Although everybody is busy trying to unravel the crisis on the National Spot Exchange Ltd (NSEL), another core issue may be waiting in the wings. India has six commodity futures exchanges (comexes). The Multi Commodity Exchange of India (MCX) is the dominant player with a nearly 85 per cent market share, followed by National Commodity & Derivatives Exchange (NCDEX) with approximately 10 per cent. The remaining 5 per cent market share is divided among four others: National Multi Commodity Exchange, Indian Commodity Exchange, Ace and Universal Commodity Exchange.
Having two dominant players commanding 95 per cent of the market is tough for any newcomer in any field. More so in a market that is regulated, so introducing product innovations and differentiation is difficult, and the first-mover advantage is probably non-existent. Getting liquidity from other exchanges is also tough. Hence, the continued financial viability of such small exchanges becomes a major concern.
How is all this related to the NSEL crisis? The crisis has sharply focused the important issue of exchange default. Although the current default concerns a spot exchange (spotex) and not a comex, the Forward Market Commission (FMC), as the regulator, is concerned about the possibility of a default on a comex and rightly so. FMC has already asked comexes to set aside an amount for a Settlement Guarantee Fund (SGF). The treasury income from that corpus will accrue to the SGF and not the exchange. That's how it is done on the stock exchanges (SEs). Although this stricter regulation is a move in the right direction since it brings parity between the commodity and capital markets, it will impose a financial pressure on the comexes that are fighting among themselves for a very small pie and are already under stress in terms of financial sustainability.
This situation is similar to the capital market more than a decade ago with respect to the regional stock exchanges (RSEs). With the introduction of the electronic trading system through the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), the RSEs became insignificant. They couldn't afford new technology, did not have the reach of BSE and NSE, lacked manpower and a brand image. Companies came to the RSEs for listing as long as it was mandatory; when that stipulation was lifted in 2003, the RSEs became redundant. The Securities and Exchange Board of India (Sebi) came out with a survival solution by allowing RSEs to float brokerage subsidiaries for their broker-members and become broker-member of BSE or NSE. However, the corporatisation and demutualisation of SEs in 2004-05 presented a huge challenge to RSEs to continue as exchanges.
Two solutions were then explored. The first was the formation of the Interconnected Stock Exchange (ISE) with 14 RSEs as owners. The objective was to make ISE a third platform from which RSE broker-members and their clients could trade on a national electronic platform such as BSE and NSE. It didn't take off and, ultimately, ISE became a broker on BSE and NSE.
The other measure was IndoNext at BSE. For this, section 13 of Securities Contract Regulation Act was amended to allow broker-members of other exchanges (read RSEs) to trade on national exchange (read BSE/NSE) with RSEs acting as a clearing house to clear trades of its broker-members. A body of all RSEs, called the Federation of Indian Stock Exchanges (FISE), was formed for this purpose. P Chidambaram, finance minister then as now, launched FISE at BSE. IndoNext, however, also didn't work.
Which brings us to the four smaller comexes fighting for 5 per cent of the market. Each is trying to garner a 1 to 3 per cent share. Sooner or later the question of financial viability will raise its ugly head. Fresh equity infusion by existing shareholders or new investors could help but does not solve the sustainability issue. The promoter-entities of comexes are big names in the public and private sector and, along with financial institutions, they represent a huge financial and technical resource base. If they were to come together on a single platform, the possibility of the survival and growth of the merged entity becomes almost a certainty.
A single entity called, say, Indocom, formed by merging the smaller comexes will have a 5 to 7 per cent market share on day one. With a combined average daily turnover of about Rs 10,000 crore, the issue of sustainability is addressed. This would offer them a reasonable opportunity to fight for market share and grow. Already, there is a broad specialisation in the market with MCX being a leader in metals and energy and NCDEX in agri-commodities. The others also have minor segment specialisation, which could become their combined USP. This will also help develop the market by offering specialisation in products and services and encouraging product innovation.
Unlike Indonext, however, where the RSEs simply joined hands to work together, Indocom should entail a deeper consolidation involving resource synergies in finance, products, technology and human capital and economies of scale in terms of costs. Doing so would reduce duplication of efforts such as marketing, business development and technology.
This development would also mean that the regulator will have to supervise fewer comexes, leading to better oversight. Better regulation with financially sound comexes would mean better governance and higher compliance levels. Ultimately, investor confidence is a function of better regulation and financial capabilities in the marketplace.
Bringing all parties to the table may be difficult but not impossible. The private parties will see the business case; the public institutions will see the benefit of strengthening the market structure. The government and regulator should see it as a systemic solution arising out of the current crisis to create a robust market. Issues like being competitors, brand image and management control and so on can be solved, though the original owners may be minority stakeholders after the merge. Management should be left in the hands of professionals. This would solve the conflict-of-interest issue.
A word of caution here from the Indonext experience. Let this initiative be led by the government arising out of the current crisis as a regulatory measure for enhancing the safety and strength of the market. With the finance ministry coming into the picture, now is the time to make our commodity market stable and secure with financially sound market intermediaries.
A consolidated comex with a diverse and disbursed shareholding, independent management and close regulatory oversight could well be the systemic solution for which all are looking. Globally, comexes are larger than equity markets in terms of dollar turnover.
Another positive outcome of the consolidation could be the integration of the spotex with the comex. In 2000, when badla was banned and derivatives introduced, Sebi considered a separate exchange for derivatives. But the close linkage of the underlying cash-equity market with derivatives meant that both segments needed to be under the same SE. This has proven a good risk-management tool across both segments.
This integration of the spot and futures segments is required in commodity markets too. An orderly, national-level, electronic spot market can be developed to reduce risks such as collateral management, warehousing and, most importantly, and for broker/client-level margining and capital adequacy. Although this integration may require a holistic approach for regulators, Comex consolidation would be quick and easy to implement.
The Indian financial system needs the government and regulators to rise above the current crisis and implement systemic solutions for a robust and credible marketplace. Only then will the work done by initial players to take Indian comexes to global levels have served its purpose.
The writer is former MD & CEO, BSE
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
