Organisation and guiding principle of commodity derivatives market in India
By Anil Mishra
There are various models for the regulation of derivative markets across the globe. In some countries, all financial markets including those for commodity derivatives and securities derivatives are organised under one regulator. Certain countries keep money market operations exclusively under Central Bank and all the other segments of financial markets under a separate regulator. Some countries have a very fragmented system of regulation with separate regulators for each class of product. Derivatives instruments in India are regulated by the Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI) and Forward markets commission (FMC). Subsequent to the passing of the Finance Act 2015, FMC was merged with SEBI with effect from 29 September 2015.
The framework for regulating derivative transactions is provided in the various Acts of Government of India such as Securities Contracts (Regulation) Act 1956, and related Rules, Regulations, Guidelines, Circulars etc. Exchange traded equity and commodity derivatives markets are regulated by Securities and Exchange Board of India (SEBI). Prior to the merging of FMC with SEBI, the Forward Markets Commission (FMC) regulated the exchange traded commodity derivatives market in India.
Guiding principles of regulatory framework
Regulatory objectives are designed to achieve specific, well-defined goals. It is inclined towards positive regulation designed to encourage healthy activity and behaviour. It has been guided by the following objectives :
Fairness and Transparency: The trading rules ensure that trading is conducted in a fair and transparent manner. Experience in other countries shows that in many cases, derivatives brokers/dealers failed to disclose potential risk to the clients. In this context, sales practices adopted by dealers for derivatives require specific regulation. In some of the most widely reported mishaps in the derivatives market elsewhere, the underlying reason was inadequate internal control system at the user-firm itself so that overall exposure was not controlled and the use of derivatives was for speculation rather than for risk hedging. These experiences provide useful lessons for us for designing regulations.
Safeguard for clients’ moneys: Moneys and securities deposited by clients with the trading members should not only be kept in a separate clients’ account but should also not be attachable for meeting the broker’s own debts. It should be ensured that trading by dealers on own account is totally segregated from that for clients.
Competent and honest service: The eligibility criteria for trading members are designed to encourage competent and qualified personnel so that investors/clients are served well. This makes it necessary to prescribe qualification for derivatives brokers/dealers and the sales persons appointed by them in terms of a knowledge base.
Market integrity: The trading system ensures that the market’s integrity is safeguarded by minimising the possibility of defaults. This requires framing appropriate rules about capital adequacy, margins, clearing corporation, etc.
Quality of markets: The concept of “Quality of Markets” goes well beyond market integrity and aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and price-discovery. This is a much broader objective than market integrity.
Innovation: While curbing any undesirable tendencies, the regulatory framework should not stifle innovation which is the source of all economic progress, more so because financial derivatives represent a new rapidly developing area, aided by advancements in information technology.
Of course, the ultimate objective of regulation of financial markets has to be to promote more efficient functioning of markets on the “real” side of the economy, i.e. economic efficiency.
Stricter regulation than cash trading: Producers and processors are exposed to the price risk hence need a system to transfer their risk by hedging. They do it by hedging their position in derivatives market which is just opposite of their exposure in the physical market. Leaving aside those who use derivatives for hedging of risk to which they are exposed, the other participants in derivatives trading are attracted by the speculative opportunities which such trading offers due to inherently high leverage. For this reason, the risk involved for derivative traders and speculators is high. This is indicated by some of the widely publicised mishaps in other countries. Hence, the regulatory frame for derivative trading, in all its aspects, has to be much stricter than what exists for cash trading. The scope of regulation covers derivative exchanges, derivative traders, brokers and sales-persons, derivative contracts or products, derivative trading rules and derivative clearing mechanism.
The regulatory responsibility for derivatives trading is shared between the exchange conducting derivatives trading on the one hand and SEBI on the other. This sharing of regulatory responsibility is so designed as to maximise regulatory effectiveness and to minimise regulatory costs.
Major issues concerning regulatory framework
Exchange-traded financial derivatives originated in USA and were subsequently introduced in many other countries. Organisational and regulatory arrangements are not the same in all countries. Interestingly, in U.S.A., for reasons of history and regulatory structure, Futures trading in financial instruments, including currency, bonds and equities, was started in early 1970s, under the auspices of commodity futures markets rather than under securities exchanges where the underlying bonds and equities were being traded. This may have happened partly because currency futures, which had nothing to do with securities markets, were the first to emerge among financial derivatives in U.S.A. and partly because derivatives were not “securities” under U.S. laws. Cash trading in securities and options on securities were under the Securities and Exchange Commission (SEC) while Futures trading was under the Commodities Futures Trading Commission (CFTC). In other countries, the arrangements have varied.
Spot or cash trading not regulated by SEBI
The Spot trading of commodities is very opaque and fragmented. There is no proper price discovery and price dissemination. There is no data on stocks lots of transaction happen on cash and never get captured or taxed. Producers are at the mercy of few traders in APMC Mandis and are exploited
Commodities derivative trading is regulated by SEBI
The trading takes place through an online screen-based trading system, which also has a disaster recovery site. The clearing of the derivatives market is done daily and mark to market benefit is given to the beneficiary on daily basis. Exchanges through the mechanism of novation take the responsibility of good delivery and also to avoid defaults. The exchanges have an online surveillance capability which monitors positions, prices and volumes in realtime so as to deter market manipulation. Price and position limits are used for improving market quality. The exchanges have arbitration and investor grievances redressal mechanism.
Information about trades, quantities, and quotes are disseminated by the exchange in realtime which are accessible to stakeholders throughout the country.