Prof. J. R. Varma: Article Abstracts

Disguised Capital Flight and Current Account Deficit

"Disguised Capital Flight and Current Account Deficit", The Efficient Frontier, March 2013

This article based on a panel discussion on the 2013 budget discusses the domestic flight from financial assets to non financial assets and the external capital flight in the form of corporate investment outside India and gold purchases by individuals.

Corporate Hedging and Distorted Benchmarks

"Corporate Hedging and Distorted Benchmarks", CFO Connect, August 2012

The ongoing investigations into the manipulation of Libor fixing have highlighted the possibility that important benchmarks underlying corporate hedges may be manipulated by large players with the possible tacit acquiescence of the global regulators. Similarly, recent developments in key crude oil benchmarks (Brent and WTI) have demonstrated that these benchmarks can be distorted by factors that could not have been anticipated a few years ago. This affects corporate risk management based on hedges that are exposed to basis risk. Corporate risk managers must recognize that to some extent all hedges involve some degree of speculation on the “basis”, and must avoid the temptation to use hedging as a justification for excessive leverage.

Still Efficient

"Still Efficient", Financial Express, April 1, 2009

The emerging consensus is wrong in asserting that mistakes in financial regulation were caused by the belief in the Efficient Market Hypothesis (EMH). I do not think that regulators were fooled by the EMH. The truth is the exact opposite; regulators were fooled because they did not take the EMH seriously and were therefore too complacent. The EMH very simply states that there is no free lunch; whenever you see an abnormally high return, EMH warns us that there must be an abnormally high risk lurking behind it. Regulators who believed in the EMH and the Modigliani-Miller theory would have regulated banks far more tightly.

Is it time to start an OTC derivatives market?

"Is it time to start an OTC derivatives market?", Business Standard, November 14, 2007 [Full text - Downloaded from Business Standard web site]

More noise, less effect

"More noise, less effect", Business Standard, October 19, 2007 [Full text - Downloaded from Business Standard web site]

SEBI’s first proposal is to ban participatory notes that have a derivative as the underlying. This is a very confusing statement. A financial regulator should respect the semantic integrity of well defined technical terms and not abuse the term “underlying” to mean what it does not and cannot mean.

Semantics apart, if SEBI bans the use of derivatives to hedge participatory notes, it would have three implications.

  1. Since cash equities are less liquid than the futures and the volatility risk of options cannot be hedged using only the cash market, the hedging costs would increase. But, a mere increase in transaction costs would not probably kill the participatory note market.
  2. SEBI’s proposal would prevent participatory notes that involve a short position in Indian equities.
  3. SEBI’s proposal would also prevent issuance of participatory notes that are essentially synthetic rupee money market instruments. It is doubtful whether any significant amount of participatory notes are of this kind.

The second major proposal of SEBI is to ban participatory notes issued by sub accounts of FIIs. In my view, this is largely an administrative measure which would not have a significant long run impact.

SEBI’s third proposal is to limit participatory notes issuance by any FII to 40% of the assets under custody of that FII. Buyers of participatory notes would have to buy from less efficient hedgers who have not reached the 40% limit. This would increase the costs and would amount to more “sand in the wheels” whose long term impact would be modest.

The 40% limit can be circumvented by an FII buying cash equities and selling stock futures or index futures. This synthetic rupee money market position would not increase the FII’s exposure to the Indian equity market but it would increase assets under custody and allow the FII to issue more participatory notes.

Internal Capital: Best Practices

"Internal Capital: Best Practices", CFO Connect, April-May 2007

Internal capital markets are the internal capital budgeting processes through which a company or group finances divisions or Strategic Business Units (SBUs). With the rise of private equity, internal capital markets are caught between:

Corporate internal capital markets have a lot to learn from private capital markets in matters like divisional cost of capital and performance metrics that are better aligned to shareholder value.

Making the long view count

"Making the long view count", Financial Express, March 1, 2007 [Full text - Downloaded from Financial Express web site]

The Indian government budget for 2007-08 presented yesterday was a tax-and-spend Budget, and neither the taxation nor the spending was capital market-friendly, but the budget contained some policy initiatives for the capital market that would enhance its vibrancy and efficiency in the long term.

  1. I welcome the proposal to allow institutional short selling and create a proper securities lending and borrowing mechanism for this purpose.
  2. I think exchangeable bonds are a good idea, both as an additional financial instrument in the marketplace and as a mechanism for unwinding interlocked corporate holdings.
  3. The elimination of tax arbitrage on mutual funds is probably a good thing in the long run for the industry.
  4. The promise to move forward on making Mumbai a regional financial hub is welcome. This initiative announced in the 2005 Budget has gone through a tortuous process, with delays in committee formation and rumours of dissent within the committee itself. The FM’s announcement hopefully means that we will see some real action backed by a strategic vision.
  5. I read the Budget speech as signalling a willingness to improve access of Indian investors to foreign securities both directly and through mutual funds. Today it is much easier for Indians to use the $50,000 limit to invest in foreign currency bank deposits than to invest in foreign stocks and bonds.

All of this means that we will have a cleaner, stronger and deeper capital market in the years to come. That is little consolation to those nursing stock market losses on budget day, but it is hugely important for the future of India.

A year of uncertainty and volatility

"A year of uncertainty and volatility", DNA, January 3, 2007

I may be pessimistic but 2007 will be a year of much greater uncertainty and volatility. The stock market, interest rates and exchange rates – the entire economic environment will be more volatile. The last two years have seen a benign global environment in which the global economy was growing well. The year 2007 raises fears on a variety of fronts.

Allow Foreign Investment in SEs?

"Allow Foreign Investment in SEs?", Economic Times, November 27, 2006 [Full text - Downloaded from Economic Times web site]

India must welcome foreign investment in stock exchanges and other exchanges. The ownership of exchanges should be largely left to market forces with minimal regulatory intervention. The regulatory goal should be to ensure that the securities trading industry is highly competitive. Exchanges have now become complex, capital intensive, technology driven businesses, Foreign capital can play a critical role in bring much-needed competition in this business. We must not allow the incumbent exchanges to wrap themselves in the flag and appeal to our xenophobia to block new competition.

A Solution to the Financial Last Mile Problem

"A Solution to the Financial Last Mile Problem", CFO Connect, September-October 2006 [Full text - Scanned Image]

This article discusses the use of eXtensible Business Reporting Language (XBRL) in the preparation of financial statements rather than just for their dissemination and analysis. Financial analysts have begun to love XBRL and the US SEC is also now pushing companies to use XBRL in their Edgar filings. Companies however tend to think of this as another investor relations expense rather than as a productivity tool for themselves as preparers of financial statements. I argue on the other hand that it is high time that we got rid of all those spreadsheets and word processor files and used XBRL to automate the financial statement preparation process completely and integrate it completely with the corporate ERP systems. This would improve reliability, increase speed and reduce manual interventions.

On Nasdaq, LSE and extra-territoriality

"On Nasdaq, LSE and extra-territoriality", DNA Money, September 25, 2006 [Full text - Scanned Image]

This article discusses the UK proposal to create a statutory weapon against the extra territorial application of US laws to the London Stock Exchange in case of its acquisition by Nasdaq.

In general, I like regulatory competition. I think of a regulator as being in the business of manufacturing and providing regulatory products and services. Consumers of these products and services (investors, issuers and others) benefit if this industry is competitive. A vigorous defence of the competitive structure of the market for regulatory services is therefore very much welcome.

It won’t reduce volatility, but create a vibrant market

"It won’t reduce volatility, but create a vibrant market", Financial Express, June 26, 2006 [Full text downloaded from Financial Express web site]

The volatility that we have witnessed so far has been benign. While there have been large losses, there have been no major defaults or bankruptcies. Risk management systems at the exchanges have held up well. The volatility has been large enough to grab headlines but not large enough to cripple the markets. Volatility on this scale serves to focus attention on the huge fundamental uncertainty that exists. Several years of booming economies and rising asset prices have led to a reduction of risk premiums to the point where risk is probably under priced in many markets. A period of heightened volatility serves as a gentle reminder that prices can go down as well as go up. If this reminder leads to a re-pricing of risk in domestic and global markets, that is also welcome.

Reconnecting Directors to the Company

"Reconnecting Directors to the Company", CFO Connect, May-June 2006 [Full text - Scanned Image] [Full text - As Submitted]

The corporate governance problems of the twentieth century were essentially problems of governance at the big investment institutions. These problems meant that shareholder empowerment ceased to be an effective corporate governance weapon. The twenty first century is likely to be different because of the rise of hedge funds and also improvements in governance at other institutions. If shareholder empowerment works, then empowerment and reform of the Board becomes less important than reconnecting the Board to the company. That leads to a different way of looking at Sarbanes-Oxley.

Sebi norms largely okay

"Sebi norms largely okay", Financial Express, April 4, 2006

The changes announced by Sebi its public issue guidelines are largely in the right direction, but much more needs to be done.

The crux of the MATter: capital gains tax is back

"The crux of the MATter: capital gains tax is back", Financial Express, March 1, 2006 [Full text - Scanned Image]

This piece is about the Indian budget proposal related to capital gains taxation and securities transaction tax. I wrote that the government seems to have realized that its decision two years ago to replace the capital gains tax on securities with a tax on securities transactions was a mistake. My article makes the following points:

Reliance Demerger as Backdoor Delisting

"Reliance Demerger as Backdoor Delisting", Financial Express, February 13, 2006 [Full text downloaded from Financial Express web site]

In January 2006, Reliance Industries Limited demerged four companies accounting for about a quarter of its market capitalization. The delay in listing these new companies means that about a quarter of the original company (representing a market value of over $7 billion) have been effectively delisted since January 18, 2006.

This has three consequences

  1. Millions of shareholders in these companies cannot trade these shares.
  2. The corporate governance provisions regarding independent directors and investor protection do not apply to these companies.
  3. These companies are under no obligation to provide the continuing material event disclosures to the exchange that a listed company is required to provide.

The result is that a company with a million shareholders is subject only to the disclosure and governance regime that applies to a mom and pop company with a dozen shareholders.

I argue that the exchanges and the regulator should not look at the listing of the demerged companies through the framework of initial public offerings that are obviously designed to make it difficult for a company to list. Rather they should use the framework of the delisting guidelines which are designed to make it difficult for a company to delist. The situation in a demerger or delisting is that the public has already put in its money and the regulator’s priority is to ensure that the company does not slip away from the clutches of the listing regulations.

Rethinking Risk

"Rethinking Risk", CFO Connect, January-February 2006 [Full text - Scanned Image]

Many Indian companies have embraced sophisticated risk management systems encompassing currency, interest rate and commodity price risk. Moving beyond a transaction orientation, these systems now cover operating and economic exposures. Companies have also started using a wide range of derivative products including in some cases exotic OTC options.

Nevertheless, two sources of concern remain. First, in several cases, the use of derivatives has gone far beyond hedging to become tools of speculation. Second, quite often there is an excessive focus on hedging accounting profits rather than hedging economic or cash flow risk. Finally, the risk management systems that have evolved in a benign economic environment need to prepare for a more hostile environment.

Risk management in corporate India is thus at an interesting inflection point. Having grown enormously in terms of technical sophistication, the time has now come for it to be adequately integrated into the strategic planning process. Otherwise risk management threatens to become the preserve either of derivative specialists or of accountants and its true potential would not be realized. In the coming years, the challenge for CFOs would be to reshape risk management systems to subserve strategic goals in a potentially more turbulent economic environment.

Yes, time to lay a road map for implementing T+1 (in Should Sebi implement the T+1 settlement system in the capital market?)

"Yes, time to lay a road map for implementing T+1 (in Should Sebi implement the T+1 settlement system in the capital market?)", Financial Express, October 17, 2005 [Full text downloaded from Financial Express web site]

Historically, settlement systems lagged trading systems because trading required only exchange of information, while settlement required a physical exchange. Today, however, both financial securities and cash are held in electronic form in the depositories and in the banking system. Technology allows us to abolish the anachronistic separation of trading from settlement. The problems with shorter settlement periods are well known and they can all be solved. India must take the lead in moving towards T+1 setllement.

Short-selling curbs help rig share prices (in Should short-selling be reintroduced?)

"Short-selling curbs help rig share prices (in Should short-selling be reintroduced?)", Economic Times, October 3, 2005 [Full text downloaded from Economic Times web site]

Removal of all restrictions on short-selling would be the single most important step towards making Indian capital markets cleaner, safer and more efficient. The short-sale restrictions in the US were a misguided knee-jerk reaction to the great depression. The Enron and other debacles there have demonstrated that continuing with these archaic restrictions was a big mistake. It is time for even the US to allow free short-selling. If our markets are more susceptible to market manipulations than the US market, we should move faster than the US to remove these restrictions. We must create an effective and viable mechanism of securities lending and allow both institutions and individuals to short-sell without restriction.

FSA order on Citigroup misguided

"FSA order on Citigroup misguided", Financial Express, July 20, 2005 [Full text downloaded from Financial Express web site]

The order that the Financial Services Authority (FSA) of the UK has passed against Citigroup Global Markets Limited (CGML) in the Euro MTS case imposing a fine of $25 million is total nonsense. Clearly, the FSA lacked either the evidence or the courage to say that Citigroup had manipulated the markets. At the same time, the FSA was unwilling to let them off without any penalty. What they have done therefore is to impose a penalty under regulations that have no bearing on the case at all. This means a penalty is imposed without having to prove any serious charges against Citigroup.

We have seen a dismal failure to make material disclosures to the public

"We have seen a dismal failure to make material disclosures to the public", Financial Express, June 20, 2005 [Full text downloaded from Financial Express web site]

When the Reliance settlement was announced on Saturday, the disclosures regarding the contours of the settlement were so woefully inadequate that both the media and the investors were forced to rely on rumours and inspired leaks in order to understand the implications of the Reliance settlement.

In fact during the last seven months of disputes in the promoter family of Reliance, we have seen a dismal failure to make material event disclosures to the public and a dismal failure of regulatory enforcement to ensure that this disclosure does happen.

Making Customers Pay for Regulatory Services

"Making Customers Pay for Regulatory Services", Business Line, August 30, 2004 [Full text downloaded from Business Line web site]

It is often said that regulation has a cost but does not have a price. This article argues that several regulatory services can and should be priced. This would increase efficiency, improve accountability and allocate regulatory resources to the areas where they are most valuable.

The article proposes one priced regulatory service: regulatory review of corporate accounting filings. In India neither SEBI nor the Registrar of Companies has a system of carrying out a regulatory review of the accounting statements filed by companies. Any body should be able to pay the prescribed fees (approximately Rs 100,000) to the regulator and seek a review of the filings of any company. The result of the review when completed should be publicly released and the person paying the fees should not have any priority in receiving this information.

Should govt hold special audit?

"Should govt hold special audit?", Economic Times, August 18, 2004

It can do neither harm nor good. To prevent malpractices, we need to improve detection, investigation and punishment. In India, the biggest weakness is in the detection mechanisms.

Stabilization or Socialization

"Stabilization or Socialization", Business Standard, June 21, 2004 [Full text downloaded from Business Standard web site]

The proposed market stabilisation fund runs counter to the very purpose of a stock exchange which is to allocate risk optimally among investors and thereby help in the optimal allocation of capital in the economy. The market stabilisation fund is an idea that harks back to the age when these functions were performed by the government. It would be a gigantic put option gifted by the government to stock market investors and totally inappropriate when the government is trying to cut subsidies in other areas.

Electronic Transparency

"Electronic Transparency", Business Standard, April 12, 2004 [Full text downloaded from Business Standard web site]

In electronic markets, regulations must be implemented by computers after being embedded in software. When regulators ignore this fact, the result is: (a) The true regulatory regime is not disclosed to the public, (b) the true regulatory regime is not arrived at by open and transparent processes, but is effectively decided by a group of software developers with only imperfect guidance in the form of the English text of the regulations, and (c) there is incomplete accountability for software errors because, after all, it is not possible to prosecute a computer.

It is, therefore, necessary to recognise the actual computer source code itself as the authoritative text of the regulation. The computer source code must be open and transparent and must be subject to the same public disclosure and comment process to which we subject the English text of our regulations. An independent auditor must then certify that the software that is actually used is the same as what is disclosed.

Stock lending is need of the hour

"Stock lending is need of the hour", Business Line, March 15, 2004 [Full text downloaded from Business Line web site]

India today has electronic trading, rolling settlement, derivatives, dematerialisation and well functioning clearing and settlement processes. The most important thing, which is lacking is a well functioning stock lending scheme. It is time to remedy this shortcoming.

Single stock futures have been spectacularly successful in taking over the leverage function of traditional quasi-derivative settlement systems like badla. But, the stock lending mechanism remains practically defunct and has failed to take over the role that badla played of facilitating short selling. As a result, it has become very difficult to short a stock in the cash market.

Short selling is extremely important for ensuring price discovery and protecting market integrity. A market without short selling is an open invitation to company managements and other manipulators to rig up the prices of stocks.

Discretion in margins

"Discretion in margins", Business Standard, March 1, 2004 [Full text downloaded from Business Standard web site]

Indian regulators and market participants appear to believe that exchanges and regulators should exercise their discretion to change margins or impose special margins in response to changing market conditions.

However, such discretion is both unnecessary and undesirable. Unnecessary, because simple rules based on recent volatility do a very good job of modifying the margins as market conditions change.

Undesirable, because discretionary regulations are often highly destabilising and could pose a threat to market integrity.

Should Sebi ban unregulated hedge funds?

"Should Sebi ban unregulated hedge funds?", Economic Times, January 27, 2004 [Full text downloaded from Economic Times web site]

The idea of banning investment in India through participatory notes by foreign hedge funds and other unregulated entities stems from the confluence of two mistaken ideas:

The reality is that:

We should simply end exchange controls, allow anybody anywhere in the world to buy our stocks and derivatives, and allow Indians to trade stocks and derivatives from around the world here and abroad.

Cash versus physical settlement

"Cash versus physical settlement", Business Standard, January 19, 2004 [Full text downloaded from Business Standard web site]

Single stock futures and options can be settled either by physical delivery or by cash payment. In India, there has been much controversy about the two modes of settlement with proponents of each mode decrying the other as speculative and vulnerable to manipulation.

Apart from transaction costs, there is no difference between cash settlement and physical settlement. Even these costs do not apply to most trades because they are squared off before expiry. The choice of settlement mode can, therefore, be safely left to market forces. But if the regulator chooses to intervene, it should be on the side of physical settlement because it imposes lower transaction costs on hedgers and arbitrageurs at the cost of higher transaction costs on speculators.

Insider trading should be a civil offence

"Insider trading should be a civil offence", Business Standard, October 06, 2003 [Full text downloaded from Business Standard web site]

Insider trading is notoriously difficult to prove. Regulators, therefore, seek extraordinary powers to compensate for the weakness of evidence. However, regulators have rarely used their powers judiciously and have always tended to pursue specific high-profile cases for extraneous reasons. Therefore, insider trading should be a civil offence rather than a criminal offence and the right to initiate proceedings for this should lie not with the regulators but with the investors themselves. Sending the insider to jail or stopping him from trading does nothing to recompense the suffering investors.