Basel III might add more hurdles for trade finance

One of the hottest topics in commodity trade finance is the impact of Basel III. A majority of practitioners view Basel II as unfairly tough on trade finance in terms of capital requirements under the Standardised Approach, compared to the "one size fits all" approach of  Basel I (with its 20% credit conversion factor for trade finance). Evidences also suggest that the implementation of  Basel II has contributed to a drain out of available trade finance, particularly on SME sector. The safe, short-term, and self-liquidating character of trade finance has not been properly recognised under the Basel II framework and the proposed revised rules ("Basel III") seem to raise additional hurdles to trade finance.

Traders require letters of credit (LCs) and other loans to arrange for the shipment and delivery of their goods. As per WTO, about 80 percent of international trade is financed by some kind of credit. Among the trade instruments that came under the regulatory microscope in the aftermath of the crisis, include off-balance-sheet tools such as LC. These have become prime targets for increased regulation and additional capital charges, to the frustration of commodity traders and banks alike.

It is very positive to see the regulator striving to improve the banking system and aiming to tackle excessive leveraging, one of the focus of Basel III. This all sounds good except for the fact that trade finance might end up being an unexpected casualty in the end again because it also enjoys an off-balance sheet treatment which would now have to bear a flat 100% credit conversion factor.

While there is logic in tightening the treatment of some toxic off-balance-sheet financial instruments, there is less sense in stricter regulation of LC and similar trade bills. The question of why off-balance sheet trade exposures are not being automatically incorporated into the balance sheet (to avoid the leverage ratio) is one of its subtleties. It is argued that the off-balance sheet management of these exposures is necessary and in most cases only a temporary treatment of what would eventually become an on balance-sheet commitment.

The five-fold increase of capital requirements for off-balance-sheet letters of credit would increase the cost of banks in offering such risk mitigation products. Either that cost will be passed on to the customers (commodity traders), making it even more difficult for smaller businesses to trade internationally, or, in the absence of incentives to issue LC, customers may simply choose to use on-balance sheet products such as overdrafts to import goods (as these carry less stringent documentary requirements) which may prove to be potentially far more risky for the banking sector in general.

Unlike some western and European countries, open account financing is not appreciated in India. Traditional LC brings in more security and is highly appreciated. Therefore, the prudential treatment and cost of letters of credit is critical for India.

As the committee is sitting to finalize Basel III, the traders across the world will hope that the fear factor does not translate into unfair treatment of Trade Finance… the impact of that shall be profound in movement of commodities.


Published in The Economic Times 13 Sep, 2010

Investing in Precious Metals can be Tricky

It takes two to tango but a bunch of ill-informed commodity analysts to create hype around contango. Investors in precious metals must avoid the drove of commodities analysts – as there are few signs of intelligent-life.

Despite the tall claim that India is no longer a price taker for gold but a price setter, the claim does not cut much ice. We are all clueless of the happenings in the international market. Price and investment hype have come at a time when internationally one large market maker is sitting with the largest concentrated-position in the gold market in history (“short”), while the other large entity is sitting with the largest concentrated-position in the history of the silver market (also “short”). They are investing in commodity which has become genuinely “scarce”, due to the manipulation of the market.

The explanation of "hedging" by gold and silver mining concerns is even more amusing. Miners sell forward their future output, essentially selling naked, sometimes going out as many as several years. Then they cover part of their short position through purchases of call options. One can hedge physical gold, but can one hedge gold locked up in ore deposits!

In an Indian scenario a buy-and-hold strategy has become the profit-making proposition for many. The gold market has always been a contango market. This means that the gold spread has always reflected the carrying charge, the opportunity cost of carrying gold, most of which is foregone interest. The reason a large contango is rare is because it’s too easy to profit from it.

In the technical jargon of the futures markets, the basis is the spread between the nearest futures price and the cash price in the same location, but a strange phenomenon has manifested itself. Rather than remaining constant, the basis as a percentage of the rate of interest has been vanishing and now has dropped to zero. Has anyone checked the Indian “basis”? What about physical delivery… still a chimera or is it quality certification issue which ensures that this remains a chimera.

Growing numbers of investors are being drawn towards this market of buying precious metals. With festival and marriage season about to start….Gold, gold, gold...everyone may say...let us collect gold by which we shall remain wealthy... The banks, exchanges, analysts, brokers, mutual funds are misguiding people who seek to protect their wealth. Gold is a cleverly designed trap. This trap has caught the middle class, upper-middle class, and upper class, totally off guard. Hundreds of thousands of hard-working people will invest their savings in gold, believing that the risk is non-existent, and that their wealth is protected against severe market fluctuations and hyper-inflation.

Gold had lost nearly eight seven percent of its investment purchasing power between 1980 and 2000. That was during the best period for growing businesses in the twentieth century.  It is often said “Buy facts and sell fiction” but how does one distinguish which is the fact and what is the fiction …. at a time when analysts are manipulated and there are hardly any facts apart from the rumors. And what if the entire gold futures turn towards “backwardation”? Will that be a fact or fiction…..

Published in The Economic Times 06 Sep, 2010

CII Panel: The evolving 3PL Supply Chain Scenario: From People Driven to Process Driven Sep 01, 2010 Taj Mahal Palace. Mumbai

L to R  Shyamal Gupta (Chief Business Officer, NCMSL), S Narsimhan (Senior VP, Reliance Retail), Surabhi Upadhyay (Anchor, Bloomerg UTV), Abhraham Mathai (VP SCM Aditya Birla Retail), A Balakrishna  (Head-  SCM Gati) 

Now is the time for a clearing house vertical

It is well-known that futures exchanges utilise a wellcapitalised central clearing house. The clearing house mitigates the risk of settlement failures by isolating the effects of failure of a market participant. This prevents credit events at a firm from cascading onto others firms. A famous illustration was when Nick Leeson, a 28-year-old trader at Barings, lost $1.4 billion on trading futures. The losses drove Barings (a 228-year-old institution and ‘Banker to the Queen’) into bankruptcy but that did not threaten the market or any counterparty. 

The clearing function of commodity exchanges in India is executed by inhouse clearing & settlement departments. However, a clearing requirement and an exchange-trading requirement are NOT the same thing. A clearing requirement necessitates that all eligible derivatives be cleared on a central clearing house whereas an exchange is a platform for trade execution. The only thing that an exchange-trading requirement adds to the clearing requirement is “pre-trade price transparency.” The need for a clearing house ‘vertical silo’ is intensifying as an increasingly important part of market reforms in the wake of the financial crisis. 

A clearing house acts as a buyer to every seller, and a seller to every buyer in transactions, stepping in to complete a trade if one party defaults. If an additional margin is required on any account, then the clearing member of that account must post the additional margin before a specific time in the next business day.

There are numerous examples of exchanges having their own independent clearing house (as it has turned into a lucrative business). A few years back, ICE severed its link with LCH to start its own clearing house. The possibility of replicating the Japanese model (different from the LCH model) is immense. The Japan Commodity Clearing House (JCCH), an independent centralised clearing house operation, began providing services for transactions of all commodity exchanges in Japan in 2005. JCCH is organised as a company owned by all Japanese commodity exchanges and the Japan Commodity Futures Industry Association, an association of the futures commissions merchants. 

One approach could be that exchanges may need to contribute capital to the clearing house or perhaps offer stocks in the clearing house to other investors. Of course, this shall require related changes in the clearing house structures including the issues “for profit”. A very large capital requirement for technology and the ability to continually advance technology and systems to stay in competition with international standards is affected by this decision. 

In an environment where Chinese walls of ownership between banks, broking companies, trading companies and commodity exchanges are rapidly vanishing, the real action may be starting to take place below the waterline in the mundane world of clearing. The regulator has already restricted brokers to trade on their exchanges. The regulator for the sake of good governance can ask ownerbankers to stop issuing bank guarantees to the members of their ‘own’ exchanges. Moreover, by having a clearing house, the ’real’ counterparties will not get intertwined in any opaque manner in the clearing function. Since the beginning, new-generation futures exchanges in India have not encountered any clearing and settlement breakdown but does that mean that going ahead we can ignore international best practices of having clearing houses. 

Published in The Economic Times 30 Aug, 2010

Essential Commodities Act needs more teeth

Recently, a godman was caught in a video with an actress which made national news. Sometime later, cases were booked against him under the Essential Commodities (EC) Act near Bangalore. It so happened that the godman had prayed with fire around him as penance. Officials of food and civil supplies department had seized blue kerosene (used in PDS for BPL family) which was being used for his meditation penance. If convicted, the godman could invite seven years of rigorous imprisonment along with fine. Strange are the uses of the EC Act…., stranger are the ways how the act is often used by the local officials which are in variance with the main objectives.

The commodity sector not only faces multiple laws but the laws are often archaic. Ever since the commodities boom began, financiers & NBFCs have been setting up funds to “invest” in physical commodities. The EC Act was conceived with a naïve understanding of the fact that the merchant hoarders are the cause of price rise. The annual report of the Ministry of Consumer Affairs (concerned ministry) gives amusing facts about the action under EC Act which looks more like the statistics of a police station.

When the prices rise, there is a clockwork reflex on the part of politicians to blame speculators or speculation which is followed by kneejerk raids. The raids not only disrupt normal commodity supply chain but also hamper its organized growth. It affects warehousing and it discourages large and honest players to operate in the market. As the implementation of the EC Act remains in the hand of the local bureaucracy who have very poor understanding of the trade, the reactive actions disrupts the supply chain further. Under the EC Act, if a person against whom prosecution has been launched is acquitted, the confiscated stock has to be returned or the value thereof should be paid. Interestingly, in most of the cases where confiscation is ordered, the parties ensure that the prosecution is not launched or the prosecution loses the case and thus confiscation becomes null and void.

The raids which are often conducted before festivals of Diwali & Holi, should have acted as a deterrent against the unscrupulous dealers. However, these raids often ensure that ample “bachae ke liye mithai” (sweets for the kids) are available for the local executive powers during festivals and all these are done “khushi se” (happily with consent).

Essentially, the EC Act aims to ensure easy availability of important commodities to consumers; however doubts have been raised about the effectiveness of the Act. India is ill equipped to handle financial speculation in commodities market. As in the financial sector, the clear boundaries between brokers, physical traders, commodity producers and banks are tending to become blurred. We are yet to see the activities on the scale conducted by the likes of Vampire Squids (Goldman Sachs) and others to manipulate the commodity prices internationally. However, financial speculation can substantially increase commodity price volatility as the speculators follow a price trend (up or down) with systematic financial engineering. We have learned the hard way that scholarship on financial crises tends to be reactive, meaning we are less than prepared for the next “Big One” in India.

Published in The Economic Times 23 Aug, 2010

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

Milk co-ops need Agile bosses

Dairy cooperatives have a lot to do with India emerging as the world's leading milk producer. However, most of the co-operative federations are not professionally managed today. In fact many of them outside Gujarat are now run like `regular' parastatals, invariably headed by career bureaucrats. The alternative does not lie in changing organisational design and the operating system which will undermine the role of co-operatives.

Success in dairy industry shall continue to be in the ability to build a robust procurement network which gives raw material cost advantage along with assurance of regular supply. Large MNCs in India have failed in the dairy sector on this account. “Aarth Shakti” (money power) has not got translated into “Lok Shakti” (people power). Moga (Nestle) and Etwah (Levers) have remained laboratory cases while Anand (Amul) has got replicated. A strong backward integration in the form of cattle-feed supply, vaccination availability, breed improvement programmes and profit-sharing with farmers are some of the things that none of the private sector companies nor the MNC’s have been able to replicate and amplify. Farm gate price paid for milk in India is the highest in the world largely due to a strong co-operative presence. Failure of integrated dairy experiments like “Aarey” has not deterred a non-milk co-operative to branch out in the same direction recently. Also joint ventures and foreign collaboration have become order of the day.

Lately, India is under intense pressure to open up its market in dairy produce, especially cheese, from European nations. The EU is keen to get any market opening abroad in a bid to compensate for the troubles facing milk farmers at home. A few years back there was a sudden interest in advising India how to manage the dairy sector and cooperatives when it was emerging as the world's leading milk producer. No doubt the advice came from a Netherland based entity. The US dairy industry is also itching for access to India and the U.S. government is examing legal alternatives for access.

In Europe, when the entire milk requirement for production of cheese and value added products are satisfied “profit is maximized”, the remainder is processed into butter and SMP (Skimmed Milk powder), often referred to as ‘residual production’. This is distinct from patterns of production that is followed in India where priority is given to production and distribution of liquid milk for masses. In India, SMP is important for curbing excess supply due to strong seasonal fluctuation of milk and reconstituting the same during milk shortages.

The recent incident of protestors vandalizing the tankers of imported milk only demonstrates the lack of understanding by the political class of machinations of the large milk producing nations. It is even more surprising that when a minister promotes private sector dairy in his constituency instead of a co-operative dairy, these protestors don’t even raise an eyelid for the local farmers. Perhaps it is time that India demonstrates that if it can produce 112 MMT (Million MT) of milk (09-10) compared to only 10.40 MMT in 1961, it also knows what the best way to manage a growing dairy industry. For this, Indians need to move from “Me” to “We” mentality.

The dairy sector has assumed critical importance for India as it provides work and income to landless farmers. The ruling dairy and milk managers are yet to demonstrate the leadership quality, passion and logic in negotiations, political acumen and stubbornness that Dr. Verghese Kurien “father of White revolution” had demonstrated. Once confronted abusively about the market share by an arrogant New Zealand High Commissioner, Dr Kurien had fittingly replied “If all of us Indians decide to get together and spit on your country, your country will get drowned in our spit”. Unfortunately, the current breed of milk leaders are more concerned in protecting their own turf by creation of ‘services’ to ensure that they remain at the helm of affairs.

Published in The Economic Times , Aug 09, 2010