Govt to spice up derivatives play

The government will soon give its approval to Sebi to allow mutual funds to not only trade in the commodities market but also permit options and hybrid derivatives. The move will integrate commodity derivatives with equity and currency derivatives as hedge instruments.

By Jayanta Roy Chowdhury
  • Published 20.03.17
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New Delhi, March 19: The government will soon give its approval to Sebi to allow mutual funds to not only trade in the commodities market but also permit options and hybrid derivatives. The move will integrate commodity derivatives with equity and currency derivatives as hedge instruments.

An expert committee will soon start working on framing the new rules.

Last year, the government had amended the Securities Contract Regulatory Act of 1956 to include commodity derivatives as "eligible securities", allowing mutual funds and foreign portfolio investors, including wealth funds, to invest in the commodity derivatives market. However, the rules were yet to be framed.

The government had last year also set up the Electronic National Agriculture Market (E-NAM) to integrate 585 spot markets across the country. Of these, 200 markets have been integrated. This happened after the Forward Markets Commission was merged with Sebi in 2015.

Top officials said the government would soon set up an expert committee to study and suggest an operational and legal framework to integrate the spot and derivatives market for commodities trading.

Derivatives are financial contracts for delivery in the future, sometimes with an option on price or place of delivery, which derive their value off a spot price time-series, which is called "the underlying".

The underlying asset can be equity, index, commodity or any other asset. Hybrids are a newer concept which combine equity with commodity derivatives and/or foreign exchange.

"Most foreign banks and financial institutions prefer to hedge their bets with commodity derivatives and some would like the kind of hybrids they play with in more advanced markets such as New York, but the actual amount which is placed in such instruments is low, say typically about 5 per cent of the total investment in a market. However, it gives the foreign investor a useful hedging instrument," said Amit Banerjee, an independent merchant banker advising East Asian portfolio investors.

Goldman Sachs and JP Morgan have been among the key players in the commodity and hybrid instrument markets abroad.

"Using derivatives breaks risk into pieces that can be managed independently, that is why they are popular and India is merely following a global trend," said Banerjee.

A Sebi-appointed committee has already proposed the introduction of exchange-traded products such as options based on commodities, besides revision of warehousing norms and improvement of the delivery and settlement mechanism.

However, officials warned that the principle challenge for them as policymakers would be to ensure "designing regulations and rules that prevent excessive risk taking by market participants while not stalling financial innovation".

"All this must ensure that derivative transactions are properly traded and prudently supervised," said officials.

The caution stems from the fact that derivatives have in the recent past been connected with a number of high-profile crashes that roiled the global financial markets. Critics blame derivatives, especially hybrids, for bankruptcies and collapses, including Enron in 2001 and Lehman Brothers and American International Group in 2008.

Investment guru Warren Buffet had recently said that "some of these things get so complicated that they're very hard to evaluate and went on to add that they were "still a potential time bomb in the system".