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

Warehouse receipt system can help develop market mechanism

A well-developed process can provide a focus for improving the entire commodity chain.

The Warehouse Receipt System has a potentiality of a very high socio-economic payoff in India but it has not taken off due to various regulatory constraints.

The WDRA (Warehousing Development and Regulatory Authority) is authorised to regulate only the negotiable warehouse receipts of the commodity ecosystem.The authority has not been mandated nor does it have the jurisdiction to regulate the entire warehousing space, which remains a domain of various State Warehousing Acts. Even, non-negotiable warehouse receipts do not fall under the regulatory ambit of WDRA.

Since its constitution in 2010, the authority has not been able to convince the banks to use negotiable instruments for agricultural funding in any significant scale due to many structural defects in the WDR Act itself. The bankers privately confess that negotiability of the warehouse receipts in the current context of the Act does not give them adequate safety and assurance of repayment.

In case of default, the authority does not have the power to insulate the lender of safe return of the borrowed capital. The regulator has no direct control over the actions of the accredited warehouse, which may move stocks around without the knowledge of a regulator who is not on site.

The WDR Act has considered the structural robustness of the warehouse as fundamental to the accreditation process whereas in reality, the credibility of entities managing these warehouses has primacy on which the transactional business rests.

Therefore, it is important that warehouses should be adequately capitalised to carry on the activity. The adequacy of capitalisation and credibility of the warehousing entity has been totally ignored in the spirit of the Act.

Moreover, if a warehouse operator goes bankrupt, it may also be difficult for the bank to prevent priority being given to other creditors. To make the system successful, it requires careful analysis of the legal issues and a very rigorous set of guarantees and oversight mechanism.

Sometime back, the FMC (Forward Markets Commission) had directed the commodity exchanges to adhere to the standards of WDRA norms for accreditation of warehouses for exchange delivery. However, it must be noted that WDRA has no jurisdiction over any commodity exchange’s delivery mechanism. A registration with WDRA does not empower the authority to regulate the delivery on futures market.

The FMC is the supreme authority in case of anything that governs the delivery process along with the commodity exchange’s warehousing.

Warehouse receipt systems can play a central role in developing the framework of modern market institutions. A well-developed WRS can provide a focus for development of the entire commodity chain, providing incentives for a range of different parties including farmers, financiers, traders, processors and public sector buyers.

Difficulties stemming from the policy and institutional framework have made the introduction of WRS a difficult undertaking in India.

Published in The Business Line on 14th August, 2014

Modern Storages Are a Must for Ensuring India’s Grain Security

Investment in storage infrastructure belonged traditionally to state agencies as investment of this type was viewed as economically unattractive and too complicated for the private sector.

In recent times, subsidies have been used as financial instruments to attract private investment into storage infrastructure by effectively de-risking the investment. It is a moot point that in spite of modern silos like the one put up at Moga, why others have not taken off.

The Centre has already announced a scheme for construction of godowns through private investors under a 7-10 year guarantee scheme.

Due to political and sometimes constitutional reasons, making outright privatisation of storage infrastructure is difficult and therefore concessions have been extremely popular.

A concession provides its holder the right to operate a service for a limited period of time (usually 20 years) at the end of which all the assets go back to the government. The concessionaire is responsible for all investments as well as other eventual targets specified in the contract in exchange for the right to the cashflow of the users’ payments. However, there is a growing disenchantment with concessions in particular.

Public investment in storage infrastructure has been declining as a proportion of both total government expenditures and GDP. Government agencies provide 61% (60 MT) of India’s total agri storage capacity which also includes a hired capacity of 23 MT. Dominant producers of food grain and related agriculture products are the major users of godowns and storage capacity. The cost of building silos to store a million tonne of food grains may be about Rs 600 crore considering that the required land is made available by state governments. State warehousing corporations under Government of India like FCI have already planned galvanised silo storage systems.

Replacing bags of jute with any other material will not solve the problem of wastage. If we are planning to store food grains in galvanised silos in bulk, we should also plan for the distribution system through bulk containers. This could be planned with the help and expertise of authorities connected with the Indian Railways.

Grain safety is as important as grain saving. Each region in India has evolved storage methods to preserve grains. In villages, we have grain gola (silos); made from wood or local material that protects the grain from moisture and rodents. In most cases, villagers use neem leaves or plantbased pest resistant methods to repel pests and fungus.

However, these silos-like structures are small and they are suitable for storing village produce for a year or two. These time-tested methods are being abandoned in recent times as they are replaced with concrete godowns, with support from central and state government under various schemes. Akin to many areas of government expenditure, government subsidy programmes are often at risk of corruption and fraud at the cost of taxpayer. The extent to which these two factors affect the subsidy policy is difficult to fully estimate because it is not commonly detected or reported to official sources. Precise figures are difficult to obtain and governments are also often unwilling to publicise occurrences of fraud and corruption out of fear of bad publicity or public concern at their lack of oversight.

 *all figures in the table are in million metric tonne

Published in The Economic Times 

Price Rise and Inventory Management

When two elephants fight, it is the grass that gets trampled

-African Proverb

The next time you find that a can of your favourite beverage to be expensive then don’t blame it to government’s mismanagement. The battle of price has gone beyond the realms of monetary and fiscal policies. It is now being fought between a financial giant Goldman Sachs and a beverage giant Coca Cola. The centre of the issue is a warehousing company Metro International Trade Services.

The price of aluminum (a key input needed for the canning) has gone up by 13% since January this year. The current price of $2500 is way above the price of $1700 in June 2009. The increase is occurring despite rising inventory. Global aluminum stockpiles on the London Metal Exchange have grown from below a million tonne in 2007 to currently more than 4.5 million tonne. Metro’s stockpile totals 25% of the aluminum on LME or about 12% of the world’s warehoused aluminum. In February 2010, Metro’s acquisition for a reported $550 million by Goldman was one of the deals where financial institutions entered the littleknown world of warehousing operations. If the current stockpile remained even over a year, Goldman Sachs would earn revenue of $230 million from Metro's warehouses.

However, space rental is hardly the reason for owning a warehouse. Direct connection to the physical markets for metals can give metal traders an enormous edge in understanding the demand and supply realities and help make profitable buy-andsell decisions. This stockpiling model of commodities is becoming more and more accepted as the newest method to influence prices and secure trading advantages. It has been seen in silver with physically-backed ETFs.

During the recession in late 2008 and 2009, Metro began stockpiling aluminum. With reduced demand, producers needed a place to put their aluminum output to maintain production. They could do this by housing the metal in warehouses and selling the warrants of the metal on the LME. Metro charges a storage fee of 42 cents a tonne each day to the LME warrant holder on aluminum sitting in its warehouses. It uses an incentive system to bring in far more aluminum than it allows leaving its warehouses, causing long delays in the delivery of the metal and, in turn, inflating prices. Once the metal is in the warehouse, the producers who are paying rent sell ownership of the metal on the LME. But the created bottleneck of delivery leaves new owners waiting for months for their product to be released.

According to LME rules, only 1,500 tonne of aluminum is required to leave the warehouses each day, but an unlimited amount can enter. 

The LME created the rules in a different era when stockpiles were much smaller. The issues weren't as glaring as they are today, and it's unfair for the LME not to change dynamically with the system. Coca-Cola alleged it takes more than seven months to access its purchases from the Metro warehouses. During this time, they pay a storage fee. This means less aluminum in the physical market when the need for aluminum is rising.

Coke is accusing Goldman of limiting the supply that is leaving its warehouses, trying instead to increase stockpiles and artificially boosting the prices that producers can charge. Taking money from small consumers through financial market manipulation of commodities is very well known. But now this time, the financial giant is messing with one of the premiere global companies.

Published in The Economic Times