Mint Explainer: Why MCX is warming up to a wider pool of FPIs

India’s largest commodity derivatives exchange has opened its doors wider to foreign investors in its biggest segment, after a previous attempt to secure their interest did not take off as expected. (Reuters)
India’s largest commodity derivatives exchange has opened its doors wider to foreign investors in its biggest segment, after a previous attempt to secure their interest did not take off as expected. (Reuters)

Summary

Mint explains why MCX is banking on wider categories of foreign portfolio investors to increase participation in commodity derivatives trading

MCX, the stock exchange with India's largest commodity derivatives segment (CDS), recently allowed Sebi-registered foreign portfolio investors (FPI) under the categories of corporate, individual and family offices to trade in oil and natural gas derivatives, which made up 77% of its March turnover. 

MCX did this to widen the participation of investors in the commodity derivatives segment, which largely comprises hedgers and retail traders in bullion and base metals derivatives. But how effective will this move prove in deepening the market? Mint joins the dots. 

What are commodity derivatives contracts?

Commodity derivatives contracts are those backed by underlying commodities such as gold, silver, crude, and copper. Unlike in the equities markets, where securities exchanged between two counterparties are not in physical form, most  commodity derivatives contracts result in the delivery of a physical commodity such as gold or silver bars or copper rods. However, energy products such as crude oil and natural gas are settled in cash.

When was trading in commodity derivatives launched?

The government in 2003 re-introduced forward trading in commodities after a four-decade ban, and established the National Multi-Commodity Exchange, the National Commodity and Derivatives Exchange, and the Multi Commodity Exchange of India. 

While the NMCE and the NCDEX specialised in spice/plantation and farm products, the MCX was conceptualised as an energy and metals bourse. These exchanges were regulated by the Forward Markets Commission, which was merged with the Securities and Exchange Board of India in 2015.

Later, the NSE and the BSE too launched trading in the commodity derivatives segment in 2018.

The MCX is the leader in the commodity derivatives segment, accounting for 97% of the turnover in February. The NSE has a 2.6% market share, followed by NCDEX at 0.4% and BSE at 0.00006%.

What is the purpose of allowing more categories of FPIs to trade in the commodity derivatives segment?

Sebi wants to deepen the market with broader participation from retail, wholesale and institutional traders. Currently, participation is restricted to a few companies, and retail and wholesale traders.

To increase institutional trade in the segment, as in the equities cash markets, Sebi in 2017 permitted Category III alternative investment funds, mutual funds, and portfolio management services to trade in commodity derivatives. 

So a mutual fund launching a gold exchange-traded fund could hedge on MCX gold or silver. Similarly, AIFs that are long on metal stocks could take opposite positions on MCX metals or crude. However, this hasn’t played out as expected.

In foreign exchanges such as those on the Chicago-headquartered CME Group, the world’s leading derivatives marketplace, hedge funds take contrarian bets to actual users such as oil and metals producers.

Also read: MCX makes another stab at getting more FPIs on board 

On Indian commodity exchanges, it’s a bit of a chicken-and-egg situation, say market players. Institutions enter when there is liquidity as their positions tend to be huge. But if they don’t enter then the liquidity will not increase. 

Which is why Sebi is pushing hard to widen participation in the commodity derivatives segment.

What happened with earlier attempts to widen participation?

In October 2018, Sebi allowed eligible foreign entities (EFEs) having actual exposure to Indian commodities to participate in the commodity derivatives segment for hedging, but that also came a cropper.

In September 2022, Sebi discontinued the EFE route and foreign investors were allowed to participate in the segment through the FPI route prescribed by the regulator. To begin with, Sebi restricted their trading to cash-settled commodities and indices based on cash-settled commodities . 

It laid out two categories of FPIs: Foreign portfolio investors excluding individuals, family offices and companies could trade in the commodity derivatives segment with the same positional limits applicable to eligible domestic clients. The other three categories were allowed to trade only up to 20% of the position limit reserved for clients.

A position limit is the maximum quantity a client can trade in a commodity. For instance, in crude, the positional limit is 480,000 barrels across contracts (many contracts run concurrently), and in natural gas it is 6 million mmBTU.

Since the first category of FPI, which includes AIFs, banks, financial institutions, foreign depositories, venture capital firms, and partnership firms, didn’t hop on to the bandwagon as desired, MCX on 20 April opened up its commodity derivatives segment to the other three categories.

MCX now hopes that FPIs under the categories of corporate, individual and family offices will use direct market access to increase trade in crude and natural gas, which accounted for 77% of MCX’s total turnover of ₹26.83 trillion in March.

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