Multi Commodity Exchange (MCX) of India: A great business to own

MCX as the name suggests is an electronics commodities exchange where users can trade on future contracts of 49 commodities as present. The main volumes are derived from 4 major commodities – Gold, Silver, Copper and Crude. Deriving technological edge from the use of trading platforms (primarily ODIN) provided by the promoters – Financial Technologies, MCX has gained sustained monopoly in commodity trading in India.

It commanded a premium 86% market share in commodities (FY12) with more than 2,170 registered members operating through over 346,000 trading terminals (more than 150k terminals have been added in the last one year which would mature in terms of trading volume with a lag), spread over 1,577 cities and towns across India.

MCX is the exchange with 3rd largest global volumes in commodities in terms of contracts traded with record highest volumes in Silver, second highest volumes in Gold and natural gas and third highest in Crude.

It has been certified to three ISO standards, including ISO 9001:2008 Quality Management System standard, ISO 14001:2004 Environmental Management System standard, and ISO 27001:2005 Information Security Management System standard.

 

Huge growth potential ahead

The Indian market is at a nascent stage with only 2 million entities trading in commodities as compared to around 20million in equities. Also global futures commodities volumes vis-à-vis physical trades are much higher than they are in India. For example: futures gold volumes are 70-80x that of physical trade v/s 17-18x times in India

Commodity exchanges were authorized in India only in April 2003, and the industry is far from mature. Hence continued demand for underlying commodities in a growing economy and expansion in the mix of hedgers and speculators will facilitate continued growth in traded volumes.

The market is at a relatively nascent stage with Gold, silver, crude oil and copper being the four largest commodities traded on the Indian exchanges, constituting 70%+ of the total traded value in FY11 and 80%+ of the total traded value in FY12.

The increase in physical market volumes consequently increases the hedging requirements for industry players, influencing derivative trading volumes. Growth in trading volumes of any commodity on the exchanges has been a function of price volatility. As long as there is volatility in the prices of a particular commodity, it will act as a volume growth driver for the exchange.

Though the total volume, an annual value traded of US$3.7 trillion appears substantial, the underlying capital invested is not substantial, given the leverage implicit from use of very low margins in the futures instrument. Currently, the average daily value traded is ~US$12bn. Assuming a margin requirement of 10%, the underlying margin money of ~US$1.2bn (Rs 6,300 Cr) is only 0.1% of India’s deposit base. Hence there are huge opportunities to growth ahead.

 

Understanding the ‘MCX’ advantage: Entry barrier and Moat

It is important to understand what forces equip an exchange to gain leadership and sustainability of that leadership going ahead.

The growth in industry has been driven mainly by the top 4 commodities (Gold, Silver, Copper and Crude) which accounted for highest majority of turnover. MCX has created deep pools of liquidity in these commodities, thereby creating high entry barriers for new participants.

Furthermore, and more relevant, is the impact cost (spread between highest bid and lowest offer) for which MCX has a relative advantage as it can offer a narrower bid-offer spread than other exchanges can because it offers access to large pools of liquidity.

From an end-client’s perspective, the benefit derived from a lower exchange fee at other exchanges is negligible when compared with the advantage gained from a better transaction price by trading at MCX.

Note: It is this deep pool of liquidity that made NSE a lethal force and garner majority market share from incumbent BSE in equities market. 

 

Leadership in new technologies from parent Financial Technologies

MCX is provided with technology platform by its parent, Financial Technologies India, who are one of the leading developers of exchange related software and technology. This gives MCX a competitive edge that is difficult to replicate.

Exchanges require constant technology upgrades and support, necessitated by regulatory regime and market forces. MCX is able to obtain speedy and efficient technology solutions from FTECH. MCX’s current technology infrastructure is sufficient to handle daily trading volumes of up to 10 million transactions. So far, it has handled a high of 1.8 million trades in a day.

MCX will have a much shorter lead time to introduce newer products like Options, as and when they are permitted. This market readiness leads MCX much ahead of the competition.

 

Operating Leverage

Since a large portion of MCX’s costs are fixed ones so any upside triggers in volumes and hence the topline can significantly boost the profitability. The only significant variable cost in its expenses is the fees paid as a percentage of transaction revenues towards technical services agreement to its parent Fin Tech.

Fixed costs are 60-70% of the overall expenditure at MCX hence potential growth in volumes implies better profitability going forward.

 

Newer revenue potentials: Data Services

Being the largest commodity exchange in India MCX is the key source of data on commodity trends. This provides MCX the opportunity to benefit from market data product and information offerings, as is the case for various leading exchanges in India and the rest of the world.

Internationally, revenues from selling market data products, analytical tools and price-feeds constitute 5-15% of exchanges’ revenues, on average. As the market for commodities trading grows, algorithmic trading systems, sophisticated quantitative approaches to risk management, will create demand for trading-related data and analytics.

The company currently has such arrangements with the following entities:

• Bloomberg Finance L.P.
• NewsWire 18 Private Limited
• IQN Data Solutions Private Limited
• Reuters India Private Limited
• Interactive Data (Europe) Limited
• TickerPlant Limited

Cash and Investments: Stakes in subsidiaries

MCX’s residual stake is now 5% in Dubai Gold and Commodities Exchange (DGCX) with a book value of Rs2.18 Cr and it has a direct equity stake of 5% in MCX-SX plus 634.17 million warrants (each warrant entitles the holder to subscribe for one equity share of Rs1 each of MCX-SX).

The company has negative net debt with huge investments in liquid mutual funds. This contributes to around Rs 170 of cash per share. The holding of 5% in DGCX is currently valued at 100 Cr+ which is marked at book value of ~2 Cr under investments.  So effectively we have 190 Rs cash sitting on per share.

The new MCX exchanges are mostly in areas with negligible competition (Bahrain, Botswana, Mauritius) and replication of the India story can generate good returns.

 

Shareholding pattern: distributed ownership

The promoters Financial Technologies (India) Ltd holds 26% as they are stipulated by SEBI norms to hold max 26%. 

	Jun-12	Mar-12	(IPO)7-Mar-12
Promoters (Fin Tech)	26.00%	26.00%	26.00%
Public	74.00%	74.00%	74.00%
FII	31.44%	33.27%	7.81%
DII	23.54%	22.41%	26.27%
Bodies Corporate	8.80%	8.89%	7.46%
Retail	10.22%	9.43%	32.46%

What is significant is that retail has sold off its stake to more long term mature holders (FIIs and DIIs) who have steadily accumulated. Going forward this will be a low liquidity thinly traded stock as most investors will simply hold this for long term.

The major point to note here is that no individual investor (barring promoters) can hold more than 5% in MCX, which leads to distributed ownership. MCX’s top 10 non promoter shareholders (as on 30-06-2012)

Sl No.	Investor Name	%age Stake
1	Fid Funds (Mauritius) Ltd	5.00%
2	Passport Capital LLC	4.90%
3	Merrill Lynch Holding (Mauritius)	4.79%
4	Aginyx Enterprices Ltd	4.79%
5	Euronext N V	4.79%
6	IFCI Ltd	4.79%
7	NABARD	3.06%
8	Corporation Bank	3.00%
9	NSE India	2.45%
10	Bennett Coleman (Times Group)	2.24%

 Major future triggers: FC(R)A bill approval

The Forward Contracts Regulation Act [FC(R)A] bill if passed can potentially unlock huge opportunities in terms of

• Introduction of commodity options trading
• Introduction of trading in intangibles (e.g., freight, rainfall and commodity indices) which are not permitted in India at present. Trading in commodity indices, in particular, if allowed, could provide a boost to turnover.
• Allowing participation from banks, mutual funds and institutional investors in the Indian commodity futures market.

These are huge triggers and introduction of any or all may see huge sudden upside in the stock. Under the current pro-reform mood, it is this anticipation that is fueling the short term rally in MCX. 

 

Major future triggers: Value unlocking from stake sale in subsidiaries

The second trigger and value unlocking potentially arises from stake sale in MCX-SX which currently offers trading in currency futures and options and has been permitted to start operations in equity future and options by SEBI. The approval is subject to the condition that the combined voting rights of FTECH and MCX in MCX-SX will not exceed 5%. This paring down needs to happen within next 18 months.

Earlier, FTECH held 31% and MCX held 38% in MCX-SX. Then, to comply with SEBI guidelines for starting equity trading, they reduced their stake in MCX-SX to 5% each through conversion of excess equity stake (beyond 10%) to warrants. The warrants will be sold to banks and financial institutions. This stake reduction contributes to a one-time gain of around Rs 110-120 per share for MCX shareholders.

MCX-SX is expected to go live in the equities segment by November 2012.It has successfully launched currency options in the recent past and has a market leadership in currency futures (market share of ~44% in FY12).

Key risks

Higher regulatory risks due to speculative nature of trades

The commodity futures exchange industry is highly regulated. The key regulatory body, the FMC, has in the past prohibited trading in certain commodities.

For example, in May 2009 it ruled that no new sugar contracts could be launched. Similar suspensions have taken place for commodities such as wheat and rice. 

Recently, the FMC banned all futures trading in guar and launched an investigation into potential price manipulation of other farm commodities, as per an article in the Business Standard dated March 29, 2012. These risks may not have a significant effect on MCX, in particular, given that trading in agricultural commodities is a relatively small component of its trading volumes.

However, similar bans on any of the top traded commodities – Gold, Silver, Crude and Copper may pose significant risk on volumes and hence revenues.

 

High proportion of costs incurred towards parent and group companies

Over 40% of MCX’s operating costs are towards various fees paid to the parent, Financial Technologies (Fin Tech) and promoter group companies. Its agreement with Fin tech for IT infrastructure and software services, costs MCX 12.5% of its transaction fees in addition to a fixed charge of INR12 Cr per annum, constituting a major portion of operating costs.

What is alarming is that costs incurred towards Fin Tech have gone up from ~19% of operating expenses in FY08 to ~47% in FY12. Also, the variable fee was revised upwards to 12.5% of transaction fees in FY11, from 10% in FY11 and will come up for revision again in October 2012. This overhang of increase in technical services fee (as a % of transaction fee) could be potential threat to MCX’s profitability.

 

Significant dependence on a few commodities

The aggregate value of commodity futures traded at MCX has been concentrated mainly in four commodities – gold, silver, copper and crude oil. During FY12, over 90% of volume contribution comes from the top 4 - Gold (27%), Silver (37%), Crude Oil (16%) and Copper (10%).

During FY12, 94% of the total traded value has been from these four commodities. Any period of low volumes in any of these 4 would impact overall volumes adversely.

Revenues tied to value traded fee and commodity price volatility.

As seen in April 2012, a downward spiral in Gold volumes in physical markets significantly affected the volumes in gold futures thereby affecting revenues for MCX. Spurt in trading volumes in the recent past (50% CAGR over FY09-12) was mainly attributed to an increased volatility and rise in commodity prices coupled with launch of mini futures and a ramp up in customer base. All these has effectively set a higher base in FY12.

Repeating the earlier success and surpassing it on the higher base of FY12 may prove to be quite challenging.

 

Sharp fall in commodity prices : Double Impact

With a lower volatility in leading commodities and a visible pressure in prices of leading commodities (gold, silver, crude oil), growth in trading volume may moderate to low double-digit over FY12-14E.

Trading volumes are highly dependent on volatility in commodity prices, which may be dictated by overall price trend in key commodities across the world. Growth in quantity traded correlates with the increase in volatility. Furthermore, in the case of precious metals, growth in quantity traded also correlates with price rises.

Rising prices usually drive higher volatility because a sustained price increase in a commodity potentially attracts higher participation and hence potentially higher volatility. Changes in commodity prices have a two-fold impact for MCX: they influence both the quantity traded and the value traded (as value traded = quantity traded x value per unit of quantity traded).

As MCX charges a transaction fee on value traded, as prices fall, quantity traded growth will also be lower, resulting in a lower turnover and hence lower transaction fees. The impact of price movements on turnover growth and hence transaction fees is thus amplified.

Lock-in period for pre-offer shareholdings

MCX completed its IPO in Feb, 2012. The pre-offer shareholding is subject to a lock-in of one year from the date of allotment (February 27, 2012) in the offer with the exception of

1. Shareholdings of current employees of the company who were allotted shares pursuant to ESOP schemes     
2. Venture capital funds/venture capital investors who have held shares for at least one year as on the date of the red herring prospectus (Feb 10, 2012) 
3. 20% of the promoters’ shareholding which is subject to a three-year lock-in period.

Based on the above, ~60% of the shareholding is subject to such a one-year lock-in (till Feb 27, 2013). Hence there may be additional selling pressure on and after the lock-in expires.
 

Cannibalization of Future volumes from introduction of Options trading

If Options trading is introduced with the approval of FC(R)A bill part of options growth could cannibalize futures trading (similar to what happened at NSE which introduced equity options trading in June 2001).


Disclosures:  No current positions, have invested in the IPO and during subsequent downward spiral. Have booked profits and currently have no open positions in the stock.