Category: finance

Investment banks, scientific research and cows

I’ve commented earlier on this blog about how investment banks indirectly fund scientific research – by offering careers to people with PhDs in pure sciences such as maths and physics.

The problem with a large number of disciplines is that the only career opportunity available to someone with a PhD is a career in academia. Given that faculty positions are hard to come by, this can result in a drop in number of people who want to do a PhD in that subject, which has the further effect of diminishing research in that subject.

Investment banks, by hiring people with pure science PhDs, have offered a safety net for people who haven’t been able to get a job in academia, as a consequence of which more people are willing to do PhDs in these subjects. This increases competition and overall improves the quality of research in these topics.

Beef is like investment banks to the dairy industry. I recall an article (can’t recall the source and link to it, though) which talked about V Kurien of Amul going to a meeting called by the Union government on banning cow slaughter. Kurien talked about his mandate from his cooperative being that everything was okay as long as cow slaughter wasn’t banned – for that would kill the dairy industry.

Prima facie (use of latin phrase on this block – check)  this might sound like a far-fetched analogy (research to cows). However, cow slaughter has an important (positive) role to play in encouraging the dairy industry.

When you buy a cow, you aren’t sure how good it is in providing milk, until you’ve put it through a few cycles of childbirth and milking. If after purchase it turns out that the cow is incapable of producing as much milk as you were promised, it turns out to be a dud investment – like getting a PhD in a field with few non-academic opportunities and not being able to get a faculty position.

When cow slaughter is permitted, however, you can at least sell the cow for its meat (when it is still healthy and fat) and hope to recover at least a part of the (rather hefty) investment on it. This provides some kind of a “safety net” for dairy farmers and encourages them to invest in more cows, and that results in increasing milk production and a healthier dairy industry.

This is not all. Legal slaughter means that there is a positive “terminal value” that can be extracted from cows at the end of their milking lives. Money can also be made off the male calves (cruel humans have made the dairy industry one-to-many. Semen from stud bulls is used to impregnate lots of cows, and most bulls never get to fuck) which would otherwise have negative value.

A ban on killing cows implies a removal of these safety nets. Investing in cows becomes a much more risky business. And lesser farmers will invest in that. To the detriment of the dairy industry.

There are already reports that following the ban on cow slaughter in Maharashtra last year, demand for cows is going down as farmers are turning to the more politically pliable buffaloes.

Similarly, with the investment banking industry seeing a downturn and the demand for “quants” going down, it is likely that the quality of input to graduate programs in pure science might go down – though it may be reasonable to expect Silicon Valley to offer a bailout in this case. Cows have no such luck, though.

Payment systems

I had lunch today at a rather fancy Japanese restaurant here in Barcelona (I’ve forgotten if I wrote that blog post last year on how you get fantastic East Asian food of all kinds here). I didn’t pay a fancy price – this concept called “Menu del dia” (menu of the day), one of the very few good things instituted by General Francisco Franco meant that you can get cheap weekday lunches at most restaurants in Spain.

The above (Katsudon and beer), along with some noodle soup and two sushis and a cup of coffee, set me back by €13, which isn’t too bad by Barcelona standards (most weekday lunch platters at restaurants cost ~€10).

While eating I noticed that other patrons at the restaurant were walking up to the bar to pay the owner directly, rather than asking for the bill at the table.

So once I was done with eating and drinking, I went up to the bar to pay. The owner had seen me coming and had prepared my bill, which he presented to me. As I reached into my pocket, he got out the card swiping machine.

It might have been a shock to him when I presented a €20 bill instead, and he had to scramble to produce the change from somewhere inside the kitchen (the other patrons before me had all paid by card).

While this is one data point, it’s interesting how the economy here has moved to a situation where the default method of payment is through credit/debit card, rather than by cash (though my favourite bakery refuses to accept card for payments less than €5). The ease of card payments (most debit cards nowadays come enabled with NFC, though a fair number of merchants still insert the card to read the chip) combined with ubiquity of cards has meant that card usage has started trumping cash.

It will be interesting to see how the payments ecosystem will develop in India, which is still largely a cash economy. My belief (and hope) is that India will leapfrog credit/debit cards (as it has leapfrogged landline telephones and big box retail, moving directly to mobile phones and e-commerce) and take up electronic payments in a big way.

IMPS (immediate payment service) is already a fantastic protocol for bank-to-bank transfers, and the costs are extremely low. In April, the Unified Payment Interface (UPI) will be rolled out, which makes transfers to hitherto unknown people even easier! If our banks do a good job of implementation, there is a good chance it might get adopted widely (long back I’d made a case for the RBI to subsidise such payments).

Admission of errors and bad bank loans

I have a policy that whenever I make a mistake, I admit it. I believe that suppressing an error does more harm than good in the long run, and it is superior to admit it at the time of discovery and correct course rather than keeping things under wraps until the shit hits the fan (a la Nick Leeson, for example).

There is another reason I like to admit to my mistakes – by doing so frequently, I want to send the signal that I’m self-aware and self-critical and aware of what I’ve done wrong. This, I believe, sends a signal that I should be trusted more, since I have a grip on rights and wrongs.

It doesn’t always work that way. There was a company I once worked for, where my responsibilities meant that my errors had an immediate material impact on the company. I don’t know if this (direct material impact) mattered, but my signalling went horribly wrong there.

The powers-that-were came from a prior belief that people would suppress their mistakes as much as they could, and that I was admitting to them only because I couldn’t suppress them further. Their reaction to my constant admission of mistakes (I was writing production code, a bad bad idea given my ADHD) was that if I were admitting to so many mistakes, how many more of my mistakes were yet to be discovered?

In other words, the strategy backfired spectacularly, possibly given the mismatch of our priors, and I later figured I might have done better had I tried suppressing (or quietly fixing) rather than admitting. That, however, hasn’t led to a change in my general strategy on this issue.

I was reminded of this strategy when State Bank of India and Punjab National Bank released their quarterly results last week. Their stocks got hammered on the back of drastically reduced profits on account of higher provisions – an admission that a significantly higher proportion of their loans had gone bad compared to their earlier admissions.

The question that comes to mind is whether the increase in provisioning and admission of bad loans should be taken as a credible signal that these banks are cleaning up their balance sheets (which is a good thing) or whether it only indicates a bigger tip of a bigger iceberg (in which case I’d be paranoid about my deposits).

Not knowing what strategy these banks are playing (though statements from the RBI suggest they’re likely to be cleaning up), I guess we have to wait for results over the next couple of quarters to learn their signals better.

Continuous and barrier regulation

One of the most important pieces of financial regulation in the US and Europe following the 2008 financial crisis is the designation of certain large institutions as “systemically important”, or in other words “too big to fail”. Institutions thus designated have greater regulatory and capital requirements, thus rendering them at a disadvantage compared to smaller competitors.

This is by design – one of the intentions of the “SiFi” (systemically important financial regulations) is to provide incentives to companies to become smaller so that the systemic risk is reduced. American insurer Metlife, for example, decided to hive off certain divisions so that it’s not a SiFi any more.

AIG, another major American insurer (which had to be bailed out during the 2008 financial crisis), is under pressure from its activist investors led by Carl Icahn to similarly break up so that it can avoid being a SiFi. The FT reports that there were celebrations in Italy when insurer Generali managed to get itself off the global SiFi list. Based on all this, the SiFi regulation seems to be working in spirit.

The problem, however, is with the method in which companies are designated SiFis, or rather, with that SiFi is a binary definition. A company is either a SiFi or it isn’t –  there is no continuum. This can lead to perverse incentives for companies to escape the SiFi tag, which might undermine the regulation.

Let’s say that the minimum market capitalisation for a company to be defined a SiFi is $10 billion (pulling this number out of thin air, and assuming that market cap is the only consideration for an entity to be classified as a SiFi). Does this mean that a company that is worth $10 Bn is “systemically important” but one that is worth $9.9 Bn is not? This might lead to regulatory arbitrage that might lead to a revision of the benchmark, but it still remains a binary thing.

A better method for regulation would be for the definition of SiFi to be continuous, or fuzzy, so that as the company’s size increases, its “SiFiness” also increases proportionally, and the amount of additional regulations it has to face goes up “continuously” rather than being hit by a “barrier”. This way, the chances of regulatory arbitrage remain small, and the regulation will indeed serve its purpose.

SiFi is just one example – there are several other cases which are much better served by regulating companies (or individuals) as a continuum and not classifying them into discrete buckets. When you regulate companies as parts of discrete buckets, there is always the temptation to change just enough to move from one bucket to the other, and that might result in gaming. Continuous regulation, on the other hand, leaves no room for such marginal gaming – marginal changes aer only giong to have a marginal impact.

Perhaps for something like SiFi, where the requirements of being a SiFi are binary (compliance, etc.) there may not be a choice but to keep the definition discrete (if there are 10 different compliance measures, they can kick in at 10 different points, to simulate a continuous definition).

However, when the classification results in monetary benefits or costs (let’s say something like SiFis paying additional regulatory costs) it can be managed via non-linear funding. Let’s say that you pay 10% fees (for whatever) in category A and 12% in category B (which you get to once you cross a benchmark). A simply way to regulate would be to have the fees as a superlinear function of your market cap (if that’s what the benchmark is based on).

 

Matt Levine describes my business idea

When I was leaving the big bank I was working for (I keep forgetting whether this blog is anonymous or not, but considering that I’ve now mentioned it on my LinkedIn profile (and had people congratulate me “on the new job”), I suppose it’s not anonymous any more) in 2011, I didn’t bother looking for a new job.

I was going into business, I declared. The philosophy (that’s a word I’ve learnt to use in this context by talking to Venture Capitalists) was that while Quant in investment banking was already fairly saturated, there was virgin territory in other industries, and I’d use my bank-honed quant skills to improve the level of reasoning in these other industries.

Since then things have more or less gone well. I’ve worked in several sectors, and done a lot of interesting work. While a lot of it has been fairly challenging, very little of it has technically been of a level that would be considered challenging by an investment banking quant. And all this is by design.

I’ve long admired Matt Levine for the way in which he clearly explains fairly complicated finance stuff in his daily newsletter (that you can get delivered to your inbox for free),  and more or less talking about finance in an entertaining model. I’ve sometimes mentioned that I’ve wanted to grow up to be like him, to write like him, to analyse like him and all that.

And I find that in yesterday’s newsletter he clearly encapsulates the idea with which I started off when I quit banking in 2011. He writes:

A good trick is, find an industry where the words “Monte Carlo model” make you sound brilliant and mysterious, then go to town.

This is exactly what I set out to do in 2011, and have continued to do since then. And you’d be amazed to find the number of industries where “Monte Carlo model” makes you sound brilliant and mysterious.

Considering the difficulties I’ve occasionally had in communicating to people what exactly I do, I think I should adopt Levine’s line to describe my work. I clearly can’t go wrong that way.

 

Blockchain and real estate

Based on the title of this blog post, you might assume this might be about Honduras, where there is a proposal to use the blockchain to store land records. The problem with Honduras is that there is no “trusted third party” – nobody even trusts the government, for example, so the best way to store land records is in a decentralised hard to tamper manner.

Over the last few days I’ve been reading up a bit on blockchain and bitcoin and how it works and so on. I haven’t yet got to the math – that it is described as “proof of work” irritates me no end (given that work should be evaluated on output rather than input).

So I see that what makes blockchain secure (apart from the miners having to agree on every transaction, and securing bunches of transactions using cryptographic hashes) is that every block contains within itself a hash of the previous blocks. In other words, the entire sequence of transactions is maintained.

The way “normal currency” (like cash) works is that only possession matters, not history. So the fact that there is a hundred rupee note in my pocket means that I can spend that money, and nobody has a track of how that hundred rupee note reached my pocket. This makes the system insecure since if a pickpocket picks this note, there is no proof (apart from possibly catching him in the act red-handed) that he picked it from my pocket.

With bitcoin, on the other hand, there is a record of how each bit of currency (no pun intended) ended up where it ended up. So even if someone were to magically “steal” my bitcoin, the historical records show that this legitimately belongs to me, and that makes it secure.

This reminds me of the paperwork involved when we bought our apartment in Bangalore last year. Normally you would imagine that a certificate indicating that the title currently rests with the current owner is enough to conduct a real estate transaction. but lawyers and bankers here are not satisfied with that.

The paperwork for the apartment I bought went back sixty odd years, when the land on which the building was built was first “allotted” by the City Improvement Trust Board. If I have to sell this apartment on, along with the certificate that I own this apartment I’ll have to furnish copies of this entire history going 60-70 years back. And the way property deals are done here, I don’t expect the system to change.

So this is what makes real estate such a prime candidate for using blockchain. Not only is a third party (such as the government department that stores land records) not trusted, it is a standard practice to include the entire history of every land or property going back several years. A sale transfers ownership, but in terms of paperwork, a layer gets added, not replaced.

This shows why real estate is such a prime candidate for moving to blockchain for storing transactions. It is ironical that a small and crime-ridden country such as Honduras is showing the way on this. It is time for countries like India to consider similar uses. But first, we will need to digitise existing records and make sure there is exactly one owner for each piece of property, and blockchain can’t help us with that challenge!

Darwin Awards in Investment Banking

Some 20 analysts from Goldman Sachs and 10 from JP Morgan have been dismissed after it emerged that they were cheating during some mandatory tests during their analyst training program.

As the article says, it is not unusual for bankers to assist each other when it comes to tests in mandatory training and compliance, since they are seen as being time consuming and repetitive.

In that sense, that these guys copied or helped each other is not news. What matters, though, is that they got caught in the process. And that is unacceptable for a banker.

If you look at how investment banking has been shaped over the last decade or so, there have apparently been several people who have fudged stuff – from financial results to key rates to benchmarks, and gotten away with it because they haven’t got caught. And they continue to remain successful bankers.

So in the banking culture, fudging is okay, but getting caught isn’t. By getting caught fudging in tests during their training program, these analysts have betrayed the one skill that is necessary for being a successful banker, and for this reason they have been rightly weeded out.

It’s like the Darwin awards, except that for these guys it is only the end of their careers in banking.

Revisiting IPOs

I’ve written several times (here, here and here) that the IPO pop is unfair to existing shareholders since they end up selling the stock cheaper than necessary. Responses I’ve received to this (not all on the blog comments) have mostly been illogical and innumerate, talking about how the pop “increases the value of the entrepreneurs’ holdings”, and that the existing shareholder “should be happy that the value has gone up” rather than wondering why he sold his shares at the low value.

Thinking about this in the context of the impending Cafe Coffee Day IPO, I realised that a pop is necessary (though not maybe to the extent of the MakeMyTrip and LinkedIn pops), because investors need some incentive to invest in the IPO rather than buying the stock in the secondary market after listing.

Secondary markets have superior price discovery compared to primary markets since the former have several (close to infinite) attempts at price discovery, while the latter have only one attempt. Also, prices in the secondary market change “slowly” (compared to the price difference between primary and secondary market), so even if someone has invested at a price they later have dissonance with, they can reverse the investment without incurring a high cost.

For this reason, if you want to invest in a company and want to know that you are paying a “fair price”, investing in secondary markets is superior to investing in primary markets. In other words, you need a higher incentive in order to buy in primary markets. And this incentive is provided to you in the form of the IPO pop.

In other words, the IPO pop is an incentive paid to the IPO buyer in exchange for investing at a time when the price discovery is in a sense incomplete and cannot be particularly trusted. Rather than pricing the IPO at what bankers and bookbuilders think is the “fair price”, they will price it at a discount, which offers IPO investors insurance against the bankers having made a mistake in their pricing of the IPO.

And how much to underprice it (relative to any “fair price” that the bankers have discovered) is a function of how sure the bankers are about the fair price they have arrived at. The greater their confidence in such a price, the smaller the pop they need to offer (again, this is in theory since investors need not know what fair price bankers have arrived at).

The examples I took while arguing that the IPO pop is unfair to existing shareholders were MakeMyTrip and LinkedIn, both pioneers in some sense. LinkedIn was the first major social network to go public, much before Facebook or Twitter, and thus there was uncertainty about its valuation, and it gave a big pop.

MakeMyTrip was a travel booking site from India listing on NASDAQ, and despite other travel sites already being public, the fact that it was from an “emerging market” possibly added to its uncertainty, and the resulting high pop.

So I admit it. I was wrong on this topic of IPO pops. They do make sense, but from a risk perspective. Nothing about “wealth of existing shareholders increases after the pop”.

Expanding IMPS

I hate carrying and transacting with cash. I find it extremely inconvenient and ineffective. The only place where I’m happy carrying and transacting with cash is Spain, where there is a high rate of pickpocketing, and carrying cash puts a floor on your downside.

There are several reasons to this. Cash is messy and dirty. Cash is prone to mutilation. Change is a massive problem. Even from the point of view of the central bank, printing currency costs significant money. When splitting bills at dinners I’m usually the guy who uses his card and “friendTMs”.

Recently (much belatedly, as I figured), I discovered IMPS. This service by the National Payments Corporation of India allows you to transfer money realtime. I used it once to transfer money between two bank accounts held (at different banks) by me. The “funds received” SMS arrived before the “funds transferred” SMS. It’s actually real time.

I had to make a payment to someone else last week and I had a problem with my ATM Card. Using the Citibank Mobile App, I discovered I could pay him up to Rs. 1000 without a second factor authentication, and only knowing his account number and bank IFSC code. The transaction took less than a minute. If he has a “MMID”, I could do the transfer using that ID and his mobile number, without him giving me his bank details. Again instantaneously.

So I’ve started wondering what prevents the tender coconut guy down the road (with whom I have a perennial change problem since a coconut costs Rs. 25, and 5 rupee notes/coins are hard to come by) putting up a board with his mobile number and MMID so that I can pay him through IMPS. I wonder the same about other vendors that I encounter in daily life.

The problem is one of product management and pricing. One reason credit cards haven’t taken off as much in India is that many vendors are concerned about the (~2%) interchange fees they pay on every transaction. So far I haven’t been charged for IMPS (at either end). Popularising and marketing it needs funding, though, and some kind of transaction fee structure needs to be figured out.

Currently, you have apps like Pockets, PingPay or Chillr that allow IMPS transfers. The beauty of these apps is that they eliminate the need for sharing MMID (which recipients have shared with the app on registration), and money can be transferred using the recipient’s Mobile Number only. The problem, though (as I had mentioned in this LinkedIn piece), is that these apps are currently building walls around banks, not permitting interoperability.

Since transactions take place on IMPS, there is no technical constraint. It’s about the war between these apps which prevents inter-bank integration. Given the network effects, though, it makes eminent sense for these platforms to merge and consolidate (or for one to “beat” the other), since this will unleash the “2ab term”.

Having watched the payments sector in a while now, I’m fairly bullish that electronic and mobile payments will take off in a rather large way here. What I’m not so clear about is what kind of pricing model will emerge, who will pay for it, and who will ultimately make money from it.

Two way due diligence

In a cash-and-stock or all-stock acquisition, does due diligence take place one way or both ways?

This is a relevant question because not only are shareholders of the acquiring company acquiring shares of the target company, but shareholders of the target company are also acquiring shares of the acquiring company.

Take, for example, Foodpanda’s acquisition of Tastykhana in 2014. The source of this snippet, of course, is the brilliant Mint story about Foodpanda earlier this week.

Shachin Bharadwaj, founder of TastyKhana, a Pune-based start-up that Foodpanda acquired in November 2014. After spending two months inside the company, Bharadwaj was disturbed about the lack of processes and had uncovered several discrepancies—fake orders, fake restaurants, no automation, overdependence on open Excel sheets, which were prone to manipulation, and suspicion over contracts awarded to vendors.

“I know I am making allegations,” he told the people in the room. “All I am asking is that we do an independent audit.”

The others were not interested.

“The past is the past,” said Malhotra. “Let’s just resolve the differences and find a way forward for you and Rohit to work together.”

So Foodpanda acquired Tastykhana, and the Tastykhana founder (who became a Foodpanda employee) later found out that Foodpanda wasn’t the company he had assumed it was, and now owning shares of a company he had overestimated, he rightly felt shafted. It’s unlikely that due diligence happened “the other way” in this acquisition.

I had written on LinkedIn a while back about how employees accepting stock in a company that is hiring them are implicitly investing financially in the company, and that they need to be able to do due diligence before they make such an investment. Acquisition works in a similar way.

So I’m repeating myself yet again in this blog post, but is “reverse due diligence” (acquiree checking acquirer’s books) a standard practice in the M&A industry? Does this work differently in big company markets and in startups? Do acquirers get pissed off when acquirees want to do due diligence before getting acquired (when being paid in stock)?

Note that this doesn’t apply to all-cash deals.