Commodity exchanges: Managing risks

DERIVATIVE PRODUCTS emerged as hedging devices against fluctuations in commodity prices. Hence one of the most important functions of a futures commodity exchange is the containment of price risk. Unlike shares and securities, commodities have distinct features that are inherent in them — such as perishability, storage and corrosion. In commodities, the risk gets extinguished only when the underlying commodity is consumed. In the case of agro-based commodities, the risk gets activated by sensitive events. Therefore, managing risk in a futures commodity exchange calls for continuous vigil.

Worldwide, in a futures exchange environment, deliveries of the underlying commodity are less than 5 per cent of the volume of turnover. The remaining contracts are settled at a settlement price arrived at by the exchange between buyers and sellers. In this context, the exchange must ensure that the various issues relating to risks are addressed properly to ensure confidence of the players in the market.

In a commodity exchange, market sentiment plays a vital part in the movement of prices. In agro-based products, the behaviour of the monsoon will affect price movement. Of course, nowadays, because of the existence of buffer stocks in most commodities, the impact of a drought will not be severe in the year in which it occurs.

The price movements can be regional, national or global in nature. Any of these will be reflected in the futures prices of contracts taking place on the exchange.

The commodities exchange does not have a direct role in the price movement. Similarly, the exchange must not be concerned about the price movement so long as there is a system in place and there is no cornering or manipulation of market. It must ensure proper correlation between prices in the spot and futures markets and take prompt action to avoid cascading effects on the system users. It looks into various issues and guarantees the performance of the contracts by analysing the risks on a continuous basis.

The launch of on-line trading has enabled the practice of novation by which the exchange becomes the counter party for all the trades taking place under it. In other words, the exchange takes the opposite position and guarantees all the trades. To ensure completion of a transaction, a fidelity fund is created by the exchange. It is also supplemented by some portion of the funds received as turnover fees charged on the members. The interest received is credited to the funds account and the fund is kept separately and exclusively used for guaranteeing the trades. Most commodity exchanges rarely touch their fidelity funds because of the robust system in place to take care of defaults.

However, creation of the fund alone will not provide a guarantee for all the trades. It is the assessment of the risk and clearing of trades on a continuous basis that help in the containment of the risk. Normally, the exchange collects the marked to market margin on a daily basis. The outstanding positions are marked to market to the closing price and the difference is calculated and debited/credited to the respective accounts. This will ensure that all outstanding open positions of the clearing member are marked to the prevailing market price.

Similarly, the exchange fixes the circuit breaker price limit within which prices can fluctuate on a single trading day. Past data serve as a benchmark for fixing the circuit breaker limit. The price ranges are fixed in such a way that all participants are able to trade safely as it gives flexibility for the players to buy and sell without hitch.

The exchange fixes the maximum number of lots for each clearing member to transact on the basis of margin deposited. Delivery margin is imposed whenever a near month contract is reached. This is to ensure that the funds pay in/pay out is completed as per settlement schedule. The exchange has also powers to impose margins on a particular member if the trading exceeds a particular limit and in the event the authority feels it necessary it can impose an ad hoc margin.

Margin calculation is not allowed to strangle the market. Whatever be the type of margin, it is imposed meticulously taking into account both systemic and non-systemic risk associated with the commodity. If the margin imposed is not scientific it will lead to malfunctioning and this area requires market experience, analysis and assessment of risk and a proper method to convert the risk into monetary terms.

Any risk containment measures must be supplemented with market intelligence and a strong on-line and off-line surveillance mechanism in order to help the exchange in its smooth settlement of transactions.

R. Pattabiraman

(Head, Operations and Surveillance, e-commodities limited)

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