Sebi. Photo: Aniruddha Chowdhury/Mint
Sebi. Photo: Aniruddha Chowdhury/Mint

Mumbai: India’s capital markets regulator is planning to revamp commodity market rules to introduce transparency, reduce risks and include new participants, such as banks, mutual funds and foreign portfolio investors, to improve liquidity.

The makeover plan was proposed by the Securities and Exchange Board of India’s (Sebi) Commodity Derivatives Market Advisory Committee at its first meeting on Friday, three people directly familiar with the development said.

The panel was formed after the commodities market regulator, Forward Markets Commission, was merged with Sebi in September 2015.

Mint has reviewed a copy of the panel’s agenda note.

The proposed norms are likely to be introduced after floating a discussion paper on the matter within a month, the three people said, requesting anonymity.

To weed out trading risks taken by investors because of limitations in types of commodities contracts, the panel has proposed introduction of new exchange-traded products such as options based on commodities. The committee has also proposed to revise warehousing norms, improve the delivery and settlement mechanism, and look at ways to improve the electronic connectivity between the physical market, the warehouse supply chain and the commodity exchanges.

This is to ensure that there is clarity for all market participants and regulators about the quantity and the quality of the goods available across the warehouses, their actual prices and their positions in the warehouse supply chain. This, according to one of the people cited above, will curb chances of excessive speculation and risks of any possible settlement defaults that may cause a loss to investors.

“The markets will not deepen and become reliable without institutional participation. The recent cases of manipulation were also a fallout of the lack of institutional participation as there was lack of accountability over the traders and clients,” said Chirag Shah, a senior vice-president and head-commodities and global futures, at PhillipCapital (India) Pvt. Ltd, a financial advisory.

In the Rs.5,574-crore settlement scam at National Spot Exchange Ltd, it was found that the commodities that were documented were not in warehouses, leading to a payments crisis.

Shah added there is no argument for these financial institutions to invest in the commodity derivatives market as derivatives are not considered an investment in the strictest sense.

“Financial institutions should participate in commodity derivatives market as hedgers, whether the hedging is for their own position, like in the case of bullion or the buyer/borrower is asked to hedge on a rule-based approach,” Shah said.

The Sebi panel, in its agenda note, has proposed the introduction of new commodity derivatives products on the exchanges, such as options and index futures, index options, weather derivatives and so on,to improve the market’s liquidity.

At present, only futures contracts are allowed in the commodity derivatives trading space.

“Considering the shallowness of commodity derivatives market…introduction of such new commodity derivatives products may be conducive for the overall development. It can also complement the existing futures contracts and make the commodities market more robust and efficient,” the Sebi note read.

The panel said that options contracts give hedgers a form of price insurance, the cost of which is the option premium determined during its trading.

“They give the option buyers the opportunity to limit losses, but ensure profiting from favourable changes in the futures prices,” the Sebi agenda note said.

Also, trading in commodity derivatives and options contracts may allow banks to offer customized derivative products, suiting hedging requirements of their clients by blending credit products with hedging products, the panel said in the note.

The panel also proposed to allow mutual funds to launch commodity schemes that may allocate investments in commodities such as oil, metals, agri-commodities, commodity derivatives products, and so on. Currently, only schemes based on gold are allowed by Sebi.

The Sebi panel has proposed that banks, FPIs, mutual funds, pension funds and certain alternative investment funds be permitted to participate in commodity derivatives trading.

Allowing entry of new categories of investors in the commodities trading space will mitigate risks of volatility and defaults by deepening the market for hedgers, according to the panel.

Another key proposal under Sebi’s consideration is to overhaul the existing price discovery mechanism to ensure that every commodity and its derivatives are priced fairly as per the quality and the quantity of the commodity. The Sebi panel has suggested a new price polling mechanism for the spot market as contracts rely on the commodities’ prices in the spot market, and fair spot price will ensure a fairness in derivatives pricing.

Accordingly, the Sebi panel has suggested a review of the price polling mechanism and introduction of one that will suit the Indian market conditions.

The panel has also proposed that the regulator should ensure a close watch on the physical markets to reduce asymmetry between the polled and the actual spot price.

At the exchange level, prices are currently polled from a number of physical market participants from various centres of the country through a spot-polling mechanism. The method employed for arriving at the final settlement price is a part of the contract specifications of the commodity.

The Sebi panel feels that under the current polling systems, in the event of low liquidity in the physical market or inadequate arrivals of goods of a specified quality, the price polled for a commodity is often extrapolated by the participant merely on the basis of perception.

Also, according to the panel, there is a lack of transparency in the polling mechanism due to anonymity of the participants and there could be many participants polling prices with a vested interest in the pricing of the commodity. “It is essential for any derivative contract that linkage is ensured between derivatives prices and their underlying spot prices. In the absence of this linkage, derivatives may not be able to fulfil one of the primary objectives of their existence—price risk management or hedging,” said the note.

The panel has also suggested a review of the norms to lower risks of unprecedented volatility in prices of commodities and their derivatives and prevent the market from default risks.