The Hindu Business Line : Future of the commodity futures market

Currently, there are more than two-dozen commodity exchanges, of which, three are national and the rest regional. The differences between the national and regional exchanges are summed up in Table 1.

Barring the National Multi-Commodity Exchange (NMCE), commodity exchanges function almost the same way as stock exchanges — the trading pattern, the board structure, controls and privy to selective information are the common threads. Since these exchanges operate on a limited scale for a specific product — though nothing bars them from branching out — their scope and function are rather restricted.

One of the major concerns of the regulators is the abysmally low volumes in most of these exchanges.

If the volumes are not reasonably good there will be no liquidity, as a result of which one of the economic functions of futures trading — price discovery — will not take place. If there is no price discovery, there is no risk management.

Is there a need, therefore, for non-performing exchanges? The answer is both simple and complicated. These exchanges may be instructed to fall in line and in case of failure to perform, they may be closed, by not renewing their licences. But such a move may not be politically acceptable.

Interestingly, in securities trading, despite the NSE and the BSE grabbing the volumes and, thereby ensuring the hibernation of all other exchanges, none of the latter could be closed down by SEBI.

The real issue, therefore, is whether the commodity exchanges need to be resurrected by revamping them at various levels?

Single vs multiple commodities

Some of the non-NMCE commodity exchanges have a large basket of commodities to trade in. But barring 2-3 products, there is virtually no business in the others. The reasons for this are:

Not all products generate similar trading volumes: Success of one product need not automatically mean success in other products because all commodities do not qualify for futures trading. And this is so because:

i) the commodities should be capable of being graded;

ii) there should be a large number of buyers and sellers for the commodity.

iii) the commodities should be free from price controls/restrictions;

iv) they must be capable of being stored for a reasonable period of time.

v) the market for them should be vibrant and active; and

vi) there should be some mismatch between supply and demand.

There are different players for different commodities: Players who are accustomed to dealing with one commodity may not have the same expertise in respect of others. So, the volumes generated by one set of players for Commodity X may not be the same for Commodity Y. This logic holds good for derivatives of the commodity too.

For example, the phenomenal success of soya-oil trade on the National Board of Trade (NBOT) could not be replicated in respect of soya-bean or soya-meal.

Cross commodity risks/hedging: There is no proper mechanism to assess inter-commodity risks.

Even similar commodities traded on more than one exchange that do not have uniform contract specifications would be covered in this segment. The example shown in Table 2 would clarify the position.

The prices quoted on these exchanges vary depending upon the contract specifications. Uniformity in contract specification in respect of the same commodity being traded on various exchanges has not yet happened on the Indian exchanges.

Moreover, if the commodities have different varieties, the variety produced/consumed maximum should be allowed as the tradable variety and other major varieties may be accepted for delivery with premium and/or discounts on the tradable variety, as the case may be.

India is a country with varied consumer interests and tastes. Some of the commodities are region-specific and some highly seasonal. So, it is not always possible that trading in all the commodities flourishes on all the exchanges.

Online vs outcry

In the current set-up, online trading at the national level is mandatory in respect of NMCE. While there is no compulsion on other exchanges to go online, the Government would like them to slowly graduate into automation mode or face natural extinction. So far, though, nothing significant has happened.

As commodity markets are besieged by the parallel market, bringing them into transparent mode through a system of online process would be a Herculean task.

Also, online trading, per se, does not generate volumes. Most of the exchanges may find it difficult to go online because of financial constraints. Commodity exchanges do not have the financial muscle of stock exchanges, which are flush with funds because of listing fee incomes.

And the volumes in commodity exchanges are not significant enough to get into online trading. But if public demand is for an efficient and transparent system, then the natural choice would be to go for online trading.

Why it is not happening, then, is because of the absence of the large number of clientele, as in the case of stock market.

Demutualised vs mutualised set-ups

Demutualisation is the buzzword in both the securities and commodities markets. A demutualised set-up is one that segregates ownership rights from trading interests.

Setting up a brand new demutualised set-up is easy and implementable, whereas such an exercise in respect of an already existing mutualised set-up is rather difficult to implement and achieve the desired results. The reasons for this are as follows:

Tendency to cling to power by existing broker-members.

Modus operandi of segregating ownership and trading rights of the members.

Valuation of the existing exchange and the tax implications thereof.

Surrender of ownership rights by the existing members pursuant to demutualisation over a specified period of time.

Restructuring at the management level.

None of the existing mutualised stock exchanges could be demutualised till date. Instead of insisting they demutualise, it is better that the new exchanges be set up as demutualised entities.

One school of though believes that demutualisation is still a concept and without the active involvement of brokers/traders, commodity exchanges cannot generate adequate volume and function efficiently.

All that can be said at this juncture is that the operations of the exchange should not be left to a few who have trading interests.

Professionalism vs conventionalism

Most of the exchanges do not seem to believe in investing in human resources. When competition hots up, it is the best people in a company who steer it to success.

The importance of training and hiring appropriate persons for the job cannot be undermined.

Hedgers vs speculators

Both hedgers and speculators are necessary for creating adequate liquidity in the market.

But, like the markets abroad, we have not been able to categorise members as speculators or hedgers, as they perform different economic functions. Where speculators are not allowed to take delivery, the net open position of the hedger will result in compulsory delivery.

Moreover, speculators attract more margin than hedgers and with varied limits to do business. In India, a member acts as both hedger and speculator at very short intervals, depending on what turn the trade takes. Whether this practice is healthy or not is debateable. But too much speculation will not lead to correct price discovery, and unwarranted price movements not backed by delivery may lead to the market losing its integrity.

Delivery vs square-offs

Delivery need not be an integral part of commodity trading if there is a perfect price discovery mechanism. Theoretically and technically, futures prices on the date of delivery will converge with the ready prices.

But in reality, where the price movements are fast in respect of any given commodity, the ready delivery prices fluctuate even on the last trading day whereas the delivery rate once fixed is final — which is applicable to both square-offs and physical delivery in the exchange.

It is with reference to this that the delivery and pricing thereof is vital.

Hedgers cannot square off the position and, hence, are obliged to take delivery. The modus operandi may be i) compulsory delivery, ii) seller obligation or iii) buyer obligation. Depending on the type of commodity traded, nature of volatility and availability of the commodity in question, one of these options may be implemented.

Again, depending on the nature of the product, the settlement rate may either be the last trading rate or the average of the ready prices for two or three days, including the settlement day.

The underlying principle is that the settlement rate should conform with the market trend and be acceptable to trade and industry.

There is need for a right blend of technology and trade practices. What is practiced abroad should not be followed ditto. Unlike in the US or the UK, Indian disciplinary and penal laws are not effective enough. Stringent provisions are necessary to bring to book those carrying on illegal trades.

It will take quite some time for this market to stabilise in India. A vibrant commodities market may be achieved if the following aspects are looked into:

Politically sensitive and economically insensitive commodities should be avoided for futures trading.

Contract specification should be uniform across the exchanges to facilitate proper arbitrage.

The role of the traders may be defined properly so that their interests do not clash with the functioning of the Exchange.

Ensure participation of a wide spectrum of persons associated with the commodities market.

Introduction of other derivative products, such as options, index futures, and trading on certified warehouse receipts, will increase the volume of operation.

Dissemination of information among the exchanges will give a total picture about a members' overall exposure, the risk perspective attached to that and its impact on other markets.

At present, each commodity exchange sees the other as its competitor rather than working together to promote the cause of futures trading.

(The author is Executive Director, National Board of Trade Ltd, Indore.)

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