Prepared by

And

International Consultant

[Our interim report, which was submitted on November 22, 1999, had included recommendations on developing exchanges as well as brokerages. Since then, there have been several changes in the landscape of commodity futures trading in India (some of it attributable at least in part to our Interim Report). Hence, this final report focuses on our original brief – making recommendations for creating successful brokerages on Indian commodity exchanges.]

The global futures industry is undergoing a period of immense change. This change has an even greater impact than the late 70s dramatic expansion in the industry when financial futures were introduced. This time the industry – both exchanges and brokers – is facing severe contraction in the number of players, though not necessarily of the total volume of business.

Therefore, previous international brokerage models may no longer be as appropriate a benchmark to guide India’s development of its brokerage industry. Our report takes into consideration, this monumental change.

There are 18 existing commodity exchanges in India offering domestic contracts in 8 commodities and 2 exchanges that have permission to conduct trading in international (USD denominated) contracts. Many of the traded commodities and most of the existing contracts are specific to India. While the exchanges have varying degrees of success, the industry is generally viewed as unsuccessful.

The creation of successful brokerages relies on successful exchanges. They are part of a whole. While outside the scope of this report, we have commented briefly on exchange issues as well as detailed comment on brokerages as per our brief. Exchange issues are attached in appendix1. However brief comments are below.

In the past two months, the Forward Markets Commission (FMC) has moved quite rapidly in setting up a "core group" to look into setting up a National Commodity Exchange (who’s recommendations are expected shortly). It has expanded the palette of commodities that certain other existing exchanges are permitted to trade. Beyond this, the FMC has made it clear that they are open to new suggestions and would be more pro-active than ever in accelerating the pace of development of professionalized commodity futures trading in India.

The further good news is that after over two years of stonewalling, the existing exchanges – with a few still notable exceptions – have finally recognized (and acknowledged) that they need to embrace new technologies, and, above all, modern – and transparent – methods of doing business.

Having said that, it is important to point up some of the potential problems that exist even within the "new" world.

The key issue to be addressed in setting up effective exchanges is credible corporate governance, which, of course, starts with ownership. The current trend in the international markets is for ownership and access to trading rights on the exchange to be separate issues. [In fact, just recently, the CEO of the London Stock Exchange has gone on record stating that in a few years the LSE will probably no longer exist as it does today; more likely it would be part of a technology company.] Owners – i.e., shareholders – can also have access to trading rights, but trading right holders need not be owners.

The exchanges should be set up from the start as for-profit companies with the board of directors selected by the shareholders of each. Particularly given the historic credibility problems, the new guard of exchange developers need to carefully consider the selection of the original directors, ensuring a reasonable balance of trading and non-trading interest.

Further, the management of the exchange needs to be strictly independent of the brokers and end users. Without this separation, the integrity of the exchange will be in question and it will be difficult or impossible to develop liquidity.

Of course, even with credible exchange management – and, of course, contemporary implementation of (probably Internet-based) technology and contract design – liquidity will not just come.

The exchanges will have to be marketed aggressively to a wide range of potential users, from domestic traders and financial institutions to international traders and financial institutions to retail speculators (again, domestic and international) and, ultimately, commodity funds.

We believe that the FMC will need to participate in this marketing process, partly to clear the regulatory hurdles (notably tax and banking) and partly to assist the exchanges in encouraging the development of national – and, ultimately, international – brokerages.

The brokerage industry will also have to go through considerable change to service these users.

While the FMC needs to participate in setting standards on an umbrella basis, each exchange will have to define the minimum standards for brokers (as for market makers and other users) based on capital, expertise and experience.

We also recommend that there be a transition period (not exceeding one year), where each exchange – with, of course, reference to FMC – sets initial standards for their brokers. This will be prior to a proposed full-fledged development of a national brokerage system with uniform standards for capital adequacy, structure, management responsibilities, etc. as there are in currently developed markets.

There would, of course, be different categories of brokers, including IBs (introducing brokers), each of which would have to meet different levels of each requirement.

We envisage the entry of international broking houses, either in joint ventures with domestic brokers or independently (depending on government approvals).

We envisage the evolution of hub-and-spoke type set-ups, where a large number of micro-brokers would share services such as centralized back office, administration, clearing and direct access into the trading system.

Currently, the domestic exchanges have about 1,700 brokers between them, the vast majority of them being two or three man operations. These smaller operators are envisaged to be micro brokers under the hub of a larger broker or service provider.

Market volumes may grow. But in a new world, where a small number of multi-commodity exchanges compete for liquidity in a wide spectrum of commodity (and possibly financial) futures contracts, the brokerage industry will have to come to terms with the fact that there will be a substantially smaller number of brokerage firms. They may, in toto, still employ the same number – or even more – people, but control of broking will rest in fewer, more professional and/or electronic hands.

Nonetheless, the process will prove considerably simpler than it appears on paper, largely because time has – and will always continue to – weed out the old and bring in the new. Already, on most existing exchanges there are at least a couple of brokers who will be market leaders in no time at all. These are usually young, technology savvy individuals, who may or may not have come from a family history in the commodity business.

All the FMC has to do is set the regulatory guidelines, add some well-focused networking and leave it to market forces to develop the industry.

The global futures industry is undergoing a period of immense change. This change has an even greater impact on the industry than the dramatic expansion in the industry when financial futures were introduced in the late 1970’s. This time the industry – both exchanges and brokers – is facing severe contraction in the number of players, though not necessarily of the total volume of business.

Key factors affecting exchanges include:

1. the trend toward electronic trading from open outcry;
2. the emergence of electronic communication networks, ECN’s, as competitors to exchanges;
3. globalization of financial markets where players now use multiple products on multiple exchanges;
4. very few, if any, new products available for futures exchanges to launch.

These factors have forced exchanges to;

1. compete with each other – many of them are now trying to "steal" products that are trading on other exchanges
2. attempt to globalize their operations to cater to a more internationalized set of customers
3. seek alliances – sometimes international – in order to compete more effectively against other exchanges and ECNs
4. become for-profit organizations to be able to raise capital as necessary and increase the speed of decision-making to enable them to face competitive pressures.

As we prepare this report, there appear to be two major alliances being created. One is the Globex Alliance formed by the Chicago Mercantile Exchange, Matif and SIMEX, with the Montreal and Brazilian Futures Exchanges joining in recently. The other alliance is the CBOT/Eurex Alliance with the possibility of Hong Kong’s Futures exchange joining. [now being merged with the HK Stock Exchange]. The sands continue to shift and it is conceivable – in fact, likely – that in six months there will be other alliances, perhaps some between traditional exchanges and ECNs.

The impact of these changes on brokers is dramatic. The rise of screen trading, which has given brokers’ customers the ability to access markets directly via their own trading terminals, is having a major impact on how a brokerage operates.

The key change is that this has resulted in execution services becoming commoditized – i.e., there is little value in providing execution services and clients are not inclined to pay a fee for this. This trend, which was in the making for a few years now and which has also occurred in the stock-broking industry, is widely established and is/has been eating into the profits of brokers.

To retain their margins and to compete, brokers have been forced to provide other services such as clearing, execution in global markets, and more analysis and strategic advice. Some futures brokers are also expanding their product base to include margin FX trading services and selling of managed futures funds to their retail clients. Other brokers are becoming stockbrokers as well.

With margins more or less continuously under pressure, brokers have been reducing overheads, which largely translates to cutting staff. This has led to a vicious cycle where cutting resources (staff), they can offer fewer services to clients, which in turn reduces margins and, sometimes, results in loss of customers and a fall in brokers’ incomes. Not unexpectedly, it is the large clients who are the first to access markets directly, and thus the effect on brokers is particularly severe.

Another aspect of the change is a trend of large clients becoming more global in their trading outlook; this has meant that brokers have also needed to internationalize their operations in order to provide what their customers want. Alliances with brokers of other futures exchanges have become commonplace. In addition, large brokerage operations have established (or bought /merged) branch offices in major financial centres.

One of the responses has been the emergence of the "micro-broker". These brokers are 2-3 man operations who service their clients by providing low cost execution and strategic advisory services. To reduce overheads, several micro-brokers combine under an umbrella organization - a brokerage service organization – that provides desk space, information sources, administration and legal support and, importantly, clearing services. This structure enables small brokers to survive by sharing overheads. This emerging trend is expected to continue. Technology has enabled small brokers to have equal access to information as the larger brokers, allowing such micro brokers to be successful.

Statistics from the U.S. (the largest futures markets in the world)

Year # of FCMs

1. 334

1. 498 – peak
2. 385 – NFA took over registration from CFTC

1. 240

One of the key structural consequences of all the above changes is that brokers are being forced to reduce their loyalty to their home exchange. Historically, exchange members were usually brokers and the rules to run the exchange were set up by committees of members. Under open outcry, each broker’s staff and resources were committed to one particular exchange – it was their office, so to speak. With on-screen markets, however, a broker can – and, as we have seen above, needs to – trade as many products that suit him, irrespective of which exchange it is being traded on.

Further, there has been a growing trend for exchanges to demutualize and become for profit organizations. This means exchanges will be run as commercial organizations and not necessarily in their interest of its former members who are brokers. This further reduces any loyalty to exchanges by the brokers.

The ECN’s have been accelerating this process. These are basically agreements by major brokers to pool their trading and liquidity into an electronic trading network that is independent of the exchange. Thus, the top 10 brokers of a particular futures contract may agree to execute their trades through an ECN. Say, these brokers control 50% of the market, which will now move off-market to an electronic network resulting in lower fees for the exchange and a fragmentation of the market. Further, smaller brokers – who are not part of the ECN – will lose access to the liquidity.

Thus, the delinking of brokers and exchanges is a continuing process in the modernization of futures trading.

The introduction of screen trading systems has freed brokers to consider a wider gambit of products to offer their clients. Thus many have diversified not just into other exchange products but related financial products such as leveraged share trading, leveraged FX trading and offering mutual fund products to their retail clients. Institutional futures brokers have less room to move since institutional clients are already serviced for international products.

Other trends includes the following.

1. Futures Brokers are downsizing and cutting costs to remain profitable in the new screen based environment.
2. Brokers have much less loyalty to any one particular exchange.
3. Large players are getting direct access to the futures markets, via exchange screens, and, therefore, have less need for brokers.
4. Brokers have to access other markets around the world to offer full services to retain their larger clients, who are already internationalized; further, even small trading clients have diversified the markets that they trade and require international access.
5. Globally the industry is merging. Futures brokers who have not been profitable – and this is a substantial number – are being sold or merged.
6. There is increasing interest by brokers in harnessing their clearing services to generate profits from this sector. Execution is less important. Clearing margins is now the major profit source.
7. Micro brokers are growing. This has been through either a large brokerage service organization providing all administrative services for a number of smaller brokers or having a small broker buy a complete brokerage [execution/ processing] facility through the internet and using this service to offer futures trading products. An example is the software offered for sale by Mr. Market.
8. Exchanges are merging or forming alliances. Instead of creating more new exchanges, the world’s exchanges are falling in number.
9. Demutualisations are occurring. Exchanges are not being member owned but rather for profit firms.
10. Futures Exchanges and stock exchanges are merging due to increased competition and the need to get overhead costs down. It is likely that exchanges will be very different organizations within two years due to these dramatic changes occurring.
11. The old structures of member, membership organization, and exchanges are disappearing. The centre of a market is no longer the exchange but the multitude of dealing screens of brokers and end user’s dealing rooms.

These trends need to be monitored by the FMC to ensure that as it is not using obsolete models from the international arena, to makes changes to its futures industry.

The Australian and Malaysian experiences are articulated below. While there are structural lessons to learn, we note that time and change are moving ever more rapidly.

These two countries have been used as comparisons for the following reasons.

1. Both countries are based on laws derived originally from the United Kingdom, same as India.
2. Both have commodities based industries where the futures industry was formed.
3. The markets are not too large and too old so that comparisons and recent history can be used as guides.
4. One became reasonable successful [top 10 largest exchange] while one did not succeed in a significant way.

When the Sydney Futures Exchange was formed in 1960, it was a pure agricultural futures exchange for wool. The wool industry of growers and processors saw the need to manage their wool price risk. At the time, Australia contributed the bulk of world wool production and processing yet the price was set in London purely for historical reasons.

The exchange was formed out of the opportunity for the local markets to set its own price in Australian dollars and to enable different industry participants a mechanism to manage their risk. The brokers to the exchange developed from the wool merchants and physical wool brokers who acted as the middle-man between growers and processors. These organizations saw an opportunity to offer a new service to its clientele and in return, generate a new revenue source from their existing operations.

In the 60s and 70s, new commodity products such as beef, gold and silver were introduced. A retail community of traders developed but numbers remained relatively small in terms of retail clients and commodity brokers themselves.

Volumes remain very low until the late 1970’s when the exchange volumes exploded from the introduction of financial futures products. This explosion in volumes occurred on all global exchanges that introduced financial products.

As the financial products started to dominate, financial institutions began to buy into brokerages. They did this as part of an aggressive worldwide industry move for financial institutions to increase their fee income, rather than rely on interest rate margins.

They bought into stock brokerages as well as other futures brokerages. They did it also to offer their services as a financial ‘’supermarket’’ or one-stop shop for their institutional clients.

For a brief period in the late 80s and early 90s, competition was so aggressive that some firms were offering futures broking services at below cost as ‘’loss leaders’’. I.e.; they sacrificed their futures profits to entice customers to become clients whereby there would be sold other services such as foreign exchange trading and treasury services where profit margins were higher.

Their larger financial resources meant that they could be more active in marketing the futures industry and gave the industry more respectability. This increased marketing meant that the other brokers needed more resources to compete, which resulted in them being bought out by other financial institutions or strengthening their operations with more resources and capital.

By the early 1980’s, a large number of retail customers were speculating in futures contracts. "Bucket Shop" brokers sprung up offering "trading" in international futures contract. These were mostly fraudulent operations designed to illegally take money from unsuspecting investors. As a result, the SFE introduced rules in the mid-1980’s to stop the operations of the bucket shops. All futures trading now needs to be regulated.

The Kuala Lumpur Commodity Exchange [KLCE], established 1980, was previously the only futures exchange in Malaysia, trading palm oil futures and averaging 1000-2,000 lots per day for most of its existence.

In the mid-1990’s with two new financial futures exchanges opened within the year. KLCE introduced a subsidiary called the Malaysian Monetary Exchange to offer interest rate futures. A private sector initiative to launch stock index futures resulted in the formation of the Kuala Lumpur Options and Financial Futures Exchange or KLOFFE.

Volumes were disappointing in both exchanges although KLOFFE managed to trade around 5,000 lots per day at its peak, which was about 2 years after launch and just before the onset of the Asian financial crisis. MME with its interest rate contracts did not fare well, averaging just under 800 lots at its peak.

The recent launch of these two futures exchanges offer interesting insights and lessons for India.

1. Fragmentation into three futures exchanges took significant amount of regulatory time for all concerned [brokers, regulator and exchanges] to sort through applications and procedure documentation.
2. Rules were slightly different for each exchange resulting in significant regulator, exchange and brokerage staff time devoted to sorting though regulatory and exchange issues.
3. Separate markets – one was screen-based and one was floor traded – resulted in higher staff overheads for brokers to service both markets. Consequently as one exchange was seen to be less successful than the other and since cost was a significant issues, brokers graduated away from one exchange and devoted all resources to the other. This started a self fulfilling spiral where fewer brokers resulted in less volumes which caused other brokers to also withdraw.
4. The screen traded system purchased by KLOFFE was like buying a Rolls Royce when a Mini Minor was all that was required. The overheads and expense to maintain such a system resulted in significant cash outflow from a struggling exchange, which would have been better off having devoted more resources into education and marketing. High exchange fees also hampered the building of business.
5. Regulatory permission granted, in a fragmented way, to different sectors of potential users [such as the retail market, the corporations/industry, the banks and the fund managers]. For example, fund managers were only granted permission to use KLOFFE contracts after the launch.

Permission was not granted to all participants at the same time. Education of these users therefore was done piece meal. This meant a critical mass of trading volume was difficult to generate since not all potential participants were ready.

In a futures market, success depends on generating critical mass as soon as possible. This means all potential participants must be ready with regulatory permission and sufficient training and education from the first day of trading.

6. Insufficient training of staff at brokers and exchanges resulted in salaries for experienced staff skyrocketing. This increased the cost to brokers and meant there was a shortage of experienced staff amongst other brokers and end-users, which restricted the creation of critical mass of trading from day one.
7. The selling of membership seats [of the exchange] in a quasi-auction basis resulted in buyers that speculated on buying up futures seats with the sole intention of selling it at a higher price, rather than developing a brokerage operation. This pushed up the cost for the bona-fide firms that were planning to build a brokerage operation.
8. The poor performance of the futures industry has recently resulted in the KLOFFE being taken over by the stock exchange in Malaysia and the MME merging with KLCE to form COMMEX. This recognized the waste of resources in having multiple exchanges and their different rules and systems.
9. Brokers were required by the regulator to demonstrate they had sufficient expertise by producing an internal "operations manual" for approval by the regulator. What followed was that several large consulting firms were paid by the brokers to write the manual, which was then signed by the broker and given to the regulator. The consulting firms were paid very high fees. Arguably the brokers did not learn much from the exercise because they paid some else to fulfil the regulatory request for a manual.
10. There is already talk that the two separate Malaysian exchanges now should merge. This is occurring in Hong Kong and Singapore where the stock and futures exchanges have merged and in Australia where the process of merging is under negotiation.
11. A number of international and domestic service providers particularly in the risk management and software business for futures, moved into Malaysia sending their sales team to solicit business. Because of the significant demand at a particular point in time by the brokers and the exchanges for these services, some of these service providers were swamped with business. Because the Malaysians were limited in their knowledge of international pricing, in some cases the Malaysians paid a much higher rate than one would have been charged internationally for these services in areas such as futures risk management, consulting etc.
12. The internationalization of exchanges and brokers means that there is significant interest by offshore brokers and exchanges in the Indian market. India can capitalize on this interest by attracting these brokers and exchanges to the country.
13. The sharing or transfer of technology and knowledge is critical to the success of a young futures industry. In Malaysia, many expatriate brokers were transferred to the country to kick-start the market.
14. One critical issue however was the escalation in salaries amongst domestic staff, which made the brokerage industry suffer from low profitability due to salary cost blowouts see 7, above).
15. Globally, there has also been a closer alignment between financial and agricultural futures markets. There is opportunity for the agricultural futures industry to work with the financial futures industry in order to share expertise and combine resources in order to preserve costs and expand opportunities using the same futures industry infrastructure.
16. This issue obviously is fraught with organizational politics and negotiating pressure. The futures sector [whether agricultural or financial] that is seen to be more sophisticated in India will be able to negotiated from a stronger position in terms of developing the combined industry.
17. However for the agricultural futures industry in India, the offshore experience is that the financial industry in futures is much larger than of that in agriculture. In terms of negotiating this means the agricultural futures industry would be in a weaker position.

The field visit was conducted from Oct 3 to Oct 13 by the team of the international consultant (Mr. David Chin), the domestic consultant (Mr. Jamal Mecklai) and Mr. Indrava Dutt, who works with Mecklai Commodities. In addition to several meetings with the FMC, the team visited

1. BOOE
2. EICE
3. Reserve Bank of India
4. A wide spectrum of traders and brokers
5. Commercial banks

There are 18 existing commodity exchanges in India offering domestic contracts in 8 commodities and 2 exchanges that have permission to conduct trading in international (USD denominated) contracts. Many of the traded commodities and most of the existing contracts are specific to India. While the exchanges have varying degrees of success, the industry is generally viewed as unsuccessful.

With the Finance Minister having addressed the issue of extending futures trading to the oilseeds sector in the 1999 budget, the FMC requested applications from associations/interested persons for setting up a futures exchange to trade across the vegetable oils complex. They have thus far received 22 applications, but no decision has yet been taken on who/where/when this is to begin

Under the recommendations of the R.V. Gupta Committee set up by the RBI in 1998, Indian corporates are now permitted to use overseas futures exchanges for hedging underlying commodity price risk under provided they comply with certain application and reporting procedures. In reality, some Indian corporates have unofficially been using these overseas exchanges for several years through their offshore-based trading subsidiaries. Under the new regulations, some companies have indicated that they would be interested to shifting their hedging operation home since it simplifies accounting issues; on the other hand, there are others who find the unconscionable tax treatment of hedging losses a negative.

3.3 Reasons for the lack of liquidity in existing futures exchanges.

Recommendations are provided in italics below each of these points. Details of these recommendations are outside the scope of this report. However, in our preliminary draft, we discussed some of these issues which are now attached at Appendix I.

3.3.1 Exchange integrity in doubt. Exchange staff is usually the staff of the exchange promoters, who in turn are the dominant traders in the underlying physical markets. The president or chief executive office of the exchange is usually one of the dominant players in the physical market. Other traders are wary of trading in the futures markets due to this situation where possible conflicts of interest can occur.

3.3.2 Users of the exchange – i.e., individual traders, hedgers, speculators, etc. – need to register their full details with the FMC. Internationally, there is no registration of users required. This adds an unnecessary layer of regulatory costs as well as considerable fear of privacy invasion – this is a significant issue anywhere, but more so in India where there is still a large parallel economy.

3.3.3 Tax issues. Currently, Indian tax law does not permit losses on a futures transaction to be treated as a business expense - i.e., enable it to be offset against, say, a profit on the underlying physical trade unless there is a definite underlying contract.

While this is better than nothing – prior to this change, "speculative losses" as they were called, could only be set off against "speculative profits". It still constrains users since there is no certainty that the CBDT (Central Board of Direct Taxes) will not demand evidence of an underlying position for each futures loss, which would be extremely onerous to prove.

3.3.4 Stamp duty apparently can be arbitrarily imposed by the state in which the futures exchange is located. While stamp duty may be low, it can be increased by the state as a revenue raising exercise and therefore, potentially can threaten the viability of a futures industry.

Such a situation of uncertainty may hamper brokers wanting to expand operations. The risk is once there is a viable exchange, state governments may see it as a golden goose to pluck. The success of futures contracts lies in its very low transaction costs. Stamp Duty puts another layer on this and in countries such as Australia, there is no stamp duty charged.

3.3.5 Strong competition from the unofficial or havala markets. These unofficial markets have been established for many decades and have built up a reasonable reputation in terms of integrity and liquidity.

Some unofficial markets trade 20-30 times the volume of the "official" futures exchanges; they are localized often in close proximity to the official exchanges; although there are some havala exchanges that have cropped up and have been operating for years in independent centres. They can have as many as 10+ market makers providing prices, and are usually closely linked to the physical trade.

With no regulation except regulation by ‘reputational risk’, these markets are usually very cost effective and, therefore, attract speculators and the smaller hedgers. These markets also provide a wider range of competing products, making it difficult for a more regulated official exchange to compete.

In particular, options on futures already exist in the unofficial market. Thus, if the official markets do not have option contracts, it will be one more disincentive for players currently active in the unofficial markets to move to the official markets. However it is a chicken and egg situation - international experience shows that options should preferably be introduced after futures contracts are successful.

3.3.6 Limitations in the underlying markets

In some markets where there are existing futures contracts, the underlying physical market may have insufficient depth and size to enable the development of a successful futures market. In some cases, it is only ‘one way’ business.

For example, the castor oil market is almost a 100% export market. Thus, Indian participants would generally be only interested in selling forward via futures. If there are no natural buyers in the futures market, then it is difficult to generate liquidity.

The associations and the FMC have recognized this and have hence permitted an international contract in castor oil, but it has not yet developed any liquidity for several other reasons, including ineffective marketing of the contract.

Again, in other Indian markets, there is an imbalance of players. For example, in coffee, the trade is dominated by the top 5 players who control 80-90% of the volume.

Some markets have price controls – price support.

Producers [farmers] have little incentive to use futures; in fact this is also the international experience. In some cases, the farmers have a high profit margin as well as holding power - i.e., cash flow is not a problem so they can – and will – wait for prices to be attractive rather than selling immediately. This reduces their perceived need for forward hedging.

3.3.7 In most instances, brokers are single-commodity players, partly because of history and partly because of the circumstance of the exchange itself. If exchanges can provide more than one commodity, it allows brokers to have more and varied revenue sources to enhance their business operations; this would provide brokers with an incentive to invest more and develop their business by seeking a broader range of clients.

The case for multi commodity exchanges have already been widely made.

3.3.8 Limitations of clearing/surveillance/warehousing facilities – to addressed by the other consultants.

See Appendix 1. These include; establishing 2-3 national multi-commodity exchanges rather than giving 23 new exchanges to form for the edible oils sector.

Providing centralised education facilities and standards. See also 4.3.3 below.

Providing a central clearing facility for all exchanges but allowing them to run the execution and product development and marketing activities independently.

Again please note the above recommendations are outside the scope of this report.

In our interim report, we had recommended that the government should take the initiative to set up three core groups, each of which would be mandated to set up a multi-commodity nationwide exchange. In fact, the government has constituted one core group mandated to set up a National Commodity Exchange and has, in parallel, provided some of the existing exchanges with a wider palette of commodities to trade.

While this approach does fall somewhat short of our most effective scenario, it does go some ways towards creating a reasonable amount of competition in the industry, which, in and of itself, will lead to some of the structural changes we were recommending.

We note, here, too that the FMC has, in principle acknowledged that an internet-based trading platform may provide the most cost effective exchange and that they would remain open to other applicants over time.

However, the FMC has not, as yet, addressed some crucial structural issues – such as the need for exchanges to have improved integrity, etc. – which were brought up in our interim report.

Thus, the scenario today looks like a little bit of both the old world and the new world. The old world still controls, but the new world appears to be gaining ground. Thus, many of our recommendations, which are based on the continued existence of the old world, may already be coming into practice in certain exchanges.

Typically the evolvement of brokerages occurred as follows.

• In most commodity futures markets, commodity futures brokers evolved from the physical side of the business finding an opportunity to provide additional services via risk management and futures.
• The most successful investigated how operations worked in offshore brokerage houses and, in many cases, replicated their services in the domestic market. Such services included more sophisticated reports on forecasting the commodity physical and futures markets, providing comparative pricing reports from similar markets around the world, as well as their regular execution services.
• As in any business, successful players tried to focus on certain areas of expertise in order to differentiate themselves from their competitors.
• They also tried to broaden their customer base, selling, for instance, to retail speculators, both from within the commodities industry or outside of it. Retail stock traders became interested in trading commodity futures to diversify their products traded.
• Large banks, particularly rural banks, saw the opportunity to offer futures broking services as a complete one-stop service for their rural clients. These rural banks bought into futures brokerages and provided the extra capital and credibility to the brokerage community. This pushed existing, independent brokers to professionalize in order to compete for business with the bank backed brokers.
• In addition, large stockbrokers also bought into futures brokers with the intention of offering the supermarket concept of financial trading services. Once one broker bought into a futures broker, other similar organisations followed in order to match their competitor’s strengths.
• International brokerage houses also saw business opportunity and bought into domestic futures brokers. Again their new capital and professionalism resulted in the local brokerages being forced to also increase their size and professionalism.
• Some large clients of these brokers bought into brokerages also when they calculated that it was cheaper for them to buy a membership and do their own futures trading as a member instead of paying brokerage to their brokers.
• As local retail clients became more sophisticated, their demand to diversify their markets resulted in local brokers also needing to offer access to international products. Consequently, the domestic brokers established ties with international brokers.
• As the industry developed, some exchanges offered financial products. These grew to become the dominant products for exchanges which meant bank backed brokers became commonplace. However in other exchanges which did not offer financial products, the main brokers came from the trade industry.
• Smaller brokers grew to service a growing retail customer base.
• In the late 80s and early 90s, the brokerage industry had become extremely over-brokered. Price wars erupted. There was even the case of one broker offering free brokerage during the lunch hour. Banked backed brokers in particular used their brokering units as loss leaders to entice customers into using other and higher margin services of the bank such as treasury services.
• With this excess broking capacity, and the introduction of screen trading, consolidation has been taking place during the 90s.
• Introduction of screens and the ability of smaller brokers to have access to market information means that the old demarcations between types of brokers are fading. The standard demarcation was the line between brokers having access to the trading floor and those without. As screen based markets this line is no longer an issue. The issue is capital adequacy to protect clients from too small a broker who may have insufficient funds to carry the business.
• In fact, even as we write this, there are significant changes – both in terms of consolidation as well as in terms of structure – going on in the brokerage industry worldwide. Merrill Lynch has exited from the commodity futures business; ED&F Man has bought Tullett & Tokyo’s currency futures business; Cantor Fitzgerald are licensing their electronic trading platform to derivatives markets worldwide, etc.
• Thus, in articulating a set of regulations for brokerages on Indian commodity exchanges, we need to take cognizance of these fundamental changes sweeping the industry – it makes little sense to set up rules to regulate brokers that cannot economically exist.

There are around 1,700 brokerages in India today, many of which are single proprietary concerns. Few, if any, of them trade on more than one of the 18 existing exchanges; equally, few, if any, of them intermediate in contracts in more than one commodity. Clearly, some substantive changes in this structure will be necessary as the new world of commodity futures trading emerges in India.

Again, it must be stressed that virtually all of the brokerages are family-run operations having been handed down through generations of trade. Thus, in general, there is a lack of a professional focus which is crucial for the development of a successful modern brokerage industry.

Further, regulations have prohibited financial institutions from participating in commodity futures, which also points out another important lacuna that needs to be addressed – that of developing commodity futures trading skill among financial players.

And finally, other brokers – in, say, equities, fixed income and/or foreign exchange markets – have been regulated by bodies other than the FMC and, if truth be told, are regulated more as pariahs than as genuinely necessary market participants.

Thus, those with the skills and market understanding (generally) lack the professionalism; while those with the professionalism lack the skills and/or market understanding. There have been moves in recent years with some financial institutions making attempts to understand commodity markets and, in some instances, attempts to bring stock brokers into the commodity trade.

While the rules and regulations of the domestic exchanges we studied are on the whole quite satisfactory for exchanges in the emerging stage of their development, we need to recognize the speed at which the brokerage business is changing internationally.

Thus, in addition to articulating technical issues that must be complied with – such as capital adequacy, structure, etc. – we must also look at structural ways in which the FMC needs to modulate the regulations to encourage the development of brokerages in India.

We need to point out here that there are certain functions and guidelines for brokers that are laid down by the regulator (internationally), but operationally brokers are responsible to the exchanges on which they trade, and only the exchanges are directly regulated by the regulator (FMC). Of course, the regulator must have instant access to any trading records of any broker on any exchange – fortunately, the strides made in technology render this virtually a non-issue with all modern exchanges being electronic and, increasingly, Internet-based.

It is recommended that broker structures be standardized to enable easier regulation for FMC. It will also lower costs for the brokers who want to join multiple exchanges.

Initially there should be only 4 broker categories:

1. Broker-Traders who are able to trade for themselves via their proprietary book and also to provide broking services to external clients.
2. Brokers only- these members would not be able to trade for themselves but provide brokerage services only to external clients.
3. Proprietary Traders only – these are traders who do not have any external clients but trade only for themselves.

Only the above three broker types would have direct access into the trading system. Each of these broker categories would have access to futures contracts traded on the exchange based on a minimum capital requirement. Class 1 and 2 are allowed to handle client monies. [i.e.. receive funds ,for initial and variation margins etc.]

The clearing house should provide limits on the number of contracts each category of broker can trade based on their net total assets. These issues we assume will be covered by the clearing consultant.

There should be a category of broker called Introducing Brokers (IB). IBs will not have direct access to the trading system and cannot handle client monies. Correspondingly, IB’s will be under less stringent reporting to and regulation by the exchange.

They would be entities who have their own pool of clients and will use the brokers (1 and 2, above) to execute their client orders.

We also specifically recommend that we should not initially permit IBs to have proprietary trading rights. This is because it is difficult to oversee the possibly 1700 brokers that have both the ability to trade for themselves and trade for clients, since this provides the most potential for conflict of interest.

Additional broker categories can be introduced in future when the exchanges are more mature. It should be noted that internationally, brokers and exchange membership structures evolved over time. This evolution reflected changes in the maturity of the futures industry, underlying physical markets, new players in the futures industry and the gradual entry of smaller players. For example; at the Sydney Futures Exchange, locals – i.e., individual players in the trading pit, trading their own capital – were only established in 1985, 25 years after the exchange was first created.

It should also be noted that the international trend is to broaden access to the markets. Electronic trading systems now mean that potential users are no longer required to be physically present on a trading floor.

The trend is for "straight through processing" whereby end clients of brokers actually input directly into the trading system. There are in-built risk management software that provides adequate checks and balances to ensure that the client has the authority to trade, enough capital in the account and does not exceed predetermined limits set by the sponsoring broker. This software is provided by third parties or by the broker themselves in order to protect their capital position from "rogue traders".

Based on international experience, most brokers fall into the category of brokers, broker-traders and IBs. There will be few proprietary trading firms until the volumes are large. We note, however, that the relatively simple structure we have articulated will need to remain flexible and be relatively fluid, given the potential changes in technology, players and international trends which affects the broker/exchange relationship.

Most brokerages have developed into large corporations. Individuals are usually limited to becoming the IB type broker who does not accept monies from clients.

Given that most Indian brokers are small, it also means they have little in the way of resources. It is expected that most IB’s will gradually merge due to market and competitive forces. For example, as new financial brokers enter the Indian futures industry, they will force smaller IB’s to become bigger to match their services and marketing reach.

It is recommended that large institutions are encouraged by the FMC to become brokers. As this occurs market forces will see that the small brokers merge/be taken over by larger brokers or become niche players. This is explained further in 4.3.10 below.

In the U.S., the adjusted net capital [US cash and cash equivalents – i.e., US treasuries] for all FCM brokers (irrespective of which or how many exchanges they trade on) is the greater of 4% of customer margins or $250,000.

Further, there is the 6% early warning rule – the FCM (broker) has to inform CFTC when customer margins rise to the level that they reach 6% of broker capital.

Most FCMs have capital of 6-8% of customer margins (in other words, internal controls are stronger than regulatory requirements). 80-90% of capital is used for this regulatory purpose. Remainder is needed for membership, fixed equipment working capital etc.

In Australia capital requirements are as follows

In Malaysia, capital requirements are as follows

Major category – i.e., access to trading floor, able to do client and own trading NTA RM500,000 ---approx US$130,000; plus have net adjusted capital of RM250,000--- US$65,000 or 5% of client funds.

Licensing is provided by the regulator and the exchange in a form known as co regulation.

Broker licencing can be divided into 2 areas.

The member of the exchange by virtue of being a member means there is already a form of oversight by the exchange. Ie the member would have had to fulfil certain exchange mandated obligations.

However, as a second layer of regulation, employees of members, who advise and deal in futures on behalf of clients, must be registered. To obtain such a registration, they must

Similar licensing arrangements to be made in India – i.e., any one dealing in futures for clients must be registered. To be registered, one needs to be

• a member/employee of an exchange. [i.e., broker or employee of broker in the 4 categories in 4.3.1]
• character assessment—e.g., no conviction of fraud.
• Pass exam.

These assessments are set by the FMC and undertaken by the exchanges.

These standards will ensure an equal quality of advisor nationally. In addition it is more cost effective for the FMC to obtain the necessary information for exam standards which are passed on to the exchanges rather than each exchange using international consultants to develop their own set of standards. In most cases the only differences in exams between exchanges will be on product issues.

As a transition phase, existing employees of members of exchanges who have actively participated in futures business over the [say] past 2 years [or shorter, subject to skill and experience being assessed by the exchange.] could be grand-fathered ie they will automatically be registered without having to do the exam.

Brokers to submit monthly report to the respective exchanges detailing brokers NTA, liquid assets, and ANC.

Recommendation

For this practice to be introduced ; sample forms are attached

Be independently audited annually; submit annual report and quarterly statements.

1. Exact time and date when the client instruction was given
2. Full details of the client instruction – e.g., buy/sell, quantity, month
3. Exact time instruction was passed to the floor for execution
4. Exact time the instruction was executed, cancelled etc
5. Records to be kept for 5 years.

1. Bans front running
2. Bans withholding of orders
3. Prohibits price manipulation (attempted usually on close to change final price which affects margin and P/L numbers)
4. Prearrangement with other brokers or traders

1. Client agreement form

1. details contractual arrangements and risk of trading for the client
2. rules of exchange where broker acts as principal – e.g., no front running
3. fees and commissions charged
4. right to close client positions – i.e., when margins not paid
5. interest paid on client margins
6. segregation of client monies
7. documents to be provided by the broker for transactions done

1. Records to clients

1. Daily statement showing

1. date
2. transaction done (bought/sold, quantity price, expiry month)
3. Commissions deducted
4. Margin required

1. Monthly statement showing

1. opening and closing cash balance in client a/c
2. Details of deposits and withdrawls in the a/c
3. Contracts still open
4. Any outstanding margins to be paid

1. Client funds

1. Must be kept in bank
2. A/c to be designated client segregated a/c
3. Broker cannot withdraw form a/c except to pay margins or commissions related to the clients transactions
4. Keep accounting records for each clients money in the segregated a/c
5. Client’s funds are not available to pay the creditors of the broker in the event of insolvency

1. Rules of conduct

1. Types of orders defined
2. Cross trading rules
3. No simultaneous buy and sell order from the client
4. Trading infractions
5. Errors in trading and dispute arbitration

1. Segregation of front and back office – no person to be directly responsible for both
2. Only licensed advisors to advise clients
3. Advertising/marketing material documents [including electronic forms] to be accurate and truthful, making no promise of profits and always indicating possibility of losses if profit is mentioned

In India, no such management procedures are in place. Recommended to be introduced. (see comments under Broker licensing, above)

It is clear that the days of the single "local" broker-trader are numbered. While Chicago continues to hold out, LIFFE – once the second largest futures exchange in the world – has recently gone electronic, resulting in a large number of the individual brokers (a) switching professions, (b) joining up with large brokerage houses, or (c) joining up with hub-and-spoke type brokerage establishments.

Thus, it stands to reason that as the number of exchanges in India consolidate, primarily as a result of technology pushing margins down, we will see a similar movement in the domestic brokerage industry. We believe it makes sense to take cognizance of this prospective movement and build the regulatory structure as well as, perhaps, an incentive framework to accelerate this process.

In the new world of commodity futures in India, we believe that brokers in category 1and 2 will evolve into the following businesses:

1. national commodity brokers, each of which would provide access to futures contracts in a variety of commodities on different exchanges to their customers
2. national brokerage firms, each of which would provide access to futures contracts in commodities as well as financial instruments to their customers; these would, of course, have to get regulatory clearance from both FMC and SEBI
3. international brokerage firms, which would enter India either directly or in joint ventures with Indian companies (who may or may not be in the commodity trade initially)
4. stockbrokers and banks will buy futures brokers to offer a wider range of services to their clients.
5. specialist brokerage firms, that provide high quality research and execution on one (or a small number of) commodity(ies) and trade on a single exchange
6. hub-and-spoke type set-ups, where a company sets up the requisite infrastructure, including technology, back office and client reporting software, office space, access to research, etc., and leases desks or seats to individual brokers or groups of brokers; the hub could have any number of types of relationships with the spokes, including straight rental of facilities, profit sharing or a combination of both; here, the individual brokers would have to bring their own trading access rights to the table and comply with all necessary requirements laid down by both the FMC and the exchanges on which they trade
7. introducing brokers, who would not have any trading access, but would serve as conduits to any of the above brokers who would have registered access to any or all of the exchanges
8. micro-brokers, which currently form the bulk of the brokers on Indian commodity markets, will continue to exist but will obviously need to be able to provide service above and beyond that available from their higher infrastructured competitors to remain in business.

We note, of course, that these brokers will have to comply with the regulations laid down in the previous section which conform to international standards. This raises a chicken-and-egg situation since the bulk of the brokers with access to business (i.e., trade contacts) and market understanding have neither the technological expertise nor the infrastructure to conform to the required specifications.

On the other hand, non-commodity companies (whether broking or otherwise) who would have the infrastructure and capital capabilities may be unwilling to participate since there is generally a lack of retail interest in commodity futures. In fact, it is clear that this fact – that overall business volume is currently very low – is one of the key reasons why the historic exchanges have maintained such low (and ineffective) standards for their operations and brokers.

We note that it is obvious that people will only invest in, and develop, a business if they believe there is adequate profit potential. We also note that we are assuming – and, in fact, believe – that for successful commodity futures trading – or, for that matter, successful trading of any entity – there needs to be a market mechanism.

Whether that mechanism is human interface telephone-based voice brokers, open outcry brokers, or electronic screen trading are all issues of efficiency and cost. But the fact remains that any market needs intermediation.

Given that the current level of liquidity in domestic commodity futures markets is poor, it would be impossible to get new players to participate in the industry as brokers or get existing players to invest in the required infrastructure to comply with reasonable international standards.

Unless, of course, they were convinced that there would be adequate liquidity to provide a reasonable return. This is, in fact, one of the key jobs for futures exchanges – whether existing or new. This is where the exchanges themselves need to improve. Recommendations for improvement are provided in section 3 above and in the appendix.

While the equity market is being held up as an example, it is important to recognize that there is – and always has been – a retail equity cult in the country (and, for that matter, in most countries).

However, there is no real retail level interest in commodity futures – in fact, even players with underlying exposures are suspicious of commodity futures contracts.

Given this, the only window open to create liquidity is to attract financial players and commodity hedge funds. While the exchanges will doubtless attempt this, their efforts will fail because of regulatory constraints on banks and other financial players, as well as constraints on foreign investment into certain sectors.

Thus, we believe that the FMC themselves need to look at – and find ways of addressing – any regulatory constraints that inhibit the development of market volumes

The first step could be to encourage domestic financial institutions to build commodity trading desks. This move has already started with gold, which should be seen as the most sensitive of commodities.

We believe that the FMC should work with RBI and SEBI to permit – nay, encourage – the setting up of commodity funds, either by banks, bank subsidiaries, mutual funds or NBFCs.

This would generate an initial amount of non-trade linked volume, which could encourage non-trade related companies to move towards the broking business. Obviously, the exchanges would have to play their role in this process; however, FMC needs to clear the regulatory path or else, like most good intentions, that’s all they would remain.

We also recommend that international futures brokers are invited to consider setting up joint ventures with Indian futures brokers. The recent Malaysian experience suggests that the international skills and experience can be put to good use.

We repeat that it is the exchanges – who would profit from it – who should spend most of the resources in marketing their contracts to different types of users. However, given the regulatory constraints and the poor liquidity at the current time, we believe the FMC should play a role in clearing the path for the exchanges’ marketing strategies.

• Exchange integrity needs to be improved.
• Registration of users with the FMC be reduced to only those who have large positions.
• Tax issues need to be clarified to allow futures losses to be offset against physical profits.
• Clarification from Indian states that there will be no arbitrary stamp duty imposed.
• A phasing out of the Havala markets as official exchanges start to succeed.
• Reviewing the existing contracts critically to recognise those who have very little likelihood to succeed based on structural limitations and thus not to put resources into these contracts that are doomed to fail.
• Introduction of multi-commodity exchanges including limiting the 23 proposed exchanges in the edible oil sector into two or three national multi-commodity exchanges.
• Providing centralised education facilities.
• Providing central clearing facility for all exchanges but allowing them to run their execution, product development and marketing independently.

• Streamline broker structures nationally amongst exchanges into four broker categories, these being

Direct access

1. Broker-traders,
2. Brokers only
3. Proprietary traders only.

Indirect access

• New exchanges should have these broker categories implemented immediately. Existing exchanges should have a one-year transition period where as they merge or improve, they can also streamline their brokerage structures to this national standardised structure.
• The other transition recommendation is to encourage large institutions to become brokers. By doing so, the smaller brokers will be forced to improve to match the resources and skill base of the larger institutions.

• Capital adequacy for the brokers should be introduced based on the broker category type. Setting the capital requirement as a percentage of client monies seems the most appropriate and flexible approach. IB’s should have a much smaller capital requirement as they are not handling client monies; however, there should be an exchange determined minimum.

While new exchanges should introduce these capital requirements immediately, as a transition recommendation, we recommend a one-year period where capital requirements are introduced for all broker types on existing exchanges

• Brokers will need to licensed with the exchanges providing the bulk of the registration procedures.

Existing brokers with a minimum of two years experience can be grandfathered with the licenses, provided that they comply with stipulated processes of reporting of brokers financial position, audits and client records.

• The recommendations should be implemented immediately.

• Recommend that financial institutions be encouraged to build commodity trading desks and that stockbrokers are encouraged to investigate the possibilities of buying futures brokers. The different regulators of these organizations will need to discuss how they can work together in terms of co-regulation. Essentially large institutions are to become active brokers in the futures industry.

The major changes occurring in the international futures industry points to the need to be aware of structural changes in the relationship between brokerages and exchanges. We have tried to articulate a process that both takes the current Indian structures into consideration and also tries to leapfrog ahead looking at international developments.

We believe the key to this process is to attract bigger and more experienced firms to become brokers. They will be drawn from international futures brokers seeking to enter India, and financial institutions in India seeking to broaden their services. In addition to implementing the micro-structural recommendations we have made, there will also have to be substantial work done by the FMC to ensure that the process of deregulation – across market and regulator boundaries – is accelerated.

Of course, simply clearing away the regulatory hurdles to allow the entry of financial players – difficult as it is – would not automatically result in highly liquid, well-intermediated futures contracts. There would need to be a substantial amount of education, retraining and structural work done by the FMC and the exchanges with the existing and potential brokers.

First off, there exists a large pool of market intelligence within the current broker community but many of them simply lack the resources to develop themselves into either specialist brokers or national commodity brokers. Even if they do have resources, there is often a lack of drive because they do not "see" the business potential.

In our view, the FMC needs to assist the exchanges in creating lists of brokers rated according to (a) capability, (b) resources, and (c) commitment.

The exchanges’ marketing departments may also be in a position to provide lists of other entities, currently not brokers, who have indicated interest in participating in futures trading.

[We note, here, that this aspect of our recommendations do not strictly require the FMC to participate. Once they are able to clear the regulatory ground to ensure that some non-trade related liquidity comes to the market, the rest of the job should be handled by the exchanges, who, after all, will be the ones to profit from increased business. However, given that the FMC currently has a constituency of some 1,700 brokers, we feel it is important that they participate in this process.]

Brokers who have resources but a fear of commitment should be encouraged to participate in revenue-sharing agreements with either existing brokers who are short of resources or new entrants who are willing to put up the capital for the newly structured enterprise. (perhaps, banks, NBFCs or equity or fixed income brokerage houses).

Again, this function is really one for M&A-type consultants, rather than a regulator – perhaps, FMC;s role would be to organize a series of seminar/workshops where such groups could be brought together, after, of course, ensuring that the regulatory path is cleared for domestic and/or international financial (or, more specifically, non-trade related) entrants. These events should, of course, be paid for by the exchanges.

Brokers who are clearly lacking resources but have market knowledge, a customer base and an enthusiasm to develop their business should be encouraged to come together in hub and spoke operations. Note that the hub of such a structure need not have any commodity trading experience at all; it could, for instance, be a technology or infrastructure company.

Again, FMC could play the role of intermediary in a series of training workshops funded by either the exchanges or non-commodity companies who see either strategic or revenue value in creating such hubs.

In our view, the process will actually prove considerably simpler than it appears on paper, largely because time has – and will always continue to – weed out the old and bring in the new. Already, on most existing exchanges there are at least a couple of brokers who will be market leaders in no time at all. These are usually young, technology savvy individuals, who may or may not have come from a family history in the commodity business.

All the FMC has to do is clear the regulatory hurdles, add some well-focused networking (including keeping themselves open to new proposals and ideas) and stand out of the way.

As a very smart man once said, "The regulator should be like God; we all know he is there, but we never see him unless things go wrong!"

It is clear that it is impossible to develop an effective system of regulation for brokerages unless the exchanges themselves are restructured to meet best international practices. Thus, in discussion with the FMC, we have included this section on the development (or redevelopment) of exchanges in the report.

From the earlier discussion, it is clear that in the medium term, only a very small number of exchanges will survive and, hopefully, thrive. Again, looking to the developments in the international arena, it is likely that these will trade several different commodities, may involve financial futures as well, and may also be linked up with international exchanges. Taking cognizance of these certainties, we make the following recommendations.

It is recommended that the FMC allows only up to three multi commodity nation-wide exchanges to be established. More than one exchange is necessary to ensure that no monopoly exists. In fact, two exchanges may be sufficient to generate enough competition; however, given the diversity of commodities to be traded, the different geographical producing areas and the ambitions of a wide range of constituents, we believe having three exchanges – at least at this stage – would be a good idea.

There is an argument that the FMC should allow any number of exchanges to develop on the basis that we should let the market decide the ultimate winner. However, it is clear that ultimately only a handful – not more than 2 or 3 – exchanges will survive and it would seem meaningless in this day and age to waste both investors’ and regulators resources to start with too large a number of potential participants.

The process of getting to this set-up from the current diversity will be discussed in the transition section.

The exchanges should be set up with the most forward looking governance. This starts with ownership. Ownership does not necessarily mean access to the trading system. The current trend in the international markets is for ownership and access to exchanges to be separate issues. Owners – i.e., shareholders - can also have access to trading rights, but trading right holders need not be owners. This could provide a better approach for some brokers, who may not want to put up the capital for ownership but only the necessary capital for access to trading rights. [Note for clearing house ownership/capital issues—refer to clearing house consultant]

Owners (shareholders) will provide the initial capital for the exchange. Ideally, the exchange should be a for-profit company – as mentioned earlier, this is the trend internationally – with the board of directors selected by the shareholders. The Board will be responsible for the overseeing the running of the exchange, but not actually running it themselves.

Particularly given the historic credibility problems, the selection of the original directors should be carefully considered. The directors should include an official from the FMC and a professionally selected chief executive of the Exchange. The other directors should be appointed to ensure credibility – perhaps including one financial institution or bank head, one representative of non-commodity industry, one respected representative from the legal/audit profession. Obviously, the other directors should represent the interests of different groups of stakeholders in the business – say, representatives of the commodities industry, including association heads, broker representatives. Broker representatives may be elected from the pool of permit holders on the Exchange.

Management of the exchange needs to be strictly independent of the brokers and end users. Without this separation, the integrity of the exchange will be in question and it will be difficult or impossible to develop liquidity.

Committees such as product committees, arbitration committees, marketing committees, etc., can be established, to will enable the views of many other stakeholders in the industry such as brokers, end users, information providers, to be heard. These committees will act as a sounding board for the management of the exchange to get market feedback, market experience views in order to run the exchange efficiently

Once the exchange management and committee governing structure is in place, then product specifications for various commodities need to be drawn up with the help of the committees and exchange management conducting in depth research. Given the recommended structure – multi-commodity exchanges which incorporate some of the existing exchanges – it is likely that some of the product design functions will already be in existence.

Consideration is needed to decide on whether each of the exchanges uses their own trading and clearing systems or whether either or both of these functions should be common. Clearly, combining systems will result in better usage of resources, but at the expense of reducing competition amongst exchanges. Perhaps, it may be best to focus on building a single clearing system but to permit individual exchanges to have their own trading systems.

The board will need to set up specific requirements to be met by different types of players to gain access to the trading system. We have already articulated the international best practices and these will need to be adjusted to Indian circumstances. For instance, the $ 250,000 net worth requirement could be converted at PPP exchange rates which would take it to Rs. 25-35 lakh. The core group promoters (see below) would need to decide what is an acceptable level of capital given the expected volumes of trading, the potential for profit and, of course, the needs of the promoter company. There could – and should – be different categories of access controlled by capital considerations, education level and infrastructure.

Brokers should not need to be members – i.e., shareholders - of the exchange. They can be permitted access based on a certain capital requirement and on expertise and experience.

Market-makers, who could be brokers with a proprietary trading capability or simply financial players who have an interest in using their risk capital on the exchange, will also need to be encouraged and provided access based, of course, on appropriate capital, education, etc., issues. In our view, this is a key issue. Liquidity in any futures contract is largely provided by non-trade based players – i.e., financial players, who have no underlying commodity position and are simply using the market to leverage their balance sheet and/or balance the risk on their trading books by diversifying the contracts they trade. It is crucial that regulations be amended, if necessary, to enable Indian financial players (whether banks, financial institutions, NBFCs or whatever) to access commodity futures.

Access issues will need to be standardized between the three exchanges in order to have brokers able to effectively administer their membership/access administration. It will also allow the FMC to more easily regulate the membership structure.

A large pool of participants including brokers, exchange management, potential and existing users need to be educated about futures. In addition, accountants, auditors, tax officials, software providers, regulators and decision makers such as company directors also need to be aware of the role futures play in risk management and the impact of futures on the underlying industry.

Importantly, the directors and other decision-makers of potential end users [corporations] need to be educated. International experiences suggest that the worldwide negative publicity over futures and derivatives losses and incidences of fraud/mismanagement by treasury officials in large corporations, has resulted in directors being wary about granting permission to the corporations they control, to utilize futures. A comprehensive education and marketing campaign needs to be established by exchanges and brokers to overcome this obstacle.

In addition to brokers, market makers, and Indian corporations, there are three other potential users of the exchange who need to be encouraged - international corporates, individual speculators and professional fund managers.

International corporates will only be interested in products that are not available elsewhere or where the Indian exchange (either on its own – unlikely – or in a JV with some international exchange) provides better liquidity or an arbitrage opportunity. Already, there are two contracts which are open to international participation and which are denominated in dollars – black pepper and castor oil. However, neither of these is currently functional for many of the above stated reasons – i.e., lack of credibility of Indian futures markets – and we need to recognize that even after the structural changes discussed herein are implemented, a significant marketing effort will be needed to bring international players to the scene.

Individual speculators must be encouraged to use the official exchanges rather than the unofficial markets. Existing business on the unofficial exchanges indicate their appetite to trade and their existing expertise. Further, the prospects of one exchange providing access to both commodity futures and, say, stock futures could broaden the user base.

The exchanges should also have a marketing program to encourage specialist mutual funds that trade futures contracts on a speculative basis with the intention of providing an attractive return to investors (and also provide diversification and non correlation benefits to an investor’s portfolio). International experience suggests that this ‘CTA’ industry (or managed futures funds industry) has been a significant contributor (up to 25% of US futures exchange business) to liquidity and the success of the futures industry. In India, the mutual fund industry is in its infancy and it would be appropriate to consider changes to the rules and regulations on Indian mutual funds, which are under the jurisdiction of a separate regulator, to enable them to participate in this window of opportunity.

The FMC should note that the international futures exchanges all evolved from poorly regulated markets to the better regulated markets that they are now over a period of time. While certain minimum standards have to be defined, it may be appropriate to layer on regulations – perhaps as new products are permitted – as the industry grows.

Given the issues to be addressed listed above, our recommendations – primarily that India should have three multi-commodity exchanges (one or more of which may also trade financial futures and/or have linkages with international exchanges) – and the current structure, we believe that implementation can be in four areas.

Thus far, FMC has attempted to maintain as democratic an approach as possible, permitting more or less any group to bid for running futures trading. While theoretically – and from a politically pragmatic standpoint – this may be all very well, the net result has been far less than acceptable.

In our view, there are two alternative approaches that could be followed in setting up the multi-commodity exchanges. One approach would be to ensure competition from Day 1. Here, the FMC could select the three best applications out of the 22 they have received for the edible oils complex. Each of these should be awarded the mandate to go ahead, with the additional mandate that they would be free to add other commodities after one year. Thus, there would be 3 edible oil exchanges plus the 18 existing exchanges, each of which will have the opportunity to evolve to being a multi-commodity exchanges. In a year’s time, the market will have determined which of these are likely to be the most successful; the others will simply wither away due to a lack of support or merge with some of the others. This may be the simplest way of forcing the exchanges to merge and strengthen. If it is left to negotiation instead, this process will take too long. While this approach would have the advantage of ensuring competition from Day 1, it may be difficult – both from a political standpoint and from a quality standpoint – for the FMC to make the selection. Further, since it would reinforce certain focus points (if, for instance, FMC were to select the BOOE application as one of the winners, that group would have disproportionate influence on the evolution of the exchange), which may make it difficult to bring different segments together.

The second approach would be to permit monopoly trading for a brief period – not exceeding one year. While the intention of having three exchanges is to ensure competition, it may make sense at the start – partly to enable the new entities to have a certain period of monopoly growth – to choose the different exchanges based on different commodity types. Perhaps, there could be one exchange in the south trading plantation commodities (coffee, sugar, pepper and other spices, rubber, jute, tea, cotton); one in the west/central region trading oils and oilseeds; and one in the north trading grains and root crops (rice, wheat, potatoes, etc.).

Under this approach, the FMC, with the loud backing of the government, should select three core groups, one to develop each exchange. These groups could be mandated to have authority for a fixed period – say, one year – to select the promoters for each exchange and to work with them to ensure a certain level of viability in the given time period. The core groups should obviously include respected leaders from industry, finance, government and the professions from each of the regions, and should be provided with a secretariat and a budget. The budget could be compensated by fees payable to the FMC by different categories of players; in particular, opening up the market to international participation – Phase III – could provide a good source of finance.

Each core group should be mandated to "sell" its exchange to an appropriate blend of investors and to articulate a process whereby existing futures contracts are incorporated into the multi-commodity exchange. Obviously, the current holders of trading rights – i.e., the existing associations/exchanges – will need to be compensated for giving up these rights, and each core group will need to work out an effective via media for this.

They would also need to define the minimum standards for brokers, market makers and other users, based on technical inputs (as listed above and from the recommendations of the other consultants). To make regulation more efficient, the core groups should be constrained to provide the same reporting processes for their individual exchange members and to the FMC. Education and retraining of existing players would need to be a crucial aspect of its job. In particular, the core group could assist in the setting up of micro-brokers, where several small brokers could share infrastructure facilities. Given that much of the existing commodity trade in India is family run, this will be a tricky task. Clearly, marketing will be a large part of their job.

Each core group would also need to look into the other Phases – i.e., whether or not it made sense for their particular exchange to incorporate financial futures, which would require co-ordination between regulators and/or whether or not it made sense to involve international participation. Clearly, in two instances, international participation is already mandated – i.e., black pepper and castor oil. The core group should also look at joint venture possibilities with international exchanges. For instance, it may make sense for the edible oils exchange to JV with both CBOT and COMMEX, Malaysia for the soybean meal and oil and palm oil contracts, respectively, but run its own mustard, rapeseed and groundnut contracts, and, perhaps, create an edible oils index contract, which could prove attractive to international players (i.e., customers of CBOT and COMMEX).

The core groups should also be mandated to assess whether their particular exchange would benefit from incorporating financial futures contracts as well. It would seem from looking at current international practice that each core group will come out in favour of incorporating some financial futures into their arsenal to maximize their constituents’ capital utilization. We note that there has already been some talk in this direction even among the current, inefficiently run exchanges.

Clearly, this process would involve an interface between the different regulatory faces of the Indian government, since financial futures (such as they are) are governed by the SCRA and regulated by SEBI while commodity futures are governed by the FCRA and regulated by the FMC. We would recommend that the government set up a committee, including one representative from each of the core groups, to look into how the regulations can be merged, or, at least, be made more compatible. We recognize that this is a tall order – however, the government appears to be more open to change than at any time before, and, in any event, the market will not wait. As has been seen an endless number of times before, players will find a way to take economically sound decisions, even if it means transgressing the rules. It is a new millenium and it is more than time that age-old laws and rules be shaken loose of decades of prejudice and dust!

Running in parallel, the core groups should assess the viability of bringing in international players, not just into the "international contracts" already approved, but also into the domestic futures markets. This would be extremely useful in rapidly improving liquidity since international market makers are always looking for new windows in which to diversify their capital and leverage their skills. Again, international brokerage houses will – for the same reasons – be keen to expand into new markets. This would bring in much-needed technology and skills and would also provide an opportunity for domestic brokers to form joint ventures, where they would provide the customer access and the JV partner would provide, say, the capital and modern skills. The good news is that much of the political selling and regulatory work has already been done over the last five or six years in providing international players access to the domestic equity markets.

The core groups could also look at the political viability of permitting international players to participate in the equity of the domestic multi-commodity exchanges. In the current environment, this would be an excellent move since there is a real synergy between the needs of the Indian market and the needs of international futures exchanges (to diversify their product line and customer base to seek new windows of revenue).

The FMC should create a national education resource center from which exchanges can utilise to provides training, education and examinations in order to train and register their members staff.

This service would allow a large pool of people to be educated quickly and at low cost. Further, it would ensure that the standard of education are roughly equal. Costs will be reduced since there is no replication of education courses that need to be created [or purchased] by each exchange.

A few months into the process, the FMC should organize an international conference at the centre – possibly with the involvement of the financial futures industry – to attract the attention of international brokers and service providers, as also to spur the interest of domestic players both from within and outside the commodity trade.