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Commodity Derivatives in India

Background

TheCommodity FuturesMarket 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 byinstitutions for futures tradingin 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 futuresinstruments. 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 thepositive roleof 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

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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 theCommodity FuturesMarket. 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:

a) The commodity should be homogenous in nature, i.e., the concerned commodity shouldbe 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;

b) The commodity must be capable of beingstandardizedinto identifiable grades;c) Supply and demand for the commodity should be large and there should be a large

number of suppliers as well as consumers;

d) The commodity should flow naturally to the market without restraints either ofgovernment or of private agencies;

e) There should be some degree of uncertainty either regarding the supply or theconsumption or regarding both supply and consumption,

f) The commodity should be capable of storage over a reasonable period of time. Economic functions of the futures markets

In a free market economy, futurestradingperform two important economic functions, viz. price

discovery and pricerisk 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.

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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

theriskof 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 twomarketsso 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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