THE National Commodity Exchange Limited (NCEL), Pakistan’s first electronic commodities futures exchange is expected to commence trading operations in June after repeated delays since it was first registered by the Securities & Exchange Commission of Pakistan three years ago. “All that’s left now is minor tweaking of rules so in the worst case, we should be up and running in the first week of July,” says Assim Jang, managing director of NCEL.

Trading will begin in three month gold futures contracts followed by rice contracts within six weeks, and then contracts of cotton seed oil cake, sugar, red chillies and lentils. NCEL, a 283-member demutualized exchange will represent a major step for Pakistan into the complex world of derivatives trading. Futures are a type of derivative which is a contract that derives its value from an underlying asset.

Specifically, futures is an agreement between a buyer and seller under which the seller promises to deliver a specific commodity on a specific future date to a buyer for a predetermined price to be paid on the delivery date. So where in an asset, like a share, you either buy or sell and the transaction (without leverage) is over, trading in futures only requires a margin to be paid down. From there on, you are exposed to the risk of paying additional margins until the end of the contact. As a result, the losses can be many times your initial margin and that’s why trading in derivatives is notoriously risky. The Barings Group’s $1 billion loss from trading Nikkei futures and Sumitomo Corporations’ $2 billion loss trading copper futures are well known. Risk management: That raises the question of who will trade commodities futures in Pakistan, especially given the blood-curdling futures contract crisis at the Karachi Stock Exchange in March. Jang says investors in Pakistan only have the share market and property to choose from and this will open up a new investment avenue for them. But experts worry that the involvement of common investors will be detrimental given the poor understanding of financial markets and the tendency to over-speculate that exists.

“Futures has been given a wrong label [by the March crisis in the stock market],” says Jang. “But the KSE is nowhere near our level of risk management. We have position limits in place at the broker and client level, which are monitored in real time. And if these limits are breached, there are real penalties imposed. In March at the KSE, there were no position limits.”

He also says risk is not linear but complex and margins are based on underlying volatility. Moreover in addition to margin calls which are based on marked-to-market prices, once in a week margin requirements can also be increased based on persistent increases in prices.

NCEL has followed the example of India’s National Commodity & Derivatives Exchange in developing trading regulations, risk management and market monitoring and prime technology has been deployed as well. But risk management has been taken a step further. For example, NCEL has pre-trade verification systems in place so that orders entered by clients are first verified against the client’s position limits and margin deposits before being processed. This is not the case at India’s exchange.

Similarly, NCEL will monitor transactions not just at the broker level (as the Karachi Stock Exchange does) but down to the client level with the use of a unique client ID system. There will be no offsetting between clients as has been the case at the KSE, positions will be marked to market on a daily basis and the variation margin will be accepted in cash only.

Circuit breakers at 7.5 per cent on both the upper and lower levels will be in place to provide a cooling off period even though on the flip side, these breakers tend to accelerate the rate of decline before market close and delay the price discovery mechanism. “They’re a mixed blessing,” says Jang.

Market monitoring also promises to be stringent. Trading activity will be monitored till the client level and if position limits are breached, penalties will be imposed and access to the system will be limited only to reducing positions.

Need for commodities futures: Jang says the primary benefit of commodities and futures trading will be price transparency in commodities markets. At present the urban-rural spread in commodities markets is about 15 per cent. “The delta between the wholesale and retail markets will narrow, price volatility will come down substantially and the rate if inflation will come down,” he says.

Farmers are expected to benefit from the futures exchange since it will provide future price information about commodities they are sowing and harvesting. “Prior to sowing a crop, farmers can look at futures prices and sell a contract in the futures to lock in his profit market and then sell when he harvests the crop,” says Jang. “But it will take us five years to get to that stage.” Trading on NCEL:

Here’s how trading will take place: If you’re a client interested in trading, you will log onto NCEL’s website (ncel.com.pk) and locate a registered broker. When you contact a broker, you will then fill out an account opening form, a risk disclosure document and a digital certificate subscriber agreement. Then, a bank account will be set up by your broker in your name at Muslim Commercial Bank to collect and pay margins. This will ensure brokers are actually collecting margins from clients, which has not been the case at the KSE.

Since MCB allows for 24 hour online banking, timely payments to top up margins will be possible. Then the broker will set you up on the system with a trader account. The broker will also request system access for you for via NCEL’s website. NCEL will create a separate account for each client using a unique client Id system and passwords will be put on a USB key which will be sent by NCEL directly to you. You will then deposit the money with your broker bearing in mind that 50 per cent of the margins required will have to be in cash. You will also pay your broker Rs5000 for the USB key. Then you’re is ready to trade on the electronic J-Trader system between 10am to 12pm to start with which will later be increased to 24 hours.

You can check your positions and profit and loss statement in real time on the system. Margin calls will have to be met the same day on the T+0 system without which default will be registered, trading rights suspended, your broker fined (he will pass the fine onto you) and all deposits frozen till payment is received.

Worries persist: This process is expected to get underway next month. Until then, the NCEL should address two questions of some concern. First, will the exchange will be able to generate sufficient volumes to become a vibrant futures market? In gold, NCEL expects to generate volumes equivalent to 25 per cent of the gold spot market in which 50 tons of gold are imported every year. But experts say that futures contracts in cotton and financials would have generated far greater interest than the commodities planned.

NCEL had hoped to launch cotton futures but this still appears a conflict area since the Karachi Cotton Association still awaits permission from the Ministry of Commerce to resume hedge trading and the SECP is still deliberating cotton futures. But NCEL hopes to launch interest rate futures some way down the road as well.

“The net interest margin (difference between lending and deposit rates) is the highest in the world and this shows the inefficiencies of the banking system,” says Jang. “Banks need tools to hedge and interest rate futures would do that.”

NCEL also plans to develop stock index futures contracts to be used as a hedging mechanism for which plans are being drawn up. The KSE has announced plans to do this several times over the last three years. NCEL also has an innovative answer for the end of badla financing and its replacement with margin financing. They’ve developed a collateralized borrowing and lending obligation, an electronically tradeable money market instrument of margin financing.

The contract will be listed on the NCEL and brokers will place bids while banks will place offers. The underlying collateral will be listed securities. Then, these contracts will be tradeable in real time. This will also aid in the development of the secondary debt market which has so far not happened. NCEL says once permissions are granted, they can put this in place within two weeks. The faster NCEL moves towards trading contracts like cotton and futures, the more the likelihood of building strong volumes. Four out of five new futures contracts fail and are de-listed in the first three years because either the contract is poorly designed or there is a lack of demand.

The second question for NCEL to address is whether it will be able to insulate its systems from the influence of powerful stock brokers who have been accustomed to either having it their way (pre-reform) or forcing the management and board of the stock exchange and even the SECP to give in to their vociferous demands. This could be a formidable challenge, given not only the culture among brokers but the fact that 180 of the 283 members of NCEL are stock brokers and even though the exchange is demutualized, it has a board that is largely skewed towards brokers with six out of eight board members taken from the three stock exchanges.

Moreover, NCEL is starting operations with a murky past. When it was licensed by the SECP in 2002, there was a severe backlash by other stakeholders since the regulator was seen as having granted permission hastily without involving others and the KSE was seen as snatching the rights to the commodities exchange.