#308 Of Arbitrage

The Jane Street Saga, US Government Buys Equity in a Rare Earth Magnets Firm, and the Used Cooking Oil Fail in India

India Policy Watch #1: Jane And The Art Of Option Trading

Insights on current policy issues in India

—RSJ

Earlier this week, I received a few messages suggesting I write about the action taken by the Indian market regulator, SEBI, debarring Jane Street (JS) from the Indian securities market.

Here’s the relevant excerpt from the interim order:

“JS Group was undertaking an intentional, well planned, and sinister scheme and artifice to manipulate cash & futures markets and hence manipulate the BANKNIFTY [Indian bank stocks] index level, to entice small investors to trade at unfavourable and misleading prices, and to the advantage of the JS Group.”

According to the SEBI order, Jane Street was manipulating the Nifty Bank (BANKNIFTY) index by building aggressive long positions in the cash and futures market close to the day the index options expire (usually Friday, the day the weekly cash-settled options on the BANKNIFTY index expired). Simultaneously, it would take significantly larger short positions in the highly liquid options market of the same index. That is, it would actively trade BANKNIFTY puts and BANKNIFTY calls that were 6-7 times higher than their intervention in the underlying cash and futures market. Now, the cash-settled index options market is far more liquid than the market for underlying shares. So, Jane Street buying BANKNIFTY shares in the morning of a Friday pushed up their prices quite easily because this is an illiquid market. Then it sold 6-7 times this value worth of options, whose price had moved up in line with Jane Street buying the shares, to unsuspecting retail investors who flocked in thinking the price was moving up on an expiry day. Later in the afternoon, it sold the large block of shares it bought in the morning, pushing down the index prices, thus making a loss for itself on this trade. But the lowered prices allowed it to make a killing on the options it had actively traded in the morning. It either bought them back or let them expire at those lowered prices in the afternoon. On the balance, it lost a small sum trading the actual shares and made 7x the profit on the options trade. SEBI believes this is manipulation; Jane Street thinks of it as an arbitrage trade that’s done by everyone on a daily basis that makes the market more efficient.

Listen, all of this is quite complicated, and all I’m interested in is analysing the regulatory response and its implications. This case is an important test for market integrity and investor protection in India. But it’s difficult to write about that without simplifying this trade in layman’s terms. So, let me briefly attempt that first and then move to the broader systemic points I have in mind. This is a hugely simplified explanation of the concepts and the events that triggered SEBI’s ban on Jane Street for manipulating BANKNIFTY.

Many banks are listed on exchanges in India. Investors can buy or sell the shares of any of these banks. Investing in a single stock is risky for an average retail investor with a regular day job. I mean that is why mutual funds exist. To make life simpler for investors, exchanges create indices where they club a set of stocks from a particular industry and offer investors the opportunity to invest in the index instead of a specific stock(s). So the BANKNIFTY index is a basket of 12 bank stocks with different weightages available for investors interested in investing in the Indian banking sector without taking an outsized bet on a single bank. Now, to complicate things a bit, let’s introduce the idea of an option here. As an investor in a stock, one of the things you are afraid of is its price falling dramatically below what you paid for it. It would be nice to have a hedge against this risk. On the other hand, you might believe quite strongly that a stock might go up sharply in the next month but you don’t have enough capital to buy that stock. It would have been nice to have a mechanism where you could indulge in this speculation of yours by betting a small amount of money. Over time, this natural need for hedging or speculation created a separate market for another instrument called an option.

How did this work?

If you owned one share of company XYZ that was currently priced at ₹1000 and feared its price would fall sharply in the next two weeks, you now had the “option” of hedging for this possible loss. You could buy a “put” option that was being offered by an entity (let’s call it a market maker) for the price to fall to ₹900 (this is called the strike price) that would expire in two weeks. The price of buying this option (called the premium) is, say, ₹20. Now, the share price of XYZ falls to ₹800 at the end of the two weeks. You have lost ₹200 because of the fall in share price. However, you had bought an option at the strike price of Rs. 900. Now that the share price is ₹800, you gain ₹100 on the option trade. And you had paid a premium of ₹20 for it, so your net gain from the option trade is ₹80. So, instead of losing ₹200 because of the fall in share price, you now lose ₹120 because you hedged by buying an option at the strike price of ₹900. If the price fell only to ₹950, you would only lose the premium you paid, that is ₹20 on the option trade.

You could work out a similar calculation with an example where you think the price of this stock will move up sharply in two weeks but you don’t have ₹1000 to buy another share. Instead what you can do is to buy a “call” option for strike price of ₹1050 at a premium of ₹30 for an expiry period of two weeks. So you only shell out ₹30 to participate in a trade where you believe the price of the stock will move up. At the end of two weeks, the share price rises to ₹1120. You make a gain of ₹70 (₹1120 minus ₹1050) for your call option that costs you ₹30; so your net gain is ₹40 on an investment of ₹30 (133% return). Contrast this with having to buy the share at ₹1000 (you didn’t have that kind of money) and then selling it at ₹1120 and making ₹120 on an investment of ₹1000 (a 12% return). If the share price only rose to ₹1040, you would lose only the premium of ₹30. It makes the speculation worth it.

As you may notice with these two examples, there are multiple benefits that the option trade brings in. First, more participants can enter the market without holding the underlying shares. This increases the information content of the market. Second, more participants and more information lead to better price discovery of the share than fewer participants. The market efficiency improves because of this. Third, it allows players to hedge their risks, leading to greater confidence in participating in the market for the long run. Lastly, more participants can now afford to enter the market by just paying the option premium, improving the liquidity in the market, which further attracts more participants because of the ease of getting in and out, thus deepening the market.

A “market maker” like Jane Street facilitates this by being a nodal entity that’s available to buy or sell options instead of individual buyers and sellers looking for each other. Typically, Jane Street would charge a small sum for its role as a market maker from those who trade with them and may make some small profit from holding or trading the options themselves. As a market maker, Jane Street isn’t expected to move the market in any direction since all it is doing is facilitating trade. But this isn’t always enough. Because the options market has more participants (because of the low cost of entry) and more information, there’s always a difference between an option's price and the corresponding share's actual price. This is an arbitrage opportunity that exists for a very short duration, and it gets quickly filled up or bridged because it’s available for everyone to exploit. Firms like Jane Street have built proprietary trading platforms that use high-frequency trading algorithms to exploit this arbitrage faster than others and make profits. This isn’t illegal. In fact, quickly closing out the arbitrage makes the underlying market more efficient.

Now, the crux of the dispute that will be fought in courts between SEBI and Jane Street is whether what JS did was arbitrage or market manipulation. The usual assumption is that the markets or indices are way too large for any single firm to influence their direction by its own trade. I mean, there will always be an impact of a single firm’s trade on the price of what is being traded, but it can’t be meaningful in moving the entire market directionally one way or the other. This is where things get interesting in India. When it comes to the cash and futures market, the Indian market is like what India is - a low-income country with few retail participants and a handful of credible stocks. A gully cricket batter with an average of 9. This makes it relatively shallow and illiquid. However, when it comes to options trading, India is Bradman with a test cricket average of 99.94. At different times, it accounts for 70-80 per cent of global volumes of equity options traded worldwide. It is oozing liquidity. The volume differential between the cash market and the option market is possibly 25x. How and why it got here, I will come to later. But this is what Jane Street used to its advantage. One Friday morning, it found the spread between the option implied price for the BANKNIFTY index versus the actual index to be around 1.6 per cent (which is huge). It went to work to exploit this arbitrage by buying the underlying stocks that constituted the BANKNIFTY. Because the real market is illiquid, this buying spree lifted the index. With the index moving upwards, it sold call options to retail traders while it bought put options. But this option trade was 15x bigger in quantum than the actual stocks it bought. In an arbitrage trade, this would have been the same quantum rather than 15x. Since the option market is huge (like 300x of the cash market) and liquid, it could absorb this trade without a material movement of price. Once the arbitrage was closed, Jane Street started selling the stocks it had bought in the morning during the close of the day. Since the market is shallow, its selling accounted for 25 per cent of the trade in the late hours of trading that day, pushing the BANKNIFTY down. It continued dumping and lowering the closing price, which meant it made 7x the profits on its put options.

For SEBI, this 15x bigger position in options trade isn’t an arbitrage play but a clear signal of knowing that the market is shallow and that any dumping by JS will lead to a downward movement of the index. This is manipulation. For JS, this is information available to all, and no one could guarantee that its buying or selling could directionally move the index one way or another. It took the 15x risk, and it paid off, so why blame it for manipulation?

My guess is Jane Street will lose the court battle. Imagine trying to convince a judge that you made ₹735 crore of profit in a single day through arbitrage. The simple question SEBI will ask is who did you profit from? Answer: retail traders. Where did the profits get booked? Answer: Singapore. That will be the end of the case. There will be some recovery of money, fines, bans, and JS will exit Indian markets for 3 years or so before making an entry again.

Which brings me to the broader issues that this saga raises.

The stark contrast in the liquidity of the cash and futures market and the options market. How can the options market be at various times much larger than the stock market itself? It should also come as no surprise that 91 per cent of retail traders lose money in options trades because they stand no chance when pitted against algo trading firms using HFT platforms. A simple explanation is that retail investors who have come into the market in large numbers during and after COVID-19 are the younger and more tech-savvy lot who love to gamble and use the enormous leverage from options. Since other gambling options are banned and betting on options is made easy and frictionless with various fintech apps, intraday trading has become a favourite pastime in India. The easy availability of small-ticket unsecured loans in the past few years through NBFCs and fintech players further aggravated this. No one remembers the losses they have made on aggregate. There is always a story of someone who has made a killing and people live in hope that they will be the next to do so. Social media influencers and WhatsApp groups have perpetuated this myth. Indians have fallen hook, line and sinker to these manipulations, like they have in other fields too.

Separately, the regulations in India have worked in perverse ways to widen this gap. Back in 2018, SEBI made physical settlement for futures mandatory, which brought down their volumes. Futures move in line with the underlying stock and the loss in their volumes went directly to options. Intra-day cash leverage is also hard to come by, so you don’t get leverage in cash markets for intra-day trade. Options, by definition, allow retail investors to get this leverage. Also, in 2020, SEBI reduced the margin requirements for option spreads which further favoured options trade. The taxation system (securities transaction tax) is also skewed in favour of options because you pay tax only on the money you make beyond the strike price and not on the value of the trade itself (0.2% as it applies to a stock). That apart, Jane Street, like many other foreign traders in the Indian market, use their Singapore subsidiary (with whom we have a tax treaty) to do the option trading (where they make profits) while they book their cash market losses in the Indian entity. Following the SEBI report, we have the familiar spectre of Income Tax authorities looking at these transactions and structure and we might have all kinds of violations that will now be fitted retrospectively. This will then apply to other traders too and put the whole option trade driven by foreign firms at risk. This is an Indian speciality where, after a mishap, the regulators, tax authority, and every other government body go into an overdrive of finding all kinds of violations using the Byzantine maze of regulations and advisories that are extant. We see this now in aviation after the Air India crash, about which Pranay has been writing in the past few editions. The other regulatory issue is what kind of intra-day position limit on individual traders can be applied to avoid a Jane Street kind of situation on a particular day. And on a more systematic basis, it should also consider having some cap on the ratio of total positions on index options to the total positions held in the underlying stocks in the index. It should be some reasonable number and not 300, as it was in this case.

We have a scenario here where SEBI has allowed options to trade like it does in a super mature market, while the underlying stock market is still rooted in the reality of India, which is some distance behind. It would be useful for SEBI to work on both sides of this equation. It should ask what it can do to deepen the cash and future markets as one of the lessons from this event. And work to temper the froth that’s built up in the option market without overdoing it and killing a market that serves an important purpose.

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Global Policy Watch: The US Makes a Rare Move

Global policy issues relevant to India

—Pranay Kotasthane

The many posts in this newsletter on the rare earth magnets (REM) saga have made three points. One, China’s REM dominance is overrated as a strategic leverage; the more it exercises economic coercion, the more it will end up creating non-China alternatives. Two, China’s current restrictions are qualitatively different from the previous ones, as they now have a formal bureaucratic enforcement structure. Even if China starts awarding export licenses generously, it will now have the mechanism to reinstitute controls as soon as the next geopolitical crisis happens. Thus, companies are now incentivised to move away from China even if there’s a REM truce in the US-China trade talks. And three, China’s REM dominance isn’t a result of some pioneering technological capability or manufacturing excellence, but a result of the economic incentives in China. If similar economic incentives change elsewhere, they too can become viable alternatives.

It now seems the motors of REM production have begun moving. Earlier this week, the US Department of Defence (DoD) signed a rare equity deal, picking up a 15 per cent stake in MP Materials, a rare earth miner based in Mountain Pass, California. With that, DoD will become its largest shareholder. This investment will be used to build a “10x” facility, to be operational by 2028, and is expected to produce 10,000 tons of REMs, an order of magnitude higher than the current annual estimate of 250-750 tons.

And that’s not even the most interesting part of the deal. Also signed is a “10-year agreement establishing a price floor commitment of $110 per kilogram for MP Materials’ NdPr products stockpiled or sold, reducing vulnerability to non-market forces and ensuring stable and predictable cash flow.”

This is a key intervention. Earlier efforts to diversify away from China failed because of the fears that a subsequent glut of Chinese REMs could flood the markets, eliminating all financial upside. That kept investors away. But China’s aggressive use of economic coercion in the current round changed the calculus. As I wrote before, institutionalising these controls makes it evident that a future disruption is guaranteed even if China agrees to resume exports. The price floor commitment proves governments are intervening to plug this market failure.

We shouldn’t forget there are several unintended consequences associated with this move. American taxpayers will be paying for the mining, which was more efficiently done outside the US. Since the government has given a procurement commitment that it will ensure 100% of the magnets produced at the new facility will be bought by defence and commercial customers, American buyers will have to contend with domestic purchase mandates, which could make their products uncompetitive, should Chinese REM makers glut the market once again. Consumer prices will increase. There’s also the problem of the government picking up equity in a private business and all the associated problems.

Nevertheless, China is an international market failure, and governments will intervene in new and economically inefficient ways to counter it. They will start using variations of the instruments China has been using thus far to acquire disproportionate power. That’s what happens when a dominant player starts abusing its market power. There’s more to come.

P.S.: Reports suggest that the Indian government is also mulling a subsidy scheme for REM manufacturers who do end-to-end processing from rare earth oxides to magnets in India.

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India Policy Watch #2: A Lost Opportunity

Insights on current policy issues in India

—Pranay Kotasthane

Earlier this week, Tim Harford’s FT column titled The law of unintended consequences strikes again caught my eye. It’s a classic perverse incentive story featuring jet fuel, subsidies, and oil.

Cooking oil is used to make sustainable aviation fuel. Moreover, used cooking oil (UCO) commands a premium for this purpose because a jet fuel maker in Europe also gets environmental greenie brownie points for sustainable use. UCO is the oil that’s left after you have cooked food in it four or five times; thereafter, it is no longer suitable for cooking but can be used as a fuel. This reuse helps reduce the environmental footprint of aviation. And so, UCO is in great demand.

Now, Malaysia produces a lot of palm oil, and its government has an oil subsidy programme. Hence, the new oil's market price is less than UCO's trading price. So, smart Malaysians in Melaka started buying this subsidised oil and selling it as UCO without going through the pain of cooking food with it! This arbitrage created a moral hazard. Instead of the proposed plan to reuse the oil that would have gone down the drain, there’s now additional demand for new palm oil, which implies more deforestation and negates the goal of sustainability.

The obvious next question was: Why aren’t Indians playing this game? India consumes a lot of oil, so why aren’t we selling new oil as UCO to aviation fuel makers? The main reason is that, unlike Malaysia, new cooking oil is way more costly than UCO. So there’s no way that people will buy oil only to sell it to jet fuel makers. This is a desirable result and points to the flaws of Malaysia’s subsidy regime.

But the follow-up question is, why is India not a huge exporter of the legitimate UCO? India, anyway, has a significant oil problem—UCO in India is really ACO (Abused Cooking Oil). There’s an entire underground network which enables restaurants to sell their UCO to roadside stalls, which keep reheating this oil well beyond its permissible capacity to prepare their own products. This ACO has several harmful health effects: atherosclerosis, hypertension, liver diseases, and Alzheimer's. Thus, selling the UCO to make jet fuel would not only be helpful for the sellers but also have positive health effects for India.

Then why isn’t it happening? The main reason is the high price differential between new cooking oil and UCO. There’s high demand for UCO from small restaurants and roadside stalls because buying new oil is nearly twice as costly. Thus, they prefer reusing unhealthy UCO over and over again. The price differential is high because India imposes high import tariffs on cooking oil to “protect” domestic farmers who supply 40 per cent of India’s demand. The low domestic oil production is further a result of India’s skewed Minimum Support Price (MSP) system, which keeps the agricultural land locked for grains.

The net outcome is that small shops avoid new cooking oil altogether. Instead, there is a high local demand for the far cheaper, unhealthy UCO for cooking. This demand raises the prices of UCO in India beyond what a jet fuel maker would be willing to pay. And so, we end up in a low-level equilibrium where there is a thriving market for UCO, not for making jet fuel but for repeated cooking.

A government serious about tackling this problem would decrease import tariffs on oil, incentivise UCO collection and aggregation infrastructure, and educate about the harmful effects of reheating oil beyond the permissible iterations. But for once, we have lost to the Malaysians in an arbitrage game.

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HomeWork

Reading and listening recommendations on public policy matters

1. [Podcast] In the next Puliyabaazi, we rate social and policy phenomena as overrated, underrated, or complicated. Listen in.

   बोल बच्चन, छुपा रुस्तम या पेचीदा? Overrated, Underrated, Complicated!

2. [Article] Read Matt Levine’s Bloomberg column on the Malaysian Fryer Oil Arbitrage.

3. [Blogpost] The Urbanomics blog has a great post on the twin global structural imbalances.

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