ROAD MAP

FOR TRANSITION OF THE MUTUAL FORM OF EXCHANGES TO DEMUTUALISED ONES

 

 

 

 

 

 

 

 

SUBMITTED TO

 

FORWARD MARKET COMMISSION

 

AUGUST 2004

 

 

 

 

 

INDIAN INSTITUTE OF CAPITAL MARKETS

(FORMERLY: UTI INSTITUTE OF CAPITAL MARKETS)

ACKNOWLEDGEMENT

 

 

 

We thank the Department of Consumer Affairs, New Delhi and Forward Markets Commission, Mumbai for reposing confidence in us for conducting this study. We wish to thank Mr. D.S.Kolamkar (Director FMC) and Mr.Anupam Mishra (Deputy Director FMC) for their insightful and valuable comments. We are also thankful to Mr.Kailsah Shahra (Chairman NBOT) and Mr.A.S Jeykumar (Executive Director, NBOT) for helping us to understand the working of NBOT exchange.  We also want to appreciate efforts of Mr.K.J.Samson (secretary IPSTA) in helping us to understand the modalities of the Pepper exchange. We wish to place on record assistance by Mr.Aditya Singhal (a student pursuing his Chartered Accountancy course), in completing this report.

 

 

 

 

 

 

Dr.Chiragra Chakrabarty                                                                          Prof G.Sethu

Assistant Professor                                                                                    Professor

 

AUGUST  2004

 

CONTENTS

 

 

 

Executive Summary

 

4

Chapter one

Structure, conduct and performance of commodities futures markets in India

 

6

Chapter two

INDIA PEPPER AND SPICE TRADE ASSOCIATION: A CASE STUDY

 

9

Chapter three

NATIONAL BOARD OF TRADE LTD: A CASE STUDY

 

18

Chapter four

Demutualization: Issues from the case studies

 

31

Chapter five

Road Map for Commodity Futures Exchanges in India

 

36

 

BIBLIOGRAPHY

 

 

43

 

 

 

EXECUTIVE SUMMARY

 

This report commences with an analysis of the commodities futures market in India using the “Structure-Conduct- Performance’ framework. It is noticed that in spite of commodity futures exchanges in India having a long history, many exchanges lack in liquidity, volumes and number of trades. In the older exchanges, right to trade, right to ownership and right to manage vest in the same set of persons. In all commodity futures exchanges, clearing and settlement is part of the main exchange. Several of these exchanges seem to be inward looking without adequate emphasis on business development. In their present situation, the exchanges do not seem to be delivering to their full potential.

 

In this examination, we studied two exchanges, viz., India Pepper and Spice Trade Association and the National Board Of Trade Limited. From these two case studies, certain inferences have been drawn about the operational weaknesses of the commodity futures markets in India. In particular, there appear to exist conflicts of interest when the trading privilege, ownership right and the management prerogative vest in the same persons(s). There are some shortcomings in the day-to-day management of these exchanges. Structural solutions are required to strengthen the day-to-day governance. This calls for seriously examining the issue of demutulisation. From these two case studies, the following issues relating to demutualisation arise:

 

 

The report outlines the steps that are required to be taken to demutualise the commodity future exchanges. It is also suggested that converting the exchanges into for-profit corporation would enable them to raise further capital. Specific actions to be initiated by different entities have been identified.

 

Major actions required from the exchanges themselves:

 

  1. Exchanges should convert themselves into demutualised for profit corporate entities. (Chapter 5 Section IV)
  2. For Trade Guaranteed Fund (TGF) separate trust has to be established by the all commodities exchanges.
  3. Exchanges should modify the governance structure by changing the structure of board of directors (Chapter 5 Section IV B).
  4. Exchange should set up the following standing committee to strengthen day to day administration:

(a)    Membership and Business Development Committee

(b)   Trading, Clearing and Settlement Committee

(c)    Margin, Surveillance and Inspection Committee

(d)   Disciplinary and Disputes Redressal Committee

  

Major actions required from the government for demutualisation of commodity exchanges:

 

Government should amend Indian Stamp Act 1889 and Income Tax Act to confer on demutualised commodity exchanges same concessions as in the case of demutualised stock exchanges. As a general matter, all policies of the Central Government with respect to demutualization of Stock Exchanges should be applicable in case of Demutualisation of Commodity Exchanges as well. The FC( R ) Act of 1952 should be amended.

 

Major actions required from the Forward Market Commisison for demutualisation of commodity exchanges:

 

1)      Initiate a dialogue with exchanges for demutualisation and corporatisation and prescribe a road map for them as listed Chapter 5 section IV A and B.

2)      Step should be taken to refurbish the Forward Market Commission along the lines of SEBI and RBI by recruiting the adequate professional expertise from the market. (Chapter 5 Section VII)

3)      Forward Market Commission should strive to setup an independent national level entity for clearing and settlement of commodity futures contracts traded on different exchanges.

CHAPTER ONE

Structure, conduct and performance of commodities futures markets in India

 

 

I.          Introduction:

 

India, unlike many other emerging nations, has a long history of futures markets. Trading in commodity futures was introduced in cotton and oil seeds in the 1920s. At present, there are 24 commodity exchanges in India covering 68 commodities. These markets are dispersed and fragmented. Several exchanges deal in just one commodity. The industry has been opened up recently after a gap of three decades. Most exchanges have acknowledged that they need to employ modern methods of business. Today, there are a few exchanges (National Board of Trade at Indore, India Pepper Spice Trade Association at Kochi, Ahmedabad Commodity Exchange) that can be called reasonably successful.  

 

The Forward Contracts (Regulation) Act, 1952 offers a three-tier framework for regulating the futures markets in commodities in India. Many exchanges follow the open outcry system. Given the small number of traders, this system seems to be cost effective. The small size is also reflected in the clearing operations in some exchanges. In India there is a weak link between the underlying physical commodity and the financial transactions related to it. It has been noticed that at times the limits imposed by Forward Contracts (Regulation) Act on contract specifications precludes legitimate risk management needs of the commercial users.

 

Futures markets in India suffer from illiquidity. Reserve Bank of India has banned large institutional players from participating in the market. Regulatory hurdles have made it difficult for the agricultural co-operatives and international users to participate[1]. The brokerage community is small, poorly capitalized, highly fragmented and remains inadequately regulated.

 

II.        Structure of the market:

 

Government of India recognizes 24 associations. These associations are styled as commodity exchanges. They are permitted to organize and regulate forward trading in various commodities. Usually, only one exchange is recognized in a city or region in any single commodity group. There are exchanges that trade in just one commodity and there are exchanges that trade in multiple commodities. There are commodities that are traded in several exchanges. Some of the exchanges are electronic. The exchanges recognized by the government are responsible for the day-to-day operations of the futures markets. These rules pertain to trading, clearing and settlement. The members of the excahnges are firms that have the right to trade.

 

Number of active members in the exchanges is quite low. As at 2001, the average number of active members was 20 with maximum of 71 and minimum of just 1![2] Many members are inactive. There is also an impression that a few members control the bulk of the volumes. This suggests a degree of concentration. In each exchange, separate trading communities dominate activity. Any person who does not have affiliation to that community faces some sort of entry barrier. The rationale behind this is, person who is not from this community, does not know much about the market because of lack of market information. Since few big players rule markets they do not want to enhance the information dissemination and hence expand the trading members domain.   In several of these exchanges, trading rights, ownership rights and management control vests in the members. It is rumoured that significant proportion of volume is diverted to gray markets, which do not have regulatory oversight.

 

In several commodity exchanges in India, the day traders account for half the trading activity. These trades are speculative in nature. The rest is for hedging purposes. Farmers rarely use futures markets directly. It is reported that hedging through futures markets forms a small fraction of the total trade in most commodities. While large exporters are constrained by illiquidity in the exchanges, small traders face poor access to credit.

 

In Indian commodity markets, the brokers’ scale of operations is small. The broking industry is fragmented. Financial strength of brokers is limited. The clients access the broker through personalized contacts. Brokers are not able to offer full services (information, analysis).

 

III.       Conduct:

 

Exchanges require investments and unless there is an adequate volume, it would be difficult to justify such investments. This led to reduced competition between associations. A few members dominated the exchanges. These factors, combined with the small size of active members and entry barriers, led to monopolistic conduct. Of late, the regulator has encouraged many exchanges to trade in the same commodity. For example, mustard is now traded in nine exchanges. There are five exchanges that trade in gur. There are three national level exchanges. This is expected to offer best services to the users at reasonable prices.

   

IV.       Performance:

 

The following are the main economic benefits arising out of commodity futures markets:

 

 

 

The efficiency and effectiveness of a commodity futures exchange is measured in terms of:

 

 

VI.      Conclusion

 

It is evident that in most exchanges liquidity is low due to low volumes, low number of trades and diversion of trade to gray markets. In many exchanges, right to trade, right to ownership and the right to manage vest with the members. It is well known that such convergence of rights could lead to problems of governance. In several commodity exchanges in India, this problem persists. Clearing and settlement is part of the main exchange. Unless arms-length transactions between trade and clearing are assured, this is not a desirable state. There should be a separate composite commodities clearing corporation to take care of clearing and settlement of all commodities of major exchanges, to begin with. Later on it should be clearing and Settlement Corporation for all exchanges. The regulator has to play a major role in establishing this corporation. They may not be the stakeholder in it but should influence the market player to become the   promoter of this corporation. The model of Clearing Corporation of Indian, which has been setup for Debt and Foreign exchange market, can be studied. To begin with, FMC can take step to start a single clearing and Settlement Corporation for Gold for all exchanges and in due course of time can expand the domain of the commodities of this corporation.  The small size of the market fosters social controls. Brokers do not offer full line of services.  Social control, while suitable for small narrow markets, would be an inadequate mechanism in a large market. At present, the commodity exchanges in India are inward looking. Neither is there an emphasis in expanding the exchange’s business nor is there an attempt to promote and develop the capacities in the industry.  The fact that a significant part of the business is diverted to gray market suggests the need for improving the manner in which the commodity futures exchanges function in India.

 

 

 

CHAPTER TWO

INDIA PEPPER AND SPICE TRADE ASSOCIATION: A CASE STUDY

 

I.          Introduction:

 

The India Pepper And Spice Trade Association (IPSTA) is an Association of members registered under Section 25 of the Company's Act. It was established in 1957 and is situated in Mattancherry, Kochi, Kerala. IPSTA has been functioning in futures trading in pepper without break since 1957. It is the only exchange in the world engaged in trading of futures in pepper.

 

This case study is organized, keeping in mind corporation process of IPSTA.  The chapters are divided into eleven sections.  The following chapter throws light on the board structure and membership criteria of the IPSTA.  Which are the two main pillers of structure of organization.  It also discusses the different procedure relating to trading contracts in the exchange. Section II and III depict the board structure and membership criteria. Tradeable contracts and trading systems are explained in section IV and V respectively. Sections VI to IX throw light on fixation of rates, clearing system, margining system and trading guarantee fund. Section X depicts the demutualisation process & problem visualized by the exchange.  Section XI makes concluding remarks.  

 

II.        Board Structure:

 

Board of Indian Pepper and Spice Trade Association consists of 15 directors. The composition of the board is as follows:

 

The board has constituted five committees to look into different aspects of the exchange management. These committees are

 

 

Some members of these committees are also members of the exchange board. For example, the chairman of Clearing House committee is a director on the exchange board. He is a trading member as well. This could create a situation of conflict of interest. The nominated directors do not seem to show much interest in the functioning of the committees.

 

 

 

 

III.       Members:

 

There are three classes of members: Ordinary Members, Institutional Clearing Members and Associate Members. The total number of members of the IPSTA is 183 (Source: Annual Report of 2002-2003).  The types of members are as follows:

Ordinary Members - can be individuals, firms, joint stock companies, joint Hindu families, corporations and others engaged in the trading of pepper and other commodities and are qualified for membership under Article 4 and who have paid the fees as prescribed in Article 5. The ordinary members in the IPSTA International Commodity Exchange Division of the Association are classified into four categories:

 

 

Ordinary Members in the IPSTA International Commodity Exchange Division of the Association have to be registered with the Forward Markets Commission.

 

Associate Members consist of (i) those individuals or firms outside India having interest in pepper and/or other commodities trade and joining the Association for securing information but having no trading or voting rights and paying no deposit, but paying the admission fee and annual subscription as specified in Article 5 and (ii) those on whom honorary membership is conferred at the Association’s discretion for the reasons that they have rendered, notable service to the pepper and/or commodities trade, i.e. individuals and Government servants or visiting delegates of overseas of pepper and/or spice and other commodity associations.

 

Institutional Clearing Members consist of banks and financial institutions that are qualified for membership under Article 4 and who have paid the fees as prescribed in Article 5.  Institutional Clearing Members of the Association shall be registered with the Forward Markets Commission.

 

IV.       Tradable contracts:

 There are two tradable contracts of Pepper in IPSTA domestic division, Malabar Garbled Black pepper and 500 G/L black pepper contract.

 

        I.      The basis for Malabar Garbled Black Pepper grade shall be, well dried with permissible mould up to 1%; free from oil wash; with light pepper permissible up to 2%; with extraneous matter such as bran, chaff, stalks and stones permissible up to 0.5%; and moisture permissible up to 11% with a tolerance of 0.5% during monsoon.

 

     II.      The basis for 500 G/L black pepper grade shall be with light pepper permissible up to 10%, moisture permissible up to 13%, extraneous matter permissible up to 2%, mould permissible up to 2% and free from oil wash.

 

   III.      Both tradable contracts shall have 12 contracts in a year as prescribed in Byelaw.

 

  IV.      IPSTA has received the permission from Government of India for trading in multi commodities, i.e. rubber, turmeric and chillies.  The online trading in rubber is expected to start by mid-April 2004.

             

There are three tradable contracts of pepper in IPSTA International Commodity Exchange Division, MLS ASTA, VB ASTA and FAQ pepper.

 

All tradable contracts shall have 6 contracts in a year as prescribed in Bye-law 29(a). The basis for MLS ASTA and VB ASTA grades shall be pepper with extraneous matters permissible up to 1% by weight; light pepper permissible up to 2% by weight; moisture permissible up to 12% by weight; mould visible to the naked eye permissible up to 1% by weight; mammalian excreta permissible up to 2.2 mg per kg (1 mg per pound); other excreta permissible up to 11.0 mg per kg (5 mg per pound); and insects permissible up to 441 per 100 kg (2 per pound).

 

The basis for FAQ quality black pepper grade shall be with light pepper permissible up to 10%, moisture permissible up to 13%, extraneous matter permissible up to 2%, mould permissible up to 2% and free from oil wash.

 

V.        Trading System:

 

The open outcry system of trading has been replaced with on-line trading system on 3rd July 2003. In the proposed system the bids and offers are matched on the basis of:

 

·        Prices

·        Order Entry Date, time, and

·        Quantity available

 

For example if there are two bids eligible to match on the same price, the one entered earlier in the system will be matched. In case the entry time is also the same, then the matching will be done for the smaller quantity first and then the larger quantity will be taken up. This will give a better chance for the smaller trader to trade.

 

In the proposed system if a member puts a bid/offer his margin is blocked. He can put an opposite offer/bid in the same contract without using additional margin. But if he puts an offer or bid in any other contract his margin will be further blocked, unless it is deleted from the pending order or squared off. He can do this in the same contract any number of times. The new system permits any number of trades within the available exposure limit. So having traded in a contract, he can square off and repeat this any number of times without using additional margin.

 

The system is adept to trade in other commodities as it follows a common margining system for all the commodities to be traded. Having put a buy for January, we can put an offer for that contract alone without using additional margin. The risk associated with different commodities is different and cannot be passed between each other.

 

VI.       Fixation of Rates:

 

The Board shall, from time to time, appoint a Daily Rates Committee of five persons from the members of the Association or the partners or Directors/Managers or Members of the Association or their duly authorized representatives, who fixes the Daily Rates. The quorum for the meeting of the Daily Rates Committee is three.

 

The Board, with the approval of the Commission, may cause the settlement rate or settlement price, as the case may be, to be determined through a manual or computer programme or algorithm. The rate fixed and registered as aforesaid shall be binding on all parties entering into contracts under the Bye-laws of the Association. The bye-law states that there should not be any objection to a rate fixed and registered by the Board or the Members of the Daily Rates Committee on the ground that some or all members of the Committee were themselves interested in the contract, for which, such rate was fixed and registered. In case a maximum and/or minimum rate or rates are fixed under these Bye-laws, for the purpose of trading in the delivery concerned, and such rate or rates are in force on the due date, then, the Delivery Order Rate shall not be higher than the maximum rate and/or lower than the minimum rate. Any rate once fixed and registered by the Board will not be open for reconsideration and shall be binding on all parties.

 

VII.     Clearing:

 

In respect of contracts transacted in the Domestic Division, a Clearing House is maintained by the Association for the purpose of transmission of documents and payments, settlements etc., between the contracting parties and under the management of a Clearing House Committee appointed by the Board. In respect of contracts transacted in the IPSTA International Commodity Exchange Division, the Designated Clearing House managed by the First Commodities Clearing Corporation of India Limited is the clearing house for the purpose of receiving and maintaining margin payments, monitoring open positions and margins, and transmission of documents, payments, settlements etc., between the contracting parties including Ordinary Members and Clearing Members.

 

The Board in respect of transactions in the Domestic Division, and the Board and/or the Designated Clearing House in IPSTA International Commodity Exchange Division, in consultation with the Forward Markets Commission shall have the power to fix floor and/or ceiling for prices of contracts traded in the Domestic Division and IPSTA International Commodity Exchange Division.  

 

There is special clearing in pepper contracts whenever the market touches the floor and/or ceiling for prices from the previous settlement price/settlement rate or opening rate of such contract on the first day the contract is traded in the Domestic Division and IPSTA International Commodity Exchange Division. The Board in respect of transactions in the Domestic Division, and the Board and/or the Designated Clearing House in respect of transactions in the IPSTA International Commodity Exchange Division, may order continuance or closure of the market or closing out of the contracts or fixing of ceiling rates following such special clearing or a consecutive second clearing on such conditions as it may deem fit in the interest of the trade in consultation with the Forward Markets Commission provided that closing out of the contracts or market or fixation of floor and/or ceiling is decided with the concurrence of the Forward Markets Commission.

 

All contracts entered into on a day shall be included in that day’s settlement. There is a daily settlement rate or settlement price in respect of each commodity and contract month. In case of contracts coming under settlement for the first time, the difference shall be calculated between the contract rate and the settlement rate or between the contract price and the settlement price, as the case may be. In the case of contracts coming under subsequent settlements, difference shall be calculated between settlement rates or between settlement prices, as the case may be.

 

The method of fixing settlement rates was changed at the instance of the Forward market Commission. The new system takes the weighted average of the last half hour trades to fix the settlement rate instead of the previous practice of considering the last traded rate.

 

 In respect of contracts transacted in the Domestic Division, member exchanges settlement accounts not later than 12 noon on the working day immediately preceding the Settlement Day. In respect of contracts transacted in the Domestic Division, balance sheet shall be prepared and sent to the Clearing House on the days and during hours fixed in that regard together with vouchers for the sum claimed. Members handing into the Clearing House, Clearing Sheet and/or statements after the hour on the day so fixed are charged a late fee at the rate of Rs. 2 for the first hour or part thereof and thereafter at Rs. 5 per hour or part thereof but no clearing sheet and/or statement are accepted after 4 p.m. on the date fixed provided that in exceptional circumstances the Office of the Association shall be entitled to accept after 4 p.m. on that day such clearing sheet and/or statements from a member and penalty in such cases may be paid by such member as may be fixed by the Board.

 

Members whose Clearing Sheets show debit balance shall pay into the “Clearing House Settlement Account”, maintained by the Association with the designated bank the amount due from them not later than the time specified in the “Clearing House Notice”. Members whose Balance sheets show a credit balance shall be paid the sums due to them the next working day.

 

In the event of a member failing to pay margin as required by the exchange, the Clearing House is entitled to investigate the circumstances and if they consider the failure proved, they shall be further entitled to order that all the member’s outstanding transactions in respect of contracts shall be promptly cause notice thereof signed by Secretary to be posted on the Notice-Board on the day of the default and on the posting of such notice all such outstanding transactions of the member shall stand closed out and the margin, if any, then standing to his credit under this Bye-law shall stand  forfeited to the Association and the Clearing House shall be entitled to invoke bye law 52 A and advice the Board of Directors. The Board or the President thereof  authorised to verify or check any statement submitted by a member. A member failing or neglecting to submit any such statement or to produce any such books or are dealt with under the Byelaws relating to disciplinary action. A registered non-member failing or neglecting to submit any such statement is liable to be suspended or debarred from dealing with any member of the Association for a period of time as may be decided by the Board under intimation to the Forward Markets Commission.

 

VIII.    Margin

 

In respect of contracts in pepper transacted in the Domestic Division, any member entering into contracts has to pay advance 100% margin before trading, calculated as per order received from time to time from the Forward Markets Commission (on first slab) on total of long or short position whichever is greater. Balance margin payable, if any, as per other slabs, shall be submitted on the same day evening. 50% of the required Margin may be deposited in the form of Fixed Deposit Receipts with a nationalised bank and banks approved by IPSTA, in the name of “IPSTA Account Member”, at IPSTA’s sole discretion. Such deposits are endorsed in favour of IPSTA along with a letter from the concerned bank confirming that IPSTA has first lien on the deposit.  Interest on such deposits is credited to the account of the member.  On request, IPSTA will refund the deposit, after clearing all dues and before refunding cash deposits.

 

As the margin deposit is covering both sides of the open position (net long as well as net short of each contract), it is further considered advantageous and safe to net the open position between contracts while calculating the Net Open Position. Therefore, if a member is holding 100 tonnes long in December contract and 50 tonnes short in January contract, his margin balance will be adequate to cover 150 tonnes and position for checking the open position limit will be considered only 50 tonnes long position (+100 –50).

 

Consider a user ABC. He has Rs1,00,000 as margin.

 

Contract

Buy

Qty (quintals)

Sell

Qty (quintals)

Net position

Net qty

(Quintals)

Pep-Dec*

B

60

S

40

B

20

Pep-Jan

B

50

S

70

S

20

Pep-Mar

B

40

S

10

B

30

 

 

 

 

 

 

 

RSS-Jan**

B

50

S

20

B

30

RSS-Feb

B

20

S

30

S

10

* Stands for pepper December contract

** Stands for rubber January contract

 

Now, for pepper he has net buy position for 50 quintals and net sell position for 20quintals. For rubber he has net buy position for 30 quintals and net sell position for 10 quintals. Let the margin collected per quintal for pepper and rubber be Rs800 and Rs500 respectively;

 

Thus in total he would have used 800*70(50B+20S)=Rs56000(for pepper)

And, 500*40(30B+10S)=Rs20000(for rubber).

In total, the user ABC has used 56000+20000=Rs76000.

 

This amount will be deducted from his 1 Lac margin after the End of Day (EOD) and his available exposure will be shown as Rs24000.

 

For calculating his net open position limit for the different commodities:

Pepper=>50(B)- 20(S)=30quintals

Rubber=>30(B)- 10(S)=20 quintals.

 

Special Margin

 

It is collected from long position holders or short position holders depending upon the price movements in the market. The Special Margin is applicable when price moves above or below a certain level. Different slabs of special margin are calculated on percentage basis of benchmark price. Benchmark price is the weighted average price of first five days’ transactions of opening of each contract.

 

IX.       Trade Guarantee Fund:

 

On the date of establishment of IPSTA Domestic Division Trade Guarantee Fund for guaranteeing the performance of transactions in the Black pepper forward contracts in its Domestic Division by IPSTA was established. All the existing members who are on the rolls of the IPSTA Domestic Division have to pay an one time contribution of Rs.10,000/- to the IPSTA Domestic Division Trade Guarantee Fund.  Ordinary members who are admitted to the membership of IPSTA Domestic Division in future have to pay contribution at such rates as may be determined by the Board of IPSTA with the concurrence of the General Body from time to time subject to minimum of Rs.25,000/-. The contributions made by present and future members of IPSTA to the Guarantee Fund shall not be refundable.

 

X.        Demutualisation: Process Initiated by IPSTA:

           

According to the IPSTA the demutualisation process means separation of ownership rights from trading rights for the members of the exchange.  To make IPSTA demutualised the following steps were proposed:

 

1.  IPSTA Domestic Division Trade Guarantee Fund.

The Board is in the opinion that once the exchange is corporatised and demutualised the trade guarantee should be a function within the exchange.  It is to the knowledge of the members that IPSTA Trade Guarantee Fund has been constituted solely out of the contribution by IPSTA and its members.  Being so, the Trade Guarantee Fund will be merged with IPSTA i the first phase of demutualisation.

 

2.  Not for profit company to divided distributing company.

 

It is to the knowledge of our members that IPSTA is a guarantee company registered under section 25 of the Companies Act, 1956 and is prohibited from declaring any dividend or extending any direct or indirect benefit to the members.  IPSTA is a charitable organization duly registered under section 12 A of the Income Tax Act, 1961, also.

 

To make IPSTA as a normal company entitled to earn, retain and distribute profit whose shares can be freely transferable in a stock exchange, IPSTA has to first first change its Memorandum and Articles of Association and then apply for the cancellation of the license issued by the Government of India, under section 25 of the Company’s Act, 1956 besides changing its name appropriately to add the word “Ltd”.

 

In the process of demutualisation, appropriate provisions will be introduced in the Articles of Association and bye laws of the Exchange to give effect to the following:

 

1.      The existing membership of all the members will be split into two, first having shareholding rights only with ownership and voting rights and others having trading rights only without having ownership and voting rights.  In other words, a member who would like to trade in the exchange should retain trading right and at the same time should transfer his shareholding right at the prevailing market rate and a member who does not want to trade in the exchange can transfer his trading at the prevailing market rate, and can retain his shares as an investment.  All these transfers will be subject to the approval of the Board.

 

Upon completion of corporatisation and demutualisation process,  ownership shares will be freely traded and will even be listed in the stock exchange.

 

2.      The Value of the existing shares and trading rights will be fixed after revaluation of entire Assets and Liabilities of IPSTA and will be based on the net worth of IPSTA after revaluation.

 

3.      Necessary amendments will be incorporated in the Articles of Association and bye laws vesting the management of the exchange in a Board of Directors, having equal representation of having trading members, shareholders and public representatives.  Besides this, members having trading interest shall not hold any official position other than member of the Board i.e. President, Vice President, etc.  Besides this, no officer will be allowed to hold the position for more than two consecutive terms and will not be eligible for re-election without the lapse of a year.

 

4.      In this process, IPSTA will lose the present tax exemption and the status and registration as a charitable organization under section 12 A of the Income Tax Act, 1961.  Consequently the possibility of attracting tax liability hitherto to accumulate fund (capital fund) need to be addressed and the Board is representing before Forward markets Commission and Central Government for appropriate amendments in the Income Tax Act, 1961 to allow for a one-time tax exemption to pave the way for the smooth corportisation and demutualisation of the exchange.  Upon the completion of this process it will, like any other company, be liable to pay Income Tax on its taxable profit and be entitled to distribute the share of profit by way of dividend.

 

 

    

XI.       Conclusion:

 

The IPSTA exchange structure can be summarized based on few market parameters. The technology support to the exchange is excellent. It has efficient banking facility for swift transfer of funds. The settlement is done daily, which implies marking to market. Delivery system is mixed. Open position at the end of the contract can be settled by cash differences or physical delivery. Physical settlement is not mandatory. The technological infrastructure is up to the mark but self-regulatory system is weak. As far the ownership of exchange is concerned it is mutual. Trading rights and ownership are integrated in the membership right. To justify the point, all the committees have some board members. All these committees plays a major role in decision making like fixation of rates, allowing of settlement after the allotted time, etc. Hence the chances of manipulation enhances drastically.

 

IPSTA located in Cochin, which is known for future trade in spices for over five decades, has not come up the way it was expected to. Kerala being the producer of lion’s share of pepper in India and Cochin being the port city where majority of pepper exporters are operating, the existing futures should have larger role to play (UNCTAD, 1995). However, in spite of having member around 185 very few members (around 60) actively engage in trading. Its international division is still a non-starter.

 

 

CHAPTER THREE

NATIONAL BOARD OF TRADE LTD: A CASE STUDY

 

I.          Introduction:

 

National Board of Trade Ltd. (NBOT) was incorporated on July 30,1999 with an intention to offer integrated, state-of-the-art commodity futures exchange. NBOT was set up to strengthen the move towards professionalism in the commodities market and to provide nation-wide trading facilities to market players in tune with the international standards. NBOT has been recognized by the Government of India to organize futures trading in Soybean, its oil and meal and Mustard seed / Rapeseed, its oil and cake.

 

Government of India has adjudged the NBOT as the best exchange on 2nd September 2003 on the occasion of the Golden Jubilee Celebration of the Forward Market Commission, Mumbai.

 

This chapter is divided into nine sections. Section I starts with introduction, section II and III depicts the board structure and membership criteria. Tradeable contracts and trading systems are explained in section IV. Whereas remaining section throws light on clearing system, margining system, trading guarantee fund and Volume. Finally section IX concludes the chapter.

 

II.        Board Structure:

           

The Board of directors are persons of repute drawn from different categories of trade and commerce. These persons have given the necessary impetus and thrust for setting up of the exchange. As members of the board, they have been offering guidance for the exchange’s proper functioning. The board of NBOT consists of 8 directors. The composition is as follows:

 

 

The overall management of the Exchange vests with the Board. The day to day functioning of the Exchange is vested with several Standing Committees.

 

The Standing committees are

 

            (a) Membership, Finance and Business Development Committee

            (b) Trading, Clearing and Settlement Committee

            (c) Margin, Surveillance and Inspection Committee

            (d) Disciplinary and Disputes Redressal Committee

 

I) The jurisdiction of Membership, Finance and Business Development Committee are as follows:

 

·        Recommend to the Board for withdrawal of membership rights (other than Clearing House obligations) subject to the provisions of Articles and Bye-laws 

II) The jurisdiction of Trading, Clearing and Settlement Committee are be as follows:                          

 

III) The jurisdiction of Margin, Surveillance and Inspection Committee are as

       follow:

 

 

IV) The jurisdiction of Disciplinary and Disputes Redressal Committee are as follows:

 

     

Some members of these committees are also members of the exchange board and are also trading members. This may give rise to conflicts of interest. These committees does not have the final say on any issues, they have only recommending power. At present the board is the final authority in all matters. To improve the quality of performance of the exchange, these committees should be given some degree of authority to dissolve the issues finally. Then the issues and resolutions can be reported in the board for records in order to play the role of watchdog.

 

III.       Members:

 

There are be three types of members: Trading, Trading-cum-Clearing and Institutional Clearing. The members can be individuals, firms, joint stock companies, joint Hindu families, corporations, banks and financial institutions and others engaged in the trading of soybean and other commodities and be qualified for membership under Article 4 and who have paid the fees as prescribed in Article 5 of the Articles of Exchange. 

 

Participants in transactions in soybean and other commodities, trading in which is organized by the Exchange who are not included in any of the above categories of members as per Bye-law 201 are called non-member clients. All non-member clients shall be registered with the Exchange through the respective members of the Exchange as per the procedure laid down by the Exchange, pay such fees if and when imposed and be responsible for their transactions as prescribed by the Bye-laws of the Exchange from time to time.

 

IV.       Trading System &Tradable contracts:

 

The trading takes place in the Ring Hall with an outcry system, which will be replaced, in gradual phases through computerized environment. All trades confirmed by the exchange are guaranteed for performance. Trading takes place from Monday to Friday between 11:30 a.m. to 4.00 p.m. and on Saturdays between 11:30 a.m. to 2:00 p.m. Online Trading takes place between 6.30 p.m. to 10.00 p.m. in evening session excepting Saturdays and between 8.30 a.m. to 11.00 a.m. in the morning session.

 

Trade shall have priority strictly in the order of price, time, non-member client account and own account. Trading limit for trading is fixed by clearing member, which is subject to over-all limits fixed by the Exchange. In order to ensure adequate safety for trades executed through the Exchange, ceiling on trading by each member is fixed. There will be daily clearing based on mark to market system; failure to clear the dues will result in automatic closing out of open positions.

 

There are few tradable contracts, structure of the contracts are given in the Appendices. Appendix I depicts the contract specification of Soya, contract specification of mustard and rapeseed are explain in appendix II. Appendix three gives contract specification of palm.  

 

V.        Clearing:

 

The Clearing House is under the management of the Executive Director. The Exchange has a daily clearing. All contracts entered into on each day shall be included in that day’s statement.  There is daily settlement rate or settlement price in respect of each commodity and contract month that is calculated on the basis of the weighted average of the last half-hour of the trading day in respect of each commodity for each contract month.

 

In case of contracts coming under settlement for the first time, the difference is calculated between the contract rate and the settlement rate or between the contract rate and the settlement price, as the case may be.

 

In the case of contracts coming   under subsequent settlements, difference shall be calculated between settlement rates or between settlement prices, as the case may be.

 

In preparing accounts for clearing, no interest is allowed or calculated.

 

In respect  of contracts confirmed by the Exchange and those transactions which have been fully squared off by the members, the Clearing Bank will forward to the Clearing House settlement accounts not later than 11:00 A.M. on the working day in respect of previous day’s transactions of the affiliated Trading Member as well as his Designated Clearing Member. No trading member can enter into any arrangement with more than one Clearing Member at any one time.

 

The Clearing House settles the daily clearing in the following manner:

 

(a)        On the basis of the Accounts Statements prepared by the Clearing House and supplied to each Trading Member and the Designated Clearing Member on a daily basis, a daily Pay-in and Pay-out Sheet (called Daily Clearing Sheet) for each commodities traded in the Trading Ring is  prepared.

 

The daily clearing sheet shall, consists of the following to the extent possible:

 

 

(b)        The Daily Clearing Sheet in respect of the previous day transactions confirmed by the Exchange is sent to the Bank duly signed by the Executive Director by 10:00 A.M.

 

(c)        The Designated Clearing Member ensures that sufficient balance in his account or the Affiliated Trading Member account so as to enable the Bank to debit the respective accounts by 10:30 A.M.

 

(d)        The Bank intimates by 10:40 A.M. any debit entries, which have not been cleared by a Clearing Member.

 

(e)        In case no such intimation as stipulated in (d) above is received by the Clearing House, the Pay-out for that Daily Clearance shall be declared by 10:50 A.M. on the same day of the Pay-in day.

 

Any discrepancy noticed in the daily clearing sheet shall be rectified by the Clearing House in the next succeeding Daily Clearing sheet subject to Bye-law 1111, the Trade Guarantee Fund is utilized in the manner specified in the Bye Laws of the Exchange.

 

           

VI.       Margin

 

1. Initially Security Deposit collected from Trading Member is earmarked for doing business based on the price band concept; in case of Trading Cum Clearing Member, member is allowed for free trade based on the above principle up to 40% of the security deposit.

Member Type                          Security Deposit Collected

            TM                                           1,50,000/-

            TCM                                        10,00,000/-

 

2. The member is allowed to have NOP as per details given below. These limits are represented in terms of Soyoil quantity as all commodities that are traded is indexed to Soyoil and then margins arrived at.

 

Index value: Base of conversion is Soyoil, and factor of conversion is revised on monthly basis on settlement rates of respective commodity with respect to Soyoil settlement rate. Each traded commodities unit is calculated with this factor to convert into Soyoil unit.

 

3. Graded Margin based on NOP concept:

 

                                                            (Net Open Position)    

                        Slab                 Margin(%)                    TM                  TCM

                        Free Limit         NIL                             200                  533

                        I                       1.5                               100                  267

                                                                                  -------------------------

                        II                      3.0                               75                   200

                                                                                  -------------------------

                        III                    3.0 (*,$)                       375              1000       

                                                                                  -------------------------

                        IV                    4.0 (*,$)                       750              2000

                                                                                  -------------------------

                                                                                     500             1330

                                                                                  -------------------------

                                                                  Total:          2000            5330

 

                        (*         Cash /Clearing Bank FD )

                        ($         Permission of Exchange and TCM)

                        (#         NOP in terms of Soyoil.)

                        (ü        Margin Collected On-line.)

 

Separate limit for clients are also allowed which are as follows (NOP in terms of                Soyoil):

 

                        Slab                 Margin             Client's Net Open Position

                                                                                    From    -   To

                        I                       4%                               0          -  500

                        II                      5%                               501      -1000

                       

4. Additional Margin: This margin (collected in cash) is levied on Net Buying/Selling in case of bullish/bearish trend respectively from the members for the contract. If the rates range beyond four circuits breakers 5% margin on net buying/selling for each additional circuit breaker is levied subject to the overall margin of 20%.

 

5. Delivery Margin:  It is collected @ 25% (collected in cash) of the settlement value, which is calculated on the apportioned quantity for delivery on the second day of settlement from the buyer.

 

 

VII      Trade Guarantee Fund:

 

The guarantee fund involves the contribution of Trading Members as well as Clearing Members fully taking into account the rights, duties and obligation of each member of the Exchange to honour its commitments to the Clearing House notwithstanding the fact that the Clearing Member is ultimately responsible for the Clearing House operation for self as well as his affiliated Trading Members.

 

            The Guarantee Fund comprises of the following:

 

a)      Initial contribution by the members at the time of admission towards security deposit.

 

b)      Initial contribution by the members at the time of admission as contribution towards trade guarantee.

 

c)      Appropriation of 25% of the initial contribution by the members at the time of admission as entrance / admission fee.

 

d)      Appropriation of 30% of the transaction fee charged from the members by the Clearing House in terms until the corpus amount reaches Rs. 125 lakh.

 

e)      Appropriation of 25% of the clearing fee charged from the members by the Clearing House until the corpus amount reaches Rs. 125 lakh.

 

f)        Appropriation of 50% of the maintenance charges collected from the members until the corpus amount reaches Rs. 125 lakh.

 

g)      Appropriation of 50% of the fines and penalties levied from the members until the corpus amount reaches Rs. 125 lakh.

 

   

Any income (subject to taxation) including capital gains arising from the investments made by the guarantee fund can be used only for the purpose of augmenting the guarantee fund and cannot be transferred to Reserve Fund.

 

The guarantee fund is utilized by the Board on the recommendation of the Clearing House exclusively for the purpose of extinguishing the obligations of the Clearing House.

 

Contributions towards guarantee fund shall be the property of the Exchange and is non-refundable to the members.

 

The guarantee fund shall not confer any right or privilege upon any member in any manner whatsoever (inclusive of any voting right).

           

Only the initial contributions towards guarantee fund and interest accrued thereon is maintained in the names of the respective individual members.

 

           

In respect of two or more amalgamation or conversion of membership rights, the guarantee fund will be either merged or transferred, as the case may be.

 

In respect of financial obligations arising out of the transactions confirmed by the Exchange under the Bye-laws, the Exchange has the unilateral right to use whole or part of the Trade Guarantee Fund contribution to settle the financial obligations of the Clearing House as provided for in its Bye-laws.

 

A Trading-cum-Clearing Member can make voluntary contribution to guarantee fund corpus from time to time in addition to compulsory appropriation made by the Clearing House from the clearing fees charged. Such an additional contribution or part thereof shall be refundable once in three months or such other dates as may be prescribed by the Trading, Clearing and Settlement Committee but will not be eligible for any interest payment or shall it confer any beneficial interest whatsoever.

 

VIII.    Volume:

The average volume traded on the Exchange has been about 70,000 tons in ’02-03, and is expected to rise once other commodities are also traded. As far as volumes are concerned NBOT performs much better than other regional exchanges in India.

IX.       Demutualisation: Process & Problem: As information stated by NBOT , we are reporting the same things in the following paragraph.

 

                        After establishing itself as one of the most successful commodity exchange in India within two-three years of its existence, the National Board of Trade (NBOT) took effective steps to venture into certain other commodities.  Since its incorporation, NBOT has been primarily a soy seed and oil commodity exchange with very few other commodities.  In order to strengthen the exchange, an application to the central government was made for multi-commodity trade and for granting national multi-commodity exchange status to NBOT.

 

The central government authorized nodal agency for commodities exchanges in India, the Forward Commission ( FMC ) agreed in principle and asked NBOT for completing the process of establishing online trading system and making NBOT a demutualised entity.

 

Since NBOT was already a corporate entity there was no need for corporatisation.  However, NBOT was a “not for profit” company under Section 25 of the Companies Act, 1956.  So, thereafter, in line with the suggestions made by FMC in respect of de-mutualization an application was prepared and submitted to the office of the Regional Director, Western Region, Department of Company Affairs, Mumbai for obtaining approval for suo-motto surrender of Section 25 License of the company and convert the company into a company limited by shares and among other details, following material documents were enclosed with the application:

 

Ø      Copy of the applicable set of FMC regulations

Ø      Copy of the Board Resolution

Ø      Copy of the approval of converted company’s Memorandum and Articles by FMC

Ø      Copies of the last 3years annual reports

Ø      List of existing members

Ø      List of existing Directors

Ø      Board Resolution proposing authorized share capital

Ø      List of prospective subscribers for Memorandum of Association of proposed company,

Ø      Copy of the license granted under section 25 of the Companies act, 1956.

Ø      Copy of the Memorandum & Articles of guarantee company

Ø      Copy of the Memorandum & Articles of share capital company

 

 

 

 

 

FMC scrutinized the Memorandum and Articles of Association of the proposed share capital company in view of the proposed demutualisation and approved the same.  After receiving the approval of the FMC with respect to the above documents, an application was also made to the office of the Regional Director, Western Region, Department of Company Affairs, Mumbai for obtaining approval with respect to the same.  Simultaneously, NBOT convened extra-ordinary general meeting of the members ( of Sec 25 company ) and approved the concept of demutualisation as well as the Memorandum and Articles of Association of the proposed setup.  In the same meeting it was decided to transfer the entrance fee paid by the members into security deposit for trading purpose.

 

A report on the de-mutualisation was forwarded by FMC to the Regional Director.  In compliance with the applicable provisions of the companies Act, 1956, the requisite meetings were held and appropriate resolutions were approved by the Board of Directors and Members of National Board of Trade and accordingly all relevant forms were filed with the office of the Registrar of companies, Madhya Pradesh, Gwalior.

 

Scrutiny of balance Sheet was carried out by the office of the Registrar of Companies, M. P. Gwalior and after getting satisfied with the replies and clarification the same was taken on record for furthering the process of demutualisation of NBOT.  Draft of supplementary bye-laws was prepared which was to be required after de-mutualisation and the same was kept ready after the approval of the Board for submitting the same to FMC for necessary approval and record.

 

On getting satisfied with the functional compliances in this regard, a No Objection report was sent by the Registrar of companies, Gwalior to the Regional Director, Mumbai for revocation of Section 25 License recommending the conversion of NBOT into a company limited by shares.  The Regional Director issued the order of revocation of Section 25 status of NBOT.  The order was to come into effect on compliance of formalities like issue of share capital, reduction in number of directors etc.

 

NBOT explored the possibilities of getting subscription from banking and non-banking companies in the capital of the proposed NBOT Limited and in this connection, communications and conversations were exchanged with senior bank officials and high net worth investing non banking companies.  NBOT management, in line with the demutualisation requirements, which involve separation of trading rights with ownership rights, opted for placement of equity shares to such financial and non financial institutions or companies which did not have such trading interests and for this process constituted a committee of directors for demutualisation and authorized it to compute the prospective capital structure of the Exchange alongwith the eligibility criterion for subscribers who would be allotted the shares.

 

 

 

On realizing the fact that the in-house infrastructure of NBOT was not having specialization in the process of placement of equity share capital, it was decided to appoint a state level consultancy organization as Advisor and M. P. consultancy Organisation Limited ( MPCON ) was appointed the Advisor the issue of capital.  MPCON designed a detailed Profile of NBOT for circulating the same amongst prospective investors.  It identified prospective investors for NBOT.

 

After closure of the subscription, State Bank of Indore returned the Application forms to NBOT and the subscription amount to the regular bank account of NBOT.

Committee Constituted by the Board of NBOT for demutualisation of the present Section 25 company scrutinized the applications and recommended the allotment of shares.  The Board of NBOT made the allotment accordingly.  The necessary documents as prescribed by the Regional Director of Department of Company Affairs were executed and filed with the Registrar of companies, Gwalior.  Fresh certificate of incorporation of a converted company limited by shares having name NATIONAL BOARD OF TRADE LIMITED was issued by the Registrar of companies, M. P. Chattisgarh, Gwalior. 

 

 

The steps initiated by NBOT for demutualisation

 

The National Board of Trade has taken following steps for demutualisation

 

Ø      Ministry granted in-principle approval to NBOT on 3.1.2003 to set up nation wide multi commodity exchange within ten months time frame for completion of criteria Inter aila, demutualisation and on line trading stipulated for the same.

 

Ø      The board of Directors of the exchange decided to demutualise the exchange in their meeting.

 

Ø      The demutualisation as understood by NBOT was to keep trading interest separate ownership interest of the exchange and management.

 

Ø      An extra ordinary meeting was conducted on 27.11.2002 to discuss the issues relate demutualisation.

 

Ø      Draft articles of association and memorandum was approved by the Board at their meeting held on 27.11.2002 and same ware submitted for approval of the Commission.  A few directors includig erstwhile public nominee subscribed to the memorandum of articles of association.

 

Ø      The NBOT which was registered under section 25 of companies Act was first converted into for profit company by applying to Regional Director, Deptt. Of Company Affairs, Mumbai on 25.2.2002.  The NBOT got approval from Regional Director to have authorized capital of Rs.10 crores.  Out of 10 crores, initially, NBOT proposed to raise capital of Rs. 1 crores through share capital.

 

Ø      In order to separate ownership rights from trading rights, it was decided to grant to all existing members trading membership and ownership of the exchange was transferred to 7 companies.

 

Ø      It was decided to give shares to financial institution also.  Since no financial institution came forward to subscribe to the shares of the exchange on the ground that the exchange was not a for profit company, it became necessary to contribute a for profit ongoing company.  They approached a consultancy agency for private placement of shares.  Out of 14 applications, 7 applications made by companies were found to be meeting parameters fixed by the committee set up by the Board were selected and approved by the Board of allocation of shares.

 

Ø      The Registrar of Companies issued a Certificate of Registration of Company limited by shares vide certificate dated 1.8.2003.  Old Board of Directors were replaced by the new set up of Directors in demutualised set up.

 

Ø      The NBOT proposed to transfer the deposit of existing members into security deposits.

 

 

Meanwhile, Commission received complaints from soyabean Oil processors association, Indore alleging that:

 

a)         NBOT is privatized in non-transparent manner by allotting sharesto dummy companies.

 

 

b)         Company was not valued for allotment of shares, many reserves like annual profit, company reputation, projected income and reserves like trade guarantee fund etc. were not considered for valuation of NBOT and

 

c)         Existing members were not given option to have shares instead of trading right.

 

 

Based of preliminary examination of the facts of this case, Commission suggested the following steps and has sought Ministry’s approval so that direction in the matter may be with Ministry:-

 

a)                  NBOT may appoint a reputed Merchant Banker and a Valuer through a transparent procedure and get the value of the Exchange prior to demutualisation evaluated.  The valuer may also get the value of the trading membership as well as the shares of the Exchange evaluated.

 

b)         An option may be given to trading members who were on roll of the exchange prior to demutualisation to acquire shares of the Company provided they are willing to forego trading rights in accordance with the done by the valuer/merchant banker.  Total member of shares offered to shareholders would be decided keeping in view (c) below.

 

 

c)         The equity should be offered in a transparent manner.  The pattern of equity holding should be such that the majority of the total equity to public financial institutions repute.

 

 

IX.       Conclusion:

 

Government of India has declared NBOT as the Best Exchange in 2003. It has also been awarded the National Online Multi-Commodity Exchange Status in principle. The Exchange has discontinued itself as a Section 25 Company. It has a good reputation and a good system for trade. However, a recent news item that NBOT would not opt for a national status is something that needs explanation. Further, the free limit given to the trading members up to a particular net open position could be avoided. The practice of trading members controlling the board of the exchange needs to be reviewed as it is against the principles of good corporate governance.


 

 

 

CHAPTER FOUR

Demutualization: Issues from the case studies

 

 

I.          Introduction:

 

Two exchanges have been studied to understand the situation in the commodity futures exchanges in India. From these two case studies, the following issues relating to demutualization arise:

 

 

 

II.        Composition of the standing committees:

 

 

The committees should be formed such that there is no conflict of interest in discharging the committee functions. These committees deal with technical matters and, therefore, the members should possess sound knowledge of the exchange business. Further, the members should show the desire to take active part in the proceedings of the committee meetings. It will be possible to attain this, if these committees have person who has full knowledge about the market but not trading members. They will be motivated to work if they are compensated very efficiently. These committee members should be adequately incentivised to contribute their time and energy to the task of managing the exchanges. Incentives would be in the form of suitable sitting fees, perquisites, and office support essential for them to discharge their function well.   

 

The main objectives of Demutualisation are transparency and absence of conflict of interest. These objectives have to be borne in mind at the time of framing of the byelaws of every commodity exchange. The exchanges should be encouraged to identify independent persons who could be members of the committees. Forward Markets Commission should clear the names of such persons. The standing committee decisions should be final. The board of the exchange should not alter them except in the rarest cases. 

 

Appropriate changes in the bye-laws of every commodity exchange be carried out, specifying who should be appointed on the various committees, their qualifications and whether they can become a director on the board or not.

 

 

III.       Powers of the Committees:   

 

The various committees that we have studied in these two exchanges are not decision making bodies. They are recommending bodies. The board of the exchange takes the decisions. Given the previous recommendation, it is appropriate to empower the committees to take decisions. If the Committees have professionals and people who do not have trading interest, it is feasible to give such committees wide powers to take decisions. The board can be informed of these decisions in a routine reporting format. In exceptional situations that impinge on policy matters, the board may review the decisions to put in place appropriate policy framework.

 

The powers of the standing committees to take decisions need to be widened. The decisions of these standing committees of Disciplinary and Disputes Redressal Committee  (after they are constituted in the manner prescribed above) should be based on rules and procedure. These decisions should not be altered by the board of the exchange. There may be a mechanism for appeal when penalties are high. There may be a single appellate authority (with a few benches) for all exchanges, which can be FMC.  

 

 

IV.       Chairperson, members of the board and trading rights:

 

The purpose of demutualisation is the segregation ownership rights and management. The board composition should provide for independent functioning, absence of conflicts of interest, and skills for sound oversight on the management. The members of the board should have no role in the day-to-day functioning of the exchange. The Chairpersons of the Board as well as of various committees should not enjoy trading rights. A full-time professional CEO for the exchange should be mandatory. The chairman of the board should be a non-executive chairman.

 

In our study we found that the chairman of the board as well as chairmen of standing committees enjoy trading rights. Appropriate amendments have to be made in the bye-laws of each exchange to remove this situation. In the stock exchanges, the Kania Committee has recommended that people who have substantial interest in the functioning of the stock exchange, e.g., brokers, should be not allowed to hold chairmanship of the exchange and committees.

 

The various committees that support the day-to-day functioning of the exchange should be composed predominantly of professionals who are independent and are keen to take active part in the committee work. They need to be compensated suitably.

 

 

The three issues discussed above indicate certain weaknesses in the current model of commodity exchanges. There is a case to improve the functioning of the exchanges. Demutualization is a way to achieve this. However, Demutualisation has to be seen in certain context. Consider the following:

 

 

 

V.        Indian commodities exchanges and the advantages of demutualisation :

 

Till few years ago, the commodities market in India was unorganized and did not meet the highest standards of professionalism. There was inadequate regulation and supervision of the exchanges. A study conducted by the Forward Market Commission in 2000-01 highlights the functioning of the existing commodities market in India, both organized as well as unorganized. This study indicates that if effectively managed and if professionalised, commodity trade would have a huge positive impact on the Indian economy and would be very beneficial in the long run. It is noteworthy that things are beginning to change. Markets have been opened recently and there is a sincere effort to set up larger national level exchanges. The regulator is called upon to play a developmental role as well as a regulatory role.

 

 

The choice before the smaller regional exchanges would perhaps be to grow bigger or seek merger with a larger exchange. Growth needs funds and a demutualized exchange has limitations in this regard.

 

 

VI.       Demutualisation however has some shortcomings as under:

 

 

However, the benefits outweigh the demerits and demutualisation has become an accepted norm world over. All the major Stock Exchanges of the world have either demutualised or are in the process of demutualising. Lower transaction costs, efficient management etc. are commonly cited reasons for demutulization. The case with International Commodities Exchange is similar.

 

 

VII.     Conclusion:

 

The Chicago Merchantile Exchange, in its Memorandum to Demutualise, states the following, which sums up the case for demutualisation:

 

(1) Improve the current governance and managerial structure to facilitate accelerated decision-making;

(2) Change the current financial decision-making model to emphasize stockholder value;

(3) Create a catalyst for pursuing new business strategies;

(4) Unlock members’ equity holdings by allowing them to sell a portion of their interest in Existing CME; and

(5) Provide an indication of interest of and an instrument for working with strategic partners.

 

 

CHAPTER FIVE

Road Map for Commodity Futures Exchanges in India

 

 

I.          Introduction:

 

Till now we have studied the broad issues relating to commodity futures markets in India. Two exchanges were studied in detail. Commodity futures exchanges in India have done reasonably well considering the situation in India. However, the prevailing industry structure and regulatory framework have resulted in some weaknesses. These have been discussed in Chapter IV. It appears that the members of the board of the exchange considerably influence the day-to-day management of the exchange. Some of the members of the board are also trading members of the exchange. This gives rise to governance issues. Keeping the governance issue in mind and looking ahead, it seems that the exchange governance should be benchmarked against emerging global practices. Most exchanges, financial securities exchanges as well as commodity exchanges, are gradually shifting towards demutualization coupled with corportization. It seems to be an appropriate time to consider this approach for commodities futures exchanges in India as well.

 

II.        Principles of Demutualization:

 

In the current structure of Association of Persons, the three rights, namely, right of ownership, right to trade and the right to manage the exchange vest in the trading members. For effective governance, these rights should be segregated. The right to manage should vest in a professional agency appointed by the governing body. The governing body should lay down the policies and the managing agency should manage the day-to-day affairs of the exchange in a professional and independent manner.

 

The current trading right to the members of the association of persons should be split into two rights, one of ownership and the other of trading privileges. Over a defined period, these rights should vest such that the persons with trading rights do not possess undue influence on the governance of the exchange.

 

III.       Corporatization:

 

One solution to the new structure would be corportization of the exchange. Corporatization has the additional advantage of ability to bring further capital as and when required. This would mean that the exchange would be a for-profit company owned by shareholders. When the hareholders contribute capital, they should get some thing in return. This can be either dividend or right of control of some form or other. In a for-profit entity, shareholders receive dividends and may be inclined to tarde this off to managemnt rights. To begin with the persons with “right to own” will be the shareholders. The shares should be listed on a stock exchange. Over a period of time, through trading on the exchange, the ownership rights may migrate to other persons. The corporation will be managed to maximize shareholder wealth. This presupposes that the interests of the other resource providers and customers will have to be adequately served for the company to survive and grow in a competitive fashion.

 

IV.       Road map to wards demutualization and corporatization:

 

Specific action from the exchanges:

 

A. Demutualization and corporatization

 

  1. The exchange will change the Memorandum and Articles of Association to define the future structure and role of the exchange and its constituents
  2. The exchange (if it is a company u/s 25 of the Companies Act 1956) will apply for cancellation of license issued earlier.
  3. The Exchange will ascertain from the Registrar of Companies the availability of the proposed name in which it proposes to register as a company.
  4. Each membership right will be split into one share (each with one voting right) in the new company and one trading card and assigned to each member.
  5. While the promoter and institutional shareholders may be permitted to hold up to 25% each, individual shareholders may be permitted to hold up to5% of the voting rights. This provision is required to avoid concentration of voting power.
  6. Decide a date by which the voting rights in the hands of persons having no trading right will be equal to at least 51% of the total voting rights in the company.
  7. Shares will be listed on a stock exchange to ensure liquidity and free trading. This would enable public shareholders to show interest in holding the equity shares of the exchange.
  8. A professional valuer will be appointed to value all assets and liabilities of the exchange and prepare a balance sheet as at the date of change. However, it would be prudent on the part of FMC to appoint a team of such expert valuers, who can suggest a uniform valuation model for all exchanges under the process of demutualisation. This will help all the exchanges, going for demutualisation, they can apply a similar valuation methods which will reduce all the ambiguity.
  9. Trade guarantee fund are required for proper functioning of the exchange. It is required to be ensured that the funds from TGF should be utilized only for that specific purpose of guaranteeing the trades. It is like premium of insurance, once paid by the member, they have no rights on it. At the same time exchange should not utilize it for any other purpose other then for the purpose for which is earmarked. So technically speaking every exchange should form a separate trust for such type of funds. Once a single national level-clearing corporation comes into picture such funds can be transferred to the clearing corporation.     
  10. A mechanism should be put in place to provide for transfer of trading rights from those who wish to relinquish to those who wish to acquire. There are two options to all commodity exchanges to choose either card system or deposit system. It should be left to the exchange to decide which model they like to opt. The commercial implication of these two models is that while under the card system the existing members get trading right in the new entity without any deposit receipt, under the deposit receipt system the members get a deposit receipt. Therefore, even if there may be a lock in period in respect of refund of deposit amount, which would involve huge cash outflow.  After the lock in period if any member wants to relinquish its right it may lead to cash flow of the exchange. There is no cash outflow in the card system. In the card system, if he wants to relinquish his right he has to sale its trading right in the market and exchange will not be involved in it and hence there will be no cash outflow from the exchange. Our suggestion is that exchange should go for card system to ensure there is no cash drain from the exchange. The performance of the exchange will determine whether there should be a premium or discount on trading price of the card.

  

B. Governance structure:

 

  1. Articles of Association to be amended to specify the composition of the Board (number, categories, number in each category) of Directors of the company. The management will vest in the Board of Directors. In the long run it would be ideal to have the board of directors comprising only of directors representing shareholders and public/government. As a transition measure, however, directors could represent shareholders, trading members and public/government. Equal representation for each of these three categories may be considered. Names of the directors will have to be approved by the Forward Markets Commission. The rational behind the one third is that one single majority group can force no decision. In due course of time exchanges’ should try to attain a board structure where there will be no directors representing trading members. The example of such board is National Stock Exchange board of directors.
  2. Tenure of directors will be governed by the provision of the Companies Act 1956. In addition comparable provision from SEBI guidelines may be followed. In corporatised, demutulised stock exchanges, there are 3 categories of directors on the board. The first category is directors who represent the institutional promoters interest. Their tenure is governed by the provision of the companies Act, 1956. The second categories of directors are independent directors and are designated as public representatives. They retire in the next AGM or after one year whichever is lesser but can be reappointed in the AGM. The third category is SEBI nominees and is permanent.
  3. Day-to-day management of the exchange will vest in the exchange administration headed by the Chief Executive Officer. The Board of Directors will appoint the CEO. The appointment and removal/dismissal will have to be cleared by the Forward Markets Commission.
  4. Chairman of the exchange’s board will have no executive power.
  5. No member with trading right will hold any executive position in the exchange.
  6. Separate the working of trading division and the division of clearing & settlement. There should be an arms length relationship between these two divisions.
  7. The committees should be setup to assist the CEO in day-to-day work. Committees will be

(a)    Membership and Business Development Committee

(b)   Trading, Clearing and Settlement Committee

(c)    Margin, Surveillance and Inspection Committee

(d)   Disciplinary and Disputes Redressal Committee

     Membership and Business Development Committee would offer strategic advice to the board. Trading, Clearing and Settlement Committee overseas the daily business process of the exchange. Therefore the recommendation of this committee should be submitted to the board for taking follow-up action through the CEO. Margin, Surveillance and Inspection Committee should advice the CEO in strengthening the risk management system in the exchange. Disciplinary and Disputes Redressal Committee discharges a quasi judicial function. The exchange board may provide details rules of procedure to this committee and let the committee be independed entity. The decision of the committee should be binding on parties involved.

 

             The committees should be formed keeping in mind the points number II,III and IV of Chapter IV.

 

  1. The committees will consist of board members as well as experts. A person with trading right or a person who is connected to a person with trading right will chair no committee.
  2. There should be clear procedures and policies for these committees. These committees should take decisions in a professional manner.

    

V.        Tax matters:

 

In order to facilitate the Demutualisation as well Corporatisation of Stock as well as Commodities Exchanges in India, the GoI has given many tax incentives at the time of corporatisation. However, so far only Stock Exchanges that have demutualised have got tax benefits. The present Income Tax Laws do not provide for any tax exemptions for Commodities Exchanges upon their demutualisation. In light of the same the FMC should pursue this matter with the Central Govt. and request the GoI to make necessary amendments in the Tax Laws, whereby,

 

 

On subsequent sale of shares by the members, the entire income on such a transaction is subject to Income Tax. However, FMC could request to GoI to provide for some time period, (say within 1 year of demutualisation process) during which if the shares are sold, there would not be any tax liability in the hands of the transferor. This may be done, as it would expedite the process of demutualisation. Also since not many commodity exchanges in India are demutualised, nor have there been many instances of commodity exchanges having demutualised, it would work as a sweetener, and many exchanges would prefer to get themselves demutualised.

 

VI.       Specific actions required from the government:

 

Tax in respect of transfer of assets from the existing Commodity Exchange to New Demutualised Entity

“As per announcement made by the Government, any transfer of assets by the existing Exchange to the new demutualized Exchange in accordance with the scheme of demutualization duly approved by SEBI will not attract any tax liability, neither in the hands of transferor nor in the hands of transferee. Therefore, it is proposed that the legal documents for transfer or conversion of assets will be executed only after approval of demutualization scheme by SEBI and all such transfers will be strictly as per scheme approved by SEBI.”

In accordance necessary notification be obtained by FMC from the government granting tax exemption upon the demutualization of Commodity Exchanges as well.

 

 

Tax in respect of past assessments of the Exchanges

 

FMC should request CBDT or Ministry of Finance to issue a Notification to the effect that, there will be no tax implication on the Commodity Exchange in respect of its past assessments, irrespective of such change in the nature and status of the organization to avoid any complication from the Income tax department

 

Tax implication in the hands of the members at the time of demutualization

 

“As per announcement made by the Government, any assets acquired by the members from the Exchange in accordance with the scheme of demutualization duly approved by SEBI will not attract any tax liability, neither in the hands of transferor nor in the hands of transferee”

 

This policy of the Central Government with respect to demutualization of Stock Exchanges be applicable in case of Demutualisation of Commodity Exchanges as well.

 

Tax implication in the hands of the members at the time of subsequent transfer of shares / sale of trading rights

 

“Any person getting allotment of shares during the financial year 2003-04 and holding shares at least for a period of one year from the date of allotment and sell/transfer subsequently, they will be exempted from capital gain tax as per the scheme notified by the Hon’ble Finance Minister. Therefore, if the shares are allotted by a Demutualised Stock Exchange to the members during the financial year 2003-04 and subsequently they sell the shares after holding it at least for one year, there will no tax implication.

 

However, entire money received by such members on sale of trading rights at any point of time will be considered as income in the hands of the transferor and will be subject to payment of income tax.”

 

The above principle applicable to Stock Exchanges be applied in case of Commodity Exchanges as well.

 

Apart from the above we recommend that FMC should request to the Government to exempt incomes of the Demutualised Commodity Exchanges for a particular number of years. In other words provide for tax holiday u/s 10. The period of such exemption should be decided by the Government and the FMC taking into consideration the views of the Exchanges under its purview.

 

Also u/s 10(29A) incomes of Coffee Board, Rubber Board, Tea Board etc. are exempt. FMC could request to the Central Government that on similar lines Exchanges dealing in such commodities, their incomes should be exempted or a new clause under this section be inserted.

 

Amendment in Section 47 so as to not constitute the transfer of Capital Assets upon demutualization, as “transfer” under the Income Tax Act 1961, thereby not attracting Capital Gains tax. This is however only on transfer of assets at the time of demutualization. Thereafter subsequent transfers be will be taxable, after the stipulated period in the hands of the transferee.

 

Implication of Stamp duty:

 

The process of demutualization would involve transfer of assets running in crores of rupes by the existing exchanges to the proposed company/new entity. If the State Government imposes stamp duty on this transaction, the duty payable will be in crores. This will be detrimental to the Exchange, because the process of demutualization has been initiated as per Government directive to improve the trade practices and so, it is manifest to find ways so that there is no incidence of stamp duty in the entire process or its impact it not very high.

 

 

 

VII.     Specific actions required from the Forward Markets Commission:

 

 

 

Bibliography

 

Burr A.W. and Anjaria (2000) Report on Market Monitoring and Surveillance for Commodity Exchanges, Forward Markets Commission.

 

Doris Neuberger, Structure,m Conduct and Performance in Banking Markets, JEL .

 

Frida Youssef (2000), Integrated report on Commodity Exchanges and Forward Market Commission, World Bank Project for the improvement of the commodities futures markets in India.

 

G Dessalegan, T.S.Jayne, J.D. Shaffer (1998), Market Structure, Conduct, And Performance: Constraints on Performance of Ethiopian Grain Markets, Working Paper, Ministry of Economic Development and Cooperation, Addis Ababa.

 

M.H. Kania,(2002) Report on Corporatisation and Demutualisation of Stock Exchanges.

 

Susan Thomas,Agricultural Commodity markets in India: Policy issues for growth Indira Gandhi Institute for development Research.

 

Sahadevan, K.G. (2002), Derivatives and Price Risk Management: A study of Agricultural Commodity Futures, Indian Institute of Management, Lucknow.

 

Sahadevan, K.G. (2003), Commodity Derivatives and Futures Trading: A study of the Sources of Market Failure and the Policy Options for its Revival, Indian Institute of Management, Lucknow.

 

Indian Managing Price Risks in India’s Liberalised Agriculture: Can Futures Markets Help? UNCTAD report (1996)

 

Forward Markets Commission, Government of India (1999), Forward Contracts (Regulation) Act, 1952.

 

Balance Sheet and Website of NATIONAL BOARD OF TRADE (Indore)

 

Balance Sheet and Website of INDIA PEPPER AND SPICE TRADE ASSOCIATION (Cochin)

 


[1] Please see portion A( Broad  Government Policies) and item 2 in Portion B ( Regulatory Perspective) in Frida Youssef (2000), Integrated report on Commodity Exchanges and Forward Market Commission, World Bank Project for the improvement of the commodities futures markets in India

[2] Sahadevan, K.G. “Risk Management in Agricultural Commodity Markets: A Study of Some Selected Commodity Futures”

[3] Kumar Mangalam Birla Committee on Corporate Governance (2000) says  “not les than fifty percent of the board comprises of non-executive directors. The number of independent directors would depend on the nature of the chairman of the board. In case a company has non-executive chairman, at least one third of the board should comprise of independent directors and in case a company has an executive chairman, at least half of the director should be independent”

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