What would it take to increase liquidity in base metals futures

Metals are a key barometer of any country’s economic growth and countries have taken many measures to facilitate the growth and efficiency of metal markets.

While trading volume of commodity derivatives has grown at a rapid pace in India, liquidity has remained largely limited to the near-month contracts. The low volume of the long-term contracts limits their role as an indicator of future prices for a horizon that matters for commercial firms. The low liquidity largely owes to the low rate of participation of entities with long-term trading interests. This needs to be addressed by attracting longer-term players to the domestic market.

A study on the base metal markets led to the following observations on the steps needed to improve liquidity and reliability of the longer-maturity base metals futures contracts.

• The first step would be to shore up liquidity in the longer-term contracts with the following steps. First, encourage greater institutional participation, including that of banks, in the Indian commodities derivative markets. Banks could be allowed to trade in base metals and extend both financial and metal loans to commercial firms.
• Secondly, transaction costs need to come down to attract greater liquidity, particularly volumes from non-commercial institutions. The commodities transaction tax (CTT) has made the Indian markets less competitive. The direct impact of CTT and its incidental adverse impact on liquidity, together have made trading costlier in India.
• Thirdly, charging lower margins for long-maturity contracts can help attract greater liquidity. Such a margining approach is successfully followed at SHFE, LME and CME.

Any significant improvement in liquidity would also require the following measures.

Availability of base metal inventory: Non-commercial players, who arbitrage across the commodities markets, should have adequate access to inventory to encourage delivery-based participation. Exchanges need to work towards creating onshore availability of inventory and collaborate with international exchanges to set up accredited warehouses in the free trade zones (FTWZ) in India.

The local exchanges may also consider setting up warehouses in FTWZs. Policy measures may be explored to encourage delivery based participation from international entities who can trade across the domestic and international markets.

Cost-effective financing: Cost-effective financing of base metal inventories is an important for increased participation of both commercial and noncommercial entities. Creation of warrants and raising finance is normal globally with effective risk mitigation through technology which needs to be promoted in India.

Furthermore, allowing banks to offer structured products to producers and fabricators is important. The central bank should take initiatives to educate the banks about the opportunity to develop structured solutions in the financing of base metals business and trade. IFSCA could also play an encouraging role as it has the power to allow international banking units to facilitate such a service.

GST Structure: The delivery of the base metal contracts in India is not offered in locations of choice of the commercial firms. The current practice imposes significant tax compliance cost in making metals available at their preferred locations.

This arises due to the fact that when an entity is taking delivery of a contract in Bhivandi, it has to pay SGST in Maharashtra, which cannot be transferred to any other state as input credit. Given the high value involved in base metal transactions, participants prefer to avoid such high upfront costs. Bringing the contract delivery under the inter-state movement of goods (IGST), when the entity is located in a state other than Maharashtra, would be advisable as the IGST paid by the customer can be availed as input credit against the GST liabilities.

Deepening the spot market: Traders in the commodities futures market do not have an effective recourse once the notice of delivery is given as there are no vibrant spot markets. Hence, it is important to examine the viability of a regulated spot delivery platform linked to the futures exchanges. It could

also be achieved by launching daily rolling settlement of futures contracts, similar to LME, where the fulfilment can be forwarded to a future time point.

Visibility of domestic benchmark prices: The base metal ecosystem participants refer to the international price benchmarks such as the LME prices more often than the domestic market prices. Most of the international commodities markets, recently the Chinese markets, have developed through the active involvement of the government.

Therefore, it is ideal that the government nudge the participants to refer to the domestic price benchmarks. For instance, government departments and agencies should progressively use the rupee-denominated metal prices from the domestic market for fixing customs duties, earmarking export incentives, tendering by state-owned firms involving domestic sourcing etc. However, such a move is ideal only when all the other measures are in place, failing which it will lead to distortions.

Commodities price risk management: Encourage listed firms to better manage their commodities price risk. The following steps could be taken in this regard: (a) disclosure requirements under listing norms should be strictly enforced, (b) banks be advised by RBI to assess commodities price risk in their lending decisions, and (c) rating agencies should take into account the commodities risk disclosures in their rating decisions.

Lastly, incentivize the MSMEs in India to hedge through the domestic market by offering interest rate subsidies on their loans. Firms that use the exchange-traded contracts for hedging with appropriate disclosures should be charged lower margins than non-commercial position.

Developing commodities market knowledge: Knowledge of commodities markets is quite limited among potential participants in India. The regulator should take active steps to promote commodities market courses, in topics such as commodities trading and commodities risk management.

(This article is based on research conducted by Joshy Jacob, Associate Professor, Indian Institute of Management, Ahmedabad.)