The fissures in the National Spot Exchange model have quite expectedly been greeted with umbrage given the loss of money involved due to a failure of systems. The fact that the ministry of consumer affairs had warned of the inappropriate contracts much earlier did not lead to any action as the system was working just fine. The amount involved is quite large and it appears that the combination of the settlement guarantee fund as well as commodities stored in the warehouses cannot match the payments that are to be made. What are the implications or rather the lessons to be learnt from this story?
The idea of having an electronic spot exchange is to mimic what happens in a mandi in a transparent manner so that there is efficient price discovery and all parties are better off with counter-party risk guarantee being provided by the exchange. To make this work, systems of warehousing, assaying and weighing have to be in place, which improve the quality of infrastructure in the farm sector. This was the idea when these exchanges came on board, and the recent episode of what can go wrong is a lesson for all of us.The two immediate takeaways are that we require regulation at the top and adequate risk practices in place within the exchange so that there is orderly trade which results in delivery. The absence of regulation was the first lacunae because the way contracts were structured, it could be defined as being a spot or futures transaction. Also, given that players took advantage of the settlement cycles of 11 or more days, there was inherently interest arbitrage at the corner. This allows speculators or investors to buy and sell without having to take delivery of the commodity.Therefore, APMCs, FMC and probably a combination of RBI and Sebi would all be potential regulators as it involved spot sale, futures sale and financial investment. But the sector got away with no regulation. Ideally, all contracts should have been settled and delivery taken on the same day which would have been cumbersome but with less risk.Second, the exchange should have had its risk as well as surveillance systems in place. Typically, all contracts should result in delivery which was not the case here. Therefore, for this market to develop delivery should be mandatory. The surveillance systems were lax as it was assumed that nothing could go wrong as most transactions were by investors where the commodity was being traded multiple times. It was not expected that the ministry would ban these contracts as they overlapped with the futures market. Therefore, neither the physical commodity nor the positions taken really mattered. So, for a stock of, say, 100 tonnes, there could be 10,000 tonnes worth of contracts. The same is less likely to happen in a futures market as the regulatory systems are in place with margins, position limits and mark-to-market processes being in place.At a fundamental level it raises the question of whether or not commodities should be treated as financial products. This question takes the trail back to the Jalan committee which raised the issue of financial infrastructure companies being profit motivated. For an exchange to be profitable it has get volumes, and to enable this goal, it has to reach out to a vast community. We need to generate liquidity and a pure hedgers market will not do. Therefore, the spot or futures transaction in commodities has to resemble a financial product—just like, say, equity. The National Spot Exchange model was mimicking more the futures market rather than a mandi and was attractive on account of the assured returns that could be procured on the basis of a simultaneous buy and sell transaction. If the conventional mandi model is followed there would not be too many players at the terminal and the price discovery process would be less robust. So, it was necessary to get in more players with trading ability.Treating commodities as a financial product has its own set of issues as it becomes analogous to dealing with shares of a company. The difference is that when it comes to a share, there is no underlying risk and the only people affected by the share price going wrong are the owners of the company. But when it comes to commodities, the players who determine the price, especially in the spot market case, were generally investors who probably would not have known what commodity they were dealing in. But their decisions can affect the price of the product across the country and hence the ultimate consumers.Intuitively the concept of treating commodities as a financial product is compelling because inflation is normally always positive, which means that one will always gain in such a situation. There can be seasonal variations that add to volatility and make it an attractive investment option. Thus, in the medium term, one has to gain in commodities and any statistical exercise on returns on commodities which is found in presentations made to potential investors talks of returns of 20% on bullion, 10-20% on metals and 8-15% in farm products, in normal times. Add a crop failure and the returns on farm products could be upwards of 30-40%.An interesting question posed is whether financialisation of commodities also poses a conundrum for the commodity futures market. Does the futures price drive the spot price? If it does, then such trading runs the risk of being responsible for price inflation, which was the reason behind various bans imposed. On the other hand, if it is not, then there is no sanctity to such a market because we are not really talking of price discovery.Quite clearly, the commodity market has gotten into yet another controversy with the futures segment living with a shadow of bans while the present story would mean revisiting the ground rules of a spot market. The FMC will now be the regulator, but the question really is once we set the house in order, will the market ever be what it was like before?A corollary is whether commodity markets, either in the physical form or as financial futures, better off if they are overseen by a regulator which is savvy in terms of the product being dealt with. As both e-spot and futures in commodities are financial products, there is now a strong case for shifting the FMC to the ministry of finance. This has been debated for a long time with the clinching argument for being that the ministry of consumer affairs is more tuned to commodities. But as things have turned out, commodity trading without a large element of financialisation is not sustainable. Thus, the case can be transferred to the ministry of finance for better oversight with FMC, like Sebi, being made an independent regulator.
The idea of having an electronic spot exchange is to mimic what happens in a mandi in a transparent manner so that there is efficient price discovery and all parties are better off with counter-party risk guarantee being provided by the exchange. To make this work, systems of warehousing, assaying and weighing have to be in place, which improve the quality of infrastructure in the farm sector. This was the idea when these exchanges came on board, and the recent episode of what can go wrong is a lesson for all of us.The two immediate takeaways are that we require regulation at the top and adequate risk practices in place within the exchange so that there is orderly trade which results in delivery. The absence of regulation was the first lacunae because the way contracts were structured, it could be defined as being a spot or futures transaction. Also, given that players took advantage of the settlement cycles of 11 or more days, there was inherently interest arbitrage at the corner. This allows speculators or investors to buy and sell without having to take delivery of the commodity.Therefore, APMCs, FMC and probably a combination of RBI and Sebi would all be potential regulators as it involved spot sale, futures sale and financial investment. But the sector got away with no regulation. Ideally, all contracts should have been settled and delivery taken on the same day which would have been cumbersome but with less risk.Second, the exchange should have had its risk as well as surveillance systems in place. Typically, all contracts should result in delivery which was not the case here. Therefore, for this market to develop delivery should be mandatory. The surveillance systems were lax as it was assumed that nothing could go wrong as most transactions were by investors where the commodity was being traded multiple times. It was not expected that the ministry would ban these contracts as they overlapped with the futures market. Therefore, neither the physical commodity nor the positions taken really mattered. So, for a stock of, say, 100 tonnes, there could be 10,000 tonnes worth of contracts. The same is less likely to happen in a futures market as the regulatory systems are in place with margins, position limits and mark-to-market processes being in place.At a fundamental level it raises the question of whether or not commodities should be treated as financial products. This question takes the trail back to the Jalan committee which raised the issue of financial infrastructure companies being profit motivated. For an exchange to be profitable it has get volumes, and to enable this goal, it has to reach out to a vast community. We need to generate liquidity and a pure hedgers market will not do. Therefore, the spot or futures transaction in commodities has to resemble a financial product—just like, say, equity. The National Spot Exchange model was mimicking more the futures market rather than a mandi and was attractive on account of the assured returns that could be procured on the basis of a simultaneous buy and sell transaction. If the conventional mandi model is followed there would not be too many players at the terminal and the price discovery process would be less robust. So, it was necessary to get in more players with trading ability.Treating commodities as a financial product has its own set of issues as it becomes analogous to dealing with shares of a company. The difference is that when it comes to a share, there is no underlying risk and the only people affected by the share price going wrong are the owners of the company. But when it comes to commodities, the players who determine the price, especially in the spot market case, were generally investors who probably would not have known what commodity they were dealing in. But their decisions can affect the price of the product across the country and hence the ultimate consumers.Intuitively the concept of treating commodities as a financial product is compelling because inflation is normally always positive, which means that one will always gain in such a situation. There can be seasonal variations that add to volatility and make it an attractive investment option. Thus, in the medium term, one has to gain in commodities and any statistical exercise on returns on commodities which is found in presentations made to potential investors talks of returns of 20% on bullion, 10-20% on metals and 8-15% in farm products, in normal times. Add a crop failure and the returns on farm products could be upwards of 30-40%.An interesting question posed is whether financialisation of commodities also poses a conundrum for the commodity futures market. Does the futures price drive the spot price? If it does, then such trading runs the risk of being responsible for price inflation, which was the reason behind various bans imposed. On the other hand, if it is not, then there is no sanctity to such a market because we are not really talking of price discovery.Quite clearly, the commodity market has gotten into yet another controversy with the futures segment living with a shadow of bans while the present story would mean revisiting the ground rules of a spot market. The FMC will now be the regulator, but the question really is once we set the house in order, will the market ever be what it was like before?A corollary is whether commodity markets, either in the physical form or as financial futures, better off if they are overseen by a regulator which is savvy in terms of the product being dealt with. As both e-spot and futures in commodities are financial products, there is now a strong case for shifting the FMC to the ministry of finance. This has been debated for a long time with the clinching argument for being that the ministry of consumer affairs is more tuned to commodities. But as things have turned out, commodity trading without a large element of financialisation is not sustainable. Thus, the case can be transferred to the ministry of finance for better oversight with FMC, like Sebi, being made an independent regulator.
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