Commodity futures: Waiting for the gains

Business Standard, 18 April 2016

The big idea in the field of financial markets is that all trading is the same, regardless of the instrument being traded. The first policy step which reflects this understanding was the merger of FMC into SEBI, which took place in February 2015. This ought to yield numerous benefits for financial development. The pace of change, in harnessing the achievement of February 2015, is disappointing.

At heart, all financial instruments are alike. There is some traded security. There are orders to buy and sell. There is some mechanism through which trades are matched. These go into a clearinghouse and are settled at a depository. The role of the government is to prevent market abuse, ensure soundness of the clearinghouse, uphold the regulatory functions of securities infrastructure institutions, and do consumer protection. At heart, all these things are the same for a share, a bond, a currency futures, Nifty futures, gold futures or monsoon futures.

In India, for historical reasons, we had a great deal of fragmentation of financial markets. We had three pieces: equities and long maturity corporate bonds with SEBI, commodity futures with FMC and the Bond-Currency-Derivatives Nexus at RBI. This led to waste. Where one securities firm would suffice, three securities firms were created. Consumers had to suffer the burden of additional transactions costs. Supervisors were unable to see the full picture as it was broken up across three regulators. Innovations did not rapidly transmit from one part of the market to another.

RBI, SEBI and FMC all took divergent policy strategies. The one which worked out the best was at SEBI, where NSE and BSE built a very good equity market. Hence, it made sense to merge commodity futures and FMC into SEBI. This was talked about in the late 1990s. In the early 2000s, it was almost done, but the UPA victory in May 2004 derailed the process. The Percy Mistry, Raghuram Rajan and B. N. Srikrishna reports all emphasised the unification of all organised financial trading. The NSEL crisis helped disrupt the erstwhile political economy. In one of the biggest achievements of the Modi government, in February 2015, FMC was merged into SEBI. At the time, the bond market was also merged into SEBI, but this got rolled back.

With the merger of SEBI and FMC, what changes can we expect? The first area of change is the gains for securities firms. Instead of creating one firm which will trade in SEBI's world and another firm that will trade in FMC's world, it becomes possible to have a single securities firm which trades in equities, corporate bonds of maturity more than 1 year, and commodity futures. This yields economies of scale and scope. It also improves knowledge sharing and system building as (say) the same skills and software are applied to gold futures arbitrage as are applied to nifty futures arbitrage.

The second area of change is the gains for product development. The FC(R)A had numerous restrictons on what products were permissible. Cash settled products were strictly not permitted, and FMC had allowed them to come about through a complicated fudge. Options trading and commmodity index derivatives were banned. Now that commodity futures are just `securities' under the more modern Securities Contract Regulation Act (SCRA), all these products are immediately feasible. Exchanges should be able to launch de jure cash settled products, commodity options, and commodity index derivatives.

The third area of change is foreign investors. In the earlier environment, there were concerns about ethical qualities in a subset of the commodity derivatives business. Now that those problems are out of the way, it is possible for the Ministry of Finance to open up access to foreign participants. With agricultural commodities, India is a major player by world standards on a dozen products; perhaps India can make the world price in these. If we can dream big, we can do this for gold as well.

The fourth area of change is a shift in objectives of regulation. Securities market regulation is about market abuse, soundness of the clearinghouse, and consumer protection. It is not about the market price. A sound securities regulator is the referee on the football field: he has to ensure fairplay, but he must have no opinion on the outcome of the match. FMC, and its mother department, often had a view on whether a certain price was too high or too low. With the shift to DEA and SEBI, such considerations should be blocked.

The fifth area of change concerns securities exchanges. We now have four significant exchanges in India: NSE, BSE, NCDEX, MCX. We should now have conditions where any exchange can trade any product. E.g. it should be possible for NCDEX to trade Wipro futures, for MCX to trade dollar/rupee futures, and for BSE to trade gold options. The decisions about what products are traded should only be shaped by commercial considerations at the exchange. A related issue is the fragmentation of membership and procedures within exchanges into `segments'. This needlessly increases bureaucratic overhead. A securities firm should have to establish exactly one MCX membership, and after that, he should get access to screens and to fat pipes for algorithmic trading in all products traded at MCX.

The sixth area of change concerns the time of day. With nifty, rupee, gold, etc., India faces vigorous global competition. It is important to move up to near-24-hour trading so as to increase India's global market share.

The seventh area of change is required at SEBI. SEBI was once a sectoral regulator. It should now ascend to becoming the financial markets regulator. It would make sense to re-organise SEBI as three departments, for legislative, executive and quasi-judicial functions.

A full 14 months have elapsed, after the historic achievement of February 2015. Better project management is required, to obtain these seven gains for the economy from one of the biggest achievements of the Modi government.

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