Making gold ETFs deliver

Apart from the obvious operational issues, it is not clear that the present system of trading allows investors to get the biggest bang for their buck.

The mutual fund industry has proposed to launch Exchange Traded Funds (ETFs), which are to be available for trading on stock exchanges. Funds collected by the mutual fund will be invested in gold and hence the net asset value of the ETF will be largely dependent upon the price of gold minus the administrative costs of the asset management company (AMC) and the mutual fund.

Legal meaning: Under Section 15 of the Forward Contracts Regulation Act (FCRA), forward contracts in gold can be conducted only by or through members of associations (read exchanges) recognised by the Forward Markets Commission (FMC). Since ETFs provide for the delivery of gold on a future date, they become a forward contract under FCRA. Gold has been covered under the Sebi (Mutual Fund) Amendment Regulations, 2006 which enables mutual funds to invest, keep custody of and also trade in gold. But, the term "securities" as defined under Securities Contracts Regulation Act (SCRA) does not cover gold. The regulation cannot supersede the basic provisions of SCRA and FCRA.

Operational issues: At present, mutual funds are not allowed to trade in commodity exchanges. If gold prices crash, gold ETF units will also crash and AMCs will not have any way to protect investors' wealth. Since there are no internal accruals to gold like dividend, rights, bonus, and so on, but there is a recurring cost in terms of storage, vaulting, insurance and security arrangement, how mutual funds will service the investors is still an open question.

This project will need AMCs to acquire expertise in buying and selling gold in the physical market as well as safe storage. Whenever they issue new units or whenever they redeem some units, buying or selling of gold has to be done. Buying of gold from the physical market involves issues like the purity of gold, identifying exact carats, and so on. AMCs may not have the requisite expertise to do this. At the time of buying, they must be careful about its source, because gold trade is often affected by issues relating to impurities. Any unorganised / unauthorised routes may create problems if sources other than banking channels have been tapped to acquire gold.

Similarly, for the sale of physical gold, there is no structured physical market. There could be problems relating to lack of transparency and settlement defaults. Banks and financial institutions do not buy gold; they only sell it. Further, gold cannot be exported under the existing rules.

Vaulting of gold is another serious issue. If AMCs maintain the vaults themselves, it would be risky. If they keep it with some bank, they may not be able to monitor whether the same gold is being used by the custodian for sale. If they insist on bank guarantees from the custodian equivalent to the value of gold, it would add huge costs to the entire system.

The valuation methodology adopted by the mutual funds is based on London Bullion Markets Association (LBMA) AM/ PM fixing. But when the AMCs buy or sell gold, they have to do it in the Indian bullion markets, which could be different in terms of the parity price. This may create a distortion in valuation.

The entire mechanism of gold ETFs is based on the successful functioning of authorised participants. An authorised participant is supposed to buy gold out of his own funds, deliver such gold to the custodian, get equivalent units from the mutual fund, provide two-way quotes on the NSE for the units and liquidate the physical gold when he wants to convert his unit holdings to cash. It would be a tough task to find authorised participants willing to assume all such responsibilities.

At present, the volatility in commodity prices, price movement in spot markets, price movement in futures market, international reference prices, and so on, are monitored by the FMC and commodity exchanges. But they will not have access to data relating to ETF trading, which may create a threat to market integrity.

Sales tax compliance: The sale of units by a mutual fund can have either of the following connotations:

It can be the sale of units based on the prevailing price of gold, where a unit is a derivative of gold, since it derives its value from the prevailing price of gold. If we go by this definition, it becomes a forward contract in gold, which must be regulated by the FMC.

Alternatively, it is an instrument through which the mutual fund sells gold to the investor on the date of investment against payment, after which the mutual fund provides custodian facility for the safe upkeep of the gold. If we follow this definition, gold ETFs go outside the purview of the FMC, since they become ready delivery contracts. But unfortunately in this case, the nature of transaction will be that of the sale of gold by the mutual fund to the investors as the ownership rights are being transferred by the fund to the investor. Therefore, it would attract sales tax. This is practically impossible because investors selling units will not have sales tax numbers.

The investor would be a net gainer only if gold appreciates between the date of buying and selling minus the load on account of expenses and AMC costs. If the price remains constant or depreciates, he would be a net loser.

The basic expertise of AMCs, which ensure value creation for the investors, lies with the active management of assets and churning out portfolios in accordance with market dynamics. But in the proposed gold ETFs, mutual funds would be doing passive management only. Major fluctuations in gold prices typically take place during evening sessions of the Commodity Exchange of New York (COMEX). In case of wide fluctuations, investors will not be able to buy / sell units as the NSE would not be open at that time.

Therefore, mutual funds should raise funds for gold ETFs as per Sebi guidelines, but trading in ETFs should be allowed on commodity exchanges with due permission of the FMC. It would be a perfect solution and would also be fully compliant with the present legal framework in the country.

(The writer is MD & CEO, National Spot Exchange and Director, MCX)