 The vision of the Exchange is to revolutionize agriculture through creating a dynamic, forward-looking, efficient, and orderly marketing system that serves all. To do so, the Exchange cannot be a club for the well-informed, well-connected, or highly capitalized, but rather an institution that serves and engages all market participants- farmers, farmer groups, processors, traders, exporters, aid agencies, input suppliers, industrial buyers, and consumers.
The fundamentals
At its simplest, a commodity exchange is essentially a way of organizing trade between buyers and sellers on the basis of formalized rules and procedures known and agreed upon by all market participants and self-enforced by the members of the exchange themselves who defend the integrity of the market. The core principle of an exchange is to create incentives for self-enforcement by its members, the private market actors, although an exchange also depends on the regulatory and legal environment provided by the Nepal government.
A primary function of an Exchange is coordinating buyers and sellers. Related to this, an Exchange creates market transparency by providing information on product grades, on prices, and on offers and bids for given products. This signals opportunities for profitable trade; it levels the playing field between farmers and others with better information; and it opens up new markets within and outside of the country. Another central function of an Exchange is to provide security to transactions, making it less risky to trade across long distances, across time, and with unknown counterparties.
Core elements…
There are six core elements required for a successful exchange:
A trading platform:
An exchange needs a system to match multiple offers to sell and bids to buy, whether this is a system where buyers and sellers are physically present or an electronic system where trading is done remotely. The trading platform must be efficient, robust, not too expensive, and fit with clients needs. With advances in information technology, traditional open outcry trading is giving way to electronic trading. But, with technology, NSE provides a trading system that efficiently matches offers and bids.
Contracts:
The exchange needs to offer contracts that are commodity and grade specific, with standard specifications for grade, lot size, delivery, payment, measurement, and dispute resolution, among others. By offering standardized contracts, the exchange makes it easier, cheaper, and less risky for unknown partners to trade with each other. But the contracts need to be ones that the target clients need or are looking for and they need to be well designed to reflect actual trading practices.
Counterparty risk management:
One of the key reasons for trading on the exchange is because it greatly reduces the likelihood of contract default or non-performance. The exchange manages counterparty risk in a variety of ways: through imposing discipline on its users with strict rules of trade, through requiring margin deposits of funds in advance of bidding, through requiring that products be weighed and graded and deposited in an insured warehouse in advance of an offer, and through operating a clearing and settlement mechanism, where the Exchange itself or an affiliated body ensures that payments are made against delivery and vice versa. To ensure this, the Exchange must work closely with banks as well as warehouse operators.
Product integrity:
Unlike a commodity exchange, a commodity exchange involves the transfer of ownership of a physical agricultural product that must be graded, weighed, stored, handled, and ultimately delivered from one location to another. This greatly increases the complexity of a commodity exchange. The Exchange’s viability depends on whether it trades products of integrity, with grades that are well understood and unadulterated, and guarantees that the sample truly represents the entire lot, that what is in the warehouse is actually there in the quality, quantity, and condition in which it was deposited, and that it will be delivered in that condition at the completion of the trading transaction. For this to happen, the Exchange must work very closely with warehouse operators, insurers, and transporters.
Viable regulation and enforcement:
Ultimately, the whole exchange system relies on trust – trust in the exchange (and its clearing house), trust in the brokers to whom clients entrust their money, and trust in the warehouses who will issue the pieces of paper that will actually be delivered on the exchange. A good system of regulation is necessary to ensure such trust. Although the exchange is a self-regulatory organization, there needs to be an over-arching regulatory and legal infrastructure in place to ensure regulation at different levels: self-regulation by the brokers, warehouses and the exchange, regulation by trade associations who license and monitor their members, and regulation by a state regulator, such as an Exchange Commission.
How it works…
To begin, it is understood that all orders to buy and sell on the Exchange are made by Members, who either trade for themselves or on behalf of others. Because members are liable for their transactions, membership is limited and is on the basis of very clear and transparent criteria, including trustworthiness, performance, capital adequacy, and willingness and continuous ability to follow the Exchange rules.
To trade on the Exchange, the owner of a physical product must bring the product to a certified Exchange warehouse, where it is sampled, graded, weighed, and issued a certificate. That certificate represents the identity of the commodity, and is the basis for a transaction on the Exchange. The certificate must be safe from fraud. One way to reduce possible fraud is through an electronic certificate, which is directly transmitted to the Exchange. In addition, samples of the product are retained by three parties: the seller, the warehouse, and the Exchange, in the event of dispute on quality.
The product itself, once certified, must be secure and protected against adulteration and it must not disappear. One way to reduce this risk is to go beyond issuing a product certificate to a warehouse receipt system, which requires that the product be physically stored in a bonded Exchange warehouse. A warehouse receipt is thus effectively legal title to the product. In this way, the role of the warehouse becomes analogous to a bank, crediting and debiting deposits of an asset which, in this case, is a commodity asset, rather than money.
Once the warehouse receipt is issued, the seller can proceed to make an offer to sell a certain number of contracts (at a standard lot size and grade) on the Exchange. Because contract terms are standard, the key parameters are the price, delivery time, and location. Before the seller makes the offer, the Exchange will have received directly from the warehouse (if possible electronically) the receipt and the sample. The seller makes the offer using through a broker who is either working on the seller’s Member account, if the seller is a member, or on the account of a Member who is offering intermediary services to the seller. For example, if a cooperative union who is not a member of the exchange wishes to sell a given amount of maize on the Exchange, it would deposit the grain in an Exchange warehouse and transmit a sell order to a broker, who is part of a brokerage firm that is an Exchange Member.
On the other side of the transaction, a buyer similarly places a bid order through a broker. Analogous to the seller who made deposited the commodity in an Exchange warehouse before the sell order, the buyer must move funds into what is known as a settlement account before submitting a buy order. The amount of money that is placed in the settlement account can either be a margin, or percentage of the total transaction value, or the total. This depends on whether the contract is for immediate delivery (spot) or for later delivery (future). Here too, the Exchange must receive direct information from the bank confirming the amount held in the settlement account before the transaction occurs.
At any given time, multiple actors are in the process of making multiple offers and bids. Exchange trading hours is restricted to achieve a maximum number of orders in a short period. The function of the Exchange is to match these many offers and bids as they come in. Once a match is done, the deal is recorded and the deal price is automatically posted on the information system. The continuous updating of deal prices and their dissemination electronically in real time to all market participants, including remote farmers and consumers, is vital to increasing market liquidity and competition. Once the deal is made, the process of clearing and settlement of the contract begins. Thus, the Exchange’s back office tracks the delivery of the product and the transfer of funds. If there is a dispute, the Exchange pursues the matter through its arbitration mechanism, rather than resorting to courts, which are time-consuming and ill-equipped to handle such disputes.
In short
While seeming complex, an exchange is a carefully crafted and time-tested market institution where market relationships play themselves out. An exchange relies on trust and integrity and is ultimately a test of the alignment of incentives of the individual players in the game with the interests of the market as a whole, and even of society. That is why it is critical that exchanges rely on a membership structure and why private market actors must drive the exchange. This said, there is a fine balance between the market players, the Exchange, and the country.
As described in this brief article, a commodity exchange goes far beyond agriculture, dealing in the world of finance, legal underpinnings, and even information technology. But it is still about a product grown by a farmer somewhere in the country and consumed somewhere else. And, because it deals with a physical product, a commodity exchange has far more complexity than the exchange of stocks. It also involves many actors at very different levels, from the smallholder farmer to the agro-industrial conglomerate. At its core, though, it is simply the institutionalization of the oldest game in history, the transfer from seller to buyer and back again. |
