Physical commodities have traditionally been traded in bilateral over-the-counter (OTC) deals or through brokers. But these opaque OTC trades are set to be replaced by exchange-based trades in a bid to improve transparency for market participants and help increase market liquidity.

The predominance of OTC trades opens the door to market manipulation – and the opaqueness of these transactions is compounded by the difficulty of price discovery. Those market participants with intimate knowledge of the location, quantity and quality of physical commodities will always have an advantage over their less knowledgeable peers.

Opaqueness skews the market in favour of a minority of participants, which deters new entrants from trading and makes banks less willing to finance trades. The result? Poor market liquidity and stagnation in the local and national economies of commodity-producing regions.

This need for greater transparency is the driving force behind the move to exchange-based trades for physical commodities. Increasingly, regulators are pushing for trades to happen in a transparent, centralised venue.

With exchanges as independent overseers of secure, safe transactions, the hope is to increase trust from existing and new buyers and sellers, as well as encouraging financing banks to come back to the table.

Why exchanges make sense in the physical economy

Physical commodity exchanges can provide the legal, operational and technological infrastructure to support more transparent, liquid markets, offering significant benefits in several key areas:

• Liquidity: Moving from opaque bilateral trades to a transparent centralised venue increase transparency, which reduces risk and encourages participation.
• Price discovery: With access to a broader range of ‘unseen’ sellers at competitive prices, price discovery becomes fairer and easier.
• Risk management: By shift the management of counterparty risk on to a central exchange, reducing the time and expense of administration and minimising legal risk exposure.
• Financing: A secure, transparent exchange gives banks the level of confidence they need to finance commodity trades.
• Quality assurance: Exchange-based grading gives buyers confidence in the quality of the product they’re procuring.
• Traceability: Reliable, centralised records of provenance, title and ownership ensure trust and confidence along complex physical commodity supply chains.

But to trust the market, you need to trust the exchanges…

While central exchanges offer many benefits in principle, all these benefits are based on market participants having a high degree of trust in the exchange itself.

In India, for example, this was highlighted during the National Spot Exchange Limited (NSEL) scam, when NSEL defaulted on payments to around 13,000 investors and brought the commodities spot market in India to a grinding halt.

While the NSEL fraud devastated the market, it was just one in variety of complex factors that have prevented physical markets in India from fulfilling their potential. An historic mistrust of warehousing practices, for instance, has hindered market liquidity for many years.

But a new national regulator, the Securities and Exchange Board of India (SEBI) is taking steps to address concerns over transparency and risk in commodity markets, eliminate the poor warehousing practices of the past, and ensure fair price discovery.

The conditions are right for change

It seems a perfect storm is brewing in India, where the government and regulators are committed to creating more transparent commodity markets.

Alongside SEBI’s efforts, the Warehousing Development Regulatory Authority (WDRA) is leading the transformation of warehousing and receipting that will be vital to secure the long-term viability of India’s markets.

The work of SEBI, WDRA and other agencies will be crucial in reviving India’s physical markets, helping increase transparency and trust in commodities exchanges and encouraging growth in the variety of markets and derivative products available to traders.

Three converging factors will underpin the future success of the country’s physical commodity exchanges:

1. Improved warehousing – While new frameworks to promote and enforce warehousing best practices are welcome and long overdue, there have also been significant improvements in India’s warehousing infrastructure over the last few years. That means products are coming to market more evenly over the course of the year, rather than immediately after harvest, helping increase liquidity.
2. Digital technology – Electronic platforms for clear traceability and auditability are now available that could eliminate concerns over market manipulation and ensure trusted transparency – improving confidence and liquidity in physical commodities markets.
3. Regulatory pressure- There’s a growing political will, both globally and within India, to decrease risk by increasing transparency and centralisation through exchange-based trading. And as we’ve seen in so many markets, once regulators begin applying pressure, changes are bound to happen.

Find out more

To learn more about why exchanges are the future of physical commodities trading, sign up to get our white paper, The Six Benefits of Trading Physical Commodities on an Exchange.