Commodity Derivatives Market in India

Commodities

Commodity Derivatives Market in India

Economic and Political WeeklyMarch 31, 20071152partofaproject called the “agricultural marketing informationsystem”. A write up placed on this portal sums up the fundamentalissues facing the spot market for agricultural commoditiesin India today:The purpose of regulation of agricultural markets was to protectthe farmer from exploitation by intermediaries and traders and alsoto ensure better prices and timely payment for his produce. Overa period of time these markets have, however, acquired the statusof restrictive and monopolistic markets, providing no help in directand free marketing, organised retailing, smooth raw materialsupplies to agro-processing, competitive trading, informationexchange and adoption of innovative marketing systems andtechnologies. The farmer cannot sell his produce directly in bulkexcept on a retail basis to consumers. Farmers have to bring theirproduce to the market yard. Exporters, processors and retail chainoperators can not get desired quality and quantity of produce fortheir business due to restrictions on direct marketing. The pro-cessor can not buy the produce at the processing plant or at thewarehouse. The produce is required to be transported from thefarm to the market yard and only then it can be purchased andtaken to the plant. There is thus an enormous increase in thecostofmarketing and the farmer ends up getting a low price forhis produce. Under the Agricultural Produce Market CommitteeAct,only state governments are permitted to set up markets.Monopolisticpractices and modalities of the state-controlledmarkets have prevented private investment in the sector. Thelicensing of traders in regulated markets has led to the monopolyof licensed traders acting as a major entry barrier for a newentrepreneur. The traders, commission agents and other function-aries organise themselves into associations, which generally donot allow easy entry of new persons, stifling the very spirit ofcompetitive functioning.India is one of the top producers of a large number of com-modities and is also a major consumer of precious metals andenergy. It has a long history of trading in commodities and relatedderivatives. The institution of a formal commodity futures marketin India is almost as old as in the US and UK. References tosuch markets in India appear in Kautilya’s Arthashastra.Forwardtransactions in major agricultural commodities, knownas ‘satta’ in parts of northern and western parts of the country,have existed for a very long time, often being on the fringes ofthe law in recent times. Although any definitive history of thisactivity is hard to come by, what is indisputable is that sattahasbeen an inseparable part of the body of markets for com-modities. The Cotton Trade Association began futures tradingin 1875 in Bombay. Derivatives in oilseeds started in Bombayin 1900, raw jute and jute products in Calcutta in 1912, wheatin Hapur (Uttar Pradesh) in 1913 and bullion in Bombay in 1920.Before the second world war, a large number of commodityexchanges and trading futures contracts in several commoditieslike cotton, groundnut, groundnut oil, raw jute, jute goods, castorseed, wheat, rice, sugar, precious metals, like gold and silverflourished throughout the country. The markets were liquid withhigh turnover. However, the common perception that futures andother derivatives fuelled speculation in essential commodities andhence were inimical to the interests of farmers and consumersalike by exacerbating the effects of both glut and shortagesprevailed. With the economy witnessing sporadic shortages inessential commodities from the mid-1930s, restrictions oncommodityderivatives began to appear, particularly after theoutbreak of the second world war in 1939. Taking advantageof various legislations like the Cotton Prohibition Act, 1939 andthe Defence of India Act, 1935, the provincial government ofBombay banned trading in cotton options in 1939. Later in1943,forward trading in oilseeds and foodgrains, spices andvegetable oils, sugar and cloth were prohibited. After the endof the secondworld war, the prohibitions were retained withnecessary modifications in the Essential Supplies TemporaryPowers Act, 1946, since the Defence of India Act, 1935 hadlapsedby then.After independence, on adoption of the Constitution in 1950,the subject of stock exchanges and futures markets was placedin the union list, i e, under the jurisdiction of the Indian Parliamentand the central government. Subsequently, restrictions on boththe derivatives as well as the spot markets in commodities wereimposed by way of the Forward Contracts (Regulation) Act, 1952(FCRA) and the Essential Commodities Act, 1955, with the latterfinding a place in the ninth schedule of the Indian Constitutionwhich made it immune to judicial review. The FCRA whichprovides the legal framework for the regulation of forwardcontracts in commodities all over the country, among other things,prohibits options in commodities and imposes severe restrictionson the cash settlement of forward/futures contracts. FCRA appliesto goods, which are defined as movable properties other thansecurity, currency and actionable claims. Under FCRA, the centralgovernment has been entrusted with most of the regulatorypowers, which are to be exercised on the recommendations ofthe Forward Markets Commission (FMC) that was set up in 1953.The FMC functioning under the ministry of consumer affairs,food and public distribution of the central government is the nodalbody for regulating the functioning of the futures exchanges inthe country.By the mid-1960s, the government imposed a ban on futurestrading in most of the commodities, except the very minor oneslike pepper, turmeric, castor seed and linseed. Subsequently,futures trading in castor seed and linseed was suspended in 1977.As is the case in such situations everywhere and at all times,the prohibitions, which continued for several decades till veryrecently drove the market underground.The process of liberalisation started in the early 1980s when,on the recommendations of the Khusro Committee, forwardtrading in potato, ‘gur’ (sugar cane jaggery) and later in castorseed was allowed. The turning point for commodity futures inthe country was the setting up of the Kabra Committee in 1993,which recommended allowing futures trading in 17 commoditygroups. However, it was much later in 2002-03 that a series ofmeasuresbythe central government provided a real boost to thecommodity futures market in India after three decades of nearhibernation. First, in early 2003, the government gave mandates(through a FMC notification) to four entities to set up nation-wide multi-commodity exchanges. Also, the permitted list ofcommodities under the FCRA was expanded. The positive roleof commodity futures market was articulated in the nationalagricultural policy of the central government in 2000, which wasfollowed by the removal of the ban on futures trading for allcommodities in 2003. In the meanwhile, from 1998 onwards,domestic entities facing commodity price risks were permittedto engage in derivatives transactions in overseas markets for riskmanagement purposes.A number of regulatory measures were also imposed on existingcommodity exchanges in line with international best practices,viz, daily mark-to-market margining; time stamping of trades;novation of contracts and creation of a trade guarantee fund; anddemutualisation for the new exchange.

Economic and Political WeeklyMarch 31, 20071153At present, there is a two-tier structure for commodity ex-changes in India: regional and country-wide. Regional exchangesare permitted to have only a limited number of contracts whosemembership is local. Currently, they number 21. Countrywidenational exchanges are multi-commodity electronic exchangeswith a demutualised ownership pattern. Currently, there are onlythree such exchanges, viz, Multi-Commodity Exchange (MCX),Mumbai; the National Commodity and Derivatives Exchange(NCDEX), Mumbai and the National Multi-CommodityExchange(NMCX), Ahmedabad.IIForward and Futures in Commodities – OutlineGiven below is a description of the essential aspects of theforward/futures markets, from an international perspective.MechanismIn a futures or forward contract, one party agrees to buysomething in the future from a second party, while the latter agreesto sell it. The buyer is said to be long the contract and has agreedto buy (take delivery of) the specified good. The seller has a shortposition in the contract and has the obligation to sell (deliver)the good at some time in the future. The act of buying is alsocalled going long, while the act of selling is called going short.The contract specifies both the quantity and quality of the good,price, delivery date, and delivery location.Many futures contracts have delivery options inherent in them.For example, a contract may specify a range of goods of differentquality that can be delivered. Or it might offer several locationsto which the goods can be delivered or several dates on whichthe delivery can be made. Usually, the short positions get theseoptions, e g, if the contract offers a range of delivery dates, theshort decides when to make delivery.Buyers of futures contracts believe that the price of the goodwill rise, whereas the sellers believe that the price will fall. Futuresand forwards are zero net supply. For every buyer of a contract,there is a seller. The profits and losses realised in futures andforward contracting also represent a zero-sum game.However, there are several ways in which futures contractsdiffer from forward contracts: Futures contracts are standardised;only the price is negotiated. For example, every gold futurescontract is identical in that the amount of gold (called the contractsize), quality of gold, delivery date, and place of delivery arespecified. In contrast, all elements of forward contracts arenegotiated: each contract is custom-made. For example, in aforward contract, two parties A and B can agree that on January31, 2007, party A will deliver 100 kg of gold to the town ofRajkot, Gujarat and on that day B will pay Rs 95 billion.Futures contracts are usually more liquid than forward contractspartly because they are standardised. Futures trade on futuresexchanges. One who is long a contract can always eliminate his/her obligation by subsequently (but prior to the delivery date)selling a contract for the same good with same delivery date.Conversely, a short can close his/her position by later buyingthe same futures contract. Each of these actions is calledoffsettingatrade. Thus, if one is long a gold futures contract,the position can be closed simply by selling a similar contract.In contrast, most forward transactions are illiquid and cannot beoffset so easily.Since forward contracts are agreements between two parties,each party faces the risk that the opposite party will default,particularly in the event of an adverse price movement. Forexample, party A has entered into a forward contract with partyB,whereby the latter agrees to sell 100 kg of gold at a price ofRs9,50,000 per kg in 91 days’ time. If the price of gold risessubsequently, party A benefits and party B loses. If B has notalready bought the gold to be delivered or entered into anoffsetting contract, default by B becomes a possibility, particu-larly if the adverse price movement for B is significant. This maycause A to incur a loss, in the sense that A will have to buy thecontracted amount of gold from another seller at a higher price.This is typical of most contracts that involve settlement ordelivery at future date based on a price that is agreed on before-hand. In this example, party B would face the possibility of defaultby party A if the price of gold falls subsequently, by reverselogic. Risk of default by a party to a contract is known as creditrisk. In other words, in a forward contract, the parties face creditrisk vis-à-vis each other. Futures trades obviate the assumptionof credit risk. Once a futures price has been agreed upon, anda trade is completed, the clearing house of the exchange becomesthe opposite party to both the buyer and seller. A clearing houseis an agency associated with one or more exchanges. Its functionstypically are: (i) to match, process, register, confirm, settle,reconcile, or guarantee trades; (ii) to become a party to each tradeso as to nearly eliminate credit risk; (iii) to operate the mark-to-market process (collecting and paying variation margin); and(iv) to handle the delivery process. A clearing house may be asubsidiary of an exchange or an independent entity. When partyA goes long a futures contract, he/she buys it from the clearinghouse; when party B goes short a futures contract, he/she sellsit to the clearing house. The clearing house is thus, always neutral.The number of futures contracts obligated for delivery is knownas the open interest (OI). Since the clearing house is a party toevery trade, buyers and sellers of futures contracts only have tobe concerned about the financial integrity of the exchange onwhich the contracts trade, provided their broker-member, alsoknown as futures commission merchant (FCM) does not fail. AFCM is the futures industry’s equivalent to a stockbroker. Theclearing house only guarantees that its members will be paid.Customers of a failed broker-member do bear default risk. Theclearing house guarantees all payments of profits as long as itsmembers are solvent. The requirement that traders post a marginand the process of marking-to-market protects the exchange byensuring that buyers and sellers abide by the obligations of theircontracts.Most futures positions are eventually offset. Only a smallpercentage of a futures contract’s OI ever results in the goodbeing delivered. The delivery is performed by way of transferringthe ownership title over the underlying goods that are requiredto be kept in a designated warehouse of the exchange. This isdone by endorsement and delivery of the relevant warehousereceipt. However, there are some futures contracts that are cash-settled. When this is the case, there are no provisions for deliveryof the good; only cash profits and losses are exchanged. Cashsettlement is desirable when delivery costs are large, whenmanipulation by traders who might corner the available supplyof the deliverable asset is possible, or when the futures priceisbased on an index. In contrast, since forward contracts arecustom-made, and not usually traded on any exchange, most ofthese agreements terminate with the delivery of the specified good.

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Economic and Political WeeklyMarch 31, 20071155For pricing purposes, the most important difference involvessecurity deposits, also known as margins, and the timing of cashflows. In a forward contract, no money changes hands initially.Two parties simply agree on a fair forward price for later delivery.The only time a cash flow will take place is on the delivery date.At that time, the cash flow is defined as the difference betweenthe forward price initially contracted and the actual spot priceof the good on the delivery date. This cash flow is also the profitrealised from the forward transaction. Thus, while profits orlosses on forward contracts are realised on the delivery day,thechange in the value of a futures contract results in a cashflow every day. Margin requirements and marking-to-marketboth determine these cash flow consequences. One importantconsequence of this is that the relationship between thecontractprice and the price of the underlying commodity is moreconvex in the case of a forward contract than in the case of afutures contract, in much the same way a zero coupon bond isgenerally more convex than a coupon bearing bond of thesamematurity.In addition to the clearing house, there are other safeguardsfor the futures market, chief among which are the requirementsfor margins and daily settlements. Before trading a futures contract,the prospective trader must deposit funds with a broker. Themargins serve as a good faith deposit by the trader, the mainpurpose of which is to ensure that traders will stand by theircontract obligations. The margin requirement also restricts theactivities of traders and hence, the volume of trades. However,beyond a point, high margin requirement crowds out the smallplayers. The margin requirement varies from contract to contractand may vary by broker as well. The margin may be posted incash, a bank guarantee or government debt securities.There are three types of margin. The initial deposit describedabove is the initial margin – the initial amount a trader mustdeposit before trading any futures. The initial margin amountin large exchanges are now-a-days based on value-at-risk esti-mates of the contract in question and are generally of the orderof 5 per cent of the value of the underlying commodity. Anothersafeguard is the daily settlement or marking-to-market, by whichthe traders are required to realise gain or loss in cash on eachworking day.To illustrate the daily mark-to-market settlement with a hypo-thetical example, consider party A who has bought a futurescontract in gold for Rs 70 per gm on January 10. The contractcloses at Rs 68.5 on January 11. This means that party A hassustained a loss of Rs 1.5 per gm. Assuming that the contracthas an underlying of 100 gm of gold, the party A has lost Rs150,which is deducted from the margin deposited by it. When thevalue of the funds on deposit declines to a certain level calledthe maintenance margin, the trader is required to replenish themargin, bringing it back to its initial level. This demand for abigger margin amount is called margin call. The additional marginthat the trader must deposit is called the variation margin. Themaintenance margin is generally about 75 per cent of the initialmargin. Failure to pay the variation margin will lead to the futuresposition being closed out. A trader can withdraw funds in excessof the stipulated margin at any time. It is clear that the initialmargin needs to cover only one day’s price fluctuation.The margin system functions through a hierarchy of marketparticipants that links the clearing house with the individualtraders. The members of an exchange may be classified into twogroups: clearing members and non-clearing members. The formerare also members of the clearing house, while the latter are not.As a consequence, any non-clearing member must clear his/hertrades through a clearing member.The clearing house demands margin deposits from its membersto cover all futures positions that are carried by them. Generally,clearing members undertake very few trades on their own accountand act as intermediaries for non-members and others to trade.The latter deposit margin funds with a clearing member and theclearing member, in turn, deposits margin funds with the clearinghouse.Closing of futures position can take place through delivery,offset and exchange for physicals (EFP).Most futures contracts are written to call for completion of thesame through the physical delivery of a particular good. In recentyears, however, more and more exchanges have introduced futurescontracts that allow completion through cash settlement. In a cashsettlement, the difference between the price of the contractprevailing on the previous working day (on which the last mark-to-market was done) and the spot price on the date of deliveryis settled. As mentioned before, few futures contracts are actuallyclosed through either physical delivery or cash settlement.By far, most futures contracts are completed through offset orvia a reversing trade. To achieve an offset, the trader transactsin the futures market to bring his or her net position in a particularcontract back to zero. For example, if party A is long in a goldcontract for delivery in March 2007 to the extent of 10 contracts,the position can be brought to zero by selling an equal numberof the same contract at any time before the delivery is due. Ifparty A does this, the clearing house will recognise it, and he/she is absolved of any further obligation.A trader can also complete a futures contract by engaging inan EFP, in which two traders agree to a simultaneous exchangeof a cash commodity and futures contracts based on that cashcommodity. Illustratively, party A is long in a particular oilseedcontract and is interested in taking physical delivery, while partyB is short in that contract and owns stocks that could be delivered.Party A and party B can bilaterally agree on a price to buy/sellthe stock to the extent of the underlying contract amount andagree to cancel their complementary futures positions. Theexchange notes that their positions match and cancels their futuresobligations.Economic Functions of FuturesFutures markets perform two main economic functions: pricediscovery and hedging. Price discovery has been defined asrevealing information about future cash market prices throughthe futures market. There is a relationship between the futuresprice of a commodity and the price that market participants expectto prevail at the time of delivery of the futures contract. Theforecasts of prices that are likely to occur in the future that canbe drawn from the futures market compare quite favourably withother types of forecasts in terms of accuracy. Hence, futures pricesserve an economic purpose by helping market participants makebetter estimates of future prices, so that they can make theirconsumption and investment decisions more optimally. To illus-trate, a farmer who has the option of raising more than one cropon his land can use the futures prices for delivery at the timeof harvesting with respect to each option as an importantconsideration for arriving at the optimal decision regarding whichcrop(s) to raise. This aspect is becoming increasingly relevant

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Economic and Political WeeklyMarch 31, 20071157uncertainty seek insurance form another group which is some-what more risk tolerant.Expected Rate of Return on Commodity FuturesA number of theoretical frameworks have been used forunderstanding the source of commodity futures price returns: thecapital assets pricing model, the insurance perspective, the hedgingpressure hypothesis and the theory of storage. None of theseperspectives is the final word on commodity price determinationor prospective returns from investing in commodity price futuresbut they are part of the evolution of thought about commodityfutures investing.Futures TerminologyThe commodity futures market has its own terminology,vocabulary and jargon. Following are a few of the commonlyused terms:Commodity trading advisors: A commodity trading advisor (CTA)is a person or a firm who directly or indirectly advises othersregarding their futures trading. This category also applies toindividuals who advise the public through the media. A com-modity pool operator (CPO) is a person or a firm that operatesor solicits funds for a commodity pool, which is a collection offunds for engaging in futures trading activities.Commodity trading pool: A commodity pool is similar to a mutualfund for investment in stocks and bonds.Arbitrage:Many alternative definitions of arbitrage exist. How-ever, there are two essential elements which must be fulfilledinall types of arbitrage: (i) it generates riskless profit; and (ii)thereis no net investment. If an asset, a commodity or a financialinstrument is priced differently in two or more markets, arbitrageis a possibility. Derivative instruments are priced on the principleof “no arbitrage” which means that it should be possible toreplicate a derivative by buying and selling the underlying cashinstrument accompanied by borrowing and lending.Alignment of the prices of the same commodity or its deriva-tives across markets and locations takes place through arbitrage.Basis:The basis receives a great deal of attention in futurestrading. The basis is the current cash price of a particular com-modity at a specified location minus the price of a particularfutures contract for the same commodity:Basis = Current cash price – Futures priceFutures markets can exhibit a pattern of either normal or invertedprices. In a normal market, prices for more distant futures arehigher than for nearby futures. In an inverted market, distantfutures prices are lower than the prices for contracts close toexpiration. The interpretation of the basis is particularly crucialfor agricultural commodities, whose supply tends to be seasonal.A negative basis is referred to as contango, while positive basisis referred to as backwardation.A basis changing from negative to less negative/positive isdescribed as strengthening and vice versa. Changes in basis affectthe hedging outcome where the hedge is closed out beforematurity. Short hedgers benefit from a strengthening basis butare adversely affected by a weakening basis. The opposite is thecase with long hedgers. Basis is generally more volatile inrespect of futures for agricultural products. Hence, understandingof basis risk is crucial for hedging the price risk on agriculturalproducts.When the futures contract is at expiration, the futures andspot price must be the same and hence the basis should bezero. This behaviour of the basis over time is known asconvergence. For a well functioning futures market, fluctuationsin the basis should be much less compared to the fluctuationsin the price of the futures. In other words, the basis should bemore stable than the futures price, when those prices areconsidered in isolation. The relatively low variability of the basisis very important for hedging.Regulation of Futures MarketThe regulations generally aim to control both the entry intoand operation of futures markets. All contracts generally needprior approval from the regulator. Subsequent to the entry, theregulation focuses on the operation or performance of the con-tracts. On the operational side, the regulations seeks to providea marketplace that fulfils the economic functions of futuresmarkets by prohibiting practices that can interfere with the processof price discovery or the efficient transfer of risks. For example,practices that make futures prices behave as poor indicators offuture spot prices reduce the usefulness of the futures marketfor price discovery. Since speculation is a necessary element ofall markets, including the futures market, regulations do notaim to curb speculation per se. Instead, the single mostimportant challenge for regulation is to prevent distortion ofprices through price manipulation, which is one of the most fearedaspects of the futures trading abuse. The other areas of concernto the regulators include insider trading, front running, and theeffect of futures trading on the riskiness of the cash marketfor commodities.The best practice regulations have the following elements:Duties and responsibilities of brokers: The broker essentiallyrepresents his/her customers in the exchange and the clearinghouse. The clearing house holds the clearing member responsiblefor all the accounts that the latter carries. The broker shouldhavea duty to keep the exchange informed about the activitiesof its customers and to ensure that these activities are proper.The most important aspect to be taken care of brokers in thisregard is the “know your customer” rule. The next importantthingis the observance of the OI position limits by brokers fortheir own account trades and also for trades on behalf of clients.For a commodity with OI limits, no single trader is allowed tohold more than a certain number of contracts on a net basis.Thisrule limits the influence of a single trader on the marketand aims at preventing the trader from controlling the futuresprice.Moreover, the trading of some customers is restricteddue to the nature of the customer’s business. For example,some financial institutions are allowed to trade only certaintypesof futures for hedging purposes. The broker for suchaninstitution has a responsibility to ensure that prohibitedtrading does not take place. In general, the broker is respon-sible for knowing the customer’spositions and intentions, forensuring that the customer does not disrupt the market orplacethe system in jeopardy, and for keeping the customer’strading activities in line with industry regulations and legalrestrictions.Duties and responsibilities of exchanges and clearing houses:First and foremost is the requirement that exchanges and clearinghouses should control the conduct of their members. To do so,exchanges should formulate and enforce rules for their

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Economic and Political WeeklyMarch 31, 20071159members andfor trading on the exchange. Generally, the rulesof each exchange are designed to create a smoothly functioningmarket in which traders can feel confident that their orders willbe executed properly and at a fair price. Thus, all exchangesprohibit fraud, dishonourable conduct, and defaulting oncontractobligations. Exchange rules generally prohibit fictitiousand prearranged trading. In order to prevent what is known asfront running, the rules also prohibit a broker from trading his/her own account at the customer’s requested price before fillinga customer’s order. Front running gives the broker an unfairadvantage, since the broker uses his/her special knowledge oforder flow or market movement to obtain an unethical personaladvantage.Cash Settlement versus Physical DeliveryThe relative merits and demerits of physical delivery and cashsettlement in derivatives markets, especially for commoditieshave been outlined in various analytical debates and also inempirical research on this subject. The votaries of physicaldelivery argue that the “fear of delivery” disciplines the marketand keeps away speculators. Those in favour of cash settlementargue that derivatives markets, in general, and futures exchanges,in particular, are not platforms for trade and delivery in thephysicals but are intended for risk management. The limitationsof the spot market can be overcome by means of cash settlementwhich would enhance liquidity and thereby make price discoverymore meaningful.Commenting on this issue, the inter-ministerialtask force on convergence of securities and commodity derivativemarkets (chairman Wajahat Habibullah) set up by the centralgovernment in 2003 said:The central question about cash settlement is that of obtaining well-respected and trusted settlement prices. If there is an underlyinghighly fractured spot market, where good data is not available,then it is difficult to construct a well-respected settlement price.In this case, economic agents would not trust a cash settled contract,and would prefer a physically settled contract.The choice between physical delivery and cash settlement boilsdown to a trade off between a short squeeze or cornering of stockson the one hand and credibility of the spot price used for cashsettlement, on the other.Futures contracts with physical delivery are typically writtenwith the seller given the flexibility to choose the grade of theunderlying commodity to deliver (quality option); the location todeliver (location option) and the time to deliver (timing option).Such flexibility is mandated to the short. These options willreduce the futures price from what it would be without suchoptions. If the prices of the underlying commodities are perfectlycorrelated, the quality option has no value. A larger discount isexpected when the price correlation among the set of deliverablesare lower. If there is only one deliverable commodity, the timingoption has no value. Indeed the short should optimally deliverthe commodity at the first permitted opportunity. When thecontract permits more than one deliverable commodity, there isan interaction between the timing and quality option.Manipulation occurs in the futures market when some playersuse the delivery features of a contract to manipulate prices intheir favour. Market cornering is a common type of manipulation.To do this a trader holds a significantly large portion of stocksof the underlying commodity as well as long futures position.If he/she demands delivery on the long position and refuses tosell the stocks in the spot market, the shorts will have difficultyacquiring sufficient commodities for delivery. Thus, the longmanipulator squeezes the shorts by charging a high price torelievethe shorts of their obligation to deliver. A broader listof deliverables reduces the possibility of market manipulationof this type but it comes at a cost. A broader list reduced hedgeeffectiveness.The difficulties with cash settlement also arise out of anothertrade-off. The spot price applied for settlement is generally takenas the average spot price over a specified period prior to thesettlement date. If this period is too short, there is a possibilityof price manipulation taking place, both by the longs as well asshorts. The possibility of price manipulation can be reduced byextending this period but in that case convergence and hedgeeffectiveness will suffer. Throughout the life of a futures contract,its price is linked to the expected value of the contract at maturity.Consequently, contract settlement specification has direct effectson the futures price behaviour. Due to interactions between thespot and futures markets, the spot price and basis may behavedifferently in the two types of settlements.Empirical research does not provide any definite clue aboutwhich of the two – physical delivery or cash settlement – is abetter option. Some studies revealed that after cash settlementreplaces physical delivery, both spot and futures contracts becomemore stable. Price convergence is smoother as the basis is lessvolatile and hedging effectiveness improves. All in all, anyrational choice in this regard should be based on: price conver-gence, basis stability and hedging effectiveness.IIIExperience with Commodity Futures MarketVolume Growth and Early Signs of SpecialisationWithin a short time, the newly set up multi-commodityexchanges have been able to introduce a good number ofcontracts, a fairly good proportion of which are liquid, and havebeen attracting increasing volumes.An indication of the growth of trading volumes in futures inrecent years is provided by Table 1, which shows the comparativeposition in this regard over the last one year with respect to someof the most traded contracts.At the level of exchanges, the following stylised informationpertaining to the first fortnight of December 2006 are worth noting:Table 1: Turnover in Select Commodities inIndian Commodity Exchanges(Rs crore)CommodityTurnoverDecember 2005December 2006Per CentIncreaseGold26,28433,23826.5Silver16,91126,53056.9Crude oil4,3179,815127.35Methanol5,8352,732(-) 53.2Guar seed7,60613,46377.0Refined soya oil7174,707556.5Chana (chick peas)15,0986,696(-)55.65Pepper98404312.2Rubber178452154.0Desi urad (black legume)13,1501,929(-) 85.3Soya bean7871,739121.0Source:FMC website (www.fmc.gov.in – accessed in January 2007).

Economic and Political WeeklyMarch 31, 20071160Multi-Commodity Exchange of India, Mumbai (MCX): 49commodities were traded, of which gold, silver, and copperattracted the highest volumes. Aggregate value of trades wasRs98,200 crore.National Multi-Commodity Exchange of India, Ahmedabad(NMCX): Seven commodities were traded, of which rubber,pepper and raw jute attracted the highest volumes. Aggregatevalue of trades was Rs 922 crore.National Commodity and Derivatives Exchange, Mumbai(NCDEX): 38 commodities were traded, of which guar seed,chana and pepper attracted the highest volumes. Aggregate valueof trades was Rs 38,734 crore.Turnover of trades at the 21 regional exchanges was minisculecompared to these numbers. At the time of their launch, all thethree major exchanges introduced trading on largely similarcommodities but with the passage of time, clear signs ofspecialisation have emerged. MCX has emerged as the world’sthird-biggest gold exchange, after COMEX and TOCOM.Maturity Profile and Contract SpecificationThe contracts being traded on the multi-commodity exchangesare available for monthly maturities up to the next 12 months,depending on the underlying commodity. Physical delivery isby way of transfer of warehouse receipts, accompanied bydocuments in support of quality. The exchanges impose penaltyfor delivery failure. The other essential aspects of a contractspecification can be explained with the help of an example(Table2).For certain types of commodities, flexibility in quality isintroduced by making it possible for slightly more superior orinferior quality vis-a-vis the specifications to be delivered, inwhich case the price is adjusted by the application of a pre-definedpremium or discount.Modes of DeliveryPhysical delivery is compulsory with respect to all essentialcommodities. For Soyabean and soya oil, physical delivery isat the seller’s option. For others, physical delivery is by mutualconsent of both the seller and buyer. With respect to the lastmentioned type of futures contract, the settlement usually takesplace in cash. The dominant opinion in the market is that thephysical delivery rule acts as an anchor and fear of deliveryprevents excessive speculation.Storage and Delivery InfrastructureEach of the exchanges has a chain of accredited warehousesthroughout the country. Each warehouse has appointed gradingand assaying specialists who certify the quality of the commoditybeing placed with it and the exchange guarantees the same. Oneof the exchanges has promoted warehousing companies for thispurpose. As in the case of commodity exchanges worldwide, theincidence of physical delivery does not generally exceed 7 percent of the contracts traded on the Indian exchanges.As mentioned before, warehousing capacity in the countryis inadequate. The public sector warehousing behemoth –Central Warehousing Corporation – has 493 warehouses inthecountry with a combined capacity of 9.3 million tonnes. Inaddition, there are provincial warehousing corporations.However, their combined capacity – of the order of about12million tonnes – falls far short of the growing demand in thisregard. Since warehouses are intended to provide storagespace,arrange quality testing and certification to facilitateorganised buying and selling, there should be a statutory backingfor such activities that would also enable proper regulation oftheir activities. A central level warehousing law is yet to beenacted in India.At the initiative of some of the exchanges, a firm beginninghas been made in introducing dematerialisation of warehousereceipts with the involvement of a few exchanges, theiraccreditedwarehouses and NSDL. This has made it possible fortrading, clearing, and settlement with respect to commodityfutures to be carried out along the lines of equities in India.However, use of physical warehouse receipts is still verymuchprevalent.In India, there is no depository law with respect to commodities.Hence, the demat mechanism has been designed through specifictripartite legal agreements between the exchange, NSDL and thewarehouses as per the Indian Contract Act, 1872.An offshoot of these initiatives has been the formation ofNational Collateral Maintenance Corporation at the central leveland warehousing corporations in a few states. Still another isthataccredited warehouses in many places have assumed thecharacter of mandis and are now being increasingly used forspotbuying and selling. To the extent of the stocks of com-modities of different grades in a warehouse, delivery on sale orsettlement of futures contracts in that commodity on maturitycan take place in that warehouse itself, without involvingphysicalmovement of these commodities. Near month futuresprice now lead the market in respect of many a commodity,especially in locations at close proximity to the warehouses. Thishas affected the pricing power and market control of the localtraders and middlemen.In other words, expansion of warehouses, though modest sofar, has improved the spot trade infrastructure. This, in turn, hasTable 2: Contract Specifications for ChanaTrading unit10tonneQuotation/base valueRs/100 kgMaximum order size100 tonneTick size (minimum price movement)Re 1Daily price limits4 per centPrice quoteEx-Delhi, inclusive of all taxes and leviesInitial margin5 per centMaximumopenpositionallowedFor individual clients: 4000 tonnes. Fora member, collectively for all clients:25per cent of the open marketposition.Hedging against physical stock is allowedwithout any quantity limit, subject to theapproval of the exchange.Delivery unit10tonneDelivery centre(s)Within 20 km of the municipal limits ofDelhiQuality specifications1Allvarieties of Rajasthan desi chana,except Sawai, Madhopur andBharatpur are deliverable.2MP desi of Dabra, Inder Garh, Daboand Morena varieties are alsodeliverable.3The material will be tested using a3.75 meter sieve.4For the purpose of testing, onesample of 250 gm will be taken fromeach bag.Source:NCDEX website (www.ncdex.com – accessed in January 2007).

Economic and Political WeeklyMarch 31, 20071161had the following consequences: (i) screen-based pricing;(ii)reduction of information asymmetry; and (iii) break downof local monopoly.Futures Price PatternNear month contracts of wheat, sugar and oilseeds are generallyat a premium over the spot price (contango), which reflects thecost of carry. For far off months, the prices are sometimes indiscount (backwardation). Backwardation in near months hasbeen observed during inter-harvest months and also when thereis any issue with quality. There has been no incidence of severeshort squeeze that often leads to discount in the near months.One episode of deep discount in the near months in the case ofurad took place in early 2005. Basis is stable, with highcorrelation seen between futures and spot prices. Hedging utilityis significant.OI limits ensure that the aggregate open position is only a smallproportion of the aggregate physical stocks available. No singlemember is allowed to account for more than 5-6 per cent of theaggregate OI.Futures prices in India are increasingly becoming more alignedwith those in international markets. This is truer of futures inmetals, including precious metals and crude than agriculturalcommodities, which is not surprising since the contract speci-fications in the case of the former are more aligned. A glimpseat Table 3 would provide an indication of the prices of contractson crude oil and wheat on domestic and international exchangesas on January 22, 2007.Interpretation of commodity futures prices is complex, evenin the best of situations, since unlike financial futures, commodityfutures are affected significantly by commodity-specific factorswith respect to production, supply, storage, quality grades,government regulation, market convention, etc. Backwardationfor all maturities generally indicates a surge in the currentdemandfor building stocks, with expectations for price easingin future. Contango for all maturities may indicate the oppositesituation. However, demand for commodity futures for portfoliodiversification purposes may also lead to a contango for mostmaturities.RegulationThe website of the FMC describes the objectives of regulationas: (i) to create competitive conditions; (ii) to avoid futures pricemanipulation that can have adverse implications for spotprices;(iii) to ensure that the market has an appropriate risk managementsystem; (iv) to ensure fairness and transparency in trading, clearing,settlement as well as in the management of the exchanges; (v)toprotect and promote the interests of various stakeholders, par-ticularly non-member users of the market.The regulatory measures prescribed by FMC consist ofthefollowing: (a) limit on net OI, as at the close of trading.Occasionally, intra-day open position limits are prescribed;(b)circuit-filters or limits on intra-day price fluctuations intheeventof excessive volatility as well as circuit-breakers thatprescribe upper andlowerbounds for prices in situations ofexcessive volatility but only on the request of exchanges;(c)impositionof a special margin in the event of sharp pricemovements that extend beyond one day (done only on therequest of the exchanges); and(d)emergency measures suchas suspension of trading or compulsory closing out of positionsin extreme situations.The FMC has imposed OI limits on different commoditiesfrom timetotime. The FMC has put an embargo on membersproviding portfolio advisory services. Disclosure of servicesprovided to clients by members is a regulatory requirement.Members have been allowed to have subsidiaries abroad forcommodity-related activities, with certain safeguards. The FMChas asked exchanges to set up investor protection funds to befunded by penalties collected by exchanges for violation of rules.Commodity Futures and Inflation:Fire and BrimstoneGlobally, the era of the futures market in commodities hascoincided with the steady fall of world prices of cereal grainsin real terms in the last century, although the contribution offutures markets alone in this regard is hard to determine inpreciseterms.Still more imprecise is the recently articulated opinion thatfutures trading in commodities, especially in certain agriculturalcommodities, has caused inflation. A case for stricter regulationof futures trading is sought to be built on this opinion. This isreminiscent of the immensely popular and politicallycorrectopinion that prevailed in the 1950s and 1960s that hoard-ing was the root cause of shortage of food grains. Policies torestrict foodgrain movement and state monopoly over collectionand storage did not yield any tangible benefit for the commonman then. It was only when the supply side factors were appro-priately addressed through better technology and better incentivefor farmers that there was a turnaround in agriculture. A psy-chological factor also seems to be at play. Since food securityis a matter of vital concern, particularly for a country like Indiawith a vast and impoverished rural population, faced with scarcityand high prices, the society and polity feel more secure if awrongdoer can be identified forthwith, who could thereafter bevilified and condemned by all and sundry.Globally, prices of commodities, especially agricultural com-modities have been rising for some time now. In the case of cerealgrains – chiefly wheat – fall in output caused by largely stagnantprices over the last decade, on the one hand, and climatic changes,on the other, together with a secular rise in demand arising outTable 3: Comparative Futures Prices in Indian andOverseas ExchangesCrude OilWheatDelivery MonthNYMEXMCXDelivery MonthCBOTMCXPricePricePricePrice(US$/(Rs/(US$/ (Rs/barrel)barrel) bushel)100 kg)February 200751.992389February 20071081.9March 200753.42440March 20074.671089April 200754.32479April 20071089May 200755.04May 20074.801088.7June 200755.68July 20074.86July 200756.23September 20074.90August 200756.72December 20075.01September 200757.17March 20085.04October 200757.57May 20084.94November 200757.95July 20084.84December 200758.28December 20084.90January 200858.55July 20094.55Source:NYMEX, CBOT and MCX websites (www.nymex.com; www.cbot.com& www. mcxindia.com – accessed in January 2007).

EPW