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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 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:
(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.
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