The right fix for commodity exchanges

The Securities and Exchange Board of India has taken up the task of sprucing up commodity trading with great zeal ever since it took charge of exchange-based commodity trading last September. The task before the regulator is, however, far from easy. Commodity exchanges have so far existed as a closed club with relatively lax regulations that provided room for price manipulations and other unfair practices. Investors and traders have been giving these exchanges a wide berth due to thin volumes and erratic price movements on the counters.

The regulator deserves to be lauded for going about the task of tightening the rules and framework in a methodical manner. Since last October, SEBI has issued a slew of circulars dealing with various aspects of commodity trading, eligibility criteria for commodity exchanges and trading members, risk management practices, improving disclosures and restraining abrupt suspension of contracts.

The latest move to introduce options on commodities is aimed at giving a boost to sagging volumes on the bourses. But correcting flaws in the rules is the easy part. If commodity exchanges are to thrive in future, liquidity on the bourses needs to be enhanced, quickly.

The primary objective of commodity exchanges is to help commodity users such as importers, exporters, retailers and manufacturers hedge their price risk. They can do this by buying or selling commodity futures and options. These exchanges also help in discovering prices of agri-commodities that do not have a unified spot market. Farmers can benefit by the prices discovered on these exchanges.

While many stakeholders claim that farmers can sell their produce on these exchanges, that is a trifle far-fetched. These products are too complex for farmers to understand and use. Two, there aren’t enough warehouses to enable physical delivery, and three, it is hard for farmers to match physical delivery with the quality and quantity specifications in the contracts.

Currently, commodity exchanges are unable to help either hedgers or aid price discovery due to the extremely thin volumes. Commodity contracts, both agri and non-agri, worth around ₹25,000 crore, are traded on the bourses everyday. Of these, more than 80 per cent of the volumes come from non-agri contracts such as the bullion and energy contracts. Since these are traded actively in international markets, price discovery does not happen on Indian exchanges. Bigger users of these commodities tend to hedge their exposure in international exchanges.

It is, therefore, in agri-contracts where there is an urgent need to bolster liquidity; but only ₹2,000- ₹3,000 crore of turnover takes place in these contracts every day on the commodity exchanges.

Further, hedgers account for less that 1 per cent of the trades done on NCDEX and MCX (the largest exchange for agri-commodities), according to SEBI. Brokers trading on their own accounts are responsible for more than half the turnover. While exchanges do have the facility for deliveries of agri-commodities, hardly any physical stock is stored or delivered through exchange warehouses.

Not only is the liquidity in agri-contracts extremely thin — the top-traded agri-contract trades less than ₹500 crore a day — trading is also concentrated in the hands of a few players. A look at the events leading to the castor seed contracts suspension in March this year helps to understand the situation better. SEBI’s investigation following this suspension revealed that a clutch of clients who had exposure to these contracts defaulted on their payment commitment to the trading members, who asked the exchange to square off these contracts. The defaulting clients collectively held around two-third of the open position in February castor seed contract, amounting to ₹540 crore. SEBI also noted that the position collectively held by these clients was approximately 10 per cent of the annual production of the entire country.

Similar manipulations have occurred often in the past leading to suspension of other agri-contracts, and it happened again in June this year, leading to the suspension of chana contracts.

Such concentration of trading can be checked if more participants enter the commodity markets. Many experts are asking for banks, foreign portfolio investors and other financial institutions to be allowed into the Indian commodity markets to help improve liquidity. But despite tighter rules and greater surveillance, these large players are unlikely to enter the market as long as turnover is low. Trading in large quantities is next to impossible in counters where daily volumes are just a few hundred crore. Impact costs are also high in such counters and exit becomes extremely difficult when there is a steep fall.

An easier solution to this liquidity issue would be to allow the large stock exchanges such as the BSE and the NSE to launch commodity derivative platforms. Both these exchanges have expressed willingness to commence commodity trading whenever SEBI allows them to do so. The regulator has been dragging its feet on this decision so far, probably because it wants to put the house in order before the masses troop in.

But permission has to be granted as soon as possible for various reasons. One, the stock exchanges have been operating under SEBI for more than two decades now and have better risk-management and surveillance systems in place. These exchanges have managed to keep their heads above water in times of severe stress such as the 2008 crisis, highlighting the robustness of their systems.

Two, traders and investors in the equity market will find it easier to try their hand at commodity trading once it is offered by the same exchange. Brokers will not have to become members of multiple exchanges, and smaller brokers who have membership of only NSE or BSE can begin offering commodity contracts to their clients. Surplus in the trading accounts of clients, set aside for equity trading, can be used for commodities.

It can be argued that commodity trading is different from equity and might not attract many players, but when the NSE and BSE launched currency derivatives, existing clients did start dabbling in these contracts too, resulting in decent volumes in the currency contracts traded on exchanges.

If the objective is to develop a market for commodity derivatives, then there is no need to confine it to commodity exchanges alone. The problem of concentration of trading in a few clients and price manipulations will disappear once liquidity steps up. It will also become easier to attract institutional investors once liquidity improves in these contracts.

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