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(Reproduced from original article in Outlook Business)

It’s a perfect David vs Goliath plot. The only difference is that here, David did not even have to fight the giant — Goliath simply surrendered in the battle for supremacy in the estimated Rs 100 lakh crore Indian commodity market. David, or Kotak Mahindra Bank, is now the single-largest shareholder in India’s largest commodity bourse, holding 80% share of the commodity market, while Goliath, MCX, has been summarily vanquished.

To understand the present context, one needs to go back to 2010, when Uday Kotak first unveiled a commodity exchange called ACE. This was the first regional futures exchange to go national with a multi-commodities futures trading platform after the Kotak Group got approval from the commodity markets regulator, the Forward Markets Commission (FMC), for a complete transformation in the exchange platform after picking up 51% stake. Though the foray into the commodities exchange was a first by any private sector bank in the country’s history, the marketplace at the time was very different. The Jignesh Shah-owned Financial Technologies India (FTIL) was the leader, with its Multi Commodity Exchange (MCX) staking claim to a staggering 80% market share.

Within three years of its inception, MCX toppled the agri-commodities exchange, National Commodity Derivatives Exchange (NCDEX), to emerge numero UNO. (see: Fast and furious) Its name notwithstanding, ACE never really managed to pose a threat to other exchanges, remaining a peripheral player with around 1% market share. But, in a quirk of fate, ACE finally got to trump MCX by becoming its owner. This curious turn of events happened largely on account of the undoing of Shah, whose overarching greed led to his collapse and the handing over of India’s premier commodity exchange on a platter to Kotak, which was more than happy to lap up the opportunity.

The story of MCX is inseparable from that of Shah, who, after a meteoric rise, is now riding the tail of a vanishing flare. MCX was founded by Shah in November 2003 and initially offered facilities for online trading of commodities and clearing and settlement of commodities futures transactions.

The technology support and infrastructure was supplied by Shah’s FTIL, which went in its favour when it issued an IPO in March 2012 to become the first listed exchange in the country. It was thought that since a promoter was supplying the technology, a competitive arrangement would lead to lower operational costs. Bids poured in to the tune of Rs 35,000 crore for an issue size of Rs 663 crore and the stock saw a listing gain of 26% over its issue price of Rs 1,032. MCX progressively grabbed increasingly larger share of the commex pie to reach its current sovereignty over the market. How did this come to be?

A Charmed Decade

One of the world’s first commodity futures market emerged in India as early as 1875, when trading of cotton futures started in Mumbai, a by-product of the Indian economy’s then overwhelming dependence on agriculture.

In 1952, the Forwards Commodities (Regulation) Act (FCRA) was passed and FMC was instituted in Mumbai the next year as the commodities markets regulator. However, the post-independence period saw the growth of this market being stifled by a socialist government paranoid about speculation and price rise, compounded by a lack of understanding and deep suspicion of the effects of a large-scale futures market.

Post-liberalisation, the picture changed once again, with futures trading picking up speed and several multi-commodity exchanges and regional exchanges springing up around the country. Today, a few players — including MCX, NCDEX and the National Multi Commodities & Derivatives Exchange (NMCE), in that order — dominate the commex market. MCX started around the same time as the other two. How, then, did it achieve its near-monopoly status?

“MCX profited immensely from a first-mover advantage in the non-agricultural product space and from the fact that it was aggressive in forging tie-ups. The main difference between MCX and other players is that it was primarily involved in trading non-agri products versus other exchanges such as NCDEX,” says Naveen Mathur, associate director (commodities and currencies) at Angel Broking. Immediately after its inception, MCX tied up with Bombay Bullion Association (BBA) for bullion futures, Bombay Metal Exchange (BME) for futures in non-ferrous metals, and Solvent Extractors’ Association for edible oils futures, all of which helped it immensely in cornering a large chunk of the non-agricultural futures market. (see: Moving away)

After three years as the No.2 player, MCX finally edged past NCDEX in 2006, aided by a surge in gold futures volumes. This was when it also emerged as the third-largest commex for gold futures trading in the world, behind the New York Mercantile Exchange and Tokyo Commodity Exchange. Many traders switched to the Indian exchange because it had been tremendously successful in providing liquidity to contracts and reducing impact costs.

From then on, market share increased progressively as futures trading in non-agri products such as metal and bullion began to dominate the market. To counter this, NCDEX introduced gold futures trading in 2013. However, not much has changed. “For traders, NCDEX remains the agri exchange and MCX is the international commodities exchange,” says Kunal Shah, head of commodities at Nirmal Bang. Today, around 80% of the total commex turnover comes from non-agri products, explaining MCX’s dominant market share. In FY14, it enjoyed a 99.46% market share in bullion trade and 98.66% market share in the metal trade. (see: The road to El Dorado)

Gloomy Days

Starting 2013, MCX faced a slew of negative news that took the stock on a roller-coaster ride. In early 2013, the government announced a commodity transaction tax (CTT) — amounting to 0.01% of the transaction value — to be levied on the sellers of non-farm futures starting July. This tax was imposed on items ranging from gold and metals to sugar and edible oils. Only 23 pure agricultural commodities, such as cotton, wheat and potatoes, were exempt from the tax. This led to a severe drop in commexes’ topline over the financial year and they reported a 62% fall in turnover in 2014. Metal and bullion bore the brunt of this fall, with a steep 70% drop in turnover. Agricultural commodities fared slightly better, with a 14% drop. From Rs 125 lakh crore the previous year, MCX’s exchange turnover dropped by 39% to Rs 76 lakh crore in the first 10 months beginning April 2013. Prior to the CTT, MCX’s average daily turnover had increased by 53%, from Rs 21,000 crore in FY10 to Rs 32,100 crore in FY11 and by 57% to Rs 50,300 crore in FY12. A market correction took place to adjust for the truncated turnover. MCX stock prices fell by almost 50% in the period from December 2013 to April 2014, from a high of around Rs 1,600 to Rs 830. However, the knockout punch was still to come.

“A change in the regulatory climate will also end up driving non-linear growth for MCX”—Paul Parambi, Group strategy head, Kotak Mahindra

On July 31, 2013, a sordid affair came to light. MCX’s spot exchange, the National Spot Exchange (NSEL) defaulted on payments of Rs 5,574 crore, in what is now infamous as the NSEL scam. It was discovered that NSEL was issuing forward contracts only on paper; the underlying commodities did not exist in the company’s warehouses and, in some cases, the warehouses themselves were non-existent.

Shah and FTIL, which owned a 99.99% stake in NSEL, were heavily implicated and FTIL stock prices crashed along with investor confidence. The domino effect of FTIL’s bad Street credibility spilt over to MCX — the market price fell by 7% in a day’s trade. In a fortnight — which can be a lifetime in the stock market, in some cases — the price hit rock-bottom, down 65% from Rs 690 to Rs 243.

The combined effect of the CTT and the NSEL debacle led to a drop in volumes and resulted in MCX losing a portion of its market share to NCDEX, which has reported a 12% rise in turnover and whose market share has jumped from 11% to 18% in the first quarter of FY15. “Around 35-40% of the drop in volumes has been a result of the CTT. Beyond that, it is the contribution of the negative sentiment in connection with the NSEL issue,” says Angel Broking’s Mathur.

The turn of events led to a steady exit of institutional investors from MCX. Compared with 58% on June 30, 2013, the stake of institutional investors had dropped to 36% a year later. In December 2013, FMC declared anchor investor FTIL “not fit and proper” to run MCX and ordered it to sell its 26% stake and exit the exchange business. Its shareholding pattern displayed the share of retail investors doubling from 7% in June 2013 to 14% in June 2014, many of whom were probably banking on an open offer from a potential buyer for FTIL’s doomed holding.

To compound matters, in May 2014, a forensic audit report by PricewaterhouseCoopers (PwC) that unearthed serious corporate governance issues was made public. The report said that MCX’s management was executing decisions taken by FTIL’s senior management. It highlighted questionable ‘one-sided’ transactions, stating that while 25% of FTIL’s revenue came from supplying technology to MCX, MCX didn’t have the requisite bargaining power. In July 2014, MCX announced that it was looking to scale down its technology contract with FTIL to five years, extendable to 20 years, from the current contract of 33 years, extendable to 99 years. A clean divorce was in the works.

Enter Kotak

The bidding process commenced in April 2014. Companies such as Reliance Capital, the BSE and Kotak Mahindra Bank swooped down on the FTIL holding with non-binding bids following the FMC announcement. On May 6, Sebi issued brand new guidelines mandating that only domestic commexes, stock exchanges, depositories, banks, insurance companies or a public financial institution could hold 15% stake in commodity exchanges. Individuals and other kinds of companies could only hold up to a total 5% stake. After this development, Kotak Mahindra Bank emerged as the frontrunner in the bidding race, with a bid of Rs 459 crore for a 15% stake in MCX, at an average price of Rs 600 per share.

If the Lok Sabha clears the FCRA Amendment bill, it will give a much-needed fillip to the commodities market by driving up volumes four to five times

“MCX was a unique opportunity for us. We believe it is a strong franchise. From our perspective, we like the financial infrastructure space. It’s a strong play on the India story; if the India story does well then the commodities space will do well and the equity markets will do well,” says Paul Parambi, group strategy head at Kotak Mahindra Bank. Parambi is banking on the FCRA regulation being passed soon for MCX to transform into a cash machine. “As regulations get freed, options trading is permitted and restrictions on the trade of certain commodities are removed, non-linear growth to MCX will happen,” he says.

Parambi adds that this is a purely financial investment and that Kotak is in it for the long haul, not for short-term capital gains. “However, we will constantly evaluate once the deal is closed,” he says. The ACE experience was a good opportunity for Kotak to learn the ropes of the commex market. “What we’ve learnt from various exchanges is that if there is a player who’s got a good market share in a particular space, for example, MCX in bullion and metals, and NCDEX in agri-commodities, it’s difficult to take market share from them, which is why when we got a chance to acquire a 15% stake in MCX, we went for it,” he explains.

However, there are some possible downsides. Parambi lists them all in a flurry of ifs. “If some events that we are expecting do not come about, if volumes do not grow as one might hope for over time, if potential liabilities because of events in the past turn out to be larger than we expect, and though we do not expect this, if competition is able to take share away from MCX,” he says.

A Mixed Bag

A week before the Kotak announcement, maverick investor ‘Big Bull’ Rakesh Jhunjhunwala acquired a 2% stake in MCX at Rs 664 a share. Jhunjhunwala’s strong market credibility did wonders for investor confidence and significantly boosted valuations, helping the stock price reach a 52-week closing high of Rs 679.7.

But really, it is the Kotak development that has done much to assuage investor confidence. “With this deal, confidence of investors is likely to be boosted, as the overhang around its issues with its earlier parent, FTIL, is now behind it. This will also likely aid sentiment of potential customers of MCX, who had arguably curtailed transactions post-FTIL related issues since average daily value (ADV) traded went down by about 30%,” says Gautam Chhaochharia, head of research at UBS Securities India. However, it isn’t enough to drive up prices significantly. “The key push will be regulation instead of ownership,” says Ashish Chopra, analyst with brokerage firm Motilal Oswal. The regulatory push Chopra is talking about is an amendment of the FCRA, which was tabled in the Lok Sabha in March 2013 after being stuck in a Parliamentary quagmire for the past seven or eight years. The amendment will provide autonomy to FMC, introduce new products such as options and indices trading in the commodities futures market and allow banks, mutual funds and insurance companies to participate in the futures market. It will also drive up volumes four or five times the current levels and provide a much-needed fillip to a beleaguered commodities market.

“With the Kotak deal, investor confidence in the new entity is likely to get a boost”—Gautam Chhaochharia, Head of research, UBS Securities

However, not everyone is as optimistic about the FCRA. “I’ve been in this industry for the past 10 years. They keep saying FCRA will be passed, if not in the Budget session, then the monsoon session or the winter session. Sometimes it’s presented through an ordinance but somehow it lapses every time. I’ve only been disappointed so far but I’m still hopeful,” says Mathur. Nirmal Bang’s Shah expects some positive developments in the next six to eight months, but feels FCRA is only one part of the picture. “More than FCRA, the government should focus on making market-making legal. Today, corporates like Hindalco hedge risk in the international commodities market because the domestic market lacks depth. If even 10% of the money that is going out is diverted to the domestic commodities market, volumes will shoot up three or four times,” he says.

Today, the MCX stock is also riding on hope. Its market share has declined by around 6% from 86% to 80% since the last year and it has reported a 42% decline in volumes and 43% drop in net profit. Profits in the March ’14 quarter have declined by 36% from Rs 76.63 crore to Rs 43.75 crore, while revenue has slipped almost 50% from Rs 126.66 crore to Rs 63.96 crore. However, the company has zero debt and possesses ample cash reserves of Rs 388 crore as on September 2013. MCX has more than 2,100 registered members, compared with 800-1,000 members in NCDEX. “The market impact cost or trading cost in the non-agri space for MCX is lower than NCDEX because of high liquidity, while transaction charges are higher. Conversely, for agri-products, NCDEX has lower impact cost and higher transaction charges. Both exchanges keep transaction charges low for the products they want to promote,” says Mathur. For example, MCX charges Rs 2.1 for Rs 1 lakh of turnover for metals and energy contracts, compared with Rs 0.75 for agri-commodity contracts.

The combined effect of the CTT and the NSEL debacle has been to NCDEX’s advantage. NCDEX has also benefited by the introduction of evening trade and smaller-sized future contracts in chana and castor seed. To counter the prolonged fall in volumes, MCX decided to cut transaction charges in the trade of all commodities in March 2014.

Analysts feel MCX’s performance has bottomed out and expect its EPS to increase from Rs 24 to Rs 27 in FY15 and go up to Rs 32 in FY16. And investors remain largely optimistic, barring a few uncertainties. “The business enjoys the largest market share in its segment. The exchange market is only 10 years old and is at an evolutionary stage in India. Today’s volume rates may not justify it but there is good scope in the future,” says Chopra.

Another major factor that is maintaining investors’ hopes is that once the FCRA amendment is passed, MCX will see its topline shoot with negligible capital expenditure, as it is already technology-ready. MCX, courtesy FTIL, has a vast network of more than 400,000 trading terminals spread across 1,900 cities in the country. The technology infrastructure has a capacity to handle up to 10 million transactions daily. The trading high so far has been 1.9 million trades. If the FCRA is passed and volumes shoot up, market sources say MCX will bring in a flood of money to its investors with almost zero capex, providing excellent return on equity (RoE) levels in the future. In FY14, however, the company’s RoE has fallen to 13.3%, compared with 28% in FY13 and 32% in FY12. (see: In a pincer)

The ownership issue has been settled with Kotak playing the knight in shining armour. Corporate governance issues have also been largely resolved so far, with MCX reportedly in the process of appointing a new CEO. “It will be a good bet for the extreme long term, in case you are planning to just buy the stock and forget about it and wait for the monopolistic position MCX enjoys and impending regulatory changes to yield benefits,” says Chopra. Chhaochharia is also bullish on the stock. “We believe stock would trade at premium valuations in the near-medium term, given FTIL overhang is now resolved and there are hopes around Kotak driving growth in business,” he says.  At current levels of Rs 836, the stock is trading at 26 times its FY15 and 22 times its FY16 estimated earnings, a figure that is in line with its Asian peers, which are trading at 20-28x FY16 PE range.

But it’s not a completely rosy picture. There are a few issues that still require resolution and some unknown liabilities might play spoiler. “The market is awaiting the resolution of the technology issue since FTIL is still a vendor. It is concerned over certain interoperability issues that PwC highlighted in transactions between the parent and MCX,” says Chopra. However, since the current arrangement is tilted towards FTIL, any freshly negotiated agreement with a new software vendor will work out in favour of MCX.

Also, the fact that MCX might have to face tax liabilities in the range of Rs 800-1,000 crore as a result of unaccounted related-party transactions between MCX and FTIL is making some jittery. However, it is thought that these liabilities are accounted for in valuations. At least on the NSEL count, investors need not worry. “Though there are around 1000 brokers common to NSEL and MCX, there is no direct cross liability nor are any top MCX brokers distressed. Otherwise, the impact would be visible by now not only in MCX but also in other exchanges,” says G V Giri of IIFL. In spite of these issues, there is a general feeling in the market that the worst is behind MCX. “As they say, it is darkest before dawn. This is the state of the commodities market today. We had CTT and then the NSEL scam but now things are finally looking up,” sums up Nirmal Bang’s Shah.