This report is based on field visits to East India Cotton Association (EICA), Mumbai; the Domestic and the International Commodity Exchange Division of the India Pepper and Spice Trade Association (IPSTA), Kochi; Coffee Futures Exchange India Limited (COFEI), Bangalore; International Castor Oil Division of the Bombay Oilseeds and Oils Exchange Limited (BOOE), Mumbai; and the SOPA Board of Trade (SBOT), Indore. We are most grateful to the chief executives, officials and members of these commodity exchanges.

This report is also based on extensive discussions with policymakers and regulators, and potential users of commodity derivatives contracts. We gratefully acknowledge the co-operation of officials of the Forward Markets Commission (FMC), Ministry of Consumer Affairs and Public Distribution, Ministry of Agriculture and Co-operation, Department of Economic Affairs, the Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI), the National Bank for Agriculture and Rural Development (NABARD), National Association of Warehousing Corporations and the National Association of Food and Civil Supplies Corporations. Their suggestions have been most valuable towards the formulation of the recommendations included in this report.

The assistance provided by the Indian Institute of Technology, Chennai, and Rinsy Ansalam in extensive modelling and stress testing is gratefully acknowledged. CommodityIndia.com and Foretell Capital Trust provided commodity price data for the modelling. Their assistance is gratefully acknowledged. We are grateful to the Office for Futures and Options Research at the University of Illinois, Urbana-Champaign for comments and feedback.

This consultancy report to the Forward Markets Commission, Government of India and the World Bank on the Guidelines for Clearing House Ownership, Operations and Bye-laws is aimed at strengthening the clearing and settlement process in the commodity exchanges in India. The consultancy assignment has six purposes.

Purpose 1: To upgrade and strengthen the clearing functions of the commodity exchanges so that the clearing functions are streamlined, trades are guaranteed and clearing functions help in improving the confidence of market participants and thereby improve the breadth and liquidity of markets.

Purpose 2: To work towards having one or a limited few clearing houses that clear and guarantee the contracts traded in several commodity exchanges.

Purpose 3: To evolve a system of margins and methods of its payment for the clearing operations.

Purpose 4: To have an action plan to move from the present system to a new system in a phased manner to be accomplished over next one or two years, including the phasing and steps to be taken in each phase.

Purpose 5: To strengthen the capacity of the FMC to assess the quality of clearing house operations and practices by the commodity exchanges.

Purpose 6: To hold a workshop where the necessity and importance of clearing is put across and the action plan can be explained along with the role of various functionaries and institutions in this process.

The report addresses five of the six purposes. The workshop conducted in New Delhi between February 7 and 9, 2000 discussed the action plan. The role of various functionaries and institutions in the clearing and settlement process was explained.

This report is aimed at commodity exchanges; members of commodity exchanges; prospective members of exchanges; prospective members of clearing houses, including banks and financial institutions; and the FMC. The specific objectives of the consultancy are listed in Annex 1.

This consultancy was carried out as part of the joint programme of the World Bank and the Government of India for improving the functions of commodity futures exchanges in India. The 1996 World Bank report, Managing Price Risks in India's Liberalised Agriculture: Can Futures Markets Help?, evaluated Indian agriculture futures markets. The World Bank report acknowledges India's long experience in operating and managing commodity futures markets. It notes that restrictive policies have not provided India's agriculture futures market a chance to contribute to price risk management and discouraged them from upgrading their institutional capabilities.

In our field visits and in our discussions, policymakers and decision-makers in the central and state governments reinforced such an evaluation. Their evaluation as well as that of potential users is that Indian agriculture futures markets lack the necessary capability to support large scale hedging.

The World Bank and policymakers in India have recognised that the inadequate capability to support large scale hedging stems from the vulnerability of futures open interest to systemic risks induced by contracting parties or participants of the commodity exchanges in India. Systemic risks, a combination of credit risk and liquidity risk, have an adverse effect on the capability of commodity exchanges to support large scale hedging. Such an effect is not confined to the Indian markets. However, when Indian agriculture markets become more open to the global supply and demand functions, the impact of systemic risk would be more pronounced. Therefore, to provide India's agriculture futures market a chance to contribute to price risk management it is necessary to equip them with the capability to manage systemic risk so as to support large scale hedging.

The institutional improvement of India's agriculture futures market has received focussed attention since 1993 from both policymakers and regulators in India. The Kabra Committee Report (1994) and the World Bank Report (1996) are widely regarded as the principal sources for policies aimed at the rapid modernisation of the agriculture futures markets.

The World Bank has played a vital role in enabling commodity-intensive developing economies to continually effect institutional improvements to manage volatile commodity prices. Commodity-intensive economies have used a variety of policies and instruments to manage volatile commodity prices. The use of policies aimed at production and buffer stocks has dominated the use of market-based instruments in developing economies. Such policies have usually required budgetary outlays by the governments of developing economies. In contrast, market-based instruments such as commodity futures, futures options and swaps have dominated the approach to price risk management in the developed economies. Empirical evidence gathered over the last three decades shows that market-based instruments are more flexible, effective and efficient compared with policies aimed at production and stocks in managing price risks.

The World Bank has initiated several programmes aimed at propagating information pertinent to the management of price risks using market-based instruments. The flexibility, effectiveness and efficiency of these instruments have motivated these efforts. The World Bank has continually evaluated the need for polices and programmes aimed at expanding the use of market-based instruments where such usage is expected to be more cost effective than other budget-based instruments.

Clearing and settlement operations constitute one of the many components identified by the World Bank and the Government of India as critical to the modernisation programme. The other components include commodity exchanges' rules and regulations, trading procedures, delivery system, trade supervision, regulation and monitoring, and promotional and development activities. The successful pursuit of these comprehensive components is expected to have a favourable impact on the confidence of users and potential users with a favourable impact on liquidity of futures contracts. The focus of this report is on clearing and settlement operations aimed at mitigating systemic risk. The action plan, principal recommendations pertaining to the establishment of a central clearing corporation and a brief discussion of the recommendations follow. The action plan is based on visits to some of the commodity exchanges and discussions with policymakers and regulators; it is aimed at the listed purposes.

The action plan comprises major policies, supporting policies and principal processes that should be addressed and enunciated by the Government of India and the FMC.

While the existing commodity exchanges and their affiliated clearing houses provide very valuable insights towards structuring institutional processes aimed at supporting large scale hedging, they are characterised by serious inadequacies pertinent to financial resources and human resources. Clearing institutions offer efficiencies of a large magnitude in the containment and mitigation of credit and liquidity risk. However, investments in financial and human capital are necessary to tap such efficiencies. Investments in these usually follow a step function and have to be in excess of a nontrivial minimum at each stage of evolution. Therefore, these investments offer considerable economies of scale and scope. The Indian economy is very large and needs significant capabilities in clearing and settlement. Fragmentation of such capabilities would not be optimal. Concentration of these capabilities would be optimal and the size of the Indian economy can support a large central commodities clearing corporation.

This report recommends the establishment of one central commodities clearing corporation. It is referred to as the National Commodities Clearing Corporation of India Limited (NCCC) in this report. The proposed NCCC has seven principal objectives.

Principal Objectives of the NCCC

The seven principal objectives that have influenced the structure of the proposed NCCC are listed below.

1. To have the necessary capabilities to clear and settle open interests of a very large magnitude, i.e., facilitate large scale hedging.
2. To enable existing commodity exchanges regardless of their technological sophistication to have access to reliable and cost effective clearing and settlement processes based on formal novation and complete clearing.
3. To have the necessary capabilities to provide clearing and settlement for contracts executed on the proposed national multi-commodity exchange (NMCE).
4. To enable commodity exchanges and clearing members to exercise control over the clearing institution's policies and processes.
5. To have a structure of netting and payments that is unambiguously immune to a payments contagion.
6. To enable vigorous capital efficiency.
7. To support risk-based provision of supplementary resources aimed at managing default.

Principal Features of the NCCC

Ten principal features are recommended for the NCCC. These are aimed at achieving the principal objectives. The recommended features are listed below.

1. The NCCC should be an independent clearing institution owned by commodity exchanges including the NMCE.
2. The NCCC should be a for-profit organisation. Its general structure and profit orientation should reflect the London Clearing House (LCH), the FCCCI and the PCCCI and the clearing house division of COFEI. The NCCC may be established by merging the interests of commodity exchanges and clearing members in the FCCCI, the PCCCI, the EICA, the SBOT and COFEI.
3. It should have a base capital of at least Rs.1.4 billion. The base capital would be adequate to support large scale hedging of almost all agriculture produce except food grains, pulses and dairy products.
4. Clearing members should contribute to more than 60 percent of the NCCC's equity and should provide risk-based resources aimed at managing default.
5. The NCCC should enable commercial banks, co-operative banks, co-operative societies and financial institutions to participate in the equity and clearing activities.
6. Warehousing companies should invest in the equity of the NCCC in order to bring about synergies and tight communication in respect of the market for physicals.
7. The netting system should be based on formal novation and complete clearing in order to conserve the capital of clearing members.
8. Contract and payment netting at the level of clearing members should enable clearing members to remain liquid and solvent to support the needs of commodity exchange participants. This would minimise the probability of a payments contagion.
9. Commodity exchanges should engage in decentralised credit and liquidity risk management in order to prevent overflow of any contract or payment crisis from spreading to another exchange through common clearing members.
10. The NCCC should position itself to take advantage of innovations in banking, money settlement and warehouse receipts systems.

The definition of futures contracts recognises contractual obligations as a combination of two distinct components. They are distinct but not independent. Futures contract is a contractual obligation for the long (the buyer) to buy at a future date at a price determined at the contract's inception. The seller is not specified. A futures contract is a contractual obligation for the short (the seller) to sell at a future date at a price determined at the contract's inception. The buyer is not specified.

A futures contract cannot be simplified into an obligation between counterparties to make a future-dated exchange at a price determined at the contract's inception. This is the most important reason why futures contracts are settled through novation where a clearing house is the common counterparty that emerges because of novation.

Futures contracts are standardised contracts. In a futures contracts the contracting parties negotiate only the price. Quantity, quality and the time of delivery are standardised by the exchange on which the futures are listed for trading. The components of standardisation are made known to the participants of an exchange by the exchange through contract specifications. Standardisation is not the sole or principal distinction between forward and futures contracts. Internationally, the definition of futures contracts assumes the elimination of counterparty risk. Elimination of counterparty risk is achieved through the process of novation and the interposition of the clearing house as the common counterparty.

For the buyer and the seller to perform independently and yet enable sellers and buyers to reap the benefit of contracting, the risk and the outcomes of their default need to be managed. Clearing houses are institutional arrangements aimed at the management of non-performance. Exchanges that adopt complete clearing lower the probability of non-performance of buyers and sellers and mitigate losses. The global record of successful management of non-performance is largely due to the internalisation of information and incentives obtained when a clearing house offers performance guarantees. Exchanges choose to have institutional arrangements such as clearing houses aimed at managing the outcomes of non-performance.

Clearing is the process of reconciling and resolving obligations between buyers and sellers. If clearing is reliable, buyers and sellers can buy from and sell to any seller and buyer most efficiently. Settlement follows clearing. It is the last step of the clearing process and extinguishes the obligations between buyers and sellers.

Direct clearing systems feature bilateral contracts with terms specified by the counterparties to the contract. Exchanges relying on direct clearing systems chiefly serve as mediators in trade disputes. Direct settlement involves the bilateral reconciliation of contractual commitments. Direct settlement is obtained through delivery or by offset between the original counterparties. Direct settlement has some disadvantages. It may lead to the accumulation of substantial losses as maturity of contracts increases. The failing counterparty has incentives to gamble in hopes of resurrecting net worth. This further increases credit risk.

Direct settlement limits settlement to the original counterparties. This is particularly important in the case of contract offset because the ability to obtain direct offset depends on the joint interests of both counterparties.

Ringing settlement involves netting of numerous claims and counterclaims. It applies the principles of multilateral netting and facilitates contract offset by increasing the number of potential counterparties. Ringing settlements reduce counterparty credit risk by reducing the accumulation of dependencies as contracts are offset. Ringing settlements also lower the cost of maintaining open contract positions, chiefly by lowering the amount of required margin deposits. Exchanges employing ringing methods generally adopt a clearing house to handle payments.

Ring settlements are arrangements between three or more counterparties having an interest in settling their contracts. Incentives to enter a ring stem from reduced exposure to counterparty risk and from reductions in the cost of maintaining open positions. To achieve these benefits, participants in a ring are required to accept substitutes for their original counterparties. The change in the identity of the original counterparties is referred to as novation. Some commodity exchanges in India have adopted rules and practices that facilitate ringing settlements thereby enabling access to those benefits.

Consider four parties having positions in a contract requiring delivery of five tons of sugar in a month's time. A sold to B at Rs.14/kg; B sold to A at Rs.13.30/kg; C sold to B at Rs.13.58/kg; and D sold to C at Rs.13.02/kg. Rules enabling settlement through rings must provide finality for all offsets arranged through rings. Referring to the above example, finality is obtained when neither B nor D can enforce a claim against C should their substituted counterparty fail to perform. Some commodity exchanges in India have not clearly intended finality.

To facilitate ring settlements, exchanges have adopted centralised mechanisms for payments and deliveries. These arrangements perform like bank clearing houses. Counterparties realising a loss following a ring settlement submit a record of their offset contracts along with a suitable payment (by cheque) to the clearing facility. These offset contracts are matched with the offset contracts submitted by counterparties realising gains. The clearing house credits a clearing account in the amount of payments received and debits this account when it disburses payments to counterparties realising gains. Deliveries are made by passing delivery orders to the clearing facility that then passes them to parties taking delivery. Clearing fees are usually included in the transaction fee.

Complete clearing interposes the clearing house as counterparty to every contract. This measure ensures that contracts are fungible with respect to both the underlying commodity and counterparty risk.

Novation is achieved through a third party mechanism that interposes itself between the seller and buyer of a futures contract leading to the elimination of counterparty risk. Such elimination is usually accomplished by the presence of a clearing house and processes employed by it to be the counterparty in all futures contracts traded on an exchange. The clearing house in such cases has an explicit role; the nomenclature alone is insufficient to determine whether the clearing house plays a role in novation and the resultant mitigation or elimination of counterparty risk. Several alternatives are available to accomplish novation.

Novation and the resultant reduction or total elimination of counterparty credit risk has a significant influence on the willingness of participants to trade futures contracts. The main component of the first purpose - improving the confidence of market participants and thereby improving the breadth and liquidity of markets - is related to both standardisation and the elimination of counterparty credit risk.

Complete clearing interposes the clearing house as the counterparty to each side of every exchange-traded contract. Contracts agreed to on the floor of the exchange and accepted for clearing require the clearing house to take the buy side of every contract to sell and the sell side of every contract to buy. This role substitutes the credit risk of the clearing house for the credit risk of individual counterparties. Thus, contracts exchanged in a complete clearing system are completely fungible: grade standards imply that commodities underlying contracts are the same and complete clearing implies that all contracts have equivalent credit risks. Futures contracts have all these intended properties.

Novation and the resultant reduction or elimination of counterparty credit risk are in the interests of commodity exchanges; such elimination of counterparty credit risk gives exchanges and participants an opportunity to trade without having to continually assess the risk that a counterparty would default on its obligations.

Novation and complete clearing enables all participants to pay attention only to the risk that the third party or common counterparty - the clearing house - would default on its obligations. The joint and simultaneous assessment of the risk that a clearing house would default on its obligations is of significance to participants, members and the commodity exchanges. Breadth and liquidity are always in the best interests of a commodity exchange.

While enlightened self-interest is more than sufficient to achieve standardisation, it may not be sufficient to influence a commodity exchange to adopt novation and complete clearing for the elimination of counterparty risk. In the absence of competition among commodity exchanges for listing and trading a commodity contract, all economic users of that commodity and the commodity contract would necessarily have to patronise the exchange that lists and trades that commodity and the commodity contract. Having accomplished the spatial and temporal concentration of all potential participants, the commodity exchange enables most participants to assess the bilateral risk that one or more participants may default on obligations.

The failure to adopt novation and complete clearing may not necessarily be a result of the exchange's failure to pursue its self-interest. The creation of an institutional process for complete clearing requires nontrivial financial and human resources. Small exchanges that earn small revenues through small trading volumes may find it more attractive to pass by or postpone any decision aimed at establishing a framework for novation and complete clearing. They and their members may find it more economical to restrict their attempts at containing default risk by collegial and informal processes. This low cost approach to the containment of default risk imposes no particular disadvantage on a commodity exchange that (1) enables all potential participants to assess one another and (2) faces no threat of competition from other exchanges whereby some or all existing members may migrate to the competing exchange(s).

Trading, clearing and settlement constitute the three important components of the commodity markets. Trading has typically occupied the prime spot in the regulatory environment in India. Such a focus has been reflected in the rules and regulations of commodity exchanges. However, the other two components - clearing and settlement - have a very significant role to play. Unreliable clearing and settlement militate against the success of trading systems and trading institutions. The streamlining of clearing and settlement system, as we see it a from a total system perspective, is necessary in order to increase the reliability and success of trading institutions. The reliability of global trading institutions or exchanges has over the last 25 years been increasingly predicated on the robustness of clearing and settlement institutions.

A systems view is essential to appreciate the importance of the three principal components and the sub-components. The principal functions classified under trading, clearing and settlement are given below (Table 1). It may be observed that a large number of critical functions are performed by the clearing and settlement system. A few functions are common to the systems. Given the common functions and the large number of critical functions that are performed by the clearing and settlement system, it may be seen why the specification, streamlining and regulation of clearing and settlement have come to the fore over the last 25 or more years.

The success of exchange-traded contracts results from the efficiency, transparency, speed and security of three components of the composite system - trading, clearing and settlement systems. Each component has its own role in determining the success of commodity contracts and in achieving the economic objectives of listing and trading commodity futures contracts and futures options contracts.

Netting is the principal step towards the creation of economies of scale in the context of contractual obligations among market participants. Netting may be applied to monetary obligations and asset obligations. Netting creates economies of scale in the case of single commodity exchanges. It creates economies of scale and economies of scope in the case of multi-commodity exchanges.

Registering futures transactions between counterparties is an important first step before any netting methodology is applied. The application of a netting methodology consolidates the obligations of registered transactions between counterparties. The manner in which obligations are consolidated determines how gross obligations existing between counterparties are simplified. Every gross obligation between counterparties is a source of risk and a component of cost. The lowering of risk and cost related to the management of outstanding futures obligations is a function of the process of consolidation.

Netting can be accomplished in one or more forms and the effect of netting is dependent on the chosen netting arrangement. In any case, netting is applicable only to like transactions and obligations. The objective of netting is to enable counterparties to meet obligations through one single payment and one single delivery of the like asset defined in the contract. The method of netting determines if there is a single payment and delivery between each pair of obligated counterparties or one single payment and delivery for each obligated counterparty and participant.

Distinctions between types of netting extend to the number of counterparties involved in the simplification process. In bilateral netting, the payment or contractual obligations is simplified between pairs of counterparties. The principal economies resulting from bilateral netting are reductions in the cost of making payments and reductions in the opportunity costs associated with maintaining margin or collateral deposits. Margin or collateral deposits are maintained by futures markets participants to proactively provide for the costs of default. Bilateral netting also results in the considerable reduction of risk.

The role of a clearing house is often illustrated in a three-party situation. We have presented most of the issues related to netting and the establishment of clearing houses through a two-party setting. However, a three-party setting is used to demonstrate multilateral netting. The two counterparties in the examples that follow, A and B, are not bound in the bilateral relationship by choice; they happen to be counterparties because of commercial compulsions.

Example 1: If A owes B Rs.15 and B owes A Rs.20, their obligations can be completed by making the respective payments. If payment transactions are cumbersome and costly, a cost reduction and an increase in convenience are obtained by netting the two due amounts. In this example, netting is possible since the two monetary obligations are in the same currency unit. In all other examples that follow, payment obligations are in Indian rupees and are, therefore, amenable to netting.

This payment netting allows A and B to complete their respective obligations on payment of Rs.5 from B to A. Results similar to this are common in futures markets where one counterparty receives and another pays without any corresponding exchange of an asset at the time of mark-to-market.

There is risk reduction in this netting arrangement. It avoids default by A after B pays Rs.20; it avoids default by B after A pays Rs.15. It reduces the risk to Rs.5 that is payable by B to A. A faces this risk; B faces no further risk. To eliminate the potential for default, A and B could make independent payments of Rs.15 and Rs.20 respectively to a third and common party that is creditworthy and then receive Rs.20 and Rs.15. The third and common counterparty may be regarded as the clearing institution. Such flows are common in payment-versus-payment (PVP) systems. Both A and B would have to accept the creditworthiness of the third party ex ante and perhaps endow upon it the necessary creditworthiness if other counterparties were evaluating the credit risk and liquidity risk of A and B.

However, it is not necessary for A and B to share the same intensity of purpose in the creation of the third and common counterparty. In fact, they would not share the same interest and intensity of purpose. Netting and the introduction of third and common counterparties introduce new asymmetries where none existed earlier. The financial collapse of the third and common counterparty after A made the payment but before B does would allow B to save Rs.20. The financial collapse of the third and common counterparty after B made the payment but before A does would allow A to save Rs.15. The financial collapse of the third and common counterparty before any payment is made would allow B to save Rs.5. The financial collapse of the third and common counterparty makes B better off than it does A.

The above asymmetry is the result of the relative magnitude of risk introduced by A and B. Since B introduces more risk than A into the system (with or without netting) that involves a constructive role for a third and common counterparty, B stands to gain from the financial or organisational collapse of the common counterparty. In contrast, A does not introduce any net risk and stands to lose. The gross risk introduced by A is less than the gross risk introduced by B.

If B had the alternative to not perform, a characteristic of all futures contracts, B derives an unambiguous advantage from the collapse of the common counterparty. In such circumstances, as in this bilateral obligation where B introduces more gross risk and can default, B would prefer to commence the commercial relationship with A and the common counterparty with a 50 percent or 50:50 ownership along with A of the common counterparty. The financial collapse of the common counterparty, even if it were merely a special purpose vehicle, would impose more costs on A than on B.

Therefore, A would be more interested than B in the structure of the third and common counterparty and its institutional continuity since A faces a payment risk while B faces no risk but can opportunistically choose to not perform. A's dependence on the third and common counterparty's expeditious treatment of dues would be significant if A owed C Rs.5 in some other bilateral transaction but depended on the receipt of Rs.5 to complete the payment. Any delay in the processing of payments by the third and common counterparty would force on A an involuntary default. As the net recipient, A would be quite interested in the expeditious processing of payment obligations and also interested in a payment system that enabled A to receive Rs.5 from the third and common counterparty and to pay C Rs.5.

There are many other possibilities in this example that requires two parties to make unequal payments to one another simultaneously. If temporal shifts in the redemption of obligations are introduced, the magnitude of risk to be borne by the counterparties changes adversely. However, with this simple bilateral obligation chain, we have introduced some useful constructs such as the third and common counterparty and alerted participants in and regulators of the Indian commodity markets to the asymmetric interest that counterparties would have in the structure of common counterparties.

We have also identified A as the counterparty that has more interest than B in the expeditious processing of obligations and effecting payments. The existence of such interest in payments is the basis for PVP systems and real time gross settlement (RTGS) systems. PVP could be used in single-currency obligations and multiple-currency obligations.

A introduces less risk than B does but has more at stake in the efficient, effective and risk-free functioning of the common counterparty. The asymmetry in the outcomes of credit risk introduced by A and B would be eliminated if B were required to invest in proportion to the risk that is introduced. This method of reducing asymmetry is not new. Margins are usually stipulated on the basis of risk introduced by counterparties. If the common counterparty were an institution independent of A and B and had its own financial resources, it would require B to deposit more margin than A to utilise the services of the common counterparty. If the common counterparty were to be established by A and B, even if for a temporary purpose, the financial stake could reflect the ratio of gross risk introduced by A and B, that is, in the ratio of 15:20. However, since A has a net inflow there may be a preference for a ratio based on net obligations and net risk. B may resist such a move. In this example, the ratio is lopsided (0:5) since it is bilateral. In a multiparty example, it would not be lopsided. The basis for capitalising clearing houses and the setting of clearing limits based on financial net worth are principal issues that need emphasis while establishing a framework for clearing in India.

These inferences are influenced by gross obligations and gross risk and the method of netting adopted to simplify obligations. The principal input to credit risk management protocols is the measurement of gross and net risk introduced by counterparties. Methods of netting play a nontrivial role in mitigating credit risk. More importantly, methods of netting have a nontrivial impact on liquidity risk.

Example 2: In contract netting between two bilateral counterparties, the asset side of the contract is considered along with the payment side. The asset side reckoning is applicable to like assets and permits no departure in any manner. Suppose A owes B Rs.15 for the purchase of 3kg of salt and B owes A Rs.20 for the purchase of 4kg of salt. If the payment side was handled in two gross parts, and the asset exchange side was handled in two gross parts, there would be four steps towards extinguishing the obligations. The risk would be considerable.

Bilateral netting can be effected on both the payment and asset side with the objective of reducing risk. The bilateral netting process would require A to deliver 1kg of salt to B and a payment of Rs.5 from B to A. This obligation requires simultaneous delivery of salt and payment of Rs.5. If the price of salt fell below Rs.5/kg, B would have an incentive to default. If price of salt rose above Rs.5/kg, A would have an incentive to default.

A and B could use a system of delivery-versus-payment (DVP) to exchange value and asset through a third and common counterparty. The role of the third and common counterparty would have to ensure that simultaneity is achieved where possible and default risk is discouraged where necessary. Ex ante, both A and B would have a significant interest in the expeditious processing of obligations since the price of salt could fluctuate up or down. This example emphasises the need for common counterparties to use high-speed equipment, say, computer, to process obligations. The example also points to the need for keeping salt in a state where it can be delivered to the common counterparty in a contemporaneous manner to match the payment. Commodity warehouses could operate along with common counterparties to effect DVP.

Example 3: If B owes A Rs.20 for the purchase of 3.8kg of salt, and A owes B Rs.15 for the purchase of 3kg of salt, A delivers 0.8kg of salt and B pays Rs.5 on the specified date after bilateral netting. This example reckons with two different prices of salt in the two contracts. Different prices are a feature of most futures marketplaces for the same underlying asset and for the same delivery date. The differences are driven by the time at which the contracts are entered into.

Example 4: If B owes A Rs.20 for the purchase of 3.8kg of salt, and A owes B Rs.15 for the purchase of 3.8kg of salt, A has no obligation to deliver any salt but B is obliged to pay Rs.5 on the specified date after bilateral netting. This example is similar to the preceding example but the bilateral netting produces results that are identical to the first example. This example reckons with intense volatility of price of salt, a feature that futures and options marketplaces and clearing houses are required to manage all the time.

The return to a state of netted obligation that is identical to that of the first example is intentional. Both hedgers and speculators achieve a significant part of their hedging and speculative objectives by closing out obligations at or before expiration of futures and options contracts. Such closing out is of course voluntary. Upon closing out or offsetting a long position with a short position in the same commodity and contract month, only the payment side remains. The management of credit risk and liquidity risk under the circumstances would then have to reckon with the hypothesised outcomes and suggestions included in the first example.

Example 5: If B owes A Rs.20 for the purchase of 4kg of salt and A owes B Rs.15 for the purchase of 2kg of silt, the payments side alone may be netted if A and B so desire. The asset side cannot be subjected to netting. This example captures a situation that is more likely to obtain if two or more single commodity exchanges choose to adopt common clearing. Common clearing indicates second order centralisation. Second order centralisation involves the establishment of a few clearing institutions that can clear and settle futures contracts traded on several commodity exchanges.

The obligations in this example may be met in one of several ways. The monetary side could be handled through PVP or through a net payment of Rs.5 by B to A. Salt and silt transfers could be effected through delivery-versus-delivery (DVD). A and B would agree to the PVP or the net payment only if the DVD could be supervised by and assured by a creditworthy third and common counterparty. Such an acceptance is more likely if the salt and silt were certified and stored by the same warehouse. If the PVP or the net payment is effected successfully and the DVD fails, B is exposed to risk. If the DVD is effected successfully and the PVP or the net payment fails, A is exposed to risk.

The obligations may also be met as two independent DVP tasks. The choice of PVP-cum-DVD or two DVPs would be determined by the creditworthiness of a common counterparty. It would also depend on the existence of warehouses that certify and store salt and silt. If one of the two commodities were not amenable to such treatment, it is likely that either A or B would not accept to PVP or net payment.

This example shows that netting efficiency in payment cannot be disassociated from processes aimed at effecting delivery of assets, especially commodities. Netting efficiencies are predicated on the reliability of physical transfers of commodities. Common clearing or the utilisation of one clearing house would enable netting of payments or PVP. However, for participants to have confidence in the netting of payments or in PVP, cost effective asset transfers that are contemporaneous with money settlement are a prerequisite. This example also shows why it is necessary for the FMC to focus on warehousing and warehouse receipts in order to take advantage of the dormant economies of scale and scope in clearing through netting.

If there are difficulties in achieving a system of cost effective asset transfers that are contemporaneous with money settlement, the FMC should encourage exchanges to pursue DVP in each commodity or DVD within an exchange or both such that at least some of the efficiencies associated with payment netting are realised. Payment netting contributes to more than 75 percent of the efficiencies that clearing houses generate in single-currency systems. In multiple-currency systems, payment netting contributes to more than 55 percent of the efficiencies generated by clearing houses.

A special case of the fifth example arises in the context of obligations pertaining to gur, potato and castor seed that are traded on two or more exchanges. An obligation to deliver gur in one exchange may not necessarily be amenable to offsetting against receipt of gur in another exchange. That makes the gur for delivery the equivalent of salt and the gur to be received the equivalent of silt.

The FMC should encourage exchanges to initiate and establish a programme for netting transfers of gur, castor seed and potato. This can be achieved through a common programme aimed at warehousing and the issuance of warehouse receipts. In our view, such a programme would also encourage the emergence of one or more exchanges for the trading of onion futures in India. The netting of commodities would support the netting of money settlements.

Multilateral netting is discussed next. Multilateral netting extends the economies and efficiencies by simplifying existing payment or contractual obligations across more than two counterparties.

Novation is the process and device that facilitates a higher order of netting. It involves the legal substitution of gross obligations by the net of these obligations, subject to a netting agreement. When obligations are simply netted, the obligations continue to exist. Even though the counterparties usually regard their obligations as being offset, a payment obligation may be restored on default of a counterparty to the net. Such restoration is indicative of the absence of legal provisions for netting.

On the other hand, when obligations are subjected to novation, the original obligations are extinguished by subsequent transactions that create new, consolidated obligations. Novation refers to the creation of new obligations. The benefit of consolidation through novation requires legal substitution of counterparties and a legally valid agreement among the original counterparties to accept and abide by the consolidation of obligations.

Since novation is based on the legal substitution of counterparties, it enables the substitution to have effect on all obligations included in the contract once novation is accomplished. Therefore, it is applicable to both monetary payments and the exchange of assets. Two examples follow. The immediately following example involves asset transfer. The succeeding example involves monetary payments that are amenable to netting.

Example 6: Consider two obligations in a multilateral netting scheme. The first obligation requires A to sell five tons of sugar to B, and the second requires A to buy five tons of sugar from C. By multilateral netting, the resulting obligation would require B to buy five tons of sugar from C, and A to do nothing. If there were no novation, if B does not perform on the settlement date, A is still obligated to buy five tons of sugar from C. This would be true even though A had no net obligation at the time of settling the two obligations.

If novation is valid, A's holding of a contract to sell five tons of sugar to B would be offset or cancelled by the purchase of a contract to buy five tons of sugar from C. This requires B to buy from C, and such a requirement should have legal validity at all times regardless of any default. A should have no need to perform any renewed obligations once the offset is effected and novation is legally valid.

The above example illustrates that the significance of novation increases when credit risk implications are considered. Novation creates a direct exposure for B from the new contract with C and a direct exposure for C from the new contract with B. B is now directly affected by C's failure to deliver sugar; C is affected by B's failure to take delivery of sugar or to pay. This exposure is involuntary since neither B nor C chose to trade with the other.

In this example of novation in a multiparty setting, B is directly affected by C's capability to perform the contract; C is directly affected by B's capability to perform the contract. This makes a material difference to the credit risk faced by B and C who had initially contracted with A but had no contracts with one another.

The resultant credit exposures arising from novation have important effects on the incentives to enter into a multilateral netting agreement. Creation of involuntary direct credit exposures reduces incentives to enter into a multilateral netting agreement. A direct credit exposure is the risk of loss owing to the operations of the counter party. The possibility that contract novation may assign an unsuitable counterparty will deter involvement with a clearing facility.

If the scope of novation is extended to create a common counterparty as in the first example given under bilateral netting, then neither B nor C is exposed to the credit risk of the other. The common counterparty is the clearing house in the context of futures and futures options contracts. Since B and C face the same counterparty, they both have an incentive, even if not equal, to accept the role of the common counterparty as an important risk intermediary and a facilitator. A too has an incentive to accept the role of the clearing house as a credit risk intermediary since it allows A to be free of all residual obligation upon the default of B or C. All residual obligation is that of the clearing house.

The introduction of the central and common counter party generally leads to the amelioration of problems associated with credit exposure and credit risk. If the common counterparty has a credit quality higher than that of A, B and C, all three counterparties derive significant benefit. None will object if all obligations among them are replaced by contracts with the central counterparty. If A, B and C can agree to create the common and central counterparty with higher credit quality, they all derive benefits.

Contracts requiring A to sell to B become contracts requiring A to sell to the central counterparty and B to buy from the central counterparty. Contracts requiring A to buy from C become contracts requiring C to sell to the central counterparty and A to buy from the central counterparty. There is no objection to this arrangement because each original counterparty buys or sells as originally intended, but does so with a common counterparty whose credit quality easily exceeds the participants credit quality. Thus A buys five tons of sugar and sells five tons of sugar, B buys five tons of sugar and C sells five tons of sugar. Their counterparty is the central counterparty or clearing house.

This explains why futures are contractual obligations for the long to buy. The selling counterparty is not specified. Similarly, futures are contractual obligations for the short to sell. The buying counterparty is not specified. This is the most important reason why futures markets settle buy and sell obligations through novation where the clearing house is the common counterparty that emerges because of novation.

Example 7: Consider a four-party setting in which six obligations remain to be settled. The six obligations have been determined after recording of transactions but before any netting (Table 2).

The number of payment flows (six at the beginning) and the value of funds to be paid and received drop consequent to bilateral netting from six and Rs.115 to five and Rs.85 respectively. Multilateral netting leads to a further decrease to one and Rs. 25. This example illustrates the efficiency gains that result from multilateral netting and novation. The cost of effecting payments falls. The inherent liquidity risk and credit risk decline significantly.

Novation causes a significant consolidation of obligations. However, it produces new counterparties who may have had no contractual obligations at the time of transacting. Novation produces very useful efficiency gains of a large magnitude but the gains come at a price. It requires counterparties to accept the credit risk of untested and unevaluated counterparties. In this example, C faces the risk of default by D. As in the example in which obligations to buy and sell sugar were novated, the introduction of novation and a common or central counterparty enables C to evaluate the common counterparty's credit quality. C does not have to be confounded or discouraged by the credit quality of D. In fact, the achievement of the efficiency gains in the effecting of payments and the mitigation of credit risk and liquidity risk are predicated not merely on the novation of obligations but on the interposition of the central counterparty.

Complete Clearing or Unconditional Guarantee?

In our meetings with policymakers in India, the importance of the interposition of the clearing house as the central and common counterparty was discussed. Such a discussion was based on the neutral position adopted by the L.C. Gupta Committee between (1) formal novation and the interposition of the central counterparty and (2) unconditional guarantee of performance by the clearing house. The L.C. Gupta Committee was constituted by SEBI. SEBI is the regulatory authority for the stock markets in India. Stock exchanges can choose either of the systems until the establishment of a central clearing corporation. The L.C. Gupta Committee has, however, mandated the implementation of full novation and the interposition of the clearing house upon the establishment of the central clearing corporation.

Full novation and the interposition of the clearing house produce efficiency gains and then formally eliminate all residual risk resulting from the default of counterparties who remain with consolidated obligations. The residual risk after formal novation is Rs.25. It is faced by C. The interposition of the clearing house imposes on the clearing house a residual risk of Rs.25. Though the value of the gross payments required to meet all the obligations is Rs.115 without any netting and Rs.85 after bilateral netting, the net residual risk declines to Rs.25. Such an efficiency gain is an important outcome of full novation and formal interposition of the clearing house. The common counterparty has at worst to deploy Rs.25 of own funds as collateral to guarantee performance to C. The cost of mitigating credit and liquidity risk is a function of Rs.25.

The system of unconditional guarantee by the clearing house permitted by the L.C. Gupta Committee and accepted by SEBI is not predicated on the legal acceptance of consolidation of obligations. The system of unconditional guarantee adopted by the BSE imposes an extraordinary cost on the clearing house. The clearing house faces a gross risk (since the guarantee is unconditional) of a maximum magnitude of Rs.115 without bilateral netting and Rs.85 with bilateral netting. Bilateral netting does not require any legal provision since it accomplishes netting without novation. We expect the legal system in India to assess the gross risk arising from the unconditional guarantee at Rs.85 or more. Multilateral netting would enable the gross risk to decline to Rs.25, which is the net residual risk, but it would not enable the clearing house to offer an unconditional guarantee. Multilateral netting is based on and gives rise to conditional circumstances. Hence, unconditional guarantee and netting beyond the level of bilateral netting are not compatible. A clearing house that chooses a system of unconditional guarantee has to deploy Rs.85 of own funds as collateral to guarantee performance to C or have an equivalent amount as margins from members though some members may have no net obligation. The cost of mitigating credit and liquidity risk is a function of Rs.85. A considerable amount of collateral efficiency is lost. This is avoidable.

A system of formal novation and the interposition of the clearing house as the common counterparty and a system of unconditional guarantee are both aimed at protecting counterparties from the credit risk of other counterparties. Full and formal novation backed by a clearing house of high credit quality improves the efficiency and acceptability of netting. The efficiency in managing residual risk and thereby the credit and liquidity risk is considerable. In contrast, the efficiency in managing systemic risk in a system of unconditional guarantee imposes a cost of large magnitude that is avoidable. Moreover, neither system can protect counterparties from credit risk and liquidity risk if the system has inadequate collateral. Providing collateral to a clearing institution that accomplishes full novation and legally valid interposition in order to manage residual risk rather than gross risk is easier and more efficient.

The adoption of complete clearing characterised by formal novation and the interposition of the clearing house as the common counterparty is recommended. The adoption is a prerequisite for sustaining open interests in a range of commodities. The adoption of complete clearing characterised by formal novation and the interposition of the clearing house as the common counterparty would require modifications to the Forward Contracts (Regulation) Act.

We draw attention to the fact that the Securities Contracts (Regulation) Act, an Act that is based on the Forward Contracts (Regulation) Act, has been amended to enable trading and clearing of derivatives. However, the Securities Contracts (Regulation) Act has not been amended to give effect to novation and the interposition of the clearing house. The amendment to the Securities Contracts (Regulation) Act stipulates the settlement of equity derivatives through a clearing house of the stock exchange in accordance with the rules and bye-laws of such stock exchange. The amendment does not specify novation and interposition. It also expects each stock exchange to have its own clearing house.

Since the Forward Contracts (Regulation) Act is the principal Act of the Government of India that deals with contracts for prospective performance, it would be most appropriate to amend the Act to cover novation and interposition by clearing houses, and the functioning and regulation of clearing houses. Futures, options and futures options are contracts for prospective performance. Regulations of the CFTC apply to both contract markets and clearing organisations. Similarly, the applicability of the Forward Contracts (Regulation) Act should be extended to commodity exchanges and clearing organisations. The amendment to the Act would lead to the sustenance of open positions and open interests.

Futures trading in gold is regulated under the Act. Banking institutions in India are expected to have a significant interest in trading gold and gold futures. Their participation in the gold futures marketplace is predicated on the availability of formal novation and the interposition of the clearing house as the common counterparty.

The costs imposed by settlement guarantee funds that skirt the issue of novation and interposition but offer unconditional guarantee are of a very large magnitude. Such a large magnitude of own funds of one or more sources may be inadequate to provide the necessary collateral for several single-commodity exchanges in India. It would also be unavailable in the case of a clearing house that is designed to clear and settle contracts traded on two or more exchanges. The temporary choice permitted by the SEBI-constituted L.C. Gupta Committee between complete novation and unconditional guarantee does not appear to be anything more than a Hobson's choice. There is no efficient alternative to full novation and interposition by the clearing house.

A system of settlement guarantee funds and unconditional guarantee may be appropriate though inefficient for an exchange that has assessed the direct costs and the dead-weight losses resulting from defaults. It would be quite inappropriate for a group of exchanges. Since each exchange has its own membership rules that are administered in a decentralised manner, each exchange and its members would be contributing to total systemic risk in different ways. This characteristic is common to all decentralised systems. In such a decentralised framework, it is unlikely that all exchanges that agree to second order centralisation, i.e., central clearing, would abide by any pecking order when there are two or more defaults.

Centralisation of guarantee against defaults ignores the decentralised action of exchanges, their members and customers of the members of the exchange. It also ignores their private interests and incentives of exchanges and their members. Efficient risk mitigation disallows any unwarranted mixing of centralisation of responsibilities and decentralisation of responsibilities. The presence of a centralised and unconditional guarantee, regardless of how unconditionally the guarantee is administered, takes away the incentive for individual commodity exchanges to undertake such of those actions aimed at controlling the introduction of risk into the central system. The FMC should discourage the emergence of situations characterised by moral hazard. The system of settlement guarantee fund aimed at providing unconditional guarantee to participants has been adopted by the BSE. Such a model is inappropriate in the context of second order centralisation. It is inappropriate even in the context of first order centralisation since it results in unwarranted inefficiencies.

Moreover, since there are only a few financially sound commodity brokerages in India, we expect the necessity of one or more commercial banks to supply own funds to act as collateral to support the mitigation of credit and liquidity risk. Banks are most unlikely to supply collateral to commodity exchanges and clearing houses that offer unconditional guarantees since their initial capital that acts as collateral is exposed unconditionally to complete liquidation. The method of netting and novation would determine the success of India's efforts aimed at the modernisation of its commodity exchanges and clearing houses. The determinants of choice of clearing facilities is discussed next.

Businesses, regulators and the general public determine the structure of clearing facilities and organisations. Preferences of businesses and market participants and regulatory policy have influenced the choice of clearing mechanisms. Public policy has seldom had a direct influence in the choice of clearing mechanisms.

Preferences of businesses and market participants are driven by the pursuit of cost effectiveness. It is rational for contracting counterparties to share incentives that are associated with the selection of clearing procedures that are cost effective. Costs considered by businesses and market participants usually include direct costs entailed in clearing their contracts plus any dead-weight losses incurred when contracting parties fail to perform. Dead-weight losses refer to costs imposed on one counterparty by another counterparty that has failed to perform.

Clearing involves the recording of obligations of each participant to other participants, netting of obligations by the adoption of one or more methods, and the settlement of obligations. Direct costs are related to the process of clearing. Costs related to margin and other collateral is one of the principal components of direct cost to participants. Dead-weight costs include the costs borne by a participant when a counterparty fails to perform or chooses not to perform.

Businesses and market participants would choose those clearing procedures that minimise the combined direct and dead-weight costs. Direct costs would be expended only if the pre-existing or potential dead-weight losses and the expected reduction of these losses justify the direct costs. Businesses and market participants would not incur direct costs if potential dead-weight losses or the expected reduction of dead-weight losses or both were trivial.

Clearing organisations permit centralised record keeping of obligations and the settlement of obligations; centralisation and concentration enable the emergence of scale economies. Clearing houses provide scale economies of a large magnitude in the management of risks associated with credit and liquidity. Since scale economies determine the raison d'être of a clearing house, the impact of scale economies on the components of total cost determine the structure and content of clearing processes. Direct costs respond to scale economies while dead-weight losses do not normally respond to scale economies. However, dead-weight losses are functions of the volatility of prices of assets that underlie trades among participants.

Dead-weight costs are also functions of the value of the alternative to not perform. If more participants valued the alternative not to perform, there would be more dead-weight losses and counterparties in general would be more willing to incur direct costs. Therefore, combined costs are direct functions of the number of market participants, and the number and complexity of traded contracts.

It is therefore reasonable to argue that as the number of contracts and participants increases, economies of scale and scope in clearing are likely to arise. Volatility of asset prices also drives the search for economies of scale and scope. The presence of and the need for these economies of scale and scope accelerate investment in the development of improved clearing facilities. Exchanges that face no competition from other exchanges may have little incentive to minimise combined costs if a significant part of the dead-weight losses can be opportunistically and asymmetrically imposed on some but not all participants. The opportunistic and asymmetric imposition of costs would deter many participants and lead to a loss of revenue to the exchange. If a commodity exchange were a monopoly, it would have no incentive to expand revenues through greater participation.

This characterisation leads to four propositions: (1) single commodity exchanges are unlikely to undertake investments in the development of improved clearing facilities, (2) commodity exchanges that attract only a small number of businesses and participants to trade are unlikely to undertake investments in the development of improved clearing facilities, (3) commodity exchanges that trade a single commodity whose price volatility is less than normal are unlikely to undertake investments in the development of improved clearing facilities, and (4) commodity exchanges that enjoy a statutory monopoly are unlikely to undertake investments in the development of improved clearing facilities. The four propositions are consistent with the proposition of Tsetsekos and Varangis (1997) and the empirical evidence presented by them.

However, there could be one or more exchanges that provide the exceptions to the set of four propositions. A single commodity exchange that trades a volatile commodity could benefit from investments in the development of improved clearing facilities, especially if it faces competition in the national market or global market or both.

The first futures clearing corporation that was incorporated in Chicago in 1925 had the objective of reducing credit risk and liquidity risk faced by participants in the commodity futures market. The period of incorporation of the Board of Trade Clearing Corporation (BOTCC) to undertake complete clearing of contracts traded on the Chicago Board of Trade (CBOT) coincided with the significant increase in the (1) number of participants, (2) number of commodities traded, (3) output of commodities and (4) volatility of prices. The date of incorporation also coincided with the initial years of regulatory oversight by the Grain Futures Administration (GFA) of the United States, a fact that is often misconstrued as the raison d'être for the BOTCC. Despite this synchronism, the innovation of the incorporation of the BOTCC and the guaranteeing of contract performance were the results of the efforts of businesses and market participants. The establishment of the BOTCC for performing complete clearing was not imposed on the CBOT by the exchange's regulators. Members of the CBOT had expressed interest in provisions to guarantee contract performance via an incorporated clearinghouse.

Regulatory policy was instrumental in the structuring of an institutional process aimed at complete clearing and the incorporation of a clearing house in 1972. However, the regulatory policy did not pertain to commodity futures. The CBOT had already incorporated BOTCC to provide complete clearing five decades before the pronouncement of any regulatory policy. The initiative for complete clearing and the incorporation of a clearing corporation came from the Securities and Exchange Commission (SEC) of the US in the context of equity options. At the time of the listing of equity options on the Chicago Board Options Exchange (CBOE) in 1973, only call options were approved by the SEC and listed by the CBOE. Put options were listed later. The CBOE was the first exchange in the world to list equity options.

The SEC quite correctly understood that call writers had an incentive to default on their obligations to in-the-money call holders, especially after receiving a premium from call holders at the time of selling calls. The value of the choice to not perform is not confined to futures. Such a value characterises options too but with an intensity that is considerably greater than in the case of futures.

First, prices of options are determined by several factors. The estimate of volatility of the underlying asset's price is one of the principal factors. Changes in the estimate of volatility magnify the volatility of the price of the option and thus enhance the value to call writers of the choice to not perform the option contract. The enhancement is greater in the case of American options than in the case of European options. Empirical evidence shows that volatility of options prices is of a very large magnitude compared with the volatility of futures prices. Therefore, option sellers are more likely to choose to default than futures sellers or buyers.

Second, call writers receive call premiums from call buyers at the time of selling calls to call buyers. If call writers choose not to perform after receiving the call premiums, the dead-weight losses borne by call buyers rise in magnitude. Futures sellers receive no premium from futures buyers; futures buyers pay no premium. The impact of dead-weight losses in the case of options is considerably more than in the case of futures. Expected dead-weight losses to option buyers and gains to option sellers are greater than the dead-weight losses to futures buyers and gains to futures sellers. The dead-weight losses include the premium and the opportunity loss resulting from the default by the counterparty.

The SEC, as the regulator of the equities and equity options markets, assessed the magnitude of dead-weight losses in the case of options to be high enough to warrant direct costs of a magnitude that was commensurate with the required and expected reduction of dead-weight losses. Recall that direct costs are amenable to economies of scale and scope. The SEC influenced the establishment of the Options Clearing Corporation (OCC). The OCC was organised as a corporation in 1972 under the laws of the state of Delaware. The OCC became the clearing house for clearing equity options traded on the CBOE.

Later when the American Stock Exchange (AMEX) sought the approval of the SEC to trade equity options, the SEC directed AMEX to avail the complete clearing services provided by the OCC. The SEC also directed AMEX to subscribe to the equity of the OCC. Other applicants were given similar instructions. However, the economic benefits of clearing through the OCC had become so clear and acceptable that the New York Stock Exchange (NYSE) chose to clear its equity options through the OCC without being directed by the SEC.

The OCC is the sole equity options clearing institution in the US. Its status as a monopoly is derived from the SEC's assessment of dead-weight losses, direct costs aimed at reducing dead-weight losses and the economies of scale and scope pertinent to direct costs and complete clearing. It is owned equally by the US exchanges that provide markets in options. Those exchanges are AMEX, the CBOE, the NYSE, the Pacific Stock Exchange and the Philadelphia Stock Exchange. The NYSE has agreed, subject to certain conditions, to transfer its options market to the CBOE. The OCC expects to repurchase the shares of its stock held by the NYSE after the transfer becomes effective.

The OCC's principal business consists of issuing equity options, providing facilities for the clearance and settlement of transactions in options, and providing incidental services to its clearing members and to the markets on which options are traded. When the OCC issues an option, it becomes obligated to purchase (in the case of a put) or sell (in the case of a call) the underlying equity for the stated exercise price if the option is exercised. In the case of a cash-settled option, the OCC is obligated to pay the exercise settlement amount when the option is exercised. Clearing members are generally securities firms that assume responsibility to the OCC for the settlement of transactions in options and the performance of the obligations undertaken by writers of options.

The establishment of the OCC was evaluated by the Commodity Futures Trading Commission (CFTC) of the US. In particular, the costs and benefits of complete clearing and the impact of economies of scale and scope were evaluated. In 1976 the CFTC stipulated that futures exchanges should clear futures contracts through multilateral facilities provided by clearing houses. This stipulation was made explicit in the context of financial futures. Commodity futures exchanges had by then adopted complete clearing through multilateral facilities for commodity futures. The CFTC specification enabled commodity futures clearing houses to add financial futures to their business. The CFTC's requirement specified in 1976 was based on the potential for exploiting the economies of scale and scope in the US market.

The SEC and the CFTC have both been driven by the potential for exploiting the economies of scale and scope in the US economy. The SEC was explicit in its policy aimed at influencing the (second order) centralisation and concentration of activities related to the clearing of equity options. The SEC policy was aimed at both first and second order centralisation and concentration. The CFTC has focussed on first order centralisation. However, most of the contract markets and clearing houses regulated by the CFTC are so large that any emphasis on second order centralisation would lead to the emergence of very unwieldy institutions. The CFTC would perhaps be an activist regulator if the BOTCC, the clearing house division of the CME, the clearing house associated with the New York Mercantile Exchange (NYMEX) and the New York Clearing Corporation (NYCC) were found inadequate in coping with global competition. The NYCC is the clearing house for the New York Board of Trade (NYBOT).

The CFTC's vision statement provides evidence of its orientation towards the premier position of the US economy in an era of untrammelled globalisation: Preserve and promote the vital role America's commodity markets play in establishing fair prices for goods and services and managing the risks of their production, marketing, and distribution in the world economy.

The CFTC is responsible for ensuring the economic utility of futures markets by encouraging their competitiveness and efficiency, ensuring their integrity, and protecting market participants against manipulation, abusive trade practices, and fraud. Through effective oversight regulation, the CFTC enables the commodity futures markets to better serve their important function in the nation's economy of providing a mechanism for price discovery and a means of offsetting price risk. The mission of the CFTC is to protect market users and the public from fraud, manipulation, and abusive practices related to the sale of commodity futures and options, and to foster open, competitive, and financially sound commodity futures and option markets.

The financial integrity of futures and options markets depends on the robustness of their arrangements for clearing and settling trades. The vigorous pursuit of economies of scale and scope pertinent to clearing institutions fosters financially sound commodity futures and option markets. The financial soundness of commodity futures and option markets is fundamental to any economy since financial soundness of exchanges fosters competition among brokerages and other service providers. Clearing institutions are critical to the fostering of financially sound, competitive exchanges and brokerages. The pursuit by regulatory agencies of economies of scale and scope in clearing institutions is consistent with policy objectives aimed at fostering open and competitive markets that are characterised by efficiency and integrity. The FMC can influence the pursuit of economies of scale and scope in India. The need for sustaining open interests of a large magnitude would enable and require the pursuit of economies of scale and scope in India.

Commodity exchanges in India have in general operated with the assumption that credit and liquidity risk and the resultant dead-weight losses are of a small magnitude. Therefore, direct costs aimed at mitigating dead-weight losses have also been of a small magnitude. Given the small assumed magnitude of dead-weight losses (default costs) and direct costs, economies of scale have not been of any importance. Moreover, as single commodity exchanges with statutory monopoly status, economies of scope have also not been of any importance.

Commodity exchanges in India have been structured in a manner that enables exchanges to proactively control dead-weight losses. Such control has been exercised through membership rules. In almost all exchanges, members are the principal users of the exchange. A separate class of users (customers) that accesses the exchanges through members is quite small, if such a class exists at all. The existence of a separate class of users would lead to higher dead-weight losses and higher direct costs. Exchanges and their members have avoided the higher costs by restricting the usage of commodity exchanges to a small class of member participants. The barriers to access are neither obtrusive nor obvious. The absence of promotional literature and campaigns related to (1) commodity exchanges, (2) the use of futures contracts and (3) the mechanism for accessing exchanges is not surprising.

The general view hitherto held by policymakers and regulators that futures trading was inimical to the broad economic interests of India required and enabled commodity exchanges to confine access to members. Therefore, the social benefits of commodity futures contracting have been available to a few participants in the economy. The inadvertent withholding of the benefits of futures contracting may be regarded as an invisible component of direct costs. There are other invisible components of direct costs.

Margins, price limits and position limits are the most dominant components of processes aimed at dealing with dead-weight losses. They are set in a manner that only a few trades would progress to the stage of default. The three components are set in compliance with the directions issued by the FMC. Trading volumes and liquidity in general and open interest in particular are small in the commodity exchanges and are in part a result of the three dominant components. The three components – margins, price limits and position limits – have in particular had the most adverse impact on open interest. Such an adverse impact imposes a cost that is an invisible component of direct costs.

High trading volume does little to soften the impact since high trading can coexist with small open interest. Trading volume is often incorrectly used as a barometer of activity of a commodity exchange. While high trading volume is certainly desirable, it does not automatically promote accretion of open interest. However, low trading volume is not desirable since it discourages potential hedgers and speculators who may fear poor liquidity. Low trading volume is also a drain on the resources of an exchange. High trading volumes bring more incomes to exchanges and signal potential liquidity to hedgers and speculators. Therefore, it is rational for commodity exchanges to pay attention to trading volume even if open interest is compromised. However, it would be appropriate if regulatory institutions such as FMC laid as much emphasis on open interest as on trading volume.

Open interest is of greater economic significance than trading volume in the context of futures and options contracts. An open interest comprises one open position by a long or buyer and one open position by one short or seller. An open position represents an investment by a long and a short, even if such an investment is leveraged. An open interest in a futures contract signals the confidence of the long and the short that their investments would remain viable until expiration or until the investments are liquidated voluntarily by them. Rational longs and shorts would signal their confidence in the viability of their investments only if they are certain about the financial soundness of the exchange and, in particular, its clearing and settlement processes.

Futures contracts are usually marked to market daily and the question pertaining to viability is dealt with each day. A futures position cannot be viable over the long term if it is not viable in the short term. However, the viability of a futures position in the short term does not guarantee its viability in the long term. Daily mark-to-market helps to ameliorate uncertainty but does not eliminate the chances of an involuntary liquidation over the intended term of a futures open position. Any involuntary liquidation as a result of default by another participant would not be in the interests of a hedger who has a pre-existing risk in the underlying asset and where the hedge has to remain in place until the pre-existing risk ceases to exist. Any involuntary liquidation would also not be in the interests of a speculator who has an estimate, even if stochastic or risky, of a particular price in the future and an expected profit commensurate with the risk. As a result of the nontrivial chances of involuntary liquidation of a futures open position before the completion of some intended term that is greater than a day, Indian commodity exchanges are characterised by small open interest even though they may have handsome trading volumes. The magnitude of open interest is measured relative to production of the commodity.

Low open interest is a result of inadequate clearing and settlement strengths but may be confounded by position limits imposed by the FMC and the exchanges. However, if the confounding impact of position limits is ignored, the very small open interest found in Indian commodity exchanges is a sign that both hedgers and speculators do not expect open positions to be viable. The lack of confidence has a direct and adverse impact on hedging as well as on price discovery.

The two principal benefits of futures contracts are hedging and price discovery. The benefits of hedging and price discovery occur over the long term. For example, it is customary for firms in the business of extracting vegetable oils from oilseeds to hedge against price risk. Firms hedge against total firm risk by selling edible oils futures over a certain horizon and, more important, by simultaneously buying oilseeds futures with expiration terms spread or stacked over the period of crushing between one harvest and the next. Any period between one harvest to the next is certainly long term in the commodity markets. In such circumstances, hedging by the extracting firm would need speculators or other natural counterparties such as edible oil traders, oilseeds farmers and co-operatives or all of them. More importantly, such counterparties should have an economic incentive to support their open positions through expiration and be confident that they would be able to unwind their positions in a liquid market when they reach the end of their horizon pertaining to speculation or hedging. In the absence of such incentives and confidence, oil extracting firms, oilseeds farmers, seeds co-operatives and oil traders would turn to over-the-counter (OTC) contracts, legal or otherwise, to hedge against price risk. Speculators would turn to short-term trades with a marked preference for day trades. They would also turn to being the intermediaries or counterparties or both in the OTC market for hedging against price risk.

The above example is descriptive of most of the commodity markets in India. There are a few significant exceptions. The example provides two useful pointers to potential outcomes. First, the process of price discovery is seriously impaired if commodity market participants turn en masse to OTC markets. Second, futures markets will not be comprehensive in serving the hedging needs of market participants if open positions cannot be carried from one day to the next with certainty after mark-to-market. Involuntary liquidation of long-term positions is a far more serious threat compared with the involuntary liquidation of short-term positions. Therefore, futures markets would be biased towards short-term hedging and speculation. Both outcomes are results of poor confidence of longs and shorts in the viability of their investments until expiration or until the investments are liquidated voluntarily by them. The poor confidence is a result of inappropriate management of costs of default through a financially sound clearing institution.

Impaired price discovery and a bias towards short-term hedging and speculation need not neces