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Commodity Derivatives in India

Category : MCCP-Commodities

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.

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