FMC and SEBI: Finally in step

The merger of the Forward Markets Commission (FMC) with the Securities and Exchange Board of India (SEBI) is a major milestone for the commodity futures market in India. This idea is not new; it was floated seriously at least 12 years back when the commodity market was revived and three national level exchanges were in the field. At that time it was felt the FMC should remain a separate entity, given the unique nature of this market.

The commodity market came under the regulation of the FMC and was guided by the FCRA of 1952 with the FMC being a division of the ministry of consumer affairs (MCA). The argument put forward was that the market was young and needed attention and expertise. It could not be treated as a financial instrument since it involved the physical delivery of goods which in turn had a bearing on spot markets and prices. Therefore, the MCA would have oversight of this market. The spot markets are regulated by the APMC Acts which fall within the jurisdiction of State governments.

Over the years, the market has matured. In between there was a dent to the credibility of commodity markets with the NSEL failure, but the futures markets have carried on through this turmoil and emerged more resilient.

There have also been controversies regarding their links with inflation which has led to the banning of futures trading in specific commodities. Conditions have stabilised since, and there is evidently a need to take this market to a different level.

One way of looking at commodity derivatives is like any other financial instrument as is the case in several markets, including the US. Since India has separate regulatory structures — the FCRA and SCRA Acts dealing with commodities and securities — integration would be required. The first step taken earlier was to bring the commodity futures market under the ministry of finance and, as an extension, merge the FMC with SEBI.

What would this mean for the market? Commodity derivatives can now be looked upon as a financial instrument analogous to equity or debt. This will bring all derivatives under a single regulator just like in the US where the CFTC controls and regulates them.

This will be good news for brokers if there is integration of the two trading platforms. There will be some housekeeping to be done as all brokers need to register with SEBI. Exchanges too have to comply with the networth norms.

It is not known if the stock exchanges will be allowed to deal with commodities and vice versa for commodity exchanges. If permitted, there would be further competition in both markets, leading to consolidation at some point of time, which is always the case for financial infrastructure. The major consideration is to ensure that risk from one market does not spill into the other. This was the primary reason for commodities being separated from securities.

The consequence, however, was that the same broker firm would open a commodity outfit and then trade from the same office space under two banners. With a single regulator now for both the markets, and hence also for the exchanges, this issue needs to be resolved: whether or not there is need to have separate companies trading in two segments with separate risk capital.

The existing exchanges will definitely see a shakeout as stock exchanges venture into this space. It is unlikely, however, that in the absence of consolidation they can make a useful dent in the business of existing players. This is so because historically it has been observed that exchanges tend to get specialised in specific products and generate liquidity to the extent that it is difficult to wean away business. Hence MCX retains primacy in bullion and energy while NCDEX dominates the agricultural spectrum. New exchanges have come and barely survived, and more often than not been marginalised by market forces.

Therefore, it is not expected that things will be different if stock exchanges open these platforms. However, one never can tell.

There are several expectations from the commodity market. The FCRA permits trading only in tangibles and hence indices were kept out of the ambit. This becomes pertinent now as weather indices could be useful for farmers, provided they understand the product. With such an index in place they can take insurance against rainfall through a market-oriented product.

Further, the FCRA does not allow trading in options, and with this market coming under SEBI there is expectation that then same will be enabled.

However, one must not overstate the business to be generated from options as globally options clock just 10 per cent of total business. In fact, from the top 20 contracts traded in farm and energy products, soyabean and corn feature on CBOT and crude oil on ICE.

But options would be useful again for farmers as they would resemble an MSP of the government, though in this case it will be options on futures.

Education will be important to ensure that they work for that community. However, it is expected that such options will enhance the use of futures and, in these uncertain times for farm output, would be useful tools.

An area that can see some momentum, even though SEBI has moderated expectations for the first year, is enlarging the field of players. Today, banks are not allowed to trade as banking regulation does not permit it.

Banks can play a role as aggregators for farmers and also cover themselves for the credit risk in lending to farmers once backed by a futures contract. Similarly, while direct trading may not be advisable now, at a later date it could be considered just like equity exposures under their investment limits.

Another area includes capital market participants such as mutual funds and FIIs which can add depth. Mutual funds can add value by diversifying their portfolios.

Today, it is debt, equity and hybrid products. Now with SEBI allowing such investments over time, there can be a sea change for the retail investor. However, given that delivery issues exist, there have to be exit routes to ensure that they do not get loaded with delivery.

Maybe special contract of non-deliverables can be considered. The same holds for FIIs where similar contracts have to be designed, since delivery can lead to challenges on the export-import front as well as stocking when there are shortfalls in production of commodities.

On the whole we can expect exciting times, but the market needs to be patient because SEBI will roll out reforms gradually, after consolidation takes place at the regulatory level.

The writer is the chief economist of CARE Ratings. The views are personal

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