Commodity Market in India Essay Example

country is Rs 1,40,000 crore (Rs 1,400 billion). Introducing futures trading will further expand the size of the commodities market.

Commodity Market

The commodity market is a crucial part of a country's financial markets. It is where various products such as precious metals, base metals, crude oil, energy, and soft commodities like palm oil and coffee are traded. Developing a dynamic, lively, and liquid commodity market is of utmost importance.

This would assist investors in managing their commodity risk, engaging in speculative commodity trading, and capitalizing on market arbitrage opportunities.

Evolution in India

The establishment of Bombay Cotton Trade Association Ltd. in 1875 marked the initiation of the first organized futures market. In response to dissatisfaction among prominent cotton mill owners and merchants regarding the operations of the Bombay Cotton Trade Association, Bombay Cotton Exchange Ltd. was formed in 1893.

In the early 1900s, futures trading in various commodities has a rich history. The Gujarati Vyapari Mandali, established in 1900, played a crucial role in initiating futures trading for groundnut, castor seed, and cotton. Punjab and Uttar Pradesh had active wheat futures trading with the Hapur chamber of commerce serving as an important exchange since 1913. Additionally, Mumbai witnessed the start of bullion futures trading in 1920. In 1919, the Calcutta Hessian Exchange Ltd. was founded to facilitate futures trading for raw jute and jute goods. However, organized futures trading specifically for raw jute began in 1927 with the East Indian Jute Association Ltd.

The East India Jute & Hessian Ltd. was established in 1945 through the merger of two associations, and it traded in Raw Jute and Jute goods.

In 1952, the Forward Contracts (Regulation) Act was passed, which led to the

establishment of the Forwards Markets Commission (FMC) under the Ministry of Consumer Affairs and Public Distribution in 1953.

As time went on, several other exchanges were created in the country for trading different commodities.

Structure of Commodity Market

Different Types of Commodities Traded

Across the world, markets exist for almost all known commodities.

There are various categories of commodities, including:

• Precious Metals: Gold, Silver, Platinum etc
• Other Metals: Nickel, Aluminum, Copper etc
• Agro-Based Commodities: Wheat, Corn, Cotton, Oils, Oilseeds
• Soft Commodities: Coffee, Cocoa, Sugar etc
• Live-Stock: Live Cattle, Pork Bellies etc
• Energy: Crude Oil, Natural Gas, Gasoline etc

The commodities market is divided into two forms - the Over the Counter (OTC) market and the Exchange-based market. Similar to equities markets,
there are spot and derivatives segments. Spot markets operate as over-the-counter markets where only individuals involved in specific commodities,
such as farmers or wholesalers can participate. Derivative trading takes place through exchange-based markets with standardized contracts and settlements.

The world has 8 leading commodity markets: New York Mercantile Exchange (NYMEX), the London Metal Exchange (LME), and the Chicago Board of Trade (CBOT).

India's leading commodity markets

The government has now allowed national commodity exchanges, such as BSE ; NSE, to engage in commodity derivatives trading within an electronic trading environment. These exchanges are expected to provide a nation-wide anonymous, order driven, screen-based trading system overseen by the Forward Markets Commission (FMC). As a result, four commodity exchanges have been approved to start operations in this capacity.

India is home to multiple commodity exchanges, such as the Multi Commodity Exchange (MCX) located in Mumbai, the National Commodity and Derivatives

Exchange Ltd (NCDEX) also based in Mumbai, the National Board of Trade (NBOT) situated in Indore, and the National Multi Commodity Exchange (NMCE) located in Ahmedabad. The trading volume on these futures markets is quantified using Indian Rupees (Rs.).

In Crores)Exchange2003-042004-05 FIRST Half NCDEX149054011 NBOT5301451038 MCX245630695 NMCE238427943 ALL EXCHANGES129364170720 1. 10 Volumes in Commodity Derivatives Worldwide 2. Commodity Futures Trading in India 2.
Introduction
Derivatives as a tool for risk management initially emerged in the Commodities markets.

Both financial and commodity markets utilize derivatives as hedging tools. While the underlying asset may vary between commodities and financial assets, the fundamental concept of a derivative contract remains consistent. Nevertheless, there are distinct features specific to commodity derivatives. In financial derivatives, contracts are typically settled in cash, with physical settlement being infrequent due to the non-bulky nature of financial assets that do not require specialized storage facilities. Conversely, commodity derivatives necessitate physically settling the underlying bulky assets, thus requiring warehousing.

The variation in asset quality is not significant in financial underlyings, but it can greatly vary in commodities, which is a crucial factor to manage. Futures trading offers several benefits to the industry, including hedging price risk, the ability to make spaced out purchases instead of large cash purchases and storage, efficient price discovery to prevent seasonal price volatility, increased flexibility, certainty, and transparency in commodity procurement, facilitating informed lending, reducing default risk for banks through hedged positions of producers and processors, increasing lending for the agricultural sector with transparent pricing and storage, using commodity exchanges as distribution networks for retail agri-finance from banks to rural households, and providing trading limit finance to traders in commodity exchanges.

Moreover, exchange members can

benefit from futures trading by gaining access to a potential market larger than the securities and cash market in commodities, utilizing robust and scalable state-of-the-art technology deployment, and trading in multiple commodities from a single point in real-time.

• Traders would have the opportunity to be trained as Rural Advisors and Commodity Specialists. Through them, various rural needs such as bank credit and information dissemination could be fulfilled.

Why are Commodity Futures important? One common response in the financial sector is, "We require commodity futures markets in order to generate volumes, brokerage fees, and opportunities for trading."

I believe that the main point is being overlooked. We need to consider the role of commodity futures in India's economy from a broader perspective. In India, government intervention has historically been prevalent in the agricultural sector. The government intervenes by maintaining buffer stocks, fixing prices, imposing import-export restrictions, and implementing various other interventions. Many economists believe that liberalizing the agricultural sector could bring significant benefits.

In this scenario, questions arise regarding the maintenance of buffer stocks, the smoothing of price fluctuations, and protecting farmers from vulnerability to price crashes when crops are harvested. Additionally, farmers need signals indicating future demand for wheat or rice. The futures market has a crucial role to play in addressing all these aspects.

If there is a anticipated shortage of wheat in the future, the prices of futures in the present will increase and transmit signals to farmers who are making decisions on what to sow. This system of futures markets will contribute to the improvement of cropping

patterns. Additionally, if I am a wheat farmer and have concerns that prices will decrease by the time of the harvest, I can choose to sell my wheat on the futures market. Selling at a predetermined price today protects me from any fluctuations in price. Nowadays, agricultural activities demand investments as farmers need to spend on fertilizers, high yielding varieties, and other expenses.

Farmers are concerned about potential financial losses due to price fluctuations when they invest in crops. They prefer a fixed future price to protect themselves from the impact of fluctuating prices. Additionally, the existing storage system managed by the Food Corporation of India is deemed ineffective. The futures market presents a solution by balancing current and future prices through arbitrage. This entails traders buying now and selling in the future if the future price is high and the present price is low. Conversely, if the future price is low, traders will make purchases in the futures market.

These activities generate their own "optimal" buffer stocks to stabilize prices. They are also highly effective when trading agricultural commodities; futures market arbitrageurs utilize imports and exports on foreign spot markets to stabilize Indian prices. Altogether, commodity futures markets are an integral part of agricultural liberalization programs, as recognized by numerous agricultural economists. Futures markets serve as a tool to achieve this liberalization.

The text discusses the challenges and solutions for agricultural commodity exchanges in economies dominated by agriculture. It emphasizes the importance of commodity derivatives in managing price risk, but acknowledges government intervention that limits prices of many commodities. This restriction reduces the effectiveness of forward and futures markets for hedging price risk. To address this issue,

a more focused and practical approach is needed from the government, regulator, and exchanges to make the agricultural futures market a thriving segment for risk management. According to K G Sahadevan, instability in commodity prices is a major concern for both producers and consumers in countries like India where agriculture plays a dominant role. Farmers are directly exposed to price fluctuations, making it too risky for them to invest in otherwise profitable activities.

Multiple methods can be used to address this issue. Alongside government intervention to stabilize the market, actors in the agricultural sector can manage their activities in an unstable price environment by utilizing derivative markets. These markets assist in shifting risk and enable locking in prices rather than relying on unpredictable price fluctuations. Both developed and developing countries extensively employ various derivatives including forwards, futures, options, swaps, etc.

There are various prominent commodity exchanges worldwide that specialize in trading derivatives of different commodities. Some examples include the Chicago Mercantile Exchange, Chicago Board of Trade, New York Mercantile Exchange, International Petroleum Exchange in London, London Metal Exchange, London Futures and Options Exchange, Marche a Terme International de France, Sidney Futures Exchange, Singapore International Monetary Exchange, Singapore Commodity Exchange, Kuala Lumpur Commodity Exchange, and the Bolsa de Mercadorias & Futuros in Brazil. The Buenos Aires Grain Exchange is also significant in this market. In China alone, there have been numerous commodity exchange platforms established over the past decade solely focused on trading commodity futures. Notable ones include the Shanghai Metals Exchange, China Commodity Futures Exchange, China Zhengzhou Commodity Exchange,and Beijing Commodity Exchanges. These exchanges have experienced substantial growth [UNCTAD 1998]. However,in India,the utilization of such exchanges has

remained limited. This paper aims to investigate recognized commodity exchanges within India and examine the challenges and prospects of futures trading in agricultural commodities. The study will identify obstacles within their organizational structure,trading practices,and regulatory frameworks.The paper proposes policy options based on these findings to revitalize commodity exchangesIndia has a significant trading history in commodity derivatives, however, government intervention in different markets has hindered its growth. The government retains control over the production, supply, and distribution of various agricultural commodities, imposing strict regulations that limit the use of forwards and futures trading. (Refer to Table 2 for further details)

Under the Essential Commodities Act (ECA) of 1955, free trade in numerous commodity items is restricted. However, forward and futures contracts are only limited to specific commodity items as regulated by the Forward Contracts (Regulation) Act (FCRA) of 1952. The first commodity exchange in India was established by the Bombay Cotton Trade Association, initiating organized futures trading in cotton in 1875. Subsequently, several exchanges arose across the country, facilitating futures trading for various commodities. In 1900, the Gujarati Vyapari Mandali was established, becoming the first organization to engage in futures trade for oilseeds in India. Additionally, the Calcutta Hessian Exchange and East India Jute Association were founded in 1919 and 1927 respectively, both specializing in futures trading for raw jute.

In 1921, futures in cotton were organized in Mumbai by the East India Cotton Association (EICA). Before the outbreak of World War, several exchanges were established in major agricultural centers in northern India, primarily dealing with wheat futures until it was banned. Exchanges like those in Hapur, Muzaffarnagar, Meerut, and Bhatinda were founded during this time. The trading

of spice futures was initially organized by the India Pepper and Spices Trade Association (IPSTA) in Cochin in 1957.

Futures in gold and silver were introduced in Mumbai in 1920, but they were later prohibited by the government in the mid-1950s. Although options are currently allowed in the stock market, they are still not permitted in the commodities market. During the pre-independence period, commodity options were traded, including options on cotton until they were banned in 1939 [Ministry of Food and Consumer Affairs 1999]. However, with the passage of FCRA in 1952, the government lifted the ban on futures trading. As part of this act, the Forward Markets Commission (FMC) was established and given regulatory powers.

In 1966, the government banned futures trade to control price movements of agricultural and essential commodities. This resulted in the closure of all exchanges and the rise of unofficial and informal futures trading. In 1980, the government reintroduced futures trade for selected commodities based on the Khusro Committee's recommendation. Further liberalization efforts in the 1990s led to the appointment of an expert committee chaired by K N Kabra in 1993, which advocated for the reintroduction of futures trading and its expansion to include more agricultural commodities and silver. The National Agricultural Policy 2000 also aimed to reform domestic and external markets and eliminate regulations in agricultural commodity markets to prioritize the agricultural sector.

It has also suggested expanding the scope of futures markets to reduce the wide fluctuations in commodity prices and manage the risk caused by price changes. In line with this proposal, more agricultural commodities are being included in futures trading. At present, there are 15 exchanges operating in India

engaged in futures trading for 30 different commodities (see Table 1 for details). Recently, two exchanges, namely IPSTA in Cochin and the Bombay Commodity Exchange (BCE), have been upgraded to international exchanges to handle international contracts for pepper and castor oil, respectively. Additionally, permission has been granted to two other exchanges: The First Commodities Exchange of India in Kochi (for copra/coconut, its oil and oilcake) and Keshav Commodity Exchange in Delhi (for potato). Futures trading is expected to commence at these exchanges soon.

There are plans to establish eight more exchanges, some of which are expected to start operating soon. The government has also allowed four exchanges, namely EICA in Mumbai, Central Gujarat Cotton Dealers Association in Vadodara, South India Cotton Association in Coimbatore, and Ahmedabad Cotton Merchants Association in Ahmedabad, to conduct NTSD contracts in cotton. Recently, the trading of sugar futures has also been permitted as part of the further liberalization of trade in agriculture and dismantling of ECA, 1955. Approval has been given to three new exchanges, e-Commodities in Mumbai, NCS Infotech in Hyderabad, and e-Sugar India.Com in Mumbai, to conduct sugar futures. Despite having a significant membership strength and potential for large trade volumes, many existing exchanges have become weak. This paper later presents observations made during visits to six of these exchanges. The number of actively trading members in all these exchanges is extremely low.

It is crucial to understand why traders who have established exchanges are not enthusiastic about actively participating in trading. Many exchanges have experienced the unprofitability of trading and cannot rely on it as a full-time business. Any efforts to revive exchanges and stimulate the futures market in

India must tackle this issue first. It is intriguing to note that even in commodities with active domestic and international ready markets and volatile prices, futures trading in those commodities does not attract merchants. The IPSTA in Cochin, which has been involved in futures trading for spices for more than five decades, has not gained much interest from traders.

The futures exchange for pepper trading is unique worldwide. Kerala, which produces the majority (around 95 percent) of pepper in India, and Cochin, the city where most pepper exporters operate, should have a larger role in this exchange [UNCTAD 1995]. Surprisingly, despite having over 150 members in the exchange, only about 10 representatives occupy cubicles in the trading ring during trading hours. Upon investigation, it is discovered that these members come from families with a long history in the pepper trade, and no new outsiders have joined. The reason for the members' desire to maintain the exchange's specialized focus on a single commodity remains unclear.

The BCE, which is perhaps the wealthiest exchange in India in terms of infrastructure, is also struggling with the issue of a barren trading ring. Despite having almost 600 members, only a handful are actively participating in trading. According to Table 1, the volume of castor seed futures dropped from 2.53 lakh tonnes in 1996-97 to a mere 10,000 tonnes in 2000-01.

The EICA, being one of the oldest exchanges in the country, has a unique history to share. In India, cotton has a longstanding tradition of futures trading. The trading of cotton futures began in 1857 and persisted until its suspension in 1966. Cotton holds great potential for futures trading because of its

unpredictable and uncertain supply, as well as its fluctuating prices. Within a single crop season, prices can vary significantly by around 7.

The output of cotton in India has fluctuated by as much as 14 percent over the past decade, with a growth rate of 5 and 26.2 percent. India is currently ranked third in terms of cotton production and second in terms of consumption worldwide. Additionally, cotton is categorized under the OGL list with no import duty, and the quota system for its exports is expected to be eliminated by 2005. However, the current state of the cotton exchange and Indian cotton futures contract is similar to other exchanges. Although membership in the exchange exceeds 400, only around 10 members actively participate in trading.

The government's indirect control on supply and prices through its procurement is often cited as a reason for the lack of attraction and value in the cotton futures market. However, the success of futures markets in other commodities suggests that there is potential for growth in this sector in the country. Promising trading activities in various exchanges such as the National Board of Trade at Indore, the Chamber of Commerce in Hapur, the Viajai Beopar Chamber in Muzaffarnagar, the Ahmedabad Commodity Exchange, the Bhatinda oil exchange, and the East India Jute Exchange in Calcutta indicate positive prospects for futures trade in agricultural commodities. Commodity futures contracts, which are an improved version of forward contracts, involve agreements to buy or sell a specific quantity of a commodity at a predetermined price, with settlement occurring on a future date. Unlike forward contracts, futures contracts are standardized in terms of quality and quantity, as well

as the place and date of delivery. The commodity futures contracts in India, as defined by the Forward Markets Commission (FMC), must be conducted through recognized associations, ensuring that trading adheres to the rules and regulations set by the association.

• It is common to enter into contracts in the futures market using a standard variety called the 'basis variety' and allowing for the delivery of other identified varieties known as 'tenderable varieties'.
• These contracts have fixed units of price quotation and trading, which cannot be changed by the parties involved. The delivery periods are specified.
• In the futures market, sellers have the option to deliver goods against outstanding sale contracts. They can deliver goods at the trading association's location or at other pre-specified delivery centers.
• In most cases, actual delivery of goods rarely occurs in the futures market. Transactions are usually closed before the contract's due date, and settlements are made through payment of differences without physically delivering goods.

Transactions are mostly squared up before the contract's due date, and contracts are settled by payment of differences without any physical delivery of goods taking place. The terms and specifications of futures contracts vary depending on the commodity and exchange. These terms are standardised across the trading community in respective exchanges and are designed to promote trade in the specific commodity. For example, the contract size is important for managing risk, as it determines the potential gain or loss relative to changes in price levels in monetary terms.

It also impacts the required margins and commission charged. Likewise, the margin that needs to be deposited with the clearing house has consequences for customers' cash position as it

ties up working capital for the duration of the contract they are involved in. Regarding organizational setup, commodity exchanges in India have been restricted to futures trading. These exchanges are member associations that offer organizational support for conducting futures trading in a formal setting. A board of directors, largely consisting of association members, manages these exchanges.

Among the members of the FMC, there are representatives of the government and the public. The majority of board members have been selected from the association's members who have a business and trading interest in the exchange. The board then appoints a chief executive officer and their team to help with the day-to-day administration of the exchange.

To capitalize the exchange, there are various categories of members who contribute through equity participation, admission fees, security deposits, registration fees, etc. These categories include ordinary members, trading members, trading-cum-clearing members, institutional clearing members, and designated clearing banks.

The requirements for membership and the composition of members differ from one exchange to another. Some exchanges have exclusive clearing members, broker members, and registered non-members in addition to other categories of members. The clearinghouse is an organizational setup attached to the futures exchange. Its responsibilities include handling all back-office operations such as matching buy and sell transactions, executing trades, clearing and reporting all transactions, and settling transactions upon maturity by either paying the price difference or arranging physical delivery. The clearinghouse also assumes all counterparty risk on behalf of buyers and sellers. In a forward market, there is no clearinghouse, so buyers and sellers face counterparty risk. However, in a futures exchange, all transactions go through the clearinghouse, which automatically becomes a counterparty

to each transaction. The clearinghouse takes the position of a counterparty on both sides of the transaction by selling a contract to the buyer and buying the identical contract from the seller.

Traders have a position in relation to the clearinghouse, which ensures risk-free transactions and provides financial guarantees using funds from members and margins. The clearinghouses' organizational structure and membership requirements vary between exchanges. The BCE and IPSTA have independent corporations specifically for clearing and guaranteeing futures transactions. COFEI has a clearinghouse as a separate division, while other exchanges such as the Chamber of Commerce, Hapur; Kanpur Commodity Exchange (KCE), and EICA, Mumbai have in-house clearinghouses. The clearing and guarantee responsibilities in these exchanges are managed by a separate committee known as the clearinghouse committee.In order to become a member of the clearinghouse, individuals must contribute capital in the form of equity, security deposit, admission fee, registration fee, and guarantee fund contribution. The required amount of capital depends on the organizational structure of the clearinghouse. For instance, in the BCE, trading-cum-clearing members must provide a minimum of Rs 50,000 each for equity and security deposit, as well as an annual subscription fee of Rs 500. Additionally, members are required to have a net worth of Rs 3 lakh.

Similarly, COFEI requires a contribution of Rs 5 lakh towards the equity fund and Rs 5 lakh towards the guarantee fund, along with an admission fee of Rs 40,000 for a trading-cum-clearing member. However, in exchanges where the clearing house is integrated into the exchange, the payment requirements are lower. For instance, KCE only requires a payment of Rs 25,000 for the security deposit, Rs 1,000 for the

registration fee, and Rs 500 for the annual fee for a clearing-cum-trading member. Margins, also known as clearing margins, are deposits made by traders to the clearinghouse as a show of good faith, typically in cash. Traders are required to maintain two types of margins with the clearinghouse: initial margin and maintenance or variation margins.

The success of futures is strongly influenced by their impact. When traders engage in futures trading, their up-front working capital is blocked as non-interest bearing deposits payable to the clearinghouse. The margin requirement plays a significant role in this process. A higher margin requirement prevents traders from participating in trading, while a lower margin can weaken the clearinghouse's financial position, making it more susceptible to default. Internationally, numerous developed exchanges maintain a low margin on positions due to their superior financial strength and the substantial volume of trade they handle, resulting in significant income for these exchanges.

However, in many exchanges in India, this has not been the case. For instance, the minimum lot size in pepper requires an initial margin liability of Rs 30,000 for domestic contracts and US$ 312.0 for international contracts. Moreover, the volume of transactions in these clearinghouses is extremely low in several Indian exchanges, rendering their financial viability questionable.

To ensure the financial integrity of the exchange and mitigate counterparty risk, clearing members are subject to limits on their trade positions (exposure) in addition to mandatory margins. These limits vary among different exchanges, with some being strict and others more flexible. Typically, the limits are determined based on the members' equity capital, security deposit, or a combination of both, as well as the settlement guarantee fund.

In BCE,

the exposure limit for a clearing member is calculated as 50 times the face value of their contribution to the equity capital of the clearinghouse, plus 30 times the security deposit maintained with the clearinghouse. On the other hand, COFEI sets a limit of 80 times the sum of a member's equity investment and their contribution to the guarantee fund.