India should not let Finance become a Frankenstein monster

On January 20th, I read in THE HINDU that Indian stockbrokers wanted the Securities and Exchange Board of India to roll back its new risk management norms for derivatives. I was both amused and not amused. Along with Praveen Chakravarty and Ajit Ranade, I had written about the need for tightening risk management norms for derivatives exposure in Indian stock markets. Prior to these op.-eds., in our co-authored book, ‘Economics of Derivatives’, Dr. T.V. Somanathan and I had highlighted that derivatives were almost wholly used for speculation (=gambling) rather than for hedging.

That does not mean they needed to be banned but the losses from such speculative activity should be borne wholly by the participants who engage in them and that they should not have systemic consequences.

Based on the news-story, one does not get the impression that the brokers have provided any solid arguments or evidence that the proposed margining requirements would do zilch to reduce risk. In fact, their very protest is solid indication that it would. If it resulted in a lower volume or transactions in the derivatives markets, it is good for systemic stability.

This is a classic example of the case of socially useless finance. India, at this stage of development, does not need to go out of its way to facilitate such financial market activities. Instead, it should do what SEBI is trying to do now.

My co-author Gulzar Natarajan and I have finished our manuscript, ‘The Rise of Finance: causes, consequences and cures’ and we have received the first proof from the publisher. We hvae a special chapter on India. India needs to avoid repeating the mistakes that the West made with respect to Finance. The West allowed Finance to become a Frankenstein Monster and India does not have to repeat that mistake.

The myth that secondary market trading facilitates efficient capital allocation in primary markets has been persisted with, for too long, without being subject to the burden of proof. Shrinking investment horizons alone should have let that theory be put to rest permanently. It has not.

Buttonwood, in its penultimate column in ‘The Economist’ last year had written on the ‘Flaws in Finance’. There was a link to his earlier article published in May 2015. Both the short piece from May 2018 and the long essay he had written from May 2015 are thoughtful and make for good reading. But, his conclusions are vague. Here are two samples:

For all their criticism of mainstream economists, the challenge for the behavioural school is to come up with a coherent model that can produce testable predictions about the overall economy. [Link]

Here is the second one:

For too long economists ignored the role that debt and asset bubbles play in exacerbating economic booms and busts; it needs to be much more closely studied. Even if the market is efficient most of the time, we need to worry about the times when it is not. Academics and economists need to deal with the world as it is, not the world that is easily modelled. [Link]

In contrast, witness the most practical suggestion from Cliff Asness:

Making people understand that there is a risk (and a separate issue, making them bear that risk) is far more important, and indeed far more possible than making a riskless world. And if I may go further, trying to create and worse, giving the impression you have created, a riskless world makes things much more dangerous. [Link]

Honestly, the call for new models, etc., are either diversionary or distracting. They are not needed. One does not have to have new behavioural models that incorporate human irrationality. In fact, all that is needed is for policymakers to be reasonable.

(1) You may believe that markets are mostly or, for the most part, efficient. I do not. But, you can accept that humans can and do make mistakes. That is reasonable assumption.

(2) That one does not ignore empirical evidence is a reasonable thing to ask of policymakers

(3) That one requires policymakers to be able to see through the self-interested demands of the financial sector is not such a onerous demand either.

(4) Policymakers simply have to stop writing CALLS and PUTs for the financial sector. That is what Cliff Asness is saying in the quote above. Central banks do not have to remove risk from the lexicon for the financial sector and, in the process, encourage them to take excessive risks that put the economy and their goals for the economy in peril.

The fear of surprise, volatility and the realisation that policy will not be beholden to the financial sector even if there is short-term pain need to be inculcated in the financial sector.

What India’s brokers ask of SEBI is what the American financial sector has been asking of the Federal Reserve in the last thirty years and been getting, up to yesterday.

India does not have to walk the American way in this matter.

2 thoughts on “India should not let Finance become a Frankenstein monster

  1. I happen to be a trader in India’s derivative markets and also happen to know many number of other fellow traders. Contrary to popular perception (and indeed I had the same before I became a trader myself) that risk management is lax or missing in much of the individual trading community, I find that most traders focus almost exclusively on risk management (and returns take care of themselves). This comes from a sense of vulnerability and limited capital and hence I do not know of any trader who does not have Stop Losses or a risk management plan in place.

    In light of recent findings, we find that even sophisticated market participants such as banks, MF’s and Central Banks making blunders w.r.t. Risk Management. How can we explain serious lapses on the part of these professionals whose primary job is to protect capital and provide reasonable rate of return on capital. At best they were ignorant and at worst complicit in the act. Either way they don’t come out shining.

    Actually, our margin requirements for derivatives are already very high as compared to other markets, even for low risk fully hedged positions. Physical Settlement in single stock derivatives may not lead to lower volumes, but increased volatility towards the end of the settlement cycle as margin requirements increase from T-5 or T-3 days.

    I think financial education and certification is a more effective entry barrier for people wanting to participate in the derivatives market. Currently, there is no restriction on who can participate in the derivatives market. Thus, not only can we reduce the number of people in the trade, but also be more hopeful that those who are in the trade, know what they are doing.

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  2. Physical settlement is important. SEBI is moving in the right direction. NSE and brokers stand to lose if derivative volumes fall as a consequence.

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