Why brokers are up in arms against MCX over the April crude oil contract

They say the exchange muscled its way in to force negative pricing on the contract without tweaking its software to protect traders, the way Nymex has done

Over the past two days, broker members of MCX, India’s largest exchange for commodity derivatives, are up in arms against the manner in which the April crude oil contract was settled by the bourse. They have valid reasons to present their side of the story against an exchange that has used its financial muscle to have its way.

What is the core issue?

MCX crude oil is the most liquid contract and generates the highest volumes on the exchange. The contract was launched 15 years ago and was based on US shale oil price indicator WTI (West Rexas intermediate), which is traded on New York Mercantile Exchange (NymEx). The kind of crude oil India imports is more akin to Brent Oil but for trading purpose WTI settlement has proved to be more suitable and easier to track. This is why, when another Indian exchange tried to trade in Brent oil based futures it began struggling with liquidity issues.

What happened on the Nymex?

With the US also going under lockdown in the battle against coronaVirus, shale oil demand fell sharply and existing storage capacities were almost full, forcing buyers have to organise their storage. Shipping tankers were used to store some quantities, though oil was not transported. The problem is that shale oil wells can’t stop producing immediately, so they started offering cash back and offering oil for free. This is what fostered the negative price quoted on the Nymex.

Nymex, under the CME group, had received information from its field team a week back about such possibilities, and tweaked its software to enable a negative price quote. This also enabled traders on the platform to be prepared for negative pricing. The contract on Monday closed at minus $37.63 a barrel.

And on MCX?

Negative price quotes were not possible on the MCX software and brokers who traded in crude oil understood that the maximum loss for them would be that contract price could be zero or 100 per cent loss. Several retail traders began buying small lots and some proprietary traders went long in crude at lower prices assuming there is money to be made in taking bullish positions. Very fair judgment.

What happened on Monday?

Aprill Crude prices, especially WTI, started falling because the problem in the US was of a very short term and limited to the current month contract. On the MCX, usually before expiry, open positions are carried over and shifted to the next month. But May Crude on MCX was quoting Rs 700 higher, making it difficult to take that much of a price risk. When the trading ended, the closing price announced was Rs 995 a barrel as per closing price norms, though the last trade was at Rs 965. Those who bought the April contract but could not shift to the next month allowed the contract to expire at whatever expiry price the MCX announced. However, unlike Nymex, Indian brokers were not alerted by MCX about negative price and all thought that the settlement price could be zero at the least.

Provisional settlement price of one rupee

On Tuesday morning, MCX issued a circular that April crude oil settlement price would be provisionally fixed at one rupee per barrel. At this price, the loss for alll the buyers combined was Rs 80-85 crore as per market estimates. The MCX formula, as mentioned in the contract, has been consistent with settlement of crude oil contract happening at the Nymex closing price on the day the MCX contract expired.

So what is wrong?

Following the lockdown, MCX trading like all commodity exchanges, usually ends at 5pm instead of 11.30pm for non-agriculture commodities. The negative price was quoted on Nymex only in the late hours and much after Indian trading closed. MCX's software was not capable of trading in negative and hence had the trading on MCX continued late, no trade would have taken place with negative price or price quoted in Minus.

Nymex is a deliverable contract and MCX is only cash settled. As a result selling oil at zero and offering cash back by the sellers to lift the oil is understandable and such trades took place on the exchange platform where shale oil producers had sold oil and cash backs were also accounted in price traded on the exchange. This was not the case in India.

Brokers had told investors buyers that there cannot be price below zero. Margins for Buyers on last was 70 per cent and maximum 30 per cent they had to pay. But later in the day after 4 PM MCX came out with the circular disclosing final settlement price at Rs. minus 2884 as per Nymex Monday close of $ minus 37.63.

What happened after the negative price?

The MCX clearing corporation which ensures settlement blocked trading margins which brokers had with them and brokers started selling open positions and all commodities price fell sharply. Brokers sought to present their case with the market regulator Sebi and even MCX. Brokers say that none gave them hearing opportunity and MCX decision was implemented unilaterally.

The regulator Securities and Exchange Board of India is understood to have advised the exchange to follow terms of the contract. And brokers started making all possible noise. Tweeter was full of such complaints where investors also complained to Prime Minister’s Office, sebi, regulator, exchange, media and all possible source whom they felt can help raise their voice.

Ultimately on Wednesday brokers were to High court but since court works for a few hours they were waiting for their case to be admitted. Brokers avoided going to Securities and Appellate Tribunal.

Loss estimates

Market veterans estimate that 13 players, most of whom were algorithm players, made a killion of Rs.450 crore due to windfall negative price settlement. Around 115 brokers lost the money which they says actually their clients lost but they cannot ask them to pay. Investors said on tweets that many brokers were forcing them to pay all the loss beyond 100 per cent. However, due to lockdown, actual recovery by brokers from clients is very difficult.