Clearing corporations in OTC derivatives

The Economist makes the same point I made earlier this month in the Economic Times about the risk of introducing clearing corporations clearing and guaranteeing OTC derivatives and exotics. In my opinion and also the magazine, this has the potential of a big blowup which would bring down the whole system.

And while regulators fret that some banks are “too big to fail”, they may be creating another set of institutions of equal systemic importance. “With their myriad clients the big trading banks in effect function as CCPs already,” says Darrell Duffie of the Stanford Graduate School of Business. “Why double their number?”

I'm happy that, though we are a minute minority, there are views which go against the common wisdom of a big guarantor of exotic products. Luckily for the system, the OTC market place is too big to fit into the exchange and clearing market place (at 10 times the GDP of the world). So we will hopefully not do too much damage in the short term.

QIP pricing - all is well

I disagreed with Prof. Jayanth Varma, my colleague at the institute, on the pricing related to Qualified Institutional Placements. I think that the current rules are fair and put a floor of two week averages of highs and lows. My points are:

• The two week's price is not a two week old price and therefore is not a historical price, but a means of calculating a recent price. Any assertion that it is a bureaucratic irritant is incorrect, there is no human intervention and there is an objective price calculation - therefore there is nothing bureaucratic about the pricing.
  
• There is nothing arbitrary about the two week pricing - at least nothing more than yesterday's price or yesterday's price at 3.00 pm.
• I am all for a floor price - we saw 15 years back the kind of misconduct which occurred when private placements were made at steep discounts to the market price. In fact, whereever the law permits, the shareholders are always shortchanged - e.g. takeover regulations permit a 25% premium as non compete fees to the exclusion of public shareholders - and suspiciously all trasanctions with non compete are at exactly 25% levels.
• Finally, I don't think there is an inherent right of a company to issue shares to the exclusion of existing shareholders. Private placements (including QIP issues) are exceptions to the rule. The rule being rights offerings and public offering in that order.
  

See the transcript on CNBC

Rationalising rights issue disclosures

This week SEBI Board also rationalised the disclosures for rights issues based on the existence of continuous disclosures. Though perhaps in the right direction, there is danger in this half baked approach of improving rights transactions without fixing the problem of improved continuous disclosure by companies of information. Here is my post of the 13th March 2009 discussing the issue:

"SEBI has put out a "Discussion paper on rationalisation of disclosure norms for Rights Issues". In brief, the paper seeks to reduce the disclosures by companies seeking to come out with a rights issue based on the recommendations of the disclosure advisory committee of SEBI. This is a flawed recommendation as it seeks to reduce disclosures in rights offerings - assuming a high quality of continuous disclosures by companies. In fact the quality of continuous disclosures by companies is poor because of the poor design of the fragmented disclosure regime - not because companies (even blue chip ones) don't want to properly disclose. This was sought to be remedied by introducing a far superior form of continuous 'integrated disclosures' by the same committee. Without implementing that recommendation, implementing the present proposal will be dangerous as it reduces net disclosures.

PS: See my previous post on integrated disclosures."

SEBI fees - another round of fee cuts

This is the third time in less than two years that SEBI has cut its fees - that it charges from intermediaries. The fee cuts are a result of a ballooning SEBI fund - a fund well in excess of what SEBI needs to operate for a decade or more even if it stops collecting any more fees. See my previous post on the subject. As I said earlier, the regulator would do well to hold on to say Rs. 5 billion (Rs. 500 crores) and hand over the balance to the consolidated fund of India as a one time cheque (RBI hands over a cheque each year - though the context is different as it acts as the government's banker).

OTC derivatives - US is too impractical

I wrote a piece for the Economic Times last week on the US Treasury plan on OTC derivatives, which I think is overly ambitious. Here is the piece:

"AFTER hearing a year’s worth of regulatory chest thumping — of attempting to regulate the exotic world of over the counter (OTC) derivatives — some realism seems to have seeped into the US government thought process, though not fully. The US treasury has just now come out with a short proposal to tame and confine the wild animal. The issue is that much of the issue and trading of OTC derivative securities is carried out in an opaque and bilateral world. This is a world where two seemingly very sophisticated institutions exchange packages of risks in a customised manner.

The OTC derivatives markets have rightly and wrongly been blamed for the current financial market crisis where these instruments all blew up at the same time because of the so called sophisticated financial models which were used to price them and measure how risky they were - individually and collectively. Over the past year there has been an increasingly loud call to shift these contracts to the exchange space so that there is transparency and honesty in pricing and trading in these securities and there is a central counter-party which guarantees each trade. This sounds good except for two major fallacies.

First, the nature of the instruments (though in a minority of cases) is such that many of them can never be traded on an exchange — simply because each contract is unique and customised to suit the other party’s need for risk mitigation. To be fair, the treasury plan does not attempt to move these out of the OTC’s bilateral space and correctly recognizes that a market with small number of players doing larger deals (even in India the standard size for a one year overnight index swap is Rs 100 crore) is different from a market with a large number of players doing small deals. Second, moving a market estimated at $680 trillion to a central clearance and settlement system (with risk mitigation systems like margining etc) is simply not practical even within a space of a decade or more. To get a perspective, the GDP of the entire world is around $68 trillion. Further, however wrong the financial model in the present system, the wrong model would need to be transposed to the exchange space with whatever stated improvements - for calculating margins etc. Even if such a migration was possible by regulatory edict, this could create a financial disaster which would be concentrated (in one exchange) as opposed to the diffused crisis (among many participants) we are seeing today. This shift needs to be a lot more thoughtful than is currently being touted by one and all as a cure all panacea. Assuming we can use the equity market risk mitigation systems in these complex instruments may lead us to further false comfort.

The push to send trades over to the exchanges and electronic platforms with risk mitigating systems (like margining of trades and counter party guarantees) is unlikely to be very successful even in the medium to long term given the sheer size of the market and also the size of each trade.

It seems the realisation has partly dawned on the US government and regulators and after the initial rhetoric a more sensible approach is now proposed . The same proposal also recommends a reporting system of these instruments with respect to their issue and trading, thus creating a higher level of transparency in the market resulting in potential improved understanding of the systemic impact of the risk. A similar attempt at creating transparency in the bond market resulted in substantial increases in transparency and reduction in the price of the buy-sell rates (known as the bid-ask spread in market jargon) of corporate bonds in the US some 7 years back. India also similarly implemented a compulsory reporting system in the corporate bond market in 2007 with good effects.

The proposal may be too ambitious, except in its transparency initiative and it would be worthwhile to look at its success before attempting to replicate it in India."

Superior voting rights - outlawed

In yesterday's Board meeting SEBI has come out with a prohibition on issuing superior voting rights. This is the correct thing to do and is an internationally accepted practice.

The Board decision as reflected in the PR says:

"(iv) Issue of shares with superior voting rights

No listed company can issue shares with superior voting rights. This will avoid the possible misuse by the persons in control to the detriment of public shareholders."

The New York Stock Exchange (NYSE) had prohibited DVRs from 1926 for over 50 years referring to their “long standing commitment to encourage high standards of corporate democracy”. There are still several restrictions in place in the NYSE and other markets. The SEC enacted rule 19c-4 under the Securities Exchange Act 1934 prohibiting issue of superior voting rights, but permitting issue of inferior voting rights. The former would have the effect of “nullifying, restricting or disparately reducing the voting rights” of one or more classes of outstanding common stock of the issuer. Inferior rights are permitted because anyone taking such shares purchases them knowing fully well their inferior rights and prices them accordingly and the previous shareholders do not stand diluted in their control and voting. Though the rule was set aside by courts, the rule exists now in the form of exchange rule making in the US. The European Union too has a different restriction on such DVRs.

The absence of yesterday's rule would create a situation bordering on fraud if not oppressive.

Some interesting readings du jour

Lots of interesting reads in today's FT:

The three steps to financial reform - By George Soros (it is a bit extreme - particularly his advocating outlawing of CDSes and banning non standardised derivatives - see my post of a few days back on OTC derivatives).

Interactive graphic: Caught in a regulatory web (9 US regulators plus 50 X 3 state regulators regulating just 4 financial industries in the US - see both tabs in the graphic)

The recession tracks the Great Depression by Martin Wolf

Why Keynes was wrong, and why it matters by Benn Steil

Why Keynes was right and wrong, and why it matters by Roger Farmer

Securities Transaction Tax - good for Indian investors

I whole heartedly support the transaction tax on securities trades known as STT - despite the gripe of economists that it makes trades too expensive and the markets less liquid. STT levels the field for Indian investors who would otherwise end up paying 11% odd tax on long term capital gains tax on income from equities while foreign investors take benefit of abusive tax havens like Mauritius and pay no tax. I therefore as an investor wholeheartedly support the STT. To eliminate the STT would also call for a repeal of the Mauritius tax treaty and thus imposition of capital gains tax on both us Indians as well as foreign investors equally.

Delisting Regulations - good news for investors

SEBI has come out with new delisting regulations which provide for:

a) Voluntary delisting of a listed company by a reverse book building process.

b) An easier voluntary delisting for very small and illiquid companies.

c) A very easy delisting from defunct exchanges if the same company remains listed on a working exchange.

d) Provisions for compulsory delisting for those who violate basic conditions of listing (like non disclosure of financial information) and a 10 year cooling off for the company and its promoters/ directors from raising any capital.

Those people who were expecting the reverse book building process to go away were of course unhappy. Those expecting the new regulations to introduce a 'squeeze out' of minority shareholders were even more disappointed.

I am all for the new regulations. The provision providing for voluntary delisting is fair and permits both sides of the negotiating table i.e. the buying promoters and the selling public to negotiate a price in an electronic manner. Those people who advocate a squeeze out provision - a means of forcing investors to part with their shares at some price determined by either past prices or valuation are wrong on first principles. Allowing squeeze outs is like private expropriation for private benefit. Again asserting that some investors hold out and 'unfairly' ask for 'too high a price' is also wrong on first principles - if you want something which I have, I will dictate the price depending on how badly you need to buy my property. Replace shares with a house and the principle is clear. If I have a house no one can tell me here is 50 lac (5 million) rupees, take it and get out even if the market price is only 45 lacs. In fact no one can tell me to sell the house even at twice the market price. Is holding out at twice the market price unfair? Clearly not, so is a refusal to tender at a price not unfair. In a reverse book building too, both sides of the bargain can walk away, as neither is forced to accept the prices quoted by the other. In fact there is some unfairness which is inherent even in the book building process, which is that if I as an investor refuse to sell, and most of the other shareholders sell out, I will be stuck with delisted shares (though there is a one year escape which allows investors to tender even after the book building process is over.

Even shareholder unfriendly jurisdictions like Delaware, US which allow squeeze outs (which I don't think should be allowed) go through a rigorous court approved fairness process.

I will be supporting the new regulations today (12 June) on CNBC at 10.30pm on 'the Firm'. Here is a transcript (with many typos).

US SEC's reputation