Working Committee Recommendations for fulfilling the objectives of Price-discovery and Risk Management of Commodity Derivatives Market

Transactions costs on the futures market are an impediment to arbitrage. FMC should pur-sue a program of market development, including promoting a diverse array of firms as members in order to improve market liquidity.

One way to reduce the cost of capital for the commodities trader is, to make banks and other financial institutions an integral part of trading in commodity derivatives. A number of policies and regulatory restrictions restrict banks and other financial institutions from participating in futures markets. Restrictions on banks under the Banking Regulation Act and other RBI regulated entities need to be removed so as to deepen and widen the partici-pation in these markets.

Foreign financial firms (both intermediaries and end-users) should be permitted to partici-pate in commodity futures trading. The existing system of limits on open interest and risk management provides adequate safeguards against the risk of allowing foreign participa-tion in Indian markets.

High warehousing and assaying cost adds to the transaction cost of hedgers. While use of scientific storage and grading etc. should be encouraged, one way to do so is to provide these services at low price.

Modernisation and professionalisation of warehousing is a critical policy priority that will reduce the frictions faced in arbitrage. The Ministry of Finance should engage with the WDRA and the Department of Food to pursue a work program to assist the emergence of high quality warehouses, negotiability of warehouse receipts, and spot market trading in warehouse receipts. A robust and liquid market in warehouse receipts would facilitate and encourage credit market participation in commodities derivatives in the form of loans against warehouse receipts.

Government should exempt arbitrageurs from the restrictions on holding inventory under the ECA, 1955.
In order to assist the development of organisational capability of firms operating in the commodity futures ecosystem, the government should stop the suspension of trading in an abrupt and unreasoned manner.

FMC should voluntarily adopt the regulatory governance of the draft Indian Financial Code, so as to reduce legal and regulatory risk in the eyes of financial firms, and thus as-sist the development of organisational capability in financial firms.

FMC should focus on addressing market failures through the objectives of consumer pro-tection, micro-prudential regulation and enforcing against market abuse. It should ensure that the owners and managers of exchanges have incentives that are aligned tightly with these objectives, and set up regular monitoring and reporting systems to ensure these. Apart from these functions, it should gradually step away from micro-managing contract design and market design. A review of contract designs should be undertaken periodically to ensure that these reflect the spot market realities and provide effective hedging oppor-tunities to its participants.

FMC should establish an annual process of computing measures of futures market liquidi-ty, price discovery and hedging effectiveness. This report should be released into the pub-lic domain and its implications discussed at the meeting of the FMC.

FMC and exchanges should undertake a work program, with data producers, to improve the precision of polled price series (a narrower set of grades and locations), a larger num-ber of time-series captured, and improvements in the veracity of the polled rates.

FMC should create an explicit plan on how to develop organizational capacity to execute on the above goals over the coming two years. The Government should provide it adequate freedom to manage its human resources. Exchanges should explore new ideas in contract design, to more tightly define the product with a narrower set of grades and locations, so as to reduce the frictions of arbitrage and thereby improve hedging effectiveness wherever the movement of prices of the commodities across grades and locations are not aligned.

Exchanges should explore the idea of extending trading hours that overlap with Asian and Australian markets to improve their international competitiveness. Currently, trading hours in India overlap with the European markets, but has little or no overlap with Australia and Asia, which is a large trading base that has been hitherto untapped.
February 2019
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