Multi Commodity Exchange of India Ltd’s (MCX) shares have risen by around 40% in the past three weeks. Investors are evidently excited about Securities and Exchange Board of India’s (Sebi) decision to permit trading in commodity options, besides drooling over rumours that Chicago Mercantile Exchange is likely to pick up a stake in MCX.
While the launch of options trading will undoubtedly be a great development for the commodity markets, it will be foolhardy to expect a large swing in the exchange’s fortunes anytime soon. To start with, Sebi is likely to take cautious steps, according to a person in its commodity derivatives advisory committee. For instance, the regulator may permit options trading in only one agricultural and one non-agricultural commodity to begin with. Coupled with the fact that transaction fees on options are a fraction of those earned on futures contracts, there may well be a hit on revenues in the near term.
Consider NSE’s example in the equity derivatives segment. In terms of notional turnover, options trading has been about 4.5 times the size of futures trading so far this fiscal. But because transaction fees are only applied on the option premium, revenues from options trading are about 20% lower than what the exchange earned from the futures segment. This calculation uses the base transaction fee of the exchange, and ignores turnover-based discounts; if one were to include those, the results may be skewed further towards futures because NSE has large discounts for equity options traders.
Put differently, although NSE’s equity derivatives turnover has risen at an annual average rate of 26% in seven years till financial year 2015-16, transaction revenues (based on the above calculation) rose at a rate of less than 10%.
When commodity exchanges launch options contracts, it may lead to some cannibalization, since they are far cheaper to trade and provide higher leverage vis-a-vis futures contracts. As such, revenues may take a hit in the near term. The fact that Sebi may allow only two contracts to begin with could then be seen as a blessing in disguise, as the impact would be staggered.
It also remains to be seen whether the regulator allows cash-settled European options or whether it settles for some other variant which may not be as popular with trades.
Based on global trading statistics, options are clearly not the favoured option for taking exposure in the commodity segment (see chart). According to data collated by the Futures Industry Association, options trading accounted for only 5.2% of all commodity derivatives trading globally, with futures accounting for the rest. The gap is wide because options haven’t yet been launched on Chinese commodity exchanges; these exchanges report extremely high futures volumes on the back of large retail participation.
But even in the US and European markets, where options are traded, futures account for well over four-fifths of all trading. This is quite unlike the equity segment, where options and futures trading have almost an equal share.
Will Acworth, senior vice-president for data and research at the Futures Industry Association says, “There is tremendous retail participation in equity options in the US, and there is a vast infrastructure of brokers who service those investors. There isn’t an equivalent infrastructure on the commodity derivatives side, and that’s an important reason why you don’t see as much retail trading in commodity options. In fact, to satisfy retail interest in commodity markets, securities brokers offer options on commodity ETFs with futures as the underlying assets in the funds. These products are effectively commodity options, but they are traded as securities, and hence not on futures exchanges."
The experience in India could be different, what with its high level of retail participation. Even so, the above-mentioned global statistics can’t be entirely ignored.
Of course, all of this is not to play down the import of Sebi’s move. U.K. Sinha, Sebi chairman, said this week that while the regulator has spent the past year in strengthening commodity market infrastructure and processes, it is looking at introducing more products and allowing more participants in the future. It is likely to start with entities such as mutual funds, which it regulates; although, allowing foreign portfolio investors (which it also regulates) seems to be a hot button issue for now. Widening the base of participants would do a world of good. Once commodity exchanges set up a clearing corporation, traders will have far more comfort about trading in the segment.
Of course, there are still concerns about sudden bans on certain commodities and other strictures such as low position limits and high margins. But all told, commodity derivatives trading looks set for decent growth. Will growth will be exceptional? That remains to be seen.
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