Author: SK

May a thousand market structures bloom

In my commentary on SEBI’s proposal to change the regulations of Indian securities markets in order to allow new kinds of market structures, I had mentioned that SEBI should simply enable exchanges to apply whatever market structures they wanted to apply, and let market participants sort out, through competition and pricing, what makes most sense for them.

This way, different stock exchanges in India can pick and choose their favoured form of regulation, and the market (and market participants) can decide which form of regulation they prefer. So you might have the Bombay Stock Exchange (BSE) going with order randomisation, while the National Stock Exchange (NSE) might use batch auctions. And individual participants might migrate to the platform of their choice.

Now, Matt Levine, who has been commenting on market structures for a long time now, makes a similar case in his essay on the Chicago Stock Exchange’s newly introduced “speed bump”:

A thousand — or at least a dozen — market structures can bloom, each subtly optimized for a different type of trader. It’s an innovative and competitive market, in which each exchange can figure out what sorts of traders it wants to favor, and then optimize its speed bumps to cater to those traders.

Maybe I should now accuse Levine of “borrowing” my ideas without credit! 😛

 

Books, Music, Disruption and Distribution

Having watched this short film by The Economist on disruption in the music business, I find the parallels between the books and the music businesses uncanny.

Both industries have been traditionally controlled by the middlemen – labels in the case of music, and publishers in the case of books. Both sets of middlemen are oligopolies – there are three big music labels and four (?) major publishers. This is primarily a result of production costs – traditionally, professional recording equipment has been both expensive and hard to get. Similarly, typesetting and printing a book was expensive business.

However, both industries have been massively disrupted in the last couple of decades, primarily thanks to new distribution models – streaming in the case of music, and online vendors and e-books in the case of books. Simultaneously, the cost of production have also plummeted – I can get studio quality recording and mixing software on my Macbook Pro, and I already have a version of my book that looks good on the Kindle.

Yet, in both industries, the incumbents strongly believe that they continue to add value despite the disruption, and staunchly defend the value of the marketing and distribution they bring. In the above video, for example, a record studio executive talks about how established artistes may do well going “indie”, but new artistes require support in production, marketing and distribution.

If you see blogs and news articles on publishing and self-publishing, on the other hand, most of the talk is about how little value publishers themselves bring into the marketing and distribution process. While publishers continue to have a broad monopoly on the traditional distribution chain (bookstores, primarily), they have no particular competitive advantage in the new channels.

One of the successful indie artistes interviewed in the above video talks about how he was successful thanks to the brand and following he built up on social media, which ensured that his album had several takers as soon as it was released. It is again similar to advice that authors who want to self-publish get!

As someone who has completed a book manuscript and is looking for production and distribution options, I find the developments in the indie space (across products) rather interesting. Going by all this, maybe I should just give up on the “stamp of approval” I’m looking for from a traditional publisher, and go indie myself!

I leave you with a few lines from one of my favourite poems, which I believe is a commentary about the music record label industry!

Now the frog puffed up with rage.
“Brainless bird – you’re on the stage –
Use your wits and follow fashion.
Puff your lungs out with your passion.”
Trembling, terrified to fail,
Blind with tears, the nightingale
Heard him out in silence, tried,
Puffed up, burst a vein, and died.

 

Equity financing of books

A rather uncharitable view of the book advances that legacy publishing houses give out to established (non first-time) authors is to look at it as “convertible debt”, as this piece by Matthew Yglesias points out.

An advance is bundled with a royalty agreement in which a majority of the sales revenue is allocated to someone other than the author of the book. In its role as venture capitalist, the publisher is effectively issuing what’s called convertible debt in corporate finance circles — a risky loan that becomes an ownership stake in the project if it succeeds.

Now, as I consider possibly self-publishing my book, while simultaneously attempting to sell it to established publishing houses, I realise that apart from the convertible debt, publishing a book also involves a massive sale of equity.

I’ve finished the manuscript, and edited it once. It needs further editing, but I’ve put it off so far in the hope that I can sell the book to a mainstream publisher, who will then take care of the publishing. However, given that I might end up self-publishing, and from what I read that publishers don’t do a great job of editing anyway, I might need another pass or two.

And then there are other things to be done before the book comes out in print – a cover needs to be designed, illustrations need to be put in, maybe we should get someone to do an audiobook, and all such. Now, if a mainstream publisher picks up the book, I’d expect them to take care of these. Else I’ll need to spend to get people to do these things for me.

When people first told me that royalties in book publishing are of the order of 7.5% of cover price, it was a little hard to believe. However, looking at the costs involved in the publishing process, it’s not hard to see why publishers take the cut that they take. The problem, though, is that it involves you selling equity in your book.

By going for a mainstream publisher (rather than self-publishing), you are saving yourself the upfront cost of getting your book edited, designed and “typeset”, in exchange for a large portion of the equity of the book.

Looking at it in another way, you are trading in your limited downside (what you spend in designing, printing, etc.) for what might be a massively unlimited upside (in case my book is a runaway success). For the most part, considering that most books don’t do that well, it isn’t a very bad deal. However, considering that downside is limited (in terms of costs) I wonder if it makes sense to trade it in for a large stake of what could be a large upside.

In any case, the main reason I’m still pushing to get mainstream publishers is because the self-publishing market is a “market for lemons“. With barrier to entry not being too high, lots of bad books are self-published, and so anyone who thinks they’ve written a half decent book will try to find a mainstream publisher. And this further diminishes the average quality of self-published books. And further dissuades people like me from self-publishing!

 

Intermediation and the battle for data

The Financial Times reports ($) that thanks to the rise of AliPay and WeChat’s payment system, China’s banks are losing significantly in terms of access to customer data. This is on top of the $20Billion or so they’re losing directly in terms of fees because of these intermediaries.

But when a consumer uses Alipay or WeChat for payment, banks do not receive data on the merchant’s name and location. Instead, the bank record simply shows the recipient as Alipay or WeChat.

The loss of data poses a challenge to Chinese banks at a time when their traditional lending business is under pressure from interest-rate deregulation, rising defaults, and the need to curb loan growth following the credit binge. Big data are seen as vital to lenders’ ability to expand into new business lines.

I had written about this earlier on my blog about how intermediaries such as Swiggy or Grofers, by offering a layer between the restaurant/shop and consumer, now have access to the consumer’s data which earlier resided with the retailer.

What is interesting is that before businesses realised the value of customer data, they had plenty of access to such data and were doing little to leverage and capitalise on it. And now that people are realising the value of data, new intermediaries that are coming in are capturing the data instead.

From this perspective, the Universal Payment Interface (UPI) that launched last week is a key step for Indian banks to hold on to customer data which they could have otherwise lost to payment wallet companies.

Already, some online payments are listed on my credit card statement in the name of the payment gateway rather than in the name of the merchant, denying the credit card issuers data on the customer’s spending patterns. If the UPI can truly take off as a successor to credit cards (rather than wallets), banks can continue to harness customer data.

Betting by other means

In India, officially, sports betting is illegal. Of course, there are lots of “underground” betting networks which we will not go into here. This post, instead, is about a different kind of “betting” on sports.

I’ve long maintained that Mahendra Singh Dhoni is grossly overrated as a cricket captain. While he did win that ICC World T20 in 2007 (back then his captaincy was pretty good), since then he’s shown himself to be too conservative as a captain. In that sense, I’m glad he retired from Tests (thus relinquishing captaincy as well) in 2014, paving the way for the more aggressive Virat Kohli to lead.

Even in limited overs games, I’ve maintained that while in the past he’s been instrumental in orchestrating chases, that ability is now on the wane, with last night’s choke being the latest example of him botching a chase. Earlier this year as well, he choked a chase in Zimbabwe. There are more such examples from the IPL as well.

Given last night’s fuck-up, I think it’s a great time to replace him as captain for limited overs games. I’m not hopeful of this happening, though, and this is in part due to the “betting at another level” that happens in elite sport.

Back in 2011 or 2012, a hashtag called #SachinRetire started making the rounds on Twitter. The context was that with the 2011 world cup having been won, it was a great opportunity for Sachin Tendulkar to retire on a high note. He continued playing on, though, in the hope of hitting “100 100s in international cricket”, the result of which was mostly mediocre cricket on his part.

Tendulkar’s 100th 100 finally came a year after his 99th, in an Asia Cup match against Bangladesh. He scored at a strike rate of 78, in a match India lost. A lot of the blame for the loss can be put on his slow rate of scoring, and consequently, on the 100th 100 hype.

It was another good opportunity to retire, but he continued playing, until a special Test series was organised in 2013 so that he could retire “at home”.

The dope in sports circles in those days was that while Tendulkar himself was keen to go, there were plenty of endorsements he was involved in, and those sponsors would have had to take a loss if he retired. Thus, the grapevine went, he had to take his sponsors into confidence and “prepare them” in order to choose an opportune time to retire.

Endorsements and sponsorships are the “other kind of betting” I mentioned earlier in the post. As soon as a sportsperson “makes it”, there is a clutch of brands who wants to cash in on his popularity by asking him to endorse them. The money involved makes it a good deal for the sportsperson as well.

By choosing to sponsor a sportsperson and getting him to endorse their brand, sponsors are effectively taking a bet on the player’s career – the better the player’s career goes, the greater the benefit for the brand from the sponsorship deal. In case the player’s career stalls, or he is caught in a scandal, the brand also suffers by association (think Tiger Woods or Maria Sharapova).

The concern with betting on sports in India is that bettors might try to influence the results of matches they’ve bet on, by possibly fixing them. This, along with “protecting the poor punter” are reasons why betting on sports is banned in India.

The problem, however, is that with this “other kind of betting” (sponsorships), the size and influence of the bettors (sponsors) means that there is a greater chance of the bettors seeking to influence the results of their investments.

A sponsor, for example, will not be happy if their “sponsee” is left out of his team, for whatever reason. Any negative impact on the sponsee’s career, from being dropped, to being demoted from captaincy to being sold to a “lesser club” negatively affects the brand value of the sponsor (by association).

And so, in cases where it’s possible (I can’t imagine a sponsor trying to influence Jose Mourinho’s decision, for example), the sponsor will try to influence selection decisions where it might benefit them. So Tendulkar’s sponsors will lobby with selectors to keep him in the team. Dhoni’s sponsors will lobby to keep him as captain. And so forth.

I’m not advocating that some kind of regulation be brought in to curb sponsors’ influence – any such regulation can only be counterproductive. All I’m saying is that betting already exists in Indian cricket, except that rather than betting on matches, bettors are betting on players! And so there is no real argument to ban “real” sports betting in India.

At least in that case, sponsors will be able to hedge their investments in the market rather than seeking to influence the powers behind the sport!

 

Randomising wear and tear of safety razor

A few months back, having mostly given up on my Gillette Mach 3, I decided to go all old school and get myself a safety razor. While I cut myself occasionally (one day I cut myself right on my Adam’s apple, giving me a minor scare that I’d slit my throat), I’m significantly happier with the results of this razor, compared to the Mach 3.

I find that I need to shave only a single time, compared to two rounds with the Mach3, and cleaning the razor in the middle of the shave is also far easier. And while it isn’t absolutely smooth, it leaves me mostly satisfied at the end of the shave. And I’m not even mentioning the cost saving here!

The only “problem” with using an old-school safety razor is that it takes in double-edged blades. Having used multi-blade cartridges all my shaving life thus far (my father had bought me a Sensor Excel when I was first ready to shave, which I later traded for a Mach3), I started using a single side of the blade to complete the entire shave.

In my experience, a decent blade should last about 6 shaves, as long as you use both edges of the blade equally. The challenge here was to know (visually) which side of the blade you had used, so that you could get the maximum out of the blade!

Initially I thought of using stickers or some such paraphernalia to indicate which side of the blade I’d used each time. After a little thought, however, I realised that if this was a common problem, the razor itself would’ve come with an asymmetrical head, so I could keep track. There should be a better way to keep track, I reasoned.

And so I decided that I would use each edge of the blade half-and-half in each shave. The first day, it worked. The second, I had finished shaving half my face, when I realised I’d suddenly forgotten which side I’d used. An improved method was required.

So the solution I’ve finally hit on is to randomise the edge of the blade I use each time I rinse my blade in the middle of the shave. So each time I rinse the blade, I give it a random twirl, and use whatever edge that twirl turns up for my next set of strokes. And so forth. This way, in terms of expected value, both edges of the blade are likely to wear by a similar amount by the end of each shave!

And so if I find one day that an edge is blunt, it is highly likely that the opposite edge is also as blunt, and it is a clear indication to put in a new blade!

It is remarkable how so often randomised algorithms can help you trivially solve problems that cannot easily be solved by deterministic methods!

The real benefit of direct benefit transfer

A week ago, I gave up. My LPG subsidy that is.

Having been out of the country for a few months, with our normal LPG usage being much lower than the average family’s, and having forgotten to book my spare cylinder, my LPG account had been “suspended”, for not booking a refill for over six months.

Back in the day when all domestic LPG connections were subsidised, you were required to book a cylinder every six months, else your account would get suspended. This was a measure to get rid of fake accounts and duplicate connections owned by a family (a family could have only one connection, legally).

So when I went to my dealer last week asking for my account to be unsuspended, I was told to submit my Aadhaar number to get it released. When I said I don’t have an Aadhaar number (I have one, but don’t want to use it unless mandatory), the clerk asked if I could give up my subsidy. With the LPG subsidy being a minuscule part of my overall annual expense, I quickly agreed, and after filling up a form and submitting a copy of my driving license, I had “given up”.

Later that day, my account was unsuspended, and I could presently book a refill, which arrived today. And having “given up”, there is no compulsion now to book a cylinder every six months!

The real benefit of the direct benefit transfer scheme adopted by the union government for LPG subsidy transfer is that it is now possible to have two classes of LPG connections, with several benefits.

Firstly, rules such as minimum and maximum frequency of booking don’t apply any more. Secondly, and more importantly, it is far easier nowadays to get an LPG connection – someone I know went to a nearby dealer to get a connection, and after submitting basic identification documents and paying a deposit, it took only a couple of days for the cylinders to arrive.

You might recall a campaign in the late 2000s by the then Karnataka Energy Minister Shobha Karandlaje to weed out duplicate LPG accounts in order to prevent wasteful subsidy. That brought in a regime of submitting a copy of an electricity bill to get LPG connections, in order to prevent one household from having more than one connection. Consequently, getting a new LPG connection became an absolute nightmare.

With the benefits now being targeted, and Aadhaar based, getting a new LPG connection is mostly straightforward, as long as you don’t claim a subsidy. And a lot of the times, the value of the subsidy is far lower than the additional cost of getting the cylinder itself!

In the earlier “indirect transfer regime”, this class of unsubsidided LPG connection did not exist (unless you went with one of the private sector players, most of whom have remained undependable), causing much harassment to consumers, and the need for various workarounds.

The direct benefit regime has thus not only saved the government the cost of wasteful subsidies, but also made life easier for consumers by making the market more rational!

Aswath Damodaran, Uber’s Valuation and Ratchets

The last time I’d written about Aswath Damodaran’s comments on Uber’s valuation, it was regarding his “fight” with Uber investor Bill Gurley, and whether his valuation was actually newsworthy.

Now, his latest valuation of Uber, which he concludes is worth about USD 28 Billion, has once again caught the attention of mainstream media, with Mint writing an editorial about it (Disclosure: I write regularly for Mint).

I continue to maintain that Damodaran’s latest valuation is also an academic exercise, and the first rule of valuation is that “valuation is always wrong”, and that we should ignore it.

However, in the context of my recent piece on investor protection clauses in venture investments (mainly ratchets), it is useful to look at Damodaran’s valuation of Uber, and how it compares to Uber’s valuation if we were to account for investor protection clauses.

“True value” of Indian unicorns after accounting for investor protection. Source: Mint

When Uber raised $3.5 Billion from Saudi Arabia’s Public Investment Fund earlier this year, the headline valuation number was $62.5 Billion. Given the late stage of investment, it is unlikely that the investor would have done so without sufficient downside protection – at the very least, they would want a “full ratchet” (if the next investment happens at a lower valuation, then they get additional shares to compensate for their loss). This is a conservative assumption since late stage (“pre-IPO”) investments usually have clauses more friendly to the investor, usually incorporating a minimum “guaranteed return”.

Plugging these numbers into the model I’ve built (pre-money valuation of $59 Billion and post-money valuation of $62.5 billion), the valuation of the put option written by existing investors in favour of Uber comes to around $1.28 Billion. Accounting for this option, the total value of the company comes out to $39.6 Billion.

Damodaran’s valuation, based on his views, principles and numbers, is $28 Billion. Assuming that investors and management of Uber are aware of the downside protection clauses and its impact on the company’s valuation, Damodaran’s valuation is not that much of a discount on Uber’s true valuation!

Offshoring and the daNDapiNDagaLu moment

Sometime in the early 2000s (2000 or 2001, if I’m not mistaken), there came a sitcom on Kannada television (Udaya TV, if I remember correctly) called “daNDapiNDagaLu” (no direct translation to English available, but it translates to something like “waste bodies”).

The sitcom was about the travails of five boys who had studied one of {B.A., B.Sc., B.Com. } and were subsequently unemployed. Directed by Phani Ramachandra, of the Ganeshana Madhuve and Gowri Ganesha fame, it was rather funny and mostly well received. The most memorable part of the sitcom, however, was the iconic title song (the version on Youtube is audio-only, but that will suffice for our purposes).

For non-Kannada speakers here, the song is about people who study B.A., B.Sc. or B.Com. and subsequently fail to find a job, and then roam the streets with little to do. The song also talks about the unwillingness of these people to do menial jobs, of not being of the “right caste” to avail reservations, and not having the ability to get good marks which can get them a job.

Thinking about it, the song was extremely appropriate for its times, and the release of the serial coincided with the low point of the value of a B.A., B.Sc. or B.Com. degrees in India (I remember feeling rather proud when the sitcom came out that I was studying engineering, and hence wasn’t one of “them”).

Until the 1980s or so, the possession of a bachelor’s degree qualified you for a large gamut of opportunities, mostly in the government. So it didn’t matter that much what you studied, and if you weren’t particularly useless, you’d find a job to get by on.

To take an example, my mother had a bachelor’s in biology, but spent most of her career in an accounting job (she entered the workforce in the 1970s). In other words, it didn’t matter what degree you had, as long as you had one. So people gladly did whatever degree they could get into.

In the 1990s, however, with the government sector on the decline and liberalisation not having had enough of an impact to massively expand the job market, there was trouble for these graduates. Government was no longer recruiting as it used to, and the private sector wasn’t picking up the slack either. It was at this time that most such graduates started going jobless, and the value of these degrees diminished like crazy.

It is no surprise that around the time I finished high school (2000), everyone wanted to study engineering – opportunities for most other degrees were very few. With liberalisation in the education sector having kicked in, supply in engineering college seats expanded to meet the demand (in some states at least). It was a popular meme in those days that anyone who studied for a B.A. or a B.Sc. did so only because they couldn’t get an engineering seat.

It was around this time, the absolute low point for B.A., B.Sc. and B.Com. that daNDapiNDagaLu came out. The sitcom lost its relevance rather soon, though.

With liberalisation in full swing in India,development in communications technology, and slowing growth in developed markets, “offshoring” became a thing. Companies in developed western markets figured out that they could get routine stuff done for a lot cheaper by “offshoring” them to emerging markets, where labour was a lot cheaper.

And some of those jobs came to India, which had a large pool of (hitherto unemployed) graduates, most of whom spoke English. It started with call centre jobs (where Indians were trained to get Western or “neutral” accents, and Janardhans became Johns). Then came slightly higher value adding jobs, like accounting, secretarial services, etc. Business Process Outsourcing was soon a thing, and it didn’t take Thomas Friedman too long to write The World is Flat.

With the coming of these jobs, the market for people with B.A., B.Sc. and B.Com. was suddenly opened up, and there was a range of jobs these people could do. Today, someone with one of these degrees, as long as they are reasonably capable, can expect to find a job after graduation.

Society hasn’t kept up, though. A lot of people are still in the daNDapiNDagaLu mode, and consider those studying B.A., B.Sc. or B.Com. as potential “waste bodies”, not realising that the time now is different!

Regulating HFT in India

The Securities and Exchange Board of India (SEBI) has set a cat among the HFT (High Frequency Trading) pigeons by proposing seven measures to curb the impact of HFT and improve “real liquidity” in the stock markets.

The big problem with HFT is that algorithms tend to cancel lots of orders – there might be a signal to place an order, and even before the market has digested that order, the order might get cancelled. This results in an illusion of liquidity, while the constant placing and removal of liquidity fucks with the minds of the other algorithms and market participants.

There has been a fair amount of research worldwide, and SEBI seems to have drawn from all of them to propose as many as seven measures – a minimum resting time between HFT orders, matching orders through frequent batch auctions rather than through the order book, introducing random delays (IEX style) for orders, randomising the order queue periodically, capping order-to-trade ratio, creating separate queues for orders from co-located servers (used by HFT algorithms) and review provision of the tick-by-tick data feed.

While the proposal seems sound and well researched (in fact, too well researched, picking up just about any proposal to regulate stock markets), the problem is that there are so many proposals, which are all pairwise mutually incompatible.

As the inimitable Matt Levine commented,

If you run batch auctions and introduce random delays and reshuffle the queue constantly, you are basically replacing your matching engine with a randomizer. You might as well just hold a lottery for who gets which stocks, instead of a market.

My opinion this is that SEBI shouldn’t mandate how each exchange should match its orders. Instead, SEBI should simply enable individual exchanges to regulate the markets in a way they see fit. So in my opinion, it is possible that all the above proposals go through (though I’m personally uncomfortable with some of them such as queue randomisation), but rather than mandating exchanges pick all of them, SEBI simply allows them to use zero or more of them.

This way, different stock exchanges in India can pick and choose their favoured form of regulation, and the market (and market participants) can decide which form of regulation they prefer. So you might have the Bombay Stock Exchange (BSE) going with order randomisation, while the National Stock Exchange (NSE) might use batch auctions. And individual participants might migrate to the platform of their choice.

The problem with this, of course, is that there are only two stock exchanges of note in India, and it is unclear if the depth in the Indian equities market will permit too many more. This might lead to limited competition between bad methods (the worst case scenario), leading to horrible market inefficiencies and the scaremongers’ pet threat of trading shifting to exchanges in Singapore or Dubai actually coming true!

The other problem with different exchanges having different mechanisms is that large institutions and banks might find it difficult to build systems that can trade accurately on all exchanges, and arbitrage opportunities across exchanges might exist for longer than they do now, leading to market inefficiency.

Then again, it’s interesting to see how a “let exchanges do what they want” approach might work. In the United States, there is a new exchange called the Intercontinental Exchange (IEX) that places “speed bumps” over incoming orders, thus reducing the advantage of HFTs. IEX started only recently, after major objections from incumbents who alleged they were making markets less fair.

With IEX having started, however, other exchanges are responding in their own ways to make the markets “fairer” to investors. NASDAQ, which had vehemently opposed IEX’s application, has now filed a proposal to reward orders by investors who wait for at least once second before cancelling them.

Surely, large institutions won’t like it if this proposal goes through, but this gives you a flavour of what competition can do! We’ll have to wait and see what SEBI does now.