Algorithmic Trading: Balancing Pros and Cons

This article was first published by the Global Association for Risk Professionals on June 19, 2016

https://www.garp.org/#!/risk-intelligence/detail/a1Z400000035AAdEAM/algorithmic-trading-balancing-pros-cons

Six years since allowing algo trading, India wrestles with questions familiar across financial markets  

Since first being allowed in 2008, algorithmic trading has grown to account for 40% to 50% of the turnover on the National Stock Exchange (NSE) of India.

Widely regarded as a disruptive technology, and creator of advantages for some that harness it, algo trading was defined by the Securities Exchange Board of India (SEBI) as “any order that is generated using automated execution logic.”

The late Gangadhar Darbha, who was executive director and head of algorithmic trading strategies at Nomura Securities, said, “Algorithmic trade per se is nothing but a reflection of what happens in our brains. Algo trading is the use of electronic platforms for entering trading orders with an algorithm which executes pre-programmed trading instructions whose variables may include timing, price, or quantity of the order, or in many cases initiating the order without human intervention.”

Institutional investors, insurance companies and mutual funds use algorithmic techniques for portfolio rebalancing and risk control amid large order flows on either side. Anonymity and mathematical logic to break large orders into small pieces can counter adverse price moves and manipulation.

Financial firms apply the cutting-edge technology to product development and innovation in such areas as liquidity-seeking, cross-asset and multiple-exchange trading.

While it is difficult to know the strategy or logic being applied by looking at the trade data, it seems unlikely that the algorithms act on fundamental information about companies or the economy. Algo trading takes into account quantitative information regarding trends, reversion to mean, arbitrage, etc.

It is argued that computer-assisted trading improves liquidity in the markets by breaking down large trades into smaller trades, reduces bid-ask spread and lowers risks of adverse selection and trade related price discovery. Terrence Hendershott, Charles M. Jones and Albert J. Menkveld, in “Does Algorithmic Trading Improve Liquidity?” (Journal of Finance, Vol. LXVI, No. 1, February 2011), argue that algo traders are more likely to be providers of liquidity. They also increase the speed and efficiency of trades and reduce costs of trading.

Flash Crashes

There are also purported disadvantages.

There have been many instances of flash crashes on exchanges around the world, in which automated trading has been implicated, whether due to erroneous coding, a systems failure or cascading effects of certain trades. Algo is also often blamed for causing large fluctuations or volatility in the markets.

On October 5, 2012, the CNX Nifty Index of top 50 companies traded on India’s NSE fell nearly 16% within seconds (before rebounding), causing panic amid traders and institutional players, as stop losses were triggered. Similarly, the Bombay Stock Exchange (BSE) had to annul all trades on “muhurat day” in 2011 due to extraordinary volumes. (Muhurat day is a special trading session on Indian bourses to mark to beginning of the new financial year on the Hindu calendar. It coincides with the popular festival of Diwali.)

Algo trading’s effect of improving liquidity has been scrutinized. It is alleged that algo trades focus on a few large stocks, resulting in short-term liquidity improvement only for those stocks. If this also means that trading gets concentrated in fewer stocks, then this is not good for an exchange. And if algo trading magnifies panic, it can have an avalanche effect on prices.

Technology is reducing the cost of trading and attracting large volumes. But that requires exchanges to improve the efficiency and capacity of their data servers, matching engines and bandwidth, which in turn increases infrastructure cost and has to be added back to the brokers transaction cost.

Haves and Have Nots?

Does algorithmic trading "discriminate between rich and influential brokers and common investors/retail investors and create inequality” among constituencies on the BSE and NSE, as has been alleged by the Intermediaries and Investor Welfare Association? Algo traders have a technological advantage over the regular market participants, who are not able to afford such high fixed costs.

The Technical Advisory Committee of the SEBI, it was reported in April, noted that a certain broker benefited from loopholes in the systems architecture of NSE, which were not prevented by the exchange. Larger questions regarding the role of the regulator in coming out with policies on co-location and algorithmic trading are being raised as well. The surveillance systems of the exchanges and regulatory actions against manipulative activities have not kept pace with the improvements in technology and the complexity of algorithms.

Interestingly, rampant accusations that flash orders favor insiders led some lawmakers in the U.S. to urge in 2009 that the practice be banned by the Securities and Exchange Commission. It remains legal. The Indian counterpart, the SEBI, has set an agenda for itself to come out with a discussion paper on high-frequency trading, or algo trading, in the coming three months, which could lead to regulations of those activities.

Perhaps the right way to look at it is as Darbha once said in an interview: “Algorithmic trading is not just a facility, but an aid. While algorithmic trading gives you freedom to trade, it does not replace fundamental research. It only enhances trading efficiency.”

The Indian Economy under Rajan

This article was first published by the Global Association for Risk Professionals on June 09, 2016; was updated on June 20, 2016; Co-author: Anisha Sircar, Flame University, Pune

http://www.garp.org/#!/risk-intelligence/detail/a1Z400000034vGa

Results of the central banker’s first term made a strong case for reappointment to a second

Subramanian Swamy, a Harvard University PhD in economics and a member of the Upper House of the Parliament of India, recently wrote a letter to Prime Minister Narendra Modi. It criticized Dr. Raghuram Rajan, the 23rd governor of the Reserve Bank of India, on many different counts, and urged immediate termination of Rajan’s services, on grounds that the central banker, whose three-year term expires in September, is deliberately trying to “wreck the economy.”

After saying he was open to serving a second term and leaving the decision to the Modi government, Rajan issued a statement June 18 saying he will step down.

Rajan has been generally recognized as one of the most influential and proficient governors of the RBI. He was previously chief economist at the International Monetary Fund, chief economic adviser of India’s Ministry of Finance, and the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Booth School of Business. He is credited with predicting, early in 2005, the global financial crisis that hit in 2008. He was regarded as someone with international exposure who could anticipate problems and find distinct solutions.

When Rajan assumed office at the RBI in 2013, the economic climate was characterized by a free-falling rupee, touching nearly 70 against the U.S. dollar, alongside rising deficits, high inflation and overall sluggish growth.

Early on, Rajan announced his “Five Pillars of Reform,” inspired by the three “arrows” of the Japanese Prime Minister, Shinzo Abe. The pillars were an effective monetary policy framework that was transparent, credible, clear, and that could be “understood by the broader public”; banking sector reforms to give anybody the liberty to apply and set up a bank at any time; deepening the Indian markets; providing financial services to rural areas; and the creation of a “simpler, cleaner and less value-reducing” mechanism to address financial distress so that lending was rendered easier, faster and more efficient.

Besides delivering on the promises made at the start of his term, Rajan, along with other key decision makers and other factors, helped in ensuring that India has been the emerging-markets nation to withstand a general economic downturn. Other BRICS countries were considerably weakened in the aftermath of the Chinese slowdown.

Furthermore, facing anticipated Federal Reserve tightening, the rupee remained relatively strong. Last year, when the rupee plummeted to a two-year low, passing the 66/$ mark, and Sensex tumbled after the yuan shock, Rajan assured the world that India was in a far better position to weather the volatility.

Downward Inflation

Monetary policy under Rajan has been regarded as far more clear and systematic than its antecedents. According to the new framework, the challenge was to achieve an inflation target of 6% by 2016 and 4% by 2017; that is on target, with inflation now around 5.4%.

Declining inflation has made India a favorable investment destination and paved the way for continual interest rate cuts. However, containing inflation through interest rates has not gone down well with critics such as Swamy, who has called it “disastrous” to the industry, causing unemployment.

In his May 16 letter to Modi, Swamy voiced objections to the shifting of the inflation target from the wholesale price index (WPI) to consumer price Index (CPI). That the move was recommended by an Expert Committee set up to “Revise and Strengthen the Monetary Policy Framework,” and that the committee was comprised of eminent economists and statisticians from such institutions as the Indian Statistical Institute (New Delhi), Williams College (USA), JPMorgan, Bank of Baroda and Nomura Securities, apart from being represented by the RBI, does not seem to matter to Dr. Swamy.

As explained in the committee report, “CPI inflation excluding food and fuel has remained sticky at an elevated level, averaging above 8% and playing a growing role in determining wage and price behavior in India.”

The report also stated: “Shocks to WPI inflation have no statistically significant impact on inflation expectations, indicating that targeting the WPI would do little to anchor inflation expectations”.

It is also contended that private-sector corporate investing has flatlined after peaking in 2011, that the stressed assets may lead to a decline in investment, and that this is a bottleneck that needs to be dealt with by the RBI. “In the last two years,” Swamy wrote, estimated NPA [non-performing assets] in public-sector banks has doubled.”

Bank Provisions

It needs to be acknowledged that the NPAs have accumulated over several years. But, at least under Rajan, the banks have started to recognize these stressed assets and begun provisioning for them. The first step towards solving a problem is to recognize that there is a problem – and that step seems to have been taken.

It is also argued that despite the success so far with inflation, and interest rates coming down, real borrowing costs remain high. And although it has remained relatively resilient, it is not on a strengthening trajectory, which is a cause for worry as it may engender higher inflation in months to come. The cost of borrowing/lending is determined by the banks, and Rajan has been appealing to the banks to pass on the decrease in interest rates to the customers.

Equity strategist Christopher Wood of CLSA, in one of his “Greed & fear” reports, argued that the biggest risk to India’s bond and currency markets would be to let Rajan’s term expire.

Doyens of Indian industry have come out in support of Rajan, urging a second term at the RBI. These are the same industrialists who have kept up pressure on Rajan to reduce interest rates further. So why would they be so supportive of him? The answer is simple. Rajan has “performed.”

Rajan said on CNBC Awaaz as reported June 8, “The announcement over my tenure will be made between now and September 4 when my term ends.” He acknowledged that his “long-term plan is to get back into academics, to teach and to go for research.

Rajan has now ended the suspense, stating the following in an open letter to RBI colleagues that, in large part, defended his record: “While I was open to seeing these developments through, on due reflection, and after consultation with the government, I want to share with you that I will be returning to academia when my term as governor ends on September 4, 2016. I will, of course, always be available to serve my country when needed.”

The role of TPAs in the Health Insurance Eco System

This interview was first published in IIB Bulletin, Vol. 2, Iss. 4, 2016, pp.11-12

https://iib.gov.in/IIB/Articles/IIB%20Bulletin%20IIRFA2016.pdf

Malti Jaswal, has close to 30 years of experience in the General Insurance industry in India in different capacities; marketing, operations, claims management etc. She has worked with both public sector and multinational insurers. Since 2008, she is working in health insurance field and is an active member of multi‐stakeholder working groups on health insurance in India. She is a regular speaker at health insurance forums and she has published papers relating to Universal Health Care, Third Party Administrators (TPAs) best practices, claims management, and fraud control.  

 

She has also been a member of sub-committees of Ministry of Health on Categorisation of Hospitals and Costing of Care. As a Consultant, she worked on varied projects relating to health insurance training and education, Information Technology (IT), payer-provider exchange platforms, cost control, and fraud control.

 

She has developed a Certification Course on Health insurance for Insurance Institute of India. She is currently working as the Chief Operating Officer of the Health Insurance TPA of India Ltd (HI TPA), a joint venture of the four public sector general insurance companies in India, namely, National Insurance Company Ltd., New India Assurance Company Ltd., Oriental Insurance Company Ltd. and United India Insurance Company Ltd, along with GIC of India.

 

In a conversation with Dr. Nupur Pavan Bang of the Indian School of Business, Hyderabad, Jaswal talks about the need for HITPA, the important role played by TPAs and fraud in Health Insurance claims.

You have worked extensively in the field of Health Insurance. Can you tell us about the role of TPAs in the Health Insurance Industry in India?

The concept of TPAs came to India around the years 2001-2002. That was the time the Insurance sector was opened up to the private players. The private players, when they started, didn't have in- house capability of running 24*7 claims support functions and wished to focus on core areas to build business. Public sector companies also did not have such capabilities though Mediclaim (generic term for health insurance product of PSUs) is being sold since 1986. Thus outsourcing seemed a natural choice. This gave birth to the concept of TPA in India. The TPAs were licensed by the Insurance Regulatory and Development Authority of India (IRDAI) to ensure that certain minimum requirements were met to set up a TPA. 

There are 30 licensed TPAs in India. So what is the purpose of setting up another TPA- Health Insurance TPA of India (HI TPA), promoted by four public sector general insurance companies?

The growth of business in health insurance has been exponential in India in the last decade with a year-on-year growth of 25%-30%.  To handle the growing business, robust processes, latest systems and technology and trained people are needed. However, the required investment did not happen across the spectrum of TPAs and the TPA industry remains under capitalized even today.   

Most of the large private sector insurance companies, including standalone health insurers, gradually started setting up in-house TPA/claims management facilities to have better control and do not use TPAs in big way anymore. Public sector insurance companies however continue to use the TPAs because of certain peculiarities of 24*7 operations. The terms and conditions of employment contracts of public sector general insurance companies are not generally geared for engaging manpower for round the clock services nor is rest of infrastructure.  In my view perhaps, it is also realized that the demanding nature of 24*7 TPA services required by customers, could be delivered more efficiently and effectively through a non-public sector entity.

Thus it seems to be a considered decision for the four public sector companies to come together, pool capital and create such an entity. This way, adequate capital investment could be made in HI TPA from an IT perspective because robust IT infrastructure and trained manpower are the key requirements for the TPAs to handle complexities of current health insurance products and high volumes. The four companies already enjoy the benefit of scale when bargaining with the hospitals together under Preferred Provider Network (PPN) arrangements.

Would HITPA also provide services to private insurance companies? And would the PSU companies use only HI TPA’s services in the future?

As of now the TPA license given by IRDAI to HI TPA is only for the four public sector companies. We have represented to IRDAI to make the license open to service business of private insurers.

There is absolutely no doubt that PSU companies will continue to use multiple TPAs. There is no intention of moving business completely to HI TPA as voluminous business is being serviced by various TPAs and retaining competition in essential to ensure that all parties deliver value to the customer.  At the same time if there is an entity with adequate capital, trained and skilled resources, robust processes and IT infrastructure, which can in a way, set the benchmarks for the entire TPA industry in India; it will surely bring better practices and impact the market in a positive way.  HI TPA aims to be that entity.  

You mentioned that the concept of TPAs came to India around 2001-2002. Prior to that, the public sector companies were managing the claims in-house. Since many of the private companies are now setting up in-house TPAs and claims processing teams, why can’t even the public sector companies continue the earlier practise of settling the claims in-house?

Claims management is an integral part of any insurance operation world over.  Since inception public sector insurance companies have had high quality technical manpower to do so for all lines of their business. The companies were also managing health insurance claims in-house prior to 2002.

In 1986, retail Mediclaim was launched for the first time in India by the public sector companies. The practice from 1986 to 2000 was that the customer would pay the hospital from her pocket and get the expenses reimbursed later from the insurance company which could take many days/weeks. With the entry of private sector companies in joint venture with large and experienced international insurers, cashless facility was introduced, as one of most customer friendly service.

For cashless facility to work, TPAs were inducted to organize and facilitate the same 24*7*365. TPAs facilitate networking with the hospitals on one hand and cashless/claims processing for the customers on the other.   

So the TPAs only process cashless claims?

A claim is a claim whether on cashless basis or on reimbursement basis.  Cashless is a customer friendly process wherein customer need not pay for treatment and then file claim later.  However customer has every right to seek treatment in any non-network hospital (so long as it meets the criteria) and file for reimbursement claim.  A claim is admissible and payable depending on terms and conditions of the policy, on what risks are covered, to what extent etc. The TPAs process both types of claims, however traditionally (and even today), role of TPA is primarily considered to facilitate cashless and all other services around the same e.g. 24*7 call center, issuance of member id cards, hospital network etc.   

Does the TPA pay the claims?

As per IRDAI guidelines, claims are required to be paid and repudiated by insurers directly to customer/provider.  TPA’s role is to process the claims as per guidelines of the specific insurance company and subject to terms and conditions of the policy.   The TPAs do not carry the risk, nor are involved in selling or underwriting. 

Some accounts put Health Insurance frauds to the tune of 15% of all health insurance claims in India. That is huge and puts a lot of burden on the customers in the form of increased policy premiums. Would HI TPA be instrumental, to some extent, in controlling fraud in health insurance?

As the health insurance industry has grown in India, so has the number of fraud cases and also modus operandi of fraudsters is getting sophisticated.  High growth tends to loosen controls and here in India we do not have Health Regulator. HI TPA aims to fulfil the twin objectives of its creation - enhancing customer experience and bringing in greater efficiency in Health Insurance claims processing.  Efficiency in claims processing would also incorporate better handle on controlling and managing fraud.

Can you elaborate on the ways in which fraud may be controlled?

The main job of TPA is claims processing and managing the hospitals network. TPAs handle the claims process right from the point of intimation to the settlement of the claim. TPAs have good IT systems. Policy data is integrated with their systems. Policyholder and members’ (people covered in the policy in the case of family and group policies) profiles are available with the TPAs as also the details about network hospital. All this information, coupled with the knowledge about medical practices and hospital tariff should make it easy to detect any outlier behaviour or pattern.

For example, let’s say a customer reports a non-emergency claim 1000 kilometres away from home.  It should ring a bell. If it's a non-emergency claim, why would a patient go to a hospital which is so far away from home unless it’s a specialty treatment like cancer.  Another example, if there is a very large reimbursement claim of say Rs400,000 or more, it should raise an alert. Why a customer would chose to pay such a large sum out-of-pocket and not avail the cashless facility made available in so many good tertiary care hospitals in normal circumstances.

During the entire chain of events, from intimation to payment, there are at least 5 or 6 trigger points, which a smart system and skilled manpower should be able to detect. Next step is data analytics in retrospect. Sometimes small value claims can slip through. But if analysed appropriately, those leakages would also become apparent over a period of time and amenable to control.

In India, there is no proper definition of what is a financial/insurance fraud. In the absence of a clear definition, even if a fraud is detected, the companies may choose to not pursue it if the amount is small. Even when a company decides to take legal recourse, the battle is often very long drawn and not worth the effort. As an industry, are there any steps being taken to tackle this lacunae?

It's indeed a big lacunae – there is no definition of insurance fraud under Indian laws nor provisos to deal with the same. There are three angles to fraud management; one is detection, second is recovery, and third is prevention/deterrence and punitive action.  Right now the insurance industry in India is primarily focused on detection and to some extent on recovery.  Not losing the money is the first and foremost priority. Unfortunately, prevention through punitive deterrent action is missing because our legal system and penal codes have not yet caught up with the changes in the financial and insurance domain. The Insurance Act of 1938, in spite of the recent amendments to it, doesn’t carry any active provisions to handle fraud. Punitive action is necessary for effective deterrence.

There have been industry level discussions at the Federation of Indian Chamber of Commerce and Industries and the Confederation of Indian Industries about what can be done to tackle fraud in the absence of legal provisions and health regulator. There have been suggestions to involve the Indian Medical Council to prevent doctors from conniving with the customers and hospitals to exaggerate claims or be a party to the fraud in any way. A few companies have started issuing letters to hospitals and doctors to seek explanation when a certain course of treatment seems unreasonable.   ‘Name & shame’ guidelines have been discussed.  

IRDAI has taken cognizance of growing menace and ways to control the same. IIB is also now directing lot of action to health data collection and analysis, hospital registry has been set up for the first time. Though a small step, data sharing of fraudulent customers and fraudulent hospitals has now started. Hopefully in times to come, we shall see more action on this front.  

Beyond the Profit Motive - The Example of Tata

This article was first published on www.famcap.com, an online Family Capital Magazine, on May 13, 2016

http://www.famcap.com/articles/2016/5/13/viewpoint-beyond-the-profit-motive-the-example-of-tata

No company evokes Indian business better than TATA. The legendary family business founded by Jamsetji Tata in 1868, TATA has established a domestic and international reputation that is arguably greater than any other Indian business.

When it comes to the numbers, TATA is truly impressive. The TATA Group is the holding company of 29 companies listed on the Bombay Stock Exchange. It accounts for 8 percent of the market capitalization of the Bombay Stock Exchange. TATA has made its mark in every major industry in India - steel, power, automobile, aviation, information technology, telecommunications, financial services, consumer goods, education, healthcare, and more.

But perhaps its role in the building of India and placing the importance of community before the profit motive are factors that have contributed most to its success - certainly from the point of view of many of its stakeholders. The journey of development of India can be traced through the house of TATA and the businesses that they ventured into. And during that journey profitability was not the only thing on the company’s mind. Indeed, nation building was just as important, if not more so.

For example, when the family built TATA Steel in Sakchi, now Jamshedpur, TATA also established an entire city around it. When the Taj Mahal Hotel was built in Mumbai, it was “to attract people to India”. When Tata Hydro Electric Power Supply Company was established, it was with the hope that Bombay would become a “Smokeless City”. And today the mission of the TATA Group continues to be: “To improve the quality of life of the communities we serve globally, through long-term stakeholder value creation based on Leadership with Trust”.

The early founders of the company - Jamsetji Tata, Sir Dorabji Tata and Jehangir Ratanji Dadabhoy Tata - worked to uplift the country and to improve the quality of life of the people around them. This was so central to their decision making that many times they put the importance of the community before their own wealth. In fact, profits were always secondary to Jamsetji Tata, and this tradition has been followed by his successors. But because they pursued excellence in whatever they did profits followed.

Sometimes in the world where instant gratification is so dominant in most societies there is a need to go back to the life and times of people like Jamsetji Tata and the other earlier pioneers of TATA to understand and appreciate their values just a little bit more.  

Mutual Fund Liquidity, Interfund Lending and the Role of Governance

This interview was first published by the Global Association for Risk Professionals on April 14th 2016

http://www.garp.org/#!/risk-intelligence/detail/a1Z40000003Bs4TEAS/mutual-fund-liquidity-interfund-lending-role-governance

Lending programs best help fund families weather crises when the funds are well governed, Prof. Vikas Agarwal says

Liquidity dries up during periods of crisis when there is flight to quality in the markets. The credit crisis of 2008 was exacerbated by illiquidity of assets. The Southeast Asian currency crisis of 1997 and the collapse of Long Term Capital Management in 1998 also brought attention to liquidity as a factor in systemic and market risks. In late 2015, it was an issue in the closing of the Third Avenue Focused Credit fund, which faced redemption pressures on its holdings of distressed-debt assets.

A March 21, 2016 U.S. Treasury Department press release (https://www.treasury.gov/press-center/press-releases/Pages/jl0393.aspx) regarding a Financial Stability Oversight Council meeting, stated that “the Council discussed its ongoing assessment of potential risks to U.S. financial stability from asset management products and activities, including a discussion regarding potential financial stability risks related to liquidity and redemption risks and risks associated with the use of leverage by asset management vehicles.”

Vikas Agarwal, H. Talmage Dobbs Jr. Chair and Professor of Finance, J. Mack Robinson College of Business, Georgia State University, says that open-end mutual funds bear significant costs because of their unique obligation to provide continuous, sufficient liquidity to their investors. “One potential channel for these costs is the fire sale of assets by fund managers to meet investor redemptions,” he says, citing Joshua Coval and Erik Stafford, “Asset fire sales (and purchases) in equity markets,” Journal of Financial Economics 86, 479—512 (2007). “An investor in an open-ended fund can exit anytime. Investors especially withdraw their money when the market is down, when it is the worst time for the fund manager to sell the assets.”

A London Business School (University of London) PhD in finance who has served as a distinguished visiting scholar in the Securities and Exchange Commission’s Division of Risk and Economic Analysis, Prof. Agarwal (http://www2.gsu.edu/~fncvaa/vikasgsucv3.pdf) has published extensively on hedge fund and mutual fund subjects. Interviewed recently by Dr. Nupur Pavan Bang of the Indian School of Business, Hyderabad, the professor discussed the provision and impact of interfund lending within mutual fund families, once they have obtained permission from regulators to set up interfund lending programs (ILP).

Would it be less expensive if the funds maintained enough cash or borrowed from banks to deal with redemption pressures?

Funds can easily hold the cash to deal with the problem, but cash does not earn any returns. If the fund has a liquidity buffer, then it can lead to a drag on performance. Funds have to pay fees to maintain any committed lines of credit, and interest expenses when borrowing takes place. If the fund has an uncommitted line of credit, it is possible that when things go bad, even the banks may refuse to lend. There can also be some restrictions imposed by shareholders on external borrowings in order to avoid leverage in funds.

What kinds of costs do funds incur in the event of a fire sale of assets?

A fire sale forces unwinding of illiquid positions in a short period of time at disadvantageous prices. In addition, there can be costs related to predatory trading. If a mutual fund experiences outflows, other market participants such as hedge funds can try to take advantage of “distressed” funds by front-running (e.g., short selling the securities that the mutual funds are expected to sell in a fire sale) or by buying the securities sold in a fire sale at cheap prices.

How can funds minimize some of these costs? Can they borrow money when facing redemption pressures?

The 1940 [Investment Company] Act prevents affiliated funds (those belonging to the same fund family) from engaging in any kind of transactions — for example, borrowing and lending — with each other. The rationale is that such interfund transactions should not result in one set of investors being worse off than others who might benefit. There is some evidence in the literature that in order to create star funds, fund families engage in cross-fund subsidization. For example, families can allocate the hot IPOs to their better-performing funds and, as a result, other funds in the family are worse off. [Jośe-Miguel Gaspar, Massimo Massa and Pedro Matos, “Favoritism in mutual fund families? Evidence on strategic cross-fund subsidization,” Journal of Finance 61, 73—104 (2006)]

But, in the 1940 Act there is a provision that allows the fund families to obtain an exemption from the Securities and Exchange Commission to engage in interfund lending if they can fulfill certain requirements. The underlying idea is that if there are controls in place to make sure that there is no cross-fund subsidization, then it seems okay for the funds within a family to borrow/lend amongst them. This is something that the fund family needs to convince the SEC about when applying for the ILP.

How would an interfund lending program work?

There can be saving on the transaction costs when funds engage in borrowing and lending to each other within a fund family. Let’s say that the borrowing fund can borrow outside at 5%, and the lending fund can lend outside at 3%. In such a case, the funds can settle down at a rate between 3% and 5%, say 4%. So the lender is actually able to earn a return which is greater than what they would earn outside 4% rather than 3%). The borrower’s rate of 4% is cheaper than the 5% rate outside.

Effectively, ILP creates an “internal capital market” for fund families and has become more popular over time. In 1987, Fidelity Investments was the first to apply to the SEC for the ILP. By 2013, funds with almost 40% of the equity holdings of all mutual funds had applied for the ILP.

What kind of compliance and controls does the SEC look for?

The onus is on the fund family to convince the SEC about the proper administration and implementation of the program. The board of directors is obliged to monitor and review the fund’s participation in the ILP for compliance. If the fund is not well governed, it can be expensive in the long run to ensure compliance and to make sure that the program is implemented in the right way. It takes about a year or so for the SEC to finish the process of reviewing an application and deciding whether to grant permission to the fund families for interfund borrowing and lending. In addition, the funds are required to obtain shareholder approvals and fully disclose material information about ILP to engage in interfund lending.

If the lending fund has cash, why would it not invest directly in risky assets rather than lending to the other fund?

The lending funds are typically money-market funds, which are not really trying to do fancy stuff. The borrowing funds are mostly equity funds. The idea here is that liquidity shocks to funds within the fund family are not perfectly correlated. The ILP essentially relies on the heterogeneity in the assets and liquidity characteristics of the funds within the family. So if one fund is experiencing outflows while the other is not, then one fund can demand liquidity while the other can supply it.

Can you elaborate on how governance of the fund has an impact on the performance of the fund?

In my working paper with Haibei Zhao, “Interfund lending in mutual fund families: Role of internal capital markets” [version: March 8, 2016], we show that families which are well governed perform better than those that are not. A better governed fund indicates that the ILP will be implemented in the right way.

Some of the proxies of fund governance are the size of the fund family and the fund itself, and the characteristics of the managers. Larger fund families and larger funds are likely to be better governed. Funds with fewer managers are less likely to have the free rider problem and hence should be better governed. Younger managers with career concerns are likely to be more disciplined, and hence associated with better governance.

Then there is certainly a reputational cost if the program is not well administered. When investors realize this to be the case, the fund will face outflows, and such cost is greater for larger funds and families.

How do the managers’ characteristics play out?

We find that there is a decline in the sensitivity of the managerial turnover to past performance after the funds apply for the ILP. This, in turn, implies that there will be less pressure on the managers in terms of outflows after they have performed poorly. As a result, bad managers will continue to stay in the funds, which can actually hurt future performance. So this is a cost of applying for the ILP for funds that are not well governed. Note that in well-governed funds, such costs will not be borne by the funds since the managers would be fired subsequent to poor performance.

Do fund families that have ILP perform better than those that do not?

We find that funds belonging to families that have ILP show better performance — if the funds are well governed. Moreover, as mentioned earlier, the sensitivity of flows to past performance goes down after the ILP.

In the mayhem that followed the September 11, 2001 attacks on the World Trade Center, a lot of funds experienced outflows. The funds which had the ILP actually suffered less, because ILP helped them absorb liquidity shocks much better. In fact, there was a release from the SEC [No. 25156, September 14, 2001] which stated that those funds which have the ILP could borrow from other funds within their families, and the borrowing limit was relaxed for a period of five business days after the markets reopened.

Incidentally, we also notice that the number of applications to the SEC for ILP approval is more around crisis periods such as 1998-1999 (LTCM), 2001-2002 (dot-com bubble) and 2008.

What is the impact on funds’ liquidity after their families participate in ILP?

Illiquidity of portfolios goes up, and there is an increase in the portfolio concentration of borrowing funds. Specifically, our analysis shows that there is a drop in the overall cash holdings of the equity funds, as they do not need to keep as much cash to meet investor redemptions.

Overall, how would you rate the ILP as a tool for liquidity management?

In principle, the ILP is a good idea, but it has costs associated with it if the funds are not well governed. In other words, the benefits of ILP accrue to well-governed funds. We also show that the funds use the ILP for the right reasons. Only about 7% of the funds which have ILP used it during the period of our study. We find that funds borrow when they experience outflows and poor performance. Also, we observe that well-governed funds are more likely to borrow, consistent with the benefits accruing to such funds.

India’s Path toward Open Trade

This article was first published by the Global Association for Risk Professionals on March 14, 2016; Co-author-Anisha Sircar (Flame University, Pune)

http://www.garp.org/#!/risk-intelligence/detail/a1Z400000031uPG

FCAC – full capital account convertibility – may be inevitable but requires careful preparation

“If countries do not plan for an orderly integration with the world economy, the world will integrate them in a manner which gives them no control over events. Thus, the question is not whether a country should or should not move to capital account convertibility, but whether an orderly or a disorderly transition is required.” — SS Tarapore, former deputy governor, Reserve Bank of India

SS Tarapore, a former deputy governor of the Reserve Bank of India (RBI), passed away on February 3, 2016. He wore multiple hats — writer, columnist and teacher — apart from being a dyed-in-the-wool macro-economist and central banker. He was well known for his views on full capital account convertibility (FCAC). It is as a mark of respect that we revisit the issue of FCAC for India.

The Reserve Bank of India has been contemplating permitting FCAC — an important step that would bring about many changes through liberalization of the use of foreign exchange as well as domestic currency. At the same time, one is left wondering whether India is ready for such a move, considering the impact on movement of capital, volatility of exchange rates and potential disruption of overall macroeconomic stability.

In the recent foreign policy adopted by the government, India aims to be made an integral part of the global trade system by 2020. Given this background, Capital account convertibility (CAC) emerges as a key factor in determining the feasibility of trade between countries.

Integral to the monetary policy of any economy, CAC defines the ease with which financial assets may be converted into those of a different currency. Simply put, flexibility in capital account would ensure no restrictions exist on foreign investments with respect to ownership of assets or purchasing of capital — factors commonly involved with phenomena such as real-estate bubbles or setting up subsidiaries in other countries. A flexible capital account would also involve the ability to convert domestic into foreign currency for a resident to purchase a foreign asset, and vice versa.

Investment Flow

CAC enables movement of foreign capital into the country, paving the way for foreign direct investment (FDI) into domestic projects and portfolio investment in the capital market. With the investments comes access to a global pool of resources and technological advancements.

Lifting capital restrictions could be looked at as a policy measure or incentive to bring about more macroeconomic prudence and stability. This could all potentially result in a stronger domestic and even international economy, as India may expand its market share in foreign economies, receive better returns and possibly experience more progressive policies overall with foreign exposure to the reform processes. Flexibility in the capital account can thus accelerate the economy of an emerging market.

Indian policymakers have until now maintained certain restrictions on asset inflows and outflows: on foreign investors, on resident Indians, and on companies wanting to borrow or spend money abroad.

As part of the reforms process in India, triggered by the balance of payments crisis in 1991, and since 1994, the Indian rupee has been convertible on the current account. Many types of controls have since been replaced. The currency is no longer pegged. FDI norms have been significantly eased. For foreigners and non-resident Indians, there is an equal and reasonable amount of convertibility in India, despite the persistence of several procedural restrictions.

Concerns from Abroad

While FCAC is desirable in principle, events elsewhere have been discouraging and lead some to believe that an open capital account invites economic crisis, and closed capital accounts ensure security.

The Asian financial crisis of 1997-98 saw easy and hazardous fleeing of capital from the country, which severely hampered the economy. During the crisis, Thailand, Indonesia, South Korea (followed by Hong Kong, Laos, Malaysia and the Philippines) were severely affected; India was relatively insulated because of a stabilization policy that involved restrictions on capital flows.

The ‘Grexit’ fiasco also resulted in harsh capital controls.

Globalization and risks of contagion are almost inescapable today. Not to miss the bus on globalization, yet remain insulated from crisis due to the contagion effect, is a task, not many would envy.

As India’s economy grows, FCAC is regarded as inescapable, and resisting it would be futile and counterproductive. Much more macroeconomic management and safeguards would be required to facilitate this movement.

Preparatory Steps

Most evidence points to the inevitability of full capital account convertibility in the near future, and thus the focus must be on the need for better preparation. The RBI has been creating prudential regulations for a framework to guide, monitor and enforce FCAC in India.

However, many things must be kept in mind before FCAC is undertaken, such as monetary policy, fiscal and foreign trade balance and, in the Indian context, banking system reforms. Strong macroeconomic stability is required before implementing full convertibility, especially to withstand global shocks.

As the late Deputy Governor Tarapore envisioned, FCAC must be implemented in an orderly fashion, taking into account all risks and other influencing factors, along with a well-researched, holistically-approached analysis of its impact on the Indian market, informed by successful policies and paradigms in other countries and supervision by analysts and committees from the field.

Budget 2016: Healthcare cannot wait, Mr Jaitley; healthy India can hasten wealthy India

This article was first published by www.firstpost.com on February 26, 2016.

http://www.firstpost.com/business/budget-2016-healthcare-cannot-wait-mr-jaitley-healthy-india-can-hasten-wealthy-india-2644650.html?utm_source=FP_CAT_LATEST_NEWS

The Indian Health care industry is growing at a rapid pace (CAGR of 17%) and is expected to become a US$ 280billion industry by 2020^[1]. Even so, nearly one million Indians die every year due to inadequate healthcare facilities and close to 700 million people have no access to specialist care^[2].

There are wide gaps between the rural and urban population in its health care system. A staggering 70% of the population still lives in rural areas and has no or limited access to hospitals and clinics^[3]. 80% of specialists live in urban areas^[4].

Improvement in health care infrastructure and facilities and ease of access to them is the only way India can fight against diseases. For that to happen, the Government spending on Healthcare must go up. However, the state of affairs, as they are now, is not very encouraging.

The average growth in expenditure on total healthcare is not only lower than the average GDP growth rate, the expenditure is still lower (as a % of GDP) than the expenditure of even low-income countries, as classified by the World Bank (See Figure 1). India is a low-middle income country as per the World Bank classification. In fact, the growth in expenditure on total healthcare in India has been decreased from what it was a decade ago (from 4.3% to 4.05%).

Figure 1: Health care expenditure as a % of GDP

Sources: Health care expenditure as a % of GDP has been taken from the world development indicators, World Bank.

In a talk at Harvard School of Public Health (HSPH) in 2012, it was noted that India spent about $40 per person annually on health care where as the United States spent $8,500. The entire GDP of India was $1.6 trillion then while the U.S. health care spending alone was $2.6 trillion.

K. Sujatha Rao, a former secretary of health and human welfare in India (2009-2010) and director-general of the National AIDS Control Organization (2006-2009) iterated, “What is very interesting is that India spends so little, but there are hospitals there that are comparable in terms of outcomes”^[5].

The problem essentially lies with the Government hospitals and their infrastructure. While there are many universal health care schemes being run by the Central and the State Governments in India and the Government hospitals offer treatment and essential drugs free of charge, the fact that the government sector is understaffed, underfinanced and that these hospitals maintain very poor standards of hygiene forces many people to visit private medical practitioners and hospitals. 

Besides the lack of overall healthcare infrastructure, the second most important influence on India’s healthcare industry is its lack of a medically insured population and high out-of-pocket expenditure.

According to Annual Report to the people on Health by the Ministry of Health and Family Welfare, Government of India (December 2011) about 71% of the total health care expenditure in the country was borne by households out of their pockets^[6]. Out of pocket expenditure is any direct outlay by households, including gratuities and in-kind payment, to health practitioners and suppliers of pharmaceuticals, therapeutic appliances and other goods and services whose primary intent is to contribute to the restoration or enhancements of the health status of individuals or population groups, as per the definition given by the World Bank. Out of Pocket expenses figures by World Bank for India stand much higher at 86% for the year 2012.

The NDA Government did plan to bring about a 'complete transformation' of the health sector and even worked on the blueprint of the world's largest universal health insurance programme, partially inspired by US President Barack Obama's grand insurance-for-all project which is popularly known as "Obamacare"^[7].

The Government now needs to act on its plans. The Union Budget 2016 must allocate more money to the healthcare sector. The sector is in dire need for funds to improve their infrastructure and skill sets and to increase capacity. There are leakages of allocated funds at all levels. It is important to link initiatives like the Digital India to bring in more transparency in the allocation of funds and its expenditure by the Government Hospitals and Medical Officers.

It is said, “Health is Wealth”. Mr. Jaitley, while steps to improve the Economy are much appreciated, a healthy India will hasten the progress towards a wealthy India!

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[1] http://www.ibef.org/industry/healthcare-india.aspx

[2] http://www.indus.org/healthcare/HealthcareIndia.html          

[3] http://forbesindia.com/blog/health/5-things-to-know-about-the-indias-healthcare-system/

[4] http://www.indus.org/healthcare/HealthcareIndia.html          

[5] http://www.hsph.harvard.edu/news/features/jha-rao-us-india-health-care-systems/

[6]http://mohfw.nic.in/WriteReadData/l892s/6960144509Annual%20Report%20to%20the%20People%20on%20Health.pdf

[7] http://ibnlive.in.com/news/indian-government-working-on-worlds-largest-health-insurance-scheme/482670-37-64.html

Mr Jaitley, we expect a 'positive' Budget from you

This article was first published in the business section of www.rediff.com on February 24, 2016; Co-author: Anisha Sircar (student at the Flame University, Pune).

http://www.rediff.com/business/report/budget-2016-special-mr-jaitley-we-expect-a-positive-budget-from-you/20160224.htm

India’s economic growth and foreign investment have been picking up and inflation has been falling under the Reserve Bank of India Governor Raghuram Rajan after a long time. Even the Balance of Payments appears to be in a better shape. All eyes are now on the Union Budget 2016. It is left to the structural announcements of the Budget to inspire markets into taking a directional call. The indices (Sensex and Nifty) have been falling ever since the beginning of 2016, due to oil prices, Chinese economy, global economic uncertainty and the bank NPAs back home.

In the last Budget, incentives to businesses like 100 per cent deduction for Swachh Bharat and Clean Ganga contributions, and hike in service tax was appreciated. The last Budget focussed on long-term growth by propelling fiscal consolidation, capital expenditure, and revised deficit targets to be met over the next 3 years. What needs to be seen is how much of what was Budgeted was achieved or implemented.

In this article, we visit the key areas in which announcements by Finance Minister, Arun Jaitley are anticipated.

In the pre-Budget consultations by Arun Jaitley and his team, it was implied that the Budget this year will revolve around the social sector and inclusive growth. Key demands throughout the sectors are:

·         Financial aid for medical innovation,

·         Increases in pensions,

·         More allocation for secondary education and schemes like Krishi Unnati Yojana, and,

·         Crop insurance.

With the Make-in-India project coming into fruition, higher education will need massive funds from the government to meet manpower needs and import duties will need cutbacks.

Hike in anti-dumping duties is expected, particularly since the devaluation of the Chinese yuan, which has increased the chances of China dumping cheap goods into the Indian market, thereby jeopardising India’s domestic manufacturers and ‘Make-in-India’.

The ‘100 Smart City’ project rides on expectations of increased funds. The start-up industry has been promised benefits from Modi’s Start-up India launch, and hopes of increased avenues of PPP continue to give shape to Digital India.

With the government’s focus on IT/digitisation and business-friendly investments, the general positivity regarding the Union Budget 2016-17 is justifiable; a focus on infrastructure, employment, skill development and monetary encouragement for companies to focus more on R&D and fund allocation will be appreciated. Additionally, further increase in standard deductions for the Income Tax will be very welcome, given the increasing cost of living.

GST would bring in favourable uniformity in the tax system and lower tax rates, is expected to be discussed in the upcoming Budget. Measures to combat issues such as black money and escalating NPAs for banks (March 17, 2016 is the RBI deadline for clearance of bank balance of sheets) especially inhibiting sectors from achieving self-sufficiency are awaiting concretisation.

Announcements with respect to divestment plans, foreign direct investments, capex for private investment, start-up policies, and the overall tax framework are being looked forward to. An increase in public expenditure and encouragement of private investment could be the key to boosting growth.

Without allowing expectations to hit the roof, the Union Budget 2016-17 may be thematically inclined towards all-inclusive economic growth for India. The year may witness the establishment of stronger ties between micro-economic and macroeconomic growth, which would invariably be reflected by stock markets in some measure, as well as by its impact on individuals, companies and the overall economy.

The country has achieved a considerable amount of positivity, activity and attention in the past year through digital inclusion, local manufacturing and entrepreneurial inspiration. The new Budget would do well to fill up the gaps and pave a strong way forward to ensure that the optimism surrounding it is not short-lived.