In the last post I narrated the story of the two kids who grew up on different sides of the road called Ethics. From here on, allow me to put the names on these anonymous guys and clarify some of the background.
The talented interesting kid, on whom we bet on, is Multi Commodity Exchange of India (MCX). MCX is India’s largest commodity exchange, world’s largest silver and gold bullion exchange, second largest in copper and natural gas futures and third largest in crude oil futures.
Exchanges, we all know is an excellent business to own. It is a business where the platform is the unique selling point and the business merely takes a rent from traders to use this platform. Minimal capital expenditure requirements, minimal working capital needed and yet plenty of cash coming in. It is the business equivalent of a toll booth.
Naturally this business will have a very high return on capital. However, the biggest advantage of this business is not in the numbers but in the nature. The traders need a place to buy and sell most efficiently. Thus they need maximum liquidity to conduct their business. Now this need of liquidity keeps them bounded to an exchange which already has plenty of traders. That is, traders will go to a place because there are other traders. So as the number of traders congregate it becomes a far more attractive place to visit for newer traders. As a result there is a snowball effect in the number of traders frequenting it. This is a classic case of winner takes all syndrome at play. However lets explore this dimension a bit more.
What is the threat faced by MCX from competition?
To answer this, lets solve it backwards. Lets assume a new exchange has indeed set up. However there are no traders on its floor. Will any single trader switch from MCX (the older dominant one) to the newer one? What does that imply? It has a huge switching cost for the users of this platform.
Additionally, opening exchanges is not an easy job due to regulation. Coupled with the fact that MCX is one of the three permanent national exchange as recognized by FMC(link here). This has the advantage of rewarding a huge amount of trust and reliability on MCX as an institution. Also, this enables MCX to innovate its products more freely.This makes it far more difficult for an upstart competitor to ‘steal’ a lead over MCX. Thus there are significant barriers to entry in place. Moreover the advantage of scale (and trust) should be big enough for MCX to ride out a storm . Hence we can reasonably conclude there is a definitive barrier to entry and there is a high switching cost .
The rotten egg of a brother I was talking about is National Spot Exchange Limited(NSEL). NSEL due to regulatory laxity (there is no spot exchange regulator in India) has been able to commit huge amount of fraud. The actual issue was this:
NSEL had 1 day contracts which had its payment date based on T+2,T+4 sometimes even T+25 days cycle. That is a trade occurring on 1st Jan 2013 will have its cash payment on T+25 i.e 26th of January 2013. This led people to pocket a seamless amount of riskless arbitrage, by shorting a contract getting an X amount day after tomorrow (on T+2 leg) and covering it at the end of the day on T+25 leg. This led to people earning a risk free return by investing in a bank during these 23 days. Annually it came to 12-15%.
Commodity prices should fluctuate and they were not fluctuating. On the NSEL they were “fixed”. If the spot or three-day contract was “x”, the thirty-day contract was one or 2% plus “x” depending on the commodity. One simply bought the three-day forward contract and sold the thirty-day contract. You paid for the two-day contract. You waited for the 30-day contract to end that you sold at a higher price. And pocketed the difference.
That changed the fortunes of the NSEL and volumes perked up. Average monthly trading volumes shot up from Rs 1000 crore to Rs 28,000 crore till May 2013. Financial Technologies derived 57% of its profits from NSEL. The higher the trading turnover, the higher the revenues an exchange makes.
This arbitrage issue was carrying on for a long time, till the word spread and more traders came in to encash on this risk free system. Because regulation was absent and the management had its eyes focussed on turnover and trades the management found it difficult to curb this. It soon came to a point where the contracts floating on the market didn’t have underlying commodities to back them. Brokers to rope in more investors decided to issue hundreds of contracts on the underlying of a single warehouse receipt. That is they were trading on “empty promises”. The management knew about this festering problem but chose not to act.The commodity market regulator FMC found out what was happening and banned forwards trading. This resulted in a mad scramble for those who were stuck to claim the underlying to salvage their losses. However the emperor was wearing no clothes.
The parent company(the father) is Financial Technologies of India(Ltd) and specifically Jignesh Shah. Jignesh Shah is known for his belligerence.He has publicly proclaimed himself to be Dhirubhai Ambani of financial markets. Coupled with it, arm twisting of SEBI officials post retirement is also reported. Rumours are there this was done because Jignesh Shah’s dream of a stock exchange named MCX-SX was not allowed to be under his direct control.
There were reports that the ministry was not happy with Sebi as the market regulator led by Bhave was not budging on several corporate issues, including the granting of equity licence to MCX-SX and manipulation of shares of the erstwhile Reliance Petrochemicals Ltd (since merged with Reliance Industries Ltd).
A well known economist (Ajay Shah) is needlessly harassed because he chose to write in a newspaper against the some of the arguments of FTIL in the MCX-SX and SEBI case.
FTIL ‘s core business is to sell trading software. Yet it owns 26% of MCX and 26% of MCX-SX and acts as an anchor investor. Pursuant to this imbroglio, FMC has passed an order asking FTIL to reduce its stake in MCX from 26% to 2%. As a result both FTIL and Jignesh Shah(and his men) have lost the status of ‘fit and proper persons’ to run this exchange.This is a fit response because the management knew about this from the first day. Even when the rumours were breaking out they were in denial. Many of the management officials did their rounds of major brokers and FMC regulator (who was taking an interest in the issue) promising total fulfillment of all obligations. With this ensuing scandal, FTIL stock crashed from a high of 800 odd bucks to a low of 100. MCX too got painted by the same brush and dropped from 1431 (in February) to 250 in December.
Now, the incumbent CEO has changed from FTIL insider (Sreekanth Javalgekar) to an independent FMC appointed person R.Premkumar, a retired IAS officer. He himself has come on media and explicitly commented that there is no connection between MCX and NSEL. Ravi Kamal Bhargava, a retired IAS officer, has been appointed as Chairman of the Audit Committee till the reconstitution of the board. Bhargava is currently FMC-nominated independent director on the MCX board. (link here )
This leaves us with the question of trust. Imagine this- what will cause the maximum apprehension in the mind of traders in MCX? Answer: Non fulfilment of their trades. However FMC has quickly moved in and asked for a formation of a robust and well funded Settlement Guarantee Fund. As of 31st December 2013 the Settlement Guarantee Fund of MCX stood at 367cr. With these new incremental changes, it looks like traders can afford to be less apprehensive.
In short, MCX is moving away from a more risky setup to a less risky setup, resulting in an increased assurance for those using its platform. This assurance of safety is different from that of trust. Spoken a little differently, a man might know that the rope is going to take his weight easily, but he wont trust walking on it over Niagara. Still more, a layman may be able to walk completely straight on a thin line on ground; however may not trust his ability to ropewalk over the Rockies.
Thus, the point here is, traders and brokers might be interested in switching due to low trust. But are the switching costs low enough to enable them to transition? Evidence doesn’t point towards any slump.Secondly, with the installation of a new chairman and an audit committee, has it led to stability?I believe it has.
Here MCX will just need time to ride over this storm. With a strong moat, MCX does have time in its favour. Especially one has to remember this problem has cropped up not in MCX but in NSEL, a completely different entity. NSEL and MCX are different in their setup. While NSEL is not at all regulated, leading to lopsided harmful incentives prevail, MCX is far more regulated and far better regulated.
However not everything is hunky dory. There are also certain risks in MCX. MCX is facing a severe volume erosion. However it is not plausible to conclude that NCDEX is stealing away over MCX. The total value in itself is seeing a sharp tumble. While in the past months, there has been a switch seen from MCX to NCDEX (9 out of past 12 months the volume growth or decline in NCDEX has beaten MCX), the total value has also fallen sharply. This sharp tumble can be ascertained to levying of commodities transaction tax as well (which is extremely high 10/- per lakh).
I won’t argue that NSEL case has not spooked brokers. It has. But my question is, Is it irreversible?
Disclosure: Long MCX