1. Broad Government Policies
2. Regulatory Perspectives: What Should the FMC Focuses on
3. The Day to Day oversight of Commodity exchanges
4. Brokerage Regulations

1. Management of Commodity exchanges
2. Market Monitoring and Surveillance
3. Clearing
4. Physical Delivery Aspects
5. Detecting, Preventing and Coping with Market

Manipulation Attempts

6. Essential Support Functions

This report has been written as part of the final activities of the World Bank project for the improvement of commodity futures markets in India. The activities to be undertaken under this project were as follows:

1. technical assistance to commodity exchanges:

• To improve their operations,

• To strengthen their institutional capacity,

• To develop a strategy for upgrading their trading bye-laws and clearing operations, as well as their development capacity.

2. strengthening the institutional capacity of the Forward Markets Commission

Several consultancy reports were written under this project, and this report integrates the recommendations made in four of them:

• Guidelines for Clearing, Ownership, Operation & Bylaws: Ms. Suzanne Sweeny and Mr. G. Ramachandran.
• Consultancy on Brokerage in Commodity Markets: Mr. David Chin and Mr. Jamal Mecklai
• Consultancy on Development Plan Market Monitoring Surveillance for Forward Markets Commission: Prof. William Albrecht
• Consultancy on Development Plan Market Monitoring Surveillance for Commodity Exchanges: Mr. Alan Burr and Mr. D.C. Anjaria

It also incorporates some of the key recommendations made in this consultant's earlier report (November 1998) entitled Training and educational plan for the Forward Markets Commission and Indian commodity exchanges. Overall, the consultants agree on virtually all the key issues and recommendations. It is indicated where they disagree.

After a brief introduction underlining the context of commodity exchange policy in India (changing local and international conditions, and rapidly improving technology), this report organizes recommendations under three headings: the role of the regulators; the role of the exchanges; and issues related to multi-commodity exchanges. In terms of regulation, the roles of the exchanges and the government regulator (FMC) are complementary. Figure 1 on the next page gives an idea of how (taking into account the recommendations made in the consultancy papers) regulation in India should look like.

Chapter 2 is on regulatory policy. While exchanges are directly regulated by the Forward Market Commission, several other government policies also have an influence on their functioning; in a number of areas, the FMC needs to take the lead in coordinating policy changes with other government departments (eg, taxation issues, stamp duties). With respect to the FMC itself, recommendations are grouped in three areas: the necessary re-focusing of FMC's activities; the need to expand FMC's remit to new areas (eg, national brokerage regulations); and the ways in which FMC can improve its day-to-day management of exchanges.

The chapter on commodity exchanges addresses how they can improve their functioning and performance. It addresses management issues, which are probably of key importance if exchanges wish to attract new categories of users; exchange regulations; and essential support functions, including promotional and other activities that exchanges should undertake.

The issue of multi-commodity exchanges, which is the focus of the final chapter, is particularly relevant because India needs commodity exchanges that have a larger reach and are more efficient than the traditional exchanges. Unfortunately, the traditional exchanges are facing difficulties in innovating. The final chapter discusses some of the issues in matching the needs of the country and the constraints of the traditional exchanges.

India does not have a large nation-wide commodity market, but isolated regional commodity markets. In parallel with the underlying cash markets, Indian commodity futures markets too are dispersed and fragmented, with separate trading communities in different regions and with little contact with one another. While the exchanges have varying degrees of success, the industry is generally viewed as unsuccessful. The exchanges – with a few exceptions – have acknowledged that they need to embrace new technologies, and, above all, modern – and transparent – methods of doing business. But management often find it difficult to chart out a route into the future, and have had difficulties in convincing their membership.

Next to the officially approved exchanges, there are many havala markets. Most of these unofficial commodity exchanges have operated 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 often localised in close proximity to the official exchanges. They offer not only futures, but also option contracts. Transaction costs are low, and they therefore attract many speculators and the smaller hedgers. Absence of regulation and proper clearing arrangements, however, mean that these markets are mostly "regulated" by the reputation of the main players. Many market participants feel that as this system has worked well for a long time, there is no reason to fear a breakdown of this system based on trust. However, this clearly cannot be the base for government policy, which has a duty to protect the public against the risks that use of these markets pose.

The regulatory agency for commodity exchanges is the Forward Markets Commission (FMC). In recent years, the FMC has made great efforts to bring about greater discipline and transparency in the markets, and has also added to its roles that of promoter of commodity exchanges. Curiously, it is the trading communities themselves that are behind in this process, largely because of the lack of acceptance of the discipline and regulatory practices of the modern futures markets.

As a result of globalization and liberalization, more and more farmers and traders are becoming exposed to the vagaries of world commodity prices, and to heightened international competition. As s result, the importance of commodity exchanges and other tools for the transfer of risk (essential elements of an efficient market place) is increasing. Meanwhile, developments in, primarily, technology and communications are driving a drastic upheaval of the commodity exchange sector. Key factors affecting exchanges include:

• The trend towards electronic trading; even the exchanges that have a legacy of open outcry (and the concomitant problem of floor brokers keen on defending their turf) are now moving towards electronic trading.
• The emergence of Internet-based commodity exchanges and Electronic Communication Networks (ECNs) using a combination of dedicated networks and the Internet, as competitors to exchanges.
• Globalization of financial markets, where players now use multiple products on multiple exchanges.
• Few new products available for futures exchanges to launch.

These factors have forced exchanges to:

• Compete with each other - many of them are now trying to steal products that are trading on other exchanges.
• Attempt to globalize their operations to cater to a more internationalized set of customers.
• Seek alliances, often international, in order to compete more effectively against other exchanges and ECNs. Futures Exchanges and stock exchanges are merging due to increased competition and the need to get overhead costs down.
• Become for-profit organizations and de-mutualize to be able to raise capital, in particular for the technology necessary to adapt to new trading realities, and increase the speed of decision-making (indeed, the largest single benefit of de-mutualization has probably been a change of culture).

These developments have also had a dramatic impact on the way that those involved in the futures industry, and in particular brokers, function. Key developments are as follows:

• Futures Brokers are downsizing and cutting costs to remain profitable in the new screen based environment.
• Brokers have much less loyalty to any one particular exchange.
• Large players are getting direct access to the futures markets, via exchange screens, and, therefore, have less need for brokers.
• Brokers have to access other markets around the world to offer full services to retain their larger clients, who are already internationalised; further, even small trading clients have diversified the markets that they trade and require international access.
• Globally the industry is merging. Futures brokers who have not been profitable – and this is a substantial number – are being sold or merged.
• 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.
• Micro brokers are growing. This has been through either a large brokerage service organisation 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.

Various government policies still hinder the growth of commodity exchanges. Given the recognized need for India to have efficient exchanges in the face of liberalization and globalization, FMC should take the lead in coordinating with the responsible Ministries and other government entities a change of these policies. This would not necessarily reduce the government's possibilities to intervene in commodity markets, but would ensure that such intervention does not hinder, or even critically damage, commodity futures markets.

A first issue is taxes. Different tax treatment of speculative gains and losses discourage many speculators from participating in official futures exchanges, thereby affecting the liquidity of the markets. Hedgers are affected as well: the necessary link between futures and physical market transactions is too rigidly defined. Tax issues need to be clarified so that futures losses can be offset against profits on the underlying physical trade and vice versa.

A second problem is stamp duty. Stamp duties on trade in commodity futures exchanges should be nil, except when physical delivery is made. Now, stamp duty can be arbitrarily imposed by the state in which the futures exchange is located. Clarification from the Indian states in which there are exchanges that there will be no arbitrary position on stamp duty is recommended.

Third, many institutions (particularly financial institutions but also, in a less direct manner, cooperatives) are not permitted to engage in commodity futures trade. The rules which prevent such engagement need to be modified.

Finally, the role of government entities directly involved in commodity trade should be reconsidered. The direct purchasing practices of these entities now damage the potential of commodity exchanges. If a federal or state government wishes to continue direct interventions in commodity markets, it could, if it wished, pass through the commodity exchanges. This would ensure effective market intervention (the effect on prices will be immediate), and, as long as done within clear policy guidelines, does not destroy market mechanisms.

The FMC needs a new focus, a stronger role, and an improved day-to-day oversight of exchanges. The Forward Contracts (Regulation) Act, 1952, does not properly allow for many of these changes. Certain parts of the FR (C) Act would become superfluous if the changes mentioned below were adopted (eg, the references to transferable delivery contracts), others need to be changed (eg, the ban on options), and the FR (C) Act does not provide the FMC to take on necessary new roles, eg properly regulating brokerage activity. FMC may therefore consider the overhaul of the FR (C) Act, as long as this does not slow down those changes that are both necessary, and possible under the Act.

With respect to focus, the first issue is that the perspective of regulators should move away from a concern about preventing volatility towards protecting market integrity. the regulators must set the regulatory template under which each of the exchanges is permitted to operate and is expected to run its business. The regulators therefore must satisfy themselves that the exchange business is being conducted in a proper manner. They are likely to set guidelines for exchanges and will need to satisfy themselves at all times that exchanges are conducting their businesses in line with those guidelines.

Second, the FMC should move more aggressively to limit the Havala markets (or at least increase their regulation to be on par with those of the futures industry). On the assumption that Havala markets provides unofficial risk management services to the players, a one-year transition period us recommended.

Third, the FMC should change the portfolio of contracts that are traded. It should abolish NTSD and TSD contracts, and have only tradable futures contracts. The FMC should also allow exchanges to introduce option contracts. Knowledge has now sufficiently spread, and technology sufficiently improved, to make this possible. The FMC policy of approving futures contracts for exchanges near the regions producing the underlying commodities should be discontinued. Instead, FMC approval should be given to exchanges with the acceptable infrastructure and a potentially large trading community/membership, irrespective of the exchange location in relation to the commodity-producing centre.

Furthermore, it is important that the FMC seriously re-examine its priorities in its process of regulatory reform. The FMC’s current market monitoring system functions in a reasonably satisfactory manner most of the time in the current environment of small, single commodity exchanges with low volumes, contracts of short duration and exchange self-regulation. But if exchanges are to grow and are to play a bigger role, better regulation is needed. However, FMC is a small agency (it is advisable for the Indian government to consider strengthening it) with a small staff and inadequate capital resources. It should not devote the major part of these resources to attempting to modernise the existing single commodity exchanges. It is not efficient to devote a large amount of resources to the regulation of what will soon be an obsolete method of trading. Instead, it should develop the skills and procedures necessary to manage a national multi-commodity exchange.

With respect to the established exchanges, the FMC can also take a two-track approach. For sufficiently well-managed exchanges (with strong trading, information, clearing and self-regulatory systems) there are at least two items the FMC must change soon: One of these is the requirement that the FMC approve a new futures contract each time a contract expires on a commodity exchange. The other is the establishment of minimum and maximum prices for futures contracts. Furthermore, it should consider offering these exchanges the possibility to introduce option contracts.

As an industry grows, as technology changes, as customer needs change the appropriate type and scope of regulation is almost certain to change also. Thus, regulatory flexibility is critical to the long run success of both regulation and the industry it regulates. In the particular case of FMC, there are two key roles that it has to take on: setting up brokerage regulation, and enhancing its promotional role.

Worldwide, brokerages are generally regulated by a self-regulatory organization (a "national brokers association") which, apart from arbitrating disputes and the like, also sets and enforces educational standards. This is a model that is surely advisable for India; but as brokers so far have failed to organize themselves in this manner, the task will fall on FMC (eventually in cooperation with SEBI). A framework for sound brokerage and customer protection regulation is further discussed in section C.

Furthermore, 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. 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 FMC could 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. The FMC should work with RBI and SEBI to encourage the setting up of commodity funds, either by banks, bank subsidiaries, mutual funds or NBFCs.

It is common for regulators to draw up their supervisory criteria and to invite exchanges to present a formal report annually to show how they intend to comply with the regulations over the coming year of operation. This is the Regulatory Plan.

FMC should try to give as much self-regulatory powers as possible to exchanges and to the brokerage community. It should set the general framework, and have the right to ask for various types of information from the exchange in respect of the dealing that is taking place. FMC must be careful not to impose too restrictive or too onerous a set of responsibilities in respect of reporting on the exchanges.

In its day-to-day oversight of exchanges, the FMC should firstly, ensure that the exchanges properly follow the rules; and secondly, should deter and punish manipulation attempts.

The FMC should establish a group of surveillance and monitoring experts within its staff. Among others, these should monitor the exchanges to ensure that trading remains open in all contract months at all times as stipulated and impose a reporting requirement on any disruptions or closures, the details thereof, and the reasons thereof. The board should be held responsible for the justification and ought to be warned if it appears that the disruption was not warranted. Furthermore, commission staff should work with exchanges to establish reportable and speculative position limits and to be able to receive data from the exchanges in a timely manner. The FMC must to acquire additional hardware and software, and develop programs for preparing the necessary reports.

With respect to combating manipulation, FMC’s policies and practices merit a radical overhaul.

In the United States, manipulation is defined as "any and every operation or transaction or practice (...) calculated to produce a price distortion of any kind in any market either in itself or in relation to other markets (...) Any and every operation, transaction (or) device employed to produce these abnormalities in price relationship in the futures market is manipulation." The Commodity Exchange Act (section 9(b)) makes it a felony for any person to manipulate or attempt to manipulate the price of any commodity, and (section 6(b)) provides for civil penalties for (attempted) manipulation. Although one does not need to copy United States rules, any regulator or exchange which wishes to handle situations of market crises due to manipulation attempts in an efficient manner needs a similarly broad-based regulatory definition of manipulation (which will be upheld in court), and regulation which punishes manipulation attempts.

Such a broad definition of manipulation also allows regulators to intervene early, rather than after the fact: in effect, if they see behaviour that is likely to cause a price distortion (e.g., the building up of artificially large futures positions), they can react immediately.

In order to handle market crises which are due to manipulation attempts in a successful manner, what is needed are:

2. A strong regulatory framework
3. The ability to monitor what happens on exchanges. Exchange management should form a first line of defence (and be punished if they do not do their job properly), but regulators should keep continuous track of market developments too.

It is much easier to take steps to prevent a disorderly market than it is to prove that manipulation has occurred. Thus, the FMC must concentrate on detecting and deterring attempts to manipulate the market. The most important element should be a large trader reporting system that enables the Commission to monitor all large market positions. This should be complemented by a system of speculative position limits with exemptions for those with commercial hedging needs. The FMC needs to receive information from exchanges on the day’s activities at the end of each trading day. It needs to be able to compile reports from this information and to analyse these reports promptly. Procedures to identify and examine unusual changes in basis and spreads should be established. Threats to market integrity should be reported to the senior officials at the Commission immediately. Senior officials should review surveillance reports on a regular basis.

The global futures industry is undergoing a period of immense change, and previous international brokerage models may no longer be as appropriate a benchmark to guide India’s development of its brokerage industry. Nevertheless, a few guidelines for stimulating this development can be given. Firstly, the entry of international broking houses, either in joint ventures with domestic brokers or independently, should be stimulated. Second, FMC should stimulate the evolution of hub-and-spoke type set-ups, where a large number of micro-brokers would share services such as centralised back office, administration, clearing and direct access into the trading system – this will enable many of the current brokers to survive. Third, the FMC should stimulate the brokers to organize themselves, and take on as many self-regulatory functions as possible.

There should be, in India, a national brokerage system with uniform standards for capital adequacy, licensing, structure, management responsibilities, etc. It would be best to have one combined futures industry and futures industry regulation for both the agricultural and financial markets, and this particularly applies to brokerage regulation. The FMC needs to set standards on an umbrella basis; but each exchange will also have to define the minimum standards for brokers (as for market makers and other users) based on capital, expertise and experience. There should be a transition period (not exceeding one year), where each exchange sets initial standards for their brokers.

Brokers (after the transition period) should meet the following requirements:

• Mandated capital adequacy. The regulators should seek to minimize any risk to investors and threat to the stability of the market from the failure of an institution because it becomes unable to meet its liabilities. Currently, a broker's membership at the exchange is solely dependent upon fulfilling the financial requirements (in form of upfront payment or equity participation, membership, admission fees etc.) levied by the different exchanges. There is a need for mandated capital adequacy for brokers together with measures to monitor that the capital is, in fact, maintained.

• Licensing. In India, there is no requirement of any form of licensing. A broker can start trading once he fulfils the exchange requirements. There is no educational requirement. It is advisable that anyone dealing in futures for clients is registered. To be registered, one would need to:

- be a member/employee of an exchange

- pass a character assessment—e.g., no conviction of fraud.

- Pass an examination.

In order to obtain authorisation (or a license) the applicant has to establish, to the satisfaction of the regulator, that both it and its senior staff are ‘fit and proper persons’. The application of the "fit and proper person" test may exclude those who have previous criminal convictions, are bankrupt or have previously been publicly censured by a regulator. In addition, individuals such as directors and key employees may well be required to possess suitable professional qualifications and experience. The regulators will also monitor whether the authorised person continues to be a "fit and proper person".

Customers trading on derivatives exchanges entrust their funds to financial intermediaries. They receive information about the nature of the risks of these transactions from those with an interest in inducing customers to engage in such transactions. Accordingly, firms, exchanges, self-regulatory agencies and governmental regulators must establish regulations addressing customer protection and fairness. These regulations typically include procedures to ensure the fitness and competency of those who deal with customers, appropriate disclosures to customers, documentation to ensure customer authorization for transactions, sales practice rules intended to prohibit misleading sales conduct, segregation rules which require the separation of customer funds from the funds of the firm and rules which require that customers' orders get priority over firm orders.

A key role of the regulator is to protect customers. While ultimately, customers are responsible for their own actions, the regulator has to ensure that:

• potential users of exchanges are properly informed about the benefits and risks of futures exchanges (that is to say, there has to be a "code of conduct" for brokers);
• users are able to obtain information about whether a particular broker is "legitimate" (so there needs to be a licensing system, and information about brokers should be easily accessible);
• it is easy for customers to complain when they feel their broker has not done his job properly;
• there needs to be a good mechanism to investigate brokers, when there are such complaints;
• brokers who break the rules are banned from the industry (which implies the need for a nationwide brokerage registration system);
• and there is a customer protection fund in case a broker falls bankrupt.

But these regulations are not sufficient: they just ensure that brokers who use Indian exchanges treat their clients properly. Brokers who use overseas exchanges, or who claim to use local exchanges but do not, fail outside of the purview of regulation as described above. Unfortunately, governments cannot afford to leave this unregulated. As the FMC, the exchanges and the brokers have a vested interest in ensuring that the industry has a clean image, it is advisable that FMC's remit is extended to cover all use of futures by clients other than large corporates; if SEBI or another regulatory entity is to regulate financial derivatives, then the customer protection rules of SEBI and FMC need to be well-coordinated.

The regulators need to ensure that brokers follow Conduct of Business Rules. These rules seek to regulate the way in which authorised firms conduct their business with their customers. They are wide-ranging in their scope and because a breach of them can lead to civil liability or a claim for compensation, they are quite detailed in nature. The Rules regulate a number of different areas including advertising, customer agreements and the suitability of the products and services provided.

• Advertising. The Conduct of Business Rules insist that adverting must be fair and not misleading. Additionally, an investment advertisement must contain a risk warning relating to the risks associated with the investments being advertised. The unsolicited oral promotion of services or products, commonly known as ‘cold calling’, is also heavily regulated.

• Customer agreements. Before an exchange member can operate on behalf of a customer a client agreement should be in place. The exchange or the regulator may wish to define the minimum acceptable content of such an agreement.

• Suitability. A broker needs to check the capacities of his client before undertaking any agreement. Before opening any account for a customer the broker must satisfy himself of the bona fide commercial need for the customer to open the account. He must be satisfied that the customer’s quality of management, commodity experience and commodity business knowledge together with their systems and staff will enable them to fulfil the obligations and commitments they undertake when they sign the agreement. Such agreements need to be reviewed regularly and the brokers will need to be sure that the customers continue, at all times, to demonstrate that they are fit and proper persons to be conducting derivatives business.

A mechanism for settling customer complaints is also needed. Each exchange should have a "first-line-of-defense" complaint mechanism, and there also should be a national (well-advertized) mechanism. In order for customer complaints to be properly evaluated, it has to be obligatory for brokers to maintain client records. These should include details of when customer orders are given (time-stamping) and the exact details of the order. Furthermore they must record when the order was given to the floor trader and the time that the execution was confirmed back. Was it executed in full or piece by piece? Was the order cancelled? Was an error made and if so how was the error resolved? Such records should be maintained in writing and made available for inspection and stored as a permanent reference for a period of time (5-7 years, depending on legal convention) as with accounting records for example.

Customers’ deposits and positions should be protected and kept separate from those of the members. Most countries separate clients’ assets from those of the firm to whom they are entrusted, either by national law or market regulation. The Client Money or Segregation regulations are intended to provide investors with additional protection in the event of a firm’s insolvency. Member firms must prove that they maintain segregated assets at all times.

Finally, it would be useful to have a customer compensation scheme, to which all brokers contribute. However, without properly regulated exchanges, any customer compensation scheme would rapidly become bankrupt which is why most schemes normally only protect a strict category of regulated firms and investors who deal through them. Compensation is not normally applied to investors operating outside a given regulated environment. For this reason, regulators also need an active policy to combat bucket shops.

Bucket shops are companies that take customer orders for buying or selling futures (or options), but never execute these orders on the exchange. Instead, they keep the orders (or the largest part of them) on their books, often reporting profits on initial trades so that customers increase their investments. They commonly employ high-pressure "boiler-room" practices, making exaggerated claims on profit potential of futures and options trading. Ultimately, they will report to customers that all their funds have been lost in an unexpected market move. If customers try to claim their money before this happens, they will either hold off payments (possibly using strong-arm techniques), or disappear. They often target relatively vulnerable groups, such as poor, recent immigrants (a practice known as "affinity trading") who have limited knowledge of the futures industry and may not know where to find legal or regulatory recourse.

Bucket shops do not really differentiate in the products they offer. Commodities, foreign currency, stocks, it's all the same, as they do not intend to lay off their positions in any case. They offer what they think the public is most likely to buy, and if commodity futures grow in prominence, their offer is likely to include commodities. No measure of regulation will stamp out the practice - it is still in existence to this date in the US, despite strong enforcement of brokerage regulation.

Bucket shops do not commonly use the exchanges, and thus fall outside of the normal regulatory remit of the exchange regulator. However, given the damage that bucket shops can do to the reputation of futures trade, and the overriding objective of the regulator to protect the public at large, regulators commonly deal with bucket shops in an active manner. It would be advisable for the FMC, preferably in cooperation with SEBI, to play such an active role. Regulatory efforts should have the following components:

• "Legitimate" brokers should have practices that are clearly discernible from those of bucket shops. Rules on broker-customer relations need to be strictly adhered to.

• These legitimate brokers as well as the exchanges should be made allies in the fight against bucket shops. They should be made to understand the damage that bucket shop practices can do to their industry, and be given an efficient means to report suspected bucket shops to the regulator.

• Customers should be able to recognize bucket shop practices, and be made aware of the risks of using them. FMC should encourage the press to write on this issue, and facilitate public access to information on legitimate brokerages (eg, list them on the Internet and make lists available through various outlets). Standard forms that brokers are supposed to use can also be posted on the Internet.

• The FMC should strongly enforce anti-bucketing rules against the licensed brokers. Its audits should be such that it can detect bucketing practices. If it determines that an individual broker has engaged in bucketing, it should ban this broker from the futures industry, and fine his/her firm. FMC regulations need to be drafted in such a way that it can take these strong actions.

The ideal situation would be for the Indian government to give FMC the authority to impose significant fines for bucketing practices. Those fined should not be able to fight the fines in court, but needs access to recourse on a special FMC panel. If such a situation is not possible in India, then bucket shops should pursued in court, and Indian legislation needs to be such that they can be severely punished.

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

In recent years, the clearing operations of most exchanges has improved dramatically, partly because of FMC’s insistence on a system of daily clearing. Although one of the teams of consultants favour going back to bi-weekly clearing system, this would seem to be a step backwards – ensuring that members keep funds with the clearing banks, and facilitating and permitting electronic fund transfer is a better alternative.

The regulator’s role with respect to clearing is to ensure that the system is strong enough to defend market integrity even in times of crisis. The regulator should not impose a certain system of clearing (eg, separate clearing house or clearing department). The clearing corporation or clearing house will in some cases be a division of the exchange. In some instances the clearing organisation will be an independent body and may provide its services for more than one exchange. Various models exist in different international markets for good business reasons.

However, in the Indian context, a more pro-active role of FMC is defendable, or even desirable, in particular to point out the consequences of certain choices. For example, if margining arrangements do not allow for the offsetting of positions (eg, long March, short May), then clearly this adds extra costs for the users and will reduce market volume. If exchanges are to facilitate use and improve the delivery process, then the use of warehouse receipts is called for – and clearing houses have to be able to manage this. Also, it is clear that if the traditional exchanges wish to compete with the proposed new national multi-commodity exchange (which would presumably have strong corporate backing), then merging their clearing houses/clearing departments should be an essential component of their strategy.

India is rapidly doing away with its barriers on commodity imports and exports, opening up the country’s commodity sector to foreign competition. In order for the domestic industry to be able to compete on an equal footing to its counterparts in other countries, India must develop commodity exchanges that meet international standards in the areas of market integrity, financial integrity and customer protection. Unless these standards are met, exchanges will make only minor contributions to the growth and stability of the Indian economy, and international firms and large domestic firms with significant hedging needs will not use these exchanges.

The thirty-year ban on futures exchanges has had an adverse repercussion on the growth and functioning of Indian commodity exchanges. It has forced people, skills and money to flow to other markets, leaving an older generation of traders in charge not in tune with the new market infrastructure and regulatory practices. While commodity exchanges have done remarkably well in the face of adverse conditions, these conditions have now changed. What was appropriate for the exchanges in the mid-1990s is no longer so today. The FMC has been trying to modernize the exchanges by requiring them to implement changes and using the withdrawal or even suspension of approval for trading in some commodities. Many of the commodity exchanges are now responding and have been making efforts to deal with their problems and imperfections.

India needs a more efficient, more comprehensive commodity futures industry. This futures industry should be organized in line with best international practice. That is to say, the system must rely to the extent possible on self-regulation (with powers vested in the exchanges and in the brokerage community, and the government's regulatory role limited to setting the general framework and ensuring that exchange- and broker-level self-regulation works properly); enable very low transaction costs; be financially secure; and be dynamic. This chapter discusses recommendations to exchanges on how they can modernize. It starts with a discussion of governance issues, and then moves into a discussion of market surveillance and clearing. Recommendations are given on contract design and delivery issues. The role of brokers, and how to modernize the brokerage community, is also discussed. The chapter concludes with other essential support functions that exchanges need to provide.

One of the main issues in setting up effective exchanges is a credible corporate governance. The current trend in the international markets is for ownership and access to exchanges to be separate issues; owners – i.e. shareholders - can have access to trading rights, but trading right holders need not be owners. In any case, 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. In addition, in order to run the exchange efficiently, committees need to be set up to act as a sounding board for the management of the exchange, and to assist in the exchange's self-regulation and strategic planning.

Ownership of an exchange can be separated from access to the trading system. Owners – i.e., shareholders - can also have access to trading rights, but trading right holders need not be owners. The exchanges in India are all mutual organizations, like has traditionally been the case in the West. However, de-mutualization can have a number of advantages. It provides the ability to respond and adapt to a fast-moving world, and to compete with new forms of electronic trade (such as Business-to-Business Internet exchanges); it enables the exchange to tap into equity capital, necessary for expansion; it can leverage the brand name of the exchange; and alliances can be created, for example with financial firms or technology providers. Even though the vested interests of traders on an open-outcry, mutually-owned exchange make it very difficult to de-mutualize, most western exchanges have taken this step in recent years.

The exchange needs a Board, appointed executives, and independent committees. The Board is there to set exchange policy and to be the ultimate supervisors of the exchange as a business, but should delegate the running of the exchange and its administration to appointed executives. The constitution of the board should represent the trading members and broker representatives of the exchange together with the Chief Executive of the exchange, certain non-executive directors, some of whom may be lay-directors. This board will oversee the running of the exchange and will decide upon the delegation of certain aspects of the strategy to separate committees.

Exchange boards need to invite independent directors. In this, it is essential to avoid any divisiveness or confrontation situation. For this purpose, in line with the international practice at CME and other exchanges, the exchange boards should appoint the independent directors, not the FMC or any other body. Directors should be truly independent as regulators, supervising the boards, reviewing their decisions and even remitting them in question, but not be a party to the decision making.

The appointed Executives their staff are charged to act in compliance with its regulations. In their day-to-day functions, they should be strictly independent of the board, the members and the end-users. This will ensure the integrity of the exchange and will prevent trading interests from influencing decision-making.

Committees appointed by the Board should address issues such as business development and product design, legal and arbitration, marketing and other issues. Committees should comprise exchange staff and members as well as users to advise the board and to advise exchange staff on technical issues. Members of exchange committees need to be able to make decisions on the basis of rules and guidelines, rather than based on particular interests. Providing transparency (regular reporting) on the functioning of committees helps to ensure fair decision-making.

The ability of a futures exchange to function properly depends in part upon the ability of the exchange and its regulators to ensure that prices of contracts traded on the exchange reflect supply and demand. In order to do this, the rules governing exchange operations must be price neutral and must be sufficient to detect and deter attempts to manipulate prices - market integrity should be impeccable.

Good market monitoring and surveillance is needed to ensure protection of market users and investors, which in turn should stimulates demand liquidity and turnover. The surveillance and monitoring environment should operate in parallel to and be proportionate with the commercial interests of the exchange. The conditions in Indian commodity exchanges have implications for the market surveillance function at the exchange level. Open outcry trading, which is recognised to be more difficult to human errors and intervention, is widely prevalent and preferred by market participants.

Proper market monitoring and surveillance has the following elements:

• a sound framework for regulation and compliance
• proper controls over floor trading practices
• properly enforced regulation for exchange members/brokers
• a well-performing clearing system
• a well-managed delivery system
• the capacity to detect market manipulation attempts, and act in a timely manner.

The overall authority for regulation and compliance rests with the board of the exchange and is performed via its executive. There should be a strict division between the commercial and marketing function of the exchange on the one hand and its regulatory and compliance disciplines on the other. The regulatory division should ensure that the confidentiality of any sensitive or commercial information required for regulatory and monitoring purposes is preserved and segregated. This may also require additional physical security measures, which would limit physical access to the regulatory and compliance areas within the exchange offices.

The exchange needs clear, written rules and procedures for regulation and compliance (and persons assigned to ensure that these rules and procedures are followed) in a number of areas:

• market floor operations
• electronic trading operations (where appropriate)
• market surveillance (monitoring market activity)
• member surveillance (to ascertain that members are acting in compliance with the exchange rules and that their procedures and systems promote a sound basis for their exchange activities)
• investigation (into any breaches of exchange rules and regulations)
• enforcement (where the exchange believes that there has been an identifiable breach of its rules, the matter might be referred to internal enforcement lawyers for consideration of formal disciplinary action as provided for within the exchange rules)

All modern exchanges whether screen-based or open outcry, rely on electronics technology to transmit orders, record trades, construct audit trails, and monitor surveillance. Through a reliable and sophisticated audit trail, the commodity exchange should be able to follow every stage of the transaction process. Exchange staff should focus on monitoring floor trading practices, review (through computer assistance) members’ records and analyze trading data compiled through the clearing process. The exchange should also monitor the financial solvency of its members’ firms (particularly during periods of volatile market activity).

The procedures for order execution and floor trading should be recorded either in the rules of the exchange or in a separate procedural manual. They should be vigorously enforced by the exchange.

Exchanges need to guarantee that orders reaching the market floor and the price discovery mechanisms between trading members on the floor are conducted openly in accordance with the regulations. The resulting trades must be confirmed in a timely fashion thereafter and submitted to the clearing system.

Only licensed brokers/traders and exchange staff should have access to the trading floor during trading hours. Exchange officials need to monitor and control floor trading, to ensure that traders act within the rules of the exchange. Floor rules may range across the whole gamut of regulations - from banning eating on the floor and vandalising booths to protection of customer orders. The exchange floor teams should blend in with the rest of the floor population. Individuals should be rotated in their jobs at regular intervals, say every six months, in order to keep fresh and to avoid any collusion with traders. Some exchanges use video and sound recording within the trading area, which can be used to review trading situations.

While exchange officials should be responsible for detecting abuses of the rules, a Floor Committee should be empowered to enforce discipline. Their roles may include resolution of minor disputes, decisions concerning the setting of end-of-day closing prices and of any disciplinary matter concerning conduct on the exchange floor. At a higher level the exchange should have the authority to impose strict controls which may include fines and restriction of members from trading.

There should be a strict procedure governing the manner in which closing prices (daily or at delivery month expiry) are determined. This should not be left to the traders but must be an exchange official’s decision. The accuracy of these prices must be guaranteed by the exchange. To achieve this there should be exchange officials situated amongst the traders on the exchange floor whenever trading is taking place. There should be a minimum time period, say 20 minutes, during which time all traders must write out the necessary dealing slips and deliver them for entering into the exchange’s audit trail. The time stamping of trading slips, of orders as they arrive at the floor, and the recording of the time that the trade not only was executed but was also reported back to external customers should be made standard in Indian exchanges.

Exchanges should install a price reporting system to provide local displays of prices, bids, offers, highs, lows and last traded prices together with volumes for every delivery month of any contract. Prices should also be distributed to as wide a public as possible. This should be done preferably in real-time but certainly throughout the trading day at particular set intervals. It should not be the case that prices are only announced at the close of business.

Senior market operations employees should be members of any price quotations committee and floor disciplinary committee. The former would have the responsibility for determining official prices at the close of each day in each commodity. The latter would have the power to impose, on the spot, fines on individual dealers who have committed dealing offences, or to refer cases to a higher disciplinary body.

Exchanges and their clearing corporations should have explicit rules as to the approval of and acceptance into membership of applicant companies. These rules should cover the financial integrity of the company concerned, its ownership, and the quality of its procedures and staff.

In order to verify the financial strength and compliance of member firms, the exchange should audit the financial books and records of the members. Their compliance with the rules should be strictly checked and enforced. The members must provide evidence of their financial status and that they have appropriate policies and procedures for providing accurate financial returns.

It will also be necessary for the exchange to satisfy themselves as to the expertise of the managers and the owners of the business and their rationale in wishing to use the exchange products. Why are they using these products? What are their intentions and how expert are they and what is their previous track record of activity in commodity markets?

Those applying to become member/broker must prove that they maintain effective operational and risk management procedures. Furthermore, they must be in compliance with exchange rules and standards of good practice. The company should have "fit and proper" staff, suitably qualified and experienced. Only individuals who have been trained and licensed, and have passed an examination set by the exchange should be permitted to trade on the floor. There should also be a time period attached to this so that all traders are shown to have effectively served an apprenticeship and have the necessary experience to become qualified traders.

The compliance officers of the exchange need to ensure that customers’ orders are transmitted to the floor without any delay and that there should be no malpractice in respect of brokers front-running orders or withholding orders or failing to offer them to the market at the right time. If a market permit orders to be crossed, the exchange should define procedures. If trading members are found to be colluding, doing pre-arranged deals, they should be fined or banned from trading.

This implies that it should be obligatory for brokers to maintain accurate records. The exchange should have the right to audit those records so that they are able to investigate cases of malpractice, under their overall responsibility for operating an orderly market.

Each exchange needs to have a risk-monitoring group to investigate any complaints from customers or members in connection with market trading. They should also conduct random checks. These may take various forms. One technique is to investigate particular deals, possibly market crosses for example, and establish precisely the whole audit trail for those deals. Sometimes they might also decide to undertake a complete audit into one firm’s activity during one day.

Any trading member has to have his or her trades guaranteed by himself or herself or by another member of the clearing organisation. It may therefore be necessary from time to time for a clearing member to prevent a trading member from fulfilling any additional trades or stipulating than only trades can be carried out to reduce or close positions. The exchange needs to monitor these aspects and must have surveillance procedures in place to do so. Only with timely recording of trades and their entry into computer systems to check against the necessary limits under a risk management environment can this be successfully achieved.

A strong and reliable clearing house is perhaps the single most important factor for instilling trust in an exchange among a wider public. Clearing houses or clearing departments play a major role in facilitating trade, and providing safety. They essentially perform the functions of trade clearing (the process of collecting trade information, matching trades, interposing the clearing house as a counterparty to each trade) and trade settlement (the process whereby clearing payments, margins and final payments are collected and distributed). While the clearing house does not deal directly with clients, it plays a crucial role in ensuring the financial integrity of the market and providing assurance to clients by providing strong margining and risk management procedures. The clearing house sets a range of measures in order to provide adequate protection to the clients of exchanges members.

The main set of measures concerns margining procedures and margin levels. The rules for contract margining in futures and options markets are fairly standard throughout the world. There are various systems and algorithms, which basically all perform the same crucial function – the margin called from the clearing members and from users of the market fairly represents the risk that the clearing corporation and the brokers are taking.

Margin rates must be reviewed continuously. Historical volatility and current market conditions are considered across all contracts in determining appropriate margin levels. Generally they would be set to cover a full day’s price change with a degree of confidence of greater than 95%. Sometimes a higher level of margin is employed on certain markets for speculative customer positions.

In addition to the above, the clearing house/department also needs to ensure that trades are within a firm's financial capacity by large position reporting. Action must be taken early to ensure that positions do not become too large for the members to manage and to ensure that customer positions do not become too unwieldy for the customers themselves to manage. Members must make daily notification to the exchange of all large positions above a certain declared threshold - for customers, non-customers and proprietary accounts. The exchange will analyse this information by comparing the financial exposure of a particular trader to the firm’s capital. Furthermore, the exchange should have the ability within its risk management systems to forecast potential market exposures by conducting "what if?" scenarios on large trader positions. In this way, risk managers can estimate the impact of a particular set of positions if the market move sup or down by a designated amount.

Indian exchanges need to focus on ensuring a good delivery process through a network of approved warehouses. In order for these to be used, deliverable grades of material, deliverable warehouse receipts and warrants and approved warehouses must all be published by the exchange. Exchange approved warehouses have a number of regulatory obligations under their contract with the exchange. Reporting of stocks and providing specifications of stocks held are a key responsibility of the warehouse operators and would be monitored by the exchange operations staff. Exchanges should have their own warehouse inspection group, which contains sufficient resources to monitor warehouses activity and look after the registration and liaison relationship with them.

Indian exchanges could consider the use of Exchanges for Physical (EFP’s).

Exchan ges and clearing houses should ensure that no problems are likely to occur as delivery approaches. The parties who hold long positions also need to be monitored, to ensure that they are able to take delivery, and pay the full contract value for the contracts upon delivery.

The clearing corporation should also employ strict margining procedures at the time of deliveries, which will ensure that additional margins are held from those trading members who are holding the short and long positions in the spot delivery month.

The exchange risk-monitoring group must monitor the spot position daily, and physical (deliverable) stocks at least weekly. They maintain open interest figures for all members and record positions over a certain size (say 10 lots or 100 lots, depending on the market. They need to know what the intentions of large position holders are as the delivery month approaches (insisting to see evidence of physical positions held in the cash market, and verify this information). They must monitor any unusual positions or unusual trading activity, looking for concentration of positions and unusual sizes of positions. They should observe price differences and seasonal factors. They should compare between one delivery month and the next (asking – "Is this typically what happens with this member during a delivery period?"). For all this, they should use a computerised risk management system. This would combine details of positions held and of the financial strength of members, make comparisons and generate warnings. The clearing house, if separate, would conduct a similar exercise in parallel.

In the event that action needs to be taken to contain an undesirable situation in the market, such as a disorderly market, the board should be able to delegate full powers to a special committee. The members of the committee would not have any active commercial interest in the exchange markets. This will ensure that action can be taken on the basis of confidential regulatory information without any conflicts of interest arising. The constitution of such a committee should be drawn from non-executive members of the board and would include the executive responsible for compliance and regulation. To further avoid suspicion on the acts of exchanges in the case of disorderly markets, FMC should require that decisions such as relaxation in daily/periodic price limits, or changes in net open position volume limits or special margin requirements, are approved by two-thirds or three-quarters of those board members present and by all or larger number of the independent directors present at the meeting.

Failure to deliver should be punished severely, and delays in delivery should be fined. The clearing house will take the lead in managing such default situations.

An exchange which is to remain viable needs strong public relations, training, analysis and research departments,

a) to serve its members;

b) to expand its reach; and

c) to develop new contracts.

Even with credible exchange management – and implementation of (probably Internet-based) technology and adequate 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.

One easy way for the exchanges to make themselves more visible is to improve their price dissemination by:

2) distributing these price data also to all newspapers.

As a further element in their marketing strategy, exchanges should prepare reports which explain the use of the exchange by various groups, eg. farmers, processors, banks, pension funds, etc. 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. Given that these materials strongly overlap between exchanges, it would be the most effective if these materials were developed in cooperation among the exchanges.

To better serve their members, exchanges should also prepare reports which analyze the relationship between the futures market and the underlying physical market - e.g., basis developments or seasonal tendencies.

Exchange should provide comprehensive training programmes to their staff, their members and end-users (the customers, the farmers, the producers and similar entities). The potential exists to develop these markets into the fund management communities, just as has been the case in more sophisticated Western markets.

Training for staff should encompass exchange executives as well as exchange members. One of its key functions should be to create a better understanding of the need for proper trade execution, reporting, etc., if exchanges are to expend their volumes. Exchanges should also train their staff in specialized skills, such as surveillance, so that they are able to detect threats to market integrity.

Exchange staff needs to be able to analyze possibilities to introduce new contracts, and if deemed feasible, elaborate contract specifications. This makes it possible that decisions on which commodity contract to trade are left to the exchange, and not taken by the FMC. The Exchange authorities will have an interest in coming up with the contract with the best liquidity potential. Competition among exchanges will be healthy as they seek to attract the greatest number of market participants as exchange members or non-members.

In a context of privatization and liberalization, and government intervention in agricultural marketing which will be more and more constrained by WTO rules, it is important for India to develop modern, efficient commodity exchanges. Because of the extremely fast developments in technology, the most efficient way of trading and reaching the public is now electronic trade, and more specifically, despite lingering doubts about system security, Internet-based trade. These technology-driven developments will certainly not bypass India: the country’s skills in computer technology are too wide-spread, its telecommunications policy has been improving fast, and its population (even on the countryside) has been happily embracing new communication systems.

Most new exchanges created over the past decade have chosen for an electronic trading system. Even small, relatively young and rather poor open outcry exchanges (eg, those in Eastern Europe) are now converting their system to electronic trade. The large and well-established exchanges where for a long time, the vested interest of the floor trading community blocked a change in the system are now going electronic, and are doing so very fast. New electronic commodity exchanges are sprouting up each week (see box below). This is a development that has taken many industry insiders and observers by surprise, and India’s exchange management and members are certainly no exception in having difficulty with the speed of change.

The new trading systems are cheaper, faster and safer than the traditional open-outcry system. And the barriers to creating new electronic exchanges have all but fallen away. The traditional exchanges risk to be borne away by the momentum of technology unless when they radically change their business paradigm. They will particularly need to consider giving up their own identity, and become part of a larger venture. Unfortunately, the exchanges’ moves to create their own clearing houses/departments rather than share in one common clearing house does not give much reason for optimism in this regard. Exchanges will need to catch up, and simultaneously make up for decades of forced inaction (a time in which in the western world, single commodity exchanges merged and entered into financial futures trading) and for the recent years of rapidly changing exchange technology.

The type of gradual process of mergers common in the United States and Europe during much of the second half of the 20th century now is too slow. For the FMC, which approves exchanges and the contracts they can trade, this poses a particular dilemma. On the one hand, it would be unfortunate to lose the skills and contacts to the commodity sector that are vested in the traditional exchanges. On the other, it is in the interest of the commodity sector at large that a more efficient futures industry is developed. It should also be clear that FMC cannot be expected to repress the natural pressure for development that will come from private sector groups just to protect the existing exchanges.

What are the conditions for success for a national commodity exchange?

• The people involved need to be dynamic, not driven by narrow self-interests, and need to control sufficient finance; they also need good client contacts.
• The technology used needs to serve trading needs, and has to enable access to clients.
• The regulatory framework should not be unduly restrictive in terms of trading and client access; but it needs to inspire confidence.
• The production, trade and pricing of the underlying commodities need to be reasonably free of government interference.

None of the traditional exchanges is currently in a state which would allow it to set up a national exchange by its own. If the major exchanges were to intensify their cooperation, and in particular, integrate their clearing operations and stimulate their brokers to enter into alliances with the member-brokers of the other exchanges, then they would have a good basis for creating a national exchange. However:

• This would require a new mindset and, in effect, a fairly radical paradigm shift from the management and members of the exchanges;
• Most of the brokers of the traditional exchanges are not yet ready to create nationwide alliances;
• The traditional exchanges are not necessarily in a good position to raise the funds necessary to set up an integrated national exchange;
• The resulting entity may not yet be well-placed to attract important new users, such as large corporates, investment funds and foreign firms.

An alternative scenario would be for entities currently not involved in the commodity futures industry (eg, large, well-capitalized corporates, banks, warehousing companies, stock exchanges) to set up a new exchange, to attract new users and wean part of the users of the traditional exchanges away by superior performance and lower costs.

While there is clearly interest from such investors in creating a national exchange, despite optimistic forecasts of market turnover, it is not evident that they will be successful. It is often very difficult to attract new users to a market: the market will only be truly useful if it is sufficiently liquid, so until it is liquid, many potential users will stand on the sidelines. Moreover, hedgers as well as speculators tend to go for liquidity, and ease of use and safety come second. The Indian experience with the two pepper futures markets shows that hedgers and speculators will not easily migrate to a new, better market. Such a new venture is most likely to be successful if the government decides to allocate important new contracts to such a new exchange (eg wheat, sugar, oil products, or financial futures).

The preferable way forward would be for a new, capital-rich entity to incorporate, in one way or another, the existing exchanges. It could entice some of the key members of the existing exchanges to take part in the new exchange, or it could incorporate old exchanges as a whole. The could be done on a management basis, with the new exchange signing agreements with the old ones under which it will provide them with certain services (eg, enabling trade in their contracts through a national network, clearing, promotion), on a profit-sharing basis (eg, on the basis of volume increases).

In conclusion, FMC should stimulate and facilitate the development of a national commodity exchange by large, creditworthy entities. But given the difficulties in reaching the many potential users of commodity futures contracts, FMC should encourage the existing exchanges to be part of such a new scheme. In return for giving up part of their corporate identity and their "goodwill" with those currently hedging and speculating in commodity markets, the exchanges and their members would gain access to national markets, strong credit ratings, and top-level technology. Exchanges that are not willing to make this step should be allowed to continue trading, but under proper regulatory standards, which ensure both market integrity and customer protection.