Commex regulation, governance a tough balancing act

Regulatory and supervisory responsibilities in commodities continue to remain divided among multiple regulators. 

The weaknesses of FCRA, ECA, WDRA, multiple state APMC acts and individual commodity acts have important implications for governance and stakeholder protection. And, having several regulators is costly and inefficient, especially in a country like ours. 

While the strengthening of the regulatory structure in commodity markets is important, the governance structure of the exchanges cannot be ignored. In various discussions on the commodity sector, one question that does not get the attention it merits is: on whose behalf should the commodity exchange be governed. 

Of course, conventional wisdom is that a company (or a commex in this case) is governed on behalf of the shareholders. In fact, among the various shareholders of any company (including commexes), shareholders tend to be the least loyal — selling holdings at the first sign of trouble (at times even throwing them out of their premises). Second, it is incorrect that a regulator-approved independent board (along with regulator’s own nominee) protects the interest of the shareholders most of whom have bought shares at a throw-away price. 

Commex governance is closely linked with the type of investors and the performance parameters that controlling investors establish (turnover verses price discovery). As such, it has to manage a profound conflict of interest between market making and market restraining. In a business that exists hypocritically for the “benefit of farmers”, the question then is, do we need a different breed of investors for the commex business for exchange governance? Should it be classified ”social business”? 

As the traditional role of the broker as conduit between investor and exchange is increasingly rendered obsolete by electronic communication technology, the trading function will become increasingly disintermediated. Any exchange business with a long-term view has to engage with brokers and the well-being of an exchange business lies in the wellbeing of its brokers. If commexes have a short horizon, then they engage in market making, employee poaching and at times a few of these brokers become the stakeholders in exchange. 

The quality and orientation of the investments that are flowing in the commex is not “patient capital”. The equity of banks and financial institutions is in the form of “sleeping capital” and do not add any value with its nonparticipatory stance. Thus the anchor investor may have the capacity to manoeuvre the norms of exchange governance with impunity but within the ambit of “regulation”. It is this misapprehension that lies at the heart of many concerns. Regulatory failures are inevitable any time as self-regulatory obligations imposed on an exchange are in conflict with the commercial interests of the exchange’s owners. Such commercial interests are more powerful for a mutualised exchange than for a demutualised one.

If commodity exchanges have to succeed, they have to figure out whether they want to be there, not only the next couple of years, but for the next century. The shorter the horizon investors come with, the quicker is the exit route.

Published in The Economic Times 

Ad-hoc price control efforts are disastrous in long run

An old debate continues: whether “high onion prices are good or bad” and the answer is, “it depends on whether the poor are selling or buying.” High prices benefit farmers who are net sellers, and hurt consumers in urban areas. Low prices have the opposite effect. In each case, the net effect depends on the balance between who is able to manoeuvre the policy in his favour. 

High prices do not mean high price realisation by onion farmers. It only shows a better information arbitrage by a selected few while the ‘babus’ remain the most ill informed in times of impending crisis. Price instability is a general feature of agricultural markets. The current onion price crisis has highlighted the vulnerability of inter-ministerial communication or rather the lack of it. 

Too many cooks spoil the broth is nowhere more apparent than the current onion crisis. A coordinated effort between four ministries —ministry of consumer affairs (dealing with controlling price), ministry of commerce (dealing in trade, exports & imports), ministry of earth sciences (weather forecasting) and agriculture ministry — would have yielded better price-control mechanisms. 

The architecture of decision-making at the ministerial level does not seem to be sensitive to the issue that the government’s role in a free market economy is not to bring down the price at every spike of a commodity but to create a consistent policy environment where such surprises become minimum. The executive arm is still stuck in a time-wrap when the state was supposed to control prices for the consumers (the middle class in general). 

Ad-hoc trade policy interventions such as export ban and import subsidies have always been harmful in the long run. The Left politicians (as usual) are making noise to ban forward market without knowing the fact that onions are not traded on the futures. Hopefully, they shall come better prepared the next time or should they start asking to ban oil futures on NYMEX/ICE for petrol price rise. It was also amusing to see an Opposition politician (from my school), who has refined taste for good things in life, talking about ‘aam admi'. 

What is perhaps most telling about the price increases of onions is the negative impact of their extreme volatility. Both high and low prices have winners and losers but volatility hurts everyone except traders and speculators. Stable and remunerative prices should be the goal. That will attract investment into agriculture and bring long-term benefits beyond the short-run effects. 

In the US, the ban on trading of futures contracts in onions was passed on August 28, 1958, and remains in effect as of 2010. The studies by Holbrook Working and later by Roger Gray (Stanford 1963), Aaron C. Johnson (1976) have concluded that onion prices had been less volatile during the years when the contract was active. 

While the politicians continue to make the right noise about the failures and ability of the government to control prices, the real issues of productivity, export policy, weather forecasting in a coordinated fashion remains a dream (in spite of huge investments). Past adhoc efforts on stabilising prices at a certain level by some individual countries have generally been unsuccessful all over the world. 

Price spikes in the times of market economy are going to remain chronic. Should the government continue to intervene every time during the price spike on tax payers’ money, that would be to rob Peter to pay Paul. 

Published in The Economic Times

Shift commodity risk management to finance teams

What is the right price for cotton, coffee, copper and crude? Not even a soothsayer will try to take a bet on this. Analysts will produce gigabytes of reports and charts, debating whether the market is likely to go up or down and not whether the price is correct or not. 

Except for occasional cases, most of the corporates in India do not have commodity hedge plan in place for their manufacturing activities. These large corporates have not been able to come to terms with the fact that they are not the most efficient buyers anymore. Often corporate hedge plans end with an appointment of a consultant who gives a beautiful report which never gets read, let alone be implemented. 

Managers resort to statements like “our company policy does not allow hedge programme”. Some of these large companies even arm-twist the government to change trade policies as evident from the recent case of cotton (textile companies) and a few years ago on iron ore exports (steel producers).

The creation of commodity indices and exchange-traded funds saw the amount of asset investment swelling internationally. This has greatly increased the volatility. Increased volatility has lead to riskier strategies. The ripple effect has caused even more volatile commodity prices in India, leading to shorter lead times between the price spike and the price paid by end users. 

Some of the manufacturing companies had attempted hedge programmes when the prices were high only to abandon them after a few brain-storming sessions.

Everything goes on a backburner and a flurry of activities recur only when the quarterly numbers are analysed.Somehow, the annual budgeting has become a mere ritual without much understanding of the price behavior of raw material cost and energy cost. 

The issue of whether or not to hedge commodity price risk continues to baffle many corporations. At the heart of the confusion are misconceptions about risk, concerns about the cost of hedging and fears about reporting a loss on derivative transactions. A lack of familiarity with hedging tools and strategies compounds this confusion. Corporate risk managers also face the difficult challenge of getting hedging tools (such as derivatives) approved by the company’s board of directors. 

A few years ago, when an Indian engineering giant reported losses on the hedge books, the analysts on electronic media went about giving soundbites without the slightest of understanding that the company may have made up by having a lower cost of raw materials on the physical side.

Many companies handle commodity price risk management through their purchasing departments but now treasurers are seeing the direct impact of commodity prices on profit and loss. It is a cost input. They can clearly see the impact on their need for funding and liquidity. Therefore, commodity risk should be managed by the treasury as a financial risk like any other.

Putting commodity risk management in the hands of a finance team may be an important first step but it is just the start of the process of building an effective hedging strategy. There has been an exponential growth in companies’ exposure to commodity prices and therefore the need to hedge is more acute. 

Published in the Economic Times

Convergence of price is the core issue in commexes

Arbitage tends to reduce price discrimination by encouraging people to buy a commodity where the price is low and resell it where the price is high. Price convergence is what allows futures prices to be interpreted as reliable price benchmarks for forward contracting of commodities, both by commodity sellers and buyers.

The pressure on the Chicago Mercantile Exchange (CME) and other US wheat trading exchanges to solve the price convergence problem has become more acute with the release of Senate investigation into wheat prices in 2009.

The delivery on the exchange is one of the most contentious issues. In India, commodity exchanges have pursued two routes — one which has promoted mainly exchange deliveries and the other which has ensured that no delivery is made. Neither route solves the core issue which is the convergence of the spot price with future price. Overall, the empirical results do not support the convergence hypothesis but rather a pattern of fluctuating divergences has been observed.

The existence of high ‘badla’ (cash futures arbitrage) opportunity in agricultural commodities during the initial days was caused by flaws in futures contract design. It was assumed that the differentials (premiums & discounts) between different locations as fixed (constant) and thus premium and discounts were introduced as part of the futures contract. In reality, the differentials between locations are multivariate function of transportation, quality, supply and demand situation at a point of time and do not remain fixed over a period of time.

The point that was missed is that the differentials are market driven rather than a constant factor on a time axis. Differentials have the same variability attributes that of the commodity price. Therefore, by having a constant (fixed) premium and discounts embedded in the contract itself leads to a flawed price discovery, delivery issues and proliferation of speculators.

On the other hand, the non deliverable route has caused the physical market participants to look at the futures market as punters paradise. Price manipulation during the pre-tender trading period does not create sufficient fear among speculators of getting stuck with exchange delivery in the absence of a delivery mechanism and this causes huge volatility in trading.

Some of the contracts even have two kinds of allowable deliverable quality. All these flawed contracts continue to be allowed for trading on the futures platform. The non-convergence of settlement price and spot price throws non-existent ‘quality issues’. Obviously one never understood the underpinning of the problem and had been barking at the wrong tree with quality issues, storage protocols.

Constant (fixed) premium and discount matrix has caused trading shift from location to location on screen while the benchmark has remained theoretical. The price quoted on the futures screen becomes a derivative of the non-representational premium and discount prevailing in the spot market rather than a future price.

Published in The Economic Times

The objectivity of experts in market reform panels

Both stock market and commodity markets are the pillars of the Market Infrastructure Institutions (MII) whereas in India the latter often tries to follow the practices and recommendations of the former. Occasionally, the recommendations are adopted without much understanding on participant’s maturity and relevance (eg: algorithmic trading in commodities market). 

In the murky times of Suresh Kalmadis, Lalit Modis and Niira Radias, it is important to look at recommendations and composition of any committee for these markets with skepticism. The report of Bimal Jalan Committee on “review of ownership and governance of market infrastructure institutions”, however retrogressive, is likely to get quoted in the commodity sector as well. 

The chairman of the committee is a man of impeccable reputation, pedigree and integrity. However, the composition of committee should be looked with much greater scrutiny. A regulator appointed committee to seek policy direction should not pack the committee with its own people for “soul searching”.

It would have been much prudent to have independent members to make the report look more legitimate without any conflict of interest. It is noteworthy that one of the committee members has an indirect stake in creation of a newly promoted national commodity exchange. His group company claims to have 7% to 12% stake in the daily stock exchange turnover. 

However, without getting into the question of qualification and capability of any individual, it is important that the man on the street and the market see the composition of the committees above any doubt. The member sitting on any committee seat cannot be subjective and biased, which definitely gets influenced when the business is at stake. An ideal member of a committee has not only to be objective and unbiased but also the market should see and realize that he does not get indirectly benefitted. 

The last nail on the coffin is the recommendation (on the covering note) that a fresh review is desirable only after five years. Why should Indians live with retrogressive recommendations on exchanges for five years when the volatility of market changes the institutional structures within months? It not only defies logic but creates further doubts about “public good of essential facilities doctrine”. 

Without getting into the question of whether the report plays favorite to the existing big brother against the new entrant, the committee failed to look at the larger issue of convergence of banking and financial market infrastructure. In India, due to historical reasons, the banks have substantial stakes in exchanges (stocks & commodity). Has their participation served any value to MII? Can a bank be granted a promoter’s role in an MII? Was the point considered too insignificant given the composition of the committee? What really surprises is that the committee in its eighty-five page report talks about the governance and ownership structure but has totally ignored any relevant role of the banks in the ownership structure of MII. 

Needless to mention the worldwide financial and commodity crisis was triggered by misdeeds of some of the bankers. Can we leave the operating structure of market infrastructure in hands of a few where the governance structures are directed by an ownership structure that cannot effectively add value to the institutions? 

Published in The Economic Times

What’s common between sports & commodity trade?

There is an old story about two hikers who encounter a tiger. One says: There is no point in running because the tiger is faster than both of us. The other says that it is not about whether the tiger is faster than both of us. It is about whether I’m faster than you. And with that he runs away. You guessed it right the person who ran was a commodity trader.

Traditionally while recruiting a commodity trader, one looked at the sportsmanlike traits. Surprisingly, in recent years, an increasing number of companies in the West are scrutinizing professional poker players to find talent and analytical tools, someone who has made a successful living as a poker player for a few years would more likely be a good trader than someone who hasn’t! 

The broader discipline of economics and finance has developed expertise that does take behavioral factors into account. There has been a perception shift in commodity trade from “value-based trading” to “price movement-based trading”, as a result of which, traders are no more thinking of rationality. One of the devastating myths perpetuated in commodity trade is a simplistic assumption about the behavior of people — a trader acts rationally to maximize the return. 

Investment bubble has demonstrated that traders are far from uniformly rational and the behavior of markets in general shows that behavioral factors of individual commodity traders are important for the profits and losses. 

You may often heard comments like “if the market goes down for three years in a row, it has to go up the next year!” or perhaps say it yourself ? That is ‘gamblers’ fallacy’ — a phenomenon which is very common amongst most commodity traders. 

It is normal for any commodity trader to frame the market race and hope to win by buying and selling commodities at the right time.

That doesn’t seem so hard... So what does this mean in practical terms? There are some of the companies in India who have employed technical analysts in order to take a contrarian position of the recommendations. No doubt with same data sets, same analytical tools, low depth and liquidity in the domestic market, the success rate of these companies have been much better than the others. The way people react and think in commodity market has more to do with the pressures’ rather than rational thinking. 

In India, the typical commodity trader no more fits the stereotypes which usually presented as ill-prepared, unsophisticated, unaware of the risks and undercapitalised.

It is seen that companies come and go but the traders dealing in a particular commodity line remains the same. Some of them are experienced, well-educated, financially sophisticated and well capitalised. Most of them seem to be in the area of odds against making profit; they continue to trade for the recreational reasons.

Published in The Economic Times    

Digital divide hampers growth of commodity mkts

Commodity markets and market yards used to be the physical locations where buyers and sellers met and negotiated. With the improvement in communication technology in 90’s, the need for a physical location has become less important as traders are transacting from remote locations over phone. 

The ‘E’ word in the commodity cash market seems to be the latest fad. E-products are creating sound bites rather than solutions. The solutions seem to hold more promise than they can actually deliver with the current technological reach to the masses. Internet presents physical cash markets with opportunities to increase efficiency through lower transactions costs but access remains a problem. While India has emerged as the second-largest mobile telephone market after China, in terms of computer and internet penetration India is still far behind. India has 5.1 internet users for every 100 people, which compares poorly with the corresponding figures of 39.2 and 28.5 for Brazil and China, respectively. 

Today a large majority of stakeholders in the commodity market are in the midst of the ‘digital divide’. It is not difficult to see broadband connections in the pockets of market yards of Rajasthan, Gujarat and Punjab. The commodity futures exchanges have helped in technology and digital penetration, though a majority of the physical cash market remains digitally excluded. Therefore, the growth of these commodity markets to the next level has remained elusive. 

Electronic trading makes transactions easier to complete, monitor, clear, and settle in the physical commodity space. All the considerations lead to compare a simple solution to avoid complex solutions. Such comparisons should also consider whether providing a low-cost system meets the basic needs, regardless of the use of         E-trading product. 

E-trading systems are typically proprietary software (E-trading platforms), running on COTS (Commercial off the shelf) hardware and operating systems, often using common underlying TCP/IP protocols. The emergence of electronic trading venues known as ‘Electronic Communications Networks’ (ECNs) in the late ‘90s made it possible for more entities to trade. ECNs and exchanges generally offer two methods of accessing their systems — GUI & API. GUI (Graphical User Interface) is which the trader runs on desktop and connects directly to the E-trading venues. API (Application Programming Interface) allows dealers to plug into their own in-house systems and then directly into the E-venues. From an infrastructure point of view, most exchanges provide “gateways” acting in a manner similar to a proxy, connecting back to the exchange’s central system. ECNs will generally forego the gateway/proxy, and their GUI or the API will connect directly to a central system, across a leased line. 

India ranks 43rd in a list of 133 countries, just behind China and Brazil according to the WEF’s Network Readiness Index. However, the standards on E-trading systems in commodity market with regards to authentication, encryption, transactions recording standard, pricing and slippage standard need to be created without much delay. Unless that is done and the ‘traffic rules’ are made, it would be a chaos on the E-trading highways of the commodity cash markets. 

Published in The Economic Times 

Implied volatility in commodities trade

Export populism in commodities is a phenomenon which is directly connected to the country’s backwardness profile. A mandi operator claims higher place among his peer group ‘for being a supplier to an exporter’ and exporter demands highest place of pride than his domestic counterpart in social forums. These are all ingrained in a false vanity that is often attached to international trade. 

In the controlled regime, the successful exporter had to manage the ‘babudom’ to leverage the incentives and subsidies of the government. However, market orientation brought about a change in the profile of the exporters. The established players have moved out and the less established players have moved in. The moot point is whether one makes money by exporting commodities? 

Free play of the market can be seen nowhere more dominantly than in exportable commodities like soyabean de-oiled cake (DOC) and coffee market. In both these commodities, one rarely finds a back to back parity. So, how does one make money — thru positional calls? lower interest & logistical cost or by sheer luck? 

Coffee and soyabean are the largest traded commodities in international exchanges. Implied volatilities for these commodities have been creeping up steadily over the course of past two decades and now appear a more permanent feature in their markets than was the case in the past. A detailed examination of the past underscores just how volatile these markets have become and how volatility has persisted. Since the beginning of 2006, implied volatility have frequently spiked to levels well beyond 30% in these commodities, reaching well over 60% at times. The more divergent are traders’ expectations about future prices: the higher the underlying uncertainty and hence the implied volatility of the underlying commodity. 

Does volatility matter? Prices of derivative commodities that are observed today of commodities which are traded in the major global exchanges are determined by underlying expectations and uncertainties about such expectations, pertinent to the market and the commodity. Hence, implied volatility, as reflected or inferred by the prices of derivative contracts, is an important component of the price discovery process and is a barometer as to where markets might be headed. 

Markets are failing under the pressure of oligopolistic powers. The companies that process and ship agricultural commodities are growing in size as they decrease in numbers. Empirical evidence shows that a growing disconnect between prices paid by the consumers and prices received by the producers. International Commodity Agreements, Buffer Stocking and government intervention have failed in past. 

In addition to seeking ways to increase stability in commodities market the government needs to re-think that in a market oriented economy, how can one limit the exposure to commodity price volatility and mitigate the detrimental effects of commodity wild price swings. To quote Friedman, “governments never learn. Only people learn”. 

Published in The Economic Times

India Commodity Year Book

Launch of India Commodity Year Book 2011

(L to R) Dr. Hanish Kumar Sinha, Head - Commodity Research, Mr. K. Sankaranarayanan, Head – Risk, Compliance & Technology, Sanjay Kaul, MD & CEO, NCMSL. Shyamal Gupta, Chief Business Officer, NCMSL 

There was a long felt need in the commodity world for a handy reference book covering the entire gamut of commodities with special reference to their role, relevance and price movements in the Indian markets. Also, statistical information on production, growth, demand-supply and price movements of different commodities over the last 8-10 years, at one place, was difficult to find in the published literature on commodities in India. It is in the background of such a situation that the Commodity Year Book 2009 published by National Collateral Management Services Limited (NCMSL) comes in as a gap-filler. This was repeated on 2010.

Here’s another regulator in farmers’ name

India has a unique distinction of creating monoliths in the name of farmers yet the objective is to provide a better support function to established financial institutions.

As long as there is a public acknowledgement of this fact, there is nothing wrong in creating better systems. The tagging often in the name of the farmer is done to gain legitimacy.

The most recent initiative in this space was the creation of a regulator by the name of WDRA (Warehousing Development and Regulatory Authority). The WDRA Act 2007 came into operation on October 25, 2010, almost after three years since the bill was passed by Parliament. The regulator’s mandate is to put in place a negotiable instrument in the name of warehouse receipts (WHR). The main challenge shall be to create a foolproof network wherein this instrument is not used in the manner in which a large corporate house had done previously (issuance of multiple physical shares with the same number) or the fraudulent use of bank receipts by Harshad Mehta for leveraging in the stock market.

With the increasing “financialisation” of the commodity market, the laws and governance initiatives of the government seem to have remained etched in archaic classical economics of demand-supply and individualism. Institutionalised DEF (desire, expectation and fear) has now taken over the individual’s role in commodity markets. Price manipulation and leveraging are not anymore a businessman’s individual prerogative but are achieved through well-designed plans of policy manipulations and systemic loopholes. The new regulator is expected to bring a much-desired foresight in an environment of governance myopia.

While promoting instruments for pledge & collateralised struc ture in the commodity market one needs to take into considera tion the financial ramifications of these instruments. In the current legal structure, the ministry of consumer affairs may not be well-equipped to handle a financial instrument of this nature and the equipment are available elsewhere within the country. Without direct access to the ministry of finance and RBI, WDRA may not be constrained to access a regular financial information flow, talent and resource pool.

On the “farmers welfare account”, needless to mention, a majority of Indian farmers produce a lot size which is nonremunerative to be funded by financial institutions after considering the overall transaction cost and credit delivery cost. Therefore to make a case out of WHR that the instrument is going to help in preventing distress sale and shall give better access of credit to farmers is a more of a public relations exercise which is hard to be consumed even with a pinch of salt.

The chances are that in order to achieve economies of scale for credit delivery, we might see a new financial intermediation option and not a direct credit delivery. If an instrument of such great importance gets notified (if at all) in the Negotiable Instrument Act, then can we restrict it to only “agricultural produce” that will be the death sentence for the instrument (WHR) or will that be a solitary confinement? 

Published in The Economic Times

Need clarity on tax treatment

Speculation & Hedging In Commodities Mkt Have Not Been Defined Properly

The more you earn, the less you keep,

And now I lay me down to sleep.

I pray the Lord my soul to take,

If the tax-collector hasn’t got it before I wake.  Ogden Nash 

As far as commodity futures are concerned, the grey area on the treatment of income for “speculation” or “business” remains discretionary in the hands of income tax officials. According to income tax laws, commodity exchanges are not notified derivative exchanges unlike stock exchanges. The income from commodities futures is considered speculation income in normal course. The roles of regulators, exchanges and participants in taking a collective initiative has been inadequate for lobbying with the ministry. While focused representation has resulted in corrective actions in several countries, the initiative by the industry in India on this account has been near negligible.

It has often been argued that in case a transaction done on a commodity exchange is in the nature of a hedging transaction, then the transaction will not fall in the ambit of speculative nature. In some cases when a transaction has been backed by stocks of the relevant commodity or a purchase order and the futures transaction has been entered with an intention to hedge the loss on account of price fluctuations, then the “speculative income” criterion has not been imposed on the parties.

If bidders in tenders enter a hedge transaction during the price bid on a commodity futures exchange to protect their bid price, the treatment of a successful bidder and an unsuccessful bidder may be interpreted in two ways while the intention of both had been to protect the price risk.

One of the significant differences between stock futures and commodity futures is that commodity futures may be converted into delivery while stock futures is compulsorily closed out without any conversion into delivery. However, the commodity futures market should not be seen as a delivery platform. Based on the intention of the parties entering into such transactions, one can say whether it is speculative or not.

The confusion in the current scenario is due to the lack of definition of speculation. Speculation is inevitable in any market but problems emanate from the fact that the commodity regulator in India does not seem to acknowledge in public posturing that such activity exists in this market. The speculative and the hedge profiles of the participants have not been defined properly. Some of the hedge limit-exempted entities have in the past indulged in speculative activity and have gone scot-free because of the lack of the regulatory monitoring. But why blame our regulators, even the activities of the “Wall street refiners” have gone unnoticed by CFTC.

We are talking of multiple exchange scenarios. Is it not the time for the industry to have clarity on tax treatment? Who will bell the cat? If death and tax are only the certainties in life then let us ascertain how income tax laws should be distinguishing between speculation and genuine hedging in the commodities market. Unless the mystery is resolved soon, the futures market will continue to be treated as speculative activity which will be unfortunate.

Published in The Economic Times

Prevent conflict of interest in commex ownership, trading

A Comparison of China and India’s progress has become a favourite pastime. However, it may be imperative for us to take a look at the growth of the Chinese commodity futures market from the legal environment, regulatory environment, supervision and by public opinion. Akin to India, no foreign money is allowed to participate in the Chinese market.

China’s commodity futures market dates from a trading program at the end of 1980s. As with any new venture, dozens of exchanges sprung up and speculation and market abuse were widespread. China tried to grab the industry by the scruff of the neck first in 1994 when the State Council took over 50 futures exchanges and turned them into 15, delisting a host of contracts. The changes of 1994 helped but it didn’t fix the market. So the State Council made a second attempt in 1998. Most of the 15 surviving exchanges were closed, restructured or merged, leaving the three that still control commodities trading today. 

Shanghai Futures Exchange, which was formed from a merger of the Shanghai Metal Exchange, Shanghai Foodstuffs Commodity Exchange and Shanghai Commodity Exchange, began life in its new legal form in December 1999. The other two are Dalian Commodity Exchange and Zhengzhou Commodity Exchange. Most of the contracts were scrapped while 12 were allowed to survive.

The script looks similar in India. However, the rationalisation of the number of exchanges is yet to start. 

While the first three new-generation exchanges were demutualised initially, the control management and equity structures of the new exchanges are more mutual in nature. A new game is being played... new commodity exchanges are wrapping ribbons around watermelons, tossing them out from 50-storied windows. In this game, you are a winner only if you take your money out before the melon hits the pavement. 

The rush of the “new” has seen the “mutualisation” been taken to the other extreme. It seems that there is a school of thought which is not convinced about the merits of demutualisation in exchanges. The exchanges that view demutualisation as legal manoeuvres are courting suicide. Why? It is one thing to have a mutual exchange and another to tell the world that it is a demutualised exchange. Market always smells the rat first. 

We must remind ourselves that as participants on commodity exchanges, Goldman Sachs and some other large financially powerful actors had turned the once-solid market into a speculative casino internationally. Commodities trading subsidy of Goldman called J Aron got hedge limit exemptions under CFTC’s nose... Moreover, Goldman also owned 10% stake in the Chicago Climate Exchange. There’s was also a $500-million Green Growth Fund set up by a Goldmanite to invest in green tech. The list goes on... all in the name of “arms length’s distance”. Well, you might say, “who cares?” Do we need to import worst practices of the international commodities market? 

Financial infrastructures such as commodity exchanges cannot be left alone in the hands of large financial groups to promote, manage and control while their sister concerns are into active client-based or proprietary trading and other financial services. It is one thing to make strategic investments in a commex but another to promote, control and run an exchange. The adoption of a modern corporate governance approach is essential to create the correct commex environment for growth and enhancing the value for market participants. International experience has demonstrated that things are never at an arm’s length distance and financial groups always gear up for opportune moments for market manipulations. Can the reins of the exchanges be left to large financial power houses in India to repeat the international story with an added dimension of commodity exchange ownership? 

Published in The Economic Times

Rising commex turnover doesn’t mean better price discovery

In recent times the equity re-structuring and equity participants of commodity exchange have grabbed more attention than genuine market participation on the exchanges. Commodity exchange as SRO (Self Regulatory Organisation) is more than valuation and turnovers. Sometimes it is assumed that rising turnovers on exchanges means better price discovery, however this myth needs to be relooked from the “broad base” participation in each of the contacts. There are 200 plus contracts’ that are listed on the existing exchanges and hardly any participation is observed beyond the near month in the most of the product lines.

In absence of participation profile data in public domain, we can at least assume that the regulator has access to participation data and analyses it too. Liquidity on futures market can be created through market makers but the local exchanges have remained in denial mode on this count. However, sustained depth on the exchanges can be measured by a very basic analysis of contract-wise ADMP & ADCP. (Average Daily Member Participation & Average Daily Client Participation). While a rising exchange turnover may give a feeling of growth, the market sustenance can only be ensured through participation depth.

It is being stated that up to eight national commodity exchanges shall be allowed. If the economics is the basis of investment in any industry…. can we expect the market to grow to such a level where Rs 800 Cr of investment can generate at least Rs 160 Cr (@ 25%) as Return on Investment. At current level, the total exchange revenue from exchange based transactions is believed to be less than Rs 350 Cr annually. Is it all a game of valuation rather than market participation?

Around a month back, media was full of stories like "New products like options will be allowed in the commodity market”.  Most participants feel like sitting in a poker game where one doesn’t know who the patsy is, then….. It is very likely that one who doesn’t know would become the patsy. The trouble is that many people get duped because nobody likes to hang that label on him. Commodity options in India are like this….but perhaps not for everyone….

Then why options have not taken off…the answer lies in non existence of broad based market participation and participant’s profile. Everyone likes to think of his own capital (proprietary trading) as “smart money” and other people’s as “sucker money (funds).” Market comprises more of whom... “Smarties” or “Suckers”? This will determine whether options would take off.  

We need to look at the growth story from participation point of view rather than turnovers, equity restructuring and new exchanges. With prayers and hopes, market is coming to the terms “to believe” that regulator is taking note of the relevant data so that exchanges do not remain “clubs” and graduates to be the platform of serious market participants.

“Yes, how many times can a man turn his head

Pretending he just doesn't see ?

The answer my friend is blowin' in the wind

The answer is blowin' in the wind.    (Bob Dylan)

Published in The Economic Times

Commodity repo an innovation of state-owned firms

Commodity repos have long been used by public sector undertakings (STC and others) in commodity trade as an alternative bridge financing mechanism. The interest income is structured under sale and purchase agreements of commodity. 

While the foundation of the structure is financial, the flavour of the paper trade flow allows the advantages of topline and bottomline. During the last two decades, PSUs in India have been undertaking these transactions without exotically calling it ‘repos’.

To put it simply, a repo is equivalent to a cash transaction combined with a forward contract. The cash transaction results in the transfer of money to the borrower in exchange of a legal transfer of the commodity to the lender. The forward contract ensures repayment of the loan to the lender and the return of the collateral to the borrower.


The difference between the forward price and the spot price is effectively the interest on the loan. The settlement date of the forward contract is the maturity date of the loan. The party who originally buys the commodity effectively acts as a lender (PSUs). The original seller effectively acts as a borrower, using the commodity as collateral for a secured cash loan at a fixed rate of interest. 


Commodity repos have provided liquidity for operational functions to a large number of companies (in need) that otherwise would have been tied up to inventories. In situations when companies have price views to go long on a commodity, often the liquidity positions do not allow them to hold on to the commodity. In such situations, PSUs have often come to their rescue. 

PSUs in India had been providing finance at lower-than-commercial-bank interest rates for many credit-worthy companies with speed and a lot of flexibility. A pledge-based commodity financing carries liquidation risk on borrower’s non-payment. The advantage of commodity repo is that the clarity of the ownership structure mitigates the liquidation risk (different from price risk) in case of defaults. 


Some of the commercial banks have tried to address the issue of liquidation risk with buyback arrangement. However, forced sale have often resulted in low realisation. Some banks have started viewing ownership structures as a better alternative to taking a collateral security, especially at a time when legal recourse favours ownership in case of a dispute settlement.

Some of the western financial houses call its version of repos as “commodity inventory purchase obligations” or CIPOs. Over the past five years, trade banks have began developing further refinements to the inventory financing structures.


Alternatively, Islamic financing structures of Murabaha have not been able to achieve scalability in India. The simple PSU models have been very popular. Who says Indian PSUs are not innovative?

Published in The Economic Times