Universal exchanges: Welcomed by brokers, but fraught with challenges

Sebi's move to merge equity and commodity trading businesses has been broadly welcomed by brokers but pose challenges for the bourses themselves

Come October 1 and a significant policy change could alter the landscape of India's exchange industry. From that date, market regulator the Securities and Exchange Board of India (Sebi) has allowed commodity exchanges to enter equity and currencies trading and equity exchanges to offer commodity derivatives.

This crossover will inject a whole new level of competition, potentially benefiting customers, with technology, speed of trade, number of participants and, most importantly, pricing and arbitrage determining the winners. 

But this poses challenges for the exchanges too. Apart from attracting liquidity, exchanges will have to contend with predatory pricing from competitors, attracting talent and obtaining settlement prices for globally refrenciable contracts. The latter refers to the reference price of the physical commodity underlying the derivative contracts which is used for settling derivatives or futures price (also known as the reference price). In non-agri segments, except precious metals, settlements for commodity derivative contracts on base metals and energy products are based on international prices because their prices are determined globally. This will be a challenge for new entrants, not least because the 15-year-old Multi Commodity Exchange of India (MCX) holds the licences for obtaining settlement prices from respective market leaders.    

Sebi introduced the concept of universal exchanges in December last year and gave time for three-quarters to all exchanges to get ready for the new regime. Contrary to expectations, Sebi is yet to finalise the opening up of commodity derivatives for newer participants. It had floated discussion papers for allowing mutual funds, portfolio management service providers and even foreign players with exposure in Indian commodities markets to hedge and trade in commodity derivatives but it has not notified any of these yet. Hedge funds have been allowed but they don’t have enough choice to implement trading strategies and are, therefore, not very active in commodity derivatives. Market is also still waiting for permission from the regulator to trade in commodity indices.

The Bombay Stock Exchange or BSE has emerged as the most vocal in its plan to offer commodity derivatives trading. As a start, it plans to cut exchange fees, a major challenge to existing exchanges like MCX, which currently has a near 90 per cent market share. Says Ashish Chauhan, MD & CEO, BSE, “Over the last few years, BSE has been known for its extremely fast and flexible technology and innovative pricing. Given BSE’s recent success in new businesses like currencies, interest rates, SME, MF, OFS, international exchanges and so on, our team is confident of making a difference in the commodities market.”

Other commodity exchanges are smaller and more specialised and for them, lower trading volumes has been a perennial challenge. National Commodities and Derivatives Exchange is predominant in agri- commodities, which is not a priority area for BSE and NSE. Indian Commodity Exchange or ICEX dominates the diamond trade, and Ahmedabad-based National Multi-commodity Exchanges, which was the leader in plantation commodities, has merged in ICEX. More mergers may well be on the cards in the ecosystem of universal exchanges. 

NSE, the largest in equity and index-based derivatives, is also preparing for an October launch but has not divulged details of its plans beyond saying it will start with non-agri commodities. NSE officials said it may consider launching agri-commodities derivatives at a later stage. However, NSE has 15 per cent stake in the agri-centric commodity exchange NCDEX. Sources said NSE may have to review holding its stake in NCDEX if it plans an independent entry in agri-commodities.  

MCX, said sources, sees the best synergies in currency derivatives but will launch those services at a later date. For BSE and NSE, members would get to trade commodity derivatives as part of their existing membership, which means they will not have to pay higher fees. In readiness, brokers are consolidating their commodity derivatives and equity businesses. Till last year they had to have both businesses under separate entities. Now they also have a licence to have all businesses under a new company. Those facing issues of capital gains for merging commodity and equity companies are closing down their commodity companies.

“Nearly 5 per cent brokers have consolidated their business while 15 to 20 per cent are in the process and rest will also do so,” said Sanjay Rawal, president, Commodity Participants Association of India (CPAI). Those brokers dealing in commodities, currencies and equities are doing this, though standalone commodity brokers need not do so.

MCX, said sources, sees the best synergies in currency derivatives but will launch those services at a later date. On the issue of technology, Mrugank Paranjape, MD & CEO, MCX, said, “Sebi has mandated the norms for latency [speed of data transfer or speed] and MCX will also start reporting the same by next quarter. NSE and BSE are in the range of 150-200 microseconds and we will be in the same range. As regards features, we already have everything that commodity trading needs. And for throughput, we’ve handled volumes far in excess of current numbers.”

Another challenge for MCX is that it will have to face competition on fees from new entrants. The room to cut fees is limited because exchange fees account for 20 per cent of the total expense that brokers incur for trading on an exchange platform, with various levies accounting for the remaining 80 per cent. 

In the first phase, both BSE and NSE plan to launch bullion, base metals and energy contracts. Gold and silver contracts are easy to launch because there prices are derived locally. For other products, global prices are required for settlement price. MCX gets metals prices from LME and energy products from ICE as part of licensing agreements.

Both equity exchanges are understood to be in talks with these exchanges. So far, according to the officials of Indian exchanges, none of these bourses have agreed to provide settlement prices because they feel providing prices to more exchanges in one region will fragment liquidity. 

BSE has licence from DGCX, a Dubai-based exchange for commodity prices for trading in BSE’s GIFT city exchange where daily trading has crossed $1 billion and 60 per cent of that is of commodity derivatives. Despite the challenges, brokers are not averse to the idea of universal exchanges. Such exchanges, said Rawal of CPAI, would “bring in a lot more and different varieties of investors/traders trading in commodities”.  

The biggest benefit for both brokers and their clients is fund-use efficiency. Currently, investors deposit margins for commodity derivative in the broker’s relevant company and another margin for equity or currency in a different company of the same broker. Many investors trade in equities during the day and commodities in the evening sessions. Now since Sebi is permitting brokers to merge both businesses, any margin credit in one segment will be automatically available for another segment. “This will be another big advantage of competition,” said Rawal.