Following recommendations of its Commodity Derivatives Advisory Committee (CDAC), Sebi has proposed to allow category-3 Alternative Investment Funds (AIF), typically known as hedge funds, in commodity derivatives. Market players and sources involved in the discussion process said that the entry of hedge funds, when implemented, will bring liquidity to the commodity futures and options segment. The move is the first step towards bringing institutional investors in commodity derivatives. However, initially they will be allowed only in non-agricultural commodities, as government intervention in farm commodities is likely to continue, given the sensitivity of the segment.
Hedge funds, both local and overseas, have access to cheap finance, while industry players who are actually hedging their commodity price risk on the futures platform rely on borrowed funds. 'Globally, the hedge fund play in commodities is ten times larger than in equities and such funds are often known to play the role of market movers. In India they will be playng huge volumes. We can see several big banks, both local and foreign, starting funds for commodities in the Indian market too," said Gnanasekar Thiagarajan, Director, Commtrendz, a risk advisory company.
Category-3 AIFs have to be set up by opening a company in India and get Sebi's registration. Their regulations permit them to take leverage and derivative positions and hence it is easy to allow them in commodities. Since even a foreign company can form such funds in India, the move could be an indirect entry of foreign investors in the commodity derivatives space, source involved in the discussions on the issue explained.
Sebi has a higher degree of comfort in allowing such funds, as their regulations provide that they shall deal along with custodians and hence, any increase in leverage beyond permissible level can be handled at the custodians level.
Before issuing a consultative paper on allowing hedge funds, Sebi had a several rounds of discussions with sponsors of such funds, custodians, exchanges and other market participants. As in the case of equities, here too Sebi has proposed a 10 per cent cap on positions in a single commodity. A key outcome of the meetings Sebi had with various stakeholders, and one that established some level of comfort, was the custodians' role in tracking whenever funds cross the 10 per cent limit.
An industry official, who was part of discussions, said, "Foreign funds can also set up company in India and acquire Sebi registration under AIF regulations and even an existing fund can approach its investors with a proposal to amend its prospectus, seeking permission to take positions in commodity derivatives." He also said initially, funds set up by leading investment banks, private equity funds and broking houses are most likely to enter commodity derivatives.
"However, foreign banks are already providing custodian services in equities to several foreign investors, and hence these investors will find it easy to enter commodities derivatives too," said another person involved in consultation with Sebi.
The only issue is that globally hedge funds have a better play in commodity derivatives and what attracts them to the Indian market. according to a source quoted above, is that India being largest gold consumer, it can set the price of the precious metal and foreign funds can support that process with the money power they have at their disposal.
So far as option trading in equities market is concerned, institutional players, largely foreign, makes the most money as sellers, since the risks involved here are the maximum and come with commensurate returns.