Commodity Exchange
The Commodity Exchange provides the forum (represented by clearing members) for the buyers and the sellers to buy and sell Futures and Option contracts. No financial transactions take place in the Exchange. The operations of the Exchange has now come of age in that what we see is a computerized auction prior to which was done manually a process referred to as open out cry.
The Exchange is linked to a Clearing House that takes care of the financial transaction of trades. Derivatives Clearing House is the “Hub” or the “Nerve Centre” of a Derivatives Operation in a capital market. Without a Clearing House a transparent and a sustainable Derivatives market cannot function. Essentially the mandate of the Clearing House is to act as the performance guarantor for the buyers and sellers of Derivative contracts. This is achieved by way of the Clearing House (CH) acting as the “buyer for every seller” and “seller for every buyer” of Derivatives contracts, Futures and Options. The CH while acting as the performance guarantor of the trades, the process also adds to the Liquidity and Transparency of the trading mechanism. Liquidity management leads to a whole different discussion. The stringent rules adhered to by the CH to a certain degree creates market liquidity.
CH requires both the buyers and the sellers to post a security deposit referred to as Margin Deposits. In the margin account the investors can hold highly liquid interest earning securities i.e. Short Term Treasury Bills. The CH, end of each trading sesion value the holdings at the closing market price a process referred to as Mark to Market. If the value of the holdings increases then the excess value, the variation margin is deposited to the individual investors account. If the market value has dropped the CH withdraws from the margin accounts and the investors are called upon to cover the margin deficiencies in the margin accounts. If the margin calls are not met forthwith then the CH will liquidate the position and wipe out the deal with no provision for further trading. Hence the reason why futures trading is not in the realm of retail investor and until recent times was considered as the exclusive domain of large well capitalized corporations with excess cash-flows. To give access to the retail end the market has in the recent years developed Mini-Futures contracts on the indexes.
Short Selling
Short selling is an integral part of the Derivative market. Derivative and the short selling facilitate the price discovery process. That be so, short selling, unless monitored, leads to price manipulation and kills the market. Collective action can be potentially detrimental to the well-being of the overall capital market. The collapse of the major brokerage house Lehman Brothers was precipitated by short selling. The market has to be properly regulated and all short trades must be linked to the Derivatives Clearing Corporation that must be tracked trade by trade. Risk management strategies have evolved over the years to avert market manipulation associated with short trading that can be discussed on a later date. Linking short trading to the clearing house surveillance operations supercede them all as this measure will act as an effective deterrent and the clearing members will be extremely careful not to circumvent the due process given due regards to the repercussions likely to follow.
Every endeavour must be made not to replicate or piggy-back other countries. Derivative market operations as the market matrix varies from country to country. Sri Lanka must develop its own rules to govern the Derivative market. In the event Sri Lanka blindly follows other capital market models, such short sighted decisions can be extremely costly on the long term. Sri Lanka has the potential to be a major player in the commodity trading arena. As a matter of fact it is a long felt need as the country sees unprecedented economic growth. A properly structured Derivatives market can only propel the capital markets to commanding heights.
Derivative market development
In mooting the feasibility of the introduction of Derivatives, the contracts must be authorized and a proper legal framework be in place and be enforced without fear or favour. There also must be well trained and properly licensed ethical professionals and a savvy investor community. These fundamentals will form the foundation but the introduction of Derivatives must be done in increments. A fully fledged Derivatives market will take a minimum of 10 years to gather momentum. In order to ascertain the investor receptiveness during the initial stages or during the pilot program, the prudent approach is the creation of a Call Option Index that would avert potential market manipulation by a few investors who are privy to inside information. The initial phase can be followed by introducing Call Options and the penultimate being the introduction of Put Options and Exotic Options i.e. digital and Knock-out.
Infinite opportunities
If Sri Lanka has the proper approach, given due regards to its comparative advantage as a major Tea exporter, from a strategic thrust Sri Lanka can be positioned as the Hub of the global Tea trade. This can be further expanded to areas such as Rubber. With a demand for natural rubber on the increase we must explore the possibility of introducing Derivative contracts based on Rubber. Further with the boom in Tourism another area that offers potential is the introduction of weather Derivatives. As well, the plantation companies in particular Tea, that is sensitive to weather patterns can be beneficiaries of Weather Derivatives. With a growth in Bonds, there is a need for interest rate Derivatives. Whatever the commodity may be, be it cinnamon, or be it pepper or essential oils Sri Lanka should have Derivative contracts based on them creating a market for our export commodities placing Sri Lanka in the global commodity map. Filling a gap, there are private commodity exchanges coming up and in particular South Africa as a region sees a growth in rudimentary commodity exchanges. \
Blue Sapphire Derivative contracts
The other area of interest that must be explored in detail is the creation and introduction of Derivative contracts based on Gems, Blue Sapphire. There are major commodity exchanges interested in having a strategic partnership provided there is equal interest among the stakeholders in Sri Lanka.
Education and regulation is key to success
There is a long list of possibilities associated with Derivatives. To reap the maximum benefit, it must be approached cautiously and in increments. Education and proper regulations must precede the development of the Derivatives market. With a quick grasping and literate workforce, commodity trading potentially leads the way to self employment opportunities. The policy makers should take due notice of the infinite potential this sector offers and work on the proposition in a properly structured manner.
(The writer, a regular contributor to the Business Times, is a derivatives specialist based in Toronto. He is contributing to the recent discussion on derivates in this newspaper) |
E-mail
