Of commodities trade & corruption

In new and scarier forms, entities that own either the whole or a small part of supply chain activity manipulate physical business

In India, check posts, multiplicity of taxes, awarding of supply contracts, granting of licenses, dealing with State procurement agencies, determination of customs policies often increase the chances of dealing with systemic corruption.

A large number of companies camouflage these with payment of consultancy fee whereby the agent takes all these expenses into the books and companies remain clean by the corporate governance standards. 

The scope for corruption may be declining but it is still widespread.

Commodities trade encounters corruption at various stages. A large number of unaccounted cash gets transferred without a trail in the physical market. There is no special authority to check the legality of such practices while there are many such touch points of corruption. Many large trade houses have taken up Trade Practice Compliances as an area of added importance.

This area is responsible for policies and controls for the avoidance of corruption and making sure that the companies refrain from any such business activity that does not uphold the ethical standards.

Last year, one very large US-based trading company got enmeshed in the US anti-bribery law. Some say it may not be the last one …. Others were simply not caught for the time being.

Though large fines are still unheard of here, it has been given a new spin with newfound political shenanigans.

Earlier, the trade-based money laundering allowed an opportunity to earn, move and store proceeds disguised as legitimate trade. Through this process over-invoiced and under-invoiced commodities were imported or exported around the world in restrictive and over licensed countries which allowed companies to make unethical profits.

The practices over the years have changed and more sophisticated methods are being used now. These are purely financial schemes. In these new and scarier forms, manipulations are been undertaken by entities that own either the whole or a small part of supply chain activity of the physical business. Some of them have been caught rigging prices industry-wide.

With several Indian entities entangled in headline grabbing scams, it is clear that commodity wealth not only poisons democracy, it entrenches corrupt elites and worsens inequality – it also hobbles the country.

Published in Business Line dated April 24, 2014

Addressing the hedge gap on commexes

Final expiry date delivered commodity remains unhedged

The product specifications of agricultural contracts on exchanges do not mention the year of production; yet all the safeguards are built to ensure that no old crops are delivered at the exchanges.


Creation of FED (Final Expiry Date) category of stock on commodity exchange forces a situation where liquidity will continue to be only for the near month contracts and far month contracts will hardly be traded.

A recipient of the exchange-delivered FED stocks does not have any hedge facility available. Since the last decade this has created a major “Hedge Gap” in the Indian commodity market, yet the issue remains unaddressed.

There is lot more backwardation these days to actually encourage destocking in the market. If backwardation intensifies, not only will it be less logical to store new inventories, old inventories already financed by the market (therefore hedged from the perspective of producers) will become ever more valuable.

Yet, from the perspective of the commercial users on the other side, the loss associated with the position only grows larger by the day.

Once the FED stocks are delivered, the recipient beneficiary has two choices: First, either to take delivery of the commodity in question, being fully aware of the fact that he can no longer hedge or the second choice is to financially settle the exposure at a big loss. Naturally, the second choice is not an option for most commercial users (e.g. processors), which implies that in this situation one may most likely be exercising the first choice.

This has been a major reason why the real hedgers are not participating on the commodity exchanges in India.

The current arrangement not only leaves the producer holding profitable cash, it also leaves the recipient with an ongoing commodity long in a market environment that no longer allows him to hedge it without significant cost.

One of the recurring issues that arise is lack of clarity over what precisely one is trying to achieve. The doctrine of “hedge interest” needs to be more deeply deliberated at the product designing stage to prevent and curtail the contracts from any misuse.

Published in Business Line on April 9, 2014

Will the stagnant demand in commodities encourage hedging?

The market may be responsive to fundamentals rather than any momentum trading

The commodity market, which had defied gravity during the last few years, is showing signs of slowing down.

It is not a breather but a shift to a bear cycle.

No doubt the “investors” have vanished and the herd mentality has gone out.

The standard explanation during the period of price surge was that the booming demand, particularly from China, was clashing with stagnant supply of energy, metals and agricultural produce. Talks of stagnant or falling demand are now in the favour.

The bull phase saw “weight of the money effect” where the participants took positions so large compared to overall position that they could move the prices.

However, with money becoming scarce for such activity, the market is likely to become more responsive to market fundamentals rather than any “momentum trading”. Even an oilseed trader who would have tried his hand on the trends of the gold or crude market during the last few years will increasingly restrict himself to core business by avoiding such daredevil acts.

During the past decade, “financialisation” of the commodity market had almost destroyed the information flow of the physical market adjustment mechanism. Commodities which became “basket of assets” will now be viewed more for its uniqueness and S&D (Supply & Demand) gaps.

Businesses involved in the origination, processing, merchandising, trading, handling, storage and shipment of commodities will get a flip compared to the companies who were promising investors with short terms large returns.

The acceleration and amplification of the price movement which was witnessed in the market during the last several years have come down substantially during the last six months in almost all the commodities.

The changed scenario would also encourage the long term hedge requirement of physical players in the futures market who need not be worried about frequent variation margin calls.

Companies in the physical commodities domain are likely to react to such situations by consolidating specialisation and getting back to the fundamentals of business.

As the saying goes often in commodity market “Bears will make money. Bulls will make money. Pigs will get killed” would be proven correct once again.

Published in Business Line on  March 27, 2014

Why commexes should offer incentives to encourage growth

Sops can be given in an innovative way to expand the footprint of the futures market

Commodity exchanges collect transaction charges from its members according to the average daily turnover in a slab-based system.

The recent decision of the Forward Markets Commission to give freedom to commodity exchanges to fix different transaction charges is a landmark one.

Transaction charges

The flexibility to fix the transaction charges is leading to a situation where it has sparked competition among the exchanges to grab market share in the already shrinking futures pie. Instead of using the freedom to attract more participants in their fold from different parts of the country, exchanges are looking to grab each other’s shares.

The non-agri-exchange is vying for the share in the agri space and vice-versa. This freedom to set transaction fee could be used more innovatively used to give a fillip to better geographic participation which is now concentrated mainly in the western parts of the country. If the exchanges try to do the same thing, they may not succeed.

However, if exchanges expand the network by broad basing participation that go beyond the cities and bring more and more players, there will be space for more growth.

Incentive programmes

The incentive programmes of the exchanges can enable non-penetrated geographies where knowledge and usage of the futures market is low.

Participants from these geographies can be charged a discounted fee for qualified products. Under such schemes, existing market participants are not included unless they specifically inform the exchanges about the efforts made under the programme. This will prevent misuse of incentives by the members.

The incentives apply only to electronic trades that are done by qualified registered traders in accordance with exchange policies. The participants will be eligible for discounted fees during the announced period provided they satisfy the minimum quarterly volume requirements.

CME, which is the world’s largest exchange, offers a number of such incentive programmes directed at different parts of the world.

The incentive programmes offer fee waivers or reductions to new traders from locations where the exchange has yet to make inroads. There is also an Emerging Market Programme that covers the world outside the 20-most developed economies.

The New Trader Incentive Program (NTIP) provides fee waivers for new traders associated with proprietary trading firms and trading arcades located in approved countries. Qualified registered traders can obtain fee waivers for trades of qualified products in accordance with the announced policies.

The NTIP is designed to encourage the development of new traders with no experience.

The mobile phone industry underwent a metamorphosis when it changed from call-based tariff to usage-based tariff.

The commodity futures market is yet to see a change from a value-based fee structure to a transaction-based fee structure …which may prove to be a game changer.

Published in The Business Line on March 12, 2014

Why we need transparency in energy pricing

Credible clarification of business model will help build trust in a company

All over the world, energy companies constantly assert that the reason that they raise prices is either due to the wholesale price going up or increase in the cost of exploration.

The US natural gas commodity market is among the most transparent of all the commodity markets in the world. On the other hand, a controversy is raging over current gas pricing in various parts of the country.

Credible clarification of the business model and how a company creates value will help in building trust and avoid unnecessary controversies.

Success in commodity markets often comes from maintaining an information edge on supply and demand. However, there is a consensus that transparency is the key issue. Physical commodity trading, which had been an enclave of secrecy, has got severely affected post-2008. Opaque business models will be facing increasing public scrutiny – the discussion around commodity pricing, where confusion around the value creation of a market participant has fuelled social concerns, leading to escalation into some political drama.

For companies, the benefits of transparency are not always straight forward. Some of the requirements are perceived to be expensive with no return on investment.

There is sometimes a fear that being more transparent could mean facing more troubles as adhering to the self-declared ethical standards would make them liable to a wider public scrutiny.

Ironically sometime ago, the CEO of Cargill had warned that companies must embrace ethical and transparent business practices or they may risk being vilified by the public and regulators as banks have been.

In Nigeria, the State sells over one million barrels of crude oil every day, bringing almost 50 per cent of the Government’s total budget revenue.The Government cleverly allocates export licenses to so-called “briefcase companies”. Since there is no reporting on sales, the actual buyers remain unknown. 

Without transparency, there is no way to prove or disprove rumours. Improved transparency is important not only for the market participants but also for regulators, who can only intervene if they know what is happening in the market. Although a variety of sources of information currently exist, there is uncertainty in terms of data quality and timeliness, particularly with respect to inventories.

No doubt, it needs to be appreciated that, however big one may be in terms of networking and financial prowess, working on transparency has some clear advantages for companies and management.

Whether the allegations prove right or not, there is a lack of confidence about pricing in India’s energy sector – people just don’t trust it any more.

Published in  Business Line on February 27, 2014

Why we need central counterparty clearing house

In India, futures contracts in commodities are required to be settled through clearing and settlement department of the commodity exchanges and there is no separate central counterparty clearing house. In the light of the recent “exchange collapse”, there is an impending need to guarantee execution of settlements on behalf of the respective counterparties in the exchange where a chain reaction of defaults (breaches of contract) can be prevented.

Execution venue

It is important to understand that an exchange-trading requirement has nothing to do with clearing and they are completely separate issues. 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.”

In India, people tend to think of exchanges as synonymous with clearinghouses as the transactions are cleared through exchanges’ clearing and settlement department, unlike in the US or Europe where mitigation of counterparty risk is achieved by contract “Novation”. This is a process through which a Central Counterparty or the clearing house acts as a buyer to all sellers, and vice versa.

Similar to banks’ role

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.

Thus, clearing house reduces complexity by reducing the number of counterparty relations and increases efficiency by establishing the margin and collateral requirements for its members, centralising the necessary calculations, automatically collecting or paying the respective amounts and preventing disputes (e.g. over the amount and quality of collateral).

A clearing house addresses 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.

The clearing entities’ discipline and independent roles from the exchange is indispensable for the purpose of improving commodity market credibility and develop an environment enabling trading activities by market participants with a stronger sense of security.

It is important to appropriately secure financial resources to cover breaches and reinforce the financial base of the clearinghouse (as an entity separate from the exchange) from the perspective of developing an environment in which market participants are able to participate in trading with a sense of security and reinforcing creditworthiness.

Published in The Business Line on 13 Feb, 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