Sucheta Dalal :Poor Supervision The Weakest li<x>nk In Commodities Trading
Sucheta Dalal

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Poor Supervision, The Weakest Link In Commodities Trading  

Sep 20, 2004


Reckless speculation and migration from the equity market could ruin the market even before it stabilises


In the 1980s, the two brothers were considered among the sharpest jobbers in the Bombay Stock Exchange (BSE). When the capital market switched to automated trading, they adapted and became big arbitrageurs in the equity markets. And although they were investigated for price manipulation at least once, the regulator hasnt come up with anything incriminating so far.


Recently, the brothers made a trip to south India to study the rubber and pepper markets. They told people that the Securities Transaction Tax (STT) would eat into their arbitrage margins, making their business unviable, so they were planning to switch over to the commodities market.


With trading turnover in commodities bourses having raced ahead of the BSE to cross Rs 3,000 crore on good days, their decision seems to make good business sense. But what is probably most attractive to such operators and traders is that regulation and supervision is minimal in the business. Most traders are looking for lucrative arbitrage opportunities by buying in the cash market and selling futures contracts.


Futures trading in commodities has been re-started after over 40 years with four multi-commodity bourses being allowed to offer derivative products, but a proper regulatory system to supervise the trade is still not in place. The Forward Markets Commission (FMC), which operates under the ministry of consumer affairs is the regulator, but knows little about monitoring electronic trading and detecting market manipulation.


Worse, even the bourses have no minimum mandatory technology requirements for tracking margin payments and trading patterns. They are also allowed to frame their own trading rules and margin requirements. For instance, the National Commodity & Derivatives Exchange Ltd (NCDEX) has the most comprehensive risk and surveillance controls to monitor prices. It has member-wise and client-wise trading limits that are monitored on a real time basis. It collects net margins and Value at Risk (VAR) margins and has also introduced demat deliveries and encourages traders to be settled through authorised agents.


However, the Multi-Commodities Exchange (MCX) until recently collected gross margins and the National Multi-Commodity Exchange of India (NMCE) used to recognise specific trading terminals and levy terminal-level margins, no matter how many individuals traded from a particular terminal, say traders. The FMC woke up last week after speculation threatened to go out of control and instructed the commodities bourses to charge net margins.


Speculators have caught on to the weak regulatory environment and in recent weeks, the rampant speculation in a couple of commodities has threatened to get out of hand.


The warehousing and delivery mechanism worked satisfactorily after some teething troubles. But market players are unsure if it will hold up if volumes continue to soar. Slow decision-making by government has also kept several key issues pending.


The biggest danger to this galloping trading business is poor supervision. Consider this. In June this year, a rubber dealer registered with the Rubber Board is understood to have entered a series of shady circular transactions with a sister firm on the NMCE creating a hefty Rs 10 a kg difference between cash and futures prices. It led to an investigation, but NCME chief Kailash Gupta told The Business Line that: “We have condoned this (act) since he has confessed and apologised.” That closed the investigation. The FMC neither noticed the huge gap between cash and futures prices nor did it bother to investigate; the Rubber Board had initially asked some questions but chose not to pursue the matter although it involved its own dealer. This has signalled a relaxed regulatory regime in the commodities market, attracting more arbitrageurs and speculators to the business.


In recent weeks, similar problems seems to have developed in cardamom. There is a gap between the cash and future prices and futures are trading significantly lower than cash. Cardamom growers are suffering because their price realisation remains low; many think that commodities brokers are fixing futures prices to keep them depressed. Brokers, on the other hand, worry that people are yet to understand the price discovery process; they also suspect that some cardamom traders may have formed a cartel to keep futures prices down. Consequently, say sources, cardamom growers are getting barely Rs 300 per kilo, while the spice sells at around Rs 800 to consumers. Traders remain the biggest beneficiaries of depressed prices.


Our sources say that the Spice Board has been quietly making inquiries about cardamom price trends, but the FMC has still to wake up to the need for investigation.


What worries some large traders is that reckless speculation could kill the commodities market once again. Commodity price fluctuations are far more sensitive than those in capital markets, because price manipulation and distortion immediately affects millions of people. Excessive speculation had led to a ban on futures trading in commodities (especially foodgrain) for over 40 years, yet the government is in no hurry to strengthen the regulatory structure.


At a recent meeting in Delhi, NCDEX is understood to have pressed for an amendment to the Banking Regulation Act so that rural branches of banks could act as intermediaries to enable farmers to insulate themselves from price fluctuations through futures trading.


It also repeated its long-pending demand that warehousing receipts must be treated as negotiable instruments. This requires accreditation of warehouses and the proper legislation. These demands make it all the more imperative for FMC to be brought under the finance ministry. It is only then that the commodities futures markets will develop sufficiently to allow the government to use the market mechanism to cut its food subsidy bill and its frequent intervention in other essential commodities. Otherwise, there is a real danger that speculators and arbitrageurs migrating from the equity market could ruin the market even before it stabilises.


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-- Sucheta Dalal