Nov 16

Commodity Derivatives in India

Background

The Commodity Futures Market in India dates back to more than a century. The first organized futures market was established in 1875, under the name and style of ‘Bombay Cotton Trade Association’ to trade in cotton contracts, just 10 years after the establishment of Chicago Board of Trade (CBOT) in USA and thus became the 2nd oldest commodity exchange in the world. Subsequently, many regional exchanges like Gujarat Vyapar Mandali (1900) for oilseeds, Chamber of Commerce at Hapur (1913) and East India Jute Association Ltd. (1927) for raw jute etc. came into existence. By the 1930s, there were more than 300 commodity exchanges in the country dealing in commodities like turmeric, sugar, gur, pepper, cotton, oilseeds etc. This was followed by institutions for futures trading in oilseeds, food grains, etc.

The futures market in India underwent rapid growth between the period of First and Second World Wars. As a result, before the outbreak of the Second World War, a large number of commodity exchanges trading futures contracts in several commodities like cotton, groundnut, groundnut oil, raw jute, jute goods, castor seed, wheat, rice, sugar, precious metals like gold and silver were flourishing throughout the country. Trading was conducted through both options and futures instruments. However, there was no market regulator and hence there was no uniformity in trading practices. Further, there was no structured clearing and settlement system.

In view of the delicate supply situation of major commodities in the backdrop of war efforts mobilization, futures trading came to be prohibited during the Second World War under the Defence of India Act. After the dawn of independence, the futures markets were put under the Central List of subjects under the Constitution of India. In its wake, the Forward Contracts (Regulation) Act, 1952 (FCR Act, 1952) was passed to regulate this market with Forward Markets Commission (FMC) being set up in 1953 at Mumbai as the regulator. However options, which were then perceived to be risky instruments of trading, were totally banned under the Act itself. Futures trading started to gain momentum in many commodities. However, in the mid-1960s, the Government imposed a ban on the futures trading of most of the commodities on the assumption that this led to inflationary conditions.

Reopening of the Forward Markets

The National Agricultural Policy announced in July 2000 recognized the positive role of forward and futures market in price discovery and price risk management. In pursuance thereof, Government of India, by a notification dated 1.4.2003, permitted additional 54 commodities for futures trading and 3 national electronic commodity exchanges came into operation in the same year. With the issue of this notification, prohibition on futures trading has been completely withdrawn.

Since then several changes have taken place in the Commodity Futures Market. There are now 21 commodity Exchanges in the country including five National Multi-Commodity Exchanges, located at Mumbai (3), Ahmedabad (1) and New Delhi (1). All these five national exchanges are state-of-the-art, demutualized & corporatized trading platforms with professional management from the beginning with facilities for on-line trading across the country. At present, 110 commodities have been notified for trading and more than 40 commodities are actively traded.

Suitability of a commodity for futures trading

Futures trading can be organized in those commodities/markets which display some special features. The concerned commodity should satisfy certain criteria as listed below:

  1. The commodity should be homogenous in nature, i.e., the concerned commodity should be capable of being classified into well identifiable varieties and the price of each variety should have some parity with the price of the other varieties;
  2. The commodity must be capable of being standardized into identifiable grades;
  3. Supply and demand for the commodity should be large and there should be a large number of suppliers as well as consumers;
  4. The commodity should flow naturally to the market without restraints either of government or of private agencies;
  5. There should be some degree of uncertainty either regarding the supply or the consumption or regarding both supply and consumption,
  6. The commodity should be capable of storage over a reasonable period of time.

Economic functions of the futures markets

In a free market economy, futures trading perform two important economic functions, viz. price discovery and price risk management. Such trading in commodities is useful to all sectors of the economy. The forward prices give advance signals of an imbalance between demand and supply. This helps the government and the private sector with exposure to commodities and price volatility to make plans and arrangements in a shortage situation for timely imports, instead of having to rush in for such imports in a crisis-like situation when the prices are already high. This ensures availability of adequate supplies and averts spurt in prices. Similarly, in a situation of a bumper crop, the early price signals emitted by the futures market help the importers to defer or stagger their imports and exporters to plan exports, which protect the producers against un-remunerative prices. At the same time, it enables the importers to hedge their position against commitments made for import and exporters to hedge their export commitments. As a result, the export competitiveness of the country improves.

Participants in the Commodity Futures Markets

There are three broad categories of participants in the futures markets, namely, hedgers, speculators and arbitrageurs.

Hedgers are those who have an underlying interest in the specific delivery or ready delivery contracts and are using futures market to insure themselves against adverse price fluctuations. Examples could be stockists, exporters, producers, etc. They require some people who are prepared to accept the counter-party position.

Speculators are those who may not have an interest in the ready contracts, i.e., the underlying commodity, etc. but see an opportunity of price movement favourable to them. They are prepared to assume the risk which the hedgers are trying to transfer in the futures market. They provide depth and liquidity to the market. While some hedgers from demand and supply side may find matching transactions, they by themselves cannot provide sufficient liquidity and depth to the market. Hence, the speculators who are essentially expert market analysts take on the risk of the hedgers for future profits and thereby provide a useful economic function and are an integral part of the futures market. It would not be wrong to say that in the absence of speculators, the market will not be liquid and may at times collapse.

Arbitrageurs are those who make simultaneous sale and purchase in two markets so as to take benefit of price imperfections. In the process they help, remove the price imperfections in different markets, For example, the arbitrageurs help in bringing the prices of contracts of different months in a commodity in alignment.

Nov 06

Overview of Q2 monetary Policy 2012-13

On Oct 30, 2012, Reserve Bank of India (RBI) announced its Q2 monetary policy. The whole industry was waiting for RBI to announce some measure to boost the economy. On that RBI slashed Cash Reserve Ratio (CRR) by 25 basis points from 4.50% to 4.25%.(CRR is the share of deposits banks must keep with the central bank). This reduction in CRR would inject 175 billion rupees of primary liquidity into the banking system. Industry was expecting that RBI would also reduce interest rates that can help industry and end consumers with reduced borrowing cost. But contrary to the expectation, RBI kept its key policy rates unchanged. So repo rate at 8.00% and reverse rate stays at 7.00%, the same level it has been at for the past six months. Repo rate is a mechanism of monetary policy at which the RBI lends money to commercial banks.Whenever banks have any shortage of funds they can borrow from RBI at the repo rate. A reduction in the repo rate helps banks get money at a cheaper rate and hence can further pass on the benefit to the users by reducing the prime lending rate. This is the 8th time CRR ratio has been changed since 2009 and 4th time this Calendar year. In 1992 CRR ratio was 15% of total deposits of banks.

The 25 basis point CRR cut will give room for more credit to the productive sector and, to some extent, impact the cost of banks but 0.75 percentages additional provisions on standard restructured assets surprised the banks. The benefits arising from CRR cut to banks will be offset by the additional provisioning requirements on restructured loans.

CRR%
DD/MM/YY
4.25
03/11/12
4.5
22/09/12
4.75
10/03/12
5.5
28/01/12
6
24/04/10
5.75
27/02/10
5.5
13/02/2010
5
17/01/2010
Table: 1- CRR% in last 3 years

RBI governor mentioned that interest rates are kept unchanged because the priority for him is also to manage inflation apart from economic growth of the country. In the last 2 years economic growth rate of India has slow down. The RBI lowered its FY2013 growth estimate to 5.8 per cent from 6.5% and raised its inflation estimate to 7.5 per cent from 7 percent.The markets have reacted quite negatively after the RBI’s decision to keep the interest rate unchanged. All the interest rate sensitive sectors have fallen sharply. Bank Nifty was down by 2.2 percent to 11222.8 (its lowest since September 21) while 1.1 per cent drops in the BSE Sensex. The rupee was, however, marginally up and closed a shade higher at 53.97 to the dollar after a weak beginning. The 10-year government bond traded at 8.18 per cent, down 5 basis points.

The RBI said in its guidance, “The reduction in the CRR is intended to pre-empt a prospective tightening of liquidity conditions, thereby keeping liquidity comfortable to support growth. It anticipates the projected inflation trajectory which indicates a rise in inflation before easing in the last quarter. While risks to this trajectory remain, the baseline scenario suggests a reasonable likelihood of further policy easing in the fourth quarter of 2012-13. The above policy guidance will, however, be conditioned by the evolving growth-inflation dynamic.”
RBI Governor said “We expect December inflation to peak at 8.5 per cent and come down to 7.5 per cent in March. This falling trajectory provides the RBI with an opportunity to implement “further policy easing” in 4QFY13, depending on the growth-inflation dynamics. We expect the RBI to ease repo rates by 50 bps in 4QFY13 based on our estimates of growth-inflation and CRR by 25 bps in the remaining of FY2013 (dependant on developments on liquidity) and balancing the current growth and inflation situation needed a calibrated approach which would support growth, easing of supply constraints but at the same time helping ease inflation.”

Now, RBI would prefer to watch the government’s policy reforms. If reforms go ahead as planned then inflation would come down. This in turn may prompt RBI to cut down the rate and it will encourage the economic growth of the country.