The integration of regulation of commodities trading (Forward Markets Commission) with securities market regulation (Securities and Exchange Board of India) is an important initiative currently in process in India.
Adhocism, ambiguity, uncertainty and lack of clarity with regard to policy and regulation of commodities derivatives trading has restricted India’s efforts to harness its potential and prospects in global commodity markets. It is expected that integration will empower the commodity exchange ecosystem in India to grow and mature in a manner similar to securities markets.
Commodity markets are critical for emerging economies. Studies point out high correlation of commodity prices with domestic economic growth, inflation and the pace of exports in developing countries.
The development of organised commodities markets, exchange platforms and related market infrastructure and ecosystem assumed significant interventions in the financial development policy of many countries. As the stock market assumed importance as an instrument to enhance allocative efficiency of financial resources, commodity derivatives trading emerged as a powerful instrument in managing price risk management, so vital for sustained economic growth.
What should be the regulatory agenda of a commodities regulation? It might be useful to take a look at the canvas of commodities trading. There are some global trends: (a) Paper trading in terms of derivatives value far outstrips physical trading; (b) There is prevalence of a complex range of trading strategies and technologies (including high frequency trading); (c) Trading houses are emerging as major players replacing banks; (d) There is financialisation of commodities trading with more of fund management, investment products and diverse categories of investors participating in trading.
Other global trends include: (e) Consolidation of the commodity exchange industry that extends to other market segments (a 13-year-old energy derivatives exchange, InterContinental Exchange, acquired the more than 200 years old equity exchange NYSE Euronext in 2013); (f) the growing power of commodity producers; (e) growing linkages between commodities markets across the world giving way to extended trading hours and a wide range of investment products; (f) volatility in commodities markets quite often turning into issues of public unrest leading to ad hoc policy interventions and measures; (g) and the issue of managing the interests of various stakeholders engaged in the value chain of commodities trading, and so on.
Influencing factors These trends and developments could surely have a bearing on the regulatory framework that needs to be built up as, moving forward, this market will make way for a complex market structure with more players, products, instruments and innovations that could call for a proactive and agile regulatory framework. At present, the scope of commodities trading is quite narrow in India, limited to just one product — trading in futures with most of the volumes coming from metals and minerals. Banks and domestic and international institutional investors are not allowed to trade in commodities exchanges. The passing of the amendments to the Securities Contracts Regulation Act (SCRA), which is long awaited, needs to be speeded up to expand opportunities for the growth of commodity exchanges as also empower the regulatory system.
Globally, the development of regulation of commodities trading evolved under six key areas. These are (a) transparency and reporting; (b) regulation of OTC trade and swap dealers; (c) position limits; (d) price stabilisation instruments; (e) banning certain trading strategies and actors; and (f) strengthening regulatory and supervisory authorities and international cooperation.
The background for an integrated framework for commodities regulation at the global level was initiated by the G20, followed by several other global and regional regulatory initiatives that, among others, include: the Dodd Frank Act (2010), IOSCO (Principles for the Regulation and Supervision of Commodity Derivatives Markets, 2011), Markets in Financial Instruments Directive (MiFID I), European Markets Infrastructure Regulation (EMIR), Markets in Financial Instruments Regulation (MiFIR), and Market Abuse Regulation (MAR).
MiFID II is expected to further strengthen the scope of monitoring. In February 2014, the Financial Conduct Authority (FCA) of the UK released a position paper that brought out certain specific aspects of regulation that are of importance.
Regulation issues The measures for consideration, among others, could include: regulation, systemic risk, market transparency and market conduct.
With respect to regulation, the key issues are: (a) to bring commodity firms, venues and products under the regulatory scope; (b) greater regulatory oversight by transaction reporting for commodity derivatives; and (c) commodity benchmarks used in financial contracts to be brought under regulation.
In the realm of managing system risk, the proposed measures include: (a) mandatory obligations for specific derivatives and risk mitigation requirements for uncleared OTC trades; and (b) making clearing obligations applicable to large non-financial firms subject to a hedging exemption, etc. With regard to market transparency the proposals include: (a) greater transparency in reporting to trade repositories; and (b) a requirement to publish commitments of trader reports (aggregated position information by category of trader).
In the realm of market conduct, the new initiatives include: (a) a comprehensive regime for position limits supported by a position reporting regime across types of market venues; and (b) capture of new offences aimed at market manipulation, including use and application of benchmarks. Some of these measures may already be in force in India in varying degrees. But these are likely in need of further refinement and streamlining along with incorporating new issues that are relevant to the regulatory reform.
The author is a former chief economist of the Indian Banks’ Association