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

Volatility makes commodity cos’ valuation tough

WORLDWIDE, commodity trading companies have often found themselves embroiled in controversies — whether it is ‘Oil for Food’ (Masefield), government tenders (AWB) or violation of environment laws (Vedanta). Politics and commodity trading make a heady mix — names like Marc Rich (pardoned by Bill Clinton on the last day of presidency) and Hindujas (Bofors) have not been able to keep distance from infamy. The reason: Pricing in commodities is inherently speculative. Commodities generate no direct income. Instead, one can only sell a barrel of oil or a shipload of wheat to produce cash flow. The problem is that it’s forever unclear how much cash the commodity is likely to generate until the day of transaction arrives. Therefore, owners of commodity companies are often seen in close proximity with the mighty and powerful (politicians and policy makers) to get the best price out of the proximity. Decisions are made fast which often crosses the limits of fair play. 

A few years back when a few trading companies tried to rate themselves, agencies rated them at the lowest investment grade. However, it seems global trading houses are reshaping their businesses amid the commodity price boom. They are seeking capital to diversify from their role as pure intermediaries to expand production from mines, oil fields and farms. Glencore is planning a flotation. Earlier this year, Trafigura tapped the bond market for the first time and Hong Kongbased Noble last year sold a stake to Beijing’s sovereign wealth fund (China Investment Corporation). Barely a week after the death of the heir of Louis-Dreyfus, the French family-owned conglomerate that owns one of the world’s largest agricultural commodities trading houses, is exploring an IPO for its businesses. Louis Dreyfus Commodities, the 159-year-old commodities trading house, has also engaged in deal talks with Singapore-based rival Olam. 

Uncertainty and volatility are endemic in valuation but commodities companies have volatility thrust upon them by external factors as a consequence of which even mature commodity companies have very volatile cash flows. Trading companies are generally privately or closely-held entities (with late exceptions such as ADM & ED&F). Commodities generate no income and so estimating a fair value is unavoidably speculative. In contrast, stocks, bonds and real estate (not land) enjoy the attribute of generating measurable cash flows, which can be analysed in the cause of putting a valuation on the said assets. 

Therefore, when valuing a commodity trading company, there is a danger of focusing on the recent fiscal year, which is more of a function of the macro variable like the commodity price or the growth in the underlying commodity rather than the performance of the company as such. If we accept that the normalised earnings and cash flows have subjective component, then perhaps for commodity companies we can very well say value normalisation is more a bargaining strategy if not an academic exercise

Published in The Economic Times