## Friday, September 30, 2011

### Is there a case for supervision of alternative investment funds? A new working paper

The task of financial regulation can be broken up into consumer protection (where we worry about small consumers being cheated by financial firms), prudential regulation (where we worry about the possibility of bankruptcy of one financial firm) and systemic risk regulation (where we worry about the procyclicality of financial regulation). Everything that we do in financial regulation must be motivated by one of these three issues.

In the class of fund management mechanisms, there is one interesting special case: the alternative investment management mechanisms' which include hedge funds, private equity funds, venture capital, etc. The defining feature of these is that each customer places a large sum of money under the control of the fund manager. A typical value for the minimum ticket size is $1 million. Once this is done, it is no longer possible to argue that the investor is a small consumer who might be cheated by the fund manager. A person who places atleast$1 million with a fund manager has the capability and resources to protect his own interests. Hence, the mainstream strategy utilised all over the world has been to leave these fund managers completely unregulated.

Indeed, there has been a healthy competitive tension between these investment vehicles (which are unregulated) versus mutual funds (which are regulated). Large customers have the choice between going with mutual funds, where the cost of regulation is suffered, or going to an alternative investment mechanism where this cost is not suffered. If these customers feel the gains from regulation are not justified, they have the choice of walking away and not incurring the costs.

The world over, there are debates brewing about the need for hedge funds to begin disclosing regular information on performance, positions and counterparties to regulatory authorities. For example, the SEC recently proposed a rule requiring U.S.-based hedge funds to report such information to a new financial stability panel established under the Dodd-Frank Act. Unsurprisingly, hedge funds argued against this proposal, citing concerns that the government regulator responsible for collecting the reports could not guarantee that their contents would not eventually be made public.

In a recent paper, my coauthors Andrew J. Patton and Michael Streatfield and I examine one element of the relationship between a hedge fund and its customers: disclosure about returns. The paper is titled The reliability of voluntary disclosures: Evidence from hedge funds.

Hedge funds are notoriously protective of their proprietary trading models and positions, and generally disclose only limited information, even to their own investors. However they do voluntarily report their monthly returns and assets under management to a wider audience through one or more publicly available databases. These databases are widely used by researchers, current and prospective investors, and the media.

Our paper examines the reliability of these voluntary disclosures by hedge funds, by tracking snapshots of these hedge fund databases captured at different points in time between 2007 and 2011. In each vintage of these databases, hedge funds provide their entire historical records (rather than just the new performance information since the previous vintage). Using these data, we detect that older performance records of hedge funds are revised as a matter of course. Nearly 40% of the 18,000 or so hedge funds in our sample revise their previous returns at least once over the vintages that we consider.

We then categorize hedge funds in real-time into revising and non-revising funds, and find that on average revising funds significantly underperform non-revising funds, and have a higher risk of experiencing large negative returns. This suggests that mandatory, audited disclosures by hedge funds, such as those proposed by the SEC earlier this year, would be beneficial to investors and help to prevent such negative outcomes.

SEBI has recently put out a request for comments on a proposed strategy for regulation and supervision of alternative investment vehicles. Our paper can help in thinking about the issues faced in this field on the consumer protection, and analysing the policy choices faced there. While there is much merit to the mainstream strategy of leaving this industry unregulated, our paper suggests that a small dose of supervision, focusing on basic hygiene and motivated by consumer protection, may help.

## Tuesday, September 27, 2011

### Two seminars at NIPFP

Seminars by Sanjay Banerji (today) and Tarun Ramadorai (Thursday).

## Friday, September 23, 2011

### What in the world is happening to the rupee?

The INR/USD rate is now nudging Rs.50 to the dollar. This is a big move over a short period: a depreciation of 12.1 per cent over the 84 days from 1 July till 23 September.

### What fluctuations of the INR/USD can we reasonably expect?

After the rupee became a float, so far, it has had average volatility of roughly 9 per cent annualised. Roughly speaking, this means that over a one year horizon, the movement over a year would range between -18 per cent and +18 percent, with a 95 per cent probability. More extreme movements would happen with a 5 per cent probability.

Over a period of 84 days, roughly speaking, we'd have expected this 95 per cent range to run from -8.6 per cent to +8.6 per cent. Compared with that, a 12.1 per cent move is a bit unusual.

It's only a bit unusual because the historical volatility of the INR/USD, in the period of the float, was rather low. The USD/EUR rate, which is perhaps the world's most liquid market, has had an annualised volatility from January 1999 onwards of 10.3 per cent. The INR/USD has got to surely be more volatile than this, given the inferior liquidity of the INR and given the greater macroeconomic volatility in India. Hence, I think we should consider the 9 per cent vol, that was seen in the early days of the float, as relatively unusual. The future will most likely hold bigger values for this vol.

The implied volatility of the INR/USD at the NSE has reared up to values like 14 per cent annualised. That sounds more sensible to me.

We tend to do wrong by focusing too much on the bilateral INR/USD rate. In the recent days of distress, as fear has resurged, people have taken money out of everything under the sun and put it into US Treasury bills. This has given a strong dollar at the expense of essentially every other currency. Here's the picture for the INR, against the four major currencies of the world, from 1 July till 22 September:

 1 July 22 Sep. Depreciation (per cent) USD 44.585 48.821 9.50 EUR 64.804 66.103 2.00 JPY 0.553 0.636 15.01 GBP 71.720 75.481 5.24

The picture of the rupee is much more complex than that implied by simply watching the bilateral rupee/dollar rate.

### Can RBI block such a large depreciation?

Let's think through the steps which would follow if RBI tried to sell dollars in trying to prop up the INR:

• Global trading in the INR stands at roughly $75 billion a day. If you want to manipulate this market, you need a big stick. Small trades will do nothing. If preventing INR depreciation is the goal, RBI has to go into this with trades of$2 to $5 billion a day, with the willingness to stick it out for the long run. With reserves of$281 billion, there is not much hope here. Specifically, if RBI sells $80 billion in reserves, the market will see that. They will know that further rupee defence is now going to be hard (since$200 billion of reserves is starting to look like a small hoard), and speculators across the world will start betting that RBI's defence of the rupee will fail.
• Reserve money is only $275 billion. For each$27.5 billion that RBI sells, reserve money drops by 10%. At a difficult time like this, a sharp and sudden monetary tightening will be an unpleasant side effect of defending the rupee. (This trading can be sterilised, but that has its own problems. I just want to emphasise that selling reserves is not easy and is not a free lunch).
• The rational speculator knows that the exchange rate will eventually find its level. When RBI prevents a large INR depreciation today, they are giving a free lunch to the speculator, who would take a bet that INR would depreciate in the future. Specifically, it would be efficient for domestic and foreign investors to dump assets in India, take money out at (say) Rs.45 to the dollar which is the artificial price, wait for the gradual depreciation to Rs.50 to the dollar, and come back into India to buy back the same assets. This trade generates 11% returns over a short period and is thus very attractive. In other words, a defence of the rupee would trigger off an asset price collapse in India.

Meddling in the affairs of the currency market is thus highly ill-advised for a central bank.

### Should RBI try to block INR depreciation, even if they could?

Let us play a thought experiment where RBI had $2810 billion, i.e. 10x larger than what's with us today. In that case, RBI could play in the currency market, selling$2 to \$5 billion a day for a year without serious distress. Is this a good idea?

I would argue that this is not a good idea. When times are bad, the rupee should depreciate. This drives up the profit rates of all Indian tradeables firms and thus bolsters the economy.

Under a floating rate, in good times, the INR appreciates (which pulls back the exuberance of tradeables) and in bad times, the INR depreciates (which fuels profits and thus the physical investment in tradeables). This is arguably the only element of stabilisation in Indian macroeconomic policy.

### RBI is playing this mostly right

From early 2007 onwards, the INR has been quite flexible. In particular, after early 2009, RBI's trading on the market has tailed off. There have been a few months with minor amounts of trading by RBI. This trading has mystified me, since these small trades can do nothing to influence the price. In practice, the INR has been a float.

A floating exchange rate is exactly the right stance for difficult times like this. In bad times, the best thing that can happen for India is a big INR depreciation, thus bolstering the tradeables sector.

Let's evaluate an alternative policy platform: To peg the INR in normal times but to let go in difficult times. Is this feasible? Yes. But this is very disruptive: if economic agents have been given an implicit promise that the INR will not move, then the large move (which will surely come) would cause pain. It is far better to stay out of the market all the time, and create a trustworthy structure of expectations in the minds of economic agents about what the future holds.

We had a large depreciation in the crisis of 2008, and that served India well. In similar fashion, we should welcome the INR depreciation that is accompanying global gloom.

The only element of RBI policy where I have a major disagreement is communication. RBI has never used the words floating exchange rate. RBI needs to clearly communicate to the economy that the rupee is now a market determined exchange rate, and RBI is no longer in the business of trading in this market. There is greater clarity of thought at RBI as compared with the quality of communciation; the speech writing still suffers from twinges of 1960s economics.

### What is the collateral damage of a large INR depreciation?

There are three things that go wrong alongside a big INR depreciation:

1. Firms who have unhedged foreign currency borrowing get hurt, because they have to pay back more than anticipated. A person who borrowed Rs.100 (in unhedged USD) has to pay back Rs.110, owing to the 10 per cent INR depreciation. The stock market is doing a fine job of identifying these firms and beating down their stock prices.
Of crucial importance is the fact that from early 2009 onwards, the INR had already moved to a float with a 9 per cent annualised vol. So CEOs and CFOs knew that the INR/USD rate was going to fluctuate. They were not lulled into complacence thinking that the exchange rate was going to be stable. By avoiding this moral hazard associated with pegged exchange rates, RBI's decision to float in early 2009 laid a good foundation for the structure of firm borrowing as of July 2011.
When a country has a pegged exchange rate, you tend to see a big buildup of unhedged currency exposure on corporate balance sheets. When the big depreciation comes, the big businessmen then queue up to the central bank begging for defence of the LCY. Prevention is better than cure: It is far better to have high exchange rate volatility all along, so that firms do not undertake such risks, and the toxic political economy does not come into play.
2. With an INR depreciation, tradeables become costlier. On one hand, this bolsters the profitability of tradeables firms, and thus their investment plans. But at the same time, this feeds into inflation. In recent months, tradeables inflation has been sleeping while non-tradeables have contributed to the high CPI-IW inflation. We will now see a resurgence of tradeables inflation. This will exacerbate the inflation crisis. RBI will need to stay on the project of raising rates in order to combat this inflation.
3. The government's subsidy program with petroleum products and fertilisers gets costlier when the INR depreciates. So India's fiscal crisis gets a bit worse when the INR depreciates.

This logic is rooted in high levels of de facto capital account openness. Sometimes, policy analysts think that you can have your cake and eat it too, and try to dodge these arguments by utilising capital controls. This has not worked in India, and the levels of de facto openness have only grown through the years.

### In summary, what should RBI be doing?

RBI should be focused on using the short-term interest rate as a tool to bring CPI-IW inflation under control, without distortions of interest rate policy caused by trying to meddle in the currency market. This should be accompanied by liberalisation of the Bond-Currency-Derivatives Nexus so as to achieve an effective monetary policy transmission. These are the two things that RBI needs to focus on.

India shifted away from government interference in the currency market, from 2007 onwards but particularly after 2009. This is one of the biggest achievements in India's economic liberalisation. This is a bigger issue in economic liberalisation than (say) decontrol of petroleum product prices. The INR is now a market. Nifty and INR are the two most important markets in the economy. It is time for all of us to analyse the INR as we analyse Nifty: as the outcome of a market process.

### Is RBI back to trading the INR?

We don't know. The data only comes out at monthly resolution, with a two month lag. But early signs that would show up would be unusual jumps in the weekly data about reserves, reserve money, etc. Greater transparency from their side would help greatly.

## Monday, September 19, 2011

A nice story about UIDAI, by Lydia Polgreen, in the New York Times.

A new insight into India's north-east states: they are part of a region provisionally named Zomia. An interesting article in the Chronicle of Higher Education by Ruth Hammond. The book.

On 21 April 1956, Jawaharlal Nehru did the first convocation address at IIT, Kharagpur. It's a good read, and it's surprising how much of it makes sense in 2011. E.g.: in the larger context of history, and looking at it in this way it seems to me that at the present moment there is no more exciting place to live in than India. Mind you, I use the word exciting. I did not use the word comfortable or any other soothing word, because India is going to be a hard place to live in. Let there be no mistake about it; there is no room for soft living in India, not much room for leisure, although leisure, occasional leisure is good. But there is any amount of room in India for living the hard, exciting, creative adventure of life. In case you have not yet seen the Steve Jobs commencement speech, it is worth watching.

How civilised: Literature festivals in India, by Abhilasha Ojha in Mint.

A fascinating story from rural India about the differences between boys and girls on mathematics, by Maia Szalavitz in Time magazine.

Who's to blame for India's inflation and India's Inflation Is a Lesson for Fast-Growing Economies by Alex Frangos in the Wall Street Journal.

When do stock futures dominate price discovery? by Nidhi Aggarwal and Susan Thomas, IGIDR working paper, has some surprising results.

Anupama Chandrasekaran and Vidya Padmanabhan, in Mint, on Indian ventures into farming in Ethiopia.

Raghu Dayal in the Business Standard on the huge opportunities in better India-Bangladesh relations.

Mobis Philipose in Mint, on recent developments in SEBI and on currency derivatives trading.

We need a Hazare in the financial sector by Tamal Bandyopadhyay in Mint. N. Sundaresha Subramanian in the Business Standard. Ex-SEBI member to PM: ID leaked, family at grave risk by P. Vaidyanathan Iyer in the Indian Express. CVC to Fin Min: Probe both sides' complaints by Ritu Sarin in the Financial Express. And, reportage in India Today. Spat between Abraham, SEBI, finance ministry gets murkier by Appu Esthose Suresh in Mint. Supreme Court wants petition on SEBI refiled by Nikhil Kanekal and Appu Esthose Suresh in Mint. A first and then a second article on these issues, by R. Jagannathan, on FirstPost. An editorial in the Business Standard. Subhomoy Bhattacharjee in the Financial Express.

R. Jagannathan on post offices as banks (on firstpost). And, you might like this related document.

China's A. Q. Khan problem: an article by Michael Wines in the New York Times.

A great story by Anthony Shadid in the New York Times about being on the run in Syria.

A great article by Paul Berman, in the New Republic, about Islamism.

Why is it so hard to find a suicide bomber these days by Charles Kurzman, in Foreign Policy.

Love and war, by Janine di Giovanni, in the New York Times.

What's next for the dollar? by Martin Feldstein.

Sussane Craig has a great profile, in the New York Times, of how Howard W. Lutnick brought Cantor Fitzgerald back to life after the firm was savaged in the 9/11 attacks.

## Sunday, September 18, 2011

### Market making versus the electronic limit order book

Exchanges in India all operate as electronic limit order book markets. There are no market makers'; there is just a publicly visible limit order book. Anyone is free to supply liquidity, by placing limit orders. The person who places market orders is the consumer of liquidity: he pays market impact cost. [A guide to the jargon].

Prior to the rise of the anonymous limit order book, there used to be a great deal of effort on thinking about the market maker. Market makers played a big role in many old markets. E.g. at the NYSE, the specialist' was obliged to provide liquidity. RBI established primary dealers' thinking that they would provide liquidity.

These market structures involved complicated problems of measuring the liquidity provision by market makers, correctly compensating them, avoiding monopoly power in the hands of the market market, and enforcing against market manipulation by the market maker. The rise of the open electronic order book cut through this Gordian knot.

For many years, there used to be a debate about whether the anonymous open limit order book market (where anyone can provide liquidity) is better or worse than a market maker market (where limit orders can only be placed by one or more market makers). That debate died down in the 1990s with the success of the electronic limit order book.

### Market making on the electronic limit order book

But even on a limit order book, does it make sense to pay one or more market makers to provide liquidity? The public would be free to place limit orders, but one or more market makers would be paid to place limit orders.

The positive argument runs like this. In the life of every contract, at first there is a lack of liquidity as various market participants are reluctant to take the plunge and trade on an illiquid contract. This leads to a chicken and egg problem. Illiquidity inhibits participation, and the lack of participation is illiquidity.

From a regulatory perspectives, exchanges might try to make payments for liquidity provision (or outright turnover) by various underhand means. If that is going to happen, then it is better to have this come out into the open.

But there are also important problems that can come out by going down this route. The resources that an exchange puts into portraying tight spreads or high turnover could potentially be used to improve services for customers. Market participants would make wrong decisions about an investment decision when they see a product as looking liquid on screen, whereas this liquidity is actually artificial: the screen would be falsely portraying liquidity. When exchanges compete on payments to market makers, this can degenerate into a slugfest where the deepest pockets win.

The artificial liquidity pushed by mercenary market makers would tend to lull the exchange into complacence. In the absence of market making, the exchange would run harder to solve problems of market mechanisms and contract design, and to get the word out about the contract.

### Recent developments in India

On 2 June 2011, SEBI chose to move ahead with the specification of a `Liquidity Enhancement Scheme' (LES).

By these rules, LES is applicable for individual stocks where the trading volume on the last 60 days is below 0.1 per cent of the market capitalisation. (How would this be scaled to derivatives such as currency futures, where market capitalisation cannot be defined?) I think this makes sense. The LES would be used to kickstart liquidity when it is abysmal. The moment a small amount of liquidity comes about, the LES would step aside.

Based on these rules, NSE announced a program for market making on the derivatives products recently launched at the exchange: on the S&P 500 and the Down Jones Industrial Average (launched in partnership with the Chicago Mercantile Exchange). These incentives are over and above the absence of charges by the exchange. I was disappointed to see a payment based on mere turnover. This would give the market maker an incentive to do circular trading and thus show a lot of trades. But turnover is not liquidity.

This program came into effect on 15 September. It may matter more in the coming week, given that new contract series start trading from tomorrow.

### Will it matter? How will we know that it mattered?

Derivatives on the S&P 500 and the Dow Jones indexes have gotten off to a surprisingly good start, even though there was no such program. This has perhaps been helped by unusual levels of volatility in the US after the launch of these contracts.

The early days of a contract can be a rollicking ride and even after these time-series fall into place, it will not be easy to tell whether LES was useful in the history of these contracts or not.

Similar thinking is taking place at BSE also: See Will BSE's biggest initiative work? by Mobis Philipose in Mint. The text there -- obligations such as providing two-way continuous quotes within specified parameters for quote size and spread -- sounds good, but here also there are payments per crore of turnover. By and large, the payments being made at BSE look much bigger than those at NSE.

In the case of BSE, if LES is able to lift BSE out of zero market share in derivatives trading, even after the six month period has expired, then it would be a clear proof that the LES helped. So this experiment is unlike that of NSE where it will be hard to evaluate whether or not the LES mattered.

## Wednesday, September 07, 2011

### The reversal of reforms on the New Pension System?

In December 2002, the NDA made a very big move in pension reforms. They decided that from 1/1/2004 onwards, all new staff recruited into the government would be switched out of the traditional defined-benefit pension and instead placed into a new individual-account defined contribution pension system. This was one of the major achievements of the economic reforms of that period. For a conceptual picture of the New Pension System (NPS), see this article, and for a story of that period, see this article.

An essential feature of the NPS was that it was a defined contribution system. India has a long history with getting into trouble with guaranteed returns. UTI's assured return schemes turned into a problem for the exchequer. EPS, run by EPFO, is bankrupt. When pension promises are made, they require peering into many decades into the future and arriving at estimates of longevity and asset returns. In the best of times, it is hard to make such estimates; honest mistakes are possible. In addition, when governance is weak, there are political pressures to make extravagant promises, which will look popular right now but generate staggering costs for the government in the future. As an example, rough calculations show that the implicit pension debt on account of the traditional civil servants pension in India (the one which was replaced by the NPS) stand at roughly 70% of GDP. This is a very big price to pay, for a tiny sliver of the workforce.

The NDA did the unpopular work of switching new recruits out of the defined benefit pensions. But the UPA did not follow through appropriately. At first, many years were lost in hoping that the CPI(M) would come on board the reform. After that, the legal engineering was put into place in order to get an NPS up and running without requiring the legislation. This process was slower than what one might have desired, but it has been making inexorable progress.

But now, a new existential threat seems to have come up : the Parliamentary Standing Committee on Finance seems to be saying that the fundamental idea of the NPS -- defined contributions -- should be scrapped. This would amount to a major reversal of India's economic reforms.

On this subject, see: