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 clichĂ© 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-Ă -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 )
