Lesson commodity exchanges learnt from crude prices and are they prepared for future?

Lesson commodity exchanges learnt from crude prices and are they prepared for future blog banner Lesson commodity exchanges learnt from crude prices and are they prepared for future?

On 20th April when the price of WTI crude dipped into the negative territory at $-37.63/bbl, it created a unique situation in the US. It was the first time in history that the price of crude dipped into negative territory. The US was running out of storage space and long contracts on oil actually became a liability. Long traders were willing to pay a premium jut to get out of these long trades. While Brent remained in positive, it was only WTI crude that settled in negative. The reason was obvious. While Brent futures are cash settled, WTI futures are delivery settled. Since Brent is cash settled, it normally diverges from the spot but it has the advantage that negative prices are not possible in this case.

This dichotomy created a unique problem for the MCX. Oil contracts on the MCX are settled for cash but the price is pegged to WTI crude traded on the NYMEX. The reason being that Indian crude being pegged to global crude needs a delivery underlying as it would better represent the spot price of crude oil. That created an issue for long traders and brokers. While, MCX had originally pegged the settlement price on April 20 as Rs.1, it had to subsequently set the price at Rs. (-2884) in sync with NYMEX prices. This led to oil long traders losses growing four-fold from Rs.120 crore to Rs.440 crore. However, this unique situation also served some important lessons for investors and exchanges.

Lessons for MCX, exchanges, regulators and clearing houses

The incident had some key lessons for the exchanges and the regulator also.

  • For the principal commodity exchanges, investor financial safety should be the primary objective rather than business revenues. This will also protect the integrity of markets overall.
  • It is time exchanges and brokers are more selective of clients being allowed to trade. Allowing investors who do not understand risks will not only damage the individual but also the stability of the markets.
  • Crude oil is only a reminder. Earlier, similar losses occurred for unknowing traders in guar gum too. When investors speculate and take positions beyond their means, the risk management system must have the in-built ability to red flag the same.
  • Regulators can now consider allowing retail investors only in index-based commodity futures where at least 10 assets are part of the index with equal weightage. This will reduce the risk of individual commodity vagaries. In most cases, there is no control.
  • Communication that is timely and terse is the key in such situations. At crisis times like this, SEBI should hold routine press briefings to highlight the enormity of the problem and give clear instructions to investors/ brokerages and even to the exchanges on dos and don’ts.
  • Exchanges and the regulators along with the clearing houses must have a back-up plan to handle black swan situations. They don’t happen frequently and are hard to prepare for. But they should have an abort option where the SEBI can take an overriding decision where the losses or profits are due to factors beyond their control.

There is some important learning for investors too

Brokers and individuals need to understand the risks in a trade before getting into them or enticing clients to get into such positions.

  • Broking firms like Motilal Oswal Financial Services and Religare Securities filed writ petitions in high courts against the exchange and against market regulator SEBI. But these are pointless as the risk should have been managed at the broker level.
  • A number of investors facing losses to the tune of Rs.50 lakh are protesting through social media. Here again, it is bad risk management and the onus is on brokers and clients to ensure that positions are lightened when the volatility is too high or the last week risk is too much.
  • An important lesson is that, unlike cash market, values can go below zero too. You may be trading in any asset class, be it gold, interest rate futures, currency or equity and other commodity futures. But, beware that your investment cannot only go to zero but possibly below it too.
  • The major moral of the story for retail investors to stick to asset classes they understand and where the risks can be comprehended. An important takeaway is that speculation in any commodity or asset class is a zero-sum game and it must be done with that awareness at all points of time.

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