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Thursday, August 27, 2015

How to think about one rank one pensions

Monday, August 10, 2015

Witch hunt against PNs considered harmful

by Susan Thomas.

A slightly different version of this appeared in the Indian Express today.

The Supreme Court appointed SIT on black money has asked that the ultimate beneficiary owner of every Participatory Note (PN) be traced. This brings back an old mistrust from nearly a decade ago, which careful examination suggests is misplaced. PNs help India better integrate into the global financial system. When India fixes her financial systems to become more competitive, these very PN customers will bring their business onshore.

What are PNs? PNs are one way that international investors can invest in Indian assets today. When this investor wants to invest in an Indian firm, they buy a contract from financial firms in their country. In turn, these financial firms may either choose to invest in the Indian asset. Or they can ``replicate'' Indian returns by doing financial engineering using other securities.

The investor buys a PN from a SEBI-registered Foreign Porfolio Investor (FPI). Let us call this registered FPI a "PN seller". Many times, one firm comes to buy a contract from the PN seller, and at the same time another person comes to sell it. The PN seller makes money charging fees to both. No back-to-back transaction takes place in India. The PN seller is "running a book". Sometimes the PN seller sells 100 to one person and buys 80 from another. This leaves an imbalance of 20 on his book. This net imbalance shows up as a trade in India when the FPI sells the security. This imbalance is reported as PN trades to SEBI. The PN seller is continuously selling contracts to end-users and adjusting his position in India reflecting the net imbalance. There are a number of such PN sellers in the world. Their activities are good for India because they connect the world of global finance into India.

So, PNs are a reflection of the world investment community's interest in Indian assets. When India grows, this interest will grow. The puzzle with PNs is why they exist at all. Why does the international financial investor buy a PN and not come into India directly? As with everything in finance, it about getting the best (lowest) price. There are several mistakes in Indian policy where directly trading in India means a higher price.

Three policy mistakes

India has a policy mistake in the form of the securities transaction tax (STT). Trades on Indian exchanges are charged the STT. There is no such cost for the global investor when they buy from their domestic financial firm. PN sellers are domiciled in places like London, New York or Singapore, where tax policy is done correctly and transactions are not taxed. Since the PN seller only sends his net imbalance as trades to India, the burden of the STT is lower. So customers send their orders to PN sellers.

India has policy mistakes in the form of taxation of non-residents, other than the Mauritius/Singapore channel. Some foreign investors invest in India through Mauritius or Singapore to achieve residence-based taxation. Others send their business to PN sellers, who are domiciled in places like New York, London or Singapore, where financial activities of non-residents are tax exempt, and have worked out Mauritius/Singapore vehicles to do trades in India. Hence, the PN business is helping India obtain non-resident participation in the economy, by avoiding the consequences of our flawed approach to taxation of non-residents.

India has policy mistakes on capital controls. For example, India makes it difficult for anyone to take a position on currency futures in excess of $15 million. PN sellers are domiciled in places like New York, London or Singapore, where financial regulation makes no such mistakes. By buying from a PN seller, the customer avoids this problem.

Hankering after the ultimate beneficial owner

Indian authorities want to know the ultimate beneficiary of a PN transaction. This is incorrect for three reasons.

  1. The PN related trades in India are a reflection of a net position between all buyers and sellers, it is impossible to ask who exactly is the ultimate beneficiary owner.
  2. It is when an investigation starts, that the regulator has the ability to trace the links of the chain. This suffices for regulators in 33 of the FATF signatory countries, alongside India. India is the only country asking for information about the ultimate beneficiary owner at all times.
  3. Insisting on the knowledge of the ultimate beneficiary owner will likely cause a push-back against India's attempt at extra-territorial jurisdiction. If a person in India buys a derivative in India and sells it to an investor in London, India does not have the right to ask about the London investor unless in the context of an investigation, and in cooperation with the authorities in London. Strong arm tactics for unreasonable information requests will drive up the cost of doing business in India. This is not in our interest.


To conclude, Indian regulators and Indian tax authorities, amongst others, have long expressed concerns about PN. A better understanding about how the PN market serves India's interest shows that this concern is misplaced. This market provides a valuable service by giving global investors a lower cost channel into Indian investments. Without this market, the cost to the global investment community in Indian investments would go up, their engagement with India would go down. This is not in India's interest. If we do want better knowledge about the beneficiary owner, we would do better to reform our tax policy, our capital controls and our financial regulation to bring the business directly into India. This would be far more effective in strengthing our regulatory control, without hampering much needed global investments into India.

Friday, August 07, 2015

SEBI's new "trade annulment" policy

by Nidhi Aggarwal, Chirag Anand.

One of the main functions of organised financial markets is efficient price discovery. Under certain circumstances, prices fail to reflect the correct information. These include erroneous trades or market manipulation. Trades at non informative prices impose significant costs on other market participants and the public at large. There can be a market failure in the form of a negative externality imposed on other market participants by way of distorted prices.

As has been found around the world, incidents of erroneous trades and market manipulation have been experienced in India, which have adversely affected the functioning of markets. Erroneous trades can occur either due to the so-called fat-finger trades, trades caused by bad algorithms, or buggy software. With the growth of algorithmic trading and an overall increase in the number and pace of orders entering the exchanges, the probability of such occurrences may increase.

In an attempt to address these concerns, in a circular dated July 16, 2015, the Securities and Exchange Board of India issued guidelines for annulment of trades by stock exchanges. These new provisions are required to be implemented by the exchanges within one month of the issue of the circular. The policy comes after a discussion paper released by SEBI in October 2013 on the same topic. The paper had sought public comments on a policy that proposed trade annulment on occurrence of erroneous trades under "exceptional circumstances". The Finance Research Group at IGIDR had responded to the discussion paper with an analysis of the proposed intervention by SEBI. We argued that the costs of cancelling trades under any circumstances are much higher than the benefits envisioned. The published regulation suffers from the same flaws that were present in the discussion paper.

The new framework

Traditionally, stock exchanges have been empowered to annul trades either suo moto, or on receipt of requests from stock brokers. Under the new regulation, the regulator has directed the stock exchanges to consider a trade annulment request if it is sent within 30 minutes of execution of the trade(s). This time limit can be extended to 60 minutes in case of "exceptional circumstances". The stock exchanges are required to communicate the receipt of such requests in a time bound manner to all market participants and convey a decision on the request not later than the start of next trading day. With respect to examining such requests, the circular mentions:

"2.5. .. While examining such requests, stock exchanges shall consider the potential effect of such annulment on trades of other stock brokers/investors across all segments, including trades that resulted as an outcome of trade(s) under consideration."

"2.7. Stock exchanges shall undertake annulment or price reset only in exceptional cases, after recording reasons in writing, in the interest of the investors, market integrity, and maintaining sanctity of price discovery mechanism."

In addition, stock exchanges are required to define "suitable" criteria so as to discourage frivolous trade annulment requests from stock brokers. The regulator has asked exchanges to charge stock brokers an annulment application fee which could range between Rs 1 lakh to Rs 10 lakh. The circular also says that the exchange shall penalise brokers who put in erroneous orders.

Evaluating the new framework

A clear policy on erroneous trades is a welcome step from the regulator, since a) it addresses the market failure induced by hurting the normal course of price discovery process, and b) it removes the uncertainty for other market participants on how such trades will be handled in the event of their occurrence. However, as has been argued on this blog before (see here, here and here), trade annulment is a bad solution for numerous reasons:

  1. Moral hazard: Bailing out trading firms by cancelling trades introduces moral hazard. These firms are supposed to have adequate risk control systems. With such an option in place, trading firms will be less careful in building high quality algorithms or trading systems.
  2. Deters market stabilising trading strategies: In the case of extreme events, two types of trading strategies help markets to recover: First, strategies that place orders far away from the touch, and second, the presence of active traders who come into the market to take opposite position. These strategies are often high risk strategies. Trade annulment will deter these traders to enter the market during stress events. This will reduce market resilience. The idea should instead be to make markets more resilient to such shocks.
  3. Hurts other market participants: Several market participants (especially the liquidity providers) generally take positions across several asset classes (example: equity spot and futures). Cancellation of trades on one asset class leaves them exposed to risk on the other leg.
  4. Leaves space for regulatory capture: The current policy essentially leaves the decision for trade annulment to the subjective satisfaction of the exchanges. Such vague powers give the exchanges undue power and leaves space for regulatory capture -- a dominant group of traders or large firms with large share in trading will stand to benefit under such a system, while day traders and other small traders will lose out. A previous instance of trade annulment by BSE after a trading error shows how giving powers to the exchanges to decide on trade annulment can result in undesired outcomes.
  5. Moral hazard in trading strategies: It is difficult to ascertain whether trade cancellation requests are made in good faith. Once the law allows that fat finger trades can be annulled, rogue traders can take advantage of that rule to enter into trades and get them cancelled subsequently. As an example, imagine the following steps: Long nifty vol followed by a big fat finger trade on Nifty spot followed by closeout of the options position.
  6. Ambiguity in language: Section 2.7 of the regulation uses the phrase "in the interest of the investors, market integrity". These are very broad terms, and, as discussed above, open to subjective interpretation by the exchanges. Such words should not be used when drafting law.

The issue of erroneous trades is analogous to the issues of industrial safety, where a failure occurs when a firm fails to deploy adequate safety measures to prevent catastrophic events. The Bhopal gas tragedy in 1984 is an example of such a failure. The gas leak accident at Union Carbide India Ltd. caused several deaths and affected many thousands of people. The firm failed to deploy enough resources to have developed a safety mechanism to avoid such a catastrophe.

By this reasoning, trade annulment should be prescribed only if the exchange's order matching software fouls up, or if there was a systematic breakdown of connectivity to the exchange. In all other circumstances, trade annulment is a poor strategy. It messes up the sanctity of order matching processes and questions the finality of trades. It provides wrong incentives to the doers of such acts and sets all the wrong precedents. A trading firm should be mandated to place proper checks and balances in their operations, and in the event of such a failure, should be penalised to compensate for the damage caused to other participants in the system.

Taking the example of other jurisdictions, internationally, such trades are cancelled only if the price movements are beyond certain thresholds. Even though such a practice is not recommended and often debated, there are clearly laid rules on when a trade will be termed as clearly erroneous. This leaves no ambiguity with respect to an exchange's decision on when a trade will be annulled versus not. The question of such thresholds does not arise in India since Indian exchanges already have hygiene checks in the form of margin money, price bands, circuit filters, pre-trade order limits, that should not allow large price movements beyond thresholds. Exchanges are responsible for maintaining and running perfectly functional systems with all these hygiene checks well in place. These systems should guarantee functionality and is a service provided by the exchange to the investors. Any failure in a service should be considered a breach of contract between the exchange and the investor, and the exchange should be penalised subject to the terms of the contract.

Good governance practices

The Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code issued by the Ministry of Finance in December 2013 states the good governance practices for issuing regulations. Section 4.4 'Comments on draft Regulations' of the handbook says:

"The regulator has to publish all representations received, and at least a general account of the response to the representations while publishing the final regulations."

SEBI has failed to publish an account of the representations made and explain why the clear criticisms were rejected.


SEBI's new policy on trade annulment does not address the issue of erroneous trades appropriately. If anything, it only leaves a great deal of ambiguity. Public policy thinking and regulation-making should be done in a more rational way.

Reducing delays in litigation by reshaping the incentives of litigants

by Shubho Roy.

Judicial delays are a major problem in India. There have been a number of attempts to solve these through introducing new legislation or tweaking existing laws. The tweaks usually involve putting ad-hoc numerical limits on the number of proceedings or delays. This approach has failed. A different approach is to create incentives for parties to not delay legal proceedings. This approach has been used worldwide with success. One example we show here, from the US, is Rule 68 of the Federal Rules of Procedure which sets up an interesting game to speed up litigation.

The problem

In enforcing contracts, India ranks 186 out of 189 countries. Judicial delays in criminal cases probably cause even more harm. To solve this problem the government has tried quite a few things. Amongst them are:

  1. The Arbitration Act and Conciliation Act, 1996 was made with the objective of providing litigating parties (mostly in commercial disputes) a system outside the court system through arbitrators, but within a legal system of the Arbitration Act. This law succeeded an older law of 1940 and was supposed to make India's law aligned with international law of arbitration.
  2. The Code of Civil Procedure which governs court proceedings in civil disputes was amended in 1999 (effective from 2002) requiring courts provide a maximum of three adjournments to a party in a case (times a party can delay a court proceeding for the day). This rule appears to be followed more in its breach. Similarly the costs imposed on parties for adjournments are puny compared to the actual costs in an adjournment. E.g.  Bombay caps costs for each days proceeding at Rs.100.

These attempts have not resulted in improved arbitration or reduced court delays. As a recent arbitration order against India in an arbitration under a bilateral investment treaty notes: An international investor could not enforce the arbitration award (i.e. legally collect the award) after winning the arbitration for a period of 8 years.

The government proposed an ordinance to amend the Arbitration Act, 1996 to speed up the process of arbitration. Amongst other changes, two key proposals are:

  1. A time of limit of 9 months for arbitrators to finish proceedings. If the time for proceedings exceeds the limit, the arbitrator will have to apply to the High Court to get an extension. The High Court may prevent arbitrators with long delays from taking up new proceedings.
  2. The government will cap total fees payable to an arbitrator.

These quantitative restrictions and price controls have three features:

  1. They are not new, and have been tried multiple number of times before.
  2. They have been a resounding failure in the past.
  3. They have many unintended consequences.

While speeding up arbitration is a step in the right direction, at the end if the losing party does not cooperate, the coercive power of the state has to be exercised. The Ease of Doing Business report notes that a contract enforcement in India involves 46 steps. Arbitration proceedings constitute only a fraction of those steps.

This award is symptomatic of what is wrong with squeezing the balloon in one place. We just create incentives for parties who want to litigate and delay to move their delaying tactics to other areas including:

  1. Appointment of arbitrators: When parties disagree whether an arbitration is required or who should be an arbitrator, the courts have to step in to start arbitration proceedings or appoint arbitrators. Parties unwilling to cooperate, will just use the same old delaying tactics in Indian courts to delay the appointment of arbitrators.
  2. Execution of arbitration awards: After winning an arbitration, the winning party still has to go to the court to force an unwilling losing party to pay up. Only a court order can block and transfer money out of a bank account or hold auction for a property of the loser. Again, this requires the winning party to go file an application before the court to get court official to assist in forcible takeover of properties, or get bank account records changed (usually called execution proceedings). The losing party can again use time tested delaying tactics in execution proceedings to lengthen out the suffering of the winning party.

Emphasising a single bad metric may have many bad unintended consequences. Arbitration proceedings should not be judged solely on the basis of time taken for the award. The quality of the award is also an important desirable feature of an arbitration. Arbitrary limits on time and fees work against the quality of the awards.

With the nine month deadline in the mind of arbitrators and a probable reduction of fees, the arbitrator will have the incentive to:

  1. Hurriedly finish arbitrations and push out a low quality award. Which will then be challenged in appeal before courts, thereby burdening the judiciary again.
  2. Take up more number of arbitrations to have the same level of income as before. This will have the same effect of pushing down the time and effort an arbitrator allocates to each case.

A single cost cap for arbitrator fees also ignores the complexity of modern arbitrations. Arbitrations today are not just limited to legal questions, complicated contracts in engineering, construction, high end services require specialist arbitrators with technical knowledge. Capping costs has a high risk of driving out competent and therefore expensive aribtrators outside India.

Reshaping incentives

In order to make progress, we should look deeper. We should understand the incentives of the parties to a litigation and then use policy interventions to modify these incentives. One useful example is from the US: Rule 68 of the Federal Rules of Civil Procedure. This is a more nuanced approach which discourages parties to litigate.

Rule 68: Winner beware

Rule 68 involves civil cases where the plaintiff (the suing party) is seeking monetary damages against the defendant (the party being sued). The rule has the following proposition:

At any time before the trial starts, the defendant can make an offer to the plaintiff to settle the case. Two copies of the offer terms are made. The plaintiff can accept or reject the offer. If the plaintiff accepts the offer, the cost of the trial is eliminated.

If the plaintiff rejects the offer, the judge is informed about the rejection but not the terms of the offer that was rejected (this is kept in a sealed copy with the court). If the plaintiff wins, there can be two scenarios at this point:

  1. The sum awarded in the judgment is higher than the sum offered by the defendant before the trial started.
  2. The sum awarded in the judgment is lower than the sum offered by the defendant before the trial started.

In the second case, the plaintiff has to bear the entire litigation costs incurred by the defendant from the date the offer was made by the defendant. The offer is not seen by the judge before the trial to prevent the judge's final determination from getting coloured by the offer of the defendant. The judge comes to the determination of judgment amount through the independent judicial process.

This rule is an elegant way to reduce litigation. At the beginning of a case, the judge has very little information about the merits of the case: In contrast, the parties know much more, having lived through the dispute. They are also in a better position to understand the true value of their economic loss. However, every plaintiff (who believes she will win) has an incentive to ask for more damages than actually suffered. Conversely, every defendant who knows that he has a weak case still has some incentive in drawing out a litigation, thereby delaying the eventual payout she has to make.

When an offer is made to settle, every plaintiff takes it as a signal about what the defendant thinks about the merits of her case. A high offer is interpreted by the plaintiff as that the defendant considers that the plaintiff is on strong legal grounds to win. This may push the plaintiff to continue with the trial, with the hope of getting a higher award in judgment rather than the settlement. However, by transferring the trial costs in case of a lower judgment value, a good counter incentive is created for the plaintiff. The plaintiff has to think hard about the offer and cannot reject it summarily.

Similarly, defendants have an incentive to offer lower settlement amounts because it may be used as a signal that the defendant has a good case. However, this rule gives an incentive to the defendant to make a fair and generous offer, knowing that if the court gives a lower amount the defendant will make significant savings in litigation costs.

The rule thus sets up an economic game where there is a strong incentive for both parties to avoid judicial systems without doing injustice and reducing the burden on the state.


Few problems are as important to India's emergence as a mature market economy and successful liberal democracy, as the problem of making courts work better. One element of this is a fresh approach to the administrative aspects of how courts work. The second element is to rethink rules in a way that is grounded in thinking about incentives. Compare and contrast the sophistication of Rule 68 with the 9 month and price capping rules that we are proposing in our arbitration law.

Thursday, August 06, 2015

Commentary on the MPC question

For older material: RBI independence and the IFC and How to design a Monetary Policy Committee.

And, see this on the work process that led up to the IFC.