NATIONAL COMMODITIES EXCHANGE LIMITED

(NCEL)

What It Has and What It Lacks

“We should all be concerned about the future because we

will have to spend the rest of our lives there”. 

~Charles F. Kettering

“Caveat emptor” -- Let the buyer beware

“We are moving from a world in which the big eat the small to one in which the fast eat the slow”.

Klaus Schwab, 2000 (Founder of the World Economic Forum)

INTRODUCTION

In early proto-capitalism and era of trade, Derivatives first

emerged as a tool in commodity trading. In Pre-Islamic era of

Arab region we see many people locking in commodities at a

certain price, the same people which accepted Islam later. It was

after that it initiated as a useful hedging tool in financial markets

as well. The fundamental mechanism of a derivative contract

remains the same whether the asset happens to be a commodity

or a financial asset. However there are various uniqueness,

which are similar to commodity derivative markets. In the case

of financial derivatives, most of these contracts are cash settled.

Even in the case of physical settlement, financial assets are not

bulky and do not need special facility for storage. Due to the

bulky nature of the underlying assets, physical settlement in

commodity derivatives creates the need for storage. The same

way concept of differing quality of asset does not really exist as

far as financial assets are concerned. While in commodities, the

quality of the asset underlying a contract can vary largely. This

becomes an critical point to be considered.

National Commodity Exchange Limited (NCEL) is the first

technology driven, de-mutualized, on-line commodity futures

exchange in Pakistan. NCEL’s shareholders are National Bank of

Pakistan, Karachi Stock Exchange, Lahore Stock Exchange, Islamabad

Stock Exchange, Pak Kuwait Investment Company (Pvt.) Limited, and

Zarai Taraqiati Bank Ltd and it is regulated by Securities and

Exchange Commission of Pakistan.

NCEL VISION

VISION/MISSION

FROM   TO

Price Distortion

Wide spreads or one way quote

Lack of storage

Absence of standardization

Counterparty risk

Impediments in financing

Price manipulation

Observable prices

Narrow spreads and two way quotes

State of the art warehousing

Quality certification & standardization

Complete risk mitigation

Ease

"To provide an opportunity to the farmers to farm for the market"[1]

PRODUCTS:-

At present there are 14 commodities being traded at NCEL

under following categories:

Rice

NCEL IRRI-6 Weekly Rice Futures Contract

[1] www.ncel.com.pk

NCEL IRRI-6 Rice Futures Contract

Palm oil

NCEL Palm Olein Futures Contract

Gold

NCEL Gold (1 Ounce) Futures Contract

NCEL 100 Ounces Gold Futures Contract

NCEL 100 Tola Gold Futures Contract

NCEL 50 Tola Gold Futures Contract

NCEL 10 Tola Gold Futures Contract

NCEL Kilo Gold Futures Contract

NCEL Mini Gold Futures Contract

NCEL Gold Futures Contract

Silver

NCEL Silver (500 Ounces) Futures Contract

Crude oil

NCEL Crude Oil Futures Contract

Interest rates

NCEL 3-Month KIBOR Futures Contract

TECHNICAL SETUP

Karachi Stock Exchange the biggest stakeholder, has provided the

technical support for NCEL. Trading is also facilitated through two

other stock exchanges in the country along with universal access by

Web Portal.

The automated trading system provide market participants with

online market and price discovery system guaranteeing the best bid

and offer for all market members. The exchange plans to provide a

number of services to the brokers including trading terminals at

remote places, online market information system, clearing and

settlement and comprehensive risk management system.

We can never say that Derivatives market totally eliminated the risk in

Commodities because there are certain uncontrollable risks such as

weather, production level and demand during a season, .they can

certainly be minimized. The exchange introduces an efficient clearing

fund management system, monitor the exposure carried by brokers

and adopt comprehensive risk management systems and practices in

the commodity markets in the developed world. Taking educated risks

would be possible due to the price competition and transparency once

the exchange starts operating fully.

The National Commodity Exchange Limited is the only exchange in

Pakistan that provide a centralized and regulated place for commodity

futures to be traded in Pakistan. It intend to grow into a leading

Commodity Exchange not only in the country but also in the region to

present fully automated trading, settlement and risk management

systems at par with international standards.

The exchange deal in the trading of commodities such as gold, rice

etc.

Gold was the first commodity to be traded and trading of other

commodities followed in phases.

The establishment of the exchange is the continuation of policy of

Free Trade and Economics Liberalization which is the pre-requisite of

WTO. Thus government Support it to encourage investment in the

country, regulate trading in commodities and document the national

economy.

The Karachi Stock Exchange is the largest shareholder of the

exchange and holds 40 per cent of its stocks. Lahore and Islamabad

stock exchanges, the remaining two bourses of the country, hold 10

per cent shares each and there are also other shareholders. The

exchange has a small initial paid up capital of Rs 50 million and has

successfully raised an additional Rs 260 million by giving licences to

260 brokers at a fixed amount of Rs 1 million each. Hence the cash

equity of Rs 310 million is used to develop the infrastructure

necessary to accommodate the fully automated trading.

Participants in Commodity Futures

Importers/Exporters

Commodity Financers

Farmers/ Producers

Consumers/ Industry

Traders

Corporate having price risk exposure in commodities

OBJECTIVES

The exchange aims to establish, conduct, regulate and control trade

or business of futures commodity contracts within or outside Pakistan

and to perform all allied and incidental functions to facilitate, setup

and carry on the business of chosen commodities. It also regulate the

handling exportation from and importation of commodities into the

country from its warehouses headqurtered at Karachi and Bin Qasim.

It also aspire to keep up high standards of viable honour and integrity,

to promote and instill principled and ethical practices and just and

equitable values of trade and business, to discourage and suppress

malpractices, to settle and decide points of disputes and violations in

code of conducts.

One of the positive aspects of NCEL is that it co-ordinates with FPCCI

and other local chambers of commerce, trade bodies in order to

regulate the commodity trade.

In General the Commodity prices are less unpredictable than the

stocks and this has been proved in various researches. So it is safer to

invest in commodities for Risk-Averse Investors.

Also the regulatory authorities at NCEL and SECP ensure through

continuous monitoring that the commodity prices are Demand-Supply

Driven and free from exploitation.

On the other hand the investments are subject to market risk and

depend on the individual decision as to which extent he has the ability

to bear the risk. Like any other investment there is risk of loss while

trading in commodity derivatives.

BENEFITS TO THE ECONOMY

The National Commodity Exchange is a new idea in Pakistan to

provide an opportunity for the investors both local and foreign no

matter wherever they are located in the world, in the futures trading

of the commodities throygh online website. The foundation of a

centralized and regulated market will attract investment in the

futures trading to offer new areas for investment in commodities.

A case to analyze is that The global oil prices have rouse around 2

years back to 15$/barrel but the absence of the commodity exchange

denied the people to invest as people has to go to Dubai to buy the

commodity. If gold was traded here it would have helped the investors

as well as the country to maintain gold stocks through future trading.

The single biggest benefit of futures trading in commodity is that it

would offer hedging in the commodity market, the main beneficiary of

which will be the agriculture sector. This is an important development

indeed as Pakistan still much remains an agrarian economy and the

exchange will provide marketing venues of agriculture produce or

derivatives in advance. Growers will benefit and so will the

intermediaries.

The establishment of the regulated organization in the formal sector

for the first time in the country where trading of agricultural

commodities and gold has always been done in an informal and

unregulated manner has changed the way of doing business for the

benefit of the national economy and the growers in particular. The

hedging and the market-driven speculations will also bring the much

needed price competition and transparency to help project Pakistan

as the regional commodity exchange center to attract much needed

investment both foreign and local into the country. Futures trading in

commodities is better than investment in the stock market as in it is

not static but comprise commodities which are not held physically but

are real.

Although futures hedging in commodities is no solution for price

variation and abrupt changes it does offer an opportunity for hedging

not available previously which can bring stability to some extent.

Commodity trading through futures allows the buyers and sellers a

hedge against price changes that may abruptly affect their business to

make an informed decision to improve the profits or cut the losses.

Thus the growers and the intermediaries would be able to sell the

commodities at any time on their own discretion as and when the

prices suit them.

Without a Regulated Commodity Market Place the whole mechanism

of non-transparent trading in which a commodity changes many

hands, offers no protection to the large segment of growers and

producers of agricultural commodities. It also results in trading where

a commodity varies in quantity, description, quality and price.

The commodity trading with NCEL which is accessible from around

the world through its website would benefit the large agrarian

community which previously were deprived of fair market prices of

their products.

In a traditional setting when the bumper crop comes in the market,

prices fell so low that farmers could not repay their loans, despite

abundant production resultantly in the subsequent year not enough

food is produced to feed the population.

Although Pakistan is the biggest grain producer in the region, its

traditional markets are small because of narrow networks of trust

among buyers and sellers. Most farmers trade within 12 kilometers of

their farms and only with people they know.

The National Commodity Exchange Limited provides warehousing, a

reliable payment system, real-time market information, and quality

control. Producers sell directly to the exchange, which assures

payment within 24 hours.

In the past, truck drivers took payment in envelopes filled with cash.

It was never certain if or how much of the money would make it back

into the hands of the seller. Buyers in the traditional system do not

know the quality of what they get unless they open up the sacks and

inspect the contents.

Now in the exchange setting NCEL takes the task of the commodity

evaluation and ensure the quality, so even a far-away buyer can be

confident of what he/she is buying.

Another benefit of Commodity Futures is that there is no 'Time

Decay'. Options suffer from time decay because the closer they come

to expiry the less time there is for the option to come into the money.

Commodity futures do not suffer from this as they are not anticipating

a particular strike price at expiry.

BENEFITS TO THE INDUSTRY

Futures trading in the commodities will benefit the Pakistani

industries in two distinct ways. Number one, the availability of

hedging market and the finances would help lets say the rice buyers

and sellers to trade at their own convenience according to their own

cash liquidity. Secondly, the price discovery mechanism will also

result in efficient prices to keep the production costs in check to

better compete in the international markets. Since Agriculture is the

backbone of Pakistani economy and since rice crop is the one of the

biggest earner the futures trading will also result in increased

exports.

A farmer may have a field of rice and in order to hedge against the

possibility of rice prices dropping before the harvest he might sell rice

futures. He has locked in the current price, if rice prices fall he makes

a profit from the futures contracts to offset the loss on the actual rice.

On the other hand, a consumer such as rice trader/exporter may buy

rice futures in order to protect against a rise in the cost of rice.

The open market price of individual commodities fluctuates from time

to time within a day. The contracts on can be bought or sold prior to

the delivery date thus helping a cultivator or a broker to off-load a

commodity prior to the delivery date. Thus the original seller, the

hedgers, or the average investor, the speculator, can profit through

the price movements.

Development of a futures market also help the informal and the

unorganized sector to be competitive and transparent for the benefit

of the agriculture in the country where growers continue to moan

about not getting the fair prices for their labour.

According to Mr. Chamdia(The First MD of NCEL) futures trading in

commodity will help retain between 8 to 10 billion dollars annually

once the exchange would be fully operational. In addition, the buying

and selling of futures contracts based on price speculations take place

many times during its lifetime. Trading in futures, thus results in a

much bigger economic activity then the original contract itself and in

the developed commodity markets, the futures trading runs in billions

of dollars daily.[2]

Thus to summarize NCEL provides following benefits:

Efficient price discovery protects from seasonal price volatility

and abrupt changes.

Hedging the price risk associated with futures contracts

Purchase option on discretion of the buyer as and when needed

rather than large cash purchases and its storage.

Greater flexibility, certainty and transparency in procuring

commodities would aid bank lending.

Hedged positions of producers and processors would reduce the

risk of default faced by banks who have advanced them loans.

Lending for agriculture sector would reduce the food shortage

as more farmers will be able to grow due to increased liquidity

Provide margin financing to traders in commodities exchanges.

[2] www.brecorder.com

BENEFITS TO EXCHANGE MEMBER

Ability to profit from huge commodity market which is much

secure than a Stock Exchange.

Robust, scalable, state-of-art technology deployment.

Ability to trade in multiple commodities from a single point

Iif given proper guidance Traders would be able to act as Rural

Advisors and Commodity Specialists which can guide farmers to

grow which crop, which seed to use, which type of fertilizers

are more effective etc.

WHY COMMODITY FUTURES?

The need for Futures market is often justified by the fact that

traders/brokers will have some thing to trade, large volumes and

brokerage fees.

The Derivatives market has more of a role to play in the economy.

In Pakistan agriculture has traditionally been an area with some

government intervention. Government intervenes by trying to

maintain buffer stocks, setting support prices for the farmers, and

they have import-export restrictions and a host of other interventions.

Many economists think that we could have major benefits from

liberalization of the agricultural sector in the era of free trade and

WTO.

Thus the problem is who will maintain the enough stocks for domestic

requirements, how will we smoothen the price fluctuations, how will

farmers not be at mercy of tomorrow that price will crash when the

bumper crop comes out, how will farmers get signals that in the

future there will be a great need for wheat or rice. In all these aspects

the futures market has a very big role to play.

If we think there will be a shortage of wheat tomorrow, the futures

prices will go up today, and it will carry signals back to the farmer

making sowing decisions today. In this way a system of futures

markets will improve production patterns.

Moreover if a farmer is growing rice and worried that by the time the

harvest comes out prices will go down, then he can sell wheat on the

futures market. He can sell rice at a price, which is fixed today, which

eliminates risk from price fluctuations. These days, agriculture

requires investments -- farmers spend money on fertilizers, high

yielding varieties, high cost of electricity and other charges raised by

our governmentetc. They are worried when making these investments

that by the time the crop comes out prices might have dropped,

resulting in losses. Thus a farmer would like to lock in his future price

and not be exposed to fluctuations in prices.

Futures market will produce their own kind of transition between the

present and the future. If the future price is high and the present

price is low, an arbitrager will buy today and sell in the future. The

converse is also true, thus if the future price is low the arbitrageur

will buy in the futures market. Thus these activities produce their own

optimal levels of stocks, averages prices. They also work very

effectively when there is trade in agricultural commodities;

arbitrageurs on the futures market will use imports and exports to

smooth local prices using foreign spot markets.

To summarize in today’s era of Free Trade and Economic

Liberalization commodity futures markets are a part and parcel of a

program for agricultural liberalization. Many Agrarian experts

understand the need of liberalization in the sector. Futures markets

are an instrument for achieving that liberalization.

WHAT MAKES COMMODITY TRADING LUCRATIVE ?

For risk-averse investors NCEL provides a good low-risk

portfolio diversifier

There is Less volatility in futures contract as compared to

equities markets .

Better risk-adjusted returns.

For Mutual Funds NCEL provides a good hedge against any

bearish trend in equities as there is little relationship with

equity markets.

High corelation with changes in inflation.

The NCEL System

A NCEL transaction has following components trading, clearing and

settlement. A brief overview of how transactions happen at NCEL.

TRADING

The trading system on the NCEL provides a fully computerized system

for trading futures on commodities on a nationwide basis as well as

online monitoring and surveillance mechanism. While taking order it

inquire about Its commodity, its price, time and quantity.The

exchange specifies the unit of trading and the delivery unit for futures

contracts on various commodities. The exchange notifies the regular

lot size and tick size for each of the contracts traded from time to

time. If a buy order is given the exchange will try to find a sell order

with same specification. When the orders are matched, members are

informed of the deliverable/ receivable positions or the unmatched

position if order is not successful.

SETTLEMENT

Futures contracts have two types of settlements, the continuous

settlement which happens on a continuous basis at the end of each

day, and the final settlement which happens on the last trading day of

the futures contract when the future contract expires. All positions for

settlement created during the day or closed out during the day are

settled at market to market price or the final settlement price at the

close of trading hours on a day.

On the date of expiry, the final settlement price is the spot price on

the expiry day. The responsibility of settlement is on broker. A

professional clearing member is responsible for settling all the

participants’ trades, which he has confirmed to the exchange.

While on Deliverable Contracts on the expiry date of a futures

contract, members submit delivery information through delivery

request window on the trader workstations provided by NCEL for all

open positions .

NCEL on recieving such information matches the information and

turn up at delivery position for a member for a commodity. The seller

intending to make delivery takes the commodities to the designated

warehouse of NCEL .

KIBOR FUTURE

In order to hedge against the uncertainty of the monetary policy of

the State Bank Of Pakistan, specially Bank Rate, which is dictated by

IMF rather than set by SBP these days, NCEL introduced much

awaited KIBOR Future.

Interest rate risk is one of the risk which is inherent in a Capitalist

Economy, which no one can evade in the economy.

Whether a business is exposed to Equity market bearish risk,

Currency depreciation risk, Commodity fluctuation risk or not, it will

always be exposed to Interest rate risk in the economy.

Karachi Inter-Bank Offer Rate (Kibor) represents the rate at which

banks are willing to lend funds to each other. This benchmark rate is

an important reference point as most lending transactions are linked

to this rate.

In addition to lending to consumers many Financing Instruments are

linked with KIBOR as they use “KIBOR+” formula for rate fixation.

Thus every Financial institute has a need to hedge against adverse

moves in the KIBOR specially those involved in Lending and

Borrowing. Thus NCEL provides equal access to all, companies and

individuals also have an opportunity to come straight to the market to

hedge their positions.

The Futures Trading in KIBOR has main benefit to the financial

community that they get tradable yield curve which provides

information about the Future path of the KIBOR thus they can

anticipate the change early and can take decision in a very wise way

that wasn’t possible before.

It is also beneficent for end consumers as their loans are issued at

floating rate that is “KIBOR+” approach thus they are directly

exposed to any movement in KIBORR.

One case to analyse is that of Textile and Cement sector companies

which get loans at floating rate when KIBOR was low, for their

expansion purposes. When the inflation rises the State Bank Of

Pakistan raises the Bank Rate thus KBOR Rises which resultantly

increased their Cost of Debt

Thus the Information about anticipated KIBOR movement allows

Banks and other financial institutions to develop, price, sell and hedge

a variety of financing and saving products customized to the needs of

their customers. Customers benefit from a range of better priced

products suited to their needs and banks benefit by better Risk

Management which leads to lower level of reserve requirements.

Gold

In early days Gold was used as monetary unit rather than a

commodity. Eeven in our time it is primarily a monetary asset, and

partly a commodity. People buy gold for storage of Value purposes

rather than using it . The largest buyers of Gold are considered to be

Central Banks, IMF,WB, Investment companies and large jewellery

manufacturers. Thus we can assume that gold is primarily a monetary

asset.

In Pakistan the annual Import of Gold is estimated to be 50 Tones. The

Investment in Gold is considered to be risk less and inflation

protected and a good source for Investment Diversification.It is even

considered better in risk as compared to T-bills as they have counter

party Risk. Recently KASB Mutual Fund has launched its Gold-

Protected Mutual Fund in which 35% investment is in Gold.

Gold as a commodity is special in itself because an investment in it is

Timeless . It is an effective diversifier better than cash for an

investment because it is highly liquid and responds when it is needed

most. The currency/Cash do depreciate considerably with time with

fluctuations in Interest, Inflation but Gold is not directly hit byit.

The importance of Gold as Effective diversification cannot be negated

specially during recessionary periods during which Stock markets are

marred with Slump and bearish trend. Other methods of Investment

portfolio diversification also fail when they are most needed, that is

during financial instability because of correlation among economic

indicators and volatility. Thus Gold Provides a safe hedge

In recent times we have seen that Gold prices have changed and have

gone to record prices that is Rs.39000/Tola.

Gold is considered to be a symbol of pride in our traditional culture

and we have seen a considerable consumption of it mainly in Jewelry

Industry.

The presence of Gold Futures have provided a necessary hedge

against rising prices to the Jewelry industry and Consumers as well.

The Investment Firms can also benefit from Gold Prices by locking in

Gold Today thus protecting themselves from Inflationary Pressure,

Interest Rate Fluctuation and Currency Depreciation.

NCEL – What It Lacks and What Need To Be Done

1- Lack Of Market Information:-

The NCEL on its only official website claims information being

delivered all over the country. But it failed to inform us that how it is

disseminating information in the Rural and Sub-urban Areas where

the Internet and Telecom Penetration rate is very low as compared to

Large Cities. The Small Farmers even don’t know how to write and

read in English let alone getting information from the website. The

claim that market information is transmitted all over the country is,

therefore, misleading and false.

2- Lack of Awareness Programs

The Futures market in Pakistan is Under Developed in a sense that

Commodity traders/Producers/Farmers don’t have the idea about

Futures Market and how it Operates.

They stick to old way of trading where a commodity changes 4 or 5

hands before reaching end user resulting in price

distortion/hoarding/discrimination etc. by brokers hence a wretched

farmer.

Another factor to note is the low literacy rate specially in rural areas

from where the majority of commodities come. The producer don’t

feel the need of literacy let alone the need of IT infrastructure

employed by NCEL.

NCEL should held awareness programs through out the country in

rural and urban areas in order to create awareness.

Secondly it should establish support centres in Main Rural hubs for

Support/Advice to farmers/Producers.

3- Lack of Option Hedging tool in NCEL:-

Futures’ trading is a good way for hedging against price fluctuations

but possibly not the best way.

There is another derivative tool that is Options which is not being

offered at NCEL. In Futures a farmer can lock in the commodity

against the fall in prices but he cannot benefit from the rise in the

prices thus he remains elusive to gain in market prices.

Similarly, a consumer can lock in commodity at a certain price to

protect from raise in prices but he possibly cannot gain from

reduction in prices.

Thus there is a need of an Option market in NCEL as it will benefit the

Farmers/Growers in Agrarian economy.

4- Absence of Commodities Having Hoarding/Black Marketing

Issues

Still NCEL is void of those commodities which are being Black

Marketed and are under the influence of Hoarders thus driving their

prices at artificial Levels.

The case being discussed is that of SUGAR and WHEAT CRISIS which

the nation have experienced recently.

If the Futures market was available for those commodities the prices

would have been at stable level as the path of future prices would

have been known to the producers/growers and Consumers/Industry.

Thus an equilibrium price would have been set instead of artificial

price levels

5- No Currency Futures:-

It is a very deplorable and sorry affair of state that there is no

currency Derivatives market in Pakistan where Domestic currency has

depreciated like a fruit get rotten.

The effect of currency depreciation is hefty on the economy as every

sphere of economy has taken a hit by it. The major chunk of Inflation

has come from Rupee depreciation against Uncle Sam’s Dollar. The

raw material imported from abroad used in industry got expensive

due to Rupee fall which resulted in cost of end product high to the

consumer thus Inflation.

Another case is that of Pakistan Government which has foreign loans

amounting to be more than $50 Billion. A increase of 1 rupee from a

parity of $1:Rs.60 cause rise in External loans amounting to Rs.46

Billion and at a parity of $1:Rs80 the Government of Pakistan has

accumulated around Rs.900 Billion on Foreign loans just because of

Currency Depreciation.

Thus a Futures market in Currency is Imperatives of NCEL so that

future direction of Currencies can be established and to some extent

Stablized.

This will specially help Importers, Exporters and Government as well.