See Dhananjay Mahapatra in the Times of India.

Greasing our shock absorbers by Ila Patnaik in the Indian Express, 3 February 2011. And watch her talk about the economy.

There is quite a bit of debate in India about big government versus small government. On this subject, Blanca Moreno-Dodson and Nihal Bayraktar have a note How Public Spending Can Help You Grow: An Empirical Analysis for Developing Countries. They compare a set of fast-growing developing countries to a mix of developing countries with different growth patterns. Considering the full government budget constraint, the empirical analysis shows that public spending, especially its `core' components, contributes to economic growth only in countries that are capable of using funds for productive purposes. In addition, those countries must have an adequate economic policy environment with macroeconomic stability, openness, and private sector investments that are conducive to growth. Unfortunately, their definition of `productive and core sectors' reflects World Bank ideology, and does not focus on public goods.

IT strategy for the Goods and Services Tax.

A great article on Saudi Arabia by Laurence Wright.

Tunisia and Egypt continue to be incredibly important and riveting. I really enjoy the thought, however fatuous, about every strongman across the world sleeping a little less easy. See Why Egypt should worry China by Barry Eichengreen on Project Syndicate. On the East Asia Forum, Peter Beck tells the story about how the dictatorship collapsed in Korea. Robert L. Tignor on Project Syndicate locates the present discussion in Egyptian history.

Read this interview with Andreas Wesemann.

The wonderful world of Android: link, link.

Is Your Job an Endangered Species? by Andy Kessler in the Wall Street Journal.

Abrupt change in authoritarian regimes: Gary Becker, Richard Posner.

Reliance ADAG consent order

I have long had a complaint that the fines imposed in India for violations of law are too tiny. In SEBI's entire history, big fines - of more than Rs.10 million - have seldom arisen. The economic reasoning suggests that fines have to be way bigger than mere disgorgement, in order to reflect the imperfect probability of getting caught. Fines have to be big enough to really hurt the key decision makers. Only then will they exert an influence on the behaviour of the entire market.

SEBI recently came out with a consent order on certain irregularities in the trading of shares of Reliance Communications. Some of the penalties imposed are eye-popping. Applicant companies shall not make investments in listed securities for calendar 2011 and 2012. Individual applicants shall not trade in the market in calendar 2011. The individuals involved -- Anil Ambani, Satish Seth, S. C. Gupta, Lalit Jalan, J. P. Chalasani -- have paid a settlement amount of Rs.0.5 billion.

Are these penalties big enough to hurt? The corporate treasuries have been shut off from the secondary market for 2 years, the individuals from trading on the market for one year, and a payment of Rs.0.5 billion: I think this is big enough to hurt.

I applaud this development, of moving towards bigger penalties that are big enough to pinch the immense resources commanded by individuals and firms in modern India. At the same time, consent orders require immense regulatory capacity in government. It would have been all too easy for Dr. Abraham and others at SEBI to agree to a penalty which was one-tenth as large, in the negotiation that leads up to the consent order. Nobody in India would have criticised the SEBI leadership if the size of the settlement amount had been Rs.0.05 billion. But that would have made all the difference in shifting from a penalty that hurts, to a mere minor cost of business. It requires immense resources of integrity and toughness to do what SEBI has done.

We must move in this direction, of tough orders. These developments underline the criticality of the appointments process for SEBI and for other financial regulators. In an environment of unprecedented gloom about corruption in India, SEBI's progress on being a tough regulator with the highest ethical standards is noteworthy. It shows us something about the human energies that continue to be found in the Indian State, where some teams and individuals stubbornly stand up against the malpractice and corruption which is increasingly becoming the norm, despite the considerable firepower that crooks are able to command.

This order is one more pillar in the body of case law of C. B. Bhave's SEBI. I think of Bhave's achievement at SEBI as being a series of remarkable orders. SEBI is a quasi-judicial organisation and the technical quality of this organisation is all about the quality of orders that they are able to come up with. Alongside other famous orders -- Sahara, MCX-SX, HDFC AMC front running, ULIPs, Bank of Rajasthan, Pyramid Saimira -- this is a major achievement of SEBI in nailing wrong-doing and (more importantly) scaring off other would-be wrongdoers. For each firm that is visible as having been caught trying to violate rules, there are ten other entrepreneurs who have been dissuaded from similar business strategies by watching these events unfold.

Reliance ADAG consent order

by Shubho Roy and Pratik Datta.

The SEBI Consent order under discussion has garnered wide media attention. The total settlement amount sounds very large. Certainly, it is the largest `settlement amounts' ever collected by SEBI. One could argue that the settlement amount is large enough to deter such behaviour and prevent recurrence. However, if we are skeptical about the functioning of any government agency (as we all should be) we have to wonder. Whenever you consider the size of a fine, the most important thing to remember is that it is always relative. US$150 million sounds like a large amount for a fine. If I were to tell you that this is the total fine Union Carbide paid for the bhopal gas disaster, it does not seem very large.

The traditional method of enforcing laws/regulations in most regulators is through an enforcement action. The regulator sets up an investigation, collects evidence and then places it before an adjudicating body. The adjudicating body then gives the opposite party an opportunity to defend its actions. After both parties are heard, the adjudicating authority is required to record its decision along with the reasons for arriving at such a decision. This process is long and requires large amount of resources to be spent by all parties involved. In most cases the decision of the adjudicating body can be challenged in a court of law. This leads to another round of litigation and delays. Despite these drawbacks the judicial process has one important facet: transparency. The evidence presented, the reasoning and the decision are all open to scrutiny. Any person can look at the facts and decide whether the decision was fair or not. Consent orders are not the same. They function differently.

How do consent orders work? Going by the existing SEBI regulations:

1. The concerned entity offers the terms for a settlement, by itself, to SEBI.
   
2. This offer is considered and debated amongst an Internal Committee (IC) of Division Chiefs of SEBI.
   
3. If the IC accepts the terms it is forwarded to the High Powered Advisory Committee (HPAC) which is headed by a former judge of a High Court and other wise men.
   
4. The HPAC considers the terms and recommends whether they should be accepted, declined or modified.
   
5. Two Whole Time Members of SEBI take the final decision.

These different bodies are created to prevent collusion between the officials of SEBI and the entity offering the terms of settlement. The system is quite similar to the system of consent orders used by the Securities and Exchanges Commission (SEC) in the United States.

On one hand, it appears that SEBI has imported global best practices. At the same time, it is important to remain skeptical about this area. Global best practices often do not work when mechanically transplanted: each institutional arrangement needs to be analysed from scratch, with an aim of understanding how incentives and maximisation generate behaviour under Indian conditions.

The actions that SEBI has taken in the recent months show strong signs of integrity and a tough approach towards wrongdoing irrespective of the size and nature of the entities involved. However, consent orders by their very nature are dependent on other strong institutions. These include reasonable anti-corruption agencies and a general faith in the system of governance. Each of us will have to decided whether in the Indian context the system set up for consent orders can be considered safe or not. Consent orders are a positive part of the present environment, but at the same time all of us must apply the maximal skepticism in watching how consent orders are being produced.

Author: Shubho Roy

Shubho Roy is a researcher at the National Institute for Public Finance and Policy.

On this blog:

• The consequences of criminalising cheque bouncing, 24 February 2024.
• What ails public procurement: an analysis of tender modifications in the pre-award process, 26 November 2020.
• Does India need a public procurement law?, 19 August 2020.
• Pricing education: An example from Uttar Pradesh, 21 July 2020.
• India’s low interest rate regime in litigation, 11 March 2020.
• Delays in deposit insurance, 9 April 2019.
• The rise of government-funded health insurance in India, 21 January 2019.
• Concerns with Delhi Metro, 14 December 2018.
• Diagnosing and overcoming sustained food price volatility: Enabling a National Market for Food, 6 August 2018.
• Building State capacity for regulation in India, 17 July 2018.
• Fair play in Indian health insurance, 30 April 2018.
• Estimating the impact of the draft drone regulations, 19 March 2018.
• Analysing the NMC Bill #1: Composition of NMC, 29 January 2018.
• Cost of compliance for clinical establishments, 2 September, 2017
• Concerns about how the Medical Council of India thinks about medical malpractice, 1 July, 2017
• Understanding judicial delays in debt tribunals, 16 May, 2017
• Replace voice votes, 11 April, 2017
• Drafting hall of shame: A mistake in the Reserve Bank of India Act, 1934, 30 March 2017
• Sustainable strategy to eliminate vector-borne diseases, 28 February 2017
• The RBI board: Comparison against international benchmarks, 24 January 2017
• Methods for measurement of delays in the bankruptcy process, 25 November 2016.
• Questions of law in demonetisation, 18 November 2016.
• Runs on real estate companies?, 16 November 2016.
• Constitutional law, Brexit and the Bhopal encounter, 6 November 2016.
• India needs drones, 23 June 2016.
• Understanding judicial delays in India: Evidence from Debt Recovery Tribunals, 18 May 2016.

• The regulatory difficulties of NBFCs in India, 24 December 2015.
• Payment bank entry process considered inconsistent with the rule of law, 1 September 2015.
• Reducing delays in litigation by reshaping the incentives of litigants, 7 August 2015.
• Bureaucrats in business: The tension between rule of law and commercial considerations, 16 March 2015.

• Difficulties with Special Guidance and General Guidance in the IFC, 11 February 2014.

• From clubs to States: The future of self-regulating organisations, 19 December 2013.
• The saga of criminalising and then decriminalising cheque bouncing, 15 June 2013.
• Investigating ponzi schemes: A malady, 30 April 2013.

• Evaluating responses to India's macroeconomic crisis, 28 May 2012.
• Movement at SEBI towards principles-based regulation, 11 March 2012.

• Policy and legal review of the Micro Finance Institutions (Development & Regulation) Bill, 12 October 2011.
  
• Solving the problem of black money in real estate, 5 May 2011.
  
• Legal process in rule-making: A success story in an unexpected place, 15 April 2011
• Rule of law: A pair of stories, 14 March 2011.
• Reliance ADAG consent order, 18 February 2011.

• Transactions between banks in bad assets: An interesting legal drama, 7 October 2010.
• SEBI, IRDA & ULIPs: Hurried solutions lead to poor law, 24 June 2010.
  

Watching markets work: Bad move, Nokia

I have long marvelled about how quickly the world of mobile phones has rapidly moved through four paradigms. My first mobile phone was a Nokia and they seemed to rule. But then Blackberry won because Nokia did not get the importance of email. And then Apple won because Blackberry did not look beyond email. And then Google Android seems to have won because Apple did not understand the problems of a closed system. At each stage, it looked like there was a dominant solution, but the pace of change was brutal and the king of the heap was rapidly unseated. What an amazing pace of creative destruction.

So when I heard that Nokia was now going to be quite wedded to operating system from Microsoft [press release], I thought to myself ``That can't be so bright''. Then I looked at the stock price and it said:

So the market seems to have knocked Nokia down by 18% for wanting to run with a loser like Microsoft. And what's more funny, the market seems to have knocked Microsoft down 4% for this contract too (which I don't understand - compared with being wasteland, it seems that it is good news for Microsoft to have the support of Nokia).

How to measure inflation in India

Ila Patnaik, Giovanni Veronese and I have a paper titled How to Measure Inflation in India?. The abstract reads:

What is the best inflation measure in India? What inflation measure is most relevant for monetary policy making in India? Questions of timeliness, weights in the price index, accuracy of food price measurement, and inclusion of services prices are relevant to the choice of measure. We show that under present conditions of measurement, the Consumer Price Index for Industrial Workers (CPI-IW) is preferable to either the Wholesale Price Index or the GDP deflator.

You may like to see our stock of papers.

Inflation measurement in India may just get significantly better, with the release of the new CPI. The paper should help in evaluating this new CPI and in evaluating its applications.

The extent to which reform of the capital account is or should be irreversible

This blog post is joint work with Jeetendra.

One important part of capital account decontrol is commitment. If there is risk that capital controls will be brought back in the future, this can have a variety of unpleasant effects. If there is a fear of fresh restrictions coming in on inflows, a surge of money will rush into the country. If there is a fear of fresh restrictions coming in on outflows, a surge of money will rush out of the country. A long-term commitment to openness is required, in order to rule out such behaviour.

As a consequence, when a country moves to full convertibility, this requires not just the removal of restrictions. It also requires the removal of bureacratic process including reporting requirements. As long as forms have to be filled up for `automatic approval', this can easily swing back and become a capital control through breakdowns of rule of law (as has happened in India). See the MoF Working Group on Foreign Investment on issues of rule of law in India's capital controls. It is important to pour concrete on the decontrol so as to give confidence that the controls are gone.

We don't have the exact facts, but in the UK, when they moved to convertibility (back in the late 1970s) this was accompanied by dismantling of reporting requirements.

Korea is very open; there are no restrictions on capital flows. But Korea has kept the reporting requirements and through this, they have retained controls in a certain sense. The reason is that people fear that if they report transactions, then the government may come and investigate, and ask why they are doing it. They might also ask where the money is coming from. So, even though the rules may allow capital transactions, people -- especially individuals, but also small businesses -- remain very wary of these, and refrain from wiring large amounts in and out of the country, apart from some outward investments via mutual funds, where the government can't actually see who is sending the money out. Through this, reporting requirements perpetuate home bias and inhibit international economic integration.

Today we became aware of one mechanism through which some countries have committed themselves to an open economic system: When the US signs free trade agreements and bilateral investment treaties, there are provisions which limit the extent to which capital controls can then be brought back.

A curious letter has brought this to our notice. It says: Under these agreements, private foreign investors have the power to effectively sue governments in international tribunals over alleged violations of these provisions.. How interesting. So that locks down the possibility of a reversal of reforms in countries where the US has free trade agreements, and quite a few more where the US has bilateral investment treaties.

It makes sense for investment and trade treaties to mention capital controls. Trade and finance cannot really be separated: finance follows trade, and enhanced de facto integration in each feeds the other.

Trade requires currency risk management. When an Indian firm signs a long-term contract to buy/sell with invoicing in Yen, the Indian firm needs to be sure that Japan will stay open so as to enable INR/JPY hedging in the future.

If an MNC makes a direct investment in a country, it needs some assurance that it can bring in funds (equity and loans) to finance the investment, take them out when it wants to run down its operations, and repatriate profits in the meantime. It also needs to be able to hedge its currency exposure.

Hence, entering into trade/investment contracts today is assisted by confidence that liberalisation put in place today will still be there tomorrow.

More generally, there is a big difference between (a) a move today and (b) a move today + a commitment about behaviour tomorrow. Permanent tax cuts yield a much greater consumption response. Permanent capital account liberalisation leads to more FDI and trade. A variety of mechanisms need to be found through which reforms can be given stronger commitment so as to rule out risk of reversal in the future.

What is wrong with Economics

Raghuram Rajan has an interesting piece on what went wrong with the economics profession in the
years that led up to the global crisis. His big issues: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.

I think these, in turn, are directly related to the incentives of academic publishing. It's a recurring theme in agency theory: When the principal rewards the agent for performance in a certain direction, an excessive focus upon that comes about, and performance in other directions gets contaminated. When universities created an incentive structure linked purely to peer-reviewed journal pubs, economists focused on performing for each other, instead of performing for the world.

So in our diagnosis of the crisis, just as we criticise the HR policies of banks, we should also criticise the HR policies of universities.

While I'm quite aware of the narrowing of the mind that comes about from the Western-style process of focusing on pubs and tenure, it is not easy to find an alternative HR framework. George Stigler had a fascinating little article on this (which I was unable to find: do you know it?).

In India, in particular, the economics profession suffers from the twin maladies of low pressure and the historical baggage of development/socialist economics. On average, if an Indian economics department was given strong incentives to publish more, it would be an improvement. Performing for economists is better than not performing. At the same time, on the scale of mankind, it does seem that economists need to do more in terms of performing for the world.

Why does the publishing+tenure process work well in science and engineering? I have an opinion of one element that is in play there. In science and engineering, bringing in resources through research contracts is essential for doing research because research requires expensive equipment, staff, etc. There is, then, a joint production of academic publications alongside performing for the world (which allocates research funding). Hence, when the principal asked for academic publications, this did not generate a closing of the mind. In contrast, most research in economics in the top departments worldwide does not require bringing in external funding. So that source of pressure for performing for the world is absent.

Author: Jeetendra

• What is the role of WPI in monetary policy?, 22 July 2015.

• Mythbusting: Balance of payments edition, 6 July 2011.
• The extent to which reform of the capital account is or should be irreversible, 7 February 2011.

• Free your mind, 16 May 2009.

• The oil subsidy is causing an indigestion, 8 September 2008.
  

Interesting readings

Important new facts about the Bombay attacks, by Sebastian Rotella, on Propublica. It seems that we have a name and a face for the key handler of the murderers.

Vikram Doctor about how Bollywood is (not) growing up.

Why Bombay should envy London.

Maihar music lineage: first set of shows in Bombay, Calcutta, Bangalore, Delhi.

Samar Halamkar in the Hindustan Times on making expenditure programs of GOI work.

It appears that the Mubarak regime in Egypt is now at its end game. The most interesting question now is: Will Egypt turn into a normal country, or will there be a collapse into a fascist regime as happened with Iran? In order to understand this, it is useful to read about Iran's story (Abbas Milani in the National Interest) and Carrie Rosefsky Wickham in Foreign Affairs on the Muslim Brotherhood.

Do the events in Egypt change our prior about Iran, Saudi Arabia and China? Read Eric Abrahamsen in Foreign Policy and Willy Lam on AsiaSentinel on China. Egypt's lessons for Asia by Gavin M. Greenwood on AsiaSentinel.

Evan Fraser and Andrew Rimas in Foreign Affairs on food riots.

Howcome you never see a headline like Psychic wins lottery?. Are lotteries just a tax on dumb people? I read this great story about a statistician who figured out how to win the lottery.

Paul Krugman in the New York Times Magazine on Europe's currency crisis.

The art of good writing by Adam Haslett, in the Financial Times.

Importance of the appointments process

A memorable passage from When Irish eyes are crying, the story of Ireland's economic disaster by Michael Lewis, in Vanity Fair:

...the dominant narrative inside the head of the average Irish citizen -- and his receptiveness to the story Kelly was telling -- changed at roughly 10 o'clock in the evening on October 2, 2008. On that night, Ireland's financial regulator, a lifelong Central Bank bureaucrat in his 60s named Patrick Neary, came live on national television to be interviewed. The interviewer sounded as if he had just finished reading the collected works of Morgan Kelly. Neary, for his part, looked as if he had been dragged from a hole into which he badly wanted to return. He wore an insecure little mustache, stammered rote answers to questions he had not been asked, and ignored the ones he had been asked.

A banking system is an act of faith: it survives only for as long as people believe it will. Two weeks earlier the collapse of Lehman Brothers had cast doubt on banks everywhere. Ireland?s banks had not been managed to withstand doubt; they had been managed to exploit blind faith. Now the Irish people finally caught a glimpse of the guy meant to be safeguarding them: the crazy uncle had been sprung from the family cellar. Here he was, on their televisions, insisting that the Irish banks were ``resilient'' and ``more than adequately capitalized'' ... when everyone in Ireland could see, in the vacant skyscrapers and empty housing developments around them, evidence of bank loans that were not merely bad but insane. ``What happened was that everyone in Ireland had the idea that somewhere in Ireland there was a little wise old man who was in charge of the money, and this was the first time they'd ever seen this little man,'' says McCarthy. ``And then they saw him and said, Who the fuck was that??? Is that the fucking guy who is in charge of the money??? That's when everyone panicked.''

Better execution of complex IT systems in government

The TAGUP report has been released. For the background, see the creation of the group and this blog post. The ideas of the report could give a quantum leap in the execution quality of five projects of tremendous importance -- the Goods and Services Tax (GST), the Tax Information Network (TIN), the Expenditure Information Network (EIN), the National Treasury Management Agency (NTMA) and the New Pension System (NPS). In all these areas, political consensus has been achieved but the execution has floundered. More generally, these recommendations add up to an important fresh look at how to modify the ground rules of public administration in India, so as to better cope with the sorts of challenges that are now being faced.

Update (5 May 2011): Movement on implementation of TAGUP. 

C. B. Bhave's 3 years at SEBI

I first met C. B. Bhave when I walked into his office in September 1993. I was a freshly minted Ph.D. at the time. Speaking with him made a huge difference to my thinking about finance and markets.

He had clearly figured out the key building blocks of a revolution in the Indian capital market: electronic trading, clearing corporation, demutualisation, derivatives trading, depository, etc. Most Indian bureaucrats would have visited the trading floor of the LSE and the NYSE and replicated it. He had the strength of mind to look beyond `global best practices'. And from 1994 to 2001, the revolution went from ideas to action. It is hard to find an area of the Indian economy where the reforms were more successful.

The governance problem in finance spans two rather distinct problems: regulation (the making of rules) and supervision (the enforcement of rules). The best rules in the world are pointless if they are not backed by teeth. SEBI has shaped up as one of the best success stories in India's economic and commercial law, in the way rule of law has come to prominence. SEBI's orders are on their website. They are appealed at SAT. SAT processes cases rapidly. SAT is tough and competent. It's a great arrangement.

I remember, in the dark days where accusations about the `IPO Scam' were being bandied about, Bhave said to me that he remained confident that over the years, SEBI would sort itself out, thanks to the checks and balances that come with the rule of law. It is a message that we need to apply to all other financial regulators in India.

Bhave's SEBI made significant progress on strengthening the enforcement process leading up to good quality orders. On one hand, this required improvement of staff and processes. This is, of course, work in progress. A lot of work remains to be done before SEBI consistently writes high quality stuff. But the best orders of Bhave's SEBI are much superior to anything that came before. In addition, a strong enforcement process at SEBI required political toughness in not buckling under pressure.

It is, hence, not a surprise that his time at SEBI has been an exceptional one. Here are a few retrospectives on his time at SEBI:

• Editorial in the Financial Express, 21 February 2011.
• Old challenges, new Sebi chief: an editorial in Mint, 17 February 2011.
• When a top regulator asked C. B. Bhave to stop margining FIIs... by Sachin Mampatta in DNA, 18 February 2011.
• How Bhave transformed SEBI, by N. Sundaresha Subramanian, Anirudh Laskar & Pramit Bhattacharya, in Mint on 17 February 2011.
• Impartiality will be his legacy, by Ashish Rukhaiyar, in the Business Standard, 15 February 2011.
• An interview with C. B. Bhave with Gautam Chikermane, in the Hindustan Times, 13 February 2011.
• A show on CNBC Awaaz, featuring Sanjay Pugalia, S. P. Tulsian and me, mostly in Hindi: One, Two, Three.
• C. B. Bhave sets the bar high for SEBI's new Chairman UK Sinha in the Economic Times, 7 February 2011.
  
• Bhave's great service to the Indian securities market by Mobis Philipose in Mint, 31 January 2011.
  
• Bhave, a silent warrior for retail investors by Rajesh Abraham in Financial Chronicle, 31 January 2011.
  
• Great job, Mr. Bhave by Shobhana Subramanian in Financial Express, 15 December 2010.
  
• C. B. Bhave: In the eye of the storm by Tamal Bandyopadhyay in Mint, 8 August 2010.

India: a nascent social democracy?

As India embarks on the early stages of middle income, there is interest in a more expansive outlay of expenditure for the government. This motivates the question: Can India now embark on constructing an array of welfare programs, which would ultimately add up to an approximation to a welfare state or a social democracy?

Vijay Kelkar and I wrote a paper Indian social democracy: The resource perspective on this question, for the 10th `Indira Gandhi Conference' which took place in New Delhi recently.