Can benchmarking help India’s commodity market be competitive and sustainable?

The Asia-Pacific region in commodity derivatives trading has experienced 21.5 per cent growth in 2020-21, while the Americas and Europe, West Asia, and Africa regions observed a decline of 9.1 per cent and 9.8 per cent, respectively, in the corresponding period.

While a significant share of commodity derivatives trading (73.9 per cent) comes from Chinese and the US exchanges, India’s exchanges struggle to expand their operations with a bouquet of products and a reasonable number of attract foreign firms and commercial users of commodities.

So, how can domestic commodity exchanges overcome performance bottlenecks? While benchmarking is one of the critical antecedents of 24 principles brought out by the International Organisation of Securities Commissions in early 2023, how it can improve their operations and what dimensions are essential in order to benchmark the exchanges’ performance.

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Benchmarking

Benchmarking is a way to measure business metrics and organisational success by comparing a process or the organisation to other internal processes or competitors. It helps understand industry norms and analyse how the organisation stacks up.

Commodity exchanges can use benchmarks related to the product, membership criteria, risk management, technology, and business environment to meet performance goals, keep checks and balances on business metrics, and boost market liquidity and global participation.

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There are six types of benchmarking, among which four may be crucial for commodity exchanges, namely competitive, performance, strategic, and practice benchmarking.

Competitive benchmarking focuses on comparing processes and metrics to those of direct competitors, while performance benchmarking relates to business performance. By tracking metrics and key performance indicators within the business, commodity exchanges can compare past outcomes to current product development and exchange management standards.

Strategic benchmarking helps analyse how other exchanges become successful.

Practice benchmarking related to process mapping that identifies and addresses performance gaps in commodity exchanges’ business metrics and associated functions - product and business development, technology, and risk management.

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Dimensions of benchmarking

We consider China’s and United States’ commodity derivatives markets as leading emerging and developed markets. Benchmarking follows a bucket approach embracing product, participation, and risk management adopted by the exchanges in China and US.

First is the consideration of product contributing to competitive and strategic benchmarking. In China, commodity futures are short-maturity contracts that are the volume leaders, and nine of the leading 15 futures contracts are traded in the Chinese exchanges. The futures contracts in China have smaller lot sizes than the top international exchanges.

The smaller lot applies to agricultural commodities, base metals, and precious metals contracts. However, the delivery lot size is more significant for many contracts to exploit economies of scale and curb speculation.

The trading in commodity options is limited only to relatively sophisticated investors, for example, the C5 category of investors. Options are not preferred for hedging the commodity price risk by industrial firms.

Several benchmark products are traded on the Chicago Mercantile Exchange (CME) Group and Inter-Continental Exchange. Like crude oil contracts, namely West Texas Intermediate, Chicago wheat has about 65 per cent of the global futures market share.

Benchmark contracts help determine reference prices and hedge price risks embedded in the structure of industries along the supply chains.

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Chinese derivatives market

The second dimension is participation, which reinforces the exchanges and takes corrective action through benchmarked practices and performance metrics.

For instance, China’s commodities derivative market trading is dominated by domestic retail traders with more than 85 per cent of the volume share.

State-owned Chinese firms can only hedge their risk in the international commodities markets. Due to quota restrictions, private firms find it challenging to access global commodities markets for hedging.

In the US, financial and commercial participants and self-directed retail traders participate in commodity exchanges, and institutional participation comes from banks, hedge funds, asset managers, pension funds, insurance companies, and proprietary trading firms.

Merchant traders often operate across the physical supply chains and hold open interests.

Proprietary traders render liquidity to commercial participants, who are often exchange members and account for about 84 per cent of the exchange traded volume, for example, the CME Group.

The third dimension is evaluating and implementing risk management to influence performance and strategic benchmarking. For example, the hedging for Chinese firms has been protected through restrictions on the international hedging activities of the state-owned firms, and integrating the index insurance and futures contracts can mitigate weather and price risks faced by the insurance companies and agricultural farms.

The insurance companies are effectively re-insured by purchasing OTC products of securities companies or futures risk management subsidiaries.

The uniform margin and risk monitoring system focused on net capital maintained by the China Futures Margin Monitoring Centre streamlines a cost-effective operation.

The fourth dimension is transaction fees, regulatory charges, and tax incidence on the market participants that need to be rationalised and benchmarked for emerging and global markets to improve participation.

Policy suggestions

The regulator and commodity exchanges can evaluate the pros and cons of practices followed in emerging and developed markets for benchmarking.

Following a critical evaluation, they can facilitate offering benchmarked as well as indigenised products in furthering the spirit of atmanirbharta and streamline risk management processes to make the market more reliable and competitive in price discovery, price dissemination, and risk management.

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