Wednesday, July 28, 2010

On Regulatory Zeal

By Saleem Husain.

Regulatory Zeal, along with India’s economy, is the great growth story of our time. I am alternately reminded of two very different campaigns - the “Got Milk?” campaign, focused on the absence of an essential ingredient and The Crusades, aiming for zealous universal correctness.

Let me explain in the context of my current time in India after a long stint on Wall Street, NY. Regulatory bodies in India find any and every occasion to congratulate themselves in public and private. To me this is akin to transport authorities feeling happy about low accident rates - by outlawing motorcars! Because that is what the financial regulatory framework in India is - and where the West is headed.

As in the “Got Milk?” campaign, one should focus on the absence of flexibility in broker dealers in India and see where that leads. A simple example is the Total Return Swap (TRS). It is by far the cleanest way of renting balance sheets out - which is the bread and butter of Indian banks. It is basically an instrument where the client pays a spread over LIBOR and gets the return (gain or loss) of an asset (usually an index or a collection thereof). Simple? Yes. Easy to price or hedge? Absolutely! So, sir, can I trade it…? Are you out of your mind!! But you can have corporations window-dressing their earnings at quarter-end, conning simple investors who ultimately lose money. The situation is akin to using a motor car to cut butter and a butter knife to tune an engine.

My larger point is that regulators’ ruminating on possibilities - while ignoring the possibility that the person involved may have the intellect to make an informed decision - only leads to a society where horse carriages still ferry around people; with the incumbent problem of dung several stories high, as was prevalent in NY at the turn of the century.

A person in need to sell volatility will find a way to do it. Be it under the cover of “capital origination” or by altering the company’s holding structure to permit it to do so in a location that allows it. A case in point - most CDS (credit default swap) contracts on Indian names are traded in London. If I was to round the circle, these CDS contracts may be used to create synthetic bonds on corporate debt and these ‘bonds’ could provide a proxy secondary market of corporate bonds. Interesting, except that secondary trading on Indian corporate debt is thin and illiquid.

Where does that leave us? Clearly, all markets are not created equal. Any market is a function of trust - not just between the participants and their faith in the market’s fair play but also, conversely, of the market's trust in the maturity of the player. We will have to live with differences in market structures across national boundaries and societies. However, I believe a guiding principle for regulatory bodies across markets should be that: the strength of an entity is measured not by how ferocious an attack is by a "virus" – but rather by how resilient the response is.

Saleem Husain is Director, Citigroup, New York. He earlier worked with Booz Allen Hamilton and Ernst & Young, and holds an MBA from New York University (Stern). He is currently based in Mumbai, India, and travels across the globe carrying his Kindle loaded with an eclectic set of books.

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