Early trends in election results and financial trading

by Rajeeva Karandikar and Ajay Shah.

Financial markets and the Trump victory

Donald Trump's election victory was an unpleasant surprise for the financial markets:

On equity index futures markets, the NASDAQ and S&P e-mini futures hit their price limits and for some time, effectively stopped trading. These are dangerous situations, for as is well known in the field of risk management, these `circuit breakers' convert price risk into liquidity risk, which is in many ways a bad deal. When a market stops trading, all risk management stops.

Financial markets in the Indian general elections

On 17 May 2004, when the UPA won the election, this was quite unexpected; most people had expected five more years for the NDA. Nifty crashed dramatically and the risk management systems of financial market infrastructure institutions were tested like never before (or after). High frequency data for that episode is presently not available, hence we're not able to look inside that day.

In 2009, the election result was a positive surprise, when the UPA made it across the finish line with a weakened CPI(M). We have decent data for this day, so here are some pictures. The market was ecstatic:

The turnover on the equity index derivatives market surged:

This reminds us how important trading on such days is to financial market participants, and to the managers of financial market infrastructure institutions. These were also turbulent times, with wide fluctuations of the spot-futures basis and violations of put-call parity on options markets.

Experiences in state level elections

In November 2015, the Bihar elections threw up a surprise. Till about 10am (two hours after counting started), most TV channels were reporting that BJP and allies are ahead of JDU-RJD. Only after about 11 am, a stable picture emerged.

The early hours of counting have been misleading many times. In the last UP elections (in 2012), till about noon (4 hours after counting started) it appeared that the SP would fall well short of the majority mark and BJP would do rather well. By 10 AM, NDTV and Times Now were projecting 180 seats for SP and 100 seats for BJP. There were celebrations at the BJP HQ. In the end SP got 225 seats and BJP 50.

Can elections overwhelm financial markets infrastructure?

Imagine if, on 15th May 2014, when the counting of votes for the Lok Sabha elections had begun, the early picture as reported on TV stations was very different from final outcome. Imagine if the early indicators were showing that we were headed towards a hung Parliament. The market would have crashed. Later in the day, when the full picture emerged, the market would have swung dramatically.

Even with state elections, sometimes, the stakes are very high. Consider the coming UP elections. The BJP won 73 of 80 seats from UP in 2014. The possibilities for the BJP in 2019 critically hinge on their being popular in UP. The market will thus be watching UP closely, interpreting it as a leading indicator about the 2019 general elections.

Why might early results diverge from the final answer?

Before 1999, when elections worked with pieces of paper, early trends were a statistically good predictor. The counting methodology was to first mix all the ballot papers, and divide them in 10-12 parts which would be counted, one at a time, over roughly two days. Each of these lots (which was called "a round") was a large random sample of votes from each constituency. It is not surprising that early trends often prevailed. In 1998 and 1999, we (Rajeeva Karandikar and Yogendra Yadav) had done well by making predictions on Doordarshan about the national tally based on early counting trends.

Things have changed with the induction of Electronic Voting Machines (EVMs). They now take up one booth at a time, which is not random sampling.

Most TV channels get the counting data from one syndicated source. Viewers see the same message in numerous channels, and get lulled into the feeling that the answer is correct as it has come from multiple sources. However, this one source has had methodological problems. This is also introducing errors in the early trends.

This appears to have been at work in the surprises of the UP election in 2012. A similar situation prevailed on the counting day in Bihar 2016 elections, the difference being that on TV channel which was using its own reporters were able to report the correct picture early on.

The way forward

This article is a plea to participants in financial markets to use early trends more carefully. Wait till noon before believing what you are seeing.

Alternatively, the risk management system of clearinghouses may find it useful to have larger collateral for these few days. After all, the only day when the modern Indian financial market system was really stressed was 17 May 2004.

With EVM-based elections, the counting process is pretty rapid. Perhaps we are better off with a brief pause in trading from the start of counting to its end. The Election Commission, and the exchange institutions, should think about these possibilities.



Rajeeva L. Karandikar is Director at Chennai Mathematical Institute. Ajay Shah is a resarcher at the National Institute for Public Finance and Policy.

Outlook for the currency futures

I have been very interested in the evolution of exchange-traded currency derivatives in India. Some prominent people in the field do not share this sense of possibility and importance. As an example, on 19 September, Jamal Mecklai wrote in Business Standard on this subject:

Indeed, the volume of trading in the first few days -- although quite impressive as compared to start-up futures contracts anywhere in the world -- has barely crossed $50 million on a single day, a drop in the ocean compared to even our own OTC market. Of course, futures volumes are unlikely to ever be much more than a bucket in the ocean in the global market, for instance, currency futures trades constitute just about 2-3 per cent of the OTC market. So, while I applaud the move, it is important that we don't get carried away with great expectations -- we need to understand what is the real role that currency futures can play in an economy, and as a step towards greater deregulation of financial markets.

First of all, for the economy at large, the impact will likely be relatively minor and at a second order. Contrary to the belief apparently held by the regulators, the government and the ever-eager exchanges, I can't see currency futures having any value as a hedging tool. They are not used as such anywhere in the world and there are several reasons for this.

I disagree with this pessimism. First, let's get a numerical grip of the OTC INR/USD forward market. The latest RBI WSS shows FCY/INR merchant forward business as being roughly $2 billion a day, and the interbank as being another $1 billion a day. (They show these numbers twice, once as `purchase' and once as `sales', and I suspect the correct turnover number is to only count it once). Putting these together, we're probably talking OTC business on INR/USD forwards of roughly $3 billion a day. 3% of this would be $90 million a day or Rs.400 crore a day.

I have an article titled Where are we on the currency futures in Financial Express today where I take stock of what has been happening on the currency futures market. The picture you see there is much unlike what Jamal is painting. But that article used data till 7th October, and I'm already running behind the events! Here's the full daily time-series of turnover and open interest:

Date	Open interest	Turnover
	(Contracts)	(Rs. crore)
29/08	16387	291
01/09	24078	107
02/09	33667	187
04/09	30268	178
05/09	30311	168
08/09	30632	240
09/09	28744	244
10/09	41570	198
11/09	51050	235
12/09	55733	186
15/09	60272	232
16/09	86559	456
17/09	90731	338
18/09	86494	378
19/09	78973	307
22/09	71156	259
23/09	78025	363
24/09	89343	377
25/09	92526	223
26/09	74470	200
29/09	69005	290
30/09	88426	297
01/10	96958	418
03/10	122942	429
06/10	132866	406
07/10	148552	590
08/10	151484	614
10/10	143526	936

As we see, the turnover on the currency futures market has exceeded 3% of the OTC forward market (i.e. a threshold of Rs.400 crore) from October 1 onwards. On Friday the 10th, the turnover at Rs.936 crore was more than double of this threshold. Looking into the future, I think the story has only begun; it would not be prudent to bet that at the latest level of Rs.936 crore a day, growth will cease. So I think we have to start questioning the pessimistic view that exchange-traded currency futures can't exceed 2-3% of the OTC forward business.

In parallel, also note that there is some international evidence that private players are shifting away from OTC contracting to the safety of the exchange. So it's time to question our pessimistic assumptions about what can be done on exchange.

I also disagree with the claims about hedging. Cash settled derivatives as a risk management overlay on top of a physical position is a standard technique taught in the textbooks. There is absolutely no reason why the currency futures cannot be used for hedging - except when RBI's limit that no one person can hold over 6% of the market wide open interest comes in the way.

There also, things are getting better with the growing open interest of the market. On Friday, with open interest of 143,526 contracts, the limit of 6% gives a per-client limit of 8611 contracts or $8.6 million or Rs.40 crore.

There are tens of thousands of firms in India who have currency hedging needs (owing to economic exposure) which can be adequately met within this position limit. NSE members have their work cut out for them, scouting the countryside, identifying firms with currency exposure where the position limit is not a show stopper, and getting them going on doing hedging using currency futures.

OTC derivatives and exchange-traded derivatives

Mulling over the global financial turbulence induces a focus on problems such as credit rating agencies and OTC derivatives. I have an article in today's Financial Express on the role of OTC and exchange-traded derivatives. You might like to also see this older material: link, page 152--153 of the Mistry report, link, link, link.

Closure of financial firms

Business Standard has an excellent editorial on the problems of Sahara India Financial Corporation. It talks about the difficulties of shutting down financial firms.

Raghuram Rajan's report emphasises the importance of a mechanism for swiftly shutting down insolvent financial firms. For a role model, last weekend, the US FDIC closed down two banks. Notice how swiftly and smoothly these closures were done. Here is the stock information release that FDIC puts out about such an event and here's the press release that they put out.

Compare and constrast this with the ineffectual DICGC that we have in India. After 15 years of talking about financial sector reforms, we have not moved an inch on this.

Two consequences follow when closure of financial firms is made difficult. The competitive landscape is contaminated by the perpetuation of `zombie firms' who should be dead but aren't. These firms block capital and labour that can be more productively used by other firms in the economy. And, they reduce profit rates for healthy firms and adversely affect investment in the economy.

In India, difficulties of closure of financial firms is part of the package of excuses that is offered for blocking progress. E.g. it is claimed that derivatives trading cannot be allowed to take root because some firms will experience distress when making mistakes with derivatives, and since that distress is painful for the regulator, all firms should be denied the benefits of derivatives trading.

One of the crucial elements of the policy package which has worked out right for the equity market is swift closure of firms in distress. When NSCC sees a firm which has violated rules about margins, its trading permissions are immediately rescinded (even if this involves triggering off panic amongst its customers). If the firm is not able to quickly get back into the game with adequate capital, it is thrown out of exchange membership. The equity market stands alone in Indian finance with a vibrant creative destruction process: some firms die every year, and some new firms come about every year.

Improving competition in the exchange industry

One of the many clever things that were done in the equity market reforms of the 1990s was a pro-competitive framework for depositories. The depositories legislation explicitly plans for multiple competing depositories. Further, there is an elegant decoupling between the decision of a customer about which exchange to use vs. which depository to use. E.g. it's perfectly feasible for a customer of NSE to use BSE's depository (or vice versa).

I believe competition policy is a very important element of sound government in the area of finance, and such thinking is essential to reshaping the competitive landscape. All too often, such care is not exercised in the formative phase, and we endup being stuck with a monopoly and/or conflicts of interest.

Jayanth Varma alerts us to a proposal of the US Department of Justice which has major implications for competition between exchanges. The document written by DOJ is of top quality - I really admire the human capital they are able to bring into these things - and is well worth reading.

At the essence, it is a proposal to unbundle an exchange business from a clearing corporation business. This would yield orthogonality (as above) where the choice of a exchange and the choice of clearing corporation are made independently. As he points out, this must surely be a good idea for competition, for the CME stock price dropped by 15%:

(Click on the picture to see it more clearly, or click here to see current data from Yahoo Finance.)

The logic here runs well beyond the simple idea of ensuring competitive conditions hold in both sub-industries. The DOJ's reasoning is essentially this:

If exchanges did not control clearing, an appropriately regulated clearinghouse could treat contracts with identical terms from different exchanges as interchangeable, i.e., fungible. The incentives of such a clearinghouse would be to maximize its own profits, and it thus likely would treat identical contracts as fungible. In a world of fungible financial futures contracts, multiple exchanges could simultaneously attract liquidity in the same or similar futures contract, facilitating sustained head-to-head competition. A trader could open a position on one exchange and close it on another. In such a world, a trader could execute against the best price wherever offered without fear of being unable to exit the position because there is insufficient trading interest (or of being forced to exit at a poor price) on the new entrant trading venue when a trader chooses to exit.

In addition, if exchanges did not control clearing, an appropriately regulated clearinghouse could reduce member margin obligations by recognizing offsetting positions in correlated financial futures contracts traded on different exchanges. The ability to offset correlated positions in a futures clearinghouse can significantly reduce the capital required to trade.

Here is a response from CME.

Bias in favour of exchange traded

Stephen Cecchetti expands and enlarges on his previous arguments about the importance of exchange-traded instead of OTC in achieving a sound and stable financial system. He also has some ideas on how a policy bias in favour of exchange-traded might be implemented.

New thinking on currency trading

Joydeep Mukherji pointed me to an article in Mint which points out that India's share in the global currency market has risen from 0.3% in 2004 to 0.9% in 2007. This is based on some interesting BIS data.

This is consistent with India's remarkably rapid globalisation in recent years. Of course, this number of 0.9 still lags India's GDP share. The MIFC Report has argued (Table 4.11, page 64) that for India to be considered a minimal IFC player, 5% of the world's currency trading has to be here. So the share of currency trading in India needs to grow by five to six times in achieving a minimal role in the global financial market.

The denominator - global currency trading - is pretty big. The global market runs at $3.2 trillion a day. BIS places India at $34 billion a day in 2007. If India were at a 5% market share, this would be $160 billion a day. As an aside, any wise and experienced market manipulator will tell you that it's pretty hard to manipulate a market which does turnover of $34 billion a day. So it's not surprising that the RBI is finding the going difficult.

The big weak link in Indian finance today is the lack of a properly functioning Bond-Currency-Derivatives nexus, the integrated system of spot and derivatives market (both exchange-traded and OTC) on currencies, bonds and credit risk. All these building blocks need to have liquidity based on speculative price discovery, and all of them need to be tightly integrated by arbitrage.

From the late 1990s onwards, a lot of people in India understood the universal applicability of the market design of the equity market, which uses a centralised limit order book with computerised order matching, open access for financial firms and for customers, and the elimination of counterparty credit risk at the clearing corporation.

For historical reasons, this is not how the global bond market and currency market functions. London has 30% of the world's currency trading, and initial conditions matter greatly. But in India, starting from scratch, there is less of a burden of history, and it behooves us to think from first principles. Indeed, the only path to achieving competitiveness and breaking into the established world of international finance might be through innovation.

I have always thought that if the order book market works for equities, it would work even better for bonds and currencies. The reason for this lies in the fact that the latter are a small number of macro underlyings. Order book markets are extremely good at aggregating large order flows on problems where there is low asymmetric information. Hence, if the equity market design works pretty well for 1000 equities, I think it'd work even better for 10 currencies and 50 government bonds (which is all that is needed with a well run DMO). The limit order book market doesn't work so well with a large number of small products with a lot of asymmetric information - but the government bond yield curve and currencies are just not like that.

These issues were kicking around in the Indian debate from the late 1990s onwards, by which time the success of the equity market design was starkly visible. The viability of the equity market design was accentuated in the last five years by the rise of algorithmic trading. Covered interest parity arbitrage, currency triplets, yield curve arbitrage: all these are highly automatable strategies. The algorithmic traders will blow away the human dealers, and deliver very a high quality of market efficiency in the BCD Nexus once the key markets are on the exchange platform. These, and other, arguments in favour of the exchange platform are summarised at page 152 of the MIFC Report.

With this backdrop, I saw a fascinating article Foreign Exchange Trading: New Trading Platforms Reshape Forex Marketplace by Will Acworth in Futures Industry magazine. It talks about new exchange-style trading platforms in the currency market. I find it particularly fascinating that Reuters - which has long milked the OTC currency market for all it's worth - is one of the pioneers in taking currency trading on exchange.

Early on, he says:

the FXMarket- Space platform represents the first attempt to bring a central counterparty into spot foreign exchange trading

This is incorrect. The first effort to do the central counterparty for a currency market - albeit an OTC market - was the Clearing Corporation of India Ltd. (CCIL). This was in 2002. CCIL was a great success story of Indian innovation - the idea of the clearing corporation was taken up from exchanges and applied to counterparty credit risk management on the OTC market. Unfortunately, India wasn't able to follow through on the achievement of setting up CCIL to harnessing the full benefits of CCIL, owing to deeper dysfunctionality in the BCD Nexus (see page 126 of the MIFC Report).

Currency trading with CCIL as the central counterparty harnesses all the wonderful benefits of netting, reduced operational costs, etc. CCIL complies with the `Lamfalussy Standards' where it is accepted that when one person fails, after collateral is exhausted, some losses can fall on his counterparties. While these standards are well accepted, I'd much rather see the full blown risk management that's found in clearing corporations such as the National Securities Clearing Corporation (NSCC), where the clearing corporation is good to the last drop, where customers only face losses after the clearing corporation has gone bankrupt.

Exchange traded vs. OTC

The MIFC book has argued (page 152-153) that there is a case for a policy bias in favour of exchange-trading over the OTC market.

On 5 October, Stephen Cecchetti argues in a similar vein in the Financial Times:

In September 2006 Amaranth Advisors, a US-based hedge fund specialising in trading energy futures, lost roughly $6bn (4bn) of the $9bn it was managing and was liquidated. With the exception of its shareholders, most people watched with detached amusement. Eight years earlier, reaction to the impending collapse of Long-Term Capital Management was very different: people were horrified and the financial community sprang into action. One big difference is that Amaranth was engaged in trading natural gas futures contracts on an organised exchange, while LTCM's exposures were concentrated in thousands of interest-rate swaps.

...

The difference between futures and swaps is that futures are standardised and exchange-traded through a clearing house. This distinction explains why Amaranth's failure provoked a yawn, while LTCM's triggered a crisis. It suggests that regulators, finance ministries and central bankers should be pushing as many securities on to clearing house-based exchanges as possible. This should be the standard structure in financial markets.

A critical part of any financial arrangement is the assurance that the two parties to it meet their obligations. In organised exchanges, the clearing house insures that both sides of the contract will perform as promised. Instead of a bilateral arrangement, both buyers and sellers of a security make a contract with the clearing house. Beyond reducing counterparty risk, the clearing house has other functions. The most important are to maintain margin requirements and "mark to market"gains and losses. To reduce its risk, the clearing house requires parties to contracts to maintain deposits whose size depends on the contracts. At the end of each day, the clearing house posts gains and losses on each contract to the parties involved: positions are marked to market.

Since margin accounts act as buffers against potential losses, they serve the role that capital requirements play for banks. Marking to market offers a way to monitor continuously the level of each market participant's capital.

Finally, exchange-traded securities are standardised, creating transparency: buyers and sellers know what they are buying and selling.

Returning to the comparison of Amaranth and LTCM, we can see why the former did not provoke concerns of a systemic crisis. Amaranth was required to hold margin to maintain its position in futures markets. When it started to sustain losses, the clearing house forced the sale of the positions into a liquid market; counterparties sat calmly, knowing their interests were protected. By contrast, the swaps LTCM held were with specific institutions. Since interest-rate swaps are not exchange-traded, selling them was not feasible. The collapse of LTCM would have led to defaults on the contracts and put other financial firms at risk.

This brings us to the present crisis. The defining feature is that there are securities out there no one knows how to value. We discovered this when poten- tial investors refused to accept certain mortgage-backed securities as collateral in the issuance of commercial pap-er. A failure of investors to monitor the originators of these securities had led to the creation of complex and non-transparent securities. If these were ex-change-traded through a clearing house, these problems would largely disappear.

There are many ways to encourage people to move trading into clearing houses. Are there tax and regulatory incentives that are doing the opposite? Are banks, insurance companies and pension funds being rewarded for holding difficult-to-value securities that are not exchange-traded?

The goal is to structure financial markets in a way that minimises -system-wide risk. Yet we also need to remember that there are gains to asset-backed securitisation. When the system works, it turns illiquid bank loans into readily marketable securities. This should reduce the overall riskiness of the financial system. Shifting these securities to exchanges with clearing houses would help ensure that these benefits materialise.

Prediction markets & weather derivatives

My recent post on prediction markets elicited a fascinating set of comments.

Nitin said that publicgyan is a website trying to do a prediction market on Indian underlyings. But it, as yet, deals in funny money and that won't scale. Tarun said that maybe the way out is to shift over to a funny money which has some other uses on the net.

Kaushik seems to say that while the State won't enforce against someone who won't pay his gambling debts, gambling isn't itself illegal. (Am I understanding you correctly?) I am perfectly comfortable with the task of setting up a clearing corporation which works with little support from enforcement apparatus of the government. However, I have to ask : if gambling is not illegal, why does the government periodically go after people placing bets on (say) cricket matches?

One important `betting market' which falls within the rubric of derivatives trading but not the traditional set of four underlyings (equity, debt, currency, commodities) is weather derivatives. Long ago, I had read that in the 1970s, Richard Sandor (who was then at CBOT) had noted that of all countries in the world, the biggest imaginable weather derivative was a monsoon derivative product in India. Everywhere else, weather is local. Here, you have one big random variable which shakes the life of households and firms across the country. A futures product would be able to pool the trading interests of a very large number of firms and households, in contrast with existing weather derivatives elsewhere in the world, each of which taps into a small set of interested users. The liquidity that an Indian monsoon futures contract could get is, hence, gigantic.

I have heard descriptions of monsoon derivatives which had sprung up in Bombay in the 1950s. There used to be a standardised 500 ml milk bottle in Bombay, then. One such bottle would be placed on the terrace of a building and people would stand in the rain placing bets on how far the water would fill up.

When NCDEX started the guar contract, none of us understood that this was going to be the contract where NCDEX made it. Many people were surprised at the success of futures on Guar Seed at NCDEX. In my opinion, part of the reasoning lies in the fact that it is a rain-fed crop which is highly vulnerable to the monsoon. So it's a bit of a monsoon derivative. In addition, there is inelastic supply and vulnerable output, so you get big price fluctuations - that vol surely helps the futures product.

The need for a monsoon futures remains, and given that the formal financial sector is not offering a product, there is a big underground market. I saw a fascinating article by Rashmi Rajput titled Rs 3,000 crore riding on Mumbai monsoon in The Times of India where she says:

Want to make some money while you wait for the rains? Place your paisa on June 7. At least that's what punters across India have done. There is close to Rs 3,000 crore riding on the rains in Mumbai this year: Bookies have accepted bets worth Rs 3,000 crore on the date of the arrival of monsoon in Mumbai, the total rainfall the city will record this season, and even the monthly break-up of quantum of rainfall.

And this is what the consensus is: The city will experience its first shower on June 7. The season's total rainfall will between 1,700-2,000 mm, a good 500-800 mm less than the last year. And if the money being wagered is anything to go by, the rains will be evenly distributed between June, July and August with average 400-500 mm rainfall and the monsoon will rapidly lose its steam in September with just 200 mm rainfall (See charts for rates).

When we contacted meteorological director-general Dr C V V Bhadram he refused to hazard a guess if the bookies will lose or make money, familiar as he is no doubt with the whimsy of the monsoon. "The monsoon has two branches one extends from the Bay of Bengal and the other from the Arabian Sea. The west coast receives rains from the Arabian sea. It's only after the monsoon sets in Kerala that we can monitor its movement and tell when the rains will arrive in the city," he said, playing safe.

"Generally the monsoon sets in the Kerala in the first week of June and proceeds gradually upwards. I can't comment on what the bookies are saying. Our methods are scientific and proven," Bhadram added. Though of course the bookies will bet again, all in jest, on who will be more accurate they or the Met department. Confident with their date of June 7 punters are offering only 50 paise on every rupee bet on June 7. For June 8 it is 80 paise and 90 paise for June 10.

And mind you, they too have looked at weather charts, some of them possibly prepared by Bhadram's department, and sniffed the air in Kerala. "Looking at the climatic conditions predicted by the meteorology department, we don't foresee a good monsoon. An average rainfall of around 1,700 mm to 2,000 mm is expected this season," a bookie told this newspaper shying away from disclosing his identity.

Rains apart, the bookies are looking at a good season after the disappointment of World Cup. Last year's betting business during monsoon too was badly affected by the serial train blasts and bookies could mop up just over Rs 750 crore, sources said.

"This year we expect the business to be good. In fact, it is looking good already. We have already collected Rs 3,000 crore which is double of what we collected in the entire season last year. As the season progresses, more money will pour in," said the bookie. The punters outside Mumbai seem to be more interested. "Most of the bookies are from Jaipur, Udaipur, Ahmedabad, Pali, Guwahati, Indore and Bhopal," he said.

Risk management at exchanges: thinking beyond VaR

The risk management of the NSCC is greatly respected owing to episodes like May 2004, when volatility skyrocketed but the systems worked fine. Jayanth Varma, who did a lot of the early thinking leading up to this risk management system, did a talk at ICRIER on the 9th, as part of their finance seminar series. He spoke about new ideas in risk management, and their possible application to the task of the derivatives clearing corporation.

Lessons from recent market volatility for the margin system

Margins are good faith deposits posted by market participants. While margins are normally defined by a rule book, recently there were two purely ad-hoc changes to margin required by SEBI. SEBI did an ad-hoc increase in one component of margins on 8 April, before the present bout of market volatility began. SEBI then did another ad-hoc decrease in margins on 25 May, while this bout of volatility was still underway. It is important to think carefully about the merits of such discretionary changes.

What should the correct margin be? The correct margin on a position is the size of the loss on this position that will be "rarely" exceeded. Jayanth Varma's Risk Management Group focused on a margin system which requires the sum of Value at Risk (VaR) at a 99% level, and the ETL or "Expected Tail Loss" which is E(r | r < VaR)), under certain simplifying assumptions. Intuitively, there is one component of the margin which is the VaR, which takes care of a loss on most days, and then on a few days, the loss is bigger than the VaR, but the ETL takes care of the average loss on those days.

VaR estimation is done adaptively in these schemes. Financial volatility is reasonably predictable: volatile days tend to be followed by volatile days, and vice versa. An adaptive system of margins involves charging low margins for the normal sleepy days, and driving up margins when higher volatility shows up.

So margins are raised after volatile days and vice versa. When market volatility goes up, participants are forced to put up more capital to support positions. I think this is an unhappy but essential feature of a sensible margin system. The alternative is to charge high margins all the time - which wastes capital. As long as margin changes are purely rule driven, market participants have correct expectations about what margins will be charged, under what circumstances.

Interestingly enough, the events of May 2006 were easier to handle, for the risk containment system, as compared with May 2004. Look at Nifty returns in both months:

Date	2004	2006
4	1.48	0.39
5	0.93	0.43
6	1.26
7	-1.56
8		0.79
9		0.74
10	-1.98	0.90
11	-4.02	-1.43
12	0.68	-1.39
13	0.37
14	-8.19
15		-4.11
16		0.58
17	-13.05	3.12
18	7.97	-7.01
19	4.16	-4.28
20	-1.54
21	1.05
22		-5.23
23		3.76
24	3.07	-2.65
25	-0.13	1.98
26	-0.49	1.00
27	-0.78
28	-5.02
29		0.16
30		-0.92
31	-1.68	-3.65

In 2004, the first hint of higher vol was the drop of 4.02% on 11th, which drove up margins a bit. Then, out of the blue, came the 8.19% drop on 14th (which drove up margins further). This was good preparation for 17th, which was a huge change. In contrast, in 2006, the 15th was the first big move, of 4.11%, which drove up margins. After that, margins were higher, and there was no real challenge from large price movements.

There are many myths about margins. One view is that increasing margins "cools the market" and pushes down prices. Conversely, it is felt that reducing margins tends to help "prop up the market". However, higher margins hurt both buyers and sellers equally! There is no simple relationship which asserts that higher margins yield lower stock prices, and vice versa.

The more subtle relationship is one where higher margins make it difficult to hold positions, thus reducing market liquidity. Indirectly, one could get a liquidity premium story whereby higher margins drive down liquidity and thus drive down prices. The biggest challenge at a time of market stress is liquidity: what we need most is that participants do not panic and retreat from trading. From a public policy perspective, increasing margins and thus reducing market liquidity - at a time when liquidity is needed most - doesn't seem like a bright idea.

Some believe that the system of margins induces a spiral of selling where a person is forced to make good his losses, and simultaneously submit bigger deposits, and thus collapses into distress selling. This view is inconsistent with the fact that derivatives trading is a zero sum game. For each speculator who has lost money, there is an equal and opposite speculator who has made money. While half the participants feel pain, the other half are feasting in huge profits. Just think of the joy of those who were short Nifty in the hours when Nifty dropped - they made huge profits. At the level of the country, these effects cancel out.

There are no permanent longs and there are no permanent shorts. The people who happened to be short at the right time got a lot of cash, and it is perfectly feasible for them to flip around the next instant and become buyers, if their speculative view changes.

Margin systems in India are imperfect. There is certainly more work to be done on improving the system of margins. The areas for work lie in:

• Better handling of liquidity risk,
• Shifting away from the simplifications of SPAN and RiskMetrics, and
• Shifting towards portfolio margining.

However, the basic logic of the margin system is sound, and there is little doubt in my mind that the system is strong enough to deliver soundness in the face of the time-series of Nifty returns. As evidence, note that these very systems were fine in coping with the more-daunting events of May 2004 - at which time no discretionary or ad-hoc margin changes were in the play. By international standards, we hold too much collateral. If there is a flaw in the system of margins, it lies in charging too-high margins in coping with model risk. Addressing the above three problems will help in reducing model risk and thus the extent of over-margining.

In this setting, I am unimpressed by SEBI's discretionary margin-changing decisions. Margins were raised, which hurt market liquidity, at a time when liquidity was needed most. Margins were reduced at a time when market volatility had not yet subsided. Now that SEBI has embarked on discretionary margin changes - which was not done earlier - SEBI's margin-changes are now an additional source of uncertainty for the market.

Regulators in mature market economies do not engage in discretionary margin changes. The job of the regulator is to think about the rules of the margin system. If there are problems with the rule-book, SEBI should get involved in changing the rule-book. But the job of SEBI is not to step in and make ad-hoc, discretionary changes.

In Latin America, employees of central banks and financial regulators are known to trade on currency and equity markets in order to profit from inside knowledge about government actions. Before any such accusations develop in India, it is better to emphasise a purely rules based system.

Resilient: Able to cope with big bankruptcies

For an economist, the goal of financial sector policy and regulation is: market efficiency. The normative benchmark is a market which is an unbiased and rapid processor of information, a market that is deep and liquid. For many a bureaucrat, the goal of policy and regulation degrades to "let's not have a crisis on my watch". A great deal of the follies of the real world flow from this difference.

One aspect of crisis is the failure of large finance companies. Bureaucrats working in finance regulators often have a horror of a big finance company defaulting. This makes all big finance companies "too big to fail", with it's own consequent moral hazard. But the safety net is not given out by the bureaucrat for free. The typical price that is demanded is great gobs of equity capital. The bureaucrat finds safety in seeing lots of zeros for the capital. It is mechanically assumed that an entity with Rs.100 crore of equity capital is safer than an entity with Rs.10 crore of capital.

This leads to two kinds of mistakes. One problem is in situations like securities brokerage or in asset management, where equity capital really doesn't do much, and the bureaucrat needlessly burdens the firm by demanding a lot of equity capital. This serves to merely introduce entry barriers, reduce competition, and place the burden of earning an equity rate of return for that capital upon the customers of the firms. Such a drift towards demanding more equity capital is supported by big finance companies, who are too happy to have less competition. The other kind of mistake is that of getting comfortable that firms with lots of capital are safe. The best example of these are banks.

In the context of the pension reforms, we get repeatedly asked: "What happens if a pension fund manager goes bust?". Remarkably enough, it's actually possible to handle this problem rather nicely. The customer assets are - anyway - never on the balance sheet of the fund manager. This is where agency fund management differs fundamentally from either banking or insurance, where customers are inextricably intertwined in the balance sheet of the firm. The pension fund manager is just a consultant, who is giving instructions for transactions using customer assets which are sitting with a custodian. If one pension fund manager goes bust, the regulator replaces him with another pension fund manager. Customer assets needn't be affected when bankruptcy hits a pension fund manager. This aspect underlines why substantial equity capital isn't required to be a pension fund manager.

In the context of risk management, safety comes from clever systems and procedures; not from equity capital. An incompetent bunch can mess up a big finance company with plenty of equity capital. Conversely, sound procedures and well thought out processes can correctly deliver sound outcomes even when there are very big positions and small equity capital. The futures clearing corporation is the best demonstration of how safety comes out of brainwork, not equity capital.

On this theme, Futures Industry magazine has a fascinating article on how the futures clearinghouse handled the recent disaster at Refco.

The disaster at Refco unfolded at a blinding pace. The story started on Monday morning (October 10) with a brief statement from the company. On Tuesday, the CEO was arrested. On Thursday, the shares of Refco had stopped trading and the company was forced to shut down one of it's unregulated units for want of liquidity. You don't get a crisis where the events move faster than this.

Refco was a big firm. In September 2005, it was the 4th biggest Futures Commission Merchant (FCM) measured by customer assets, which stood at $6.5 billion. Plenty of customers got spooked by seeing TV footage of the CEO being carried away in handcuffs. As the article says: According to CFTC data, the total amount of segregated funds held at Refco fell from $6.47 billion at the end of September to $2.53 billion at the end of October. In other words, somewhere in the neighborhood of $4 billion was transferred to other firms in the space of about 15 working days. In fact, I find it remarkable that all customer assets didn't leave.

The article tells the story in full detail, and I encourage you to read the intricate dance-of-death that comes about when such events arise. The bottom line is that the extremely sudden death of the 4th biggest FCM was handled perfectly by the system of futures exchanges + clearing corporations. That's what I call systemic stability. This comes about by building sound procedures and being smart; not by repressing innovation, or by requiring vast amounts of equity capital.