How to determine black marketing?

In a market-driven economy, it is difficult to determine whether the price that is being charged is black-marketing.

Recently, the Chief Minister of Bihar, Jitan Ram Manjhi, stirred up a controversy when he said that hoarding and black marketing of goods by small traders will not be treated as a crime. He may have been politically incorrect yet he was logically correct.

The hoarding and black marketing by small traders have no material impact on the demand and supply of goods in the market as the quantity of goods being hoarded by these small traders are insignificant.

Black marketing might be socially reprehensible and ethically wrong but there is nothing to prevent a businessperson from increasing the price to meet the pressing needs of the escalating cost.

In a market-driven economy, where there is no price ceiling, it is difficult to determine whether the price that is being charged is black-marketing. In the case of commodities, where there is no concept of an MRP, the concept of black marketing is even more questionable.

Blaming the small traders of hoarding and black-marketing creates more panic than to actually resolving supply side concerns. In modern commercial economy, hoarding and black marketing is a flawed logic that is often blamed for price increase. Small traders with limited financial resources can hardly make any dent on the price of a commodity or its availability.

Politicians browbeat the mythical hoarders for price rise often forgetting that the activity of hoarding needs very large and continuous supply of finance which no small trader possesses in India.

The agricultural physical market in Bihar and other States do not operate on a leveraged model and is also not a heavily financed model, unlike the trade of crude and metals in the international scenario.

In the past, it has been conclusively proven that when non-binding price ceilings are put in place to prevent price gouging in the event of natural disasters, it may actually reduce incentives for sellers to be well-stocked with goods as they will be unable to command the full market price for the commodities.

Normally, the supply and demand dictate price. However, when prices are fixed, demand outstrips supply. Thus, shortages become inevitable. As experience with rent control shows, capping prices in times of scarcity has perverse effect of reducing quantity of commodity or the service supplied.

Consumers understandably get upset when they face dramatic price increases within a short time. However, capping prices would actually lead to less being sold, as suppliers reduce the quantity that they are willing to sell in order to avoid losses. Shortages are, therefore, exacerbated.

By contrast, anyone who tries to unreasonably price the commodity will find himself with unsold supply and will be forced to lower his prices to offload it. In reality, it can be very difficult to determine the extent to which price increases are greater than “necessary” and even more difficult to determine what is black-marketing.

Published in The Business Line on 25 Sept, 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

Why FCI can’t assess its actual stock

Flawed data collection, huge wastage of grains plague the Corporation

On paper, the FCI (Food Corporation of India) is said to be holding around 67 million tonnes (mt) of stocks in its warehouse. However, no one knows how much of it exists in reality - physically.

For any Government or bureaucracy, it will be difficult to arrive and acknowledge the actual physical stocks position. Various innovations have been created over the last two years to bring down the reported stock from 80 mt.

The Modi Government had promised to clean up the mess of the previous rule. Will it be in a position to de-legitimate the legacy of the last 50 years (FCI was established in 1964)?

Two years ago, it was found in Indonesia and Malaysia that more stock of palm oil existed than what was actually being reported, primarily due to flaw in data collection. It was also a manoeuvre to keep prices at a desired level for exports with low stock reporting (the two countries being net exporter of palm oil).

The case of buffer stock in India is actually the opposite. Siphoning off huge quantity of grains in the guise of waste is one of the major issues for the FCI.

At a time when chances of lower production are looming large in the country due to lower-than-normal monsoon, it can be a disaster to even report a correct picture. The mess is being circumvented by trying to break a monolith called the FCI.

Recently, in China, the state-owned Citic Resources reported that about half of the alumina stockpiles it had stored at China’s Qingdao port could not be located, heightening concerns over the use of commodities for financing in the country.

In the case of FCI stocks, in the last 50 years, banks have never asked any stock statement assured by the fact that there is an underlying sovereign guarantee. This kind of dual reporting is not new; even the Soviet system (which India later adopted) had a complicated grain stock reporting method in which invisible stocks (nevidimeye zapasy) and visible stocks (vidimeye zapasy) were classified. These secrets were hidden under “osobye papki” (special files under highest secrecy).

No doubt, the Indian bureaucracy has developed these tricks into a fine art. The question remains whether the elected representatives can force the removal of the veil from such dark practices.

Published in The Business Line on 28 August, 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

How far can Essential Commodity Act address hoarding?

No empirical evidence to prove that action against hoarders will bring down price of commodities

Doubts have been raised in the recent times about the effectiveness of the Essential Commodity Act in the current form to control prices. On the other hand, there is no empirical evidence to prove that acting against the hoarders will bring down the price of commodities.

The annual report of the Department of Consumer Affairs gives some interesting facts about the effectiveness of the Essential Commodities Act:

		2008-09	2009-10	2010-11	2011-12	2012-13
1	Raids Conducted	268,775	157,179	187,049	173,177	132,336
2	Persons Arrested	8,001	7,725	10,754	4,235	4,057
3	Persons Prosecuted	6,425	4,073	4,329	4,214	3,269
4	Persons Convicted	790	52	148	29	413
5	Goods Confiscated (Rs Cr)	60.95	164.23	104.55	61.73	229.78

Source: Compiled from the Annual Report of Department of Consumer Affairs

It is even more interesting to observe that the conviction to arrest percentage in the post-election period of 2009 was 9.87 per cent. It was 10.18 per cent during the pre-election period (2012-13) but fell dismally below 1.5 per cent during the intervening period.

The Essential Commodities Act is often supplemented by stock control orders. Thus in some cases, the regulatory authority or prosecutor are able to get direct evidence that stocking of the commodities was done with the intention for profiteering.

It is often difficult to get direct evidence – either through documents or testimony. State government has to enforce the provisions of the Essential Commodities Act.

The short-duration spurt in onion prices, which is encountered every year and seen this year too, needs to be seen whether it is a case of price rise or price gouging.

Price gouging (a term not often used) is a situation when a seller prices commodities at a level much higher than what is considered reasonable.

In the US, laws against price gouging have been held constitutional at the State-level as a valid exercise of the police to preserve order during an emergency and may be combined (like in India) with anti-hoarding measures. Laws against price-gouging have been enacted in 34 States in the US. Exceptions are prescribed for price increases that can be justified in terms of increased cost of supply, transportation or storage.

Proponents of laws against price gouging assert that it can create an unrealistic psychological demand that can drive a non-replenish able item into extinction.

As the new Government in India is embarking on enactment of changes in the Essential Commodities Act, we must understand that statutes generally give wide discretion not to prosecute. In some of the states in the US, only one-third of complaints were unfounded and a large fraction of the remainder was handled by consent decrees, rather than prosecution.

What if an anti-hoarding law is passed where arrests are non-bailable for hoarders to symbolise opposition to scarcity? Let’s abolish causes of scarcity. Will sending people to jail bring down the scarcity?

Published in the Business Line on July 31, 2014

Why the delivery system has to be strengthened

Price discovery has often been defined as the process of arriving at a transaction price for a quality and quantity of a commodity at a particular time and place.

On the other hand, to protect margins one has to look at price drivers such as storage cost, transportation cost and natural quality deterioration. Even the usage of old or new gunny bags for packing commodities affects transactional margins.

These dynamic elements have significant impact on the margins of trade transactions.

Arbitrage rates

Some of the commodity futures contracts introduced during the last decade have “dream arbitrage” where storage rates are fixed and quality deterioration has been considered to be the responsibility of custodian of the physical goods.

On the practical side, the price of storing a physical commodity from one month to the next is freely set in the storage market. No doubt, price occurs at the intersection of supply and demand for storage services, which changes over time. As the demand for storage services rises, the price of physical storage also rises, all else remaining equal.

In contrast, the storage fees for deliverable commodities are set by futures exchanges.

Naturally, a section of the ecosystem participants take advantage of the lacuna and make profit out of this surreal situation.

Frequent tweaking of contract terms on the exchange have also resulted in participation and volumetric inconsistency from year to year.

For some of the deliverable futures contracts, prices no longer represent the expected cash market price.

Instead, it represents the price of the delivered commodities which has higher value than physical commodities because it incurs artificial storage fees without any natural shrinkage and topped with predetermined premium fixed by the exchanges.

Naturally, the market does not converge at the expiry.

Delivery structure

Non-convergence leads to welfare losses among less informed market participants, so futures exchanges and stakeholders have an interest in preventing such future episodes.

During most period of 2005-10, the price of expiring US corn, soyabeans and wheat futures contracts settled much higher than corresponding delivery market cash prices and are most likely to be repeated elsewhere if unintended results of the market delivery structures of traditional market are ignored.

We must appreciate the fact that in India (unlike CBOT/CME) we do not deal with deliverable instruments and shipping certificates. We first need to strengthen the delivery issue based on our own ecosystem.

The sooner some of these “dream arbitrages” are controlled and a move is made towards “normal arbitrage” contracts aligned to the reality of physical market, the faster agricultural futures markets will grow. This will also result in wider participation and deeper penetration.

Published in The Business Line on 17 July, 2014

Develop physical market for commodities

It will help futures market, suffering from lack of multiple pricing points, succeed.

Futures exchanges apparently have difficulty in predicting the success or failure of futures contracts. Only 15 per cent of the contracts that are introduced survive before they get delisted.

Physical market size, risk-reduction ability of the contract, cash price variability and liquidity costs influence the volume of trade and open interest of futures contracts.

During 1994-98, 140 new commodity derivatives were introduced across the world. During 2005-13 almost the same number were introduced in Indian commodity futures. In India, major farm commodities such as cotton, oils and oilseeds and jute have lost their importance in the futures market arena.

A few other agricultural commodities such as guar, chana, castor, cottonseed oil cake, rubber and mentha oil display volumes though metals (precious and base) and energy products continue to preponderate on the commodity futures scene.

The attributes of commodity that are considered crucial for qualifying for futures trade are: Commodity should be durable and it should be possible to store it; units must be homogeneous; commodity must be subject to frequent price fluctuations with wide amplitude; supply and demand must be large; supply must flow naturally to market and there must be breakdowns in an existing pattern of forward contracting.

Though the attributes mentioned above answers the question whether commodities are suitable for futures trade, however, it does not answer a more important complementary question whether the market will adopt a commodity contract for trade or not.

The economic utility of a commodity futures contract for effective price discovery and efficient price risk management depends on wide participation of the physical trade in the commodity and also non-commercial participation, giving it a desired equilibrium.

Lack of multiple pricing points in physical market and supplier concentration often causes contract failure. Energy futures contracts without the participation of the energy players (crude and natural gas producers and users) would have sufficient ingredient for failure. A market deserted by hedgers is unlikely to survive for long, as it will surely be neglected by speculators.

Without getting into the argument of “chicken or the egg”, we need to appreciate that a futures market for any commodity presupposes a close correlation between the prices in physical market.

And if the landscape of the country for the commodity has a controlled price mechanism or an oligopolistic market structure, the futures contract will have very remote chances of success beyond a certain time, however well the contracts may have been designed.

It is important that the country should direct its efforts toward developing active physical cash market with multiple players and multiple pricing points, the success of futures market will follow naturally.

Published in The Business Line on 3rd July 2014