FPIs In Exchange-Traded Commodity Derivatives: All Dressed Up And Nowhere To Go!

SEBI’s fine print leaves only two contracts open for FPIs, that offer little visible benefit but come with forex risk.

<div class="paragraphs"><p>A trader works on the floor of an exchange. (Photograph: REUTERS/Brendan McDermid)</p></div>
A trader works on the floor of an exchange. (Photograph: REUTERS/Brendan McDermid)

On June 29, 2022, there was palpable excitement among all those who follow the Indian commodity derivatives market as the SEBI board met to decide on allowing foreign portfolio investors to invest in Indian exchange-traded commodity derivatives or ETCDs. As was widely anticipated, the Securities and Exchange Board of India allowed FPIs to invest in ETCDs, with certain riders. SEBI’s permission is the culmination of a long-standing demand from various quarters to allow FPIs to invest in the Indian commodity derivatives to make this market broad-based and more liquid.

SEBI released a consultation paper on Feb. 24, 2022, titled ‘allowing FPIs to participate in Commodity Derivatives market’ which highlighted the graded approach so far taken by the regulator for allowing traders other than commodity value chain partners to trade in ETCDs.

Market Expansion Done So Far

From 2017 to 2019, SEBI allowed category-III alternative investment funds, portfolio management services, and domestic mutual funds to invest in ETCD. In fact, on Oct. 9 2018, SEBI allowed eligible foreign entities or EFEs to directly participate in the Indian commodity derivatives market, but only for “hedging their exposure”. The same consultation paper also mentions that “more than three years since the aforesaid enabling framework coming into force, the number of EFEs on-boarded on exchange platforms has been negligible and apparently the existing norms have acted as a deterrent for the EFEs to participate in the Indian ETCDs, hence, the extent of participation by such entities has been Nil”.

In this context, the SEBI board’s decision on Thursday “discontinuing the EFE route” and allowing “any foreign investor desirous of participating in Indian ETCDs with or without actual exposure to Indian physical commodities, can do so through FPI route” seems to be a welcome one. Considering the fact that there are more than 10,500 registered FPIs in India, a green light from SEBI may pave a path for them to invest in Indian ETCDs to bring in the much-needed liquidity.

A Narrower Scope, In The Fine Print

Now let us analyse the fine print as the devil lurks in the detail SEBI's press release on this matter indicates “FPIs will be allowed to trade in all non-agricultural commodity derivatives and select non-agricultural benchmark indices. To begin with, FPIs will be allowed only in cash-settled contracts”.

So what is the precise space in which FPIs have been allowed to operate? Non-agricultural commodity derivatives cover precious metals (gold and silver), base metals (aluminium, copper, lead, nickel and zinc) and energy commodities (crude oil and natural gas) derivatives traded at MCX.

Because base metal and precious metal commodity derivatives are compulsorily settled, FPI cannot invest in these derivatives. That leaves only crude oil and natural gas contracts traded at MCX for FPIs to invest in, as only these two commodity contracts are cash-settled.

In addition, although the SEBI press release does not explicitly mention which non-agricultural benchmark indices FPIs can invest in, the word “select” is likely to point towards MCX ENRGDEX. If the “cash-settled contracts requirement“ is also applicable to constituent commodities of an index, then only MCX ENRGDEX meets this requirement as it derives its value from crude oil and natural gas futures contracts. The other two indexes, namely MCX BULLDEX and MCX METLDEX may not fit the bill, as these two indices comprise commodities contracts which are not cash-settled.

Are The Products Compelling Enough For FPIs?

Now let us go a little deeper and understand why one needs to invest in commodity derivatives, other than the requirement of price risk hedging. Commodities tend to provide better diversification benefits for investors as these tend to have a negative correlation with other asset classes. Investing in commodities also provides portfolios with a hedge against inflation.

Coming back to MCX crude oil and natural gas futures contracts, let us analyse why FPIs would be interested in these two commodity contracts, if at all? Unlike other base metal and precious metal commodities listed at MCX, these two contracts exactly mirror the crude oil futures contracts and Henry Hub natural gas traded at the New York Mercantile Exchange. While the aluminium contract traded at MCX has LME aluminium quality parameters as contract specification, convergence between the domestic spot price and futures prices, the final settlement price and due date rate is arrived at by taking a poll from the domestic spot market participants. By doing so, the MCX aluminium contract reflects domestic market fundamentals and differentiates itself from the LME aluminium contract to a considerable degree. Hence, an FPI interested in the India story may invest in MCX aluminium contracts, as the same may provide the benefit of portfolio diversification. However, if the MCX aluminium contract would exactly mirror the LME aluminium contract, an FPI will choose LME to trade, as that not only provides longer maturity profile contracts but also excellent liquidity.

Domestic ETCDs need to have some specific attractions for FPIs to invest in–either they should offer commodity contracts which are not traded elsewhere in the world such as turmeric, sesame seed, jeera, and coriander or offer commodity contracts which are influenced by Indian supply-demand conditions thus making these contracts slightly differentiated from the same commodities traded elsewhere in the world. MCX crude oil and natural gas contracts do not offer any of these benefits

As mentioned earlier, the MCX crude oil and natural gas contracts not only have the same quality specification as that of the Nymex contracts but the final settlement price is also pegged to the Nymex price, thus making these two contracts mirror Nymex contracts completely.

With very little liquidity in the domestic market, and that too the trades concentrated only in the near month and next month contracts, MCX crude oil and MCX natural gas futures contracts are poor cousins to Nymex’s crude oil and natural gas futures. In addition, by investing in Indian domestic contracts, FPIs will also be taking a foreign exchange risk. Without any visible benefit associated with these two contracts along with the added forex risk, FPIs will choose Nymex contracts if they wish to add crude oil and natural gas contracts to their portfolio. In a nutshell, SEBI allowing FPIs to trade only in non-agricultural cash-settled contracts seems to be a case of ‘all dressed up and nowhere to go’.

Prabina Rajib is Professor (Finance & Accounting), Commodity Research Group - Vinod Gupta School of Management at the Indian Institute of Technology, Kharagpur. Views are personal.

The views expressed here are those of the author, and do not necessarily represent the views of BQ Prime or its editorial team.