Skidding on the fast lane – lessons from the NSE Moneylife case

Perhaps no other part of the capital markets universe is as cloaked in mystery as algorithmic (algo) trading. The very mention of this business conjures visions of silent, powerful machines that never go to sleep as they trawl the global markets. Swooping on instances of mispricing across paired products or markets, they then seek to profit as the established relationship is restored, through massive market orders.  Their rise has mirrored the increasing influence of quantitative trading strategies in today’s capital markets.

Such predominance has been made possible also through another key ingredient: - co-location (colo). As the value of algo trading took root in the trading floors of the world, firms sought to replicate algo strategies which drove down the scale of business profits. Co-locating the firm’s servers in the physical premises of the exchange alongside the exchange’s servers became an essential ingredient of processing and trading on market movements. Effectively, this led to a two-tier trading structure – one, comprising the algos and their higher trading volumes (and fees) and the rest of us, who despite our large trading numbers delivered a far lower average turnover and fees. This ensured that exchanges that were able to cater to the economic requirements of algo trading houses were able to ensure fat fees and also enhance their promoter’s equity valuations. In India, this has been a game that has largely been won by the NSE, as evident in the valuations observed in NSE stake sales.

Irksome questions have now been posed about this merry party that have grave implications for the integrity of the Indian capital markets. The troubling conclusions represent a formidable test of the resolve of the market regulator which itself is in the process of merger. At the heart of this case are the fantastic allegations that have been made by the respected journalist Ms. Sucheta Dalal in the magazine Moneylife. These in turn are based on a “whistle blower” letter that made its way to the magazine. It purports to show in shocking operational detail how a cabal of key traders aided by NSE’s operations staff managed a ring-side seat in the exchange’s algorithmic trading set-up. Further, by determining which of the clients were able to receive trading information with a lower latency than other, NSE’s staff also enabled these firms to trade on this information and enrich themselves at the expense of this HFT peers and the wider market.

To be sure, this missive is not from a whistle-blower (i.e NSE or affiliated employee) in the conventional sense of the term. The letter specifies that the author is a former employee of a HFT client of the NSE. Further, the individual’s motives are not guided by altruism. Rather, it is alleged that the NSE has given “structural advantages which are more difficult to prove” as “in quid pro quo for keeping quiet”. This arrangement, the letter mentions “is resulting in degraded performance of the algos” and “difficult for us to work in an unlevel (sic) field”.

Ms. Dalal followed up on this missive by attempting to receive a clarification from the NSE. Here, it appears that the well-respected exchange has faltered, first by failing to respond knowing about an impending article and then following up with a multi-crore defamation case on Moneylife. What appears to have miffed the exchange is the allusion in Moneylife’s articles that the Finance Ministry is seized of the matter and which has in turn led to SEBI’s and the RBI’s scrutiny of the NSE and HFT. Further, stock market crashes in the preceding months have also been attributed to algo trading.

In its judgement, the Bombay HC has come down heavily on this approach of the exchange. Highlighting how specific paras of the NSE’s response to the court are “yet another attempt at misdirection”, the HC goes on to lambast the NSE’s response as being drafted “in the hope that the judicial mind can safely be presumed to be ignorant of all matters technical and too easily overawed by an outpouring of technical jargon”.

After remarking that “Our Courts are not to be treated as playgrounds for imagined and imaginary slights for those who command considerable resources”, Justice Patel proceeded to impose financial payouts on the NSE towards Moneylife’s editors and to public cases. As of going to publication, the NSE has secured a stay on its implementation.

India’s LIBOR moment?

This case is remarkable as much for the facts surrounding it as much as it is about the limited coverage it has received. This situation is hardly an exception if the lenient, indeed near-fawning, coverage of Indian industry in the popular press is any indication. Indeed, a free press and freedom of speech are important cornerstones of Indian democracy. However, the press should realize that corporate governance is a key element of ensuring the rule of law applies to the corporate jungle. Where the press is silent or subservient to those with deep pockets and their shenanigans, is it not a slippery slope to cronyism, public corruption and the breakdown of law and order? To its credit, the government of the day has been extremely pro-active on this front, working with Indian industry to ensure the fair allocation of mineral resources, mandating that e-allocation be the framework for all public resources, and demanding that firms focus on investment rather than demand subsidies and erecting barriers to trade.

This case and its handling is also an important test of SEBI’s resolve to implement the rule of law and stand up to rule-breakers, no matter how powerful. Coming as it is on the back of the NSE-FMC merger, there is an urgent need for all regulatory agencies to work in a coordinated fashion, with the Finance Ministry leading the policy efforts. This can be first achieved by the NSE being transparent with the regulators and sharing an open assessment of issues identified, if any and their remediation.

It is naïve to expect that an organization can remain immune to some individuals who prioritize short-term, personal gain over the long term good. Instances like the LIBOR scandal have shown how even supposedly “good-standard” benchmarks can be consistently rigged across multiple firms. Public exchanges thrive on the value of their good name and the rule of law in capital markets. Any attempt to muzzle the free press run contrary to the image of a fair, innovative and technologically-savvy institution such as the NSE. 

Too big to fail – Why strong corporate governance in India needs more women in executive roles

This week’s announcement from the RBI identifying Indian “too-big-to-fail” banks pulled no surprises for its readers. These D-SIBs (domestic systemically important banks) are required to maintain additional capital buffers to ensure they can cope with any sudden capital outflows, especially of the kind seen in the last month. This represents yet another perceptive policy action by the authorities to ensure that the volatility in the financial markets does not spill over into the real economy, necessitating governmental intervention.  

News of this tag also helped to shine a spotlight on another fact of Indian corporate life - the robust talent that Indian women have demonstrated in the financial services industry, with both of these banks having women CEOs steering their helm of affairs for some time now. In addition to Arundhati Bhattacharya (SBI) and Chanda Kochhar (ICICI Bank), the financial services industry has several noteworthy stalwarts – across investment banking, credit rating agencies, private equity and within the regulator too.

This positive state of affairs however quickly worsens if one looks upward. Female representation within corporate boards has been dismal historically, a fact that prompted the regulator to call for mandatory appointment of female directors. The response of Indian companies was on predictable lines – poor compliance first led to an extension from SEBI and the eventual (and final) deadline was marred by the rush to make last minute appointments. In several instances, companies appointed the female relatives of the promoters as non-executive directors. March 2015 alone saw 308 directorship posts being filled by women. Finally, after this mad scramble, April 1, 2015 saw women directors make up only 12.3 % of the population of Indian corporate board directors. These statistics should raise serious questions in the minds of every concerned investor in the Indian capital markets as to corporate goverance in general, and board quality in particular. Have we forgotten the lessons of 2009 already?

The recent spat between BASF and SES, an Indian proxy advisory firm has opened a new front in this issue. Here, the appointment of a foreign lady director (and the subsequent appointment of a male replacement) was questioned by the proxy advisory firm. The company however held that the appointment was within bounds of the Companies Act and explained the replacement as purely for tactical purposes.

Likewise, apart from the financial services industry many sectors lack women in senior management roles too. According to the authoritative 2014 study by Credit Suisse, women participation in corporate boards globally proceeded along the management power line, with larger presence in shared services roles and a low presence in executive leadership assignments. This resulted in women being unable to reach the top executive CXO profiles in most organizations.

But does having women CEOs make a statistically significant impact to corporate performance? The evidence on this question is mixed. While the Credit Suisse study did observe that companies with board members performed significantly better on financial parameters, the evidence was positively correlated but causality could not be proved. Likewise, notwithstanding the perception of greater caution to enter into mergers and acquisitions or taking on leverage, the study found no significant difference between male and female CEOs and their leverage preferences or acquisition trends. Despite these contrasting points, studies have clearly indicated the importance of diversity in corporate boards having a positive impact on group intelligence and corporate performance. It is perhaps in this spirit and its positive implications for shareholders that greater female participation should be considered. When greater diversity is seen as the means to more widespread positive corporate behaviour in society alongside greater stability in earnings/growth for shareholders, it can be accepted as a necessary condition rather than a “good-to-have”. Likewise, when a more diverse board moves quickly to punish errant (miss-selling) behaviour, employees are less at risk of claw-back of salaries and bonuses.

So how could greater diversity then be brought about? One approach has been already discussed earlier – diversity by fiat. As we have seen in this method, the opportunities for gaming the system are considerable and could inadvertedly lead to more power in the hands of the promoter group.  Corporate Affairs believes that solutions are available across timespans. A few approaches that could be considered here are:

• Hire from the government

Companies who have appointed women from within promoter families (without a compelling case for merit) have probably not been advised of the enormous talent available within India’s public services. The average Indian is well aware of the large pool of women officials within India’s bureaucracy. Many of them have been appointed to the highest posts in India’s civil services and it is heartening to see that in some cases this talent is being tapped. Companies should make a strong representation to the current government for permitting more women representatives from the civil and armed services into directorships. Further, companies could hire more actively from the pool of retired women civil servants. True, there might exist conflicts of interest but these could be incorporated into a policy manual that provides practical solutions. For the government’s standpoint, this approach would help public servants to better appreciate the practical implications of policy nuances that India’s bureaucracy draws up.

• Make diversity a key element of reporting to corporate boards

Diversity should be reported down to a divisional level in corporate board presentations and analysed. It would be interesting for companies to overlay the divisions/regions where miss-selling has been reported with their diversity scores to identify if “group-think” or peer pressure had made a problem far more serious than otherwise. This information should be shared with SEBI which itself should be investing in to undertaking scientific research on the benefits of a diverse workforce on corporate governance, similar to that of the NSE.

• Make public sector stakeholders agents of change

Public institutions such as the LIC are large investors on the stock markets but reported instances of their dissent have been few. Governmental institutions such as the LIC and EPFO can take the lead in their interactions with the boards of their investee companies to call for greater diversity in their workforce. This could ensure the small investor whose voice is often ignored by corporates has a powerful ally to call for greater diversity. 

• Support more female entrepreneurs

An area of considerable concern has been the dismal number of women entrepreneurs who have listed their companies on the exchanges. Listing confers powerful visibility in the wider financial markets, courtesy the depth of press coverage in India. Apart from high-profile founders of companies like Biocon, there are hardly any other listed companies that have been founded by a woman. In a country with an upwardly mobile and educated workforce, such a statistic makes for grim reading. Here, it is possible that the booming private equity scene in India is able to throw up entrepreneurs whose business models have developed enough for them to take their companies public. Companies should also encourage their associates to bring in business ideas that could be catalysed into subsidiaries. Given the large proportion of women in the IT workforce, this sector could be best placed for innovation and positive results.

• Invest in creating more women-based roles in the basic sciences

At the heart of this article is the hope, nay belief, that for India to emerge as a superpower it is essential to build on its human capabilities in the basic sciences. History is a clear indicator of how technologically advanced societies have emerged as the real winners in geo-political confrontations by leveraging the intellectual capital created by their citizens, be it atomic power, ballistics or the Internet. In turn, the commercial spin-offs generated by these technological advances have provided capital markets investors with juicy opportunities for wealth creation.

India, like many other Asiatic societies places priority on the sciences sometimes perhaps to the detriment of other sectors. However, when it comes to gender equality and diversity Asian societies have been found lacking in supporting women for greater education and corporate responsibilities. While such cultural mores are definitely changing in India, this change can definitely be faster and more widespread, especially in rural India. Investing in increasing the participation of women in basic sciences (also including the dismal science) would be a smart way of redressing these imbalances.

While the fruits of this effort might present themselves in full only over the next few decades, it is important for India to commit itself immediately to greater gender equality and diversity. Whether one is a feminist, a nationalist or a hard-nosed capitalist, investing in women pays rich dividends.

Corporates beware ! SDR comes knocking, courtesy RBI

The conventional thinking in corporate lending went that the power of the bank over the borrower was inversely proportional to the size of the loan. Hobbled by laws that made loan recovery a chore, a promoter lobby determined to protect their interests and political masters who prioritized the next election to prudential norms, PSU banks seemed resigned to loan waivers and NPAs. While the 5/25 plan appeared to give banks some leverage, too often the general public has seen the banks fight shy of targeting large corporates (and their nabob promoters).

The current mood in the RBI seems determined to consign this behaviour into the dustbin. First, a tough-talking governor has finally stood up and castigated the “sweep-under-the-carpet” mentality on several occasions. This has been supplemented by a far-sighted government that has been taking bold economic decisions to ease the bureaucratic gridlock and resource constraints, coal and gas being good examples. Equally important, unlike previous administrations the government has largely refrained from second-guessing the RBI’s policy stance. This has helped restore investor confidence and manage the eventual capital flows when the US Fed raises interest rates.

But the significant (and yet largely under-reported) change has been in the RBI’s policy framework for managing bad loans. Through the establishment of the Joint Lender Forum (JLF) and the recent policy directive on Strategic Debt Restructuring (SDR), the RBI has delivered some sophisticated artillery capabilities to banks. The SDR allows lenders with the capability to convert their debt into equity and acquire management control over the firm by wiping out the promoter’s stake. Supported by generous (interim) dispensations on prudential norms and SEBI takeover codes, the SDR mechanism allows lenders to form a united front to force recalcitrant lenders into taking the tough economic decisions necessary for the firm’s survival. This is a massive change as much in the psychology of corporate lending as it is about actual policy. The RBI deserves to be richly commended for taking up such innovative approaches to structural issues, which is fast emerging as a hallmark of Dr. Rajan’s tenure, such as with payment and small finance banks.

It appears that banks are taking tentative steps along this path. On 27^th July, the first SDR “workout” was undertaken on ElectroSteel Steels’s loan of INR 9600 crores. This was followed, on August 10^th, by an INR 500 crores SDR on Lanco Infratech’s project. On 20^th August, the JLF of Jyoti Structures decided to implement the SDR to convert an INR 2,178 crore debt into equity, wiping out the promoter’s stake. So far, the market seems to be pessimistic of the economic prospects for these companies that are trading down 17%, 12%, and 11% from the time of their respective SDR announcement (all data as of 23^rd Aug, 2015).

Exiting the Chakravyuh

Anyone acquainted with Hindu mythology is aware that it was the prospect of exiting the maelstrom that made the hearts of the stoutest warriors tremble. While the SDR exhorts the JLF to keep out the past promoter and work quickly to undertake a sale of the company it is sketchy on the actual details of managing the company in the interim period. This silence extends to communicating the plan and its progress with wider stakeholders. As a consequence, the market has been largely in the dark regarding the improvement in operational parameters.

Corporate Affairs recommends the following tactical inclusions to navigate a smoother exit from the SDR –

a.     

•         Establish a stakeholder engagement plan

A financial restructuring plan spells uncertainty for employees, customers and the authorities such as the sales tax and excise departments of individual states. Often companies also have litigations that are pending at various levels of the judiciary that requires a pro-active outreach.  Employees and customers are in the dark as to the motives of the JLF, which need to be clearly conveyed and fit into the strategic initiatives of the firm. Assuming a “BAU” approach is clearly a recipe for low all-round morale, negatively impacting share prices and negotiating power for the JLF.

•  Strengthen and co-opt the executive management

It seems a naïve to expect that the removal of the promoter could somehow enthuse the firm’s prospects and the contributions of the executive management. Often where the sector itself is in the doldrums, the promoter’s actions might have precipitated the eventual collapse. Several economic sectors continue to remain in oligopolistic cliques, the resolution of which is an element of policy detail. In such a case, the management might require re-skilling and familiarization in the usage of cost management tools to improve [productivity. Management reporting, which might have been given a go-by in the previous dispensation will need to be rigorously implemented to instill operational discipline. This could assist in cost simplification and raising morale as the effect of the “quick-wins” kicks in. 

•       Involve specialist support

It is understandable to see nervousness amongst JLF constituents for incremental funding of their NPAs in SDR. However, there could be strategic investments that might be justified through improvements in capital structure, process, technological and sales effectiveness that could enhance the attractiveness of the account for a potential bidder. Specialist shops, both merchant banking and consulting arms exist within PSU banks themselves. In addition, there are a plethora of outfits that could provide turnkey support to the company which should look to outsource non-core activities. It is not clear whether these are being actively planned for the SDR accounts, but these should be considered too. The incremental expenditure might well be worth it in the asking price and the management time that it saves of the JLF team.

The path less travelled

At the risk of spouting clichés, it is very clear that banks are in uncharted territory with the use of SDR as a tool for tackling NPAs. Notwithstanding the solid support (read ear-wringing) of the RBI, it is up to the banks to embrace bold, innovative solutions. This should also serve as a recurring reminder to the other silent stakeholders – domestic financial institutions and the retail investor community.

The hubris of the promoters is as much a cause of NPAs as is the meekness of their shareholders. Participants need to take a more active interest in the functioning of the companies that they own. Selling out of companies that they don’t like is understandable, but the hero worship of the companies that they like is unpardonable. Investors should understand that today’s heroes could easily turn in to tomorrow’s zeroes. 

Much ado about nothing - Mr. Sathe's appointment to SEBI

The recent appointment of noted jurist Mr. Arun Sathe as a part-time member of SEBI should raise eyebrows, but only due to the partisan reporting that has surrounded its notification.  This episode is yet another indication that in an era of non-stop reportage and TRP pressures the notions of reasoned debate and a respect for process are being given short shrift. The charge against Mr. Sathe is essentially that as a “political man” (whatever this means) of a right-wing persuasion, he is somehow ineligible to hold any responsible office, including the role of a part-time member of SEBI. This kind of assertion is astounding in modern India that aspires to be a superpower in a culture of meritocracy and equality.

Are Mr. Sathe’s critics confident that every official in high office who is in the executive branch of government is completely apolitical? Is it correct to expect that people in public life will not hold an ideological preference in their personal lives? Should the focus not instead be on the individual’s actions prior to an appointment or even after he/she assumes the post under question?

The sad consequence of the brouhaha in this episode is that the facts are being conveniently buried. First, Mr. Sathe is a noted jurist in tax matters. The constitution of the current SEBI board (see here) is without any legal representation and hence it can be argued that he is suited to making valid contributions to SEBI’s board, especially in an era of increasing global regulation of the financial sector. Second, he has been transparent in stating his personal involvement with the RSS and the BJP, neither of which are organizations whose members are debarred from public office.  Third, the government is well within its rights to nominate part-time members to the board. In fact, this prerogative extends even in the appointment of the Chairman of the Board. Fourth, the code of conduct of the SEBI board has explicit provisions that require members to declare conflict of interest. Further, the Board also entertains unsolicited submissions from the public on conflict of interest matters, provided they are backed by material facts. If indeed Mr. Sathe is not “fit and proper” to be on SEBI’s Board, pray where is the smoking gun?

Such protest from within certain quarters is in stark contrast to the situation in countries like the USA. Here, people in high office are often noted members of the industry that is being regulated by the entity. Instances like that of Mr. Robert Rubin (Treasury Secretary and co-head of Goldman Sachs), Mr. Hank Paulson (same as Mr. Rubin), Mr. Robert Khuzami (General Counsel, Deutsche Bank and SEC) are but a few instances of a well-established system. This allows the regulator to implement policy decisions that incorporate the market realities. Closer home, the appointment of Dr. Raghuram Rajan as RBI governor helped to assure global markets and also steer the Indian economy adroitly. This government’s continuing support has helped the RBI to proceed on the path of financial inclusion with confidence.

This government has refrained from over-commenting on this case, beyond stating that due consideration has been exercised in proposing Mr. Sathe to the Board. This is in stark contrast to the unsavoury situation that SEBI found itself a few years back when Mr. C B Bhave, former Chairman and Mr. K M Abraham were “honoured” with a preliminary enquiry (PE) from the CBI for their role in providing a license to MCX-SX. Mr. Abraham had even alleged that there was undue pressure on SEBI from the Finance Ministry (headed then by Mr. Pranab Mukherjee) on this and other cases. In the face of a public backlash, and importantly with no evidence of any wrong-doing, CBI had closed the PE.

Of start-ups, IPO dreams and differential treatment

 Business Standard recently carried an interesting guest column on job creation through start-ups. The gist of the article was - create an " IPO-lite" (my term) environment for start-ups and India can have a job creation machine. The article certainly did not lack authority, what with both authors being distinguished members of the PE fraternity and Mr. Pai having a larger corporate role courtesy his Infosys association.

 My criticisms of the article are primarily the weak logical connections between job creation and start-up IPOs. Further, in coming up with a differentiated exchange for start-ups authorities would need to consider  possible scenarios which could be a slippery slope to letting in retail participation. While I attach the SEBI concept paper here, unfortunately  the responses and SEBI final regulation could not be found on the website. Lastly, the unstated "this-time-it's-different" idea that seems to inspire this article could in fact be the driver of India's second dot-com bubble.

 On a personal note, this is my second unpublished letter to a newspaper - baby days yet !

Link to IPO article by Mohandas Pai & Praveen Chakravarty

Discussion paper on alternate capital raising platforms and other regulatory requirements

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 “How IPO rules are linked to job creation” (June 3) attempts to embellish the case for an “IPO-lite” mechanism under the helpful suggestion that such proposals can enhance job creation.

Policy makers should re-check their assumptions before signing off on such proposals. While there is no doubt that disruptive business models and VC funding mechanisms are here to stay, it is a well understood that there are other factors which govern VC movements, many of which could run counter to job creation. Portfolio re-balancing (and re-investment) decisions of (mostly foreign) VCs are governed by internal factors such as rate-of-return targets, deal pipelines, and base currency movements, not to mention the relative attractiveness of other markets. No VC is under a mandate to “Make in India”. They are there to provide the best returns possible for their investors.

These returns are derived on the basis of strong management and earnings growth. In the absence of tangible earnings or a management strong enough to deliver it, any proposed exchange will quickly descend into a VCs “musical chairs” with eager participants queuing up for a chunk of shares from the early prospectors/insiders before the next round of fund-raising commences. Setting up an exchange with only institutional investors are participants is also a slippery slope to retail markets. Would MFs and/or pension funds be allowed to invest and if so, are they not deploying retail money? What happens if a start-up (with stratospheric valuations) buys a company on the main board and wishes to pays in stock? Does the exchange not discriminate against brick and mortar firms who might be in the same sector and unable to “IPO-lite”? 

The article is silent on these issues. Ironically the market factors that the article helpfully lists as the cause of poor IPO performance are the same that can stymie the “IPO-lite” policy – lofty (start-up) valuations, poor diligence (institutionalized) by merchant bankers and greedy entrepreneurs (and their VC backers). Is the scene being set for India’s second dot-com bubble?

Impressions – The King of Oil

My earliest brush with Marc Rich might have well been the event that, he believed, would bring closure to the demonization that he was subject to for 17 years of his life. Living in luxurious self-imposed exile in reclusive Zug from US authorities pursuing him on charges of treason and tax fraud, he would find himself up chanting the final prayers in his father's wake over a long-distance call and be reduced to listening over telephone to his daughter die a slow death from leukemia, while being unable attend both funerals in person. He would also complete an acrimonious (and expensive) divorce from his wife of 30 years and go on to marry another (whom too he divorced, 9 years on, in yet another expensive affair).

Somewhere in between all this, in the dying hours of the Clinton era, a Presidential pardon ended and began a new chapter in the media scrutiny in his checkered life. Washed over in the torrent of media horror, I slowly picked together the life of the secretive commodities trader who spawned the colossus that today is GlencoreXstrata.

In this world of self-seekers, both myopic and narrow minded, a shrewd calculating man focused on the long term is indeed rare. Rarer still is to see him as evil. Perhaps this is my bias, but one who thinks long term and puts relationships before profits is in my dictionary termed astute.Marc Rich was an astute man, of this I am confident. But what else was he? An amoral trader, a dutiful son, silent intelligence sentinel, a doting father or a bitter ex-husband? How does one reconcile these contradictions? What can we learn from his failures and his astounding successes – notably, creating the global spot market for oil?

The King of Oil is hence an interesting book, as it pieces together the events in Marc Rich’s life and leaves the reader as the final judge. The absurdities that accompanied his trial and the machinations of Rich’s legal term are laid out in equal measure. Hence the book does not feel like a paid advert. It is in fact a sobering assessment of an infallible truth – even the Supermen and Superwomen that the world has seen will one day fade away in their days of glory or be dragged off their pedestals by Time if they tarry too long.

Reminding us of our mortality through the life of one considered invincible is perhaps the book’s greatest contribution. In parts fascinating, in others saddening, this is a Promethean tale that must be read.

My Name is...

With a mouth like a loose cannon, I am India's latest killjoy.
Spreading trouble with gay abandon, My name is Arundhati Roy !