Saturday, November 11, 2006

Separation between commodity futures and mainstream finance

One of the (many) strange things that India does in the financial sector is a separation between commodity derivatives and mainstream finance. Everywhere in the world, it is well understood that there is only one business called the securities industry, which involves organised trading of all manner of spot and derivatives products, including derivatives on physical commodities. But in India, we have a piece of legacy legislation dating back to the 1950s which places commodity futures with the Department of Consumer Affairs, and places regulatory functions with the Forward Markets Commission. Through this, the people who do consumer protection - e.g. issues like weights and measures - are tasked with thinking about safety + soundness of clearing corporations.

If commodity futures could be merged back into mainstream finance, there would be more rapid development, by tapping into the skills, regulations and legal structure which has been created for derivatives. In addition, in the existing situation, there is a loss of economies of scale, economies of scope and competition associated with cutting up finance into separate pieces.

When you wander in the streets of India, you see boards of firms saying "Member NSE, BSE, NCDEX, MCX", which reminds you every day of the de-facto convergence of the two worlds. The customers are the same; the brokerage firms are the same. The artificial separation is caused by a piece of legislation going back a half century, done at a time when none of this was understood.

Today two developments took place which illuminate these issues. First, SEBI seems to have removed the last barriers to the trading of Exchange Traded Funds on gold. This will be done by "financial" mutual funds, traded on "financial" exchanges, and regulated by SEBI. It serves to highlight the lack of a distance between commodities and finance.

In parallel, there were some newspaper stories about the possible use of the Securities Appellate Tribunal (which was created in the SEBI context) for handling appeals against the FMC. This also makes a lot of sense, and underlines the unity of commodity futures in mainstream finance.

By international standards, separating out commodity futures into a separate market is a fairly perverse thing to do. I have no doubt that at some point, some prime minister is going to sign off on the merger of these two worlds into a single competitive market.

The US is the only country where a somewhat wonky arrangement is in place (though not as wonky as what we have in India). In the US, the CFTC is a separate regulator for all derivatives markets. They do better than India in placing all derivatives together, i.e. commodity derivatives are not separated out. The CFTC is an old agency, and its continued separation from the SEC reflects complacence, and a lack of political will, in the US. When you are the world's biggest financial system in the world's biggest economy, it's easy to get complacent with what is in place (witness the sluggish movement towards electronic trading at exchanges in the US). But here also, international competition is bringing in a new level of stress; the UK integration of all financial regulation into the FSA is increasingly leading to a shift of business to the UK. A recent article in Forbes talks about some interest in convergence.

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