TRADING MECHANISMS: A Survey of Major Exchanges of the World

(This is our term paper for the Market Micro-structure Course) 

- Surenderrao Komera

- Ganesh Sankar

Exchanges facilitate the traders with the place where they can meet to arrange trades. Only members can trade at most exchanges, these members include brokers, dealers and buy-side traders. Nonmembers trade by asking member brokers to trade for them. Till recently, traders principally used to meet on the exchange floors and execute their trades. Owing to technological advancements, exchange floors became obsolete and replaced by the electronic communications networks through which now traders meet and execute their trades. Some exchanges only provide the plot forum where agents representing different stock facilitate the trades in those stocks. Such exchanges are referred as agent or dealer driven trading systems. Other exchanges are order-driven trading systems which arrange the trades by matching the buy and sell orders according to some pre-set rules.

Over the years exchanges of varying set of rules have evolved in different parts of the world to cater the needs of the investment community. They reflect varied aspirations of widely dispersed players across the globe. Though they serve the similar set of players, and aim at the similar objective achieving the fair price for the assets, they are guided by different set of rules and practices. In the present essay, we aim to discuss and compare the trading mechanisms and trading rules of various exchanges of the world. We mainly focus on five major international exchanges such as NYSE EURONEXT, London Stock Exchange (LSE), Shanghai Stock Exchange (SSE), Singapore Stock Exchange (SGX), and Tokyo Stock Exchange (TSE); and two domestic exchanges such as National Stock Exchange (NSE) and Bombay Stock Exchange (BSE); and survey their trading mechanisms, order types and their priority rules, and risk management mechanisms.

1. NYSE EURONEXT

NYSE Euronext, the holding company created by the combination of NYSE Group, Inc. and Euronext N.V., was launched on April 4, 2007. NYSE Euronext operates the world’s largest and most liquid exchange group and offers the most diverse array of financial products and services. NYSE Euronext, as a for profit corporation operates multiple securities exchanges notably Euronext (Paris), New York Stock Exchange (NYSE),  NYSE Arca (formerly known as ArcaEx),  Euronext.liffe (derivatives), Powernext (Paris, Energy sector) and  Alternext (small and medium sized firms).

Some Statistics:

Number of firms listed: 8500

Current Market Capitalization: $ 16.7 trillion

Market Mechanism:

The NYSE has long been the leader in providing the best prices and lowest trading costs. Its unique market model allows it to accomplish this. The NYSE blends the best aspects of electronic trading and traditional open-outcry, auction market trading. To be able to trade securities on the Trading Floor, an Exchange-issued trading license is required. Only qualified and approved NYSE broker-dealer entities may acquire and hold trading licenses. Most of those holders are either floor brokers or specialists:

• Floor Brokers. Brokers represent public orders to buy or sell shares and work to get their customers the best price. Brokers participate both in person and electronically on the Trading Floor and have advanced tools to assist them in handling trades on behalf of their clients. Two main types of floor brokers work on the Trading Floor: house brokers and independent brokers. House brokers are employed by brokerage firms that hold accounts for public investors. These market professionals buy and sell securities as an agent for their customers. The majority of independent brokers are “direct access” brokers who deal with institutional investors at low commission rates.

• Specialists. Each stock listed on the NYSE is allocated to a specialist, a market professional who acts as the contact point between brokers with orders to buy shares and brokers with orders to sell shares. Specialists act as auctioneers in the specific stocks they are designated to trade at a designated location, called a trading post. All buying and selling of a given stock occurs at that location. Specialists use enhanced technology to bring buyers and sellers together, improve prices, and serve as a point of accountability for the smooth functioning of the market. The Hybrid Market automates much of what specialists do, helping them become much more efficient.

Trading Hours: The New York Stock Exchange, NYSE, is open from Monday through Friday 9:30 a.m. to 4:00 p.m. ET.

Trading process and Tick sizes: Market opens with the call auction and closes with the call auction. During the main trading hours there will be continuous trading on the stocks listed.

Circuit Breakers: To reduce volatility and promote investor confidence, NYSE is implementing a pause in trading i.e., investors are given time to assimilate incoming information and the ability to make informed choices during periods of high market volatility. The halt for a 10% decline would be one hour if it occurred before 2 pm. and for 30 minutes if it occurred between 2 and 2:30, but would not halt trading at all after 2:30. The halt for a 20% decline would be two hours if it occurred before 1 p.m., and between 1 p.m. and 2 p.m. for one hour, and close the market for the rest of the day after 2 p.m. If the market declined by 30%, at any time, trading would be halted for the remainder of the day.

Type of Orders: An order is an instruction to a stockbroker or dealer to buy, sell, deliver, or receive securities or commodities. The order commits the issuer of the order to the terms specified in the order. The following are the available types of orders on the NYSE Euronext.

Market Order:  An order to buy or sell at the best price currently available.

Limit Order: An order to buy or sell when and if a security reaches a specific price.

Good Til Cancelled (GTC) Order: An order to buy or sell at a specific price until the investor cancels the order.

Scale Order: An order to buy or sell a security that specifies the total amount to be bought or sold at specified price variations.

Stop Order: An order to buy at a price above or sell at a price below the current market. Stop buy orders are generally used to limit or protect unrealized profits on a short sale. Stop sell orders are generally used to protect unrealized profits or limit loss on a holding. A stop order becomes a market order when the stock sells at or beyond the specified price and, thus, may not necessarily be executed at that price.

2. London Stock Exchange (LSE)

The London Stock Exchange is a stock exchange located in London, United Kingdom. Founded in 1801, it is one of the largest stock exchanges in the world, with many overseas listings as well as British companies. In October 2007 the Exchange merged with Borsa Italiana, creating Europe's leading diversified exchange business, London Stock Exchange Group. Thus, the exchange is now part of the London Stock Exchange Group.

Some Statistics:

Number of firms listed: 2,899

Current Market Capitalization:  $ 2.32 trillion

Market Mechanism:

Securities are allocated to a particular trading mechanism based on a number of criteria, the most important of which is liquidity. There are currently three different mechanisms used to support the trading of UK companies. The most liquid shares are traded on the order book.

Order book Stocks:

The electronic order book, SETSTM, has transformed the way the most liquid UK shares are traded. It is a fully automated, screen based system for all of the securities in the FTSETM 100 index and many securities in the FTSE 250 index. The order book is based on an order matching system in which member firms display their bid (buying) and offer (selling) orders to the market. Orders entered into the system are displayed anonymously and are automatically executed during continuous trading when the price details match one another.

Non-order book stocks:

Trading in non-order book securities is supported by market makers who quote bid and offer prices for the securities in which they are registered, and the maximum transaction size to which these prices relate. These prices are firm to other Exchange member firms. Prices for larger transactions are subject to negotiation. Market makers are obliged to display this information to the market, throughout the trading day.

For the least liquid stocks, a hybrid market model is used, combining market maker quotes and an order book.

Trading Hours: The exchange operates its trading from Monday to Friday during 9.00 to 16.30 hours GMT

Circuit Breakers: Apparently, LSE doesn’t have any market wide or stock wise circuit breakers.

Type of Orders: The following types of orders are available for the traders.

At best (SETS):  An order specifying a volume which is filled at the best price(s) on the order book.

Execute and eliminate (SETS): An order to execute as much of an order as possible up to a specified price. The remainder is deleted.

Fill or kill (SETS): An order specifying a volume and maximum/minimum price. If the

entire order cannot be executed at this price or better, the entire order is rejected.

Limit order (SETS): An order specifying a volume and price at which execution should take place.

Market order (SETS): An order to buy or sell at the best price currently available.

LSE recently introduced the following type of order to increase the depth of the market.

Hidden limit orders: Allow participants to enter a limit order where both the price and volume are hidden. This means that participants do not know how big the order is, and unlike an iceberg where there is a continual refresh in the peak size, participants have no idea if it is there or not. These orders can only be entered where it meets the Large-In-Scale or Large Order Threshold considerations.

Hidden pegged orders: Allow participants to peg their order to, or at a differential or offset to, the Exchange’s Mid Price. Hidden pegged orders provide greater flexibility and increase the likelihood and immediacy of execution.

Mid price orders enable execution at the true mid price, i.e. within the tick size, so if the security is at a one tick spread, execution will occur at half a tick, delivering half a tick price improvement.

Minimum Execution Size: Available for non-displayed order types, Minimum Execution Size (MES) enables customers to stipulate the minimum aggregate volume against which the order can be executed in continuous trading. MES protects participants from small volume orders thereby limiting information leakage.

3. Shanghai Stock Exchange (SSE)

The Shanghai Stock Exchange (SSE) is a Chinese stock exchange or bourse that is based in the city of Shanghai. It is one of the three stock exchanges operating independently in the People's Republic of China; the other two are the Shenzhen Stock Exchange and the Hong Kong Stock Exchange. Unlike the Hong Kong Stock Exchange, the Shanghai Stock Exchange is still not entirely open to foreign investors due to tight capital account controls exercised by the Chinese mainland authorities.

The securities listed at the SSE include the three main categories of stocks, bonds, and funds. Bonds traded on SSE include treasury bonds (T-bond), corporate bonds, and convertible corporate bonds.

Some Statistics:

Number of firms listed:  864

Current Market Capitalization: $ 3.95 trillion

Market Mechanism:

In order to trade securities on the Exchange, members and the institutions should be approved by the Exchange for relevant seats and the right to trade so as to become the Exchange trading participants. These trading participants shall conduct securities trading through the Participant Business Unit for which they have applied to the Exchange. These participant business units can be directly comparable to the stock brokers of NSE/BSE.  Thus, the world second largest exchange practices the order driven mechanism in executing the trades.There are two types of stocks being issued in the Shanghai Stock Exchange: "A" shares and "B" shares. A shares are priced in the local renminbi Yuan currency, while B shares are quoted in U.S. dollars. Initially, trading in A shares are restricted to domestic investors only while B shares are available to both domestic (since 2001) and foreign investors. However, after reforms were implemented in December 2002, foreign investors are now allowed (with limitations) to trade in A shares under the Qualified Foreign Institutional Investor (QFII) program which was officially launched in 2003. Currently, a total of 79 foreign institutional investors have been approved to buy and sell A shares under the QFII program. Quotas under the QFII program are currently US$30 billion. There has been a plan to eventually merge the two types of shares in the future.

Trading process and trading Hours: The Exchange is open for trading from Monday to Friday. In case of auction trading, the opening call auction runs from 9:15 to 9:25 on each trading day, while the continuous auction runs from 9:30 to11:30 and from 13:00 to 15:00.

Tick sizes: The tick size of the quotation price of an order for A shares, bond trading, and bond buyout repo trading is RMB 0.01 Yuan and that for mutual funds and warrants is RMB 0.001 Yuan, while that for B shares and bond collateral repo trading are USD 0.001 and RMB 0.005 Yuan respectively.

Circuit Breakers:

The exchange doesn’t have any market wide circuit breakers. However, the Exchange imposes the daily price limit on trading of stocks and mutual funds, with a daily price up/down limit of 10% for stocks and mutual funds and a daily price up/down limit of 5% for stocks under special treatment (ST shares or *ST shares).

The price limit is calculated as follows: price limit = previous closing price × (1± price up/down limit percentage) .

Type of Orders:

The Exchange accepts limit orders and market orders from members.

Market orders: The Exchange accepts the following types of market orders in line with market conditions:

(1) Five Best Orders Immediate or Cancel: an order that is executed in sequence against the current five best prices on the opposite side, with the portion of the order not executed, if any, cancelled automatically.

(2) Five Best Orders Immediate to Limit: an order that is executed in sequence against the current five best prices on the opposite side, with the portion of the order not executed, if any, changed to a limit order whose limit price is set at the last executed price on the same side. Such order, if not executed, is changed to a limit order with limit price set at the best quotation price on the same side, or, in the absence of any order on the same side, is cancelled.

Limit Order: A limit order shall include such information as securities account number, brokerage branch code, securities code, buy or sell, quantity, price, etc.

However, the maximum quantity of one order for stocks, mutual funds and warrants shall be not more than 1 million shares (units).

4. Singapore Stock Exchange (SGX)

Asia-Pacific's first demutualised and integrated securities and derivatives exchange.

Some Statistics:

Number of firms listed: 774

Current Market Capitalization: SGD$650 billion.

Market Mechanism:

Trading Hours: Trading sessions are held daily from Mondays to Fridays between 9.00am – 12.30pm and 2.00pm - 5.00pm. In addition, there is an Pre-Open Routine (8.30am – 9.00am) and Pre-Close Routine (5.00pm – 5.06pm). There is no trading on Singapore public holidays. When a holiday falls on Sunday, the following Monday will be a public holiday.

Trading on the eves of Christmas, New Year and Chinese New Year will be from 9.00 a.m. to 12.30 p.m. The Opening Routine will be from 8.30 a.m. to 9.00 a.m. and the Closing Routine from 12.30 p.m. to 12.36 p.m.

Trading process and Tick sizes:

A tick size is the minimum incremental movement in the price of a stock. The minimum size of a tick is dependent on the current share price - see table below.

Share Price (S$)	Tick Size
<1.00	0.005
1.00 – 3.00	0.01
3.00 – 5.00	0.02
5.00 – 10.00	0.05
>10.00	0.10

Singapore stocks can only be traded in lots of 1,000.

Circuit Breakers:

There are no circuit breakers.

Type of Orders:

Only limit orders are permitted on the Singapore Stock Exchange.

A BUY limit order must be placed at the current offer price or down to a maximum of 6 ticks below the current offer price. If a BUY limit order is placed above the current offer price or greater than 6 ticks below the current offer price, the order will be rejected by the market/exchange.

A SELL limit order must be placed at the current bid price or up to a maximum of 6 ticks above the current bid price. If a SELL limit order is placed below the current bid price or greater than 6 ticks above the current bid price, the order will be rejected by the market/exchange.

5. Tokyo Stock Exchange

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The Tokyo Stock Exchange, or TSE, located in Tokyo, Japan, is the second largest stock exchange in the world by aggregate market capitalization of its listed companies, second only to the New York Stock Exchange.

Some Statistics:

Number of firms listed: 2,414

Current Market Capitalization: $4.3 trillion.

Market Mechanism:

There are three separate sections within the TSE market. The first, second sections, and Mothers (venture capital market). The first section is for the largest, most successful companies - often referred to as 'blue chips'. The second section is for smaller companies with lower trading volume levels. Mothers (market for the growth and emerging stocks), established in November 1999, and is for newer, innovative venture enterprises, both in Japan and overseas. And TSE market is a pure order-driven market without specialists or market makers to guide price formation.

Trading Hours: The exchange's normal trading sessions are from 09:00am to 11:00am and from 12:30pm to 3:00pm on all days of the week except Saturdays, Sundays and holidays declared by the Exchange in advance.

Trading uni: Currently the majority of domestic listed companies use a trading unit of 1,000 shares. Stocks' trading units are identified in newspapers' market pages. TSE is working to encourage listed companies with high prices and large trading units to reduce the size of their trading units to allow greater access to individual investors, who are currently put off by the expense involved in buying even one unit.

Circuit Breakers: To prevent such wild volatility TSE sets daily price limits for each stock, within the parameters of which stock prices may fluctuate safely.

Type of Orders: Basically there are two kinds of order available on the TSE equities market, 'limit' and 'market' orders.

Limit orders: The order refers to a buy or sell order with a limit price.

Market orders: An order to buy or sell at the best price currently available.

Order Priority Rules: During the trading process, priority among orders is decided on two principles; price and time priority, to ensure that all orders are handled equally and those transactions proceed smoothly.

6. National Stock Exchange (NSE)

The National Stock Exchange of India Limited (NSE) is a Mumbai-based stock exchange. It is the largest stock exchange in India in terms of daily turnover and number of trades, for both equities and derivative trading. The NSE's key index is the S&P CNX Nifty, known as the Nifty, an index of fifty major stocks weighted by market capitalization.

Some Statistics:

Number of firms listed: 1454

Current Market Capitalization: US$ 1.46 trillion

Market Mechanism:

NSE operates on the 'National Exchange for Automated Trading' (NEAT) system, a fully automated screen based trading system, which adopts the principle of an order driven market.

Trading Hours: Trading takes place in the exchange on Monday to Friday everyweek. Market opens at 9.00 am and closes at 3.30 pm, during which trading takes place on continuous basis. Post trading session is held between 3.50 pm to 4.00 pm.

Tick sizes: Rs. 0.05.

Circuit Breakers: The index-based market-wide circuit breaker system applies at 3 stages of the index movement, either way viz. at 10%, 15% and 20%. These circuit breakers when triggered bring about a coordinated trading halt in all equity and equity derivative markets nationwide. The market-wide circuit breakers are triggered by movement of either the BSE Sensex or the NSE S&P CNX Nifty, whichever is breached earlier.

·        In case of a 10% movement of either of these indices, there would be a one-hour market halt if the movement takes place before 1:00 p.m. In case the movement takes place at or after 1:00 p.m. but before 2:30 p.m. there would be trading halt for ½ hour. In case movement takes place at or after 2:30 p.m. there will be no trading halt at the 10% level and market shall continue trading.

·        In case of a 15% movement of either index, there shall be a two-hour halt if the movement takes place before 1 p.m. If the 15% trigger is reached on or after 1:00p.m. but before 2:00 p.m., there shall be a one-hour halt. If the 15% trigger is reached on or after 2:00 p.m. the trading shall halt for remainder of the day.

·        In case of a 20% movement of the index, trading shall be halted for the remainder of the day.

NSE also has the price bands for the individual securities. They are

·        Daily price bands of 2% (either way)

·        Daily price bands of 5% (either way)

·        Daily price bands of 10% (either way)

·        No price bands are applicable on: scrips on which derivative products are available or scrips included in indices on which derivative products are available (unless otherwise specified)*

·        Price bands of 20% (either way) on all remaining scrips (including debentures, preference shares etc).

Type of Orders:

On NSE, a Trading Member can enter various types of orders depending upon his/her requirements. These conditions are broadly classified into three categories: time related conditions, price-related conditions and quantity related conditions.

Time Conditions

DAY - A Day order, as the name suggests, is an order which is valid for the day on which it is entered. If the order is not matched during the day, the order gets cancelled automatically at the end of the trading day.

GTC - A Good Till Cancelled (GTC) order is an order that remains in the system until it is cancelled by the Trading Member. It will therefore be able to span trading days if it does not get matched. The maximum number of days a GTC order can remain in the system is notified by the Exchange from time to time.

GTD - A Good Till Days/Date (GTD) order allows the Trading Member to specify the days/date up to which the order should stay in the system. At the end of this period the order will get flushed from the system. The maximum number of days a GTD order can remain in the system is notified by the Exchange from time to time.

IOC - An Immediate or Cancel (IOC) order allows a Trading Member to buy or sell a security as soon as the order is released into the market, failing which the order will be removed from the market. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately.

Price Conditions

Limit Price/Order – An order that allows the price to be specified while entering the order into the system.

Market Price/Order – An order to buy or sell securities at the best price obtainable at the time of entering the order.

Stop Loss (SL) Price/Order – The one that allows the Trading Member to place an order which gets activated only when the market price of the relevant security reaches or crosses a threshold price. Until then the order does not enter the market.

A sell order in the Stop Loss book gets triggered when the last traded price in the normal market reaches or falls below the trigger price of the order. A buy order in the Stop Loss book gets triggered when the last traded price in the normal market reaches or exceeds the trigger price of the order.

Quantity Conditions

Disclosed Quantity (DQ)- An order with a DQ condition allows the Trading Member to disclose only a part of the order quantity to the market. For example, an order of 1000 with a disclosed quantity condition of 200 will mean that 200 is displayed to the market at a time. After this is traded, another 200 is automatically released and so on till the full order is executed. The Exchange may set a minimum disclosed quantity criteria from time to time.

There are also Minimum Fill and All or None orders in the NSE constitution, but are not in the system as per SEBI directives.

Order Matching Mechanism: The best buy order is the order with the highest price and best sell order is the order with the lowest price. Order matching priority rule is Price, time and followed by volume.

7. BOMBAY STOCK EXCHANGE (BSE)

The Bombay Stock Exchange Limited is the oldest stock exchange in Asia and has the greatest number of listed companies in the world. It is located at Dalal Street, Mumbai, India. It the largest stock exchange in South Asia and the 12th largest in the world.

Some Statistics:

Number of firms listed: 4700

Current Market Capitalization: US$ 1.79 trillion

Market Mechanism:

     BSE has introduced electronic trading system known as BOLT (BSE On Line Trading). With the following facility

1) This is an order driven facilitates efficient processing; automatic order matching and faster execution is enabled.

2) Trading system displays on continuous basis scrip and market-related information required supporting traders.

3) As soon as an order is matched, the confirmation of the trade is generated on-line.

4) The order matching logic is based on best price and time priority.

Trading Hours: Trading takes place in the exchange on Monday to Friday every week. Market opens at 9.00 am and closes at 3.30 pm, during which trading takes place on continuous basis. Post trading session is held between 3.50 pm to 4.05 pm.

Tick sizes: Rs. 0.01.

Circuit Breakers: In line with the SEBI regulation, market wide and scrip wise circuit breakers are similar to the National Stock Exchange of India. However, Circuit Filter of 20% is applicable on all scrips except the scrips on which derivative products are available and are part of indices on which derivative products are available.

Type of Orders:

There are various types of orders, which can be placed on the exchanges:

Limit Order: The order refers to a buy or sell order with a limit price.

Market Order: An order to buy or sell at the best price currently available.

Stop Loss Order: A stop loss order allows the trading member to place an order which gets activated only when the last traded price (LTP) of the Share is reached or crosses a threshold price called as the trigger price. The trigger price will be as on the price mark that you want it to be. There are stop loss buy as well as sell orders at the disposal of the traders.

Order Matching Rules: Matching of the orders will be in the priority of price and timestamp.

SARFAESI Act, 2002 and its Interface with BIFR

(5^th September 2009)

-Surenderrao Komera

In India, Industrial sickness has been dealt with various legislations and there have been a series of changes from time to time in the legislations to efficiently deal with industrial sickness. These legislations continued to protect the debtors at the cost of the creditors by imposing the sanctions on the later. Over time such legislations caused inefficiencies in the functioning of banking and financial institutions (creditors). For instance SICA, 1985 (Sick Industrial Companies Act), by institutionalizing the Board of Industrial and Financial Reconstruction (BIFR) aimed at protecting the sick (potentially viable) industrial units by suspending all the legal and contractual proceedings against them. Given the prevailing legal framework in restructuring and liquidation of the sick units, the claims of the creditors on the sick industrial units continued to accumulate and thereby created hurdles in their efficient functioning. Particularly, these mounting non-performing assets created roadblocks in the functioning of the banking and financial institutions and undermined their competitiveness in the global financial markets.

By considering the recommendations of Narasimham Committee II and Andhyarujina Committee to address the concerns over the mounting NPAs of the financial institutions and to provide the necessary leap for the FIs to keep pace with international institutions, GoI enacted the SARFAESI act (Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest) in 2002. This act largely facilitates the asset recovery and reconstruction.

Interface with BIFR: SARFAESI act allows the banks and financial institutions to take possession of securities, sell them and reduce non performing assets without the intervention of courts, regardless of the reference of the firms to the BIFR. In a way SARFAESI act restricts the BIFR jurisdiction and allows the secured creditors to possess the corresponding assets without its discrimination. Thus SARFAESI act may be viewed as the legislative action that undermines the efficiency and relevance of BIFR in its pursuit of protecting the potentially viable industrial units. Hence, the note calls for the reexamination of the provisions of SICA in the light of changed institutional and legislative framework.

(Views expressed above are personal and comments and suggestions are encouraged)

Parametric tests Versus Non parametric tests

Prepared on 24^th July 2009

“Fewer or weaker are the assumptions, the more general are the conclusions”.

In statistics, unfortunately the most powerful tests are those which have extensive and stringent assumptions. With this assertion, I will be presenting the most prominent discussion of Parametric vs. Non parametric tests very briefly. The following write up reflects my personal (with nascent knowledge) bias for non parametric tests.

Parametric tests (t test and f test) are the tests that have certain assumptions about the population from which the samples are drawn. The strength of the results of such tests depends on the validity of those stringent conditions/assumptions. The prominent among them are.

• Observations must be independent
• Observations must be drawn from normally distributed populations
• Those populations must have same variance
• Variables are measured at least in an interval scale

Non parametric tests are the tests that make no assumption about the populations, but share few relatively weak assumptions with the parametric tests. They are:

• Observations must be independent
• Variables under study have underlying continuity.

However the concept of power of efficiency (by increasing the sample size) ensures that non parametric tests achieve the same strength as parametric test. Moreover the criticism of the non parametric tests over their usage of information (some non parametric tests ignores the sign, some convert the scale into ranks) may be answered by eliciting the answers to the following questions.

Ø How important is it that the conclusions drawn from the research are applicable to the generally rather than only to the populations with normally distributions?

Ø Which tests of the parametric and non parametric tests use the information appropriately?

The potential answer to the former question is presented in itself. The answer to the later one may be viewed from the perspective of possible assumptions one makes about the potentially unknown populations one deals with. The issue of comparing the parametric and non parametric tests may be highlighted by presenting the short summary of the advantages and disadvantages of the non-parametric test.

Advantages of Non-parametric tests:

ü The probability statements obtained from the non parametric tests are the exact ones, regardless of the shape of the underlying population.

ü For the very small samples (say N=8), there is no other alternative other than non parametric tests unless the parameters of the underlying population are known exactly.

ü Non parametric tests are suitable in the case of the samples that are drawn from various populations with different variances.

ü No other alternative than non parametric tests in the case of the samples involving nominal data.

Disadvantages of the non-parametric tests

• In the case of the samples that satisfy the underlying assumptions of the parametric tests, application of non-parametric tests is of wasteful given their power of efficiency
• Unstructured availability of literature about the non parametric tests may confine the researcher to employ the parametric tests though their validity is vague.

The author has heavily benefited from the extensive and provocative discussions with his fellow doctoral student Yoonus C. A at IFMR, Chennai; and the writings of Sidney Siegel. The comments on the draft by Nandhini R. are highly commendable. Finally, the author is solely responsible for any mistakes and constructive comments are highly respected.

Corporate Bankruptcy Law in India

In India, there is no comprehensive law or market mechanism that governs corporate bankruptcy. The way it has been defined, ‘industrial sickness’ goes beyond the general understanding of ‘bankruptcy’. It has been defined as the extreme state where accumulated losses exceed the net worth. The stringent policies that dealt with the industrial undertakings until late 1980s fueled the persistence of industrial sickness in the country. The MRTP act (1969) prevented the private sector companies from attaining globally competitive scales of operation through its stringent definition of ‘dominant undertaking’. The FERA (1973) and Import Substitution policies that were adapted created the insurmountable hurdles to the domestic entities in acquiring the innovative technologies and forced them far behind in modernization process. This resulted in the widespread industrial sickness thereby blocking of scarce resources in unviable activities. To deal with the industrial sickness, the Government of India took various ad-hoc measures such as constituting Industrial Reconstruction Corporation of India Ltd (IRCI) in 1971; setting up of state level inter institutional committees (1980) to provide rehabilitation assistance to sick and closed units. These ad-hoc measures were not effective as they could not forge the coordinated approach to deal with the problem. In 1981, the RBI set up a committee under the chairmanship of T. Tiwari to suggest on the possible legal options/mechanisms to effectively deal with the problem of industrial sickness.

Based on the recommendations of the Tiwari committee, the Government of India enacted the Sick Industrial Companies Act (SICA) in 1985. The purpose of SICA has been the early detection of sick or potential sick companies; determination of the potential viability and timely provision of remedial measures. The economic underpinning behind the purpose of SICA is to unveil the scarce resources that were hitherto blocked with the unviable unit. In order to implement various provisions of SICA, Board of Industrial and Financial Reconstruction (BIFR) was set up in January 1987 and became functional from May 1987. Initially BIFR covered only private entities, the government companies were brought under the BIFR jurisdiction in July 1991. The SICA applies to the companies satisfying the following criteria:

• Companies specified in the First Schedule to the Industries (D & R) Act, 1951, except the industries relating to ships and other vessels drawn by power
• Companies not being ‘small scale industrial undertakings or ancillary industrial undertakings’ as defined in Industries Act, 1951.

The criteria that BIFR follows in determining the sickness of a particular company is as follows:

• The accumulated losses of the company to be equal to or more than its net worth.
• The company should have completed five years after incorporation under Companies act, 1956. (before July, 1991 it was seven years)
• The company should have 50 or more workers on any day of the 12 months preceding the end of the financial year.
• It should have a factory license.

The companies satisfying the above criterion are reviewed by the body of experts who determines the viability of the company. Based on the observations, unviable companies are winded up and potentially viable companies are recommended for the re-organization process. The companies that underwent the re-organization process will be declared as ‘no longer sick’ as and when their viability is established (as and when their net worth becomes positive).

Reference:

- T.C.A. Anant and Omkar Goswami (1997), “Getting Everything Wrong: India’s Policies Regarding ‘Sick’ Firms” in Dilip Mukharjee (ed), Indian Industry: Policies and Performance, OUP, New Delhi.

- www.bifr.nic.in.

Suggestions and comments will be encouraged!

Conceptual ideas-II

What are the indirect taxes?

An indirect tax is a tax which is imposed on one person, but paid partly or wholly by another depending on the bargaining power between them. In the sense, indirect tax is conceived as the one which can be shifted or passed on. The prominent examples of the indirect taxes are sales tax, customs and excise duties, incidence of which is transferred to (partly) the ultimate customers. In India contribution of indirect taxes to the total tax revenue of the union government is around 47% in 2008-09.

What is the budget deficit?

In India, the term budget deficit is used to describe the position in the different accounts of the budget. That is on current or revenue account and on capital account. The combination of the state of these two accounts represents the overall state of the budgetary position. The budgetary position on the revenue account represents the current operations of the government, i.e., government administrative expenses which are financed by the tax revenue. The deficit or surplus in the revenue account would be carried over to the capital account. The surplus or deficit on capital account signifies the over all budgetary position. The method of financing budget deficits is known as the deficit financing.

Where does the government look for funds where there is deficit?

Deficit is referred to the excess of expenditure incurred by government over the receipts from levying taxes, fees and so on. To reduce or eliminate the gap between expenses and receipts, modern democratic governments lay their hands on the accumulated reserves, sale of government properties, issuing debt securities which are issued in the market through central banks, borrowing from external sources such as foreign governments and foreign financial bodies and least likely increasing the taxes. In India, the budget deficit of the union government is about six percent (5.63%) of GDP in 2008-09, when sub-national governments are taken together it is about 10% of GDP which is overwhelmingly high.

What is the long run impact of the piling of debt?

In the short run debt gives the relief from the budgetary mismatch. But the accumulation of debt increases the debt service burden on the economy in the long run. Though in the short run debt adds for the economic expansionary policies, it takes away much needed cushion in the times of extreme events and causes for the contraction.

What is the relationship between deficits and taxes?

The term deficit refers to the presence of excess government expenditure over receipts from taxes, duties, fees and so on. Increase in taxes thereby tax revenue is one of the options government can exercise in reducing the burden of deficit. But such an option of increasing taxes to meet the budgetary demands is less attractive to the democratic governments.

What is the relationship between deficits and unemployment rates?

Deficit financing is the most popular economic expansionary policies particularly in the context of emerging markets. In presence of resource crunch, most of the emerging economies resort to the deficit financing as a policy measure to increase the investment spending, employment opportunities thereby increased production. In a way deficit financing reduces the unemployment rates given the economy future resilient prospects to deal with the increased deficit.

What do you understand by the term ‘fiscal responsibility’?

The term fiscal responsibility may be viewed as it is composed with three dimensions; they are managing resources, minimizing the debt and preparing for the future. Managing resources involves assessing needs, setting priorities, and appropriating funds as well. Assessing the needs in various departments and allocating the resources is the crucial part of fiscal responsibility. Preparing and effectively tiding over the potential black swan events by maintaining possible cushion is the prominent dimension of the fiscal responsibility. Eliminating the wasteful expenses, optimizing the expenditure on social security measures are the possible ways to minimizing the debt. Indian government (including sub national governments) running the deficit of around 10% of GDP as on 2008-09, enacted the Fiscal Responsibility & Budget Management to phase out the fiscal deficit.

What are supplementary budgets? Why are they needed?

During the budget year unanticipated needs may arise that affect the central government budget. A particular deparment may, for example, need more money than planned. In such a situation, the Government can revise the central government budget by proposing an increase. This is known as a supplementary budget and proposals for supplementary budgets are submitted by the Government possibly twice a year.

Your suggestions and comments will be encouraged!

Conceptual Ideas!!

What are M1, M2 and M3?

M1 is the sum of the physical money that is held outside banks, travelers’ checks and demand deposits. M2 is M1 in addition to all time-related deposits, savings deposits, and non-institutional money-market funds. M3 is M2 as well as all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets. M3 is referred to as broad money supply and is usually the number referred to when talking about money supply. M1 is generally referred to as narrow money.

What is the impact of interest rate on the economic growth?

There is a general consensus that the growth of the economy is negatively associated with the interest rates prevailing in the economy. Interest rates in an economy has twofold effect on economic growth as they act as driving force for the investment activity on one hand (supply side) and stimulate the consumption expenditure on the other hand (demand side). In specific, moderately low interest rates not only drive the increased investment activity but also encourage the individual consumption expenditure.

What Does Nonperforming Asset Mean?

A debt obligation where the borrower has not paid any previously agreed upon interest and principal repayments to the lender for an extended period of time (say, 90 days). The nonperforming asset is therefore not yielding any income to the lender in the form of principal and interest payments. Increased nonperforming assets act negatively to the growth of the economy as the scarce capital could be holdup in unviable economic activities. It is a major concern for the emerging economies as they generally face the resource crunch.

What is a fiat currency?

Fiat currency or fiat money is a type of currency whose only value is that a government made a fiat that the money is a legal method of exchange (is usually the paper currency). Unlike commodity money it is not based on any other commodity such as gold or silver and is not covered by any special reserve. It means fiat currency doesn’t have any intrinsic value and its value depends only on the confidence holders have in the economy and its government. Most currencies in the present world are fiat currencies.

What are the leading, lagging and coincidental indicators?

Usually indicators are used to predict the future outcomes, particularly future trends of the certain economic variables. Some of these indicators are published by government bodies/private organizations eg. Inflation rate, …………..and some are observed in the market place eg. Bond yields. Depending on the prediction they make, such indicators are classified into leading, lagging and coincident indicators.

Leading indicators are the pointers towards the future outcomes. Bond yields may be considered the leading indicator for the trends in the equity markets.

Lagging indicators are of useful in reinforcing or confirming the event occurring or expected to occur. Unemployment rate may be viewed as lagging indicator for the performance of the economy. Falling unemployment rates confirms the encouraging performance of the economy.

Coincident indicators reflect the situations they signify. Increased per capita consumption is the reflection of flourishing economy.

What happens to the interest rates during deflation?

Deflation refers to the fall in the general price level. It is usually caused by the fall in aggregate demand which is in turn resulted from the decline of government spending, private consumption and investment spending. Deflation can also be the result of the fall in the supply of credit and increased interest rates. But once the deflationary situation is settled in, investors mostly become the risk averse and seek for the safe heavens such as investing in treasury securities. The increased demand for the treasury securities due to deflationary conditions brings down the interest rates and some times push the interest rates into the negative territory.

How does credit crunch affect consumption?

Credit crunch refers to the reduction in general availability of credit irrespective of the rise in interest rates. It has multifold effect on the consumption expenditure, particularly on the conspicuous consumption. On the plain grounds, lack of credit availability restricts the consumption on durable goods; on the other hand credit crunch dampens the consumer confidence by causing the steep fall in asset prices, reduction in investment rates and increased unemployment rates. The recent credit crunch resulting from the US housing sector crisis brought down the consumer confidence there by consumption expenditure.

What are the important components of the budget?

Indian budget, known as Union Budget is made up of revenue account and capital account. Revenue account comprises of government revenue mainly from taxes and government administrative expenditure. Capital account comprises of receipts and payments. Receipts on capital account include the loans brought about by the government through central bank from the market as well as other government bodies and profits from the government owned enterprises. Components of payments on the capital account include government investment expenditure on assets, infrastructure etc.

What are the direct taxes?

A direct tax is a tax which is imposed directly on the tax payer. It implies that in the case of the direct taxes the immediate impact and incidence of the money burden lies on the same person. The examples of direct taxes are personal income tax, wealth tax, tax on gifts etc. Most of the modern governments earn major chunk of revenue from imposing direct taxes. In India, contribution of direct taxes to the total revenue of the union government is 53.07% in 2008-09. This reflects the significance of the direct taxes as major source of revenue for the state.

Your valuable suggestions and corrections will be encouraged!!

Corporate Governance and Control

Definitions

•  It deals with the collective action problem among the widely dispersed shareholders in monitoring and controlling the management.
  
•  It deals with the conflict of interests between investors and managers. It is also referred to deal with the principal and agent problem. 

It is generally assumed that the maximization of the shareholders’ wealth is the primary objective of the corporate governance.  Is it an efficient (economic) outcome???

 It is a Pareto efficient – if

·        The ‘firm’ is viewed as a nexus of contracts; more precisely, is viewed as the nexus of complete contracts with creditors, suppliers, clients and employees; and open contracts with shareholders who has claim on the residual returns

·        There are no principal agency problem i.e., the interests of the managers are optimally aligned to the interests of the multiple principals.

If the above two conditions are satisfied, the maximization of shareholders’ wealth is Pareto efficient. But there are some arguments: Managers exclusively working for the shareholders’ wealth maximization may lead to certain inefficiencies:

• Excess risk taking by the managers in the presence of high leverage
• Underinvestment in the case of the debt overhang.

Sound governance mechanism reduces the cost of equity, in a way good corporate governance is in the interests of the firm itself.  Then why do we need external regulation??

• Block holders (institutional investors) may keep the higher bargaining power with them.  Eg. Block holders may go for the anti takeover policies which will not benefit the small or minority shareholders.
• Managers may lobby for the more discriminatory powers.
• To ensure the interests of the all the stakeholders

Why do the investors dispersed so widely?             

• Individuals’ wealth in relation to the investments is small
• Investors may want to diversify their risk by investing their limited wealth in various firms
• Investors’ may concern for the liquidity – a large amount of stock is very harder to sell instantaneously in the secondary market.
• Regulations on individual shareholding

So dispersion is inevitable.         

There are two oversimplified corporate governance mechanisms.

1. Anglo-American Model (market based model) -

Nurtured by USA and UK.

• Accords absolute priority to the shareholders
• Shareholders monitor the performance of the management through market mechanism
• As shareholders are open contract holders and having less contractual protection, the rules are framed to protect them.
•  Short term perspective
• Criticized as it encourages the management to get obsessed with the performance appraisal and pursue short term goals over long term objectives.

2. Long term Large Investor Model (Bank based Model) –

Nurtured and followed mainly by Japan, to some extent by Germany.

• Managements are monitored by the large investors, financial institutions
• Financial institutions do participate in decision making process
• Ensures low cost of capital
• Long term perspective
• Other stakeholders have more protection than shareholders.

III. Possible Lessons from the Japanease (slump) bear market

Before deriving the possible implications of Japanese prolonged bear market for the present mess in the global financial system, I would like to investigate possible factors that caused the boom and eventual burst in the Japanese economic system.  Here I will be discussing the issue from the corporate governance perspective, whether the corporate governance mechanism added the flame to these extreme events of business cycle?

 The oversimplified corporate governance mechanisms are of two kinds, one is Anglo-American Corporate Governance Mechanism (Market based system), pioneered by USA and UK; Bank based Mechanism, nurtured and followed mainly by the Japan and Germany (Germany in the later years tilted towards market based system), is the another one. Market based system gives absolute priority to the shareholders over other stake holders. It presumes that the shareholders do monitor and impose the discipline on the management through market mechanism. It is also argued to be of having short term perspective as market gauges the performance of the management on the regular basis in terms of quarterly/half yearly accounting statements. Where as Bank based system measures the performance based on the long term growth perspective. It accords the governance mechanism to the financial institutions that monitor the performance of the managements.  In a way financial institutions posses the major stake in decision making process under Bank based system. 

 Bank based system, providing the financial institutions access to internal information to assess the potential projects, ensures the low cost of capital to the firms. This came handy to the Japanese corporate world during the bull phase of 1980s, where as the firms in the rest of the world were cautious over the investments in the light of high cost of capital.  In a way Bank based system added the flame to the Japan’s Bull Run during the second half of the 1980s.  But the same system tightened the necks of the Japanese firms during the crash and the prolonged period of bear markets (till date) as the banks became overcautious given their increasing NPAs. Thus Japanese corporate governance mechanism steepened the crash in the asset markets and contributed to the ever ending bear market conditions.

 Anglo-Saxon model, according the corporate governance to shareholders (who monitor the management performance through market mechanism) makes the management obsessed with the quarterly performance appraisals. With its short term perspective, Anglo-Saxon Model encourages the management to pursue the short term goals by forgoing the long term objectives. In a way such corporate governance model practiced in USA, UK, and Europe might have forced the yester year mighty corporations into the history and eventually caused the present mess in the global economy.

(Comments and Suggestions are welcome!!)

II. Possible Lessons from the Japanease (slump) bear market

(It has been roughly four months that i promised to write on Japanese prolonged bear market).

Boom and depression are the two extremes of business cycle which are generally pursued to be caused by an array of economic factors such as over production, under consumption, over capacity, price dislocation, over confidence, overinvestment, over saving, over spending and discrepancy between savings and investments. The foremost celebrity monetary economist Irwing Fisher attributed the business cycles to the over indebtedness and thereby deflation.  In his own words, depression in the economy is result of over indebtedness which leads to distressed selling of assets. He articulated (in 1930s) the chain of factors that lead to depression in the following way….

Over indebtedness leads to a) distressed selling and b) contraction of deposit currency as bank loans are paid off and to a slowing down of velocity of circulation. The contraction of deposits and of their velocity precipitated by the distress selling causes c) a fall in the level of prices and d) a still fall in the level of corporate net worth, precipitating bankruptcies and e) a like fall in profits leads to concerns to the private – profit society to make f) a reduction in output, trade and employment. These losses, bankruptcies and unemployment leads to g) pessimism and loss of confidence which in turn lead to h) increased hoardings and still more contraction in velocity of circulation. All these factors cause i) complicated disturbances in interest rates.  Here the complicated disturbances in interest rates are vowed to my previous post on counter cyclical regulation.

The above lengthy introduction serves as the basis for my arguments on the possible lessons from the Japan’s prolonged bear market.

 From the humiliating defeat of 1945 war, Japan has raised to the second largest economy by 1989. The tremendous growth has been attributed to the hard work (Popularly known as Japan kind of doing) rendered by its citizens and supply led and export oriented policies adapted by the then governments. During the second half of the 1980s, Japan experienced a sea change, there was a sudden spurt in the asset prices, real estate prices reached unimaginable hights, stock markets were experiencing thumping Bull Run. High asset prices coupled with low/negligible unemployment rates, increased productivity and positive trade deficit prompted the irrational speculating activates. Though inflationary situation forced the Bank of Japan to keep the interest rates high, the capital gains from the asset markets (stocks/real estates) encouraged the investors to go for investing with borrowed money. Banks also added to this malady by promptly sanctioning the loans to the investing activities. There is hardly anyone who has not stepped into the band wagon of making quick buck. By the end of 1989 Nikkie index touched 39,000 mark which raised three times more than the economy’s growth. 

Such a growth led by the speculation coupled with over indebtedness became unsustainable and rate of growth of the asset prices slowed down, interest rates over took the capital gains. Thus as Fisher rightly mentioned way back in 1930s, the over indebtedness and higher interest rates forced the distressed selling resulting in steep fall in asset prices. The crash in asset market and resulted mass corporate defaults increased the proportion of distressed assets in banks’ books. Non repayments, delayed repayments and deposit withdrawals caused the banks to adapt conservative measures. Steep rate cuts by the Bank of Japan could not yield the desired fruits, moreover resulted in debt trap. Hesitant banks keep carrying the distressed assets on their books, resulting many defunct businesses were continued to float. Such an uncertain environment counter acted against all the monetary measures taken by the Bank of Japan, further steep cuts of interest rates forced the economy into deep debt trap. Hence, the failure of the transmission of monetary policies, continued business uncertainty forced the prolonged disarray in the Japanese economic system….(to be continued)

 (Comments and suggestions are welcome)

The author is highly benefitted from the writings of Irwing Fisher and Graham Turner.

Impact of regulatory/accounting arbitrage on the Returns from Distressed securities

Here my focus will be on distressed debt securities and my idea of distressed securities is broad enough in including the investments in non-performing assets of financial institutions. Investors are generally attracted towards distressed securities/assets to earn higher risk adjusted returns.  The prominent reason for such risk adjusted returns is the arbitrage opportunity created by the regulatory/ accounting process.

  The financial institutions in general and commercial banks in particular are highly regulated. Such regulatory pressures do create the opportunity for the investors to purchase the distressed loans (NPAs) at the attractive prices. Given the regulatory costs involved in having large amount of distressed loans, many banks prefer to sell the loans at the throw away prices (even at less than the recovery value).  Such behavior of the banks may be attributed to two reasons. First, tax laws allow the banks to deduct such losses from the EBIT. Second, market pursues the larger amount of NPAs thereby higher regulatory reserves as the negative information (may be market short sightedness). The buyers of these assets (may also include commercial banks) do place them in their trading account. As the assets in the trading account are marketed to market and no ‘regulatory’ reserves need to be held against the assets in the trading account, they provide the economic value to the buyers. Hence, the sellers of the distressed assets do sell them on the regulatory/accounting reasons where as buyers of such assets do buy them on the economic reasons.

 (Your comments and suggestions do inspire me the most. Thanks….)

Does the Counter Cyclical Regulation ensure the cycle free regime?

During the run up of 2004 to 2007 world economies in general and emerging economies in particular have experienced the highest levels of consumer confidence and corporate optimism. The increased purchasing power driven by increased investments and confidence among the economic agents (I mean corporate entities and individuals) has escalated the inflationary pressures around the world.  To counter such an imbalance in the system, the apex bodies around the world have resorted to counter cyclical monetary measures such as increasing the reserve capital (which may be used in the event of negative outcome). Such a counter cyclical regulated environment has forced the firms to incur more cost of capital than market requires.  In fact during the boom times, given the confidence level in the economy, the probability of default though is very remote; the cost of capital in the economy remained irrationally high. Hence such a regulatory environment prompted the firms to shift to unregulated or less regulated activities such as structured investment vehicles which in a way caused the present trough. 

 

Aftermath of the bursting of the bubble in the housing sector, almost all the apex financial institutions around the world resorted to the (traditional) counter cyclical monetary measures which are again proved to be irrational and may contribute to the potentially void results. The trouble in the housing sector has been translated into disastrous crisis in the financial sector by the so called counter cyclical regulations of the boom period. The resulted crisis has evaporated the confidence among the economic agents and drafted vague picture about the future prospects thereby steep fall in consumer demand, accumulated inventories and unimaginable job cuts. Given the present pessimistic environment, market demands a relatively higher cost of capital from the firms and financial institutions requires higher cushion in terms of higher reserve to tide over the potential uncertainty. Counter intuitive to such an end, the regulatory bodies brought down the reserve requirements of the financial institutions and virtually advocating the low cost of capital to the firms. The credibility of these measures in the event of possible corporate mass defaults is not only questionable but they may also pose the terrifying questions about the future systemic cushion…  (to be continued)

(Comments and suggestions are hightly respected)

Inital steps - 1: Board for Industrial and Financial Reconstruction (BIFR)

What is it about?

In 1981, the Governement of India set up a committee headed by Mr. Tiwari to suggest a comprehensive legislation to deal with the Industrial Sickness prevailed in the economy. Based on its report (submitted in 1983), the GoI enacted the Sick Industrial Companies Act in 1985 (SICA) and set up the  Board for Industrial and Financial Reconstruction (BIFR) in 1987 with the objective of determining (early) the sickness and expedite the rivival of potentially viable firms and closure of unviable firms.  It was expected that by rivival the idle investments in the viable firms will become productive and by closure the locked up investments in unviable firms will find their productive uses elsewhere.

What does it provide?

It works on the provision of timely detection of sick and potentially sick industrial companies, speedy determination and enforcement of preventive, remedial and other measures with respect to such companies. They do provide the legal protection for the speedy revival of viable and closure of the unviable firms. It facilitates the required financial assistance and also provides the managerial expertise.

What is the eligibility criteria?

• Firm to be reported to BIFR under SICA should be 5 years old after the incorporation.
• Accumulated loss of the firm has to be equal or more than its net worth (paid-up-capital + Reserves).
• Firm's workforce should exceed the minimum of # 50.
• It should have the legal status for its existance (license).

Curtesy of BIFR