Hedge funds may be allowed in non-farm commodity derivatives initially

Globally, hedge funds are market movers in commodities with an exposure 10 times that in equities

The Securities and Exchange Board of India (Sebi) has proposed to allow category-3 Alternative Investment Funds, typically known as hedge funds, in commodity derivatives. This is on a recommendation by its advisory panel on the segment.
 
Those for it say this would bring more liquidity in the segment. The aim is to bring institutional investors into commodity derivatives; initially, though, this is proposed only for non-agricultural commodities. 
 
"Globally, hedge funds' play in commodities is 10 times bigger than in equity. In India, they will be big volume providers. We can see several big banks, local and foreign, starting funds for commodities in the Indian market,” said Gnanasekar Thiagarajan, director, Commtrendz.
 
Category-3 AIFs have to be set up by opening a company in India and with Sebi registration. Their regulations permit them to take leverage and derivative position. Since even a foreign company can form such funds in India, the move would be an indirect entry of foreign investors in commodity derivatives.
 
Sebi has a higher degree of comfort in allowing such funds, as the regulations on these specify that they deal with custodian institutions, the latter holding customers' securities. Hence, any undue increase in leverage can be handled at the custodian's level.
 
Before issuing its consultative paper on allowing of hedge funds, Sebi had rounds of discussion with sponsors of such funds, custodians, exchanges and other market participants. As with equities, Sebi has proposed a maximum of 10 per cent position in a single commodity.
 
A sector official says “Foreign funds can also set up a company in India and take Sebi registration under the Alternative Funds regulations. Even an existing fund can approach their investors with a proposal to amend their prospectus, seeking permission to take positions in commodity derivatives.”
 
He added that funds set up by leading investment banks, private equity funds and broking houses are initially more likely to enter commodity derivatives. “Foreign banks are already providing custodian services to several foreign investors in equity. Hence, foreign investors will find it easy to enter commodities derivatives,” said another person involved in the Sebi consultation.

The only issue is that globally hedge funds have a better play in commodity derivatives and what attracts them to the Indian market. according to a source quoted above, is that India being largest gold consumer, it can set the price of the precious metal and foreign funds can support that process with the money power they have at their disposal.

So far as option trading in equities market is concerned, institutional players, largely foreign, makes the most money as sellers, since the risks involved here are the maximum and come with commensurate returns.