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  The Case-Shiller house price index’s reading for the quarter was the lowest since prices began falling in the summer of 2006. ?Photo: GETTY

Average home prices slumped 5.1pc in the first quarter of the year from the same period in 2010, the latest report from the S&P Case-Shiller index showed yesterday.

The index’s reading of 125.41 for the quarter was the lowest since house prices began falling in the summer of 2006.

The report “is marked by the confirmation of a double-dip in home prices across much of the nation,” said David Blitzer, chairman of the committee that puts together the report. “Home prices continue on their downward spiral with no relief in sight.”

While the housing market has been a well-known Achilles heel for the recovery, yesterday also saw evidence that the country’s manufacturing sector – a robust, albeit small, part of the economy – is slowing.

A reading from the Institute for Supply Management’s index that measures the state of manufacturing around Chicago showed a decline to 56.6 last month (MAY) from 67.5 in April.

There were further signs that high food and gas prices are denting the confidence of consumers, whose spending is central to the economy’s fortunes.

Consumer confidence reached a six-month low in May, according to an index from the Conference Board, as the reading dropped to 60.8 from 66 in April.

The latest slew of readings adds more pressure on the US jobs market to continue its recovery and shore up Americans’ confidence. The monthly jobs report for May will be released on Friday.

“Weakness in manufacturing also points to a risk of a weaker-than-expected payroll report on Friday and reinforces the general sense the economy is losing steam,” said Chris Low, an economist at FTN Financial.

By Ajay Shah, on June 30th, 2011

In a liquid and transparent financial market, there is no doubt about the price. There is high pre-trade transparency, because orders are visible on the limit order book, and the best estimate of the true price is (bid+offer)/2. You glance at the screen and you know what is the price.

In a non-transparent market, it is hard to know the true price. Special schemes have to be constructed in order to measure the price. Price measurement does not happen `for free’ as a minor side effect of the very trading process.

As a thumb-rule, the best design for a derivatives contract is to use cash settlement, as long as you can be pretty certain about observing the price. If you can’t measure the price, then physical settlement is better.

Cash settlement is a great technology. But it requires sound measurement of the price.

In an OTC market, information is not visible at a glance. It is dispersed. Many traders have private information about the price, but
you do not. If you could setup an electronic order book, you would see bid and offer at a glance: these are the prices at which a small buy and a small sell transaction could be done. On an OTC market, the dealer has a sense about where the market is, but you don’t. So a natural strategy is that of asking the dealer what he is seeing.

Dealers have positions on the market, so we have to worry about what they say. Standard schemes used involve removing extreme
observations, and thus coming up with a more robust price measure. These schemes have been used in India with the NSE MIBOR (the dominant price measure on the interest rate swaps market), the CMIE measurement of commodity spot prices for NCDEX, etc.

In India, RBI is an information producer in reporting the INR/USD exchange rate at 12 noon. This `official RBI price’ is widely used in
computing the settlement price for cash-settled derivatives on the rupee. It is used for the official closing price on the NSE currency futures/options market, which in many ways is shaping up as the main market where the INR exchange rate is discovered. As an
example, yesterday (an expiration day), the open interest closed at $7.2 billion, and turnover was $6.2 billion.

RBI has not had a formal methodology for how this price is computed and reported.

I have always been a bit uncomfortable with RBI producing this vital information, since RBI has many other goals which can conflict
with the goal of producing high quality information. But for a while, this seemed to be working.

On 1 July, their methodology will change to something new:

They will choose a random five-minute window from 10:30 to 12:30 (i.e. a two-hour window).The reference rate will be computed using these five minutes.It will be released at 13:00.

I cannot imagine the logic which led up to this, but I have to say that this is not a good idea.

A two hour window is a lot of time in the life of a market. The RBI reference rate is then no longer a reference rate of the market. It is
a measure of the price at a randomly chosen time in that window. This makes it much less informative.

As an analogy, imagine if the official NSE closing price for Nifty was plucked out of a randomly chosen time from 2:30 PM to 3:30
PM. This would be a lot less informative as compared with the present methodology (value weighted average of all trades from 3 PM to 3:30 PM). It would be even better if NSE were to do a call auction from 3:15 PM to 3:30 PM and report that price as the official closing price. That would be sharp and interpretable.

All cash derivatives settling on the RBI reference rate will now suffer from a new source of uncertainty: the randomly chosen time at
which the price is reported. The cash-and-carry arbitrageur needs to sell his spot position at the exact time at which the derivatives
expire. In the case of the Nifty futures, there is a simple trading strategy which roughly approximates the Nifty closing price: In each
of the last 30 minutes, do 1/30 of your required trade. This is typically automated, i.e. it requires algorithmic trading, but it’s fully feasible.

With a randomly chosen timepoint over a two hour horizon, the arbitrageur does not know when to closeout. This will exert a negative impact on pricing efficiency and thus basis risk on the derivatives market.

If the INR/USD exchange rate is a random walk in trading time, then the 9% annualised volatility maps to a standard deviation of 28 basis points over a two hour horizon. On a base of Rs.45 a dollar, this is a standard deviation of 12.6 paisa. This is quite a bit for traders and arbitrageurs. These small issues have a disproportionate impact in contaminating market efficiency.

But wait. There are some people who know at what time the pricing is done: the banks who are polled! So suppose there is a fixed panel of banks who are asked by RBI. The moment the RBI phone call comes in, they closeout. These banks will find it profitable to do currency arbitrage while others are not. Such shifts in the currency arbitrage constitute a distortion induced by RBI’s new method of price measurement.

RBI needs to cultivate improved knowledge of finance amidst its staff.

This illustrates the importance of legal process in rule-making. If RBI had gone through a formal notice-and-comment process, then they could have heard from external experts and desisted from doing this. I wasn’t able to find a document on the RBI website explaining the rationale for what is being done.

Information production should be done by specialised information organisations. If information is produced by people who have other conflicting interests, then such sub-optimal decisions are more likely to arise.

Alternative information producers, such as Reuters, should leap into this opportunity by producing a better INR/USD reference
rate. FEDAI already has an alternative reference rate. We should all switch away from the RBI reference rate towards alternatives.

Unfortunately, many people in the trade are fearful of the RBI and would not evaluate alternatives rationally. This tells us two
things. First, RBI needs to be enveloped in the rule of law so that there is no fear of RBI on the part of market participants. Second,
RBI should not be a producer of information. As long as two private agencies are producing INR/USD reference rates, the decision in the derivatives trade about what information measure to use will be based on technical merits alone. If someone then tries to come up with a scheme where a randomly chosen time over a two hour window is used for the measurement, his market share will go to zero.

By Ajay Shah, on July 1st, 2011The recent order by the Competition Commission of India on NSE and MCX-SX has a bunch of difficulties based on a lack of understanding of new age industries where a pricing of zero is quite feasible and important, a focus on protecting a competitor instead of upholding competition, etc. I wrote about this in the previous blog post.

The most important problem with this order is that it represents a diversion away from the real story. The real story is that trading in the Indian rupee is leaving India.

The rupee is traded on three venues:

The onshore exchange-traded market (NSE, MCX-SX, USE)The onshore OTC marketThe offshore OTC market (which is called the `non-deliverable forward’ or NDF market).

In an article in the Business Standard today, Jamal Mecklai says:

in April 2011, NDF volumes, at nearly $43 billion a day, were more than double those of the onshore OTC market (about $21 billion a day), and nearly 40 per cent higher than the combined OTC and futures onshore volume. Clearly, the bulk of price discovery for the Indian rupee has migrated offshore.

While we are bickering about the valuation of one player in the onshore exchange-traded market, we are losing the plot. The real story is that India is losing the market where the rupee is traded.

This is part of a larger concern which needs to be more carefully considered. As India internationalises, domestic customers of financial services, and the foreign order flow, will increasingly shift their business to providers abroad when there are problems in the local financial system. These problems fall into three kinds:

Non-residents do not like to send orders to India given that India as yet lacks a residence-based taxation framework; they would rather send their orders to Singapore or Dubai or London which do.Indian capital controls hinder orders from non-residents: E.g. RBI prohibits FIIs from trading on the exchange-traded currency futures market (the only edge that India has in the trading of the rupee).An array of mistakes in regulations in India hinder the emergence of a capable domestic financial system (e.g. the CCI order, prohibition of options trading on INR/EUR, mistakes in how RBI will compute the INR/USD reference rate which must be used in the functioning of the exchange-traded contracts, etc.)

Our mistakes in policy on these three fronts generate a genuine possibility of a hollowing out of the domestic financial system in coming years.

The overseas market is the real source of competitive pressure. Unless overturned, the CCI order is working to reduce the market share of the onshore market.

Financial policy has two goals in this field. First, we’d like for more business to be on the transparent exchanges instead of the OTC market. This goal is assisted by a price of zero at exchanges. Second, we’d like for more business to be in India rather than the overseas market. This goal is also assisted by a price of zero at exchanges.