Here's why castor bets went awry

For the first time, the commodity futures market saw an overnight ban last week on castor seed futures as a few members were facing pay-in problems. ET explains the reasons for the fiasco

1. What was brewing in castor? Over the past year, a few entities were allegedly cornering castor stocks on the physical market and creating bullish bets on futures exchange NCDEX to jack up the price and sell it at a higher rate in the spot market.

2. How was this facilitated ? Rumours abound that a big broker lent money at a 25-30% haircut to a large edible oil trader from central India against the stocks. The stocks were procured and concomitant buy positions created on NCDEX assuming a shortfall in production. A shortfall would have made procurement by sellers for delivery difficult since the buyers had already cornered stocks. This would have raised prices in spot and at expiry, as the spot and futures prices converged, they would square off their positions at a profit while simultaneously dumping actual stocks in the physical market, profiting at both ends.

3. What went wrong ? Large carry forward stocks and around 20% higher production caused prices to plunge by 20-25% over the year. The financier made margin calls on the buyer forcing it to liquidate some of its positions, precipitating a sharper fall. Other buyers too got into difficulty because of the price collapse. A stage came when the exchange itself put some of the buyers’ positions in square off (sell) mode causing the lower circuit to be hit in the absence of any buyer on the other side. The exchange last week suspended trading in castor futures

4. Did suspension of trade create a problem in the market ? Yes it caused a lot of loss to sellers, hedgers and arbitrageurs. While the exchange averted systemic risk by closing out all contracts at last week’s settlement price, some sell side brokers privately said the exchange inadvertently or otherwise ended up giving an exit to buyers.

5. What is the solution ? Market regulator Sebi asked NCDEX for an explanation for its decision to suspend trading. The report will be submitted to Sebi this week, following which a detailed investigation will be done. Sebi also came out with a circular on position limits two days after the ban in a bid to prevent potential concentration of positions among a few entities. Against the previous practice of netting out positions to determine position limits for clients, from March, an exchange will separately add up longs and shorts in an agri contract. The higher of the two will be considered as the position enabling the exchange and Sebi to figure out concentration risk.