G N Bajpai: Convergence = single regulator

Recently, a financial newspaper reported that the ministry of consumer affairs had proposed amending the Forward Contract (Regulations) Act to empower the Forward Markets Commission (FMC) with powers similar to those of the Securities and Exchange Board of India (Sebi).

This provoked a question in many minds: Why re-invent the wheel and not facilitate a convergence of the two""the FMC and Sebi""to build a common regulatory platform?

Convergence is expected to facilitate the work of market participants and exchanges, trading, and clearing and settlement systems, operating on common principles of governance and regulations by building on the similarities of the two markets, while customising for their uniqueness and the products traded.

The economic functions of the two markets are similar. They are risk management, price discovery, and capital formation.

Commodities futures also enable transfers of price risk from producers (including farmers in the case of agro-products) and end users to other market participants.

A commodity futures contract is tradable and fungible, and issued purely for financial purposes. And the concerns and issues of fairness, transparency, efficiency, market integrity, risk management, clearing and settlement, and counter party risks are alike.

The removal of restrictions on the trading of commodities futures, the setting up of three automated de-mutualised multi-commodity exchanges, and the rise in trading volume (collective turnover of around Rs 4,000 crore a day) have demonstrated the potential of the market.

Even then, trading volumes in important products in the agro sector, except guar seed and soya oil, have not picked up.

However, there are certain inherent weaknesses in the current regulatory framework, such as lack of transparency in trading procedures, the existence of an arbitrary settlement system, lack of proper trading supervision, the absence of a safe and enforceable margin system, etc.

Regional and outcry-based exchanges do not follow the standards of their national counterparts. Reverberations of predatory pricing in one exchange are seen in the market place.

Further, the commodity exchanges do not provide for compulsory and effective counter-party risk under a uniform regulatory framework, which eventually poses a settlement risk.

"There is an urgent need to strengthen the FMC in terms of personnel, powers, finances, IT tools, etc.", says Venkat Chary, former chairman of the FMC.

All these issues can be addressed easily and growth can be fast-paced, with much lower risk, in case the institutions of the securities market are used for the commodities markets.

Globally, the trend is in the direction of a single regulator and geographical divergence is reflected in divisions of regulation on the basis of products, and not on the basis of underlying factors.

Some examples with a common regulator for the two markets are Australia, Singapore, China, Hong Kong, South Korea, the UK, and Brazil.

In the US, the Commodities and Futures Commission (CFTC) regulates all derivative products and the Securities and Exchange Commission (SEC) regulates the spot market.

Convergence yields superior efficiency and greater sophistication via direct access to a richer range of traded products and derivatives.

"The intermarriage of these two markets has the potential of providing growth impetus to commodity derivatives and opens up avenues of diversified business opportunities to securities market participants, which eventually leads to a deepening and broadening of the market," observed an inter-ministerial task force.

In a setting where the clearing corporation, the central counter-party, provides novation for a variety of products, the collateral required for a given level of safety is lower, as against having a separate corporation for each area, and it reduces the transaction cost.

As of today, statutes do not permit financial institutions like banks, insurance companies, mutual funds and pension funds to trade in commodities futures.

Convergence will facilitate their participation effortlessly and thereby increase the number of market participants.

Sebi has, over the years, brought about a transformation in the securities market. Today, the Indian securities market, both spot and futures, can be compared with the best and the most developed in the world.

The orderly development of the securities' futures market in a short time since its commencement can be gauged from the fact that the NSE has become the fifth largest market in index futures.

In single-stock futures it leads the world by a very fair margin. The risk management of the Indian securities' futures market has been appreciated by executives of the Chicago Board of Trade, the last word on commodities futures, and the system has been tested more than once during the periodic phases of turbulence in the market.

Doubts, apprehensions and concerns were expressed about both feasibility and capability when Sebi was pushing forward the shortening of settlement cycles, de-materialisation of securities, abolition of carry-forward products, introduction of securities futures, etc.

Similarly, there are concerns now that the focus on the development of the commodities futures market will suffer in case convergence happens.

Currently, the FMC is merely an advisory body, and the regulatory powers rest with the Centre. There is very little infrastructure and capability within the FMC to regulate the market.

It is yet to begin even assessing the needs of skill and technology. It has to structure its revenue model. Starting from scratch will entail cost and time, causing damage to the development and regulation of the market.

In a vibrant democracy, it is difficult to predict how long it would take to push through legislative changes.

The issue of convergence has engaged the attention of two ministries of the central government, the ministries of finance and consumer affairs, for quite some time now, and their differences on convergence surfaced much after the government's intention was stated in the Budget proposals for 2004-05.

It might be worthwhile to recall the process that might have led to the decision and its inclusion in the Budget proposals.

In fact, the subject was debated by three committees""the KR Ramamurthy committee on the participation of securities brokers in commodities futures set up by Sebi; the inter-ministerial task force on the convergence of securities and commodity futures set up by the ministry of consumer affairs, food and public distribution and chaired by Wajahat Habibullah, secretary, ministry of consumer affairs; and the working group on convergence under the chairmanship of D N Padhi, additional secretary, ministry of consumer affairs.

The recommendations of these three committees were positive. The comments of the inter-ministerial task force on convergence were candid: "Attaining growth in the commodities market without convergence will need replicating the infrastructure, regulation, resources, etc. and may be slow."

Rethink on any decision or issue is integral to dynamic decision-making, particularly in a fast-changing environment. However, an objective evaluation of merits is vital.

In a setting where a lot of catching up has to be done, particularly to bring up institutions for creating efficacy, a less expensive and least painful route should be preferred. Optimising use and speed in attaining objectives should be the touchstone for decision making.

The author is former chairman, LIC, and former chairman, Sebi.