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A curious irony
Sometimes curious ironies take place simultaneously in two different parts of the world.
In the USA, Sri Lankan-born billionaire fund manager Raj Rajaratnam was sentenced to 11 years in prison having been found guilty of engaging in a crime called ‘insider trading’ and amassing a net profit of US$ 72 million through that crime.
His prosecutors demanded the judge to keep him behind bars for 24.5 years and if any leniency is to be shown, to give him a minimum of 19.5 years. The length of the jail sentence demanded by the prosecutors is indicative of the seriousness of the crime, in the eyes of the US authorities, he is deemed to have committed.
The judge finally passed a sentence of 11 years on him which would keep the 54-year-old hyperactive investment manager virtually inactive for the rest of his life. Perhaps, like others who had been put to jail for similar felonies, he too might write a book whilst in the prison and make good on the monies he would have lost.
On the other side of the globe, in Raj’s birth country, share market regulators started to get tougher to eradicate what they had perceived as rampant prevalence of market manipulations and, according to reports, had even identified a few of the market players for engaging in illegal market practices.
The result was a widespread protest from ‘concerned investors’ for killing at a very young age a market which was just blossoming into adulthood. To prove them correct, the market activities too started to record historic downs in the recent few weeks, thereby wiping out billions of wealth which the market participants had accumulated as a group over a very brief period of just two years
Naturally, this was a matter of grave concern, making the angry investors, according to reports, ask for the head of the top regulator who they felt was the prime cause of the killing of the market at such a young age. There was a brief period of uncertainty and panic with regulators standing firmly on their ground refusing to yield. But finally the concerned investors won the battle for the day when it was announced that the concerned top regulator was to be removed from the job.
However, according to one business website, the top market regulator appears to have got a face-saving deal because he has been just ‘kicked upstairs’ to a position where he could now keep his head down and escape for the timebeing the wrath of the angry investors.
Insider trading: The crime in the share market
The crime which the US authorities fought tooth and nail and the Sri Lankan regulators set themselves to fight with new vigour is called ‘insider trading’. It is universally recognised as a crime committed against the market and therefore has been made illegal in the laws of all the countries which have started to regulate their share markets.
There is a near unanimity among the lawyers and the market best practice advocates that insider trading should be made illegal and eradicated. But there is no such unanimity among economists on the subject.
Those who believe that the markets are efficient and information is freely available to all market participants and therefore market prices reflect the changes in information feel that there is no necessity for such rules.
But those in the opposite camp, believing that markets are not necessarily efficient and there could be market manipulation by a few elite market participants at the expense of the rest, feel that there is a necessity for regulating the market to protect the small market participants from being exploited by so called elite groups.
Kautilya and Adam Smith: People needed to be protected from self-serving dealers
The Indian economist of the 4th century BC, Kautilya, belonged to this latter group: he said in ‘The Arthashastra’ that ‘merchants, artisans, craftsmen, nomadic mendicants, entertainers and similar persons are all thieves, in effect, if not in name; they shall be prevented from harassing the people’.
A similar sentiment was expressed by Adam Smith, father of modern economics, nearly 2,000 years later when he said in ‘The Wealth of Nations’ that the interest of the dealers is always to widen the market and narrow the competition.
While widening the market would help both dealers and people alike, narrowing the market competition helps only the dealers because it enables them to earn, by manipulating the market, a profit above what they would normally earn in a competitive arrangement.
According to Adam Smith, it is ‘an absurd tax upon the rest of their fellow-citizens’. He has further added that this demand ‘comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it’.
So, the popular demand is for the regulation of markets by authorities in the name of protecting the public, which, it is believed, does not happen automatically, but only when deliberate action is taken by governments.
Chulla Setti: The use of exclusive information to get rich
How could a market that satisfies the interests of different groups in a competitive manner get into such aberrations permitting one group of market participants to make excessive profits at the expense of the others? It is all to do with what is now known as ‘economics of information’.
Information on what has happened in the past, information on what is happening now and information on what would happen in the future are all vital for business success. Hence, like any other input that is used in business and enterprise, information is also demanded and people are prepared to pay for the correct type of information.
After securing information, like the up and coming businessman who arose from the gutters of the city, Chulla Setti, in the ‘Jataka’ story by the same name, there is a tendency for keeping that information exclusively for oneself in order to profit from even legitimate market dealings.
The young Chulla Setti, according to the ‘Jataka’ story, secured information on the firewood position in the king’s kitchen and managed to sell the fallen firewood from the king’s garden to king himself; here he played the game by creating an ‘Information Chinese Wall’ between the king’s gardener and the king’s chief cook.
When he secured information from the city’s traders that a shipload of horses was to arrive at the port shortly, he used that advance and exclusive information to get into forward purchase contracts with grass suppliers and sold the grass at the prices he had set to the merchants of horses. Not only that, he got into a wholesale deal with horse merchants and sold the horses to his own city folk at prices fixed by him.
But in the ‘Jataka’ story, Chulla Setti is hailed as a hero because he managed to elevate himself from rags to riches by sheer perseverance, hard work and business acumen. So, monopoly building on information and trading is a sure way to get rich quickly.
This is typical to share markets too.
Information too an input
A share market is composed of many investors, big and small, individual and institutional or retail and wholesale. All these people have only one goal: to make the maximum amount of money while avoiding making losses.
Since they buy and sell shares of companies, the health of the companies concerned and since they operate in an economy, the overall health of the economy concerned, are immensely vital for their trading operations. So, the market participants have an unquenchable thirst for relevant information, but if everyone in the market has that information, then, no single market participant can make money above the normal market profits which everyone can get. Hence, in addition to the demand they make for information, they make a demand for exclusive information too, like Chulla Setti in the ‘Jataka’ story.
Then, if they come to know a certain important piece of information, then they try to make that information exclusive to themselves to prevent the other market participants too from benefitting from it. This is because the share market has a peculiar market feature which other markets normally do not have. That is, for one participant to make super profits, he should necessarily make another market participant to make a similarly super loss at least in the very short run. Adam Smith called this imposing ‘an absurd tax on fellow citizens’.
Market decisions are economic choices
Hence, the share market operations are not pure financial or corporate activities. They are, like any other market, composed of market participants who make economic choices. All choices are made with a view to maximising the total satisfaction which economists call maximising the future expected return from a transaction.
Since the future is fraught with uncertainty, they make those choices by using all the relevant information and appropriately processing such information to correctly map out the future course of companies, markets and economies.
If everything goes according to their predictions, they make money. If it is better than the predictions, they make super money. If, on the other hand, it goes in the opposite direction, they make losses. If the market downfall is steeper, then they make super losses. So, every market participant tries to be in the first list rather than in the second list.
Then, by robbing information from a company, they can with certainty make super profits. If that is upheld by the society, why not make use of the facility to maximise gains?
The economic choice which a market participant makes in a share market is called ‘portfolio choice’ and that portfolio choice model has given birth to a new sub branch of economics called financial economics.
The credit for laying the foundation for this new subject goes to the Yale University Economics Professor Irvin Fisher who published in 1906 a book titled ‘The Nature of Capital and Income’. Fisher’s publication made several breakthroughs in the portfolio choice model: marrying it with economic theory, introduction of the scientific approach to share investment, the use of mathematics, specially the theory of probability in the choice of shares to be purchased and the prediction of the market behaviour by using statistical tools.
Rational market participants and rational markets
The subsequent economists refined what Fisher began into a whole economic theory that talked about the existence of an efficient share market.
This market has rational market participants who make rational decisions to make the best for them; they use all the information and process such information before making a choice; all participants know what happens now and in the future perfectly so that they cannot be fooled twice; since they act according to this market knowledge, the market behaviour is unpredictable and it is simply a random operation which has no clearly discernible pattern; if there is new information and everybody acts according to that new information, in the long run, market prices reflect changes in information; hence, no one can make super profits in a share market.
The random walk hypothesis
Two offshoots from this analysis which are related to each other are the random walk hypothesis and the efficient market hypothesis. The first says that stock market movements are random and when they are at one point today, they would be at a totally unpredictable point tomorrow.
The term has been coined from the movement of a drunkard who places one foot at one place and the other foot in a completely unrelated place to the first. Hence, if one maps up his walk, it would simply be on points which have nothing to do with each other. Hence, nobody can predict accurately where the drunkard would place next step just by looking at his past walk or where his foot is right now.
The implication of this analysis to the share market is that share market returns are normal, unpredictable and on average equal to what everybody gets. Hence, there is no possibility for making super profits.
The efficient market hypothesis
The efficient market hypothesis says that share markets are informationally efficient meaning that information is a common public good and what is available to one participant is available to others too. In other words, there are no Chulla Settis in share markets.
Since everybody has access to the same information set, share market prices fully reflect the changes in information. While there are many who have spoken of informational efficiency in share markets previously, this hypothesis was first presented in scientific form by Chicago University Professor Eugene Fama in 1960 in his doctoral dissertation submitted to the same university.
The efficient market hypothesis requires the presence in the market of rational people who maximise their utility or profits based on the formation of rational expectations about the future events. At any point of time, there can be one a few people who would make mistakes; but as a whole, the market is correct and no one is, therefore, able to manipulate the market and make super profits.
If markets behave according to the tenets of the efficient market hypothesis, then, it is not possible for a few market participants to exploit other participants. Since there is no necessity to give protection to vulnerable market participants, there is no role for the share market regulators. In such efficient markets, the presence of market regulators is unnecessary and irrelevant.
The historical evolution of the concept of efficient markets, its main critiques and where it stands today have been well elaborated by the free lance columnist and Editorial Director of Harvard Business Review Group, Justin Fox, in a publication made in 2009 under the title ‘The Myth of the Rational Market’. According to Fox, it is a delusion to expect rational behaviour in any of the share markets in the world.
Behaviouralists’ attack on rational markets
The proposition of the existence of rational markets came under attack by a group of economists who called themselves behavioural economists.
It was the Carnegie Mellon University economist, Herbert Simon, who first propounded in 1957 the idea that people are not rational as assumed by mainstream economists but behave within a boundary set for them by three impediments: the non-availability of all the relevant information and therefore the absence of perfect foresight; the limitation of the brain power to process the information available and limitation of time to sit down and make an informed decision.
This idea was coined as ‘bounded rationality’. Then, Simon said that people do not maximise; they simply just do what is necessary for them to keep going. Combining the two words ‘satisfy’ and ‘suffice’, he coined a new term to describe their behaviour: ‘satisfice’. Subsequently, psychologists like Daniel Kahneman and Amos Tversky presented in more concrete form this deviant human behaviour. The typical human behaviour, according to then was characterised by three attributes. First, people anchor themselves to some normalcy which they have already learned. Second, they always go by some representative principle which they consider as the typical situation. Third, they go by the most recent example which they can remember and not the best example available in their memory bank.
Regulations needed to check on market manipulations
The implication of this is that it is always possible to fool, exploit, direct, herd and manipulate people. When applied to the share market, some elite group can profit from the ignorance and the mediocrity of the rest.
This would have been at the back of the mind of the US authorities when they proceeded to put the Sri Lankan-born fund manager Raj Rajaratnam behind bars for 11 years as a warning to those who might think of setting themselves on an enterprise involving the manipulation of the share market.
The reasoning behind taking tough action on market manipulation is to restore law and order and rule of law in the market so that all market participants could play the game according to the set rules that are meant for preventing self-serving participants from harming each other. If a market is infested by manipulators and such infestation is tolerated, it loses its credibility and ability to prosper.
Further, as Gresham’s Law would have reminded the US authorities, bad market participants would have driven out the good market participants thereby making it a market of only thieves.
Kautilya’s counsel to his king in a similar situation was that ‘they should be prevented from harassing people’. The private sector friendly Adam Smith put it in a milder form when he said that their cries ‘ought always to be listened with great precaution and ought never to be adopted’.
(W.A. Wijewardena could be reached at waw1949@gmail.com.)
Sometimes curious ironies take place simultaneously in two different parts of the world.
In the USA, Sri Lankan-born billionaire fund manager Raj Rajaratnam was sentenced to 11 years in prison having been found guilty of engaging in a crime called ‘insider trading’ and amassing a net profit of US$ 72 million through that crime.
His prosecutors demanded the judge to keep him behind bars for 24.5 years and if any leniency is to be shown, to give him a minimum of 19.5 years. The length of the jail sentence demanded by the prosecutors is indicative of the seriousness of the crime, in the eyes of the US authorities, he is deemed to have committed.
The judge finally passed a sentence of 11 years on him which would keep the 54-year-old hyperactive investment manager virtually inactive for the rest of his life. Perhaps, like others who had been put to jail for similar felonies, he too might write a book whilst in the prison and make good on the monies he would have lost.
On the other side of the globe, in Raj’s birth country, share market regulators started to get tougher to eradicate what they had perceived as rampant prevalence of market manipulations and, according to reports, had even identified a few of the market players for engaging in illegal market practices.
The result was a widespread protest from ‘concerned investors’ for killing at a very young age a market which was just blossoming into adulthood. To prove them correct, the market activities too started to record historic downs in the recent few weeks, thereby wiping out billions of wealth which the market participants had accumulated as a group over a very brief period of just two years
Naturally, this was a matter of grave concern, making the angry investors, according to reports, ask for the head of the top regulator who they felt was the prime cause of the killing of the market at such a young age. There was a brief period of uncertainty and panic with regulators standing firmly on their ground refusing to yield. But finally the concerned investors won the battle for the day when it was announced that the concerned top regulator was to be removed from the job.
However, according to one business website, the top market regulator appears to have got a face-saving deal because he has been just ‘kicked upstairs’ to a position where he could now keep his head down and escape for the timebeing the wrath of the angry investors.
Insider trading: The crime in the share market
The crime which the US authorities fought tooth and nail and the Sri Lankan regulators set themselves to fight with new vigour is called ‘insider trading’. It is universally recognised as a crime committed against the market and therefore has been made illegal in the laws of all the countries which have started to regulate their share markets.
There is a near unanimity among the lawyers and the market best practice advocates that insider trading should be made illegal and eradicated. But there is no such unanimity among economists on the subject.
Those who believe that the markets are efficient and information is freely available to all market participants and therefore market prices reflect the changes in information feel that there is no necessity for such rules.
But those in the opposite camp, believing that markets are not necessarily efficient and there could be market manipulation by a few elite market participants at the expense of the rest, feel that there is a necessity for regulating the market to protect the small market participants from being exploited by so called elite groups.
Kautilya and Adam Smith: People needed to be protected from self-serving dealers
The Indian economist of the 4th century BC, Kautilya, belonged to this latter group: he said in ‘The Arthashastra’ that ‘merchants, artisans, craftsmen, nomadic mendicants, entertainers and similar persons are all thieves, in effect, if not in name; they shall be prevented from harassing the people’.
A similar sentiment was expressed by Adam Smith, father of modern economics, nearly 2,000 years later when he said in ‘The Wealth of Nations’ that the interest of the dealers is always to widen the market and narrow the competition.
While widening the market would help both dealers and people alike, narrowing the market competition helps only the dealers because it enables them to earn, by manipulating the market, a profit above what they would normally earn in a competitive arrangement.
According to Adam Smith, it is ‘an absurd tax upon the rest of their fellow-citizens’. He has further added that this demand ‘comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it’.
So, the popular demand is for the regulation of markets by authorities in the name of protecting the public, which, it is believed, does not happen automatically, but only when deliberate action is taken by governments.
Chulla Setti: The use of exclusive information to get rich
How could a market that satisfies the interests of different groups in a competitive manner get into such aberrations permitting one group of market participants to make excessive profits at the expense of the others? It is all to do with what is now known as ‘economics of information’.
Information on what has happened in the past, information on what is happening now and information on what would happen in the future are all vital for business success. Hence, like any other input that is used in business and enterprise, information is also demanded and people are prepared to pay for the correct type of information.
After securing information, like the up and coming businessman who arose from the gutters of the city, Chulla Setti, in the ‘Jataka’ story by the same name, there is a tendency for keeping that information exclusively for oneself in order to profit from even legitimate market dealings.
The young Chulla Setti, according to the ‘Jataka’ story, secured information on the firewood position in the king’s kitchen and managed to sell the fallen firewood from the king’s garden to king himself; here he played the game by creating an ‘Information Chinese Wall’ between the king’s gardener and the king’s chief cook.
When he secured information from the city’s traders that a shipload of horses was to arrive at the port shortly, he used that advance and exclusive information to get into forward purchase contracts with grass suppliers and sold the grass at the prices he had set to the merchants of horses. Not only that, he got into a wholesale deal with horse merchants and sold the horses to his own city folk at prices fixed by him.
But in the ‘Jataka’ story, Chulla Setti is hailed as a hero because he managed to elevate himself from rags to riches by sheer perseverance, hard work and business acumen. So, monopoly building on information and trading is a sure way to get rich quickly.
This is typical to share markets too.
Information too an input
A share market is composed of many investors, big and small, individual and institutional or retail and wholesale. All these people have only one goal: to make the maximum amount of money while avoiding making losses.
Since they buy and sell shares of companies, the health of the companies concerned and since they operate in an economy, the overall health of the economy concerned, are immensely vital for their trading operations. So, the market participants have an unquenchable thirst for relevant information, but if everyone in the market has that information, then, no single market participant can make money above the normal market profits which everyone can get. Hence, in addition to the demand they make for information, they make a demand for exclusive information too, like Chulla Setti in the ‘Jataka’ story.
Then, if they come to know a certain important piece of information, then they try to make that information exclusive to themselves to prevent the other market participants too from benefitting from it. This is because the share market has a peculiar market feature which other markets normally do not have. That is, for one participant to make super profits, he should necessarily make another market participant to make a similarly super loss at least in the very short run. Adam Smith called this imposing ‘an absurd tax on fellow citizens’.
Market decisions are economic choices
Hence, the share market operations are not pure financial or corporate activities. They are, like any other market, composed of market participants who make economic choices. All choices are made with a view to maximising the total satisfaction which economists call maximising the future expected return from a transaction.
Since the future is fraught with uncertainty, they make those choices by using all the relevant information and appropriately processing such information to correctly map out the future course of companies, markets and economies.
If everything goes according to their predictions, they make money. If it is better than the predictions, they make super money. If, on the other hand, it goes in the opposite direction, they make losses. If the market downfall is steeper, then they make super losses. So, every market participant tries to be in the first list rather than in the second list.
Then, by robbing information from a company, they can with certainty make super profits. If that is upheld by the society, why not make use of the facility to maximise gains?
The economic choice which a market participant makes in a share market is called ‘portfolio choice’ and that portfolio choice model has given birth to a new sub branch of economics called financial economics.
The credit for laying the foundation for this new subject goes to the Yale University Economics Professor Irvin Fisher who published in 1906 a book titled ‘The Nature of Capital and Income’. Fisher’s publication made several breakthroughs in the portfolio choice model: marrying it with economic theory, introduction of the scientific approach to share investment, the use of mathematics, specially the theory of probability in the choice of shares to be purchased and the prediction of the market behaviour by using statistical tools.
Rational market participants and rational markets
The subsequent economists refined what Fisher began into a whole economic theory that talked about the existence of an efficient share market.
This market has rational market participants who make rational decisions to make the best for them; they use all the information and process such information before making a choice; all participants know what happens now and in the future perfectly so that they cannot be fooled twice; since they act according to this market knowledge, the market behaviour is unpredictable and it is simply a random operation which has no clearly discernible pattern; if there is new information and everybody acts according to that new information, in the long run, market prices reflect changes in information; hence, no one can make super profits in a share market.
The random walk hypothesis
Two offshoots from this analysis which are related to each other are the random walk hypothesis and the efficient market hypothesis. The first says that stock market movements are random and when they are at one point today, they would be at a totally unpredictable point tomorrow.
The term has been coined from the movement of a drunkard who places one foot at one place and the other foot in a completely unrelated place to the first. Hence, if one maps up his walk, it would simply be on points which have nothing to do with each other. Hence, nobody can predict accurately where the drunkard would place next step just by looking at his past walk or where his foot is right now.
The implication of this analysis to the share market is that share market returns are normal, unpredictable and on average equal to what everybody gets. Hence, there is no possibility for making super profits.
The efficient market hypothesis
The efficient market hypothesis says that share markets are informationally efficient meaning that information is a common public good and what is available to one participant is available to others too. In other words, there are no Chulla Settis in share markets.
Since everybody has access to the same information set, share market prices fully reflect the changes in information. While there are many who have spoken of informational efficiency in share markets previously, this hypothesis was first presented in scientific form by Chicago University Professor Eugene Fama in 1960 in his doctoral dissertation submitted to the same university.
The efficient market hypothesis requires the presence in the market of rational people who maximise their utility or profits based on the formation of rational expectations about the future events. At any point of time, there can be one a few people who would make mistakes; but as a whole, the market is correct and no one is, therefore, able to manipulate the market and make super profits.
If markets behave according to the tenets of the efficient market hypothesis, then, it is not possible for a few market participants to exploit other participants. Since there is no necessity to give protection to vulnerable market participants, there is no role for the share market regulators. In such efficient markets, the presence of market regulators is unnecessary and irrelevant.
The historical evolution of the concept of efficient markets, its main critiques and where it stands today have been well elaborated by the free lance columnist and Editorial Director of Harvard Business Review Group, Justin Fox, in a publication made in 2009 under the title ‘The Myth of the Rational Market’. According to Fox, it is a delusion to expect rational behaviour in any of the share markets in the world.
Behaviouralists’ attack on rational markets
The proposition of the existence of rational markets came under attack by a group of economists who called themselves behavioural economists.
It was the Carnegie Mellon University economist, Herbert Simon, who first propounded in 1957 the idea that people are not rational as assumed by mainstream economists but behave within a boundary set for them by three impediments: the non-availability of all the relevant information and therefore the absence of perfect foresight; the limitation of the brain power to process the information available and limitation of time to sit down and make an informed decision.
This idea was coined as ‘bounded rationality’. Then, Simon said that people do not maximise; they simply just do what is necessary for them to keep going. Combining the two words ‘satisfy’ and ‘suffice’, he coined a new term to describe their behaviour: ‘satisfice’. Subsequently, psychologists like Daniel Kahneman and Amos Tversky presented in more concrete form this deviant human behaviour. The typical human behaviour, according to then was characterised by three attributes. First, people anchor themselves to some normalcy which they have already learned. Second, they always go by some representative principle which they consider as the typical situation. Third, they go by the most recent example which they can remember and not the best example available in their memory bank.
Regulations needed to check on market manipulations
The implication of this is that it is always possible to fool, exploit, direct, herd and manipulate people. When applied to the share market, some elite group can profit from the ignorance and the mediocrity of the rest.
This would have been at the back of the mind of the US authorities when they proceeded to put the Sri Lankan-born fund manager Raj Rajaratnam behind bars for 11 years as a warning to those who might think of setting themselves on an enterprise involving the manipulation of the share market.
The reasoning behind taking tough action on market manipulation is to restore law and order and rule of law in the market so that all market participants could play the game according to the set rules that are meant for preventing self-serving participants from harming each other. If a market is infested by manipulators and such infestation is tolerated, it loses its credibility and ability to prosper.
Further, as Gresham’s Law would have reminded the US authorities, bad market participants would have driven out the good market participants thereby making it a market of only thieves.
Kautilya’s counsel to his king in a similar situation was that ‘they should be prevented from harassing people’. The private sector friendly Adam Smith put it in a milder form when he said that their cries ‘ought always to be listened with great precaution and ought never to be adopted’.
(W.A. Wijewardena could be reached at waw1949@gmail.com.)
