Changing face of exchange-traded commodity derivatives in India

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Commodity derivative trading in India is set for rapid expansion after recent moves from SEBI

Commodity derivative trading in India is on a recovery phase. Despite witnessing large volume growth in exchange traded commodities in the initial years, trading nosedived sharply since mid-2012 due to various macroeconomic factors.

India is one of the largest commodity traders in the world but trading volumes through commodity exchanges are extremely limited. Globally, the size of commodity derivatives market is many times larger than the underlying physical commodity trade. Higher volumes in derivative market help to minimise the commodity price risks spread across the markets.

However, SEBI, the commodity market watchdog has recently initiated several measures to stimulate active trading interest in commodities. Steps like strengthening of exchanges and intermediaries through policy changes, adding new entities like mutual funds and Portfolio Management Services (PMS), permitting new products like options and index trading are a few such steps that are likely to increase the scope of commodity trading in the country. These efforts by SEBI have help to broad base the market by removing obstacles and making the platform viable to reach genuine participants.

Many of these steps are seen a giant leap for commodity market reform which is in line with the transformation witnessed in the Indian equity market.

MFs and PMS in commodities

Though commodity futures in the country has been in existence for more than a decade, the growth rate has not been on expected lines. Unlike equities, retail participation has been limited due to lack of understanding of the market dynamics.

In equities, many HNIs and retail participants have found comfort with Mutual Funds and PMS. There were suggestions from the market participants that the success in equity markets can be replicated in commodities too. With this objective in mind, SEBI has recently allowed Mutual funds and portfolio managers to invest in exchange traded commodity derivatives, except those on sensitive commodities. This initiative is expected to strengthen the market by attracting large volumes.

MF schemes may participate in the Exchange-Traded Commodity Derivatives (ETCD) as ‘clients’ and shall be subject to all the rules, regulations, instructions, position limit  norms, etc., as may be applicable to clients. As per rules, two categorise of products can be developed, viz. Hybrid mutual funds including Multi asset mutual funds and Gold ETFs.

Inclusion of MFs and PMS in commodities is likely to increase liquidity in far-month contracts. Presently, retail investors largely participate in equity MFs. Likewise commodity MFs can mobilize more retail participation by offering professional research related service.

Compulsory deliverable metals contracts

Trading in base metals through futures platform in India has a long history. The country’s largest commodity bourse, Multi Commodity Exchange of India Ltd (MCX), offers a comprehensive suite of base metal derivatives in its portfolio to mitigate the risk involved in metal trading.

Though these contracts offer extensive trading opportunity, global price discovery and price transparency for market participants, these contracts were never physically settled. The delivery logic of these contracts was settlement in cash on expiry. Hence, these contracts were not appropriate for hedging or stocking and key market players preferred to hedge in international exchanges due to its liquidity and contract design. Also, the local market premium or discount has not been considered in the price discovery mechanism and hence it was unattractive among real hedgers.

However, now, exchanges are ensuring compulsory delivery for all metal contracts as per regulator’s instruction. Prices are domestically discovered by a transparent spot pooling system which consider all local demand and supply factors. Hence, it is expected to benefit all key stake holders in the value chain substantially.

Compulsory delivery mechanism would improve better warehousing facilities and best practices in the system. As all deliveries are processed through Demat account it makes buying and selling easier for traders as well.

Integration of commodity derivatives with other segments of securities market

The regulator has facilitated integration of commodity derivative trading with other segments of securities market like equity, equity derivatives, debt and currency derivative segments. Earlier, the commodity derivatives were kept separate from other segments of the securities market. This was followed by the nod for exchanges like NSE and BSE to participate in commodities market. Participation of more exchanges is likely to create good arbitrage opportunities.

Permission for Eligible Foreign Entities

SEBI allowed participation of Eligible Foreign Entities (trading companies)/Portfolio investments and Alternative Investment Funds (AIF) in the commodity derivatives market. Previously, foreign entities were not allowed to directly participate in the Indian commodity futures market, even if they import/export various commodities from India. However, now, foreign entities having actual exposure to Indian commodity markets are permitted to participate commodity derivative segment of recognised exchanges for hedging their exposure.

Options, index trading and new commodity contracts

The regulator gave the nod for starting option trading in a few agriculture and non-agriculture commodities. Exchanges are permitted to offer options on commodity futures. These commodity options, on exercise, devolve into the underlying futures contracts. Currently, MCX facilitates options trading in Gold, Silver, Copper, Crude oil and Zinc while NCDEX offers option trading in Chana, Guargum, Guarseed, Soybean and Soyoil.

Approval for commodity index trading and futures trading of essential commodities would be a game changer. In a big move, SEBI has given nod for index trading in commodities. Likewise, permission for futures trade in Paddy and Moong, both of which are very active in domestic spot market, is considered a big move for the bright future of exchange traded commodities in the country.

Moves to strengthen the agriculture market

Since the start of the year, to deepen the market and for enhanced participation of stake holders like farmer-producer groups, value chain participants and foreign entities with exposure to the Indian physical market, the regulator preponed the market opening time to 9.00am instead of 10.00am.

On March 2019, to encourage the participation of farmers/Farmer Producer Organizations  (FPOs) in  agricultural  commodity  derivatives, SEBI  has reduced  the  regulatory  fee  on  Stock  Exchanges  with  respect  to  turnover  in agricultural commodity derivatives.

To protect the interest of hedgers, SEBI asked exchanges to follow the policy of having uniform trading and delivery lot size for the commodity derivatives contracts. Earlier, exchanges had different trading and delivery lot sizes for commodities which were unfavourable for traders who take physical delivery.

Uniformity in the procedure of obtaining samples of goods at exchange warehouses, modified position limit for agriculture commodities, setting up of hedge policy and hedge limit for clients & members and measures to strengthen the spot polling mechanism are other initiatives from the regulator to strengthen the market.

Conclusion

Commodity exchanges and well informed clients are very important for a strong commodity eco system. Exchanges provide transparent price discovery and efficient trading platform for clients to hedge their price uncertainty. A fair value for commodities can be determined by the participation of large number of stakeholders in the value chain.

To widen and deepen the commodity market, systematic development of markets through continuous innovation, education, research and spreading awareness among various stake holders are inevitable. Also, product innovation in line with changing market dynamics and emerging challenges will make the platform more vibrant.

Despite having large benefits to large corporates and other stakeholders, commodity trading In India is mostly limited to speculators and HNIs. Participation of hedgers are rather limited in this market due to various reasons. Once all the policy level issues associated with all stake holders are addressed by the regulator, the Indian exchange traded commodity markets are likely to scale global heighs.

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