Introduction
Organized commodity derivatives in India started as early as 1875, within a decade after it was started in Chicago. However, many feared that derivatives fuelled unnecessary speculation and were detrimental to the healthy functioning of the markets for the underlying commodities. As a result, after independence, commodity options trading and cash settlement of commodity futures were banned in 1952.
To make matters worse, in 1960s when, following several years of severe draughts that forced many farmers to default on forward contracts (and even caused some suicides), forward trading was banned in many commodities considered primary or essential. Consequently, the commodities derivative markets dismantled and remained dormant for about four decades until the new millennium when the Government, in a complete change in policy, started actively encouraging the commodity derivatives market.
Government of India, in early 2003, has given mandate to four entities to set-up nation-wide multi-commodity exchanges. Secondly, expansion of permitted list of commodities under the Forward Contracts (Regulation) Act, 1952 (FC(R)A). This effectively translates into futures trading in any commodities that can be identified. Thirdly, 11 days restriction to complete a spot market transaction (ready delivery contract) is abolished. Fourthly, non-transferable specific delivery (NTSD) contract is removed from the purview of the FC(R).
Above four policies have led to the proliferation of futures contracts' usage in India to manage price risk. National level exchanges have made availability of futures contracts across the nation in the most cost effective manner through technology and at the same time have improved the risk management systems to improve and maintain financial integrity of futures markets in the country.
Since 2002, the commodities futures market in India has experienced an unprecedented boom in terms of the number of modern exchanges, number of commodities allowed for derivatives trading as well as the value of futures trading in commodities. However, there are several impediments to be overcome and issues to be decided for sustainable development of the market.
Important milestones in Commodity Futures Trading in India
1875 - Bombay Cotton Trade Association: While there is a viewpoint that Futures Trading has existed in India for thousands of years, the first organised futures market was established only in 1875 by the Bombay Cotton Trade Association to trade in cotton contracts. This occurred soon after the establishment of trading in Cotton Futures in UK, as Bombay was a very important hub for Cotton Trade in the British Empire.
1893 - Bombay Cotton Exchange Ltd: Following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association, a separate entity, by the name "Bombay Cotton Exchange Ltd." was constituted.
Soon after the commencement of Cotton Futures, Futures trading in Oil Seeds was started by the formation of Gujarat Vyapari Mandali, which was established in the year 1900 in Mumbai. It is currently known as "The Bombay Commodity Exchange Limited" (BCE).
Futures trading in Raw Jute and Jute Goods began in Calcutta with the establishment of the Calcutta Hessian Exchange Ltd., in 1919. Later East Indian Jute Association Ltd. was set up in 1927 for organising futures trading in Raw Jute. These two associations amalgamated in 1945 to form the present East India Jute & Hessian Ltd., to conduct organized trading in both Raw Jute and Jute goods. Futures trading in raw jute suspended in 1964 reportedly on the insistence of the then State Government (WB Govt.) as there were too many reports and allegations of price manipulations which left the farmer in the lurch. The Government had no other alternative but to suspend it. The announcement to reintroduce it was made in February 2003 after the Union Government had pressed for its return.
Official Policies viz. Commodity Futures Trading in India
The futures trading market is governed by the Forward Contracts Regulation Act, 1952. This law regulated forward contracts in all commodities in India. The Act covered all goods wherein goods are defined as any movable property other than currency, security and actionable claims. Under the Act, options trading in goods & cash settlements of the contracts were prohibited. Also, only those trading houses which were recognized by the government were allowed to organize trading in regulated commodities. There was a 3-tier regulatory process under this Act:
In the 1960s, following a series of severe draughts in the country, forward trading in many commodities was banned and although two committees, the Dantawala Committee (1966) and the Khusro Committee (1980), recommended the revival of futures trading in agricultural commodities, these recommendations were mostly not implemented. The market could never fully recover and grow to its full potential. Following liberalization, the Kabra Committee was setup in 1993 to study the role of futures trading. The Committee recommended futures trading in 17 groups, allowing options trading in goods, strengthening of the Forward Markets Commission and process of registering brokers with the Commission. Most of these recommendations were accepted by the government, thus giving a much needed boost to commodity futures market in India.
In 1999, a further 7 items were added to the list of allowed commodities. The major turning point came in 2003 when 54 items were opened to the market. These included sensitive items such as wheat, rice, sugar and potato. In 2006-07, the rising WPI was blamed on futures trading and the government delisted trading in wheat, rice & urad dal. Similarly, future trading in chana, soya oil and potato was banned in May, 2008. However, overall there has been a gradual shift toward opening of the market. In 2009, about 95 commodities were trading in the futures market.
The Forward Markets Commission (FMC) is a statutory body under the Ministry of Conusmer Affairs, Food & Public Distribution. It has its head office in Mumbai and consists of a minimum of 2 and a maximum of 4 members. All exchanges (dealing in commodities) come under the overall supervision of the FMC. A few of the important functions of the commission include:
Keeping the market under observation and taking necessary corrective steps wherever required.
Make recommendations to the government to improve the working of forward markets.
Ensuring the integrity of the market and flow of information to all market participants.
The FMC has thus transformed from an organization that enforces the prohibition of forwards & futures trading in commodities to one which properly manages and regulates this growing market.
Importance of Regulation in the Commodity Market
It is widely believed that increasing financial involvement in primary commodity markets (including in agricultural products, oil, minerals, etc.) amplify price volatility in these markets. In the recent past, the huge price volatility in Brent crude (crude oil) during the recent financial crisis of 2008-09 has been blamed on the futures trading in this counter. The same played out in the other categories as well most notably in food and in minerals. There was wide spread speculation that the only beneficiaries of this increased volatility were financial and marketing intermediaries.
Regulation is needed for the efficient functioning of the futures & forwards market and to prevent market manipulation. India's own policy in this area has seen many reversals and it is only now that the government has allowed the industry to slowly take off. A move toward more transparent and capitalized exchanges would facilitate in efficient price discovery and price risk management. To discourage excessive build up in positions and speculations, the Forwards Contract Regulation Act, 1952 also specifies that every seller have the option of settling the contract with physical delivery. Settlement of a contract on a purely cash basis is not allowed for any contract.
Modern Commodity Exchanges
To make up for the loss of growth and development during the four decades of restrictive government policies, FMC and the Government encouraged setting up of the commodity exchanges using the most modern systems and practices in the world. Some of the main regulatory measures imposed by the FMC include daily mark to market system of margins, creation of trade guarantee fund, back-office computerization for the existing single commodity Exchanges, online trading for the new Exchanges, demutualization for the new Exchanges, and one-third representation of independent Directors on the Boards of existing Exchanges etc.
The Government of India permitted establishment of National-level Multi-Commodity exchanges in the year 2002 and accordingly three exchanges have come into picture. They are
Multi-Commodity Exchange of India Ltd, Mumbai (MCX)
National Commodity and Derivatives Exchange of India, Mumbai (NCDEX)
National Multi Commodity Exchange, Ahmedabad (NMCE)
However there are many regional commodity exchanges functioning all over the country.
Major Players in Futures market
Commodity futures are beneficial to a large section of the society. Some of the major players in the futures market are farmers, investors, industrialists, importers, exporters, consumers, etc.
The players can be broadly classified into 2 types
Hedgers
Hedgers are those who participate in the futures market to reduce and diversify their risks. Some of the players involved in hedging are
Farmers: In order to eliminate any loss due to decrease in prices of agricultural products, farmers take opposite position in the commodity futures.
Investors: Investors hedge in the futures market to diversify their portfolio
Manufacturers: Companies which fear an increase in price of their raw materials trade in the futures market.
Importers and exporters: They participate in futures market to hedge against possible price, demand and supply fluctuations.
Speculators:
Investors who look for high risk and high returns investment are involved in futures market. Since the futures market does not depend on equity market and also Commodity market is a huge market, the investors have very high chance of making good returns off their investments.
Advantages of hedging in futures market
Less Manipulation
Commodities markets are governed by Forward Market Commission and international price movements and are less prone to rigging or price manipulations by individuals.
Diversification
The commodity market and the equity and debt market are completely independent off each other. Any policy changes in one market will not affect the other one i.e. it is completely uncorrelated. Hence Investors who want to diversify their portfolio can enter futures market
Price Fluctuation
Wide fluctuations in price in products especially export or importing products like crude oil, agricultural products, metals, etc. will have adverse effects on the economy as well as the companies in the industry. Commodity futures help in transforming this risk to speculators. If you are a farmer, there is every chance that the price of your produce may come down drastically at the time of harvest. By taking positions in commodity futures you can effectively lock-in the price at which you wish to sell your produce
Assured Demand
If demand is uncertain for any commodity, selling commodity futures will assures demand when the product is produced. For example, farmers can sell the futures of the commodity which they are producing so that at the time of harvesting, they can have assured returns.
Assured Supply
Industries which fear shortage of raw materials may lock in the futures market. This will be a very powerful hedging tool for companies which incur huge losses because of raw materials shortage. Any shortfall in the supply of raw materials can stall company's production and make it default on its sale obligations. This can be avoided by using commodity
In most industries, the raw material cost dictates the final price of your output. Any sudden rise in the price of raw materials can compel those companies to pass on the hike to the customers and make their products unattractive in the market. By buying commodity futures, the companies can fix the price of your raw material.. You can avoid this risk by buying a commodity futures contract by which you are assured of supply of a fixed quantity of materials at a pre-decided price at the appointed time.
High Leverage
The margins in the commodity futures market are less than the F&O section of the equity market and hence risk is also comparatively lower than F&O of equity market.
Increase in holding power
One can store the underlying commodity in exchange approved warehouse and sell in the futures to realize the future value of the commodity.
Major commodity linked future products
Bullions
Metals
Energy
Oil & Oil Seeds
Cereals
Others
Gold
Aluminium
ATF
Crude Palm Oil
barley
Almond
Gold Guinea
Copper
Brent Crude Oil
kapasia Khalli
Wheat
Gaur Seed
Gold HNI
Lead
Crude Oil
Refined Soya Oil
Maize-Feed / Industrial Grade
Melted Menthol Flakes
Gold M
Lead Mini
Electricity Monthly & Weekly
Soya Bean
Mentha Oil
Platinum
Mild Steel Ingot,Billets
Gasoline
Potato (Agra)
Silver
Nickel
Heating Oil
Silver HNI
Tin
Imported Thermal Coal
Silver M
Zinc
Natural Gas
Zinc Mini
Pulses
Weather
Fiber
Spices
Plantations
Chana
Carbon (CER)
Kapas
Cardamom
Rubber
Carbon(CFI)
coriander
Turmeric
Source: MCX website
Most Active Contracts (By Volume)
Symbol
Expiry Date
Value (In Lacs)
Volume (In Lots)
LTP
GOLD
05OCT2010
28004.88
1539
18195.00
CRUDEOIL
19AUG2010
24022.75
6441
3734.00
COPPER
31AUG2010
13071.38
3821
342.20
SILVER
04SEP2010
8186.68
937
29114.00
ZINC
31AUG2010
6812.69
1393
97.95
NICKEL
31AUG2010
6622.14
2586
1028.60
NATURALGAS
26AUG2010
4619.64
1781
207.60
GOLDM
04SEP2010
3188.42
1758
18143.00
CRUDEOIL
20SEP2010
2928.01
778
3767.00Most Active Contracts (By Value)
Symbol
Expiry Date
Volume (In Lots)
Value (In Lacs)
LTP
CRUDEOIL
19AUG2010
6441
24022.75
3734.00
COPPER
31AUG2010
3821
13071.38
342.20
NICKEL
31AUG2010
2586
6622.14
1028.60
SILVERM
31AUG2010
1934
2816.44
29123.00
NATURALGAS
26AUG2010
1781
4619.64
207.60
GOLDM
04SEP2010
1758
3188.42
18143.00
GOLD
05OCT2010
1539
28004.88
18195.00
ZINC
31AUG2010
1393
6812.69
97.95
ZINCMINI
31AUG2010
1094
1070.09
97.95
LEADMINI
31AUG2010
948
949.06
100.30
Trends observed
From the above charts the following trends emerge in the Indian commodity markets.
Crude, bullion and metals are the highest traded commodity in the markets
There has been a rise in the index of commodity markets
The high volumes indicate that corporate Indian growth has prompted manufacturers, miners and traders are using the market in great numbers. Also bullion being traded in large numbers shows the gold consumption in India.
Trade in agri based futures and climate trades are also traded in the exchange.However one observes that among the market players one can see more of investor speculation especially in agricultural commodities. There has been a revere effect on the spot rates leading to speculative inflation.This had prompted the government to stop trading in futures to a variety of commodities.
Analysing major contracts traded
Bullion- Gold
Traded Value - MCX
source: MCX data
Gold has been trading a higher value as seen from the chart. This indicates more and more buyers and sellers entering the market, as MCX itself are growing.
The major traders in the gold market are:
Gold investors, who seek either currency or gold, trade here. When the dollar is down, investors follow into safe haven like gold. Gold opposes the dollar and steps in with the euro.
Gold hedgers are the retailers and industries which rely on gold.
Crude contracts
MCX CRUDE
Source: MCX data
Crude oil futures have a high correlation with global crude oil prices.
Market participants include majorly refiners and OPEC suppliers or suppliers in the global market. Speculation in this market is not domestic in origination and acts a arbitrage tool due to correlation with the international crude oil markets. Thus the contract sees high volume of arbitrage activity as well.
Companies such as airline companies may use crude to hedge their ATF prices, as ATF futures are also traded in MCX introduced in 2008.
The transaction cost of hedging are negligible since the volatility of crude and ATF is becoming highly volatile over the years making hedging essential to all users of petroleum based products and this prompts the high trading volumes witnessed in the markets.
Wheat Contracts
MCX wheat
Source: MCX data
MCX wheat has been declining in volume recently. To attract wheat trading as well as in any commodity it is essential to ensure the use of good warehousing facilities. In commodity trading physical delivery facilities are essential.
Turnover in Commodity exchanges
In Feb 2009, the turnover in Commodity exchange has increased by 53% to Rs. 7,38,892 crore from Rs. 4,84,236 crore in the previous month in 2008. Higher turnover was witnessed in bullion, energy and some of the agricultural commodities, since after the suspension on five out of eight commodities. The four national commodity exchanges- Multi Commodity Exchange
(MCX), National Commodity & Derivatives Exchange (NCDEX), National Multi Commodity
Exchange (NMCE) and Indian Commodity Exchange (ICEX) together recorded an average monthly turnover of Rs. 7,31,348 crore.
The turnover in commodity exchanges has seen a rise particularly in agri-based products since the suspension of ban on several commodities in recent times. The turnover in agricultural commodities almost doubled in 2009 compared to previous year. Agricultural commodities accounted for 38% of the total volume of trade during the calendar year 2009. But in 2010, the share of non-agricultural commodities, including base metals, precious metals and oil, has seen a notable recovery in February 2010 following the downturn in the trading in agricultural commodities. During the month, the share of gold and silver together contributed to around 44.9% of the total turnover as against 42.8% recorded in the previous month. The share of base metals has shown remarkable improvement, as their combined turnover has increased by 26.8% as against 24.2% rise recorded during the previous month.
Turnover of Commodity futures market
In 2009, the total value of the commodity futures market rose from Rs 50.34 lakh crore in 2008 to Rs 70.90 lakh crore. The commodities traded on the commodity futures market included a variety of agricultural commodities, bullion, crude oil, energy and metal products. Some of the new commodities introduced for futures trading in 2009, were almond, imported thermal coal, carbon credits and platinum. During 2009, agricultural commodities, bullion and energy accounted for a larger share of the commodities traded in the commodities futures market.
The Multi Commodity Exchange (MCX) recorded the highest turnover in terms of value of trade during 2009, followed by the National Commodity & Derivatives Exchange (NCDEX) and National Multi Commodity Exchange (NMCE) respectively.
In 2009 agricultural commodities accounted for about 16.33% in terms of value and 38% in terms of total volume traded. In terms of value, bullion accounted for the maximum share of commodity groups followed by energy and metals.
Issues
Commodity derivatives market has seen an upheaving progress in the last few years and supporting the fact is the geometrically growing numbers in the terms of value and the volume of the business along with an increase in the number of commodities allowed for derivative trading. But still there are a lot of issues which are lurking in the background and hindering the actual progress of the commodity derivative markets. The current growth rate may not sustain unless steps are taken to resolve these crucial issues. The idea behind setting up the commodity index may fail to realize its objective if the issues remain unresolved. Some of the crucial unresolved issues are
Commodity Options: Option trading in commodity market is banned by the government since a long time. Options in goods are presently prohibited under Section 19 of the Forward Contracts (Regulation) Act, 1952. No exchange or person can organize or enter into or make or perform options in goods. Futures and options together are necessary for a healthy growing market & the absence of commodity options in the market make them incomplete. The futures contracts are targeted only to be used as hedging instruments and protect the downsides of one's portfolio. The restriction on & unavailability of options trading restricts the players to make capital gains in the markets. For e.g. although futures contracts help a farmer to hedge against downside price movements, it does not permit him to reap the benefits of an increase in prices. All the major market players support that there is an immediate need to bring about the necessary legal and regulatory changes to introduce commodity options trading in the country. The matter is under the active consideration of the Government and the options trading may be introduced in the near future.
The Warehousing and Standardization: A cost-effective, convenient, sophisticated, and reliable warehousing system is necessary for efficient working and proper functioning of the commodity derivative market in the country. The government set up the Habibullah task force in 2003 on convergence of regulatory work for proper development of the commodity futures market. The task force admitted that, "A sophisticated warehousing industry has yet to come about." As the trade volumes are increasing it is important to set up and maintain independent quality testing centers in all the regions to certify the quality, grade and quantity of the commodities during settlement. These standardized practices will reduce the delivery risk of the buyer of the commodity. The location of the warehouse is of critical importance and it should be conveniently located and easily approachable. According to latest figures Central Warehousing Corporation of India, A premier Warehousing Agency in India, established during 1957 providing logistics support to the agricultural sector, is one of the biggest public warehouse operators in the country offering logistics services to a diverse group of clients. CWC is operating 487 Warehouses across the country with a storage capacity of 10.6 million tonnes providing warehousing services for a wide range of products ranging from agricultural produce to sophisticated industrial products. Warehousing activities of CWC include food grain warehouses, industrial warehousing, custom bonded warehouses, container freight stations, inland clearance depots and air cargo complexes. Apart from storage and handling, CWC also offers services in the area of clearing & forwarding, handling & transportation, procurement & distribution, disinfestation services, fumigation services and other ancillary activities. Obviously there is much scope for improvement in capacity and locations and the current facility is not sufficient for a vast country like India. Large scale privatization and Gramin Bhandar Yojana (Rural Warehousing Scheme) are a few steps taken in the direction.
Cash versus Physical Settlement: A probable reason for very low volumes of trade being settled by physical delivery of the underlying may be an inefficient warehousing system in the country. Only about 5% of the total commodity derivatives traded in the country are settled through physical delivery. Hence the warehousing facilities need to be improved to increase the efficiency of the system and enhance the incidences of settlement through physical delivery. Steps should be taken to improve the delivery system as it is the pillar of any commodity trade. Under the Forward Contracts (Regulation) Act 1952, cash settlement of outstanding contracts at maturity is not allowed, in other words all the outstanding contracts at maturity needs to be settled through physical delivery. This is a serious issue in the commodities market as to avoid the physical delivery the participants have to square off the deal before maturity. This leads to majority of contracts being settled in cash but prior to maturity dates to avoid the physical settlement. Steps need to be taken to change the laws and save participants from unnecessary hassles.
The Regulator: To match the standards of global markets a strong and independent regulator is the need of the hour. Also the increasing market activity in terms of volumes of trade being executed is ever increasing. The commodity market needs a regulator similar to the Securities and Exchange Board of India (SEBI) that regulates the securities markets. While SEBI functions independently, the Forwards Markets Commission (FMC) is under the Department of Consumer Affairs (Ministry of Consumer Affairs, Food and Public Distribution) and depends on the ministry for regular funding. To ensure the development of the commodity market the Government should grant more powers to the FMC. The SEBI and FMC can work closely with each other due to the inter-relationship between the two markets.
Lack of Economy of Scale: Commodities are traded at number of exchanges which are spread across the country. A large number of commodities are traded in the commodity derivative market but in practice only a few commodities futures are popular among the players. All these trades if carried on a few number of central exchange would lead to an efficient market for the traders and would bring economies of scale and scope. This would reduce duplication of efforts and improve the growth prospects of the market. The notion of combining the securities market and the commodities market has been discussed by the policy makers and market players since a long time. It would also improve the regulation of the commodity market. However integration of the two markets would require complete synchronization among the regulatory authorities such as Reserve Bank of India, Forwards Markets Commission, Securities and Exchange Board of India and the Department of Company affairs etc.
Legal Bottlenecks: Restrictions on the movement of goods across the states negatively impacts the functioning of the commodity markets. To develop a national market for commodities and derivatives these bottlenecks need to be removed and free flow of goods should be allowed.
Future Prospects & Conclusion
Commodity exchanges in the country are expected to play a significant role in the economic growth of the country and strengthen the Indian economy to face the challenges posed by globalization. India boasts of huge amount of commodity production in the country and has a long history in future trading of commodity. An improvement in the transparency, technology and trading regulation have significantly contributed to the progress of the commodity derivative market. Options on commodity index are being considered, once implemented these would provide market players with better risk management techniques. Further developments in the warehousing system would facilitate in seamless countrywide commodities market. Commodity future trading provides the players with an opportunity to diversify their portfolios. An integration of equity, commodity, forex and debt market would lead to better business opportunities for the market players. This convergence would result in better services for the players like India's corporate and trading community in terms of risk management solutions.
Future market in commodities needs to be better regulated and treated with caution to avoid giving a large playing ground to the speculators.
