Madan Sabnavis: Who should regulate gold funds?

The fundamental issue is whether such a fund should fall under the purview of 'securities' or 'commodities'.

Exchange-traded funds (ETFs) are in news these days as they bring with them a breath of fresh air in the world of investment. Simply put, these funds allow investors to invest in a fund which in turn deploys the money in the underlying asset which is traded on an exchange. It appears to be similar to a mutual fund directed at specific scripts, except that these units do not have a net asset value (NAV) but are traded on a real time basis based on market forces. But what happens when the ETF has gold or any commodity as its underlying?

Gold ETFs as they appear to be defined today in the Indian context would be a part of the stock market story. But the fundamental issue is whether such a fund should fall under the purview of "commodities" or "securities". This is important because the fund is based on an underlying which is a commodity and would entail physical procurement of the underlying, either to the extent of the size of the fund, or on a fractional basis depending on the structuring of the funds.

There are three issues here. The first is what should be the basis of choosing the market under which ETFs would operate as there is dualism in the structure today with the commodities and securities markets having two distinct regulators. The second is that the overall playground will have to keep in mind the extension of this concept to other commodities as this will not stop with just gold. Finally, the derivative segment, which is another logical corollary of dealing in any cash market in the same underlying, should not cause contradictions in the thought process.

Gold ETFs have a commodity as the underlying and logically should be within the domain of commodities. But, at present, the mutual funds that would be launching such funds are going to have them listed on the stock exchanges, which raises the question as to whether such a decision is based on the class of market participants or the physical underlying. Currently, mutual funds are part of the securities and not commodity markets, and hence, ETFs would be associated with the stock exchanges. But this does not sound convincing because the class of players should not determine the market. If this were to be the logic, then hypothetically if we were to have foreign currency or dollar ETFs, where the underlying is foreign exchange, would the regulatory structure come under the purview of the RBI or the Securities and Exchange Board of India (Sebi)? The answer would be the RBI as the underlying, that is, foreign currency is within the purview of the RBI irrespective of the market participants.

The usual argument given here is that the player, that is, mutual funds is regulated by the securities market and hence all its activities get regulated by the securities regulator. But a player can be regulated by a number of regulators depending on the activity. In fact, if we were to borrow an analogy from the banking sector, banks are regulated by the RBI for banking activities and Sebi when it comes to operations in the securities market when issues of capital market arise.

This leads to the second question on extension of this principle to other commodities. An ETF need not just deal in gold but can theoretically also deal with other physical commodities like crude oil, cereals, metals, pulses, fibres and so on. In such an event, there is involvement of physical procurement of products that fall in the purview of the commodity markets. The reason for keeping the commodities and securities markets separate is that commodities require a very rigorous regulatory setup as the prices of commodities affect the common man unlike securities where only the trading participants are involved.

In fact, if hypothetically we have, say, wheat ETFs, then the physical procurement of wheat could upset the applecart and cause considerable distortions in the market. In fact, any commodity-based ETF will mean an increase in the demand for the product which can be inflationary, and hence, requires special expertise to rein in this possibility. This will be the case for gold also where there would be a sudden spurt in demand for the physical metal by the fund which has to handle this issue. Besides, while gold and silver are easier to assay, there are a host of issues involving grading of other commodities that go beyond the existing limited warehousing facilities available for this purpose.

The third issue relates to the derivative markets for the products. Today, the derivative product of gold is traded on the commodity exchange. Now, the derivative product in gold ETFs, which is a logical extension of the same idea, cannot possibly be traded in the capital market when it is already being traded in the commodity market.

There is hence the need to have more intensive debate on the regulatory structure for gold ETFs as the story will not end with just gold. Currently, since these funds are being considered by mutual funds that do not have access to commodity markets, it has been tempting to conclude that the securities market would be the natural choice for listing of these products. Financial markets evolve quite remarkably with speed and the innovative mind of the financial wizard is already thinking of exotic related products.

As argued earlier, by starting with a questionable premise of choosing the market based on the participant rather than the underlying, contradictions would surface once they are extended to other commodities and instruments. This should be eschewed.

The writer is chief economist, NCDEX Limited. The views expressed are personal