The Forward Markets Commission (FMC) must be given due credit for putting up its order related to National Commodity and Derivatives Exchange Ltd’s (NCDEX) transaction charges on its website for everyone to see. It’s a right step in terms of transparency. But the order is rather unfair on NCDEX, giving the impression that the commodity bourse has been involved in financial impropriety and that members’ funds may be at risk when deposited with the exchange. This seems to be the main reason why the regulator has quashed NCDEX’s proposal to reduce fees and gain market share. If there are any doubts about the message FMC’s order sent, consider this news snippet in The Economic Times dated 2 March, “NCDEX diverted funds: FMC”.
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In post-Satyam days, this statement sends a completely wrong picture and one needs to be careful about making such statements. In truth, NCDEX hasn’t diverted any of its members’ funds. Members have to make deposits with the exchange in order to be able to trade on its platform, and need to top it up if they want to take high positions. These are the funds FMC is calling into question, but they are very much with the exchange. The funds haven’t gone anywhere. What’s changed is merely the definition of what’s known as the settlement guarantee fund (SGF). When commodity exchanges started operations about five years ago, the regulator was still finding its feet and there was no regulation on what constituted SGF. NCDEX, under its previous management, had magnanimously said that all the deposits collected from its members constituted its SGF. This is the singular mistake the exchange has made in this regard.
After studying the practice followed by exchanges worldwide, NCDEX has changed the definition of SGF, where member deposits aren’t part of it. Commodity exchanges have also been in dialogue with the regulator on SGF, but a final guideline hasn’t been issued. In its order, FMC has conveniently omitted mentioning this work-in-progress nature of what constitutes SGF and how NCDEX has changed its definition.
Globally, member deposits are part of the basic risk-management framework of exchanges and clearing corporations. SGF, or its equivalents, work as a last line of defence, and the funds that accrue to it are normally fines imposed on members, excess funds of defaulter members and the interest earned in the fund. NCDEX has changed its internal definition of SGF based on this guideline.
So what changes operationally? If member deposits were part of SGF, this is what would happen in case of a member defaulting. For example, if a defaulter owes the exchange Rs2 crore and his funds deposited with the exchange as base capital and margin money amount to only Rs1 crore, SGF would be dipped into to retrieve the balance. If SGF is made up of the deposits (base capital) of all members, each and every member trading on the exchange will have to contribute to make up for the shortfall, to the extent of Rs1 crore divided by the number of members trading on the exchange. This is grossly unfair. Why should all members pay for the mistake of a defaulting member? Therefore, the underlying principle of an exchange’s risk management system should be that the deposits and margins taken from each member and other risk management policies followed by the exchange should take care of the dues of defaulting members. In the event that all this is insufficient, then the exchange should dip into an SGF, which is a common pool, but doesn’t dip into the capital of all members. As pointed out earlier, fines and penalties normally make up this fund.
It’s important to note here that NCDEX’s risk management framework is even more conservative than the policy laid down by the J.R.Varma committee for equity exchanges, and that it hasn’t had any instance of default yet. Another inference in FMC’s ruling is that it is wrong for NCDEX to earn interest on the deposits made by member firms and treat it as part of its income. This again is a practice followed globally, including by the Chicago Mercantile Exchange. When members make cash deposits, it’s known to them that they won’t earn interest on those deposits. Of course, when they provide bank guarantees and fixed deposit receipts or equities, they remain beneficial owners and hence don’t lose out on interest or dividend. But some part of the deposit has to be made in cash and the exchange benefits from the interest income on these funds.
Perhaps NCDEX’s approach that it expects to earn higher interest income on deposits to compensate for the drop in transaction fees was an argument FMC found difficult to follow. But it seems rational for NCDEX to expect volumes to rise with lower fees, which, in turn, will shore up deposits by members who want to trade more and hence earn it higher interest income. It seems odd to some that an exchange should rely so much on investment income as part of its business plans, but that seems to be a reality in the Indian markets, where investment income makes up for a huge portion of an exchange’s revenues and profit. More than one-third of the National Stock Exchange of India Ltd (NSE) and its clearing corporation’s earnings before tax comes from interest income. Of course, NSE would still be very profitable without this income, but for an entity such as NCDEX, it’s one of its main revenue streams and FMC can’t suddenly try and snuff it out. Finally, FMC has raised issues which it has known for many months and some it has known for at least a year. That these have surfaced almost out of context at this juncture suggests a vindictive approach to the issue.
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