Why Govt policies should consider market microstructure issues

Market microstructure entails studying the impacts of market structure and individual behaviour on the process of transactions in the market. In the process, microstructure theory focuses on how a particular trading mechanism can result in a particular mode of price formation.

Though this delineation of microstructure theory apparently sounds as issues that are specific to micro-level operations of the market, more often than not, they have huge strategic and macro-level policy implications. Somehow, the understanding in microstructure issues is low in Indian commodity markets. Even research in this domain has scantily taken place, despite the existence of national level commodity exchanges for around a decade.

Due to lack of evidential research in this field, several important strategic and policy concerns related to the commodity markets are dealt through subjective perceptions and findings based on overtly simplistic mathematics.

The most critical issue arises in the context of understanding the actual transaction process, where a critical relation exists between the transacted volume, volatility, and the total transaction costs. At the very micro-level strategic decision-making process, often exchanges consider transaction fees as the prime component of transaction cost.

Transaction cost While it is true that exchanges hardly have any other variable to play with when it is concerned with transaction costs, economic literature (that has essentially evolved from the actual market trading practice only, and not from mere ivory tower research projects conducted by capricious minds) refutes the claim transaction fee is the prime component of transaction costs.

A bigger component of the implicit transaction cost arises from the impact cost of trading, which is revelation of how smoothly a participant can enter or exit from a futures contract. Impact cost, more often than not, is an inverse function of the liquidity of a contract.

So far, there is hardly any sophisticated analysis on the impact cost-volume-volatility relation in the context of Indian commodity markets. Interestingly, such an analysis estimating the revenue elasticity can have an interesting insight on setting the transaction fees of the exchanges.

The other important issue pertains to futures contract design. Literature talking about success and failures of contracts often document liquidity or the depth of a market, settlement mechanisms, and contract specification as three of the most important microstructure variables as factors of success of futures contracts.

Hardly, any systematic documented research has taken place in this category in India on how these variables affect success and failure of a contract. Such a research will indeed be of strategic help.

Variables At a macro-level often price discovery functions and hedging efficiency of contracts are evaluated. Certain critical microstructure variables such as the liquidity, impact costs, trading rules, market structures (in terms of transparency), etc., play important roles there.

Internationally, most studies have shown that increased transparency results in better liquidity and reduced transaction costs. Despite claims by various studies about electronic markets’ capacity to reduce transaction costs and promote better liquidity, open outcry systems are prevalent in major international exchanges and are often claimed to set benchmark prices for commodities globally (e.g. ring rounds on the London Metal Exchange).

These international cases serve as important reference points for microstructure research on Indian commodity markets. This also brings forth the importance of open outcry in creation of “benchmark” prices, even in the era of electronic trading platforms.

Even further, one needs to understand that critical policy and regulatory issues related to the market need to take into consideration the market microstructure variables.

This may range from the impacts of futures trading on physical markets, using regulatory instruments like position limits for market participants, to even fixing risk management mechanisms like margin requirements. All the components of trading rules affect microstructure variables like liquidity and volatility.

Moreover, even from the perspective of the commodity exchanges’ roles in creating ameliorating impacts on the broader commodity ecosystem, some studies find evidence that a liquid commodity contract with low impact cost and high hedging efficiency has helped in rationalisation of the commodity marketing chain, as can be witnessed in the case of gold and mentha oil in India.

Therefore, there is a compelling case for considering market microstructure issues, while taking critical strategic and policy-level decisions. Development in this direction requires the exchanges, academia, regulators, and policy makers to come together to chart the necessary research agenda and put that to effect.

Nilanjan Ghosh is Chief Economist at Multi Commodity Exchange of India Limited. Views are personal.

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