The Hindu Business Line : Regulation and risk management

The margin system is part of the risk management policy adopted by commodity futures exchanges. Mark-to-market as a margining system minimises the chance of default as buyer or seller is exposed to only one day of price movement. Also, the price performance of the commodity translates to an instant reward or penalty as the case may be.

In addition to margins, the exchange maintains a Trade Guarantee Fund (TGF) that can be used in case of a default. The exchange also prescribes criteria for membership. There is also the practice of prescribing norms for minimum capital adequacy. This follows guidelines issued by the government at the time of introducing online trading in commodity futures.

The principal purpose of the TGF is to guarantee settlement of bona fide transactions. Such a guarantee and demonstration, thereof, would instil confidence in market participants and protect the interests of investors. All members of the exchange are required to make an initial contribution towards the TGF.

Clearing house performs post-trading functions, such as confirming trades, working out gains or losses during the course of the clearing period (usually a day) and collecting losses from the losing members and paying out to those who have made gains.

Novation

It may be relevant to understand the concept of ‘novation’. Some clearing houses interpose between buyers and sellers as the legal counterparty, that is the clearing house becomes the buyer to the seller and vice-versa. In this sense, the contract between buyer and seller undergoes the process of novation or renewal, which is the substitution of an old obligation with a new one. This obviates the need to ascertain the credit-worthiness of each party.

The only credit risk the participants face is the risk of the clearing house committing a default. The clearing house puts in place a sound risk management system to be able to discharge its role.

Volatility

Market participants have to be familiar with ‘volatility’. It is a measurement of the rate at which prices vary or change over a given period of time; but the direction of price change (increase or decrease) is immaterial. Volatility is often expressed as a percentage and computed as the annualised standard deviation of per cent change in daily price.

Currently, there are over 20 commodity futures exchanges. Many of them are mutual bodies set up several years ago. Some exchanges are as old as 70-80 years. The latest entrants — modern online exchanges — are demutualised bodies. There is separation of ownership of the exchange from management and trading rights.

The owners do not automatically get the trading right by virtue of their ownership, but have to comply with the admission criteria.

Regulators

The exchanges are ground-level bodies to regulate trading. They are known as Self-Regulatory Organisations (SROs). Regulation is necessary to ensure that the benefits of futures trading are shared by the market participants under competitive conditions.

As the futures market price signals affect spot prices, any manipulation can adversely affect the cash market and in turn, society at large. Regulation is also needed to ensure market integrity through appropriate risk management system, in the absence of which a major default could lead to a chain reaction and collapse of the market.

The Forward Markets Commission (FMC) is a regulator for the commodity futures market, mandated to ensure fairness and transparency in trading, and promote the interest of various stakeholders, particularly users of the market who are not members of any exchange.

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