The recent woes of National Spot Exchange Ltd (NSEL) have put the spotlight on the world of commodity trading.

The exchange has had to abruptly suspend trading in a large number of its contracts as well as defer the settlement of trades that have already been executed. This resulted in rumours of a settlement crisis, leading to a 66% drop in NSEL’s parent company, Financial Technologies (India) Ltd’s (FTIL) shares.

The fear was that FTIL might have to make good NSEL’s settlement obligations, but according to the head of a large domestic trading house, the exchange is essentially facing a liquidity crisis.

The exchange has said that the rights of all who have traded on the exchange are secure.

It added that if there is any shortfall in pay-ins, it will sell physical stock from its warehouses to make up the shortfall, and if required, tap into its settlement guarantee fund to settle all obligations. Be that as it may, the episode highlights the need for better regulation of commodity markets.

Prima facie, there doesn’t seem to be anything untoward about NSEL’s erstwhile products. The pay-in for its pure spot contracts was on a T+0 basis, i.e. on the same day of the trade. The buyer received the commodity on the day of the trade from the exchange, while the seller received funds the next day by 11am. This is not very different from spot transactions in mandis or markets governed by APMCs (agricultural produce market committees) established by state governments.

In addition, the exchange offered deferred payment contracts, whereby the pay-in schedule was fixed for a future date. For instance, in a T+20 contract, the pay-in happened 20 days from the date of the transaction. Such contracts brought in a category of market participants called financiers, who simultaneously bought spot contracts and sold deferred payment contracts. The difference in the price of the two contracts, which can also be seen as the interest paid to defer payment, was the return of the financier. On the face of it, there’s nothing wrong with the design of the contracts.

However, a report in Moneylife magazine suggests that the exchange allowed trading without verifying whether the seller had stocks, thereby leading to what are called naked short sales. Another report in television channel ET Now said, citing unnamed sources, that the exchange could be overstating the amount of castor seed stock it holds. The exchange has clarified that this is untrue.

Even so, the exchange’s recent problems show what can happen when there is no clear regulation of markets. The above-mentioned allegations can be easily verified and acted upon by a regulator. Spot contracts in agricultural commodities do not fall under the jurisdiction of the Forward Markets Commission (FMC), but under state governments. As a result, NSEL wasn’t strictly under the purview of FMC or the department of consumer affairs. However, when the central government intervened because of its concerns about the deferred payment contracts and short sales, NSEL chose to cut the tenure of its contracts to below 11 days last month. Current rules state that contracts with a settlement cycle of over 11 days are forward contracts. But there is still no clarity about whether the new contracts are acceptable to the department of consumer affairs, which has led to uncertainty in the market and disruption in trading.

What about commodity futures trading? After all, there has always been the concern that oversight is weak because of the quality of FMC’s workforce as well as because of the delay in the passing of the FCRA (Forward Contracts Regulation Act) Bill. It must be noted here that a large part of the turnover in India’s commodity futures markets are closely linked to popular contracts in developed markets. Price movements in contracts such as crude, silver and gold follow the price trends in international markets and there is hardly any precedent of price manipulation in the most liquid contracts.

One fallout of poor regulatory oversight, however, is that the government has often clamped down on futures trading in agricultural commodities by banning certain contracts. This has resulted in lower participation by genuine participants, thereby leading to a higher element of trading by companies that engage in proprietary trades and financial traders. As a result, the intent of enabling effective hedging through futures trading is yet to be achieved to a great degree. Effective regulation is also important during the physical settlement of contracts, in case there are discrepancies in the quality of commodities traded. Of course, since cash settlement accounts for the bulk of total settlements, this isn’t currently a very big problem.

So while the commodity futures markets hasn’t had any blow-ups, the importance of a good regulator cannot be overstated. The dated Forward Contracts (Regulation) Act, 1952, must be amended to factor in current realities of the market as well as provide FMC the required autonomy to regulate a large market. The commodity futures market needs several reforms, including the introduction of options and allowing foreign institutional investors, mutual funds and banks to participate. These reforms must happen sooner rather than later to increase the health of the market. The central government’s plan to regulate spot market trading, however, should be drawn carefully, as this currently falls under the purview of states.

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