Sebi has already allowed the Category III Alternative Investment Funds (AIFs), including hedge funds, to participate in the commodity derivatives markets. True, such funds need to inform Sebi about the maximum investment made by them in a single underlying commodity, as also cumulative net investments made in all commodity derivatives on a monthly basis. The hedge fund investments in commodity derivatives are also subject to certain conditions, such as the funds should not invest more than 10% of the investible funds in one underlying commodity. Besides, they should make disclosure in private placement memorandum issued to investors about investment in commodity derivatives, and should take consent of the existing investors, if such AIFs intend to invest in such derivatives.
Even though the domestic hedge funds can accept subscriptions from foreign investors, owing to the complexity of taxation in India, where the hedge funds are subject to direct tax on their revenues, foreign investors do not prefer to subscribe to these funds. But Sebi is now planning to allow foreign portfolio investors to trade in commodity derivative markets, and even the finance ministry is believed to have accepted Sebi’s new move. This is quite alarming! For, these are likely to affect adversely not only the price discovery function of commodity derivatives trading, but also its price risk management function.
As it is, the hedge fund industry has as yet scratched just the surface, in terms of the overall portfolio allocation, in even equities. It has still a long way to go into even the equity market, and its F&O segment. Is it not then quite odd that Sebi has allowed these funds, as also the foreign portfolio investors, to enter the volatile commodity derivatives markets?
To be sure, the use of the word, ‘hedge’, in hedge funds is misleading. True, they tend to reduce risks of their subscribers by investing in diverse portfolios, and entering into simultaneous “buy” and “sell’ operations in different portfolio investments. But the fact remains that they mainly aim at obtaining maximum absolute positive returns for their high networth investors. Such investors have, no doubt, high risk appetite. But this appetite also craves for high returns. Such returns, however, may elude them, with the entry of their hedge funds in commodity derivatives, where prices fall as often as they rise, depending on both the absolute and relative supply of and demand for the underlying commodities, and their price and cross-price elasticities.
This is not all. As it is, liquidity in the Indian commodity markets had suffered a setback after the application of the Commodity Transaction Tax (CTT). Currently, the volumes are mostly driven by the futures contracts in precious metals, gold and silver. But the trade volumes in these precious metals are high not so much due to more trades as to the higher prices of these metals through the past decade. Thus, gold prices are currently three-four times their prices a decade back. In terms of units of trade, the present-day volumes are much smaller than what these were a decade back. The conclusion is obvious. Most commodity derivatives contracts, including in the precious metals are awfully narrow. Given the low volumes in the commodity derivatives contracts, the relatively large orders from hedge funds can widen the gap further in the bid-ask spreads, which is already quite wide, than what it used to be, a few years back. A wide bid-ask spread increases the transaction costs, and, as a result, drives away the intraday traders from the commodity derivatives markets, affecting further adversely the liquidity in the markets, impairing, in the process, their economic utility for both the price discovery and price risk management for the diverse physical market functionaries, including exporters and importers.
In fact, the low liquidity, as also the wider bid-ask spreads, have already forced many traders, particularly scalpers and arbitrageurs, to exit the markets. This exit process may be further accentuated, if such spreads were to expand more, following the trades of hedge funds. That, in turn, will discourage hugely the physical merchandise functionaries from participating in such commodity derivatives markets. As it is, the basic premise that hedge funds will usher in greater liquidity has already proved wrong, and their entry has actually damaged the overall market.
This is not all. As hedge funds aim at maximising their absolute positive returns, the pressure of their trades inevitably raise or reduce the prices of commodity derivatives, and likewise raise or reduce the physical market prices of the underlying commodities from their true equilibrium levels. True, Sebi aims to protect the investors. But, even more importantly, Sebi needs to protect the commodity derivatives from manipulation. With hedge funds investing in commodity derivatives, Sebi has simply added yet another class of manipulators to those markets. Commodity derivative markets are not actually meant for investments. These are markets for price-discovery and price-risk-management. To convert them into investment markets undermine the basic raison d’etre of these markets.
The ostensible aim of Sebi in allowing hedge funds to invest in commodity derivatives markets is to improve their liquidity. Of course, these markets presently lack liquidity. But the reason for the lack of liquidity is not the absence of hedge funds from trading in them. Such reasons are several, such as either too broad contracts, with a large number of delivery centres; or too narrow contracts, with a single delivery centre. Sebi should carefully discern such reasons, and try to remove them, instead of allowing hedge funds to invest in commodity derivatives markets, which has already reduced the economic utility and purposes of these markets, and transformed them into gambling dens.
Source: financialexpress.com