In a liquid and transparent financial market, there is no doubt about the price. There is high pre-trade transparency, because orders are visible on the limit order book, and the best estimate of the true price is (bid+offer)/2. You glance at the screen and you know what is the price.

In a non-transparent market, it is hard to know the true price. Special schemes have to be constructed in order to measure the price. Price measurement does not happen `for free’ as a minor side effect of the very trading process.

Why price measurement matters

As a thumb-rule, the best design for a derivatives contract is to use cash settlement, as long as you can be pretty certain about observing the price. If you can’t measure the price, then physical settlement is better.

Cash settlement is a great technology. But it requires sound measurement of the price.

Measuring price on an OTC market

In an OTC market, information is not visible at a glance. It is dispersed. Many traders have private information about the price, but
you do not. If you could setup an electronic order book, you would see bid and offer at a glance: these are the prices at which a small buy and a small sell transaction could be done. On an OTC market, the dealer has a sense about where the market is, but you don’t. So a natural strategy is that of asking the dealer what he is seeing.

Dealers have positions on the market, so we have to worry about what they say. Standard schemes used involve removing extreme
observations, and thus coming up with a more robust price measure. These schemes have been used in India with the NSE MIBOR (the dominant price measure on the interest rate swaps market), the CMIE measurement of commodity spot prices for NCDEX, etc.

RBI’s measurement of the INR/USD exchange rate

In India, RBI is an information producer in reporting the INR/USD exchange rate at 12 noon. This `official RBI price’ is widely used in
computing the settlement price for cash-settled derivatives on the rupee. It is used for the official closing price on the NSE currency futures/options market, which in many ways is shaping up as the main market where the INR exchange rate is discovered. As an
example, yesterday (an expiration day), the open interest closed at $7.2 billion, and turnover was $6.2 billion.

RBI has not had a formal methodology for how this price is computed and reported.

I have always been a bit uncomfortable with RBI producing this vital information, since RBI has many other goals which can conflict
with the goal of producing high quality information. But for a while, this seemed to be working.

New methodology at RBI

On 1 July, their methodology will change to something new:

1. They will choose a random five-minute window from 10:30 to 12:30 (i.e. a two-hour window).
2. The reference rate will be computed using these five minutes.
3. It will be released at 13:00.

I cannot imagine the logic which led up to this, but I have to say that this is not a good idea.

A two hour window is a lot of time in the life of a market. The RBI reference rate is then no longer a reference rate of the market. It is
a measure of the price at a randomly chosen time in that window. This makes it much less informative.

As an analogy, imagine if the official NSE closing price for Nifty was plucked out of a randomly chosen time from 2:30 PM to 3:30
PM. This would be a lot less informative as compared with the present methodology (value weighted average of all trades from 3 PM to 3:30 PM). It would be even better if NSE were to do a call auction from 3:15 PM to 3:30 PM and report that price as the official closing price. That would be sharp and interpretable.

All cash derivatives settling on the RBI reference rate will now suffer from a new source of uncertainty: the randomly chosen time at
which the price is reported. The cash-and-carry arbitrageur needs to sell his spot position at the exact time at which the derivatives
expire. In the case of the Nifty futures, there is a simple trading strategy which roughly approximates the Nifty closing price: In each
of the last 30 minutes, do 1/30 of your required trade. This is typically automated, i.e. it requires algorithmic trading, but it’s fully feasible.

With a randomly chosen timepoint over a two hour horizon, the arbitrageur does not know when to closeout. This will exert a negative impact on pricing efficiency and thus basis risk on the derivatives market.

If the INR/USD exchange rate is a random walk in trading time, then the 9% annualised volatility maps to a standard deviation of 28 basis points over a two hour horizon. On a base of Rs.45 a dollar, this is a standard deviation of 12.6 paisa. This is quite a bit for traders and arbitrageurs. These small issues have a disproportionate impact in contaminating market efficiency.

But wait. There are some people who know at what time the pricing is done: the banks who are polled! So suppose there is a fixed panel of banks who are asked by RBI. The moment the RBI phone call comes in, they closeout. These banks will find it profitable to do currency arbitrage while others are not. Such shifts in the currency arbitrage constitute a distortion induced by RBI’s new method of price measurement.

Lessons

RBI needs to cultivate improved knowledge of finance amidst its staff.

This illustrates the importance of legal process in rule-making. If RBI had gone through a formal notice-and-comment process, then they could have heard from external experts and desisted from doing this. I wasn’t able to find a document on the RBI website explaining the rationale for what is being done.

Information production should be done by specialised information organisations. If information is produced by people who have other conflicting interests, then such sub-optimal decisions are more likely to arise.

Alternative information producers, such as Reuters, should leap into this opportunity by producing a better INR/USD reference
rate. FEDAI already has an alternative reference rate. We should all switch away from the RBI reference rate towards alternatives.

Unfortunately, many people in the trade are fearful of the RBI and would not evaluate alternatives rationally. This tells us two
things. First, RBI needs to be enveloped in the rule of law so that there is no fear of RBI on the part of market participants. Second,
RBI should not be a producer of information. As long as two private agencies are producing INR/USD reference rates, the decision in the derivatives trade about what information measure to use will be based on technical merits alone. If someone then tries to come up with a scheme where a randomly chosen time over a two hour window is used for the measurement, his market share will go to zero.

And indeed, the macro backdrop had been awful lately. Both real economic and housing activity in the US have resumed their downward path, in Europe Ireland got a knock by the S&P, and in general hitherto positive voices have either retreated into the rabbit hole or turned very cautious. Basically, after leafing through a lot of independent as well as buy/sell side research I am pretty convinced that analysts and investors are in brace yourselves mode since they are all frontloading  the recession/double dip theme; “You know, it MIGHT happen but we still don’t think it will and even if it does happen, it is still a low probability event”. This is called covering your a” and the fact that many research houses who were formerly sure that the US would see no douple dip are now backtracking. Of course, this is understandable given the underlying change in the flow of economic data as well as of course markets have been in obvious risk-off mode lately.

The only real straw which we are pinning our hopes on at the moment is that the Fed will step up and pull another trick out of QE-hat or that somehow Germany is going to save the world (and here). On the former, Tracy Alloway poured some cold water on that idea today and on the latter, someone forgot to tell these people that Germany actually depends on others to get their growth. We can always look to emerging markets someone would say, but the problem here is that momentum in H02-10 is almost certain to falter. I am not talking about recession of a slump but in relative terms and as the OECD still struggles to find even a positive rate of trend growth a slowdown in the emerging world will make itself felt.

For investors then, it seems that short of staying nimble and trying to scoop up some value as the market corrects lower, there is always the US bond bonanza to dig into. Now, I know that bonds look overbought and that yields are at all time low, but just understand that bonds may very rally even more and yields slump further. The suggestion made recently by David Rosenberg that the US yield curve might actually flatten from the long end is very important in my opinion as it indicates how the Fed is likely to continue intervening in this market. I recently asked a friend of mine what he thought of all this and he returned the following quote form a director of a fixed income strategy outfit;

Suppose the Congress controlled the production of all the lemons in US. Then assume the Federal Reserve decided that it was going to use its balance sheet to buy lemons as a means of adding liquidity into the market when times were tough. While the government ramped up lemon production during tough times, the Fed not only bought most of those lemons, but sent out a clear message that it stands ready to buy a whole bunch more lemons if the economy falters.  Finally, suppose that the government started changing the rules and regulations forcing financial institutions to hold more lemons rather than limes – as lemons were deemed the only safe fruit. What happens to the price of lemons? The answer is a 2.50% 10 year note!

These are not “market prices”. The Congress, Fed and Treasury are controlling the supply, demand and the rules of the game in the US government bond market. And make no mistake – lemon production is ripping higher. Eventually people will realize there are not enough Corona bottles to stuff those lemons into and there will be lemonade all over the streets. Until then, please remember that this will go down as one of the greatest examples government price control and manipulation in history. Maybe soon we will be lining up at 15th and Constitution in DC – at the doors of the Treasury on odd and even days depending on our birthdays – in order to buy limited supplies of those precious lemons!! There is a great book by two gentlemen from the Hoover institution. The stories span 10,000 years but they all have one thing in common – when governments distort asset prices, bad things happen. It is an easy and fun read. I encourage you to grab a copy.

Finally, it has been a humbling summer watching 10 year rates move to these levels. I remain steadfast in the view that we are at least 75 to 100bps expensive in long term rates. But with the supply, demand and rules fixed by the Fed/Treasury/Congress Troika, I probably should have been more prepared for this – mea culpa. In any case, I’ll fall back on one of the better calls we have had and that is in MBS space where price manipulation is just as rampant. In fact, we can see that as the Fed has decided not to treat MBS like lemons anymore, they were quickly turned to lemonade. Once again my market screens are all red in MBS – days with 5yr futures down 5 tics and FBCL6.5s down 11 tics are amazing to watch. The 5.5/4.5 swap which peaked at 5-15 has fallen to 2 points since April. There is a lot of pain in the MBS world and it may be a good preview to what happens when government price manipulation schemes unravel. Good luck trading!

On this note, the only thing risk lovers can reasonably hope for on the back of the current macro picture is that markets move Sideways from here.

“Reflexivity can be interpreted as a circularity, or two way feedback loop, between the participants’ views and the actual state of affairs. People base their decisions not on the actual situation that confronts them but on their perception or interpretation of that situation. Their decisions make an impact on the situation … and changes in the situation are liable to change their perceptions … . The two functions operate concurrently, not sequentially” (George Soros, “The New Paradigm for Financial Markets”, 2008, p 10).

“Many critics of reflexivity claimed that I was merely belabouring the obvious, namely that the participants’ biased expectations influence market prices. But the crux of the theory of reflexivity is not so obvious; it asserts that market prices can influence the fundamentals. The illusion that markets are always right is caused by their ability to affect the fundamentals that they are supposed to reflect. The change in the fundamentals may then reinforce the biased expectations in an initially self-reinforcing but eventually self-defeating process” (Soros, op cit, p 57-8).

Does George Soros know what he is talking about? The fact that he has operated successfully in financial markets for a long time suggests to me that he might have a few clues about how they work. But I struggle to understand him.

As is the case with many other problems of understanding, I think my problem in this instance relates to definition of terms. What does Soros mean by fundamentals? If a process is eventually self-defeating then it seems to me that this means that it is inconsistent with the fundamentals of the real world – i.e. it is inconsistent with what we know to be true about such things as resource availability, technology or human nature.

When Soros suggests that market prices can influence the fundamentals he may have something less fundamental in mind such as widely accepted perceptions of investors and credit providers about particular markets or the wider economic situation. It seems plausible that a widespread view that housing was a very safe investment, for example, could be reinforced if house prices began to increase more rapidly and if credit providers perceived that this made lending more secure. Under some circumstances that might, perhaps, result in a self-reinforcing process of increases in house prices that would eventually become self-defeating, for example because increasing numbers of people might decide that they would be better off renting rather than owning a house.

If this is what Soros means by reflexivity, does it help to explain the current financial turmoil? In explaining his super-bubble hypothesis Soros writes:

“The belief that markets tend toward equilibrium is directly responsible for the current turmoil; it encouraged the regulators to … rely on the market mechanism to correct its own excesses. The idea that prices, although they may take random walks, tend to revert to the mean served as the guiding principle for the synthetic financial instruments and investment practices which are currently unravelling” (Soros, op cit, p 102).

It seems to me that the second part of that statement, relating to synthetic financial instruments, may help to explain the current financial turmoil. With the benefit of hindsight it is apparent that the world economy is suffering from, among other things, the development of a self-reinforcing belief system which led many financial firms to over-value synthetic financial instruments.

However, the first part of Soros’ statement doesn’t make sense. Regulators have not relied on the market mechanism to correct its own excesses. The current turmoil is partly a consequence of a history of financial firms being bailed out by regulators on the grounds that they were too big to be allowed to fail. George Soros is on much firmer ground when he recognizes that most reflexive processes involve an interplay between market participants and regulators (p77).

Hopefully, the regulatory environment that emerges from the current turmoil will recognise that participants in financial markets are human. It should not surprise anyone that when financiers are given incentives to behave imprudently they tend to act accordingly.