Now is the time for a clearing house vertical

It is well-known that futures exchanges utilise a wellcapitalised central clearing house. The clearing house mitigates the risk of settlement failures by isolating the effects of failure of a market participant. This prevents credit events at a firm from cascading onto others firms. A famous illustration was when Nick Leeson, a 28-year-old trader at Barings, lost $1.4 billion on trading futures. The losses drove Barings (a 228-year-old institution and ‘Banker to the Queen’) into bankruptcy but that did not threaten the market or any counterparty. 

The clearing function of commodity exchanges in India is executed by inhouse clearing & settlement departments. However, a clearing requirement and an exchange-trading requirement are NOT the same thing. A clearing requirement necessitates that all eligible derivatives be cleared on a central clearing house whereas an exchange is a platform for trade execution. The only thing that an exchange-trading requirement adds to the clearing requirement is “pre-trade price transparency.” The need for a clearing house ‘vertical silo’ is intensifying as an increasingly important part of market reforms in the wake of the financial crisis. 

A clearing house acts as a buyer to every seller, and a seller to every buyer in transactions, stepping in to complete a trade if one party defaults. If an additional margin is required on any account, then the clearing member of that account must post the additional margin before a specific time in the next business day.

There are numerous examples of exchanges having their own independent clearing house (as it has turned into a lucrative business). A few years back, ICE severed its link with LCH to start its own clearing house. The possibility of replicating the Japanese model (different from the LCH model) is immense. The Japan Commodity Clearing House (JCCH), an independent centralised clearing house operation, began providing services for transactions of all commodity exchanges in Japan in 2005. JCCH is organised as a company owned by all Japanese commodity exchanges and the Japan Commodity Futures Industry Association, an association of the futures commissions merchants. 

One approach could be that exchanges may need to contribute capital to the clearing house or perhaps offer stocks in the clearing house to other investors. Of course, this shall require related changes in the clearing house structures including the issues “for profit”. A very large capital requirement for technology and the ability to continually advance technology and systems to stay in competition with international standards is affected by this decision. 

In an environment where Chinese walls of ownership between banks, broking companies, trading companies and commodity exchanges are rapidly vanishing, the real action may be starting to take place below the waterline in the mundane world of clearing. The regulator has already restricted brokers to trade on their exchanges. The regulator for the sake of good governance can ask ownerbankers to stop issuing bank guarantees to the members of their ‘own’ exchanges. Moreover, by having a clearing house, the ’real’ counterparties will not get intertwined in any opaque manner in the clearing function. Since the beginning, new-generation futures exchanges in India have not encountered any clearing and settlement breakdown but does that mean that going ahead we can ignore international best practices of having clearing houses. 

Published in The Economic Times 30 Aug, 2010

Essential Commodities Act needs more teeth

Recently, a godman was caught in a video with an actress which made national news. Sometime later, cases were booked against him under the Essential Commodities (EC) Act near Bangalore. It so happened that the godman had prayed with fire around him as penance. Officials of food and civil supplies department had seized blue kerosene (used in PDS for BPL family) which was being used for his meditation penance. If convicted, the godman could invite seven years of rigorous imprisonment along with fine. Strange are the uses of the EC Act…., stranger are the ways how the act is often used by the local officials which are in variance with the main objectives.

The commodity sector not only faces multiple laws but the laws are often archaic. Ever since the commodities boom began, financiers & NBFCs have been setting up funds to “invest” in physical commodities. The EC Act was conceived with a naïve understanding of the fact that the merchant hoarders are the cause of price rise. The annual report of the Ministry of Consumer Affairs (concerned ministry) gives amusing facts about the action under EC Act which looks more like the statistics of a police station.

When the prices rise, there is a clockwork reflex on the part of politicians to blame speculators or speculation which is followed by kneejerk raids. The raids not only disrupt normal commodity supply chain but also hamper its organized growth. It affects warehousing and it discourages large and honest players to operate in the market. As the implementation of the EC Act remains in the hand of the local bureaucracy who have very poor understanding of the trade, the reactive actions disrupts the supply chain further. Under the EC Act, if a person against whom prosecution has been launched is acquitted, the confiscated stock has to be returned or the value thereof should be paid. Interestingly, in most of the cases where confiscation is ordered, the parties ensure that the prosecution is not launched or the prosecution loses the case and thus confiscation becomes null and void.

The raids which are often conducted before festivals of Diwali & Holi, should have acted as a deterrent against the unscrupulous dealers. However, these raids often ensure that ample “bachae ke liye mithai” (sweets for the kids) are available for the local executive powers during festivals and all these are done “khushi se” (happily with consent).

Essentially, the EC Act aims to ensure easy availability of important commodities to consumers; however doubts have been raised about the effectiveness of the Act. India is ill equipped to handle financial speculation in commodities market. As in the financial sector, the clear boundaries between brokers, physical traders, commodity producers and banks are tending to become blurred. We are yet to see the activities on the scale conducted by the likes of Vampire Squids (Goldman Sachs) and others to manipulate the commodity prices internationally. However, financial speculation can substantially increase commodity price volatility as the speculators follow a price trend (up or down) with systematic financial engineering. We have learned the hard way that scholarship on financial crises tends to be reactive, meaning we are less than prepared for the next “Big One” in India.

Published in The Economic Times 23 Aug, 2010

FMC needs real-time data to stay in touch with reality

Three developments during the last two weeks will have significant impact on how commodity futures shall be regulated. The first was the non-passage of the FCRA Bill in Parliament. Second, placing the FMC chairman and the secretary of the Consumer Affairs Ministry in the High-Level Coordination Committee (HLCC) is an acknowledgement of the important role of FMC. The HLCC is an inter-regulatory coordination committee comprising the finance secretary and heads belonging to RBI, Sebi, Irda and PFRDA. Third, Parliament passed a bill providing for a mechanism to resolve disputes between financial regulators as an ad-hoc arrangement. 
Drastic steps like redrawing the reporting ministry or the merger of regulators do not go down well in India. However, in times to come, we can expect the emergence of a new role for the regulator. While FMC currently does not have the status of a financial regulator, it is apparent that FMC cannot be denied the same for long. (This may look remote under the current reporting structure to the Consumer Affairs Ministry). 

Therefore, it is imperative that the operating regulations are strengthened to ensure that we have a safe commodity dealing environment. FMC needs to develop in-house real-time market surveillance capabilities rather than rely on the capabilities that may currently exist at the exchanges. Unless regulators collect high frequency data from exchanges and encourage their staff to explore it, they risk becoming progressively disconnected with the reality that they are supposed to regulate. 

Competition alone is not the solution to market efficiencies when it comes to commodity exchanges . FMC has an array of four national commodity exchanges and two more are in the pipeline. The first three exchanges have created a niche for themselves in bullion and metals, agriculture and plantations spaces. The late entrant is trying to replicate the success and the pipeline cases seem to wager on the share value. 

We have seen exchanges in the commodity space whose promoters have and had large trading arms. In a situation when the ownerpromoter of financial entities hires professionals to execute plans for exchanges, the logic of watertight compartments does not hold any good and a conflict of interest is inherent. Do we need to remind ourselves about the spirit of “demutualisation” for exchanges or should it be restricted to letters only? 

Published in The Economic Times 16 Aug, 2010

Milk co-ops need Agile bosses

Dairy cooperatives have a lot to do with India emerging as the world's leading milk producer. However, most of the co-operative federations are not professionally managed today. In fact many of them outside Gujarat are now run like `regular' parastatals, invariably headed by career bureaucrats. The alternative does not lie in changing organisational design and the operating system which will undermine the role of co-operatives.

Success in dairy industry shall continue to be in the ability to build a robust procurement network which gives raw material cost advantage along with assurance of regular supply. Large MNCs in India have failed in the dairy sector on this account. “Aarth Shakti” (money power) has not got translated into “Lok Shakti” (people power). Moga (Nestle) and Etwah (Levers) have remained laboratory cases while Anand (Amul) has got replicated. A strong backward integration in the form of cattle-feed supply, vaccination availability, breed improvement programmes and profit-sharing with farmers are some of the things that none of the private sector companies nor the MNC’s have been able to replicate and amplify. Farm gate price paid for milk in India is the highest in the world largely due to a strong co-operative presence. Failure of integrated dairy experiments like “Aarey” has not deterred a non-milk co-operative to branch out in the same direction recently. Also joint ventures and foreign collaboration have become order of the day.

Lately, India is under intense pressure to open up its market in dairy produce, especially cheese, from European nations. The EU is keen to get any market opening abroad in a bid to compensate for the troubles facing milk farmers at home. A few years back there was a sudden interest in advising India how to manage the dairy sector and cooperatives when it was emerging as the world's leading milk producer. No doubt the advice came from a Netherland based entity. The US dairy industry is also itching for access to India and the U.S. government is examing legal alternatives for access.

In Europe, when the entire milk requirement for production of cheese and value added products are satisfied “profit is maximized”, the remainder is processed into butter and SMP (Skimmed Milk powder), often referred to as ‘residual production’. This is distinct from patterns of production that is followed in India where priority is given to production and distribution of liquid milk for masses. In India, SMP is important for curbing excess supply due to strong seasonal fluctuation of milk and reconstituting the same during milk shortages.

The recent incident of protestors vandalizing the tankers of imported milk only demonstrates the lack of understanding by the political class of machinations of the large milk producing nations. It is even more surprising that when a minister promotes private sector dairy in his constituency instead of a co-operative dairy, these protestors don’t even raise an eyelid for the local farmers. Perhaps it is time that India demonstrates that if it can produce 112 MMT (Million MT) of milk (09-10) compared to only 10.40 MMT in 1961, it also knows what the best way to manage a growing dairy industry. For this, Indians need to move from “Me” to “We” mentality.

The dairy sector has assumed critical importance for India as it provides work and income to landless farmers. The ruling dairy and milk managers are yet to demonstrate the leadership quality, passion and logic in negotiations, political acumen and stubbornness that Dr. Verghese Kurien “father of White revolution” had demonstrated. Once confronted abusively about the market share by an arrogant New Zealand High Commissioner, Dr Kurien had fittingly replied “If all of us Indians decide to get together and spit on your country, your country will get drowned in our spit”. Unfortunately, the current breed of milk leaders are more concerned in protecting their own turf by creation of ‘services’ to ensure that they remain at the helm of affairs.

Published in The Economic Times , Aug 09, 2010

A run on bullion banks may have just begun

Description of gold by Keynes as “barbaric relic of human irrationality” is nowhere more evident than Indians insatiable appetite for gold. Gold demand shall continue to remain inelastic for Indians as it is bought mainly for store of value, future consumption (gift and wedding), last resort during bad days or mere speculation. Though India is the largest consumer, it shall remain a price taker of gold from London & New York.

A look at the last month’s price graph will show that the prices have been falling. However, a one and ten year’s price data gives an upward trend. The banks are evidently en-cashing on the Indian consumer behavior and earning handsome profits of 5 to 7 percent from gold coin sales. The banks do not buyback the gold coins sold (even though coins shall remain preserved in tamperproof packing along with Assayer certificate). Inspite of the quote variance by the banks, the gold coin sales remain buoyant.

A look at the last month’s price graph will show that the prices have been falling. However, a one and ten year’s price data gives an upward trend. The banks are evidently en-cashing on the Indian consumer behavior and earning handsome profits of 5 to 7 percent from gold coin sales. The banks do not buyback the gold coins sold (even though coins shall remain preserved in tamperproof packing along with Assayer certificate). Inspite of the quote variance by the banks, the gold coin sales remain buoyant.


LBMA, the London-based trade association that represents the wholesale bullion market with focus on international OTC (Over-the-Counter) market for gold, with a client base that includes majority of the central banks that hold gold, producers, refiners, fabricators and other traders throughout the world has just taken the highly unusual step of blocking access to statistics relating to the trading activities of its member bullion banks. This information has been available to the public since January 1997 but since last week it is available only to LBMA members. When the LBMA first made its trading statistics available, observers and analysts were shocked. No one could reconcile the statistics with other market data, nor comprehend how the bullion banks could be trading on a net basis of more than 240,000 tonnes of gold annually while the global mine output was only 2,400 tonnes.

At a recent public hearing of the CFTC on precious metals futures markets, some people had cited the LBMA's own statistics to label the "unallocated gold" accounts of the bullion banks as a Ponzi scheme. There were bullion bank representatives at the hearing but no one expressed an objection. In fact at that hearing, one of the world’s foremost authorities on the markets for precious metals, Jeffrey Christian CEO of the CPM Group had stated that 100 ounces of paper gold are traded for every 1 ounce of physical gold.

This June, the LBMA trading statistics showed that in May 2010 the average net daily trading in gold by LBMA member banks had moved to 24 million ounces per day from 16 million ounces per day…..A massive 50 percent jump within a month. That translates to $7.5 trillion annually. If an operation is running on a razor-thin fractional reserve basis, such step changes are often fatal.

Typically when people are exposed in a scandal their first reaction is to cover-up. It seems that the LBMA has now commenced a cover-up with respect to the gold trading activities of its member bullion banks, withdrawing statistics from the public domain. There is a cover-up of back-door injections of liquidity of physical gold, and the LBMA now is trying to conceal trading information. …..It appears that a run on the bullion banks has commenced.

Published in The Economic Times, August 2, 2010