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