The Son of Cash

Cash is King. Or, in the context of our Government's benefits structure, "cash is leaking". This has long been understood: I vividly recall dissecting the ills of India's subsidy framework as part of the Economics curriculum in college in the 1990s; it was a well-worn fact even then. Commentary focused on flaws in the mechanism and the mushrooming of vested interests that were bleeding the system dry. Indeed, the latter had grown so well entrenched, and critical voices so muted, that the infirmities had become part of the accepted, expected ways of working of mai-baap sarkar.

Little wonder then that, far from being shown the door, the subsidy framework has continued to flourish to this day. Consider the math: the GOI spends an estimated ₹3.65 for every rupee of benefit to reach its intended recipient. The resultant fiscal burden across the 3Fs — food, fuel and fertilizer — is clearly already unsustainable. Yet, there is every indication that the Government, reeling under the influence of NAC-chhaap Welfare State model, will escalate these economic costs further.

Before turning our attention to the future, it may be instructive to examine the design and delivery challenges that plague our distribution architecture today. First, the design itself is inherently faulty. For instance, food subsidies are funneled through the PDS, pivoted on the identification of the Below-Poverty-Line population. This tagging has been a corruption magnet. An inability to pay bribes for BPL ration cards means large swathes of genuine beneficiaries remain denied benefits, even as the state's subsidy bill continues to burgeon.

Next, lets talk about the delivery architecture. Staying with the food example, there is little control over the diversion of subsidised grain meant for BPL households to the open market by avaricious ration shop owners profiting off the price differential. Likewise, practices like adulteration, ghost BPL cards, and deliberate stockpiling lead to rampant leakages. Upstream too, we have distribution losses in acquisition, storage, and transport due to inadequate infrastructure and systemic corruption. Finally, the state is drained by an ever-increasing administrative overhead merely to keep this unwieldy apparatus afloat.

Now, the mammaries of our welfare state are expected to grow further (the GOI seems serious about the Food Security Bill). This makes the case to overhaul the entire 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 promise to empower the needy, bid goodbye to the ration-wallah's corruption and coercive power, and incentivise quality supply. Likewise, the state's unproductive subsidy burden shrinks by dismantling the PDS and leveraging technology to plan, monitor and reduce sourcing and storage expenses.

One cannot, of course, expect 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 across technology, process, controls, and change management. Helmed by Nandan Nilekani since last year, one can expect a good outcome here. Next, the farmer lobby must be managed: anything seen as encroaching on the MSP and GOI's grain offtake is a political hot potato. It remains to be seen how much political will UPA-2 possesses to tackle this. At another level, the availability of cash in a lump sum has been flagged as a potential hazard. Fears are that menfolk would drink the 'windfall' away. Not for this reason alone, but as a broader social empowerment and financial inclusion measure, the GOI would do well to channel Lakshmi directly to the Lakshmi instead.

Cash, in any event, is likely to make a return, if only in a new avatar. Even if not perfect — and we do not yet know all the questions, let alone the answers — it cannot fail to be an improvement on the mess we have today. Much of this will play out at the level of policy, even more in execution; we have seen the UPA botch both on numerous occasions. Yet, given 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 with whom I talk equities classify more as investors than traders. This means margin speculation resides around the fringes of my stock-picking existence.

I was, however, greatly intrigued by JP Morgan Chase's massive derivative trading losses last quarter. For one, the initially reported figure was an obscene $2B (frankly, my imagination runs short when faced with such astronomical sums, for reasons not entirely unrelated to my humble circumstances)! Rumours abound, too, that the actual hole to be at least twice that ungodly number (phew).

Of course, financial markets are replete with instances of mind-numbing 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 market operators whose avarice or ambition — though rarely outright ineptitude — delivered similar rude shocks. Indeed, the trail of destruction in their wake invariably claimed more than a fair share of humble retail investors alongside the institutions themselves.

Naturally, it raises the question of how organizations of considerable repute come to such massive grief. These failures are difficult to reconcile with the high calibre of internal talent on display (for instance, Jamie Dimon himself has long been a star in an industry under intense public scrutiny). Equally, we ought to understand the process or technical inadequacies that led to a failure to detect and correct the exposure in time.

In the current instance, we can rule out derivatives themselves as the primary culprit. Targeting the financial instrument is like blaming steel for knife-wounds in street crime. That out of the way, the picture is no less turbid, with mismanaged hedges at JPMC's London Treasury at its core. The sequence unfolded as follows:

JPMC, like any commercial bank holding vast client deposits, must balance returns (by investing in long-term, high-quality bonds) against liquidity (through the overnight money market, yielding near zero in a QE regime). Excessive liquidity lowers the net interest margin; holding too little invites cash shortfalls. Moreover, bond portfolios need protection, since prices vary inversely with interest rates. When rates rise, the bank faces a double whammy: its bond portfolio suffers capital losses while funding costs escalate due to higher deposit payouts. Banks routinely hedge this exposure, including through Credit Default Swaps.

By all accounts, JPMC's Treasury in London was running huge positions. This forced them to trade aggressively in a relatively small, illiquid CDS market as a hedge strategy. This created price distortions that drew hedge funds and institutional traders seeking arbitrage opportunities. Continued pressure from the 'London Whale', however, meant that the pricing skews grew larger — spread valuations swung an unprecedented 50% in three months. Stresses on CDS market players mounted: the game was becoming relentlessly capital-intensive. They were squeezed, but could do little in an unregulated market with the Whale running amok.

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

Meanwhile, this had rung alarm bells within JPMC too. Reinforcements from the core i-banking unit were sent to the 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, was this pound of flesh.

Perhaps I am guilty of over-simplification (for more gory details, refer to an excellent article on the Whale at Seeking Alpha). Regardless, the episode yields several striking conclusions. The most critical is the imperative for oversight across bespoke, illiquid derivatives markets. Another lesson is the limitations of relying on rigid, narrowly defined quantitative models to mitigate risk.

In an 'Occupy Wall St' backdrop, it is worth noting 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 familiar echo of the GFC, but other than an 'ought-to-regulate', that is where the parallel ends.

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

NCTC - Intel Inside

By all accounts, Shri P Chidambaram, our Home Minister, does not take kindly to fools. Nor, can the stakes be higher than on terror, with multiple strikes over the last 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). In that very fortnight, CBI's pursuit of Kim Davy — of Purulia arms drop notoriety — in Denmark ended with egg on its face owing to an "expired" extradition notice.

Those 'bureaucratic gaffes' were, of course, only the latest in a long history of ignominy (Kargil, 26/11, David Headley, and the Red Corridor being but a few of its more sordid recent 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 new 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 and no cellphone or financial records in his name (save, perhaps, every itinerary with return via Pakistan — potentially indicative of an ISI-LeT nexus but equally high volume, Type I error risk) thereby missing a Headley entirely. Furthermore, the potential for an assault on personal liberty and data privacy with the Government's power to obtain sensitive information without warrant or consent, bred its own share of D Thomases.

Resolution to these concerns, naturally, lay in a fully thought-through 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 is vital for seamless execution. Likewise, we have conflicts within GOI's own framework with RAW (external intel), NTRO (collection & analysis), and NIA (investigation & prosecution) — all with mandates broader than counter-terrorism. Nesting 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-à-vis his original plan (the IB centenary endowment lecture, Dec 2009). That vision subsumed the NIA, NTRO, NCRB, and NSG under the NCTC, along with counter-terror operations of RAW and the CBI. Yet, even if watered-down, NCTC remains deeply flawed, most notably in its lack of separation between analytical and operative powers. Add lack of due governance to that, and we can put the famed US military-industrial complex to shame in its reach. I hope sense prevails soon, with a better design that helps our counter-terror effort acquire effective teeth. No terrorism-frontline State (for we are unmistakably one) worth its salt should settle for any less.