Low brokerage alone will not bring investors

My interview in Business Line yesterday. Since this is based on a face-to-face interaction, I have been quoted in brief. I am reproducing the article with some additions to clarify what I mean:

The regulator has made a major disservice by making exchanges ‘for profit’ organisations. — Anand Tandon, CEO, JRG Securities 

The Government and capital market regulator SEBI’s effort to attract retail investment in equities has had little impact. Retail investors have incurred huge losses in the last few months. Even as broking firms are trying to woo retail investors with low brokerages, exclusive research reports and stock recommendations, the wild swing in the stock market has scared retail investors. The capital market is dominated by foreign institutional investors and domestic institutions, and needs a major overhaul to gain investors’ trust, says Anand Tandon, CEO, JRG Securities, in an interview with Business Line.  

Excerpts:

Why are retail investors shying away from market?

It is actually a simple problem, but also extremely complex. It is simple, because an investor will invest if there is a chance of making money. If eight out of 10 times he makes money, the possibility of losing twice is acceptable. On the other hand, if you loses eight times and make money just twice it is not acceptable, even if you hit a jackpot twice and cover up all the losses. Essentially, retail investors have not made money.

What has changed dramatically for small investors in the market?

Intense competition. In fact, the regulator has made a major disservice by making exchanges ‘for profit’ organisations. The original function of exchanges was to provide people access to capital. As opposed to that, today, as a ‘for profit’ organisation, exchanges provide liquidity pools. In the process, they create their own transaction charges. With new exchanges coming in, there is no proportionate increase in liquidity. The liquidity pool is getting divided. So, there is more and more illiquidity.

What is the impact on market intermediaries?

The competition among exchanges will have a trickle-down effect on market intermediaries. Some 20 years ago, one had to shell out Rs 4.5 crore to become a BSE member. Today, you do not even need Rs 45 lakh. An investment of Rs 4.5 crore would have become Rs 20 crore, even if it was invested in a safe product. But by bring in more exchanges, you have to pay Rs 10 lakh deposit, and become a trading member. Essentially, my investment of Rs 4.5 crore 20 years back, is equivalent to Rs 45 lakh today.The entry barriers are lower, resulting in poorer quality of new members

But competition is good for investors …

It is true to a certain extent. However, If there is such a plethora of intermediaries in the market, clients will be induced to trade more. Effectively, the market will become more short-term in nature. Providing a quality service will become a big challenge. If my competitor is willing to provide a trading account for free, I will need to match it. Of course, the compliance cost has gone to the roof.

We have to provide the infrastructure, dealing terminals, telecom backbone, and watch through every trade and keep records for eight years. The return I get is decided by the next door mom-and-shop competitor. I feel we have got into this vicious trap of over capacity. Consequently, brokerages have gone to the suboptimal level. There is no incentive for providing advisory services which will benefit investors.

What is the remedy?

In the interest of banks, the RBI can restrict banks from competing on certain services offered by them. Public insurance companies are not allowed to under cut. The Aviation Ministry, which has no business of regulating tariff, can express its concern to airlines about under cutting prices. Why does SEBI not monitor the fees charged by intermediaries, so that service quality is maintained?

Lower charges are beneficial for investors. Isn’t it?

No, not always. Take the case of the power sector. All the companies have bid the lowest price at which they can supply the power. Now, they are struggling to fulfil their commitment. Lowering brokerage charges alone will not bring retail investors back. There was a time when you could not charge more than 2.5 per cent.Now, even 2.5basis points is difficult to retain. Development of the market cannot be done in the absence of intermediaries.

Electronic currency can potentially take away the ability of central banks to control money

My column on Bitcoins that appeared in the "Poke me" section of economic times.

The unedited version (less dramatic) is below.

The future of money

Have you ever redeemed your credit card loyalty points to purchase a product of your choice? Or converted air-miles received as a frequent flyer to get some free tickets? If you have, you have already been exposed to virtual, electronic money. After all, a key purpose for money to exist is to function as a medium of exchange. These loyalty points serve the purpose of allowing you to exchange them for tangible goods and services.

When we carry out any of the above transactions, we do not see it as an alternative currency. The loyalty points can typically be exchanged for a limited set of goods, and are not universally acceptable. But what if they were? What if they worked as electronic money and were widely accepted?

Fiat money – a promise to pay backed by “confidence”

In a “Fiat Money” system – on which all contemporary economies are based, the notion of money - often represented by currency notes - is based on “confidence” that users have on the issuing authority. With no real assets backing the currency notes, issuers can issue as many notes as they want. However, economic growth cannot be assured by just printing money – it must come from higher production of goods and services. Consequently, if an issuer continues to “print” money, it will fall in value compared to other currencies or commodities.

One way to increase confidence is to back up fiat money by another commodity. Gold served as money for centuries, before it was replaced by “representative money” – where paper (representing the underlying commodity) could still be redeemed for gold. This changed in 1971 – when conversion was disallowed by the USA. Since then fiat money has been the basis of most transactions the world over.

Bitcoin – digital currency

All currency systems so far have required an issuing authority – with the ability to issue or destroy currency. In 2009, a yet unknown programmer using the pseudonym Satoshi Nakamoto published a proof of concept of a crypto-currency called “Bitcoin”. As the website (bitcoin.org) explains “building upon the notion that money is any object, or any sort of record, accepted as payment for goods and services and repayment of debts in a given country or socio-economic context, Bitcoin is designed around the idea of a new form of money that uses cryptography to control its creation and transactions, rather than relying on central authorities.”

Interested readers can study the specifics in detail at the website, but in summary, a user can create an online “wallet” and receive and pay bitcoins from it. All data (including transaction data) is stored in a distributed environment on the web. Since there is no issuing authority, the algorithm for generation of new bitcoins fixes the total number that will ever be in circulation.

Transaction ease is tremendous – there are no transaction charges (or very small ones), payments are easy to make and receive – like sending e-mails. In effect there are no political boundaries, no bank holidays and no one to censor who can receive or make payments and for what.

With reportedly only one breach which was sorted out, the system seems to offer sufficient security for people to have “confidence” in it. Bitcoins can be exchanged for regular currency at an automated price discovered basis transaction history. At present, the bitcoin website reports that daily transactions exceed $1mn per day distributed over 40,000 transactions. 

Why now?

So what makes bitcoins attractive in the current market context – and popular they clearly are (see graph of USD vs bitcoin over the past 1 year).

 

The key driver for popularity of bitcoins is risk that investors face in the current global economic environment, with central banks engaged in competitive devaluation of currency, and large financial institution risk remaining unmanageable.

Imagine if the depositors in Cyprus’ failed banks had, been holding their money in the form of bitcoins instead of holding their deposits in Euro. The Cyprus government, and European “troika” that forcibly took away almost 60% of the deposits would not have been able to get their hands on the money.

Investors have, over the past few years been using Gold and Silver as a portfolio insurance against currency devaluation and systemic risks of financial markets. However, like money, gold and other precious metals too are available to governments to usurp – and therefore, in a Cyprus like situation, are not adequate security. Bitcoins are however not accessible at a single location and, like the internet, cannot easily be controlled.

Bitcoins - the glitches

So long as bitcoins are used as a medium of transaction or as a store of value, it is highly likely that their popularity will grow. Questions arise on how governments would react – will bitcoin transactions be taxed for example?

Bitcoins offer total anonymity. One can have as many accounts as one wants. With smooth transition across borders without the use of banks, bitcoins have the ability to facilitate illegal transfer and transactions. The fact the governments’ are waking up to the emergence of online currencies is affirmed by a new law passed by the US government in mid March. It now requires that transactions more than $10,000 need to be reported.

Lastly, if its popularity rises, it will not take long for markets to start offering derivatives and structured products around it. With no regulatory framework, that would mean risk rise manifold. Despite these obvious road blocks, markets needs to look at this innovation carefully. The challenge that it throws to established order of central bank controlled currencies will, over time, lead to a re-examining of the very concept of money.

The Promise of Power

My latest article on nuclear power written for wealth insight

Nuclear power has been projected as the energy on which future growth will depend. But, it's neither feasible nor desirable...

Earlier this month, I had the opportunity to attend the book launch of "The Power of Promise" by MV Ramana. The book discusses Nuclear Energy in India and its outlook – a subject that needs greater public debate. In the context of an energy deficient India, nuclear power has often been projected as the panacea, the energy fount on which future growth of the economy will depend. The case for nuclear power is based on two major argument (a) it is cheap (b) it is non polluting and abundant.

Marshalling rare facts from a secretive nuclear establishment, Ramana argues that nuclear power as a major source of India's energy plan is neither feasible nor desirable.

Nuclear power: more expensive than coal
In 2003, an interdisciplinary study by researchers at MIT came to the conclusion "In deregulated markets, nuclear power is not now cost competitive with coal and natural gas". This study was updated in 2009. The conclusion remains: "the prospects for nuclear energy as an option are limited, the report finds, by four unresolved problems: high relative costs; perceived adverse safety, environmental, and health effects; potential security risks stemming from proliferation; and unresolved challenges in long-term management of nuclear wastes."

Ramana's conclusion is similar. He compares cost of power generated from coal to that generated from nuclear plant – using assumptions that are grossly in favour of the nuclear alternative. He assumes that coal fired generators last a decade less than nuclear reactors, have to pay more for fly-ash disposal (they don't). Simultaneously, the radioactive waste disposal in nuclear power plants is supposed to cost only 2 paise per unit (it will likely cost a lot more). Additionally, he assumes that coal travels 1,400 kms to reach the power plant (over 33 per cent of coal fired generators are either at the pit head or increasingly near ports where the coal can be imported). Despite all these assumptions, at any cost of capital over 4 per cent, coal based power generators are cheaper than the nuclear alternative on the basis of levelised tariffs.

Safety: a significant concern
None of the above factors in the cost that needs to be paid for security, and potential health issues. It is pertinent to note the response of various government departments with regard to preparedness in case of nuclear accidents. While reacting to the Parliamentary standing committee discussing the nuclear liability bill, the ministry of water resources remarked "The Secretary, water resources, was of the opinion that any nuclear incident may induce radioactive contaminations in surface, ground water bodies, and other water resources. However, he stated that the Ministry does not have any facility for testing water quality".

The Secretary, Ministry of Health and Family Welfare while deposing before the Committee mentioned that her Ministry is "nowhere (ready) to meet an eventuality that may arise out of nuclear and radiological emergencies." She further mentioned that while drafting the Bill the Department of Atomic Energy did not consult them. She added: "Since the response system to deal with any kind of emergency of such type, the hospitals are not well-equipped, it is natural that mortality and morbidity due to multiple burn, blasts, radiation injuries and psycho-social impact could be on very high scale and medical tackling of such a large emergency could have enough repercussions in the nearby areas of radioactive fall out."

Proponents of nuclear power maintain that the likelihood of a nuclear accident remains remote – not so. Incidents like the recent accident in Japan illustrate that the best systems are prone to failure and in a densely-populated country like India, can lead to disastrous consequences. As Ramana pointed out in his speech – if the manufacturers are really so confident of their equipment being safe, why are they insisting on shielding themselves from nuclear liability – clearly there remain a real and non-trivial risk of nuclear disaster.

Is the DAE plan feasible?
In 1964, Bhabha stated "There is little doubt that before the end of the century, atomic energy will be producing a substantial part of the power in India, and therefore practically all the addition to our power generation will come from it at that time". In 1972, Homi Sethna, chairman AEC, predicted that India would have 43GW of nuclear generating capacity by 2000. In reality, in 2000, India had 2.7GW.

In September 2009, the PM stated that India will have 470 GW of nuclear power capacity by 2050. To put this in perspective, out of the total generation of over 200GW in India, less than 5GW is currently nuclear. Can we really expect almost a 100 fold increase in nuclear power generation capacity over the next 40 years?

India's plan for rapid growth of nuclear power is contingent on using fast breeder reactors (FBR). FBR's generate plutonium and are supposed to provide fuel for the next reactor – a sort of chain reaction allowing unlimited amounts of fuel! However, Ramana's analysis reveals that when adjusted for the time taken for a reactor to generate enough fuel to power up the next, the theoretical rate at which reactors can be built, reduces by 60 per cent of what the DAE estimates. In other words, "a fast growth of breeder reactors is not even theoretically, let alone practically, achievable."

Rosier in the future
As with many government estimates, the future seems rosier than history would suggest. A recent example is the criticism that the government's economic mandarins are reserving for CSO's advance GDP growth estimate of 5 per cent for 2012-13. Responding to the CSO's decade low figures, the Deputy Chairman of the Planning Commission reacted "I think it (growth projection of 5 per cent in 2012-13) is very low. I have been told that CSO has taken data from April to November (2012-13) and they just projected it (advance estimates)". Hasseb Drabu's comment is worth noting - "The sources and methodology adopted by the CSO are laid out by the System of National Accounts 2008, the latest version of the international statistical standard for national accounts, adopted by the United Nations Statistical Commission (UNSC). ...In this context, it will be enlightening to know which system of national accounts in the world is not based on past data. Also, what other data can official national accounts possibly be based on?"

There cannot be a better time to warn of rosy projections based on views, not data, as we enter the Budget Session. As investors, we need to keep assumption firmly rooted to reality. And yes, India's quest for renewable energy needs to be strongly focussed on the solar option – where paradoxically, the government plans to impose an additional import duty!