Commodity Futures Markets in India: Ready for Take off? C. K. G. Nair *

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1 Commodity Futures Markets in India: Ready for Take off? C. K. G. Nair Major reforms have been initiated in commodity futures markets in India since the last few years. An article 1 by this author in this Journal compared the growth trajectories being followed by the commodity derivatives market vis-à-vis the securities derivatives markets in India at the dawn of the millennium. It was observed that though derivatives trading commenced in the securities market only in June 2000 it was growing at great speed while the commodity derivatives markets which were operational for about 48 years by then was only gradually waking up. However, subsequent few years have witnessed major changes in the commodity spectrum despite the several institutional constraints in which commodity derivatives markets still function. Commodity futures trading in India was in a state of hibernation for four decades, which was marked by suspicion on the benefits of futures trading. This is replaced by policy, institutional and market activism in the last few years. This is partly a response to the predominant role being assigned to the market forces in price determination and the consequent need for providing market-based derisking tools. It is also the result of a growing awareness that derivatives trading do perform substantial risk mitigating functions to the stakeholders. This resurgence of interest in commodity derivatives is timely since global commodity cycle is on the upswing, and experts have predicted that we are in the decade of the commodities. Concomitant to the newfound policy initiatives the market has responded by setting up modern institutions (Nation-wide Multi-Commodity Exchanges, (NMCE) and adapting some of the best practices such as electronic trading and clearing. 2 The projections of commodity derivatives trading, though widely variant in the range of Rs trillion and needs to be calibrated with sound assumptions, indicate the enormous potential of this sector not only in terms of trading but also in terms of the opportunities for developing value-added services in terms of quality warehousing, gradation and certification services, financial intermediation, modern marketing practices, modern clearing and settlement mechanism. Once the market becomes liquid the old complaint, that the Indian commodity derivatives markets do not meet the basic objectives of price discovery (with many studies indicating backwardation common place) and risk management may also vanish 3. The most important changes that have taken place in the commodity futures space were the removal of prohibition on futures trading in a large number of commodities and the facilitation of setting up modern, demutualised exchanges by the Government of India. These two initiatives together are becoming instrumental in changing the contours of the commodity futures markets in India in terms of both participation and practices. There are, however, still a number of obstacles in fully exploiting the opportunities available to the commodity eco-system. Director, Department of Consumer Affairs, Government of India. The views expressed and the approach suggested in this paper is of the author and not necessarily of NSE. 1 Securities Market and Commodity Derivatives Markets Rush vs. Slow Growth? (NSE News, December 2001). A comparative profile of the commodity derivatives markets with that of the nascent securities derivatives market was made since no comparison of the Indian derivatives markets would be useful with any counter part. This was because of the chequered history of Indian commodity derivatives trading from that of a flourishing market formally started in 1875 with the setting up of the Bombay Cotton Association but which went into disrepute during the scarcity decades of the 1960s and 70s. A comparison revealed that the rapid strides made by the securities derivatives segment in a short span was because of its sound institutional frame work in the spot side while the spot market acted as a drag on the progress of the derivatives markets in commodities. 2 The NMCEs marked a major paradigm shift in the institutional structure and market architecture of commodity futures markets. Drawing heavily from the NSE model in the securities markets these institutions are expected to unleash a chain of value added functions in the commodity derivatives markets as well as in the commodity spot market through a host of extra functions they are expected to perform. These include warehouse receipt based deliveries which would require transferability and negotiability of warehouse receipts and its de-materialisation, entry of corporates, banks, financial institutions and FIIs in commodity futures trading, dissemination of information relating to the physical markets and prices, adoption of the best technology in trading, clearing and settlement and so on. The NMCEs have started exhibiting a penchant for innovations as reflected in their attempts at co-opting warehousing agencies, bringing about transferability and de-mating of warehouse receipts account, though in a limited manner (because of the absence of a legal frame work) association of banks (for other than trading activities as trading in commodities is still prohibited for banks) polling of price information from the spot markets(from mandies)commencement of evening trading session to align domestic markets with the global markets and so on(see Economic Survey ). 3 Several studies particularly by Jain & Naik (1999), Thomas (2003), Sahadevan (2002) etal have indicated that only in a few cases the commodity futures markets performed its basic objective of discovering efficient prices. While the studies focus were different the general picture emerging was that only in the case of commodities with reasonable volumes of trading, like castor seed and pepper, the markets achieved the objective of price discovery to some extent. However, since the markets in general were too shallow the results were not unexpected.

2 Participation Box-I Changing contours of commodity futures markets in India Modern Exchanges Absent High (3 NMCEs) Commodity stakeholders (actual users) Low Medium Institutional brokers Absent Medium Banks Absent Low (not allowed in trading) FIs Absent Low FIIs Absent Absent (not allowed) Companies/corporations Absent Low Practices Independent Clearing Low Low Electronic trading Absent Medium Settlement Guarantee Fund Absent Medium Usage of Warehouse receipt 4 Absent Medium While many of the parameters have changed from absent/low to low/medium in the commodity futures markets, the profile of the securities markets show a high degree of advancement with all the relevant indicators being in the high category. With the adoption of Straight Through Processing (STP) from 1 st July 2004 the securities markets have recorded yet another milestone. This continuing dualism between the markets has been one of the major reasons for the emergence of the idea of convergence between the securities and commodity derivatives markets. Advancement of the commodity futures markets and its regulatory structure to similar to the securities markets is a major task for deriving the maximum potential from this sector. Convergence, therefore, would bring in economies of scale and scope without having to duplicate the efforts. Substantial changes have been witnessed in the value of trading in commodity futures markets. Value of trading in all the Exchanges together increased from Rs crores in the year to Rs. 1,30,000 crores during (Details at Annexure-I). An examination of the exchange-wise figures indicate that in exchanges achieved annual value of trading over Rs crores. 5 Similarly there is a quantum jump in the number of commodities in which futures trading has been started as well as in the number of contracts. While in the year 2000 only 8 commodities were allowed for futures trading in which 19 localised exchanges were offering generally one contract each, in June 2004, 80 commodities are being traded mostly by the NMCEs with about 100 contracts (Annexure-II). Some of the contracts are concurrently running for 6 months though volumes are restricted to the near contracts. The proliferation of contracts in a very short span of time has made many of them shallow or altogether disappear in the absence of enough liquidity in the market. Moreover, offering a large number of contracts for various grades/derivatives of the same commodity also makes the contracts vulnerable. This is like meeting the OTC requirements in an exchange-based environment. This highlights the need for proper research based 4 Negotiable, highly acceptable warehouse receipt, that too in electronic form (de-mat) is considered crucial to the development of commodity futures markets because it will remove many of the deficiencies of the commodity physical/spot markets such as quality risk, performance risk etc. apart from reducing logistical costs to a considerable amount. In the absence of a sound enabling legal frame work towards negotiability and de-materialisation of warehouse receipts and institutional structures for gradation, standardisation and certification the newly set up nation wide multi commodity exchanges are working around in solving these problems. This is done through accreditation of the warehouses by the Exchanges themselves and enforcing acceptability of their receipts through their byelaws and bringing in banks and financial institutions to formally enter into agreements in financing on the basis of such receipts as collateral. 5 The concept of value of trading is notional and has been worked out in terms of the volume of trading in any contract multiplied by the settlement price. Since volume of trading cannot be added up due to differential units of measurement, value of trading is the only way of making comparisons, though it is affected by the variations in prices and may give a false picture regarding the performance of a commodity exchange during times of declining prices. While the estimate of value of trading by the Forward Markets Commission is on the basis of one-way trade, exchanges normally take two-way trade and as such these figures would vary substantially. The Group on Forward and Futures Markets (2001) estimated that the contribution of the commodity exchanges was nominal at 1.2% of the GDP in 1999 which also would go up to 10% of the GDP by the year The current indications are that the markets would surpass these projections by many miles.

3 contract development and consolidation of trading activities into a few commodities and a few contracts by means of specialisation amongst exchanges. The CBOT-CME approach of trading in mutually exclusive contracts and developing niche in them despite being rivals for more than a century may be an ideal model for Indian exchanges rather than trying to do everything by all of them. In any case the forces of market will finally drive in the message of consolidation and specialisation. It is also interesting to note that the focus of some of the Exchanges is not on agro commodities, the traditional candidates for futures trading, but metals, surpassing even the efforts of century old specialised exchanges such as the London Metal Exchange 6. Further, the NMCEs are at the introspection stage of introducing new products such as commodity indices, weather futures etc., which unfortunately are not covered by the current definition of goods under the Forward Contracts (Regulation) Act, A number of reforms and initiatives are still needed in promoting India as a major futures trading hub in tune with her status of being amongst the top five producers of most of the commodities. In addition India is also a major consumer of bullion and energy products. A resurrected futures market ready to accelerate as a bullet train cannot run on the traditional tracks. Therefore, issues which would facilitate shifting the commodity futures markets on to a modern track are to be tackled on an urgent basis. The major stumbling block for the development of commodity futures markets in India is the fragmented physical/spot market. As is well known a national level derivatives markets cannot be founded on fragmented, localised cash markets. There are still several barriers to free movement of commodities in the form of physical restrictions (under the Essential Commodities Act, APMC Act, Licensing restrictions) and fiscal hurdles (differential taxes, stamp duties). Further, warehousing related issues such as the absence of quality, gradation, standardisation and certification facilities and transferability, negotiability and de-mating of warehouse receipts stifle the physical markets. The task of improving the spot market conditions is rather difficult as the list itself is daunting and comes under the mandate of various Ministries, Departments, Agencies as well as the State Governments. While considerable efforts are being directed towards improving physical market conditions particularly removing the barriers to trade by concerted efforts by the Central Government and various State Governments (a NDC Sub-Committee is also looking into the issue) the progress is slow and limited. As a substitute many are advocating, cash settlement in order to help leapfrog the commodity futures markets. However, in the absence of a well-trusted settlement price cash settlement is not an ideal way of going ahead. It would also divert focus of market intermediaries in bringing about value added services 8 for changing the frustrating physical market conditions. Another set of issues relate to the exchange structures and system of trading and clearing. Electronic vs. open out cry systems of trading is still a matter of debate though off late the world over electronic system is winning. However, continuation of the open out cry system along side the electronic one in leading futures exchanges such as the Chicago Board of Trade is still used as arguments to support the former, particularly in India where the propensity to change is rather low. While both the systems may have their own strengths, the advantages of modern technology in an increasingly integrating world cannot be compensated by traditional convenience. Similarly the Exchange structure, mutualised vs. demutualised, is also an area of debate with supporters of both the categories having strong arguments. While it has been found to be relatively easy to start a de-mutualised set up (the NSE and the NMCEs, for example) transition from mutualised structures to de- 6 While gold and silver contracts were commenced by the NMCE in September 03 both the other nation wide exchanges launched bullion contracts from the commencement of their operations i.e. October 03 by MCX and December 03 by NCDEX. Subsequently MCX started steel contracts within a few months of setting up the Exchange. The steel contract was on the business horizon of LME for the past 4 years and after considerable research and market survey LME has abandoned the idea of launching the same. Similarly NCDEX is about to launch plastics/polymer futures contracts shortly, which also has been on the agenda of the LME for quite some time. 7 One of the statutory limitations of commodity derivatives markets is the complete prohibition on commodity options. In addition the Forward Contracts (Regulation) Act does not recognise non-commodities or even near-commodities as goods defined as every kind of movable property other than auctionable claims, money and securities, is too restrictive to allow such instruments. 8 The debate on physical delivery vs. cash settlement particularly in commodity markets is an old one but still unsettled. While the advocates of physical delivery argues that the threat of delivery disciplines the market (and it is required in the case of commodities as it directly affect the lives of billions of people who are not even entering into the derivatives markets unlike the securities market where entering is optional). The protagonists of cash settlement argue that derivatives markets in any case are not for physical trade but for risk management. The limitations of the spot market can be overcome by means of cash settlement which would enhance liquidity and thereby making price discovery more meaningful. But even they admit that for cash settlement there is a need for obtaining well respected and trusted settlement prices. If there is an underlying with a highly fractured spot market, where good data is not available, it is difficult to construct a well respected settlement price (Report of the Task Force on Convergence, 2003).

4 mutualised structures is found to be far more complex 9 This is amplified by the recent Indian experience, both in the securities markets as well as in the commodity derivatives markets. The Government has announced its intention to integrate the securities and commodity derivates markets as stated in the Budget Speech ( ) of the Finance Minister. This under scores the importance of the commodity derivatives markets in the emerging scheme of things and the need for nurturing this sector for the overall benefit of the commodity economy within a proper regulatory environment. While convergence of markets may be an answer to some of the issues of regulation the need for strengthening the regulatory capability of the commodity derivatives side (even in a converged set up) has been well understood. Moreover, for effective regulation of markets, whether financial or physical, in the absence of a super regulator, an institutional structure of coordination among the various regulators will still be required. Since convergence of only commodities and securities markets are envisaged regulatory coordination with other regulators such as the RBI, IRDA and Department of Company Affairs continue to be relevant. Now that the commodity derivatives markets have not only been liberalised but has entered the convergence mode it is time to start thinking big. The limitations still haunting the commodity markets have to be removed to facilitate seamless integration of physical and futures markets as well as between the markets for physicals and financials. The ultimate objective of all these initiatives should be to reap the economies of scale and scope not only for its own sake but also to face the challenges thrown up by a borderless global market. The market participants and the regulator(s) have to brace themselves to face the challenges thrown up by the global developments of ever growing exchanges and integration of markets. 9 The central question pertains to the role of the members of a mutualised structure in the de-mutualised set up and sharing the accumulated assets of the Company.

5 EXCHANGEWISE VALUE OF TRADING ( & ) Annexure-1 Name of the Exchange 1.The India Pepper and Spice Trade Association, Kochi Value of Trading (In Rupees crores) The Ahmedabad Commodity Exchange, Ahmedabad 3.The Rajkot Seeds Oil& Bullion Merchants association Ltd., Rajkot 4.The Bombay Commodity Exchange Ltd., Mumbai 5.National Board of Trade, Indore 6.The Kanpur Commodity Exchange, Kanpur 7.East India Cotton Association, Mumbai 8.The Chamber of Commerce, Hapur 9. Vijai Beopar Chamber Ltd., Muzaffarnagar 10.Bhatinda Om Oil & Oilseed Exchange Ltd., Bhatinda 11. The Meerut Agro Commodites Exchange Co.Ltd., Meerut 12.The Rajdhani Oils and Oilseeds Exchange Ltd., Delhi 13.The Central India Commercial Exchange LTd., Gwalior 14.Coffee Futures Exchange India Ltd., Bangalore NTP

6 15.The East India Jute & Hessian Exchange Ltd., Calcutta 16.The Spice & Oilseeds Exchange Ltd., Sangli 17.The First Commodity of India Ltd., Kochi 18.The National Multi Commodity Exchange of India Ltd., Ahmedabad 19.E-sugar India Ltd., Mumbai 20.Surendernagar Cotton Oil and Oilseeds Association Ltd., Surendernagar 21.Bikaner Commodity Exchange Ltd., Bikaner 22.Multi Commodity Exchange of India Ltd., Mumbai 23.National Commodity and Derivative Exchange Ltd., Mumbai 5592 NT Haryana Commodities Ltd., Hissar Grand Total Source: Forward Markets Commission (FMC), Mumbai. Not operational NTP NT No trading permission No trading

7 Commodities in which futures trading is being currently undertaken 1. Kapas 2. Hessian 3. Indian Cotton A. SO6 L S Cotton Ahmedabad B. J34 M S Cotton Bhatinda 4. Staple Fibre Yarn 5. Sacking-A. Jute (B Twill-665 Gms) Kolkata 6. Gram-A. Gram (Chana) New Delhi Annexure II 7. Pepper Domestic-MG1 8. Turmeric 9. Pepper Domestic-500g/l 10. Black Pepper Int'l-MLS ASTA 11. Black Pepper Int'l-VB ASTA 12. Black pepper Int'l FAQ 13. Pepper A. Pepper Dommestic-MG1. B. Black Pepper Int'l VB ASTA. C. Black Pepper Int'l-MLS ASTA. D. Black Pepper Int'l FAQ. E. Pepper Dommestic-500g/L. F. Pepper - Kochi 14. Cardamom 15. RBD Pamolein A. RBD P'Olein - Kakinada 16. Groundnut Oil 17. Sunflower Oil 18. Rapeseed/Mustardseed A. Rapeseed - 42 B. Rape/Mustard seed - Jaipur 19. Rapeseed/Mustardseed Oil A. EXP R/M oil - Jaipur 20. Rapeseed/Mustardseed oil-cake 21. Soy bean A. Soy bean - Indore 22. Soy Meal 23. Soy Oil A. Ref Soya oil - Indore 24. Copra 25. CottonSeed 26. Safflower

8 27. Groundnut 28. Castor oil-int'l 29. Coconut oil 30. Copra cake 31. Groundnut oilcack 32. Cottonseed oil 33. Sesamum (Til or Jiljili) 34. Sesamum oil 35. Sesamum OilCake 36. Safflower OilCake 37. Rice Bran 38. Rice Bran Oil 39. Rice Bran OilCake 40. Safflower Oil 41. Saflower OilCake 42. Sunflower Seed 43. Crude Palm Oil A. Crude Palm oil - Kandla 44. Cottonseed - Oilcake 45. Vanaspati 46. Soybean Oilcake 47. Linseed 48. Linseed Oil 49. Linseed Oilcake 50. Coconut Oilcake 51. Gur 52. Coffee Plantation A 53. Potato 54. Sugar A. Sugar Grade M B. Sugar Grade S 55. Coffee Robusta Cherry AB 56. Raw Coffee Arbica Parchment 57. Raw Coffee Robusta Cherry 58. Castorseed A. Castorseed Castor-oil 60. Coffee A. Coffee-PlantationA B. Coffee-Robusta Cherry AB. C. Raw Coffee Robusta Cherry. D. Raw Coffee Arabica parchment 61. Guarseed A. Guarseed jodhpur 62. Castor oil Cake 63. Rubber A. Rubber Kottayam 64. Rice 65. Wheat

9 66. GaurGum 67. Aluminium Ingots 68. Nickel 69. Copper 70. Zinc 71. Lead 72. Tin 73. Gold A. Gold-Mini B. Pure Gold - Mumbai C. Kilo - Gold D. Pure Gold - Mumbai - 1 Kg 74. Silver A. Silver-Mini B. Pure Silver - New Delhi - 30 Kg (Mega) C. Pure Silver - New Delhi 75. Steel A. Steel - Long B. Steel Flat 76. Masoor 77. Urad 78. Tur/Arhar 79. Moong 80. Yellow Peas References 1. Govt. of India (1952) Forward Contracts (Regulation) Act, Govt. of India (1994) : Report of the Committee on Forward Markets, (Chairman, Kabra. K.N.) 3. Government of India (2001) : Report of the Group on Forward and Futures Markets (Chairman, Kalyan Raipuria) 4. Government of India (2003) : Report of the Task Force on Convergence of Securities and Commodity Derivatives Markets (Chairman, Wajahat Habibullah) 5. Govt. of India (2004): Economic Survey , Ministry of Finance 6. Naik, Gopal and Jain, S.K (1999) A Study on the Performance of Indian Commodity Futures Markets, Indian Institute of Management, Ahmedabad. 7. Nair, C.K.G. (2001a) : Market Dynamics and Regulatory Concerns. NSE News, June, Nair, C.K.G. (2001b) : Securities Market and Commodity Derivatives Market Rush vs. Slow Growth?, NSE News, December, Patil R.H. (2001) Financial Sector : Single v/s Multiple Regulators, Economic & Political Weekly, Nov 10, Raghuram Rajan and Ajay Shah (2003) : New Directions in Indian Financial sector Policy; A work undertaken under the aegis of a project by NCAER for Ministry of Finance. 11. Sahadevan K.G. (2002) : Derivatives and Price Risk Management; A Study of Agricultural Commodity Futures in India, Institute of Management, Lucknow 12. Thomas, Susan (2003) : Agricultural Commodity Markets in India; Policy Issues for Growth, Indira Gandhi Institute for Development Research, Mumbai.