Commodity Markets in India: An immediate need to restore credibility

Shyamal Gupta

Background

Warren Buffett’s aphorism, “It's only when the tide goes out that you learn who's been swimming naked,” has become a market cliché for good reason. The NSEL crisis has unearthed deficiencies in the non-regulated segment of the commodities market that lack adequate risk management and mitigation as well as the necessary level of transparency.

Excessive bilateral exposures with insufficient collateralization were built up in this market and this exacerbated the crisis. While commodities were traded in the exchange, the force of supply and demand in the central forum was by design not supposed to assist in price discovery but create a transaction with an assured return. The emphasis was more on trade financing rather than trade transaction. In situations like these, the design of products traded on these exchanges make it readily susceptible to manipulation. If as a result of inadequate surveillance and monitoring, trading practices, etc., a few can benefit at the expense of others, the ecosystem will lose confidence in the integrity of the marketplace. This is what has happened.

In commodities there is always a physical side of the transaction which cannot be done away with  even if there is an electronic holding of commodities, unlike stock market where once the share is in demat form the title holder remains secure, This naturally leads to the fact that dealing in commodities is dealing with a “financial PLUS” situation. If risk mitigation measures are not robust and strong then the chance of compromises are many.

Need to restore confidence:

To restore confidence in commodity markets, there is a need to assure through regulatory reforms that there will be no repeat of the NSEL type collapse. The fundamental cause (leaving aside any malafide intent) of the contract collapse lay in inadequacy of any institutional arrangement. Had there been three separate institutions involved – the exchange, the clearing house and the guarantee corporation the situation might have been ameliorated. Still it would have required great insight, forethought and energy given that the fatal flaws are not managed by the same interested parties.  In most jurisdictions, decisions regarding implementation of these measures are left to the discretion of the exchange, without any prior approval, implicit or express, required by the regulatory authority. This is dangerous and so the loophole was exploited.

It will be helpful however to make two basic points at this stage. The first is the system of margining, daily settlement and secondly the clearing house surveillance of members which is the bedrock upon which any exchange is generally based. These were all compromised.

The transaction was at spot and the prices were fixed, the transaction was believed to be completed. However, on account of being a deferred payment mechanism, the system never adopted a daily settlement mechanism and it became an “ever rolling settlement”. The clearing house function was done by the exchange by creating its own clearing and settlement department compromising on arm’s length mechanism.

In this scenario investors were enticed to provide finance against the collateral of physical stocks. In principle, this provides more security but in practice investors should have avoided becoming complacent, only because they have collateral. If investors were largely ignorant about commodity finance (a not uncommon occurrence), they may be willing simply to receive warehouse receipts issued by an independent warehouse (with the risk that the receipts are falsified), or by a warehouse controlled by the borrower (hence with no real guarantee that the commodities pledged are indeed in the warehouse, or that they will remain there), or even from a non-existent warehouse (in other words, the borrower just invents a warehousing company).

Distortion of spot transaction: 
In our real life, spot transaction is one in which we pay money and receive goods immediately. The ready delivery contract under Forward Contract Regulation Act (FCRA) states, “Ready delivery contract means a contract, which provides for the delivery of goods and the payment of a price therefore, either immediately or within such period not exceeding eleven days after the date of the contract and subject to such conditions as the Central Government may, by notification in the official Gazette, specify in respect of any goods, the period under such contract not being capable of extension by the mutual consent of the parties thereto or otherwise.” 

In negotiated deals, the so called spot contract is designed with deferred payment terms which are customized. NSEL contracts gave a new dimension to the spot transactions with deferred payment on a mass scale, in the absence of proper regulatory control. While commodity holders deposited commodity in the warehouse to sell commodity, investors bought it and sold the same in a longer settlement period. For example, if the depositor of the commodity sold it on T+2 basis and the same was bought by an investor, the investor further sold it on T+25 basis. This resulted in creation of a repo contract. Most of the transactions were driven by the opportunity to make short term and quick money.

Regulatory Vacuum: 
There was no clarity on who should regulate spot exchange. It was not under the control of Forward Markets Commission (FMC) as spot contracts are different from forward contracts. Suddenly, one day the Ministry of Consumer Affairs (MCA) felt the need to regulate the exchange.

Objective of Spot exchange: 
People with no direct interest in commodities started transaction in commodities. What is the objective of existence of a spot exchange?

Poor Audit and transparency issues: 
There was no third party verification or collateral manager to certify the availability of stocks in public domain. Even in the US, a special commission found in 1999 that mis-stated asset valuations accounted for nearly half the cases of fraudulent financial statements, and that inventory overstatements made up the majority of asset valuation frauds (Joseph T. Wells: “Ghost goods: How to spot phantom inventory”, Journal of Accountancy, June 2001).

This crisis is a great learning for the regulator, investors as well as exchanges. There is an immediate need to regulate exchanges on a comprehensive basis.

Insufficient risk evaluation and risk management capabilities

As revealed by the current crisis, the exchange system had yet another fundamental weakness: besides lacking sufficient capabilities, it was designed for inferior risk assessment and management. For complex buy and sale transaction with mismatched payment, the problem is twofold. First, many market participants lacked the ability to adequately understand that this was not a trade transaction but a funding transaction; they also lacked the ability to value the funding arrangement and, in some cases, independent valuations by a third party were not available to support them. Second, after having exposed themselves to risks, many did not have sufficient capabilities to monitor and mitigate these risks effectively (including some of the brokers who have facilitated these transactions; needless to mention that some of these entities have even applied for banking license with RBI).

Trading requirements versus clearing requirements 

A clearing requirement and an exchange-trading requirement are not the same thing. They are different. It is extremely important that people understand the difference as there's an incredible amount of confusion.

A clearing requirement is a requirement that all eligible trades be cleared on a central clearinghouse (also known as a central counterparty, or CCP). A clearinghouse provides critical counterparty risk mitigation by mutualizing the losses from a clearing member's failure, netting clearing members' trades out every day, and requiring that parties post collateral every day. Clearinghouses also centralize trade reporting, and can provide any level of post-trade transparency to the markets that you desire — same-day trade reporting, including prices, aggregate and counterparty-level position data, etc. Virtually all of the harmful opacity and murkiness of the current markets can be ended with just a clearing requirement — that is, a clearing requirement is a prerequisite for getting rid of the harmful opacity in trades; an exchange-trading requirement is not.

In sum, virtually all of the systemic risk mitigation — reduced counterparty risk, the huge increase in transparency, the reduced complexity, regulatory access to the necessary data, etc. comes from the clearing requirement.

An exchange-trading requirement, on the other hand, is simply a requirement that all eligible derivatives use a particular type of trade execution venue: exchanges (also known as "boards of trade"). It is important to remember that an exchange-trading requirement has nothing to do with clearing — they are completely separate issues. People tend to think of exchanges as synonymous with clearinghouses because, at least in the US, the big exchanges own their own "captive clearinghouses," so most exchange-traded derivatives are also cleared through the exchange's clearinghouse. But they are two separate functions entirely.

The exchange is just the trade execution venue. The only thing that an exchange-trading requirement adds to the clearing requirement is "pre-trade price transparency." Pre-trade price transparency is not always and everywhere a good thing — and if mandated for all cleared trades, it would almost certainly be a bad thing. Mandating a particular form of trade execution venue (of which there are many, and among which the competition is fierce) for all cleared trades is incredibly short-sighted, and just bad policy.

Not knowingly, of course, but the investors have clearly been fooled into believing that the exchange-trading requirement is the same as the clearing requirement (something they actually should fight for). Arguing that exchange-trading would be a better deal for end-users is NOT an argument for why public policy should require exchange-trading; it's just your view on the relative merits of the various trade execution platforms — a view which most other end-users obviously do not share. There's absolutely no reason that we need to settle these disputes by legislation. It's also important to remember that not including an exchange-trading requirement would do nothing to prevent the market from migrating onto exchanges.

The ultimate difference, then, between the clearing requirement and an exchange-trading requirement is this: The clearing requirement is what's important, and the fight over the scope of the clearing requirement is where all the action is. The exchange-trading requirement, on the other hand, is a pretty terrible idea, which even under the most optimistic assumptions would provide only minimal benefits to financial markets — it is, in other words, an extremely dangerous sideshow.

Central Counterparty (CCP)

Central counterparties (CCPs) provide clearing of all trades (risk management) and position management of all open contracts (trade management). The CCP becomes counterparty to each market participant, guaranteeing the fulfillment of each contract and nets all offsetting open positions of each trading party across all other trading parties (multilateral netting).

As the CCP keeps track of all trading parties’ open positions, it also receives exercising requests and serves as a middleman to the other counterparty of a contract being exercised. The CCP usually also generates the settlement instructions for the payments resulting from exchange traded contracts and, if necessary, for the physical transfer of the underlying asset.

CCPs have proven their worth in risk management and mitigation, for example, in the wake of the default of Lehman Brothers in September 2008. As one of the largest exchange-traded players, Lehman was the counterparty on numerous derivatives contracts. In the case of centrally cleared derivatives, CCPs achieved a near complete resolution for all open positions within less than 15 trading days. Additionally, CCPs were able to effectively shield the accounts of market participants trading through Lehman from the effects of its bankruptcy. In this way, CCPs mitigated market disruptions and prevented spillover effects, thus minimizing risks to all parties involved. The collateral that CCPs had asked from Lehman was fully sufficient to cover its obligations. In the absence of CCP in NSEL, the resolution looks dim.

Novation:

A distinct feature of any organized exchange is that credit risk between the ultimate counterparties (ie. clearing members) is eliminated through the process of Novation. Novation is used in exchanges to describe a special situation where the central clearing house interposes itself between buyers and sellers as a legal counter party, i.e., the clearing house becomes buyer to every seller and vice versa. This obviates the need for ascertaining credit-worthiness of each counter party and the only credit risk that the participants face is the risk of the clearing house defaulting. In this context, novation is considered a form of risk management.

Mitigation of counterparty risk is achieved by contract novation, i.e. the process through which a CCP acts as a buyer to all sellers, and vice versa. The CCP thereby assumes the counterparty risk of all trading parties and ensures collateralization. Following novation, which is usually handled automatically, the CCP is the universal counterparty to all contracts. Practically, each market participant only needs to be concerned with the counterparty risk of the CCP. Given that the CCP is well protected against default by the full collateralization of open risk positions, by its ability to close out positions and by its several lines of defense, complexity in counterparty relations and monitoring costs are substantially reduced.

CCPs address information asymmetry problems

Participants in a bilaterally cleared market are not able to gain a full picture of their counterparties’ risks, since their knowledge is limited to their own positions vis-à-vis their counterparties. Understandably, the effects of this uncertainty on market confidence can be devastating. By contrast, CCPs are uniquely poised to swiftly understand the positions of all market participants and are in a strong position to manage risks for a clearing member in distress. This may necessitate increasing collateral and – if needed – unwinding open positions. The well-established CCP processes for unwinding the positions of an insolvent member further foster market confidence.

A CCP reduces complexity by reducing the number of counterparty relations and increases efficiency by establishing the margin and collateral requirements for its members, centralizing the necessary calculations, automatically collecting or paying the respective amounts and preventing disputes (e.g. over the amount and quality of collateral). CCPs address operational risks by means of adequate auditing procedures (i.e. compliance with technical infrastructure requirements) that ensure the necessary operational know-how of their current and potential members.

Clearinghouses and Margins

The creation and acceptance of the clearing house as the common counterparty is not predicated on the commodity contract that is traded. It is a function of the netting methodology and the efficiency that emerges from netting. The clearing house's role as a credit risk intermediary does not require any particular relationship with any commodity. A credit risk intermediary is similar to a banking intermediary since banks perform the role of a common counterparty to savers and borrowers, and banks do not normally benefit from narrow specialisation. Diversification of borrowers is a source of strength. Since the functions of a clearing house and the particular characteristics of commodity contracts that the clearing house clears and settles do not have a tight linkage, the structuring of clearing institutions and clearing processes is not dependent on the commodities and the contracts.

Most exchanges have clearinghouses that play a central role in these markets. Most notably, a clearinghouse facilitates trade among strangers by eliminating counterparty risk and guaranteeing the integrity of the contracts. In the US, historically, each exchange has had its own clearinghouse--either formed as a separate entity or as a part of the exchange. Recently, a number of U.S. exchanges have begun exploring modes of common clearing; in other countries, such as the United Kingdom a single clearinghouse (LCH) serves several exchanges.

Only clearinghouse members can submit trades to the clearinghouse, and while every member of a clearinghouse must also be a member of the related exchange, not all exchange members are members of the clearinghouse. Clearinghouse membership involves financial requirements and responsibilities over and above those of exchange membership, including the maintenance of a guarantee deposit at the clearinghouse. This deposit serves as a reserve fund that can be used, if necessary, to meet the financial obligations of a defaulting clearing member.

It is the clearinghouse's responsibility to collect original margin from its members for the contracts traded on the exchange. The clearinghouse's original margin, which is the minimum amount clearing members normally collect from their customers, reflects historical price volatility and generally is set at a level sufficient to protect the clearinghouse against one day's maximum (or historically very large) price movement in the particular contract.

As part of the daily marking to market, clearing members each day pay to or receive from the clearinghouse funds known as variation margin. In volatile markets variation margin may be collected intraday, with clearing members sometimes required to deposit funds within one hour of the margin call.

Exchange Warehousing is an important ……yet it is an ignored area

Warehousing sounds dull. But investors should pay attention: it may be about to reshape the global metals markets. The buzz among metals traders is not about Chinese growth or US monetary policy, but a proposed change in warehousing rules by the LME. The move, coming after the LME was acquired by Hong Kong Exchanges & Clearing, aims to reduce long queues to remove metal from some warehouses in the LME’s global network. Should the LME push ahead with its proposal, traders and analysts say, the impact on the global metals markets could be dramatic, reducing the dominance of warehousing companies in physical metals markets and possibly leading to significant price drops for some metals.

Supply chains can become vulnerable to fraud, with commodities in storage at particular risk. Commodity spot activity looked set to pick up, however with increased trading activity came more risk, such as the fraud relating to goods in storage. Warehousing provides a vital function in the exchange trade of commodities, but it also provides the potential for serious losses when things go wrong.

Some lessons to be learned from International Exchange Collateral Conundrum: 

Several high-profile cases in recent years illustrate the risks and complexities involved in fraud cases.

Lessons Learned

• If one is to confirm existence or ownership of an asset, ensure the verification is done independent of the client.
• Take the warning signs seriously and investigate them promptly.
• Investigate discrepancies.
• Just because a company is profitable and successful does not mean there is not a possibility of fraud.

What is owned on paper may not be yours: Comex Warehouse Stock Report Fraud: A case which is very similar to NSEL’s misreporting of the stocks had already taken place in Comex.

In case of Gold, each bank that operates a CME (Chicago Mercantile Exchange) vault is responsible for keeping and maintaining all accounting records in connection with operating the vault.  This means that all of the reports and data that the CME uses to produce its warehouse stock reports come from the banks.  These are paper accounting records the bank produces and sends to the bean counters at the CME.  There is no actual independent audit of the reports OR of the bars themselves that are reported to be held in each bank vault.  Everything the CME publishes is based on what is reported from the banks.

A large portion of the gold that is being reported by the Comex (CME) vault operators is likely not really there to be reported. Now, "not being there" could well mean that there is a lease-claim attached to it or some other form of hypothecation. Just because bars are sitting physically in "registered" or "eligible" accounts does not mean that the intended owner of that bar has a legal entitlement to that bar.

If we review the laws connected with short-selling and hypothecation, when an asset is sold short or hypothecated, the original holder of that asset unknowingly loses legal title to it.

The fact that the legal department at the CME now requires a disclaimer about the bank reports that are used to produce the Comex warehouse gold and silver stock should tell us all we need to know about the nature of those bank reports, especially when considered in the context of all of the other frauds that banks have been involved in over the last couple decades. 

The recent thirty five per cent drain of gold inventory from the Comex represents what has been physically removed upon demand by entitled owners. By "entitled," means the party who possesses the legal title to the bars. The disclaimer was added to the inventory report as an attempt to exonerate the CME from the legal liability of fraudulent reporting by the vault operators, who are responsible for the record-keeping and accounting and reporting of the bar inventory that is supposed to be in their vaults. 

Moreover, a high percentage of the gold that remains in the Comex vaults has likely been leased out or hypothecated.  In other words, the financial reports from the banks do not legally present the actual amount of gold in Comex vaults that can be immediately removed upon demand by the original intended owner. 

In the light of this, the Bundesbank demanded some of Germany's gold to be shipped back to Germany and the Fed required 7 years to ship back just 300 tonnes of Germany's 1800 tonnes supposedly sitting in the Fed's NY vault? (Please note that Venezuela was able to have 200 tonnes of its gold shipped back to Venezuela within about 4 months).

Bank-produced paper reports at the Comex are more than likely riddled with fraud and it clarifies the difference between owning physical gold vs. owning a paper claim on gold sitting somewhere else and a claim which can be hypothecated such that one actually loses legal entitlement to that underlying asset.

How commodity markets can be made safer

The guidelines for implementation should be established on certain principles to govern the activities of institutions that provide critical functions:

Market-driven solutions: 
In general, market driven solutions (e.g. the provision of CCP clearing) are preferable as a default option. Infrastructure providers will ensure choice for market participants and promote innovation.

Promoting collateralization of bilateral exposures (preferably through third parties): 

In areas where it is not covered by CCPs, collateralization is still necessary to mitigate credit risks. Neutral third-party collateral managers can play a strong role in ensuring appropriate collateralization, while also improving the efficiency of the collateral management process. Standards for collateralizing already exist. A tightening of standards supported by statutory rules should be considered (e.g. with respect to eligibility, the valuation of exposures and collateral, as well as the reuse of collateral). Providers of collateral management should ideally be neutral and independent of any risk-taking activities. It follows that a provider’s systemic relevance increases in line with the volume of collateral under management.

Conclusion

There is evident need to reform unregulated parts of commodity market. Here, merely introducing stricter regulatory and supervisory requirements will not suffice – the commodity market needs a strengthened market structure that includes the imperatives of safety and integrity as built-in principles of sound market organization.

•  Regulatory provisions need to ensure the mandatory registration of all electronic spot contracts via CCPs or a central data repository.
• Economic incentives should exist so that a maximum of contracts are shifted to CCP clearing or, at the very least, to full collateralization of all non-CCP-cleared contracts, ideally by neutral and independent collateral managers.

Commodity spot transactions with deferred payment structures are generally used for completely legitimate purposes. But at the current stage, they have been abused. The proper regulatory and public response is to reduce the possibilities for abuse, while leaving companies (and Governments) room to benefit from the many value-added aspects of deferred payment cycles. While abuses of financial instruments can be destructive for the companies involved, this report should provide important lessons on how these instruments can be best used to create significant value.

(Published in India Commodity Year Book 2014 )