How commodity bourses can survive

The larger objective should be to strengthen price discovery mechanism and risk management in the economy.

In commodity, like any other trading one does not mind paying a transaction fee as long as profits are made. However, once an entity starts making losses, the concern on the high transaction fee becomes multi-fold. On the other hand, when commodity exchanges start making losses, they may be forced to increase transaction fee camouflaged under some other name to boost the revenue. This often causes narrowing of participation and alienation of new participation on the exchange platform.

Comexes, which till a few years ago were embarking on global ambitions, are now struggling for survival. Of the first three national exchanges that were granted license, one continues to make profit due to low cost of operation, the other is showing signs of operating losses while the third continues to struggle.

Of the three new exchanges that were granted licences, two have already closed down. The other is on the verge of closure unless it is merged with the most profitable exchange in future, considering that a common group of shareholder have significant minority stake in both. Since its inception, Indian commodity futures market had pursued a cash-carry arbitrage model for agricultural commodities and momentum trading for the globally-linked commodities. With markets maturing, the cash-carry arbitrage has shrunk for agricultural commodities and with global commodity market entering a bearish phase, participation has become a casualty on exchange that has global commodity linkage.

The exchange which has kept costs under control still has a fair chance of survival, whereas the other with high manpower and outsourced technology cost is limping for operating profit. These developments throw a very important question - what happens to shareholders’ value in these “financial infrastructures” of the country. Doesn’t it mean that erosion of the value of exchanges is causing an erosion of shareholders’ value? Is it not a provocation enough for those governing exchanges to do a deeper soul searching for the revival? While some PE investors as shareholders of exchanges maybe demanding active performance improvement from the management, they are often short of foresight, vision and definitive roadmap to revive the exchange as governors.

In such situations, it is important that the corporate and shareholder governors of the exchanges are actively engaged by the regulators and the Ministry for its survival plans. However, the buck should not stop with mere profitability plans for commodity exchange’s survival. The larger objective of the commodity exchanges are to strengthen the price discovery mechanism and risk management for commodities in the economy for which the futures trading were allowed in the middle of last decade. If the exchanges are to be taken more seriously by the policymakers, over the next few years those governing the exchanges have to be more contributory to the broader economic objective, similar to what Leo Melamed had done to CME in the seventies.

Published in The Business Line on 24 October, 2014

Raids on hoarders need to be carried out with diligence

Agencies involved in commodities should use more analytics and information for better results.

It is would be interesting to note that ahead of Diwali, food safety officials and civil supplies department suddenly become active to ensure that laws are abided in the commodities sector. What is more surprising is not the way these raids are conducted but their timing. The activism of the law enforcers before Diwali in the North and Onam, Ugadi and Pongal in the South has been consistent over the years.

Undoubtedly, law enforcement raids are most effective when they involve good intelligence and planning. On the other hand, most raids are blind and executed without adequate information.

Obviously, the raids-to-prosecution ratio is pathetic as raids are conducted without proper analysis of market information. Both Union and State Governments often promise a crackdown on hoarders and black marketers to curb artificial price rise. However, most often the theatrical raids are conducted to cover institutional impotence and incompetence in the middle of the trouble (scarcity & seasonal price rise).

Sometimes, raids by the government machinery are also done to settle personal scores. For example, in 1995 a State Civil Supplies Minister in Gujarat backed by the oil traders lobby had ordered raids on the edible oil tanks of the National Dairy Development Board (NDDB) charging them with hoarding. The fact was the Minster was enraged by the fact that he was advised to check with the Union Ministry when he sought details of stocks from the prestigious institution.

In recent times sugar, pulses and onions have become the commodities of choice for the raids. Commodities whose prices are on rise and the supplies of which are getting scarce become the targets of the raids. The agencies that suspect hoarding should monitor stock movements, trade flows and the historical consumption patterns with appropriate intelligence and market information so that the impact of the raids do not create panic in the market.

Currently, the effectiveness of income tax raids are more profound in the economy due to analytics and software support that has been put in place over the last few years.

It is time that State agencies involved in commodities should use more analytics and information for better effectiveness of the raids.

In a market economy there cannot be any bigger disaster than vanishing stocks from the shelves due to fear. Intelligent raids should be the last resort to bring semblance of logic rather than creation of fear psychosis in the commodity market.

Published in The Business Line on 9 October, 2014

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