Regulatory convergence for commodities: The pluses and minuses

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Direct Market Access (DMA) for foreign portfolio investors (FPIs) in exchange-traded commodity derivatives by the Securities and Exchange Board of India (SEBI) is a welcome step that could encourage local exchanges to offer standard contracts to Foreign Investment Institutions (FPIs), infuse liquidity and enhance institutional participation in the commodity derivatives market.

This step could be a positive outcome of organizational convergence. It is worth noting that convergence has occurred in stocks and commodities yet The Futures Markets Commission (FMC) has merged with SEBI In 2015. There are positives to organizational convergence.

Appendages

First, organizational convergence brought about organizational coordination through coherence and complementarity (Jordan and Majnouni, 2002). This has resulted in promoting openness by integrating the global derivatives market, strengthening conflict management between exchanges and their members, reducing impact costs, and improving products and market development.

Convergence also enhanced the independence of clearing houses in ensuring the performance of market participants and mitigated default (credit) and systemic risks in derivatives markets.

Although convergence has helped deregulate and improve derivatives market structure, behavior and performance, the impact of regulatory convergence on commodity derivatives has yet to be examined. Why is this important? It should be noted that the commodity derivatives market has recorded a compound annual growth rate of 10 percent and 7 percent in turnover (market breadth) and open interest (market depth) from 2015-16 to 2021-2022. In contrast, for the corresponding periods, the compound annual growth rates of turnover and open interest in equity derivatives were 71 percent and 25 percent, respectively.

Therefore, it is necessary to find commonalities and differences in the features of the overall organization, ie. Standards for membership net worth, institutional involvement, margins, risk management, and penalty structures for commodity and equity derivatives markets.

cons

Some convergence defects have also been noted. First, the criteria for net worth of membership must be of interest to the regulator. Exchanges in the US and China follow a uniform membership structure, with an institutional trading clearing member and a professional trading clearing member making an additional deposit.

However, the Indian derivatives market has not yet followed standardized membership, and these also the net worth criteria for membership require reconsideration.

Secondly, the investment limits on institutional participation, that is, mutual funds and foreign investment institutions, are a great hindrance to the development of the market. A maximum retention period of 30 days for most commodities discourages corporate participation. The maximum exposure of 10 percent in a single commodity is also very restrictive for mutual funds participating in commodity exchange-traded derivatives.

Third, the margin load for equity derivatives is 20-21% of the value of the contract traded. In comparison, it is higher for commodity derivatives contracts as the pre-expiry or bid-period margin and delivery margin (for forced delivery) make up the total margin load of 35-40 percent.

Fourth, the maximum margin charged to participants in equity and commodity derivatives is intended to ensure the performance of participants. However, peak margin snapshots are taken at random intervals, making it impossible to accurately assess and maintain margin deficiency. Since margin requirements exceed banking hours, it is difficult to maintain additional margins during the day.

Fifth, there must be a correlation between the trading margin and the price limit, and this estimate can vary for stocks and commodities. However, there is no such procedure approved by the local stock exchanges.

Sixth, the initial margin load may require reconsideration. CME Group, for example, charges 25-50 percent of initial margins as intraday margins. By comparison, 100 percent of initial margins, including the portfolio’s standard analysis of risk plus margin exposure, are charged by local exchanges.

Seventh, for market level position limit violation, the equity derivative penalty fee has a cap of 1 per cent of the value of the incremental position subject to a minimum of Rs.5,000 and a maximum of Rs.100,000. Such a limit is not applicable for commodity derivatives, and intraday position limit violations can result in a total penalty fee.

policy recommendations

We suggest some suggestions for policy actions. First, the calculation of net liquid value must be supported by the nature of the products, the valuation of the underlying assets, and the risk assessment (value-at-risk metrics).

Second, the commodity holding period could be extended to 90 days or aligned with the gold and silver delivery period to induce participation of mutual funds interested in the physical delivery of base and precious metals.

Third, excessive margin load has forced many trading members, depositors, and hedgers out of the market. Necessary adjustments should be made to the scope and margins of risk management.

Fourth, the basis for determining the period of margin risk should differ for the type of commodities underpinned by estimates of its volatility.

Fifth, the penalty structure for intraday position limit violation in commodity derivatives should have an upper limit. In addition, the penalties calculated for position limit violations during the day must be adjusted to the open position based on the end of the day, and the net amount can be collected from exchange members.

In conclusion, the regulator should enable the commodity derivatives management and gain autonomy and autonomy to align evidence-based recommendations with commodity derivative products and market development.

The author is studying at IIM Lucknow. Opinions are personal.