The Son of Cash

Cash is King. Or, in the context of our government's benefits structure "cash is leaking". We have known about this for a while: I vividly recall having dissected the ills of India's subsidy framework as part of Economics curriculum in College in the 90s; and it was a well-worn fact then. Commentary focused on flaws in the mechanism and mushrooming of vested interests that were mooching off it. Indeed, the latter had gotten so well entrenched, and critical voices so muted, that the infirmities had became part of the accepted, expected ways of working of mai-baap sarkaar.

Little wonder then that, far from being shown the door, the framework has continued to prosper to this day. Sample this: the GoI spends an estimated INR 3.65 for every Rupee of benefit to reach its intended target. The resultant fiscal burden across the 3F's (subsidy categories: food, fuel and fertilizer) is clearly unsustainably high already. Yet, there is every indication from our government, reeling under the influence of NAC-chhaap Welfare State model, that the economic cost shall escalate further.

Before casting our eye to the future, it may be instructive to take a look at the design and delivery challenges that plague our mechanism today. First, the design is inherently faulty. For instance, food subsidies are run via PDS, pivoted around identiication of BPL (below-poverty-line) needy. This tagging has been a corruption magnet. Inability to pay bribes for BPL ration cards means large swathes of true beneficiaries remain denied benefits, while the subsidy bill for the government continues to grow.

Next, lets talk about delivery. Staying with the food example, there is little control over diversion of subsidised grain (meant for BPL households) to open market by ration shopowners wanting to make a quick buck off the price differential. Likewise, practices like adulteration, false BPL cards, or stockpiling lead to leakages. Upstream too, we have distribtion losses in acquistion, storage and transport due to substandard quality and potential for corruption. Finally, the government spends a packet in administrative expenses to keep this massive rig afloat.

Now, the mammaries of our welfare state are expected to grow (the GoI seems serious about the Food Security bill). This makes the case to entirely overhaul the benefit distribution process even more compelling. Simply put, the need of the hour is to replace the corrupt and convoluted PDS with direct cash transfers to the target population. Life changes dramatically at the consumption end, with a pronise to empower the needy; bid goodbye to the ration-wallah's corruption and coercive power; and incentivize quality supply. Likewise, the government's unproductive (administrative) subsidy burden gets a haircut from dismantled PDS, reduced sourcing & storage expenses and tech-enabled planning & monitoring.

One cannot, of course, expected it to be a walk in the park. The most critical element is target identification. UID is trying to solve this tagging problem multi-dimensionally (technolgy, process, controls, change management). Helmed by Nandan Nilekani since last year, one should expect a good outcome here. Next, the farmer lobby would need to be managed: anything that is seen as encroaching on MSP and government's grain offtake, is a political hot potato. It remains to be seen how much will UPA-2 has to tackle this. At another level, the availability of cash (and presumably an increased amount) in lump sum has been called out as a cultural problem. Fears are that menfolk would drink this 'windfall' away. Not only for this reason, but as broader social empowerment or financial inclusion move, the GoI would do well to contemplate transfers to the Lakshmi, the woman of the house instead. And so on.

Cash, in any event, is likely to see a return, if only in a new avatar. Even if not perfect (and we don't know all the questions yet, far to speak of all answers) it cannot be but an improvement from the mess we have today. Much of this will be played at the level of policy, even more in execution; we have seen UPA botch up both umpteen times. Yet, for the high stakes here, let us remain hopeful.

2B Or Nought 2B

A degree in Economics and early years trading commodities mean that the markets hold me in an enduring thrall. I mostly restrict my passion to delivery trades though; F&O action is rare. Equally, those that I talk equities with are folks that classify more as investors than traders. This means that margin speculation is around the fringes of my stockpicking existence.

I was, however, greatly intrigued with JP Morgan Chase's losses on account of derivatives trade last quarter. For one, the amount involved was an obscene $2B (frankly, my imagination runs short when faced with such astronomical sums, for reasons not entirely unrelated to my humble circumstances)! I hear too that many believe the actual hole to be at least twice that ungodly number (phew).

Of course, markets are replete with instances of mindnumbing losses. I was in College when Nick 'I'm Sorry' Leeson brought down Barings. He was neither the first, nor last, in a long line of operators whose avarice or ambition (but almost never ineptitude) delivered similar shocks. Indeed, the trail of destruction in their wake often had more than a fair share of the humble investor in addition to institution in question.

Naturally, it begets the question as to how organizations of considerable repute come to such massive grief. These are not easy to reconcile with the high quality of internal talent either (case in point: Jamie Dimon has been a star in an industry under intense public scrutiny of late). We ought to know of process or technology inadequacies that resulted in failure to detect and correct the situation.

In the current instance, for starters, let us rule out that Options as a financial product itself is an issue. Arguing this is like blaming steel for knife-wounds in ghetto crime. That out of the way, the picture is no less messy, with mismanaged hedges at JPMC's London Treasury at its core. The sequence went thus:

JPMC, like any commercial bank with funds in its charge, needs to optimize returns (invest in high quality, long term bonds) vs liquidity (via overnight money market, at near zero interest in a QE world). Too much liquidity lowers the spread between investment returns and what the bank pays depositors; too little risks it running out of cash. Bond investments need protection too, since prices vary inversely with interest rate. When rate moves up it is a double whammy for the bank: its investments erode in value, and it coughs up a larger 'share' of returns due to increased interest outflow. Naturally, banks hedge such exposure, including through Credit Default Swaps (bankruptcy-protection instruments).

By all accounts, JPMC's Treasury at London was running huge positions. This forced them to trade massively in a relatively small, illiquid CDS market as a hedge strategy. This created price skews that drew hedge funds (and others) seeking arbitrage opportunities. Continued aggression from 'London Whale', however, meant that the distortions grew larger (valuations changed an unheard-of 50% in three months). Pressure on CDS market players mounted: the game was too expensive and prolonged. They were angry, but could do little in an unregulated market with the Whale running amok.

If this was bad, it soon turned worse. Perhaps realizing limitations of the original CDS hedge strategy, Whale & Co devised new plans. Defying logic, they got into related but riskier instruments, with further exposure to volatility. Hedge funds started to sense the desperation and waited for the nut to crack.

Meanwhile, this had rung alarm bells within JPMC too. Reinforcements from the core i-banking unit were sent to London Treasury. It did not take them long to figure out how untenable and inherently risky JPMC's position was. They wanted out, presenting the perfect revenge opportunity to hedge funds and CDS market punters. To liquidate the trades, these players wanted their price. $2B, or more, is this pound of flesh.

Perhaps I am guilty of over-simplification (for more gory details, refer an excellent article on the Whale at Seeking Alpha). Regardless, the episode throws up a few conclusions. The most critical is the need to regulate such specialized (and illiquid) markets. Another lesson is the limitations in deploying narrowly defined, fixed technical strategies to mitigate risk.

In an 'Occupy Wall St' backdrop, it is worthwhile to note too that this was not a case of i-banking excesses that have fired up public imagination and invited lawmaker attention lately. In fact the scene of crime at Chase commercial bank Treasury in London is far removed from JP Morgan i-bank. Of course, the starring role for CDSs is a throwback to GFC, but that's about all (or an 'ought-to-regulate' lesson at max).

Unless you own JPMC stock, therefore, the pall of gloom and hyper-suspicion is somewhat ill-founded. A sigh of relief too, may not be out of line. Until, of course, the next quake strikes.

NCTC - Intel Inside

By all accounts, Shri P Chidambaram, our Home Minister, does not take kindly to fools. Nor, can stakes be higher than on Terror, with multiple strikes over the few years highlighting our extraordinarily vulnerable national security status. Yet, when GoI shared a "50 Most Wanted" dossier with Pakistan a few months ago, it was a disgrace (two on the list were in India). That very fortnight, CBI's pursuit of Kim Davy (Purulia arms drop notoriety) in Denmark ended with egg on the face owing to an "expired" extradition notice.

Those 'bureaucratic gaffes' were, of course, only the latest in long history of ignominy (Kargil, 26/11, David Headley, Red Corridor being but a few of its more sordid chapters). Questions were asked of Indian intelligence, or the lack of it. In response we were told to think beyond the CBI, NIA, IB and RAW, all under our venerable Home Minister's charge, to NATGRID, his pet project. NATGRID would allow 11 security agencies access to 21 linked databases covering financial, travel, immigration, asset ownership, telephone and internet usage information for individuals and entities in the country.

Arguments had been made against a NATGRID style response. There were concerns around diffusing focus away from building good ol' Hum-Int with a grandiose but potentially ineffective programme. For instance, it may not raise any alert for an American citizen with Caucasian looks, no cellphone or financial records in his name (save, perhaps, every itinerary with return via Pakistan; an obvious need to brief ISI-LeT) thereby missing Headley. Equally, the potential for assault on personal liberty and data privacy with Government's power to obtain sensitive information without warrant or consent, bred its own share of D Thomases.

Resolution to these, naturally, lay in a well-considered approach. Last week's order notifying the creation of NCTC, alas, displays none of this sure-footedness. In typical PC fashion, it managed to raise hackles all over instead. Opposition-ruled states are up in arms, for one, when Center-State cooperation would be ideal for seamless execution. Likewise, we have conflicts within GoI's own framework with RAW (external intel); NTRO (collection and analysis); and NIA (investigation and prosecution), all of whom have mandates broader than counterterrorism. Nesting the NCTC under the IB, a body sans parliamentary sanction or oversight, too reeks of shoddy legal formulation, if not downright empire-building on part of the Home Min.

PC apologists may point out that feedback has gone into the current notification vis-a-vis his original plan (IB centenary endowment lecture; Dec 2009). This had the NIA, NTRO, NCRB and NSG under the NCTC; as also the counter-terror work of RAW and CBI. Yet, even if watered-down, NCTC remains deeply flawed, most notably in its lack of separation of analytical and operative powers. Add lack of governaceto that, and we can put the US miliatry-industrial complex to shame in its reach. I hope sense prevails soon, with a better design that helps our counterterrorism effort acquire effective teeth. No terrorism-frontline State (for we are unmistakably one) worth its salt should settle for any less.