Commodity Markets Also Need Nurturing before Disruption
In the past couple of weeks, I have written about how the Securities and Exchange Board of India (SEBI) wants to permit new stock exchanges and depositories with disruptive technology and vastly liberalised entry norms. This hurried proposal, if implemented, would be one of the biggest market developments after SEBI took over the regulation of commodities markets in 2015 and in 2017 introduced the concept of universal exchanges that are allowed to trade stocks, commodities and currency. 
The question is: Are we ready for such a shake-up when the regulator struggles to understand, develop and supervise the reduced number of exchanges under its charge, or control the rapid spread of tech-based trading operating outside SEBI’s regulatory penumbra, which can cause massive damage in times of sudden market volatility? 
On 14th July, I wrote about how unregulated retail algorithm trading was sucking in naïve and unsuspecting new day-traders who were being given direct access to regulated broker platforms through APIs (application programming interface). Although exchanges as well as algo writers have been asking for rules and supervision, SEBI has been ignoring them. 
On 19th July, Debashis Basu wrote in Business Standard about the massive explosion in illegal trading platforms that offer a derivative product in currencies and foreign indices. He called this ‘Digital dabba trading’ which is already so big that these companies are sponsoring cricket teams and using star cricketers for endorsement. I have since learnt that the Reserve Bank of India (RBI) has taken note of this development; but SEBI remains silent.
While these are unregulated new markets, another core area under SEBI supervision that is messy and has been dogged by frequent controversies is commodity trading. But before going into it, let’s look at how the market has shaped up in the past three decades under formal SEBI supervision.
The SEBI website lists nine stock exchanges of which eight are still operational (the Calcutta Stock Exchange is listed but defunct and under litigation). Of these, India International Exchange and NSE IFSC Ltd are international exchanges operating since 2017 at GIFT City (Gujarat), a special economic zone. They are subsidiaries of the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE), respectively, and are really in competition with the Singapore Stock Exchange.
That leaves two dominant exchanges in the equity market, down from 23 regional players and two experimental exchanges. Development has been lopsided for various reasons and NSE dominates with a market share of over 90%. Then there is the Metropolitan Stock Exchange (formerly MCX-SX), trading currency derivatives, which is struggling after the upheaval and controversy over the forced exit of its promoter Jignesh Shah.
Commodity trading was brought under SEBI during the United Progressive Alliance (UPA) regime. But it has been a sector in constant turmoil over the past two decades and badly needs focused attention. For starters, nearly two dozen regional commodity exchanges have been de-recognised. In 2002, the ban on futures & options (F&O) trading (since 1952) was lifted and four new exchanges came into existence. The Multi Commodity Exchange of India Ltd. (MCX), which had been set up by Jignesh Shah and is now run by the government, continues to dominate even after his exit and has a market share of 94%. The NSE-promoted National Commodity & Derivatives Exchange Ltd. (NCDEX) is a distant second and the Indian Commodity Exchange Limited (ICEL) is floundering with almost no liquidity, despite its marquee promoters and merger with the National Multi Commodity Exchange (NMCE) in 2018. Two other entrants in this space— ACE Derivatives and Commodity Exchange and Universal Commodity Exchange—have folded up.
Globally, commodity and securities regulation are not combined under a single regulator. Not surprisingly, putting SEBI in charge of commodities hasn’t really helped, say industry insiders. They attribute this to a lack of understanding and empathy among SEBI officials for a vastly different ecosystem, or the products and trading objectives of players and the role that it plays in price discovery and risk management. The challenges involved in delivery and settlement, including classification of product quality, warehousing and the logistics of physical deliveries across the country, are also completely different. 
The commodity exchanges also have their own operational niches. Although MCX is the dominant exchange, trading there is concentrated in metals and energy trading contracts (gold and energy and also traded on BSE and NSE), while NCDEX is considered an agricultural exchange.
SEBI officials, it is alleged, fail to grasp these differences and follow a one-size-fits-all regulatory strategy. This may work well as far as corporate governance, investor protection, supervision and enforcement rules are concerned, but highly restrictive trading rules prevented the creation of a vibrant and liquid market that can even attract large domestic producers who prefer to hedge their risk on the international market. 
“Commodity markets need nurturing,” says an industry source, explaining how the regulator’s lack of understanding is impacting the business in a scenario where the exchanges are essentially competing with the London Metal Exchange (LME) or Chicago Mercantile Exchange (CME). 
Institutional Participation 
In 2017, when SEBI took over regulation of commodity markets, a whole-time member had announced plans to increase institutional participation by permitting mutual funds and foreign institutional investors (FIIs) in the commodity derivatives markets. This hasn’t quite worked out. Although SEBI has permitted eligible foreign entities (EFEs), none of them is trading because they are required to produce proof of a hedged position in India, which is not a requirement among global competitors.
Mutual funds were permitted entry last year; but this, too, was stymied for over six months because they operate through custodians and SEBI insisted on making custodians responsible for physical deliveries like warehouses. There are similar issues with SEBI’s lack of understanding of the nature, size and duration of commodity contracts, all of which impacts market liquidity, which, in turn, keeps out the larger players and producers who would add depth to the market by hedging their price risk in India, rather than on the LME and CME. 
It is a chicken and egg situation, but one that is hard to resolve if the regulator does not understand the issues enough to play a constructive role in creating a vibrant market, while also being alert to speculative excesses and supervision issues. 
Broker Exits
Regulations have become so tight that there is hardly any operational flexibility and this has led to a steady stream of exits from the business with brokers shutting shop voluntarily and surrendering their membership, say industry insiders. Nearly 125 brokers have shut shop since January 2020. 
SEBI’s new tough margin norms are hurting commodities more than equities and have impacted volumes across asset classes. This is because the structure of commodity markets is very different. The hike in upfront margins to be collected from investors has not only impacted market liquidity but also the viability of commodity brokers. After representations from exchanges and broker associations, the regulator is reportedly planning to revamp some rules to increase liquidity for certain hedging contracts. It remains to be seen if this will make a difference.
NSEL Overhang
Finally, the investigation into the National Spot Exchange Ltd (NSEL), which imploded in 2013, continues to drag through various stages of litigation and has created its own churn. NSEL’s members were commodity brokers who were involved in luring investors to trade in the controversial ready-forward contracts of NSEL. They have taken steps to dodge punitive action by promoting new companies and quietly shifted business to these entities which have already got permission to trade. The firms under investigation are now shells and remain in limbo because SEBI has not permitted them to surrender membership until regulatory action is complete. We learn that 190 show-cause notices have been issued in the matter and orders have yet to be passed in many cases. There is also an ongoing investigation by the economic offences wing (EOW) of the Mumbai police. Another five firms have filed an appeal against SEBI’s order before the Securities Appellate Tribunal (SAT). All of this has had a debilitating impact on the industry. 
Remember, the exits in the commodity space are in addition to the 28 brokers expelled by NSE from the equity market and massive losses suffered by investors. All this only underlines the need for SEBI to get its act together on regulating the exchanges, before even thinking of disrupting this space with new rules and newer entrants. 

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