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

Why FMC should make available data on commercial hedgers

Non-commercial traders operate in the commodity futures market for gains from a rise in futures prices, whereas commercial traders, including producers and processors, utilise futures contracts to insure the future inventories against the risk of fluctuating prices.

The surge in the commodity futures trade volume in India in the last one decade has been mainly driven by non-commercial users, along with retail participation.

Classification

In the US, based on each trader’s registration with the CFTC and its positions in the Large Trader Reporting System (LTRS) database, the trader is classified as a commercial hedger or another category.

By regulation, when a trader’s position in a commodity futures contract becomes larger than a certain threshold, clearing members are obliged to report the trader’s end-of-day positions in the commodity to the CFTC.

Transactions in the physical delivery are subject to contract conditions and transport costs, cash flow and the need for storage for the physical commodity, which renders spot prices slow in their response to new information.

In contrast, futures market transactions can be implemented immediately by participants who react to new information with minor cash requirements.

Mere holding of the commodity does not always qualify a participant as a hedger, as the nature of the transaction may be financial, and a temporary ownership of goods is unlikely to change the objective of the transaction.

Objective

Commercial hedgers, who are typically net short in the commodity futures market, offer premium to attract other participants to take the long side.

The traditional hedging pressure theory takes the capacity of financial traders as given. However, during financial crises, funding and risk constraints may force financial traders to unwind positions across the holdings. The liquidation can exacerbate a crisis and cause synchronised price fluctuations, in both spot and futures markets. Similarly, financial distress can force financial traders to cut their positions in commodity futures, which, in turn, may force hedgers to reduce their hedging positions.

FMC has taken several measures to encourage participation of hedgers in commodity futures market for some time and new measures are likely to reduce the cost of hedging.

From the policy perspective, there is a need for increased attention on reporting the data of the participants in commodity futures market in India. While several exchanges in the world regularly announce the data of participation of commercial and non-commercial users in the contracts along with the distribution of open interest position, commodity futures in India are yet to begin this practice. This will definitely go a long way in broad basing the participation in the futures market.

Published in the Business Line print edition dated January 30, 2014

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

Regional exchanges may fail FMC accreditation test

Dilip Kumar Jha  (c) The Business Standard

Mumbai August 19, 2008

Even as the Forward Markets Commission (FMC) is all set to introduce norms for regional commodity exchanges to obtain accreditation as national bourses, the move is unlikely to succeed in the prevailing market conditions.

The commodity markets regulator is finalising the norms which will allow regional exchanges to convert to national commodity exchanges, without losing their identity and core competence. FMC sources say the norms will be finalised within a fortnight.

Since the introduction of national online trading platforms, regional commodity exchanges have almost become defunct, as members switched to online trading from the inherent open outcry on regional bourses. With no new members added in the past 3-4 years, trading volumes have dried up.

“Not only did they possess appreciable domain knowledge in the respective regional commodities, they also kept futures trading alive for ages in India. So, protecting their interest is of prime importance to policy-makers,” FMC chairman B C Khatua had said recently.

In the recently-listed norms for accreditation as a national platform, the regulator had introduced a clause that the minimum net worth should be Rs 100 crore. If this is extended to regional commodity exchanges as well, almost all of them will close down.

An analyst from a broking firm said that all of them put together would scarcely have Rs 50 crore of net worth. That means barring the three national commodity exchanges — MCX, NCDEX and NMCE — most of the regional commodity exchanges would have to shut shop.

Apparently, the heads of many regional commodity exchanges are ready to meet on a common platform with their respective commodities.

“All regional commodity exchanges should merge to form a national entity, with the margins of the commodity traded on their respective platform passed on to their respective accounts. Otherwise, none of them would be able to survive alone, especially when the three national exchanges are functioning and another one is shortly launching the platform,” said an analyst.

Shyamal Gupta of Kotak Commodity said that with a net worth of Rs 100 crore, it would be impossible to generate a daily turnover of Rs 2,367 crore, with Rs 400 earned per crore of transaction.

Almost all regional commodity exchanges either offer trading in a single commodity or a majority of their small volumes comes from one contract. As the government’s efforts to delist commodities continue, fear remains whether the next victim is the actively-traded commodity on one of these exchanges.

Though the National Board of Trade (NBoT) survived the recent bout of suspension of soy oil because of the support of India’s largest edible oil producer, Ruchi Soya Industries, the launch of alternate contracts of soybean and soymeal failed to generate equal volumes as soy oil. According to analysts, other commodity exchanges may not be able to survive such sudden suspension of trading.