Regulatory Watch. Reining in speculation in agri futures

One of the major concerns with commodity derivatives, as perceived by regulators and law-makers, is their ability to influence prices in the spot market. This can adversely affect the prices of articles of daily consumption, including food, and have a disastrous effect on inflation.

Derivative contracts are, however, so designed that their value is many times the value of the underlying market. Since the users can do leveraged buying, where they can take a position by paying just a fraction of the contract value (margin money), the size of the derivative market tends to get inordinately large. The concern is higher in Indian agri-commodities, where the spot market is highly fragmented, with a chunk of transactions taking place in the unorganised sector.

In order to anchor the volume in commodity derivatives with the underlying commodity, market regulator Securities and Exchange Board of India (SEBI) has set out rules for determining position limits in agri-commodities. These rules ensure that runaway prices in agri futures do not disrupt prices in the spot market.

SEBI, on the basis of the recommendations of the CDAC (Commodity Derivatives Advisory Committee), put out a circular on July 25, setting out the rules to establish this linkage.

The regulator has laid down that the limit allowed for outstanding position for each commodity contract traded on Indian exchanges shall be linked to ‘deliverable supply’. The deliverable supply is determined by adding the domestic production and imports.

The national commodity exchanges have to jointly determine the deliverable supply for each commodity every year, for commodities traded on their platforms. That is, for commodities exclusively traded on NCDEX or MCX, the respective exchanges have to determine the deliverable supply and for commodities traded on both platforms, the exchanges should jointly determine the value of supply.

The numerical values of position limits for any agricultural commodity shall be revised only if the computation in a particular year leads to a revision in value of over 5 per cent. The limits have to be put up on the exchanges’ websites latest by July 31 every year and the new limits will be applicable from September 1 of the year.

The deliverable supply is determined by taking the latest production numbers declared by the government or the latest ‘third advance estimates’ for production and imports, published by various Ministries, statutory bodies or associations. For the current year, 2017, the new limits will be applicable to all running contracts from October 1, 2017

To ensure that position limits allowed to clients vary depending on the nature of the commodity, all traded commodities have been classified into three buckets. This categorisation is done based on the average production and import data of the past five years, taken on a rolling basis. Some external factors that affect commodity prices are also taken into consideration while classifying the commodities — as sensitive, broad and narrow.

Agricultural commodities where the government intervenes to impose stock limits, import or export restrictions or other trade related barriers are classified as sensitive commodities. Commodities where there have been instances of price manipulation in the past five years of trading are also classified in this group. An agricultural commodity that is not a sensitive commodity and has average deliverable supply for the past five years of at least 10 lakh tonnes in quantitative terms and at least ₹5,000 crore in monetary terms is classified as a broad commodity. An agri commodity that is neither a sensitive commodity nor broad commodity shall be classified as a narrow commodity.

Market experts, however, think that the categorisation of all commodities with annual supply below ₹5,000 crore as narrow and restraining the limit is not a good idea. Since most agri commodities in India have a small area of production, most would fall in the narrow commodity bucket. This can lead to greater volume and hedging in just a handful of commodities, with others losing out.

Client-level position limits of commodities are determined based on these categorisations. The limits allowed to clients will depend upon the commodity they choose to trade in. If the client trades in a broad commodity, the limit allowed is 1 per cent of the deliverable supply in a particular year.

For narrow commodities, the limit is 0.5 per cent of the deliverable supply and for sensitive commodities, the limit is even lower, at 0.25 per cent of supply.

Re-classification of a commodity from narrow to broad shall be done only when the average deliverable supply of the commodity for the past five years and its monetary value exceeds 5 per cent.

Member level or position limits for brokers shall be 10 times the numerical value of the client level position limit or 15 per cent of the market-wide open interest, whichever is higher.

SEBI has also prescribed a market-wide position limit for each commodity, across all exchanges. It shall be restricted to 50 per cent of 'deliverable supply' determined for the relevant year. This has to be notified by the exchanges every year, along with client-level numerical limits.

It is clear that the regulator is trying to establish a broad framework to rein in excessive speculation in agri-commodities. But the efficacy of these rules will be apparent only after they are implemented.

SEBI needs to be open to tweaking the limits depending on the experiences of the stakeholders in the agri-commodity market.