The cleaning up of the commodities market has begun. In a major move, SEBI recently banned all forward trades across exchanges. It also cracked the whip on four large trading members and 12 of their clients in castor seed futures on the NCDEX and suspended them from trading in the market.

While the regulator needs to be given a pat on the back for its act, this is a message to small traders to stay away from playing agri commodities for speculative profits. More than a handful of agri commodities are traded on commodity bourses today and trades in some are opaque due to the absence of a large market or quoted prices that can serve as a benchmark to these contracts.

As SEBI has just started to examine commodity derivative trades closely, further moves to suspend or cancel doubtful contracts can’t be ruled out. If castor seed futures which was one of the most traded contracts on the NCDEX with average monthly turnover of about ₹8,300 crore (twice as much as in chana futures) had to meet this fate, risk is higher in other commodities.

Here, we throw light on what happened in the case of castor seed futures that led to the intervention by the regulator.

NCDEX’s suspension The National Commodity and Derivatives Exchange (NCDEX), the largest agri commodity bourse in India, announced on January 27 that it was suspending all contracts in castor seed futures. This raised eyebrows, the contract being one of the large volume generators for the exchange.

In a press release after suspension of the contract, the exchange said that the move was to “ensure market equilibrium” and that some of the members were “expressing difficulty in meeting their MTM obligations.”

The February month contract of castor seed futures corrected 20 per cent between January 1 and January 27. The contract hit lower circuit of 4 per cent and 6 per cent on January 25 and 27 respectively.

The Exchange had increased margin requirements in castor seed futures (to the extent of 5 per cent on both buy and sell side) in November to check the increased volatility in the contract. But, it was not of much use. So, in January, the exchange changed margin requirements again. It increased the extreme loss margin from 1.5 per cent to 2 per cent first and then from 2 to 2.5 per cent.

All these changes didn’t though dissuade participants from speculating on the contract. SEBI’s order on the errant trading members and their clients noted that the open interest in castor seed futures had increased sharply in January.

It also found 13 clients holding 62.5 per cent (equivalent to 10 per cent of the country’s annual production in castor seed) of the open interest in the February contract of castor seed futures. Ideally, with a sharp drop in prices, clients who held stock should have liquidated it rather than adding more long positions.

Settlement After the suspension of the castor seed contracts, NCDEX settled all open positions at the end of day prices as on January 27. With a sharp correction in prices in the week before, investors who had open long positions would have certainly suffered a loss. Had the contract not been suspended they could have rolled over their positions. Castor seed futures saw prices correct from around ₹3,600/quintal to ₹3,100/quintal in January.

Vireesh Hiremath, Research Head, Karvy Comtrade, who has clients from Rajasthan and Gujarat trading castor seed futures, said, “Open positions were squared off at the settlement price, but there is some loss of confidence. With agri commodity contracts getting suspended on and off and investors making losses, there is some apprehension to trade now…”

Clients who had stocks of castor seed in the exchange-approved warehouses, however, saw NCDEX help them sell it in the spot market through the e-platform (of NCDEX e-market, a subsidiary of NCDEX).

Marketmen say millers picked up the stock at ₹2,800/2,900 per quintal. NCDEX also negotiated the warehouse rent and reduced the Comtrack CNT charges.

What did SEBI do? Soon after NCDEX’s suspension of the castor seed contract, SEBI started its probe and in a month’s time issued an order suspending four trading members and 12 of their defaulting clients from the securities market. The defaulting clients together held a sizeable portion of the open interest in February contract of castor seed.

Investigation also revealed that there was a continuous delay (or shortage) on the part of these clients in settling mark-to-market margins.

SEBI, in its order, thus said there were risks in allowing these clients to continue to trade.

“Highly concentrated position in castor seed contracts by defaulting clients of the four members coupled with their inability to pay MTM obligations has potential to disturb market equilibrium and harm market integrity and poses systemic risks to the functioning of the market”.

It also noted that “Commodity trading members must take precautionary steps to maintain market integrity. However, in this case none of the members took any prudent measures or raised alert with respect to the position of their clients.”

In each contract of commodity futures, there is a limit on the maximum number of open positions a member, broker or a client can hold.

This rule is to reduce market concentration. In the castor seed case, there was no breach of the limits, but still, collusion among participants was noted.

To plug the loophole in the system that permitted collusion of clients in castor seed futures, SEBI issued a circular on January 29, and scrapped all old rules for determining position limits.

It said that maximum number of positions for a client in a near month contract can be only one-fourth of his overall positions in the commodity (including near, mid and far-month contracts).

Also, for the purpose of calculating the overall exposure of a client in a commodity, longs and shorts will not be netted out and they will be considered separately and higher of the two shall be considered as the open position.

Further, for members who trade on proprietary books, position limits will be determined the way it is done for clients.

The above change is a significant move. Currently clients (and members) net out their longs and shorts in near and far-month contracts and pass the test for position limits on a commodity contract easily. Now, that can’t happen.

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