In the commodity derivatives markets, risk from the lens of an exchange include market fraud risk, credit risk, liquidity risk, systemic risk and operational risk. Most of these risks are managed by the clearing house of the exchange.
A variety of risk management tools are adopted by such exchanges to preserve market integrity which includes market surveillance, limits, tight empanelment norms for trading/ clearing members, warehousing/ quality standards for physical commodities, margins and collateral for addressing defaults, and a default fund in case of insufficiency of margins of members to address default on settlement obligations.
Globally, the IOSCO and CPMI prescribe the Principles for Financial Market Infrastructures (PFMI) guidelines to provide minimum standards for FMIs (such as clearing corporations) to ensure a common and global base level of risk management across market segments. SEBI in India adopted these guidelines for commodity derivatives in 2016. Today, clearing corporations in India are well aligned with the PFMI guidelines. However, the Indian commodity derivatives market is yet to stay competitive with the global markets.
Addressing high initial margins
Initial margins (IM) in Indian commodity derivative contracts are higher than similar contracts offered by global exchanges such as the London Metal Exchange (LME), CME Group and the Shanghai Futures Exchange (SHFE) – and this impacts market attractiveness, especially for FPIs. For example, for 1 lot of MCX crude oil futures, the applicable IM is approximately USD 2,330 while in CME, the equivalent IM would be USD 700. The following contributory parameters should be re-assessed for re-calibration:
Margin Period of Risk (MPOR) or close-out period: A longer MPOR tends to produce higher IM requirements. In India, the MPOR is in the 3–4-day range compared to global exchanges where MPOR is in the 1-2 day range.
Look back period: A shorter look back period makes margin requirements too reactive to sudden market movements. In India, this is comparatively shorter than global exchanges.
Margin parameter review: Shorter reviews address specific stressed events which re-adjust to normal margin requirements where market volatility is within the acceptable thresholds. Such reviews are longer in India compared to global exchanges.
Default fund contribution: In India default fund contribution is undertaken by the exchanges only while in global exchanges, contribution is from both the exchange and its members. The latter tends to help in lowering of margin requirements.
Addressing transaction costs, other measures
In India, taxation and statutory levies significantly contribute towards transaction costs. Such high costs are often cited by market participants as a major deterrent to their participation in Indian derivatives market. For example, for 1 MCX crude oil futures lot, the transaction cost may be approximately $1.08 while a similar futures contract would have cost $0.18 in ICE Europe and $0.37 in CME respectively (excluding GST/ other levies). It is time to consider relaxing these levies to boost market attractiveness and participation by FPIs.
Secondly, many large Indian corporates also undertake their commodity hedging transactions on global exchanges – where, hedging of approximately ₹190,000 crore of notional value of such derivatives are being undertaken by them annually. Therefore, it is time for Indian exchanges to partner with such participants to introduce new products (e.g. cash settled contracts) and to incentivize them to participate in India so as to boost market liquidity.
In conclusion, while risk management is a necessary requirement, addressing the above should be undertaken in a balanced way to increase and sustain market attractiveness and liquidity.
Patel is Head - Strategy, Finance, and Operations and Co-founder of Acies. Rahul Murthi is Leader - Strategy and Structuring, Acies.