How commodity bourses can survive

The larger objective should be to strengthen price discovery mechanism and risk management in the economy.

In commodity, like any other trading one does not mind paying a transaction fee as long as profits are made. However, once an entity starts making losses, the concern on the high transaction fee becomes multi-fold. On the other hand, when commodity exchanges start making losses, they may be forced to increase transaction fee camouflaged under some other name to boost the revenue. This often causes narrowing of participation and alienation of new participation on the exchange platform.

Comexes, which till a few years ago were embarking on global ambitions, are now struggling for survival. Of the first three national exchanges that were granted license, one continues to make profit due to low cost of operation, the other is showing signs of operating losses while the third continues to struggle.

Of the three new exchanges that were granted licences, two have already closed down. The other is on the verge of closure unless it is merged with the most profitable exchange in future, considering that a common group of shareholder have significant minority stake in both. Since its inception, Indian commodity futures market had pursued a cash-carry arbitrage model for agricultural commodities and momentum trading for the globally-linked commodities. With markets maturing, the cash-carry arbitrage has shrunk for agricultural commodities and with global commodity market entering a bearish phase, participation has become a casualty on exchange that has global commodity linkage.

The exchange which has kept costs under control still has a fair chance of survival, whereas the other with high manpower and outsourced technology cost is limping for operating profit. These developments throw a very important question - what happens to shareholders’ value in these “financial infrastructures” of the country. Doesn’t it mean that erosion of the value of exchanges is causing an erosion of shareholders’ value? Is it not a provocation enough for those governing exchanges to do a deeper soul searching for the revival? While some PE investors as shareholders of exchanges maybe demanding active performance improvement from the management, they are often short of foresight, vision and definitive roadmap to revive the exchange as governors.

In such situations, it is important that the corporate and shareholder governors of the exchanges are actively engaged by the regulators and the Ministry for its survival plans. However, the buck should not stop with mere profitability plans for commodity exchange’s survival. The larger objective of the commodity exchanges are to strengthen the price discovery mechanism and risk management for commodities in the economy for which the futures trading were allowed in the middle of last decade. If the exchanges are to be taken more seriously by the policymakers, over the next few years those governing the exchanges have to be more contributory to the broader economic objective, similar to what Leo Melamed had done to CME in the seventies.

Published in The Business Line on 24 October, 2014

How to make delivery in commodity futures foolproof

A third party audit should be done periodically to ensure stock quality and quantity

The Forward Markets Commission (FMC) must be complimented for circulating the draft norms on “Strengthening of warehousing facilities in commodity futures market” in the public domain. This initiative can achieve a lot more than just transparency. If executed well, it would drive trading traffic back to commodity exchanges, which are currently bearing the brunt of the lack of confidence on the part of market participants.

Fixing responsibility

In spite of earlier directives from the FMC, exchanges had said that the onus of quality and quantity of commodities lay entirely with the concerned warehouse service provider (WSP). The current draft norms (dated August 26, 2014) and an earlier circular (dated August 30, 2013) put to rest all confusion on this issue by explicitly clarifying that commodity exchanges are primarily responsible for delivery settlement of future contracts and that WSPs act only as agents of the exchange.

The norms of net worth for WSPs have also been prescribed. However, more than net worth, it is essential that the exchange delivery activity of a WSP (which is an independent business unit) be ring-fenced from other activities.

Over the years with fading cash-carry margins, exchange deposits and exchange warehousing margins have shrunk. Therefore, WSPs need other sources of revenue. So, it will be naïve of us to say that the WSP should not engage in any activity other than exchange delivery. Yet it is essential that the liability of other activities of the WSP’s not have spill over into exchange delivery, which may seriously jeopardise the price discovery mechanism.

Covering risks

Currently, exchanges are taking cash deposits and bank guarantees (as security) from WSPs to insulate the “incident effect” of any bad delivery liability. However, on a freeze frame basis, Collateral Under Management (CUM) to bank guarantee (BG) ratio is often insufficient. There should be a standardisation of norms in this regard so that at no point should exchange deliverable goods in warehouses remain uncovered and discretionary. This can also bring in adequate variable coverage ratio into play as hundred percent coverage will be commercially unviable.

The insurance policy for all the exchange WSPs should be standardised, which in turn can be endorsed in favour of the exchanges. In case of any event of fire and other perils, the bridge pay-out to the members can be made from the Investor Protection Fund till the time the final settlement is made by the insurance companies. Currently, exchanges disclose their stock and space availability, which may turn out to be a serious systemic lacuna. In the case of NSEL, we had already seen a fatal gap in this with the exchange’s stock positions.

Independent inspections

Therefore, a regulator-owned software should be made mandatory whereby all exchanges and WSPs should enter their stock and space availability at each location. There should be third party independent audits to periodically check stock both in terms of quality and quantity. The existing cross audits by WSPs at each other’s service location is not full proof and it can lead to messier situations.

In most jurisdictions, decisions regarding implementation of these measures are left to the discretion of the exchange, without the need for any prior approval, implicit or express, from the regulatory authority. This is dangerous and the loophole can be exploited. On the other hand, allowing member/clients to do their own inspections will lead to the collapse of the delivery system and unnecessary disputes and litigation. Therefore, these stock audits should be conducted by reputed and independent inspection agencies appointed by the regulator.

Last but not the least, virtually all of the harmful opacity can be ended with a common clearing house (incorporated outside the individual exchange’s domain) and by making physical stock management more transparent. This will ensure system, process and audit integrity in the exchange delivery and settlement space.

Published in The Business Line on 11 September 2014

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

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