finance – Page 4 – Pertinent Observations

Direct listing

So it seems like Swedish music streaming company Spotify is going to do a “direct listing” on the markets. Here is Felix Salmon on why that’s a good move for the company. And in this newsletter, Matt Levine (a former Equity Capital Markets banker) talks about why it’s not.

In a traditional IPO, a company raises money from the “public” in exchange for fresh shares. A few existing shareholders usually cash out at the time of the IPO (offering their shares in addition to the new ones that the company is issuing), but IPOs are primarily a capital raising exercise for the company.

Now, pricing an IPO is tricky business since the company hasn’t been traded yet, and so a company has to enlist investment bankers who, using their experience and investor relations, will “price” the IPO and take care of distributing the fresh stock to new investors. Bankers also typically “underwrite” the IPO, by guaranteeing to buy at the IPO price in case investor demand is low (this almost never happens – pricing is done keeping in mind what investors are willing to pay). I’ve written several posts on this blog on IPO pricing, and here’s the latest (with links to all previous posts on the topic).

In a “direct listing”, no new shares of the company are issued, the stock gets listed on an exchange. It is up to existing shareholders (including employees) to sell stock in order to create action on the exchange. In that sense, it is not a capital raising exercise, but more of an opportunity for shareholders to cash out.

The problem with direct listing is that it can take a while for the market to price the company. When there is an IPO, and shares are allotted to investors, a large number of these allottees want to trade the stock on the day it is listed, and that creates activity in the stock, and an opportunity for the market to express its opinion on the value of the company.

In case of a direct listing, since it’s only a bunch of insiders who have stock to sell, trading volumes in the first few days might be low, and it takes time for the real value to get discovered. There is also a chance that the stock might be highly volatile until this price is discovered (all an IPO does is to compress this time rather significantly).

One reason why Spotify is doing a direct listing is because it doesn’t need new capital – only an avenue to let existing shareholders cash out. The other reason is that the company recently raised capital, and there appears to be a consensus that the valuation at which it was raised – $13 billion – is fair.

Since the company raised capital only recently, the price at which this round of capital was raised will be anchored in the minds of investors, both existing and prospective. Existing shareholders will expect to cash out their shares at a price that leads to this valuation, and new investors will use this valuation as an anchor to place their initial bids. As a result, it is unlikely that the volatility in the stock in initial days of trading will be as high as analysts expect.

In one sense, by announcing it will go public soon after raising its last round of private investment, what Spotify has done is to decouple its capital raising process from the going public process, but keeping them close enough that the price anchor effects are not lost. If things go well (stock volatility is low in initial days), the company might just be setting a trend!

People are worried about investment banker liquidity

This was told to me by an investment banker I met a few days back, who obviously doesn’t want to be named. But like Matt Levine writes about people being worried about bond market liquidity, there is also a similar worry about the liquidity of the market for investment bankers as well.

And once again it has to do with regulations introduced in the aftermath of the 2008 global financial crisis. It has to do with the European requirement that bankers’ bonuses are not all paid immediately, and that they be deferred and amortised over a few years.

While good in spirit what the regulation has led to is that bankers don’t look to move banks any more. This is because each successful (and thus well paid) banker has a stock of deferred compensation that will be lost in case of a job change.

This means that any bank looking to hire one such banker will have to compensate for all the deferred compensation in terms of a really fat joining bonus. And banks are seldom willing to pay such a high price.

And so the rather vibrant and liquid market for investment bankers in Europe has suddenly gone quiet. Interbank moves are few and far in between – with the deferred compensation meaning that banks look to hire internally instead.

And lesser bankers moving out has had an effect on the number of openings for banker jobs. Which has led to even fewer bankers looking to move. Basically it’s a vicious cycle of falling liquidity!

Which is not good news for someone like me who’s just moved into London and looking for a banking job!

PS: speaking of liquidity I have a book on market design and liquidity coming out next month or next next month. It’s in the publication process right now. More on that soon!

Flash Boys, Ramanand Sagar’s Ramayana and the bias in the narrative

I just finished reading Michael Lewis’s Flash Boys. It seems like a nice book on financial markets and high frequency trading (HFT), and how HFT makes money. And as is the case with Lewis, the story is very well told.

However, having worked in HFT in the past, and having written a book on market design (which will be out next month), there was one thing about the book that left a massive sour taste – that it makes a value judgment.

Fairly early on in the book, Lewis makes it clear that HFT doesn’t actually add value to the market, and in fact extracts value. And from then on, HFT and hedge funds who practice it are the “bad guys” of the book, and Brad Katsuyama and the rest of the IEX guys are the “good guys”.

If this were to be considered a journalistic account, it would be horrible due to the fact that there is not even an attempt to present the view of the opposite side – of the real flash boys (people working on HFT), and how HFT might actually be beneficial. It also fails to document whatever might be the shortcomings of IEX.

As the Ramanand Sagar retelling of the Ramayana has showed us, when you reduce a story to a story of “good against evil”, the story is robbed of all nuance, and what you get is a rather simplistic version. Any facts in the story that run contrary to this simplistic version tend to be glossed over (or reduced in importance). And what the reader gets is a wholly one sided view which may not actually be correct.

HFT is so fascinating (apart from the money it makes for its practitioners) that there exists scope to write a great value-neutral book about it (and someone who writes as well as Lewis is very well placed to write that). It is thus disappointing that Lewis has eschewed that and has instead written what effectively looks like PR for IEX.

In any case, reading the book gave me one valuable piece of input. In my book (that will be out next month), I’m starting each chapter with a quote. And the quote to the introduction of the book has been supplied by Flash Boys. It goes, ‘”Liquidity” was one of those words Wall Street people threw around when they wanted the conversation to end, and for brains to go dead, and for all questioning to cease’.

Perhaps, the quote suffices to tell you all that is wrong with the book (Flash Boys)!

Tiered equity structure and investor conflict

About this time last year, I’d written this article for Mint about optionality in startup valuations. The basic idea there was that any venture capital investment into startups usually comes with “dirty terms” that seek to protect the investor’s capital.

So you have liquidity preferences that demand that the external investors get paid out first (according to a pre-decided formula) in case of a “liquidity event” (such as an IPO or an acquisition). You also have “ratchets”, which seek to protect an investor’s share in the company in case the company raises a subsequent round at a lower valuation.

These “dirty terms” are nothing but put options written by existing investors in a firm in favour of the new investors. And these options telescope. So the Series A round has options written by founders, employees and seed investors, in favour of Series A investors. At the time of Series B, Series A investors move to the short (writing) side of the options, which are written in favour of Series B investors. And so forth.

There are many reasons such clauses exist. One venture capitalist told me that his investors have similar optionality on their investments in his funds, and it is only fair he passes them on. Another told me that “good entrepreneurs” believe in their idea so much that they don’t want to even consider the thought that their company may not do well – which is when these options pay out, and so they are happy to write these options. And then you know that an embedded option can increase the optics of the “headline valuation” of a company, which is something some founders want.

In any case, in my piece for Mint I’d written about such optionality leading to potential conflicts among investors in different classes of stock, which might sometimes be a hindrance to further capital raises. Quoting from there,

The latest round of investors usually don’t mind a “down round” (an investment round that values the company lower than the preceding round) since their ratchets protect them, but earlier investors are short such ratchets, and don’t want to see their stakes diluted. Thus, when a company is unable to find investors who are willing to meet its current round of valuation, it can lead to conflict between different sets of investors in the company itself.

And now Mint reports that such conflicts are a main reason for Indian e-commerce biggie Snapdeal’s recent struggles, which has led to massive layoffs and a delay in funding. The story has played out exactly as I’d written in the paper last year.

Softbank, which invested last in Snapdeal and is long put options on the company’s value, is pushing the company to raise more funds at a lower valuation. However, Nexus and Kalaari, who had invested earlier and stand to lose significantly thanks to these options, are resisting such moves. And the company continues to stall.

I hope this story provides entrepreneurs and venture capitalists sufficient evidence that dirty terms can affect everyone up and down the chain, and can actually harm the business’s day-to-day operations. The cleaner a company keeps the liabilities side of the balance sheet (in having a small number of classes of equity), the better it is in the long run.

But then with Snap having IPOd by offering only non-voting shares to the public, I’m not too hopeful of equity truly being equitable any more!

Upside down pricing in payment services

Some Indian banks charge for services that are cheap to execute, and offer for free expensive services

Last week I enddd up spending some time waiting at a teller counter at a bank. This was due to some mess up with a cheque I had received. During my time at the teller counter I had the opportunity to observe other people at the same counter.

There were a few people depositing cash into their business accounts. A few others were depositing cheques. What caught my attention, however, was this guy from a nearby business who came to deposit a large number of cheques.

He had an entire book of challan leaves (banks regularly issue those to business customers), to each of which was stapled a cheque. As I watched, the teller would put a seal on a cheque, its corresponding challan and another seal on the counter foil. This process was repeated for each challan in the book.

And this process was only to accept the cheques. Later on there would’ve been further effort on behalf of the bank to cash the cheque and actually execute the fund transfer. And then add in the effort of writing out all those cheques, writing out all those challans (they’re hard to print) and then take them to the bank.

It was a rather laborious process all round, on behalf of all parties involved. Yet, banks mostly execute this function for free for most customers.

On the other hand, they charge for account to account transfers, and the amount isn’t particularly small. Like this morning I was moving money from one account to another, a process that took me a minute and that wouldn’t have cost the bank any human minutes. And icici bank decided to charge me for it.

It seems like banks have their pricing and the valuation of their own effort all wrong. For electronic payments the cost is direct – what the banks have to pay the payments systems and any per use software costs. And this makes it easier to value and charge for such services.

The effort in transacting through cheques, on the other hand, is not directly measurable (though by no means an impossible exercise). There are back offices that do the job whose cost is easy to measure, but several employees who also do other things spend time processing cheques. And this difficulty in measurement means that most banks just don’t charge for cheques.

Around 2000 when foreign banks expanded their branch networks in india there was an attempt to charge customers for walking into the branch – customers were encouraged to do their business at ATMs or over the phone, instead. This was in recognition of the costs of customer walkins into branches.

Banks would do well now to do something similar for cheques as well – despite the cheque truncation system (CTS), the effort involved in organising payments through cheques is massive for the bank.

There is only one upside to cheques – and this is a downside for customers. Cheques result in money going into limbo. The payer doesn’t know when the funds will leave his account and can’t use the funds. The recipient can’t use it either until he has got it. So for the duration that the amount is “in transit” (and this duration can vary significantly) banks can happily use these funds without them being called.

It’s possible that the benefit to the banks from this float more than compensates for the pain of processing cheques. If not, cheques have no business existing any more!

India post payments bank

I’d once written about India Post Payments Bank, after a visit to a post office, and wondered if it will actually help foster financial inclusion. Now that the bank is about to launch, it seems to be doing some interesting thing, and mostly in terms of the intermediary it will be.

Being a payments bank, IPPB can only take deposits, and not give loans. It is trying to build a platform where it will simply act as a distributor for loans, and different lenders can make use of its customer transaction data and lend to its customers.

Also, since payments banks can only invest their deposits in government securities, the “float” is limited by the difference between the yield on such securities and the interest offered to depositors. Competitive pressures mean that the latter needs to be high, resulting in a thin float. Consequently, a payment bank needs to make money on payments and selling third party products such as investments insurance.

A recent interview with IPPB CEO Ashok Pal Singh gives some interesting pointers about how the bank might go about this. Firstly, the bank will dispense with the investment+insurance products, and will sell pure unbundled life insurance. The logic is that since the clientele is likely to be the hitherto unbanked, they will not be able to understand complicated products, and there is a high chance of misselling. By restricting product choice to those that are highly unlikely to be missold, the bank can ensure customer protection.

Similarly, in case of mutual funds, distributors have an incentive to recommend funds with high fees since they also tend to offer higher distributor commissions. Again, given IPPB’s clientele, the chances of mis-sale are high, and so the bank has decided to sell only index funds!

This is remarkable since index funds have hitherto been non-starters in India. Benchmark Mutual Fund had managed to establish a market, but a series of acquisitions has meant that the market hasn’t really taken off. Most financial advisors in India swear by actively managed funds. So a bank, however small, announcing that it will only sell index funds can give a massive boost to that market!

Apart from selling “simple” products such as term life insurance and index funds, the way the bank is going about the process is also interesting. Rather than tying up with a single provider of these products (as most other banks have done), IPPB plans to take the “broker” route and distribute products from different asset managers and insurers. This ensures that the rates remain competitive, though it is natural that the end salesperson might choose to sell products with the highest commissions/incentives. Nevertheless, with the products being inherently simple, the rates to the end customers are still likely to be competitive.

After over a decade of slumber, the RBI licensed a few (limited) banks last year. It is interesting to see the kind of diversity this new set of licensing has unleashed. Again goes to show that removal of barriers to entry can result in significantly better markets!

During his last few speeches, former RBI Governor Raghuram Rajan kept mentioning how full-service bank licenses will be soon “put on tap”. The sooner that happens, the better it is for Indian banking customers.

On holding stocks

I never understood one thing about investment analyst reports – the “hold” recommendation. This is “between” the “buy” and “sell” recommendations (which are self-explanatory), and it tells an investor to hold on to the stock if he already owns it, but not to buy if he doesn’t.

The problem with this is that the difference between buying and holding a stock is small, especially given the current efficiency of equity markets and consequent low transaction costs. The only difference between holding and not holding a stock is that in the latter case, you spend the transaction cost of buying the stock. That is all. Based on this, it is intriguing that the two have remained distinct analyst recommendations for ages now.

I can think of two possible explanations:

One can assume that the investor is fully invested (not holding any cash), and so buying a stock means that he has to sell something else in order to allocate capital to this stock. So in other words, the cost of getting the stock into you portfolio is higher than the trading cost itself – it comes in at the cost of another stock. With these increased transaction costs, it’s possible that it’s not worth buying the stock .
Analysts hate to admit it (look at the precision with which they dictate price targets), but there is a wide band of error around their estimates of what price the stock will trade at at some point of time in the future. So the buys are those that are much more likely to be trading up than the holds. So by saying “hold” you are saying “yeah this stock might go up, so I’m not so confident about it so don’t bother buying if you don’t have it already”.

But then there is this school of thought that says that analyst’s buy/hold/sell recommendations do not matter at all, and the value they add is in providing the investor access to the company’s management. Matt Levine has written plenty about this, and you should read his latest stuff on this.

Coin change problem with change – Dijkstra’s Algorithm

The coin change problem is a well studied problem in Computer Science, and is a popular example given for teaching students Dynamic Programming. The problem is simple – given an amount and a set of coins, what is the minimum number of coins that can be used to pay that amount?

So, for example, if we have coins for 1,2,5,10,20,50,100 (like we do now in India), the easiest way to pay Rs. 11 is by using two coins – 10 and 1. If you have to pay Rs. 16, you can break it up as 10+5+1 and pay it using three coins.

The problem with the traditional formulation of the coin change problem is that it doesn’t involve “change” – the payer is not allowed to take back coins from the payee. So, for example, if you’ve to pay Rs. 99, you need to use 6 coins (50+20+20+5+2+2). On the other hand, if change is allowed, Rs. 99 can be paid using just 2 coins – pay Rs. 100 and get back Re. 1.

So how do you determine the way to pay using fewest coins when change is allowed? In other words, what happens to the coin change problems when negative coins can be used? (Paying 100 and getting back 1 is the same as paying 100 and (-1) ) .

Unfortunately, dynamic programming doesn’t work in this case, since we cannot process in a linear order. For example, the optimal way to pay 9 rupees when negatives are allowed is to break it up as (+10,-1), and calculating from 0 onwards (as we do in the DP) is not efficient.

For this reason, I’ve used an implementation of Dijkstra’s algorithm to determine the minimum number of coins to be used to pay any amount when cash back is allowed. Each amount is a node in the graph, with an edge between two amounts if the difference in amounts can be paid using a single coin. So there is an edge between 1 and 11 because the difference (10) can be paid using a single coin. Since cash back is allowed, the graph need not be directed.

So all we need to do to determine the way to pay each amount most optimally is to run Dijkstra’s algorithm starting from 0. The breadth first search has complexity $latex O(M^2 n)$ where $M$ is the maximum amount we want to pay, while $n$ is the number of coins.

I’ve implemented this algorithm using R, and the code can be found here. I’ve also used the algorithm to compute the number of coins to be used to pay all numbers between 1 and 10000 under different scenarios, and the results of that can be found here.

You can feel free to use this algorithm or code or results in any of your work, but make sure you provide appropriate credit!

PS: I’ve used “coin” here in a generic sense, in that it can mean “note” as well.

Explaining UPI

I just paid my cook his salary for November. Given the cash crunch, I paid him through a bank transfer, using IMPS. Earlier today, my wife had asked him for his account details (last month I’d paid him on his wife’s account).

An hour back he sent me his account details (including account number and IFSC) via WhatsApp. I had to wait till I got home and got access to my laptop (Citibank app doesn’t let you add payees on mobile banking).

I get home, log in to Citibank Online. Add payee, which includes typing his bank account number twice. Get SMS asking me to confirm payee addition. I authorise payee. And after all this I am able to finally do the transfer – and I expect him to have got his money already.

For a long time I was wondering what the big deal with UPI was, given that IMPS is already fast enough. Having finally tried UPI earlier this week (it’s finally coming to iOS, but only available on ICICI now. And the implementation so far sucks, since you need to pull out your debit card for two factor authentication – defeating the point of UPI. I’m told it’s better on Android), I realise how much easier and safer the transaction would’ve been.

Firstly, the cook needn’t have sent me his account number. All I would need was his virtual payment address. I would then open my UPI app (in my case, iMobile) and click on “send money”. And then I’d add his virtual ID there, following which his name would appear. Two or three more clicks, and entering my PIN code, the transfer would be done.

No bank account number. Not even a mobile number or an email ID. Just a random string of characters would allow me to transfer money to him! And later I could give him my UPI ID, and next month onwards he could simply send me a request via UPI for his salary. And two clicks later it would be done!

Mint has reported that there are massive delays in merchants installing point of sale devices in response to the cash ban. Banks should instead seek to acquire merchants to accept money via UPI. It’s simple, it’s quick and it protects privacy.

In fact, if the bank sales staff now have bandwidth, it can be argued that all the planets have aligned for UPI to take off for merchant payments – people have less cash, point of sale devices are not available, and both merchants and shoppers have shown openness to cashless payments, and there is a push from the government.

If only the banks can bite…

Using my cook as an ATM

This happened ten days before high value notes were withdrawn, and suggests nothing about my cook’s political opinions or views.

On 30th October 2016, I paid my cook his salary for October. As it was the usual practice, I paid him in cash. He asked me if I could do an online transfer instead.

It was the first day of Diwali, and he needed to send money to his wife in Bihar. And it being Diwali, all banks were closed, and there was no way he could send money to her. So he asked me if I could do that. And if I were anyway transferring money to his wife’s account, could I send her a bit more, he asked – he would compensate me for the extra amount in cash.

And so like that I used my cook as an ATM. He gave me his wife’s account details (it was such an obscure branch that I’d to google it to find the IFSC code – wasn’t in citibank’s lookup list). I added her as a “payee” and immediately IMPSd the amount to her. And my cook gave me the extra funds I’d transferred in cash.

Later on, I told him to install his bank’s app on his newly acquired fancy phone (with a Reliance Jio sim). I’m not sure he’s done that but considering how resourceful he is, it wouldn’t be long before he does that. And more of the Bihari cooks network in Bangalore do likewise.

Nandan Nilekani, in his championing of the UPI, likes to talk about how “anybody can be an ATM” with the new technology. This was an exemplary example of that.

The only fly in the ointment was that I didn’t need cash that day – after all I’d been to the ATM earlier that morning just so that I could get cash to pay my cook – so I ended up with a lot of cash that I didn’t need. Thankfully I was able to spend it productively before the ceased to be legal tender.

Following the withdrawal of high currency notes, I told my cook I would pay his subsequent salaries by bank transfer. He gladly agreed.