Self trading is not synonymous with market abuse

by Nidhi Aggarwal, Chirag Anand, Shefali Malhotra, and Bhargavi Zaveri.

1   Introduction

Orders that match with each other with no resultant change in the ownership are termed as self-trades. Lately, there have been increased concerns regarding self-trades in equity markets in India. With no genuine trading intent, these trades are seen as manipulative in nature, aimed at artificially pumping up the turnover to portray a false picture of liquidity. Self-trades are prohibited under the present law, and SEBI has punished several firms on this score.

In this article, we argue that there are some kinds of self-trades which do not constitute market abuse. With no manipulative or fraudulent intent, a trading firm can hit its own bid or offer. Penalising firms in such situations is wrong, and can act as a deterrent to trading in capital markets. Internationally, regulators have realised such possibilities, and taken necessary steps to ensure that legitimate cases of self-trades do not get punished. The Indian regulator needs to undertake similar steps.

2   Legitimate self-trades

Self-trades are generally considered to be non bona fide transactions. However, there can be instances where genuine trading intentions within the same firm result in self-trades. Such trades can occur in the course of normal trading when i) orders from two independent trading strategies coincidentally interact with each other, or orders originated from the same trading desk match with each other due to technical and operational limits of the existing infrastructure (such as matching engine technology). The following text illustrates such situations in detail.

2.1   Manual trading

Proprietary trading firms typically have several dealers operating in multiple securities. These dealers, independently, deploy trading strategies to make profit and to manage their own risk. Orders from these independent dealer desks originate from accounts with common ownership. Such orders, though initiated with legitimate purposes, can result in self-trades.

As an example, suppose a firm has two independent dealers. Both these dealers could be separated from each other by information barriers. Suppose they pursue following strategies:

• Dealer 1: Arbitrage between BSE-NSE stock prices
Under this strategy, arbitrage opportunities arise when the price of a security trading on both BSE as well as NSE diverges significantly. By selling the security on the exchange with higher price, and buying on the one with lower price, a trader can make arbitrage gains. 

• Dealer 2: Bullish strategy
In this strategy, the trader has a view about the direction of a security's price based on his analysis. If he anticipates that the price of the security is likely to go up in the future, he will buy that security. The trader makes a profit if the price actually moves upward at a later time-period.

Suppose that at a certain point of time, Dealer 1 sees a significant divergence between NSE and BSE prices of a security, with higher price on NSE and lower price on BSE. He, thus, sends a buy order on BSE, and a sell order on NSE to pursue his arbitrage strategy. Dealer 2, at the same time, places a buy order on NSE in pursuit of his bullish strategy on the same security.

Though completely legitimate, and without an intent to manipulate, the two buy-sell orders on NSE from two independent dealers can end up matching with each other. This trade, while being unintentional and completely co-incidental, when tracked at the legal entity level of the parent proprietary firm, will be characterised as a self-trade.

2.2   Algorithmic trading

The incidence of self-trades increases much more in the case of automated trading due to higher speed and the use of algorithms for making trade decisions. Similar to manual trading, two different algorithms within the same firm could be trading completely unrelated strategies. However, orders originating from these algorithms can also interact with each other without any malicious intention.

2.3   Latency issues

Another source of legitimate self-trades could be technological limitations. Exchanges and trader terminals are situated at different physical locations which affect order placement and trade confirmation timings. Orders sent to two different exchanges could reach with a delay because of difference in the speed of computer network lines. This time delay is known as "latency".

Algorithmic trading strategies doing arbitrage across two exchanges continuously send buy and sell orders. Due to latency differences across the two exchanges, traders may get "trade confirmations" exchanges at different time-points. A possible scenario where a self-trade can happen due to such technological issues and with absolutely no malicious intent is described below:

• The arbitrage algorithm keeps sending buy orders to BSE and sell orders to NSE based on a price difference.
• For a particular set of orders, trade confirmation on one leg of the order is received from one exchange, but not from the second exchange.
• Meanwhile, the trader's algorithm sends a second pair of a buy and sell order to BSE and NSE respectively.
• Later, it is realised that the second leg of the first order on BSE did not get execution. The trader will, thus, have to reverse the executed position on NSE for the first order.
• To reverse the position, the trader sends a buy order to NSE.
• This buy order on NSE ends up interacting with the sell order sent in Step 3 resulting in a self-trade.

All of the above are cases of self-trades that can occur within the same firm, but from separate or distinct underlying strategies with genuine trading interest. These examples show that it is wrong to think that all self-trading is market abuse.

3   Regulatory mechanism worldwide

Self-trading in securities is a concern for regulators worldwide. It has, however, been recognised that such trades can also happen with legitimate purposes. As a result, regulators globally have made various changes to accommodate for such transactions.

3.1   The US securities law

In an amendment to the securities law, the US SEC approved a rule change proposed by the Financial Industry Regulatory Authority, Inc. (FINRA) relating to self-trades in 2014. In its description of the proposed rule change, FINRA noted:

• Transactions resulting from orders that originate from unrelated algorithms or from separate and distinct trading strategies within the same firm would generally be considered bona fide self-trades.
  
  Thus, the proposed rule allowed for legitimate cases of self-trades arising from unrelated trading strategies. Caution is however taken in allowing this form of activity by the use of the word "generally". In its response to a comment, FINRA noted:
  

  "although self-trades between unrelated trading desks or algorithms are generally bona fide, frequent self-trades may raise concerns that they are intentional or undertaken with manipulative or fraudulent intent".

• FINRA issued guidelines for members to have policies and procedures in place that are reasonably designed to review their trading activity for, and prevent, a pattern or practice of self-trades resulting from orders originating from a single algorithm or trading desk, or from related algorithms or trading desks.
  
  FINRA noted that even if not purposeful, a material percentage or regularity of such transactions from related desks, may give a misimpression of active trading in the security. This can adversely affect the price discovery process. It is therefore recommended that members must put in place effective systems to prevent such trades. But it also stated:
  

  "the rule will not apply to isolated self-trades resulting from orders originating from a single algorithm or trading desk, or from related algorithms or trading desks, provided the firm's policies and procedures were reasonably designed".

  In defining "related", FINRA stated its understanding that discrete units within a firm's system of internal controls typically do not coordinate their trading strategies or objectives with other discrete units of internal controls, but that multiple algorithms or trading desks within a discrete unit are permitted to communicate or are under the supervision of the same personnel and thus, are presumed to be related. It also stated that the proposed rule permits firms to rebut this presumption, suggesting that a firm could demonstrate that "related" algorithms or trading desks are in fact independent or are subject to supervision or management by separate personnel.

Subsequently, after receiving comments from market participants on the proposed rule change, and minor amendments to the proposed law, the SEC approved the proposed rule change in May 2014.

The current rule reads as follows: Under the FINRA/SEC rule 5210(.02):

"Transactions in a security resulting from the unintentional interaction of orders originating from the same firm that involve no change in the beneficial ownership of the security, ("self-trades") generally are bona fide transactions for purposes of Rule 5210; however, members must have policies and procedures in place that are reasonably designed to review their trading activity for, and prevent, a pattern or practice of self-trades resulting from orders originating from a single algorithm or trading desk, or related algorithms or trading desks. Transactions resulting from orders that originate from unrelated algorithms or separate and distinct trading strategies within the same firm would generally be considered bona fide self-trades. Algorithms or trading strategies within the most discrete unit of an effective system of internal controls at a member firm are presumed to be related."

3.2   The UK securities law

The Financial Conduct Authority's (FCA) guidance also allows self-trades for legitimate cases. As per FCA MAR.1.6.2(2):

"Wash trades: that is, a sale or purchase of a qualifying investment where there is no change in beneficial interest or market risk, or where the transfer of beneficial interest or market risk is only between parties acting in concert or collusion, other than for legitimate reasons".

3.3   Self-trade prevention mechanisms by exchanges

With no information barriers and no technological limitations, it will be optimal that trading firms implement mechanisms to prevent self-trades at their own end. However, such an ideal world does not exist. In such a scenario, could we demand that trading firms establish systems to ensure that self-trading does not happen? Since matching occurs at the exchange's order matching platform, and hence, some degree of self-trades could be difficult to detect at the trading firm's level.

For example, when two separate dealers within the same firm send their orders to the exchange at different time points, those orders may still end up matching with each other if there are no other orders in the book. This can happen if one dealer sends a `buy' limit order at some point, while the other sends a `sell' market order at some later point of time. Similarly, if there is a large `aggressive' buy order sent by one dealer, and a normal sell limit order by another dealer which sits in the book, the `aggressive' buy order will first interact with the higher priority sell orders. If still some balance of this buy order is left, it may then end up matching with the second dealer of the same firm. In yet another case, it can also happen that one dealer sends a limit `buy' order at a point of time, but due to limitations in the exchange's order matching technology, it stands in the queue. After a point, another dealer from the same firm sends a 'sell' limit order and that order stands behind the first dealer's order. These two opposite orders can also ultimately end up matching with each other.

With no malicious intent, in all the above cases, these self-trades are inadvertent and difficult to identify at a trading firm's level. Several exchanges including the NYSE, CME, Euronext, Canadian Securities Exchange, ICE, NASDAQ have implemented self-trade prevention (STP) mechanisms that alert the traders to the occurrence of a self-trade from the same member, and let them make a choice to either, cancel the resting order, or the aggressive order. Some of the exchanges including the ICE and NASDAQ give the a choice to opt for the use for this service at either the company, group, or trader level.

In India, BSE introduced a similar system in January 2015 on its equity derivatives and currency derivatives segment. It extended the facility to the equity segment in March 2015. NSE will be introducing self-trade prevention mechanism in the currency derivatives segment starting August 3, 2015. The systems, on both the exchanges, however, only cancel the incoming (active) order of the client.

4   The current regulatory framework in India

Under the current regulatory framework, Regulation 4(2) of the Securities and Exchange Board (Prevention of Fraudulent and Unfair Trade Practices of Securities) Regulations, 2003 (SEBI (FUTP) Regulations) prohibits a person from indulging in a fraudulent or unfair trade practice.

The operative part of the regulation 4(2) reads as under:

"Dealing in securities shall be deemed to be a fraudulent or an unfair trade practice if it involves fraud and may include all or any of the following, namely:-

(a) ...
(b) dealing in a security not intended to effect transfer of beneficial ownership but intended to operate only as a device to inflate, depress or cause fluctuations in the price of such security for wrongful gain or avoidance of loss; ...
(g) entering into a transaction ...without intention of change of ownership of such security;..."

Since the buyer and seller in a self-trade are the same entity, there is no change in ownership of the shares. Clause (b) of Regulation 4(2) prohibits self-trades originated with manipulative intentions.

5   Issues with past SEBI orders on self-trades

We outline a case below and highlight how SEBI has failed to provide sufficient evidence of market manipulation, and refused to recognise co-incidental and unintentional self-trading activity which occurs (a) within a firm or (b) as a result of algorithmic trading.

In the case of Crosseas Capital Services Pvt. Ltd:

(a) The Adjudicating Officer (AO) said:

"It may be noted that these different CTCL ids belong to the same Stock Broker / legal entity i.e., noticee, therefore, matching of trades amongst them will have to be considered as a 'self-trade'."
...
"Further, the argument of the noticee that final trader id may be identified by CTCL id is not the right interpretation and the self-trades at the member level has to be considered because the UCC for each client is different in case of trading for clients whereas in the case of proprietary trading the trades are executed in member's 'PRO' code irrespective of number of dealers / traders employed to execute the proprietary trading."

The AO, here, considered a proprietary firm's trading activities solely from the viewpoint of the legal entity, and not at the trader id or dealer level.

As described above as legitimate cases, self-trades occurring from unrelated trading desks, and functioning independently may not be manipulative, and need to be considered separately. Exchanges themselves, register the user id and terminal ids for each dealer. It is therefore, inappropriate to not consider trades at the level of traders or terminals.

(b) The AO said:

"... the total self-traded volume is 78,927 shares at BSE and 38,229 shares at NSE which is very high."
...
"The number of instances of self-trades executed by the Noticee is extremely high i.e. 6,051 trades at BSE and 2,985 trades at NSE which is not miniscule by any stretch of imagination as contended by noticee."

The AO states that there was a very high scale of self-traded volume. The said volumes are respectively 0.53% and 0.10% of the total quantity traded that day on the security on BSE and NSE. SEBI failed to establish materiality by comparing these numbers to an appropriate benchmark.

6   Judicial treatment of unintentional self-trades

The Securities Appellate Tribunal (SAT) has, previously, refused to acknowledge unintentional self-trades that emanate from independent terminals and traders, and has obligated firms to prevent self-trading by all means.

• In Systematix Shares & Stocks (India) Limited vs SEBI, SAT held:
  

  "..Trades, where beneficial ownership is not transferred, are admittedly manipulative in nature".

• In Anita Dalal vs. SEBI, SAT held:
  

  "Self-trades admittedly are illegal. This Tribunal has held in several cases that self-trades call for punitive action since they are illegal in nature."

• In Triumph International Finance Ltd. vs. SEBI, the Tribunal held:
  

  "The buyer and the seller were also the same. It is obvious that these trades were fictitious to which the appellant was a party. They were fictitious because the buyer and the seller were the same."

 

7   Solution

In India, FUTP regulations do not deal with legit self-trading activity which may happen within a firm without intent of manipulation. Since there is no clear law which deals with self-trades specifically, even genuine self-trades activity often falls under the "unfair trade practice" category.
In light of these issues, the following changes are proposed as a solution to deal with self-trading activity.

7.1   Legislative actions

The current SEBI FUTP regulation 4(2), 2003 should be amended as:

1. Clause (g) of 4(2) treats all self-trades as manipulative and should be removed.
2. The following clauses should be included in this section:
• Transactions in a security resulting from the unintentional interaction of orders originating from the same firm that involve no change in the beneficial ownership of the security, generally are bona fide transactions. Transactions resulting from orders that originate from unrelated algorithms or separate and distinct trading strategies within the same firm would generally be considered bona fide self-trades.
• Algorithms or trading strategies within the most discrete unit of an effective system of internal controls at a member firm are presumed to be related.
• Members must have policies and procedures in place that are reasonably designed to review their trading activity for, and prevent, a pattern or practice of self-trades resulting from orders originating from a single algorithm or trading desk, or related algorithms or trading desks.

7.2   Improvements in SEBI processes on the executive functions

The following measures should be adopted by the regulator to deal with, and investigate self-trading activity:

1. Before starting the investigation, the number of shares traded via self-trades should be significant i.e. above an appropriate benchmark, in terms of volume and value of transactions.
2. The regulator should be able to reasonably demonstrate the impact of self-trades on the price.
3. Patterns and practice of self-trades should be looked at before considering them as manipulative.
4. Exchanges should implement Self-Trade Prevention systems and offer these services to its members on a voluntary basis.
5. The regulator should issue guidelines regarding self-trading in line with the proposed changes to the law.

These rules need to be woven into the internal process manuals at SEBI on enforcement against market abuse.

8   Conclusions

At present, subordinate legislation by SEBI, enforcement actions by SEBI and rulings at SAT are unanimous in viewing all self-trading as being synonymous with market abuse. In this article, we have demonstrated that this presumption is incorrect. Some but not all self-trading is market abuse. Financial regulators elsewhere in the world have obtained greater precision in enforcing against market abuse while not punishing legitimate actions. We have shown actions that need to be undertaken at SEBI on the legislative and the executive side in order to address this problem.

The discussion above has been couched in the language of the equity market, which is the most sophisticated component of the Indian financial system. It is, however, completely general and pertains to all organised financial trading. As an example, if SEBI implements the above improvements, all this progress will immediately accrue to commodity futures as SEBI is now the regulator for commodity futures trading also. In the future, when the Bond-Currency-Derivatives Nexus moves from RBI to SEBI, similar gains will accrue there also.

Acknowledgements

We thank Pratik Datta, Shubho Roy, Anjali Sharma, and Susan Thomas for their valuable comments.

Implications of bringing commodity futures into the Ministry of Finance

Essentially everywhere in the world, we see unification of trading in all kinds of products -- spot or derivatives, equities or currencies or fixed income or commodities etc., OTC or exchange. It makes too much sense to reap economies of scale and economies of scope, both in the private sector and in the work of regulation and supervision. The arrangement in India, where the Forward Contracts Regulation Act (1952) envisages the Forward Markets Commission that is a part of the Department of Consumer Affairs, is a silly one.

Everything we have learned about how to run the equity market is valuable for commodity futures:

• The regulatory governance process at SEBI including authority to issue regulations, enforcement process, appeals at SAT, etc.
• Governance problems of Infrastructure Institutions with three-way separation between shareholders, managers and trading members.
• Netting by novation at the clearing corporation.
• Not having `badla' trading.

It is likely that the Ministry of Finance would not give an exemption to any exchange from regulation. A lot of what we saw in this field in the last decade would not have arisen if commodity futures had been placed with SEBI and MoF. But then, we have had dubious finance ministers and one should not be too confident. The price of sound governance is eternal vigilance.

Merging FMC into SEBI began as controversial ideas:

• One markets regulator or three? in the Business Standard, 1997.
• An interview in the Financial Express, 1998.
• Rethink financial intermediation in the Business Standard, 1998.

Then it turned into a government committee process:

• On 14 May 2003, a committee was setup headed by Wajahat Habibullah, who was secretary of the Department of Consumer Affairs. Key persons who shaped this work were S. Narayan, who was Secretary at the Department of Economic Affairs, and Ashok Lahiri, who was Chief Economic Advisor.
• Percy Mistry's committee said: Redraft the legal foundations for organised financial trading, so as to unify all organised financial trading under SEBI regulation. This would include currencies, equities, sovereign and corporate bonds, and commodity derivatives.
• Raghuram Rajan's report said: all organized financial trading, spanning currencies, fixed income, equities, commodity futures, exotics (such as weather and decision markets), and spanning all trading venues and forms of trading should come under a single regulator, the SEBI.
• The draft Indian Financial Code has a general and sector neutral treatment of financial regulation where all organised financial trading is the work of the Unified Financial Authority.

In 2003 and 2004, we were well on our way on getting this done. However, once the UPA government came to power in May 2004, and Sharad Pawar became the minister in charge of Consumer Affairs, it became infeasible to shrink his turf. By that time, substantial commercial interests had developed which wanted to preserve the existing arrangement, with regulatory capture of FMC.

More generally, one of the most harmful instincts of bureaucrats and citizens in India is the notion that the boundaries of government agencies are somehow sacred. There is much resistance to changing the role and function of a government agency. But every employee of government exists to serve the people of India, and we need to continually change the block diagram of government so as to best cater to the fast changing requirements of the economy.

Now we have a crisis on our hands, and policy makers have resurrected the project. While there is a news item, the details are not yet visible. The first step would be a small change in the allocation of business rules, through which the subject of commodity futures trading would shift from the Department of Consumer Affairs to the Ministry of Finance. The big step would be to repeal the FC(R)A and modify securities law appropriately; until this is done, the gains would be limited. The draft Indian Financial Code is a natural source of ideas on how this drafting should be done.

In the short term, the FMC would become a part of the Ministry of Finance. Important decisions at FMC would go up to the Ministry of Finance and ultimately the Minister of Finance for approval. The knowledge on organised financial trading at the Ministry of Finance will give us improved decisions under the existing law. We may expect considerable porting of regulations and public administration practice from SEBI into FMC.

This seems to be a season for old policy projects working out. First the Pensions Act, and now this. Nothing like adversity to make India deliver.

Implications of the Pensions Act

In 1998, the Ministry of Social Justice and Empowerment setup `Project OASIS', led by Surendra Dave, to engage in deep thinking about pension reforms. The report, which was submitted on 11 January 2000, envisaged an individual account defined-contribution system with central recordkeeping, and recruitment of fund managers by an auction which asked for the lowest fees+expenses.

This was a futuristic vision at the time, as a lot of the surrounding infrastructure had not fallen into place. In socialist India, it was quite novel to propose that households would build their own assets to take care of themselves in old age. However, the idea rapidly got widespread acceptance. More and more people started looking at the maladies around them and said that if only we had the NPS, these problems would not arise.

NPS was ahead of its time in being mistrustful of mutual funds and insurance companies. The great scandals of mutual funds and ULIPs lay in the future. Issues of consumer protection were not widely understood in 1998. But the key calls made in the NPS have proved to be the right ones: of delivering a solution that is good for the lifetime financial planning of households while giving financial firms wafer-thin margins. Apart from index funds, the NPS is essentially the only piece of Indian finance that is accessible to the average household that I trust. Thinking on consumer protection has progressed enormously in the following years, first at IFMR and then in FSLRC. Yet, the NPS designed in 2000 fares well in satisfying the consumer protection principles of the draft Indian Financial Code of 2013.

In December 2002, NPS was adopted by the NDA government as the mandatory pension system for all new recruits after 1 January 2004. All this was re-opened by the UPA government when it took charge in May 2004, and they chose to stay on course.

From May 2004 to September 2013, we were unable to make progress on the proper legal foundations. But the NPS was built and executed through a network of contracts and rules, planned out by one of India's best lawyers (P. Chidambaram), which is legally sound. All civil servants recruited after 1/1/2004 have been placed into the NPS, and by now this is shaping up to be substantial numbers. NPS has also started gradually going into the unorganised sector, with the assistance of co-contribution.

The wheels grind slow, but they grind true. I wish all this had happened faster, but it is good that it happened. The key implication of this decision by Parliament is that the NPS cannot be shut down by a future administration. To find out more, I suggest :

• Concepts of the NPS and their rationale: Indian pension reform: A sustainable and scalable approach by Ajay Shah, Chapter 7 in `Managing globalisation: Lessons from China and India', edited by David A. Kelly, Ramkishen S. Rajan and Gillian H. L. Goh, World Scientific, 2006.
• A story of how the NPS came about: India's pension reforms: A case study in complex institutional change by Surendra Dave, page 149--170 in `Documenting reforms: Case studies from India', edited by S. Narayan, Macmillan India, 2006.
• A recent look at developments in implementing the civil service pension: Civil service and Military Pensions in India by Renuka Sane and Ajay Shah. Chapter 4 in `Reforming Pensions for Civil and Military Servants', edited by Noriyuki Takayama, Maruzen Publishing, 2011.

This story is interesting not just from the immensely important problem of ageing, but also as a case study in how we achieve far-reaching change in India. I disagree with the pessimists who limit their ambitions to minor tinkering changes. We in India must constantly question the foundations; almost everything about the Indian State is broken and needs to be redone from scratch.

There has been a sea change in thinking about financial law in India thanks to the work of the Financial Sector Legislative Reforms Commission.  In 2001 and 2002 we did not know how to draft law. The PFRDA Act reflects the old ways of drafting law and will not look good to modern eyes.

Looking into the future, the story now runs on five tracks:

1. Making the civil servants NPS work properly as originally envisaged. At present it does not.
2. NPS has forked into two systems: one for the unorganised sector and another for civil servants. These need to be merged into one single system with full portability.
3. Achieving large-scale participation and sustained contribution for the unorganised sector -- while not sacrificing the heart of the NPS which is wafer thin charges. All too often, we get an urge to do to the NPS what was done to mutual funds and insurance companies.
4. Using this institutional capacity to solve the problems of EPFO.
5. We will need to adapt the PFRDA Act and the draft Indian Financial Code so as to achieve the following framework: (a) NPS would become a pension system run at the instance of the government, (b) It would be regulated by the machinery of the Indian Financial Code, (c) PFRDA would get merged into the proposed Unified Financial Authority (UFA). It is more important to be correct than to be consistent.

Too sensational: The defence of the rupee

                                       Miss Prism: Cecily, you will
read your Political Economy
in my absence. The
chapter on the
Fall of the Rupee
you may omit.

It is somewhat too sensational.

-- Oscar Wilde,
The Importance of Being Earnest,
1895.

The graph above superposes the INR/USD exchange rate and Nifty, both reindexed to start at 100 on 15 May 2013. The graph runs till 21 August (i.e. yesterday). The rupee has depreciated by 17% and Nifty has dropped by 13.7%. I feel that the drop in Nifty is substantially about the reversal of reforms of this period. On the exchange rate, I think every short seller of the world got attracted watching the government trying to defend the rupee, which has given overshooting. This problem was exacerbated because RBI had damaged the liquidity of the currency market; when a flood of orders came, the price moved more because the market was shallow.

Here's a kit of readings. By now, almost everyone thinks that the Strong Rupee Policy was a mistake. It's interesting watching people switch positions through this time-line.

• Why did we bumble on the defence of the rupee?, Economic Times, 21 August.
• Crisis and complicity, Pratap Bhanu Mehta in the Indian Express, 21 August.
• A deadly defence, Surjit Bhalla in the Indian Express, 21 August.
• The RBI should end its stop-go policies, Lars Christensen in Mint, 21 August.
• Credibility crunch, Sanjaya Baru in the Indian Express, 20 August.
• Let the rupee sink, Andy Mukherjee in the Business Standard, 20 August.
• The needless battle, by Ila Patnaik in the Indian Express, 19 August.
• Editorial in the Business Standard, 18 August.
• Editorial in the Indian Express, 17 August.
• India Inc hedges its bets by Ila Patnaik in the Financial Express, 16 August.
• Editorial in the Business Standard, 15 August.
• Will the capital controls to defend the rupee work?, 14 August.
• Editorial in the Indian Express, 13 August.
• Govt, RBI fighting a losing battle on rupee, Tamal Bandyopadhyay in Mint, 13 August.
• We don't know much about what the exchange rate ought to be, 12 August.
• Should we have picked this battle?, Economic Times, 7 August.
• Don't hold the rupee, by Abheek Barua in the Business Standard, 6 August.
• The collateral damage to banks from RBI, Ravi Krishnan in Mint, 5 August.
• RBI norms on gold imports may deal a blow to domestic jewellers, Dinesh Unnikrishnan in Mint, 1 August.

• Editorial in the Indian Express, 31 July.
• Editorial in the Business Standard, 31 July.
• Rising collateral damage, Sonal Varma in Mint, 30 July.
• Does India need sovereign bonds?, by Ila Patnaik in the Financial Express, 24 July.
• Editorial in the Business Standard, 24 July.
• RBI's rupee rescue mission may hurt government, by Anup Roy, Manish Basu, Kayezad E. Adajania in Mint, 24 July.
• India moves closer to gold import quota to stifle demand, Siddesh Mayenkar and A. Ananthalakshmi in Mint, 24 July.
• Editorial in the Business Standard, 23 July.
• Offshore funds make a killing on betting of movement of interest rates in India, by Sugata Ghosh in the Economic Times, 22 July.
• There is no method to RBI's madness, by Tamal Bandyopadhyay in Mint, 22 Jul.
• Editorial in the Indian Express, 17 July.
• Government paper sales cancelled after investors demand high yields, Anup Roy in Mint, 17 July.
• Editorial in the Indian Express, 16 July.
• Step back into the ring, by Jahangir Aziz in the Indian Express, 16 July.
• RBI, SEBI attack currency speculator; but rupee stays intact, by Mobis Philipose in Mint, 15 July.
• The taming of the rupee, by Ila Patnaik in the Financial Express, 12 July.
• The attack on the market for the rupee is a mistake, Economic Times, 11 July.
• Editorial in the Indian Express, 11 July.
• Losing currency, by Ila Patnaik in the Indian Express, 10 July.
• Editorial in the Business Standard, 10 July.
• Hedging surge prompts RBI inquiry on rupee moves, Bloomberg content in Mint, 8 July.
• Editorial in the Business Standard, 8 July.
• RBI moves to curb rupee speculators, Rafael Nam and Suvashree Dey Choudhury in Mint, 2 July.

• Rupee at 60: the options before RBI, by Tamal Bandyopadhyay in Mint, 30 June.
• How to cap the CAD, by Ila Patnaik in the Financial Express, 28 June.
• Don't try to control the rupee, by Ila Patnaik in the Financial Express, 21 June.
• Do not mourn rupee fluctuations, Economic Times, 11 June.

• Rupee will need support in coming months, Renu Kohli in Mint, 28 May.
• The arrogance of power, 12 May.
• How do you prevent rupee trades?, by Ila Patnaik in the Financial Express, 10 May.

• The rupee: Frequently asked questions, 1 December 2011.

And, you may find it interesting to see an updated picture of the evolution of the Indian exchange rate regime [methodology]:

This graph shows a moving window of annualised volatility of the INR/USD exchange rate for the last 15 years, starting from 28 August 1998. Vertical lines show the two dates of structural change of the exchange rate regime. As we see, we had volatility of 1.84% for 4.74 years until 23 May 2003. Then we jumped up to 3.87% volatility for 3.84 years. This lasted till 23 March 2007. We are now in the longest single period under one single exchange rate regime: 6.42 years spent with an annualised volatility of 8.73%. Through this period, every debate on exchange rate policy ended up in favour of exchange rate flexibility. The floating exchange rate is the only stable long-term option for India.

Call auctions and their use for the opening price on the stock market

In a SEBI circular today, we have movement on the use of call auctions for the opening price of the stock market. For more in this subject, see Call auctions: A solution to some difficulties in Indian finance by Susan Thomas, June 2010.

Currency futures: An example of how India changes

Exchange-traded derivatives originally only did commodity underlyings. The world's first financial underlying was : currencies. On 16 May 1972, the Chicago Mercantile Exchange started trading in currency futures. To any finance person, nothing is simpler than a currency futures, but unfortunately in India a mixture of ignorance, ideology and turf considerations has hindered progress.

In 1996, when NSE had just got started talking about equity derivatives, I happened to be session chairman in a conference organised by Invest India titled The future of India's stock exchanges and I remember asking Ravi Narain something like "Have you thought about other underlyings? Would you trade currency futures?". Ravi leaned into the mic and said "We'd love to.".

Most people in India were blinded by the notion of `RBI turf' and did not think seriously about this problem. When I look in my media archive I see a bit on currency futures in Extracting information from finance, August 2006, and in a few pieces before that, but these were just isolated little things. Unbanning currency futures trading was not seriously on the policy radar. When any discussion about this took place, various RBI personnel would claim that futures trading would somehow make Mother India unsafe.

In the Indian discourse, the committee report on Mumbai as an International Financial Centre, chaired by Percy Mistry (April 2007), had the first clear text on currency derivatives.

In April 2007, a column titled Currency futures now, emphasised the links between a well functioning currency derivatives market and the ability of the economy to absorb exchange rate fluctuations. (This old piece is a good response to Shankar Acharya's column in Business Standard today, where he bemoans the shift away from administered exchange rates. The price of steel and crude oil and the dollar will fluctuate: get used to it and get the right derivatives going).

It took 36 years from the date of the innovation (currency futures at CME) to get started with trading in India. For a comparison, with other innovations, India goes much faster. As an example of a technical innovation which also requires government capability, GSM telephony started up in Europe on the late 1980s and in India in the late 1990s - a gap of 10 years. So if we judge arms of the Indian state by the extent to which they impede progress, the governance quality in DOT in the 1990s was better than that seen with finance in the last decade.

On 2 September 2008, I was complaining about a crash in productivity. On 3 September 2008, I got a first detailed look at the liquidity of the currency futures market.

In a year, on 23 September 2009, one could cautiously suggest that currency futures liquidity was ahead of that on the OTC market. This was clearly visible in the article by Gurnain Kaur Pasricha on 25 November 2009. Here, we were on new terrain: nobody else in the world had done this other than Brazil. The global first-mover, the CME, would envy the liquidity of the NSE currency futures contract.

And finally, on 21 April and 22 April of this year, we see signs that the currency futures are more liquid than the Nifty futures.

How could this have been done better? There is nothing innovative about launching currency futures. There is nothing more commoditised and better understood than an exchange-traded clearing-corporation-settled cash-settled contract on a currency. But the mixture of ignorance, ideology and turf battles that impedes progress in India is alive and well.

With currencies: Currency forwards (and the NDF market) are the only choice for FIIs, who are banned from using the exchange-traded currency derivatives. Corporate users are still pushed by the existing rules to go to the OTC market. Currency options trading will now commence - but only for the INR/USD and not for other currency pairs. And futures trading on all currency pairs other than INR/USD, INR/EUR, INR/JPY and INR/GBP is banned.

With interest rates: RBI believes that with interest rate underlyings, cash settlement is somehow dangerous and that derivatives trading on short-dated interest rates will interfere with the conduct of monetary policy. I wonder how that is reconciled with OTC interest rate swaps involving MIBOR, and with the fact that all good central banks in the world are doing monetary policy without banning either cash-settled interest rate underlyings or short-maturity underlyings.

In short, currency futures is a good story and a bad story. It is a good story in that in the end, we are one of the best countries of the world in terms of getting exchange-traded currency derivatives to work. It's a bad story in that it took a lot longer than it should have, and the problems that impeded progress continue to be with us.

Goodbye great moderation, hello financial fraud?

The calculations that lead up to fraud

Under normal circumstances, the checks and balances of capitalism work fairly well, particularly in good countries, when it comes to the problems of fraud. This reflects the rational decisions of individuals who compare the benefits from two paths:

Behaviour within the rules

This yields the NPV of cashflow from now until death from being able to work and earn profits in the business.

Breaking the rules

This yields some benefits immediately. There is a certain probability of getting caught and a certain delay in getting caught. Once the person is caught, a punishment is inflicted, and the NPV of cashflow from good behaviour is lost.

The system of checks and balances has been optimised for normal times and, by and large, in good countries, it does a good job of deterring misbehaviour.

Understanding the two big recent blowups

The global economic turbulence changes the balance between these elements. For many people who have their backs against the wall, when faced with imminent disaster in their ordinary business, the payoff to the first option -- behaviour within the rules -- goes down sharply. This increases the temptation of breaking the rules.

I think this is one insight into the disclosures about fraud by Marc S. Dreier [link] and Bernard L. Madoff [link, link].

The Madoff story will inspire some to say that the concept of a hedge fund is fundamentally broken. They will argue that in good times, the checks and balances work out okay, but when volatility is high and some hedge funds have made very large losses, the temptation towards malpractice becomes irresistible, and the lack of hands-on government involvement in hedge funds is a fatal flaw.

The story is a little more complex. A more careful examination shows that both cases (Dreier and Madoff) were a bit out of the ordinary. In the Dreier case, as the NYT article by Alison Leigh Cowan, Charles V. Bagli and William K. Rashbaum says:

Mr. Dreier, 58, controlled the finances of his law firm to an unusual degree, according to lawyers there, because of the unusual way it was set up.
Mr. Dreier was the only equity partner in the firm, and deals were structured so that only he knew all the specifics and had access to all accounts, people with the firm said in court papers. Mr. Dreier convinced lawyers that such an arrangement was best by emphasizing that it would allow them to concentrate on their first love, the law, while he worried about running the firm.
There would be no executive committee. No partners meetings. Mr. Dreier would handle all administrative chores.

Their checks and balances were unusually weak for this organisation, even by the standards of tranquil times.

In Madoff's case, as Roger Ehrenberg says:

Hedge funds, the purported touchstone of the unregulated entity, are far more regulated and subject to many more checks and balances than Madoff every was. I've long made the argument that hedge funds are actually heavily regulated, not directly but indirectly through their relationships with the heavily regulated prime brokers. Forget about the negative PR and spin - it's true. Prime brokers have full transparency into the books of hedge funds, contribute data to the reporting of Net Asset Value (NAV), which is generally pumped out by the hedge funds' administrator. There is a further layer of protection offered by the hedge fund's auditor. Unless everyone is in cahoots it is pretty hard to see how a hedge fund is systematically mis-reporting NAV (except with respect to illiquid assets, but this is another issue entirely). 

Some of the biggest non-market risks of hedge funds include style drift (veering from the strategy outlined in the prospectus, such as when Amaranth's natural gas trades ceased to make it a multi-strategy fund), creeping illiquidy (taking advantage of the illiquid asset carve-out in the prospectus only to see the value of the liquid assets fall, resulting in a prospectus-breaching concentration in illiquids), overuse of side pockets (concentrated, balky public positions that don't fall under the rubric of illiquids yet result in a similar risk profile) and manager fatigue ("If I'm down 50% and it will take me years to dig out from under my high water mark, I'll just shut down"). Note that these risks have to do with the character of the manager, things that a good due diligence process should ferret out. But they really don't have to do with the veracity of the firm's positions, books and records, as third-party involvement together with the regulatory oversight of the prime brokers makes the Madoff kind of fraud highly unlikely.
But Madoff is a completely different kind of firm. It is a broker/dealer with an asset management division, enabling it to rely entirely on itself for trading and settlement. Further, it used a no-name, three-person accounting firm, unheard of for a firm of Madoff's size, scope and complexity. A purely rational trader of Madoff's stature would have set up a hedge fund business to extract 2/20 from his clients. I guess we now understand why; it would have subjected his portfolio to the unwanted scrutiny of his prime brokers. By keeping his game completely in-house and on the down low, it essentially fell through the cracks of our regulatory structure. Will this cause the SEC to redouble its efforts in regulating broker/dealers? Force changes in transparency, similar to what I've pushed for in the OTC derivatives market to the broker/dealer community? Or is it simply a matter of creating rules that ensure credible third-party involvement in the validation of assets under management/NAV in order that Madoff's brand self-dealing couldn't be sustained? 

When it comes to client funds, I believe the involvement of multiple third-parties in the validation of positions and NAV is critical. Checks and balances have to be built into the system, and by employing a structural approach to regulation as opposed to simply adding more regulations, I believe we can minimize the friction in the system while providing the necessary protections to individuals and institutions. The lack of trust so pervasive in today's financial markets just took another hit. But let's take a moment to think of the right way to address the issue (better due diligence, higher standards for fiduciaries, imposition of checks and balances with broker/dealers and asset managers working under the same roof), rather than the way that plays best for PR purposes.

In this case also, the checks and balances that prevailed on Madoff's operation were not typical of what is found with the ordinary hedge fund. The Madoff story is not an indictment of the concept of a hedge fund, but a critique of the specific form through which his fund was organised.

Benefits from the involvement of a third party

I see an analogy with the idea of the third-party repo.

A repo is a collateralised loan. You give me a security worth Rs.100 and I give you a loan of Rs.80. As the price of the security fluctuates, marking to market needs to be done to ensure safety. The difference (Rs.20) is called the `haircut'. The size of the haircut is chosen based on the price risk and liquidity risk of the security between two consecutive marks-to-market.

It is possible to organise a repo properly with bilateral credit risk exposures. If both parties were good and efficient, then marking to market of collateral values would take place properly, haircuts would be computed correctly and always maintained. But there is the risk of operational failures or outright fraud. This is where the `third-party repo' greatly improves matters. The borrower and lender do not directly deal with each other: each deals with the 3rd party who supervises the proper functioning of the transaction as time passes.

This helps simply by bringing in a third party into the transaction. It increases the number of people reconciling accounts. But at the same time, if the third party is just an accountant, there is a greater risk of his doing work only on a best efforts basis. What will really bind the incentives of the third party is for him to do netting by novation: for him to be the legal counterparty to both sides. So when X borrows from Y, at a legal level, X borrows from the third-party and the third-party borrows from Y. This ensures incentive compatibility for the third-party who is then much less likely to make mistakes.

An Indian perspective

In India, under normal conditions, blocking fraud is difficult because the probability of being caught is low, the delay in imposing punishment is high, and the punishment is often quite small.
In this backdrop, the events of 2008 have induced massive profits and losses in unexpected places. I suspect some scandals will pop up.

By and large, the world of SEBI, NSE, NSCC, CCIL, BSE, NSDL, CDSL and mutual funds works fairly well in having strong checks and balances. The life of a typical securities firm in connection with these elements of securities infrastructure is tightly integrated into IT systems run from above. These IT systems correspond to a real-time offsite supervision system. They substantially remove room for fraud. While I expect things will work out okay there, there is always the possibility of some chinks in the armour showing up.

The famous scandals of the past are instructive. Harshad Mehta exploited the flaws of the depository for government bonds. Ketan Parekh exploited the weak risk management of Calcutta Stock Exchange. Home Trade exploited the flaws of the settlement system for bonds. Each of these took place in a part of the system where the real-time offsite supervision system described above was absent. That's a fair guide to what might happen in 2009.

Problems are perhaps more likely in the less regulated companies including listed companies. Some firms have a lot of leverage on their balance sheets and some CEOs have a lot of leverage on their personal balance sheets. Some CEOs have personally given buyback promises to institutional investors who got invested in their stock. These individuals are under a lot of pressure. The less ethical of them could buckle under this pressure and resort to breaking the law.