Traders would prefer to trade on a single exchange as this lowers the bid-ask spread and impact costs, making the existence of another exchange unviable.
Is there space for more commodity exchanges? This is a pertinent question because it is accepted theoretically that more competition can bring about better solutions in any market. But in case of commodity derivatives trading in India, the story has been one of diminishing number of exchanges over the last decade and a half ever since commodity futures trading was resurrected. In fact, even traded volumes have come down from previous peaks and, presently, the impression is that they are just about stable.
The two leading stock exchanges, NSE and BSE, have now also brought commodity derivatives onto their trading platform and this adds an interesting dimension to the market. It has been observed across the globe that liquidity tends to get concentrated in trading in specific commodities on specific exchanges and it is here the early mover advantage lies. Intuitively, trading members would like to trade on the exchange which has the largest volumes and number of trades as this lowers the bid-ask spread or the impact cost. The adage ‘liquidity begets liquidity’ very much holds here. Hence, for traders who are not hedgers but more of day traders or speculators, it may not make sense to trade on different exchanges. They would prefer to concentrate their business on a single exchange. And wherever a second platform is an option, it is used for arbitraging to the extent that there are micro price differences.
In India, if one looks at vibrant trading in commodity derivatives, NCDEX has advantage in cotton, sugar, soybean, mustard, chana, guar and spices. While it started off with a wider array of products, today it is recognised more as an efficient exchange for farm products. MCX is a clear leader in gold, silver, energy products, metals and mentha. MCX has, over time, evolved to hold some can of a monopolistic position in these commodities. In a way, things have gotten compartmentalised over time. The third force in the form of a merged ICEX-NMCE would have some advantage in rubber from the latter and diamonds for the former. Total volumes traded on these exchanges have been stable in the last two years. For MCX, it was about Rs 54 lakh crore in FY18 and about Rs 6 lakh crore for NCDEX. The merged ICEX had volumes of Rs 0.36 lakh crore.
The new entrants will be looking more at bullion as they are easier to launch compared with farm products. This is where the challenge lies. Bullion trading is already concentrated in MCX and weaning away members to a new platform is difficult. Three points need to be made here. Firstly, anecdotally, it should be pointed out that when futures trading was in its infancy, NCDEX was dominant in silver and MCX in gold. But over time, MCX had taken over as the dominant player and today all trading takes place here. NCDEX has not been able to make inroads notwithstanding several products being launched to gain market interest. Secondly, today, arbitraging takes place across exchanges in different countries and therefore existing players would have to be open to a new opportunity of arbitraging across two domestic exchanges which they have chosen not to do so far. It is not certain whether they would be up to it in the absence of any incentive.
Thirdly, in the days when commodity markets had a separate regulator, FMC, equity brokers perforce had to open a subsidiary to do commodity trading to separate the risk of equity trading from this arm. Today, this is no longer an issue with SEBI being the unified regulator and hence there will be few players who have been held back on this score.
The new comexes have to, hence, address the requirements of a new set of traders who have not been active in this segment. Therefore, for the new exchanges to be successful, the approach has to be different. Brokers operating on the equity platform must be encouraged to trade in commodity exchanges too. BSE and NSE, hence, have an advantage of a committed member group. But still, moving members from MCX to NSE or NCDEX will be difficult just as it has been seen that the differentials in volumes of trading between BSE and NSE have been maintained over the years.
Gold and silver are definitely easier commodities to understand as they do not get messy like agricultural commodities which have delivery, quality and accompanying penalty issues. To begin with, some kind of incentives can be given to get equity traders to deal with commodity derivatives. This is not easy as it requires a different kind of understanding of the subject which may be a deterrent for newcomers. Besides, in order to ensure an even playing field, the regulator has to permit the same for other existing exchanges too.
Also, the sheen in commodity markets has worn off to some extent in the last few years. This is on account of a limited basket of commodities being traded and the fear of bans still being present. Alternatively, some kind of market making should be permitted here, but then it has to apply to other exchanges too and if this is done, it may negate this effect.
Interestingly, commodity derivative trading has a fairly unique history with there being several regional exchanges when futures trading was revived in 2002. But all the existing exchanges have closed down. Further attempts have been made by new entrants, too, which have not been sustainable. ACE and Universal Commodity Exchange were two new exchanges that were operational but had to close down due to non-viability.
Against this background, the new platforms could be starting from a position of disadvantage, though the existing support of the equity platform and the franchise built by BSE and NSE would be the main driving factor for this business.
A curious question that can be raised here is that, if stock exchanges have been allowed to have separate trading platforms for commodities, by the same logic, the existing commodity exchanges, like NCDEX, should be allowed to deal with shares. MCX already has this through the Metropolitan Exchange route. For an exchange like NCDEX, or even the merged ICEX, this will make sense given the barriers in commodity trading where a modicum of stagnation has set. Allowing equities, and also currency derivatives and interest rate futures, could open new lines of business. And, curiously, NSE has a stake in NCDEX and is now operating its trading platform. By similar logic, NCDEX offering the same products as NSE would be an interesting regulatory proposition even though the probability of success would be uncertain.