Home / Opinion / NCDEX is no NSEL; but its castor seed episode is a wake-up call
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Taking the commodities futures markets under its wings has been something of a baptism by fire for the Securities and Exchange Board of India (Sebi). Barely four months into the job, it learnt that the National Commodity and Derivatives Exchange Ltd (NCDEX) has suddenly suspended its castor seed futures contracts.

The extreme step suggests the exchange either didn’t have sufficient liquidity or wasn’t adequately capitalised. Sebi must move quickly to bring commodity exchanges at par with their counterparts in the equity segment, with regard to liquidity and capital adequacy. It has done well to detect fraud in this case and penalise the Ruchi Soya group and some other traders, but to stop there will be missing the woods for the trees.

When the Forward Markets Commission (FMC) regulated commodity derivatives markets, they were always perceived to be weaker in terms of regulation vis-a-vis their equity counterparts. Unlike Sebi, FMC wasn’t an autonomous entity. The castor seed suspension and the fraud that was detected later reaffirm this perception. But this has to change. Else, the very purpose of integrating FMC with Sebi will be defeated.

It’s important to note here that a suspension of a contract goes against the grain of the role an exchange performs. Modern-day exchanges act as the counter-party in each transaction; in effect, for each buyer, the exchange acts as the seller of the contract and vice-versa. Even if large trading members default, exchanges must honour their obligations to all other trading members.

One way exchanges do this is by collecting adequate margins and collateral from its trading members. In extreme situations, such as the sharp drop in the price of castor seed futures contracts in January, margins and collateral could turn out to be insufficient to honour all obligations. In such a scenario, if some trading firms default, the exchange has no choice but to use its own liquidity to honour obligations towards non-defaulting members.

It appears that NCDEX was forced to do this when a number of firms with long positions in castor seed futures defaulted on their obligations on 27 January. Instead of committing to continue honouring all obligations till expiry of the contract, NCDEX announced that outstanding positions will be forcibly settled at the day’s settlement price notified by the exchange. In addition, some traders who had short positions covered by stock in exchange-approved warehouses are being paid a compensation amounting to 3.9% of the contract value. This is to cover costs and any loss they may have incurred while disposing of their stock.

As such, this episode is not exactly like the one faced by traders at the National Spot Exchange Ltd (NSEL). While NCDEX has honoured all dues as on the date of the contract’s suspension, NSEL is still to honour a majority of its obligations.

Still, there are some disconcerting similarities between the two exchanges. Jignesh Shah, the promoter of Financial Technologies (India) Ltd, which ran NSEL, said a few weeks after the scam came to light that the exchange is a trading platform, and that the pay-in obligation is of the defaulting members. In other words, “don’t expect us to honour our role as the counter-party to every trade."

NCDEX is saying something similar. By suspending the contracts, it is effectively communicating, “A number of traders have defaulted; don’t expect us to honour our role as the counter-party to every trade until the expiry of the contract." It has done far better than NSEL by honouring all obligations as on date of suspension.

But this is far from an ideal scenario. Exchanges the world over have dealt with large defaults. When Lehman Brothers Holdings Inc. filed for bankruptcy, LCH.Clearnet Group Ltd took over its positions worth trillions of dollars. It subsequently wound down the positions, and also used hedges and other strategies because liquidity in the markets wasn’t sufficient. See: http://on.wsj.com/28YiJ8P.

It’s likely that NCDEX felt it did not have adequate liquidity or capital to take over positions of defaulting members. These positions amounted to 540 crore. As of December 2015, NCDEX had a settlement guarantee fund (SGF) of 128 crore. Castor seed prices had fallen 20% in January until they were suspended; if they had fallen another 20% by the time the contracts were disposed of, they could have wiped out most of NCDEX’s SGF.

According to a former Sebi board member, India’s arcane ownership rules for exchanges also act as a hindrance for those who want to beef up capital. Most investors are allowed to buy only 5% in an exchange. Other exchanges and financial institutions can buy 15%. If NCDEX wants to rope in a strategic investor to strengthen its financial position, current rules are a hurdle.

Besides, most Indian exchanges do not have in-house expertise or arrangements with trading firms to do what LCH.Clearnet did with Lehman’s positions. In the past, some have engaged in a fire sale of assets when a member defaulted. But with large positions, such as in the castor seed case, much more trading expertise is required for unwinding positions.

Sebi should ensure Indian exchanges have adequate capabilities for such eventualities. Besides, it should conduct a stress test of liquidity and capital of exchanges to ensure there are no repeats of the castor seed episode.

We welcome your comments at inthemoney@livemint.com

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