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Commodity market {Third Year : Financial market 2012-2013}

Table of content

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SR. NO. PARTICULARS PAGE No.

1 Introduction of Commodity Market 1

2 Commodity Derivatives 20

3 commodity exchange in india 25

4 Commodity trading 28

7 Conclusion 47

8 biblography 48


Chapter 1 : Introduction Of Commodity Market

For the former, commodity is a largely homogeneous product, traded solely on the

basis of price, whereas for the latter, it refers to wares offered for exchange.

In the original and simplified sense, commodities were things of value, of uniform

quality, that were produced in large quantities by many different producers; the items

from each different producer are considered equivalent. It is the contract and this

underlying standard that define the commodity, not any quality inherent in the product.

One can reasonably say that food commodities, for example, are defined by the fact that

they substitute for each other in recipes, and that one can use the food without having to

look at it too closely.

At present, all goods and products of agricultural (including plantation), mineral

and fossil origin are allowed for futures trading under the auspices of the commodity

exchanges recognized under the FCRA. The national commodity exchanges have been

recognized by the Central Government for organizing trading in all permissible

commodities.

Definition of 'Commodity Market’ :

“A physical or virtual marketplace for buying, selling and trading raw or primary products. For investors' purposes there are currently about 50 major commodity markets worldwide that facilitate investment trade in nearly 100 primary commodities.”

Commodities are split into two types: hard and soft commodities. Hard commodities are typically natural resources that must be mined or extracted (gold, rubber, oil, etc.), whereas soft commodities are agricultural products or livestock (corn, wheat, coffee, sugar, soybeans, pork, etc.)

There are numerous ways to invest in commodities. An investor can purchase stock in corporations whose business relies on commodities prices, or purchase mutual funds, index funds or exchange-traded funds (etfs) that have a focus on commodities-related companies. The most direct way of investing in commodities is by buying into a futures contract.

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Commodity futures markets acquiesce bartering producers and bartering consumers to annual the accident of adverse approaching amount movements in the bolt that they are affairs or buying.

In adjustment to plan a futures arrangement accept to be standardised. They accept to accept a accepted admeasurement and grade, expire on a assertive date and accept a preset beat size. For example, blah futures trading at the Chicago Board of Barter are for 5000 bushels with a minimum beat admeasurement of 1/4cent/bushel ($12.50/contract).

An agriculturalist may accept a acreage of blah and in adjustment to barrier adjoin the achievability of blah prices bottomward afore the autumn he ability advertise blah futures. He has bound in the accepted price, if blah prices abatement he makes a accumulation from the futures affairs to annual the accident on the absolute corn. On the added hand, a customer such as Kellogg may buy blah futures in adjustment to assure adjoin a acceleration in the amount of corn.

In adjustment to facilitate a aqueous bazaar so that producers and consumers can advisedly buy and advertise affairs , exchanges animate speculators. The speculators cold is to accomplish a accumulation from demography on the accident of amount aberration that the bartering users do not want. The rewards for speculators can be absolute ample absolutely because there is a abundant accident of loss.

Characteristics of commodity :

In Marx's theory, a commodity has value, which represents a quantity of human labor.

The fact that it has value implies straightaway that people try to economise its use. A

commodity also has a use value, an exchange value and a price.

It has a use value because, by its intrinsic characteristics, it can satisfy some

human need or want, physical or ideal. By nature this is a social use value, i.e.

The object is useful not just to the producer but has a use for others generally.

It has an exchange value, meaning that a commodity can be traded for other

commodities, and thus gives its owner the benefit of others' labor (the labor done

to produce the purchased commodity).

Price is then the monetary expression of exchange-value (but exchange value

could also be expressed as a direct trading ratio between two commodities without

using money).

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Commodity Market In India :

The process of economic liberalization in India began in 1991. As part of this

process, several capital market reforms were carried out by the capital market regulator

Securities and Exchange Board of India. One such measure was to allow trading in

equities-based derivatives on stock exchanges in 2000. This step proved to be a shot in

the arm of the capital market and volumes soared within three years. The success of the

capital market reforms motivated the government and the Forward Market Commission

(the commodities market regulator) to kick off similar reforms in the commodities

market. Thus almost all the commodities were allowed to be traded in the futures market

from April 2003. To make trading in commodity futures more transparent and successful,

multi-commodity exchanges at national level were also conceived and these next

generation exchanges were allowed to start futures trading in commodities on-line.

Commodities exchanges have seen a surge in commodity futures volumes in the

last few years. This rise in volumes has been led by bullion (gold and silver) trading.

Today a whole lot of commodities are available for trading in futures and the list is

getting bigger by the day. No wonder then that the commodity futures market is being

viewed as a significant business segment by many– businessmen, investors, institutions,

brokers, banks etc.

Of course there are still millions of Indians who are not aware that commodities

other than gold and silver can also be traded in on commodity exchanges like equity.

Fewer still know that commodities can be traded on-line!

1) How trading started at commodity exchanges?

Most of the commodity exchanges of today were started in the late 19th century

and the early 20th century. To understand how the commodities market works in India,

we need to understand how it works outside India. That is because the ever-increasing

pressure on the other global markets to integrate with each other and with the US

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markets, and the liberalization process that started in our country in the early 90s

necessitate the study of global markets. Let us thus take a look at how it all began.

It all started in an American city called Chicago. In the 1840s, Chicago had

become a commercial centre with railroad and telegraph lines connecting it with the East.

Around the same time, the mccormick reaper was invented which eventually led to higher

wheat production. Farmers from the Midwest came to Chicago to sell their wheat to

dealers, who, in turn, shipped it all over the country.

The Midwest farmers brought their wheat to Chicago hoping to sell the same at a

good price. The city had few storage facilities and no established procedures either for

weighing grains or for grading the same. In short, the farmers were often at the mercy of

the dealers.

The year 1848 saw the opening of a central place where the farmers and dealers

could meet to deal in "spot" grain, i.e. To exchange cash for immediate delivery of wheat.

The futures contract, as we know it today, evolved as the farmers (sellers) and the

dealers (buyers) began to commit to future exchanges of grain for cash. For instance, a

farmer would agree with a dealer on a price to deliver to the latter 5,000 bushels of wheat

at the end of June. The bargain would suit both the parties. The farmer would know how

much he would be paid for his wheat while the dealer would know his costs in advance.

The two parties would even exchange a written contract to this effect along with perhaps

a small amount of money representing a "guarantee.”

Such contracts became common and were even used as collateral for bank loans.

They also began to change hands before the delivery date. If the dealer decided that he

did not want the wheat, he would sell the contract to someone who did. Or the farmer

who didn't want to deliver his wheat would pass his obligation to another farmer. The

price would go up and down, depending on what happened in the wheat market. In the

event of bad weather, the people who had contracted to sell wheat would hold more

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valuable contracts because the supply would be lower; if the harvest were bigger than

expected; the seller's contract would become less valuable. It wasn't long before people

who had no intention of ever buying or selling wheat began trading the contracts. They

were speculators, hoping to buy low and sell high or sell high and buy low.

This saw the birth of the first central exchange in 1848 in Chicago under the name

Chicago Board of Trade (CBOT). The emergence of the derivatives market as an

effective risk management tool in the 70s and the 80s resulted in the rapid creation of

new exchanges and the expansion of the old ones.

These old exchanges are located mainly in developed nations. However a few

were created in developing countries too. The Buenos Aires Grain Exchange in

Argentina, established in 1854, is one of the oldest in the world.

2) The concept of trading in commodity futures in India.

The first organized futures market in India was set up way back in 1875 in the

form of the Bombay Cotton Trade Association. However the Bombay Cotton Exchange

founded in 1893 was the first organized commodity exchange in India.

The Gujarati Vyapari Mandali in 1900 carried futures trading in oilseeds:

groundnut, castor seed and cotton. The Chamber of Commerce at Hapur set up in 1913

was the most notable futures exchanges for wheat. Futures trading in bullion began in

1920 in Bombay. In 1919 jute trading was conducted by the Calcutta Hessian Exchange.

But organized futures trading in raw jute began only in 1927 with the establishment of

the East Indian Jute Association.

Most of these exchanges traded in region-specific commodities and the lack of a

national level exchange that could offer multiple commodities at the same platform was

felt time and again. So about a couple of years back, at a time when 21 regional

exchanges in India were offering various commodities for trading the government came

out with the national commodity exchanges, similar to the BSE & NSE, to come up and

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let them deal in commodity derivatives in an electronic trading environment. These

exchanges are expected to offer a nation-wide anonymous, order driven, screen based

trading system for trading. The Forward Markets Commission (FMC) will regulate these

exchanges.

The history of organized commodity derivatives in India goes back to the nineteenth century when Cotton Trade Association started futures trading in 1875, about a decade after they started in Chicago. Over the time datives market developed in several commodities in India. Following Cotton, derivatives trading started in oilseed in Bombay (1900), raw jute and jute goods in Calcutta (1912), Wheat in Hapur (1913) and Bullion in Bombay (1920).

However many feared that derivatives fuelled unnecessary speculation and were detrimental to the healthy functioning of the market for the underlying commodities, resulting in to banning of commodity options trading and cash settlement of commodities futures after independence in 1952.

The parliament passed the Forward Contracts (Regulation) Act, 1952, which regulated contracts in Commodities all over the India. The act prohibited options trading in Goods along with cash settlement of forward trades, rendering a crushing blow to the commodity derivatives market. Under the act only those associations/exchanges, which are granted reorganization from the Government, are allowed to organize forward trading in regulated commodities. The act envisages three tire regulations:

(i) Exchange which organizes forward trading in commodities can regulate trading on day-to-day basis;

(ii) Forward Markets Commission provides regulatory oversight under the powers delegated to it by the central Government.

(iii) The Central Government- Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution- is the ultimate regulatory authority.

The commodities future market remained dismantled and remained dormant for about four decades until the new millennium when the Government, in a complete change in a policy, started actively encouraging commodity market. After Liberalization and Globalization in 1990, the Government set up a committee (1993) to examine the role of futures trading. The Committee (headed by Prof. K.N. Kabra) recommended allowing futures trading in 17 commodity groups. It also recommended strengthening Forward Markets Commission, and certain amendments to Forward Contracts (Regulation) Act 1952, particularly allowing option trading in goods and registration of brokers with Forward Markets Commission.

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The Government accepted most of these recommendations and futures’ trading was permitted in all recommended commodities. It is timely decision since internationally the commodity cycle is on upswing and the next decade being touched as the decade of Commodities. Commodity exchange in India plays an important role where the prices of any commodity are not fixed, in an organized way. Earlier only the buyer of produce and its seller in the market judged upon the prices. Others never had a say.

Today, commodity exchanges are purely speculative in nature. Before discovering the price, they reach to the producers, end-users, and even the retail investors, at a grassroots level. It brings a price transparency and risk management in the vital market. A big difference between a typical auction, where a single auctioneer announces the bids and the Exchange is that people are not only competing to buy but also to sell. By Exchange rules and by law, no one can bid under a higher bid, and no one can offer to sell higher than someone else’s lower offer. That keeps the market as efficient as possible, and keeps the traders on their toes to make sure no one gets the purchase or sale before they do.

Since 2002, the commodities future market in India has experienced an unexpected boom in terms of modern exchanges, number of commodities allowed for derivatives trading as well as the value of futures trading in commodities, which crossed $ 1 trillion mark in 2006. Since 1952 till 2002 commodity datives market was virtually non- existent, except some negligible activities on OTC basis.

In 2002-03, Prime Minister, Shri. A. B. Vajpayee, in his Independence Day address to the nation on 15th August 2002, demonstrated its commitment to revive the Indian agriculture sector and commodity futures markets. The GOI in that very year took two steps that gave a fillip to the commodity markets. The first one was setting up of nation wide multi commodity exchanges and the second one was expansion of list of commodities permitted for trading under (FC(R) A).

In India there are 25 recognized future exchanges, of which there are three national level multi-commodity exchanges. After a gap of almost three decades, Government of India has allowed forward transactions in commodities through Online Commodity Exchanges, a modification of traditional business known as Adhat and Vayda Vyapar to facilitate better risk coverage and delivery of commodities. The three exchanges are: National Commodity & Derivatives Exchange Limited (NCDEX) Mumbai, Multi Commodity Exchange of India Limited (MCX) Mumbai and National Multi-Commodity Exchange of India Limited (NMCEIL) Ahmedabad. There are other regional commodity exchanges situated in different parts of India.

Commodity market in India The commodity markets are emerging and growing at a great pace in India after the Stock markets. These commodity markets are specially made to meet the increasing needs of people and to supply them with everything under one roof. The main advantage of commodity market is that they provide every item that is a part of our daily requirements and is often needed can be provided at one place. For instance, these commodity markets have cements, chemicals, food items like grains, cereals and fruits etc, bullion, jute and other items mace from jute, iron and steel and

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other such items. These items are available and traded in these markets in India on daily basis and are easily accessible. The investors are especially trading interest in this type of trade because the goods are daily traded and supplied. The purchase and sale of these commodities is enabled by 4 national exchanges present in India which are as follows:

Consequently four commodity exchanges have been approved to commence

business in this regard. They are:

1. Multi Commodity Exchange (MCX) located at Mumbai

2. National Commodity and Derivatives Exchange Ltd (NCDEX) located at

Mumbai.

3. National Board of Trade (NBOT) located at Indore

4. National Multi Commodity Exchange (NMCE) located at Ahmedabad.

These National Exchanges provide a very vast opportunity for the trading purposes. There are over 2,000 brokers and 10,000 active traders along with 6,000 operating terminals. The commodity markets are running very successfully under them and it has been reported that on the very first year of its commencement, there was an annual turnover of Rs. 1400 Billion and this particular amount is expected to be crossed by over Rs.10,000 Billion in the near future. The success and promotion of these commodity markets in India is tremendous and is leading to remarkable progress. All the three National Exchanges are making changes and progressing with time. The MCX has set up centers for future commodity contracts in many areas like Ahmadabad, Mumbai and Delhi. The NCDEX has joined hands with the International Petroleum Exchange, London (IPE) in order to put together the name of Indian Energy Markets with other global markets. This is a remarkable step towards the success of these commodity markets. Along with these two, the MCX has made deal with the Chicago Climate Exchange to improve the global emission marketplace by trading in Carbon and Sulfur financial instruments. There are future plans of this company to join hands with the European Climate Exchange as well. There are many regulators like Forwards Markets Commission (FMC) which controls the functions and overall regulation of these commodity markets.

Advantages and disadvantages of investment in commodity market :

Most investors typically invest in stocks and bonds, while the raw material a bit ignored. However, commodities such as gold and silver may have certain advantages for the investor, such as offering protection in difficult economic times. Gold and silver for example, may offer protection against inflation. Simultaneously raw materials have certain disadvantages, such as the volatility of prices and reduced demand from economic weakness.

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Investors usually focus on more traditional investments such as stocks and bonds. Often investors are left a bit raw, because they do not know enough or because they do not feel confident. However, much more active materials have advantages for the investor and a nice return, think of precious metals like gold, silver and platinum.

Advantages

Materials offer a good protection for investors against inflation and economic uncertainty. Gold is generally considered the ultimate safe haven in times of crisis. Strings the gold price in 2010 is still the one record to another.

1) Leverage:commodity futures accomplish on margin, acceptation that to yield a position alone a atom of the absolute amount needs to be accessible in banknote in the trading account.

2) Commission Costs: It is a lot cheaper to buy/sell one futures arrangement than to buy/sell the basal instrument. For example, one abounding admeasurement S&P500 arrangement is currently account in balance off $250,000 and could be bought/sold for as little as $20. The amount of buying/selling $250,000 could be $2,500+.

3) Liquidity: The captivation of speculators agency that futures affairs are analytic liquid. However, how aqueous depends on the absolute arrangement getting traded. Electronically traded contracts, such as the e-mini’s tend to be the a lot of aqueous admitting the pit traded bolt like corn, orange abstract etc are not so readily accessible to the retail banker and are added big-ticket to barter in agreement of agency and spread.

4) Ability to go short: Futures affairs can be awash as calmly as they are bought enabling a charlatan to accumulation from falling markets as able-bodied as ascent ones. There is no ‘uptick rule’ for archetype like there is with stocks.

5) No ‘Time Decay’: Options ache from time adulteration because the afterpiece they appear to accomplishment the beneath time there is for the advantage to appear into the money. Commodity futures do not ache from this as they are not anticipating a accurate bang amount at expiry.

6) Protection against inflation: When the economy is less, governments often have additional print money to stimulate the economy. Money is worth less and inflation occurs. If more money is reprinted, the amount of money invested in commodities is getting bigger. Demand for commodities is therefore greater so the price of raw materials will enter the height.

7) Part of a diversified investment portfolio: Commodities are often viewed as an essential component of a diversified investment portfolio. If you have stocks and bonds in your investment portfolio are recorded, it is advantageous to simultaneously possess raw materials. If the stock market crash, then you have not put all eggs in one basket. Often,

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the values of commodities such as gold and silver as the shares on the stock market go down.

8) Economic growth of emerging countries: The economic growth of emerging countries such as China, India and Brazil, demand for raw materials increased significantly. Growing economies have so many raw materials needed to make products and to boost the pace of the industry by up to date. The stronger the economy grows, the greater the demand for commodities. The greater demand, higher prices are likely to evolve.

Disadvantages

The downside to investing in commodities is quite a volatile commodity character, ie the values quite rapidly go up and down. The value of raw materials are therefore subject to price increases and price decreases rather giving you a short time as an investor can lose money fast.

1) Leverage: Can be a bifold belted sword. Low allowance requirements can animate poor money management, arch to boundless accident taking. Not alone are profits added but so are losses!

2) Speed of trading: Traditionally bolt are pit traded and in adjustment to barter a charlatan would charge to acquaintance a agent by blast to abode the adjustment who again transmits that adjustment to the pit to be executed. Once the barter is abounding the pit banker informs the agent who again again informs his client. This can yield some yield and the accident of slippage occurring can be high. Online futures trading can advice to abate this time by accouterment the applicant with a absolute hotlink to an cyberbanking exchange.

3) Safety of raw materials: Commodities are a physical investment and therefore require special treatment. Raw materials must be stored in a proper way, just think of storing physical gold bars in a vault. Moreover, you also provide a robust security of your investment, thus providing cost may entail.

4) Drop in prices economic weakness: What materials can be an advantage if the economy picks up is again a potential downside if the economy weakens. The weaker the economy, the less will be demand for some commodities such as oil. As a result, the price of the commodities could fall earlier.

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3) Global commodities derivatives exchanges

Globally commodities derivatives exchanges have existed for a long time. Table

below gives a list of commodities exchanges across the world. The CBOT and CME are

two of the oldest derivatives.

Chicago Board of Trade :

Chicago Board of Trade was established in 1948 and has trading in agricultural

produce, interests, Dow, metals and US treasuries. Soya complex, wheat and corn prices

across the world are referenced here. It has both electronic as well as open cry. It trades

both in futures as well as options. In 2005 it became a public traded NYSE listed

company.

New York Board of Trade (NYBOT) :

New York Board of Trade (NYBOT) is the world's largest commodities exchange

for Coffee, Sugar, Cotton and Frozen Concentrated Orange Juice. The exchange was

founded as the New York Cotton Exchange in 1870. NYBOT also facilitates trades in

foreign currencies and derivative indices for equities.

Kansas Board of Trade :

Kansas Board of Trade in US specializes in hard red winter wheat. Hard winter

wheat constitutes the maximum of US production. This exchange is benchmark for bread

wheat prices.

New York Mercantile Exchange (NYMEX)

New York Mercantile Exchange in its current form was created in 1994 by the

merger of the former New York Mercantile Exchange and the Commodity Exchange of

New York (COMEX). Together they represent one of world's largest exchange for

precious metals and energy.

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Tokyo Commodity Exchange (TOCOM)

Tokyo Commodity Exchange (TOCOM) is the largest exchange in Japan and

second largest commodity exchange in the world for futures and options. Crude oil,

gasoline, kerosene, gas oil, gold, silver, aluminium, platinum and rubber are the

commodities that are actively traded.

Shanghai Futures Exchange

Shanghai Futures Exchange is one of biggest exchange for copper price

determination. It also deals in aluminium, fuel oil, rubber, etc.

Sydney Futures Exchange

Sydney Futures Exchange deals in interest rates, equities, currencies and commodities.

Wool and cattle futures is its specialty.

London International Financial Futures and Options Exchange (LIFFE)

London International Financial Futures and Options Exchange (LIFFE) also know

as Euro next. Among actively commodities trades are cocoa, robusta coffee, corn, potato,

rapeseed, sugar and wheat. Robusta coffee prices are determined through this exchange.

National Multi-Commodity Exchange in India (NMCE)

National Multi-Commodity Exchange in India (NMCE) was first to get national

status in India. It is promoted by commodity relevant institutions like CWC (Central

Warehousing Corporation), NAFED (National Agricultural Co-operative Marketing

Federation of India, PNB and other.

National Commodity and Derivatives Exchange (NCDEX)

National Commodity and Derivatives Exchange (NCDEX). Pulses like

chana,urad,tur are most actively traded here. Other commodities like jeera, pepper,

mentha oil , guar and wheat,etc are actively traded.

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Multi Commodity Exchange of India Limited (MCX)

Multi Commodity Exchange of India Limited (MCX). Formed in Nov 10,

2003.The exchange has developed its reputation for trading in bullion, crude oil and

mentha oil.

Dubai Gold & Commodity Exchange (DGCX)

Dubai Gold & Commodity Exchange (DGCX) was formed in Dubai. It is

developed jointly by Dubai government as well as MCX and FTIL. At the moment it is

trading in Gold but plans to trade in others also. Dubai has an advantage of its location of

serving all time zones.

Dubai Mercantile Exchange (DME)

Dubai Mercantile Exchange (DME) is a joint venture between Dubai holding and

the New York Mercantile Exchange (NYMEX). It is still to be launched and is likely to

be an active exchange for oil futures as it is in the centre of oil producing nations.

Evolution of the commodity market in India

Bombay Cotton Trade Association Ltd., set up in 1875, was the first organized futures

market. Bombay Cotton Exchange Ltd. Was established in 1893 following the

widespread discontent amongst leading cotton mill owners and merchants over

functioning of Bombay Cotton Trade Association. The Futures trading in oilseeds started

in 1900 with the establishment of the Gujarati Vyapari Mandali, which carried on futures

trading in groundnut, castor seed and cotton. A future trading in wheat was existent at

several places in Punjab and Uttar Pradesh. But the most notable futures exchange for

wheat was chamber of commerce at Hapur set up in 1913. Futures trading in bullion

began in Mumbai in 1920. Calcutta Hessian Exchange Ltd. Was established in 1919 for

futures trading in raw jute and jute goods. But organised futures trading in raw jute began

only in 1927 with the establishment of East Indian Jute Association Ltd. These two

associations amalgamated in 1945 to form the East India Jute & Hessian Ltd. To conduct

organised trading in both Raw Jute and Jute goods. Forward Contracts (Regulation) Act

was enacted in 1952 and the Forwards Markets Commission (FMC) was established in

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1953 under the Ministry of Consumer Affairs and Public Distribution. In due course,

several other exchanges were created in the country to trade in diverse commodities.

The Kabra committee report

After the introduction of economic reforms since June 1991 and the consequent gradual

trade and industry liberalization in both the domestic and external sectors, the

Government of India appointed in June 1993 a committee on Forward Markets under

chairmanship of Prof. K.N. Kabra. The committee was setup with the following

objectives:

1. To assess

(a) The working of the commodity exchanges and their trading practices in India and to

make suitable recommendations with a view to making them compitable with those of

other countries.

(b) The role of the Forward Markets Commission and to make suitable recommendations

with a view to making it compatible with similar regulatory agencies in other countries so

as to see how effectively these agencies can cope up with the reality of the fast changing

economic scenario.

2. To review the role that forward trading has played in the Indian commodity

markets during the last 10 years.

3. To examine the extent to which forward trading has special role to play in

promoting exports.

4. To suggest amendments to the Forward Contracts Regulation) Act, in the light of

the recommendations, particularly with a view to effective enforcement of the Act

to check illegal forward trading when such trading is prohibited under the Act.

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5. To suggest measures to ensure that forward trading in the commodities in which it

is allowed to be operative remains constructive and helps in maintaining prices

within reasonable limits.

6. To assess the role that forward trading can play in marketing/ distribution system

in the commodities in which forward trading is possible, particularly in

commodities in which resumption of forward trading is generally demanded.

The committee submitted its report in September 1994. The recommendations of the

committee were as follows:

The Forward Markets Commission (FMC) and the Forward Contracts

(Regulation) Act, 1952, would need to be strengthened. Due to the inadequate

infrastructural facilities such as space and telecommunication facilities the

commodities exchanges were not able to function effectively. Enlisting more

members, ensuring capital adequacy norms and encouraging computerisation

would enable these exchanges to place themselves on a better footing.

In-built devices in commodity exchanges such as the vigilance committee and the

panels of surveyors and arbitrators be strengthened further.

The FMC which regulates forward/ futures trading in the country should continue

to act a watch.dog and continue to monitor the activities and operations of the

commodity exchanges. Amendments to the rules, regulations and bye-laws of the

commodity exchanges should require the approval of the FMC only.

In the context of globalisation, commodity markets in India could not function

effectively in an isolated manner. Therefore, some of the commodity exchanges,

particularly the ones dealing in pepper and castor seed, be upgraded to the level of

international futures markets.

The majority of the committee recommended that futures trading be introduced in

the following commodities:

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1. Basmati rice

2. Cotton and kapas

3. Raw jute and jute goods

4. Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed,

safflower seed, copra and soybean, and oils and oilcakes of all of them.

5. Rice bran oil

6. Castor oil and its oilcake

7. Linseed

8. Silver

9. Onions

The liberalised policy being followed by the government of India and the gradual

withdrawal of the procurement and distribution channel necessitated setting in place a

market mechanism to perform the economic functions of price discovery and risk

management.

The national agriculture policy announced in July 2000 and the announcements in

the budget speech for 2002.2003 were indicative of the governments resolve to put in

place a mechanism of futures trade/market. As a follow up, the government issued

notifications on 1.4.2003 permitting futures trading in the commodities, with the issue of

these notifications futures trading is not prohibited in any commodity. An option trading

in commodity is, however presently prohibited.

Table: 3 Registered commodity exchanges in IndiaExchange Product tradedBhatinda Om & Oil Exchange Ltd. Gur

The Bombay Commodity Exchange Ltd. Sunflower oilCotton (Seed and oil)Safflower (Seed, oil and oil cake)Groundnut (Nut and oil)Castor oil, Castor seedSesamum (Oil and oilcake)Rice bran, rice bran oil and oilcakeCrude palm oil

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The Rajkot Seeds oil & Bullion MerchantsAssociation

Groundnut oilCastor seed

The Kanpur Commodity Exchange Ltd. Rapeseed/ Mustardseed oil and cake

The Meerut Agro Commodities Exchange Co. Ltd.

Gur

The Spices and Oilseeds Exchange Ltd. Sangli TurmericAhmedabad Commodities Exchange Ltd. Cottonseed, CastorseedVijay Beopar Chamber Ltd., Muzaffarnagar GurIndia Pepper & Spice Trade Association, Kochi Pepper Domestic-MG1Rajdhani Oils and Oilseeds Exchange Ltd., Delhi

Gur, Rapeseed/ MustardseedSugar Grade-M

National Board of Trade, Indore Rapeseed/ Mustard seed/ Oil/ CakeSoybean/ Meal/ Oil, Crude Palm Oil

The Chamber of Commerce, Hapur Gur, Rapeseed/ MustardseedThe East India Cotton Association, Mumbai Indian CottonThe Central India Commercial Exchange Ltd., Gwaliar

Gur, Rapeseed/Mustardseed

The East India Jute & Hessian Exchange Ltd., Kolkata

Hessian, Sacking

First Commodity Exchange of India Ltd., Kochi

Copra, Coconut oil & Copra cake

The Coffee Futures Exchange India Ltd., Bangalore

Coffee

National Multi Commodity Exchange ofIndia Limited, Ahmedabad

Gur, RBD Pamolein, Groundnut Oil, Sunflower Oil, Rapeseed/Mustardseed, Rapeseed/Mustardseed Oil, Rapeseed/Mustardseed oil-Cake, Soy bean, Soy Oil, Copra, cottonseed, Safflower, Groundnut, Sugar, Sacking, Coffee-Robusta Cherry AB, Coconut oil, Castorseed, Castor-oil, Groundnut oilcack, Cottonseed oil, Sesamum oil, Sesamum oilcake, Safflower oilcake, Rice Bran Oil, Safflower Oil, Sanflower oilcake, Sunflower Seed, Pepper, Crude Palm Oil, Guarseed, castoroil Cake, Cottonseed – Oilcake,

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Aluminium Ingots, Nickel, Vanaspati, Soybean Oilcake, Rubber, Copper, Zinc, Lead, Tin, Linseed, Linseed Oil, Linseed Oilcake, Coconut Oilcake, Gold, Silver, Rice, Wheat, Cardamom, Kilo – Gold, Masoor, Urad, Tur / Arhar, Moong, guargum, Rapeseed – 42, Raw Jute, Coffee-Arabica Plantation A, Chana, Sugar (S-30), CUMINSEED, ISABGULSEED

National Commodity & Derivatives Exchange Limited

Soy Bean, Refined Soy OilMustard SeedExpeller Mustard Oil, RBD Palmolein, Crude Palm Oil,Medium Staple Cotton, Long Staple Cotton, Gold, Silver, Rubber – Kottayam, Pepper – Kochi, Turmeric – Nizamabad, Urad – Mumbai, Mild Steel Ingots – Ghaziabad, Cashews W-320-Kollam, Cotton Seed Oilcake – Akola, Cotton Long Kadi, Arabica Coffee - Hassan (New), Chilli (Paala) LCA 334, Robusta Coffee - Kushalnagar (New)

Bikaner Commodity Exchange Ltd.,Bikaner Guarseed, GramEsugarindia Limited Sugar Grade – M, Sugar

Grade – S

Multi Commodity Exchange of India Ltd. RBD Pamolein, Groundnut Oil, Rapeseed/Mustardseed Oil, Pepper Domestic-MG1, Soy bean, Coconut oil, Castorseed, Castor-oil, Guarseed, Aluminium Ingots, Rubber, Copper, Zinc, Coconut Oilcake, Gram, Sugar Grade – M, Gold, Silver, Gold-M, Rice, Wheat, Ref Soya oil – Indore, Cardamom, Masoor, Urad,

18


Tur / Arhar, guargum, Silver-M, Steel – Flat, Yellow Peas, Long Staple Cotton, Medium Stapple Cotton, Mustard Seed, Red Chilly, Maize, CASHEW KERNEL W320, Basmati Rice, Jeera, Crude Oil, Sarbati Rice, Sesame Seed ( Natural 99.1), Mentha Oil, sponge iron, HIGH DENSITY POL, KAPASKHALI, PPTQ, POTATO, Middle east crude oil, refined sunflower oil

The Meerut Agro Commodities Exchange Co.

Ltd., Meerut

Gur

Chapter 2 : Commodity Derivatives

Derivatives as a tool for managing risk first originated in the commodities markets.

They were then found useful as a hedging tool in financial markets as well. In India,

trading in commodity futures has been in existence from the nineteenth century with

organized trading in cotton through the establishment of Cotton Trade Association in

1875. Over a period of time, other commodities were permitted to be traded in futures

exchanges. Regulatory constraints in 1960s resulted in virtual dismantling of the

commodities future markets. It is only in the last decade that commodity future

19


exchanges have been actively encouraged. However, the markets have been thin with

poor liquidity and have not grown to any significant level. In this chapter we look at how

commodity derivatives differ from financial derivatives. We also have a brief look at the

global commodity markets and the commodity markets that exist in India.

1. Difference between commodity and financial derivatives

The basic concept of a derivative contract remains the same whether the underlying

happens to be a commodity or a financial asset. However there are some features which

are very peculiar 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 warehousing. Similarly, the concept of varying quality of asset does not really exist as

far as financial underlings are concerned. However in the case of commodities, the

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

issue to be managed. We have a brief look at these issues.

2. Physical settlement

Physical settlement involves the physical delivery of the underlying commodity,

typically at an accredited warehouse. The seller intending to make delivery would have to

take the commodities to the designated warehouse and the buyer intending to take

delivery would have to go to the designated warehouse and pick up the commodity. This

may sound simple, but the physical settlement of commodities is a complex process. The

issues faced in physical settlement are enormous. There are limits on storage facilities in

different states. There are restrictions on interstate movement of commodities. Besides

state level octroi and duties have an impact on the cost of movement of goods across

locations. The process of taking physical delivery in commodities is quite different from

the process of taking physical delivery in financial assets. We take a general overview at

the process flow of physical settlement of commodities. Later on we will look into details

of how physical settlement happens on the NMCE.

20


Delivery notice period :

Unlike in the case of equity futures, typically a seller of commodity futures has

the option to give notice of delivery. This option is given during a period identified as

`delivery notice period'. Such contracts are then assigned to a buyer, in a manner similar

to the assignments to a seller in an options market. However what is interesting and

different from a typical options exercise is that in the commodities market, both positions

can still be closed out before expiry of the contract. The intention of this notice is to

allow verification of delivery and to give adequate notice to the buyer of a possible

requirement to take delivery. These are required by virtue of the fact that the actual

physical settlement of commodities requires preparation from both delivering and

receiving members.

Typically, in all commodity exchanges, delivery notice is required to be supported

by a warehouse receipt. The warehouse receipt is the proof for the quantity and quality of

commodities being delivered. Some exchanges have certified laboratories for verifying

the quality of goods. In these exchanges the seller has to produce a verification report

from these laboratories along with delivery notice. Some exchanges like LIFFE, accept

warehouse receipts as quality verification documents while others like BMF-Brazil have

independent grading and classification agency to verify the quality.

In the case of BMF-Brazil a seller typically has to submit the following documents:

A declaration verifying that the asset is free of any and all charges, including

financial debts related to the stored goods.

A provisional delivery order of the good to BM&F (Brazil), issued by the

warehouse.

A warehouse certificate showing that storage and regular insurance have been

paid.

Assignment :

Whenever delivery notices are given by the seller, the clearing house of the

exchange identifies the buyer to whom this notice may be assigned. Exchanges follow

21


different practices for the assignment process. One approach is to display the delivery

notice and allow buyers wishing to take delivery to bid for taking delivery. Among the

international exchanges, BMF, CBOT and CME display delivery notices. Alternatively,

the clearing houses may assign deliveries to

Buyers on some basis. Exchanges such as COMMEX and the Indian commodities

exchanges have adopted this method.

Any seller/ buyer who has given intention to deliver/ been assigned a delivery has

an option to square off positions till the market close of the day of delivery notice. After

the close of trading, exchanges assign the delivery intentions to open long positions.

Assignment is done typically either on random basis or first-in-first out basis. In some

exchanges (CME), the buyer has the option to give his preference for delivery location.

The clearing house decides on the daily delivery order rate at which delivery will

be settled. Delivery rate depends on the spot rate of the underlying adjusted for discount/

premium for quality and freight costs. The discount/ premium for quality and freight

costs are published by the clearing house before introduction of the contract. The most

active spot market is normally taken as the benchmark for deciding spot prices.

Alternatively, the delivery rate is determined

Based on the previous day closing rate for the contract or the closing rate for the day.

Delivery :

After the assignment process, clearing house/ exchange issues a delivery order to

the buyer. The exchange also informs the respective warehouse about the identity of the

buyer. The buyer is required to deposit a certain percentage of the contract amount with

the clearing house as margin against the warehouse receipt.

The period available for the buyer to take physical delivery is stipulated by the exchange.

Buyer or his authorized representative in the presence of seller or his representative takes

the physical stocks against the delivery order. Proof of physical delivery having been

effected is forwarded by the seller to the clearing house and the invoice amount is

credited to the seller's account.

22


In India if a seller does not give notice of delivery then at the expiry of the contract

the positions are cash settled by price difference exactly as in cash settled equity futures

contracts.

3. Warehousing :

One of the main differences between financial and a commodity derivative is the need

for warehousing. In case of most exchange-traded financial derivatives, all the positions

are cash settled. Cash settlement involves paying up the difference in prices between the

time the contract was entered into and the time the contract was closed. For instance, if a

trader buys futures on a stock at Rs.100 and on the day of expiration, the futures on that

stock close Rs.120, he does not really have to buy the underlying stock. All he does is

take the difference of Rs.20 in cash. Similarly the person, who sold this futures contract

at Rs.100, does not have to deliver the underlying stock. All he has to do is pay up the

loss of Rs.20 in cash.

In case of commodity derivatives however, there is a possibility of physical

settlement. This means that if the seller chooses to hand over the commodity instead of

the difference in cash, the buyer must take physical delivery of the underlying asset. This

requires the exchange to make an arrangement with warehouses to handle the settlements.

The efficacy of the commodities settlements depends on the warehousing system

available. Most international commodity exchanges used certified warehouses (CWH) for

the purpose of handling physical settlements. Such CWH are required to provide storage

facilities for participants in the commodities markets and to certify the quantity and

quality of the underlying commodity. The advantage of this system is that a warehouse

receipt becomes a good collateral, not just for settlement of exchange trades but also for

other purposes too. In India, the warehousing system is not as efficient as it is in some of

the other developed markets. Central and state government controlled warehouses are the

major providers of agri-produce storage facilities. Apart from these, there are a few

private warehousing being maintained. However there is no clear regulatory oversight of

warehousing services.

23


4. Quality of underlying assets

A derivatives contract is written on a given underlying. Variance in quality is not an

issue in case of financial derivatives as the physical attribute is missing. When the

underlying asset is a commodity, the quality of the underlying asset is of prime

importance. There may be quite some variation in the quality of what is available in the

marketplace. When the asset is specified, it is therefore important that the exchange

stipulate the grade or grades of the commodity that are acceptable. Commodity

derivatives demand good standards and quality assurance/ certification procedures. A

good grading system allows commodities to be traded by specification.

Currently there are various agencies that are responsible for specifying grades for

commodities. For example, the Bureau of Indian Standards (BIS) under Ministry of

Consumer Affairs specifies standards for processed agricultural commodities whereas

AGMARK under the department of rural development under Ministry of Agriculture is

responsible for promulgating standards for basic agricultural commodities. Apart from

these, there are other agencies like EIA, which specify standards for export oriented

commodities.

Chapter 3 : Commodity Exchange In India

NATIONAL COMMODITY & DERIVATIVES EXCHANGE (NCDEX)

NCDEX is committed to provide a world-class commodity exchange platform

for market participants to trade in a wide spectrum of commodity derivatives driven by

best global practices, technology, professionalism and transparency.

24


National Commodity & Derivatives Exchange Limited (NCDEX) is a

professionally managed on-line multi commodity exchange promoted by ICICI Bank

Limited (ICICI Bank), Life Insurance Corporation of India (LIC), National Bank for

Agriculture and Rural Development (NABARD) and National Stock Exchange of India

Limited (NSE). Canara Bank (PNB), CRISIL Limited (formerly the Credit Rating

Information Services of India Limited), Goldman Sachs, Indian Farmers Fertiliser

Cooperative Limited (IFFCO) and Punjab National Bank by subscribing to the equity

shares have joined the initial promoters as shareholders of the Exchange. NCDEX is the

only commodity exchange in the country promoted by national level institutions. This

unique parentage enables it to offer a bouquet of benefits, which are currently in short

supply in the commodity markets. The institutional promoters and shareholders of

NCDEX are prominent players in their respective fields and bring with them institutional

building experience, trust, nationwide reach, technology and risk management skills.

NCDEX is a public limited company incorporated on April 23, 2003 under the

Companies Act, 1956. It obtained its Certificate for Commencement of Business on May

9, 2003. It commenced its operations on December 15, 2003.

NCDEX is a nation-level, technology driven de-mutualised on-line commodity

exchange with an independent Board of Directors and professional management – both

not having any vested interest in commodity markets. It is committed to provide a world-

class commodity exchange platform for market participants to trade in a wide spectrum

of commodity derivatives driven by best global practices, professionalism and

transparency.

NCDEX is regulated by Forward Markets Commission. NCDEX is subjected to

various laws of the land like the Forward Contracts (Regulation) Act, Companies Act,

Stamp Act, Contract Act and various other legislations.

NCDEX is located in Mumbai and offers facilities to its members about 550

centres throughout India. The reach will gradually be expanded to more centres.

NCDEX currently facilitates trading of 57 commodities.

25


MULTI COMMODITY EXCHANGE OF INDIA (MCX)

MCX is an independent and de-mutulised multi commodity exchange. It was

inaugurated on November 10, 2003 by Mr. Mukesh Ambani, Chairman and Managing

Director, Reliance Industries Ltd.; and has permanent recognition from the Government

of India for facilitating online trading, clearing and settlement operations for commodities

futures market across the country. Today, MCX features amongst the world's top three

bullion exchanges and top four energy exchanges. MCX offers a wide spectrum of

opportunities to a large cross section of participants including producers/ processors,

traders, corporate, regional trading centre, importers, exporters, co-operatives and

industry associations amongst others. Headquartered in the financial capital of India,

Mumbai, MCX is led by an expert management team with deep domain knowledge of the

commodities futures market. Presently, the average daily turnover of MCX is around

USD1.55 bn (Rs.7,000 crore - April 2006), with a record peak turnover of USD3.98 bn

(Rs.17,987 crore) on April 20, 2006. In the first calendar quarter of 2006, MCX holds

more than 55% market share of the total trading volume of all the domestic commodity

exchanges. The exchange has also affected large deliveries in domestic commodities,

signifying the efficiency of price discovery. Being a nation-wide commodity exchange

having state-of-the-art infrastructure, offering multiple commodities for trading with wide

reach and penetration, MCX is well placed to tap the vast potential poised by the

commodities market.

Financial Technologies (I) Ltd., State Bank of India and it's associates, National

Bank for Agriculture and Rural Development (NABARD), National Stock Exchange of

India Ltd. (NSE), Fid Fund (Mauritius) Ltd. - an affiliate of Fidelity International,

Corporation Bank, Union Bank of India, Canara Bank, Bank of India, Bank of Baroda ,

HDFC Bank and SBI Life Insurance Co. Ltd.

National Multi Commodity Exchange of India Ltd, Ahmedabad (NMCE)

National Board Of Trade, Indore

26


Chapter 4 : Commodity Trading

In this chapter we shall take a brief look at the trading system for futures on

NMCE. However, the best way to get a feel of the trading system is to actually watch the

screen and observe how it operates.

1. TYPES OF MARKETS

Trading Markets

Ready Delivery Market

Specific Delivery Market

Future Market

27


Auction Market

I. Ready Delivery Market

Cash Trades :

Cash Trades are done for one hour in the day and are settled the same day. The

Seller has to deliver the warehouse receipt and Buyer has to make payment before the

closure of the banking hours. On receipt of payment from the Buyer, Clearing House will

release and endorse the warehouse receipt in favor of the Buyer. All the trades are settled

individually on trade for trade basis.

Spot Trades :

Spot Trades done for two hours in the day are settled on the third day from the

date of transaction. The settlement is done on T+2 day i.e. Trade done on Monday will be

settled on Wednesday. The Seller has to deliver the warehouse receipt and Buyer has to

make payment before the closure of the banking hours on the third working day. On

receipt of payment from the Buyer, Clearing House will release and endorse the

warehouse receipt in favour of the Buyer. All the trades are settled individually on trade-

for-trade basis.

Weekly Trades :

Trades for weekly settlements are done during the prescribed hours in the day are

settled on the fifth day from the date of transaction. The settlement is done on T+5 rolling

day i.e. Trade done on Monday will be settled on next Monday. The Seller has to deliver

the warehouse receipt and Buyer has to make payment before the closure of the banking

hours on the fifth working day. On receipt of payment from the Buyer, Clearing House

will release endorse the warehouse receipt in favour of the Buyer. All the trades are

settled individually on trade-for-trade basis. The transactions are not netted for the

purpose of settlement.

28


II. Specific Delivery Market

Features of Specific Delivery Contracts are:

These contracts will have delivery obligation maturing beyond a period of 11 days

The terms of delivery of commodities may vary from trade to trade as decided by the

contracting parties at the time of entering into transaction. Such specific terms could be

related to delivery date, delivery center, quality of commodity, pricing basis (FOB, CIF),

payment terms etc.

The transactions are not done on anonymous basis i.e. Transactions are done

knowing the counter party.

Both the parties to trade enter into transactions after knowing the terms of contract, which

may vary from trade to trade. However, there are standard definitions for various terms of

contracts.

Exchange will monitor performance of these contracts and if required, impose

mark to market margins on the open, unsettled contracts depending upon the volatility in

the commodity.

All the members entitled to trade in a commodity will be allowed to trade in these

Specific Delivery markets.

III. Futures Market

The Futures Market is primarily intended for Hedging and Speculation. Contracts

in Futures Market results mostly in Cash Settlement and do not frequently result in

delivery. The Clearing House guarantees trades executed on the exchange. Contracts that

are not closed out and are due for delivery will be delivered and settled through the

warehouse receipts. NMCEIL is having 12 delivery month contracts as separate contracts

for each commodity being traded at NMCEIL. All contracts are settled on daily basis at

the daily settlement price till the final delivery of commodity on the expiry date.

Futures market consists of various book types wherein orders are segregated as Regular

lot orders, Special Term orders, Negotiated Trade Entries and Stop Loss orders

29


depending on their order attributes. All orders have to be of regular lot size or multiples

thereof.

IV. Auction Market

Auction Market is used by the Exchange to close out the positions of the members

who have failed to pay-in their obligations. In the Auction market, the trading member

can participate in the auctions initiated by the Exchange only. The counter orders can be

entered only during Auction period.

2. FUTURES TRADING SYSTEM

Benefits of futures market, viz., price discovery and price risk management flow

more easily from an Order-driven system rather than Quote-driven system. NMCE

follows the former system. NMCE does not support any market maker. Traders submit

orders and the incoming orders are matched against the existing orders in the order book.

Transactions are cleared and settled through NMCE’s in-house Clearing and Settlement

House, which is connected to all its Members and the Clearing Banks. Delivery of the

underlying commodities is permitted only through a Central Warehousing Corporation

(CWC) receipt, which meets highest contemporary international standards. Anonymity of

trading participants and effective risk management system strengthens the trust of the

participants in the trading system, which is a precondition for enhancing breadth and

depth of the market.

3. ENTITIES IN THE TRADING SYSTEM

Trading rights on the Exchange can be acquired by Individuals, Registered Firms,

Corporate bodies and Companies (as defined in the Companies Act 1956) by complying

with the admission norms. Membership of the Exchange follows a hierarchy, and each

level is characterized by a definitive role and incumbent privileges and obligations.

I. Trading Cum Clearing Member (TCM):

30


Is one who has the right to execute transactions in addition to a right to clear its

transactions in contracts executed at NMCE either on his own behalf or on behalf of other

Trading Members.

II. Trading Member/Broker (TM):

Is one who has the right to execute transactions in the trading system of the

exchange and the right to have contracts in his own name. The TM can also deal on

behalf of clients (Registered Non Members) or enlist Sub Brokers who may in turn have

their own set of clients. TM must settle all his transactions (and those of Sub Brokers and

Registered Non Member) through Clearing Members (Trading cum Clearing Members or

Institutional Clearing Members).

III. Institutional Clearing Members (icms):

Are professional entities providing clearing services to their institutional clients

(viz. Trading Members and their Sub Brokers & Registered Non Members). They

however do not have the right to trade on their own account.

IV. Introducing Broker/Sub Broker:

Is a Registered member of the NMCEIL who has the right to execute transaction

in the trading system of the exchange only through a TM/TCM. Sub-Brokers will settle

the transactions of clients introduced by them, through Brokers, who in turn settle

through Clearing Members (tcms or icms).

V. Registered Non Member :

Is a person who is registered with the Exchange for the purpose of dealing in

commodities through a TM. A Registered Non-member has to fulfill such requirements

as may be prescribed by the Exchange from time to time. Every Registered Non-member

will be provided a unique Client Identification (Client Id).

Eligibility Criteria for Membership

Net Worth:

31


Minimum prescribed net worth for an applicant is Rs. 50 lakh.

Net worth certificate should be computed for this purpose by following a definition of net

worth adopted by practising Chartered Accountants for finalisation of accounts. Existing

fund based asset , if any should be excluded for calculation of net worth.

In case, the company is a member of any Commodity Exchange(s), it should satisfy the

combined minimum Net Worth requirements of all these Exchanges including NMCEIL.

Paid-up Capital:

Minimum prescribed paid up capital for a corporate is Rs. 30 lakh.

In case of a partnership firm combined capital of all the partners should be at-least Rs.30

lakh.

Fees & DepositsRevised Membership Fees & Deposit structure (Effective from 21st January 2004)

No.Details

Amount (Rupees in Lacs)

1 Admission Fees (Non refundable)1.00

2 Contribution towards the Trade Guarantee Fund of the Exchange (Refundable only after the minimum lock in period) *

1.00

3 Initial Base Capital (Refundable only after the minimum lock in period) *

1.00

4Additional Base Capital (Refundable only after the minimum lock in period) *

10.00

32


5 Annual Subscription charges 0.20

Total Amount 13.20

* Minimum "Lock in" Period of 3 years.

33


FUTURE TRADING HIERARCHY

34

Ministry of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Food and Public

Distribution(Government of India)Distribution(Government of India)

Forward markets Forward markets Commission(FMC)Commission(FMC)

National Multi-Commodity National Multi-Commodity Exchange (NMCE)Exchange (NMCE)

Trading Cum Clearing Trading Cum Clearing Members (TCM) Members (TCM)

Institutional Clearing Institutional Clearing Members (ICMs)Members (ICMs)

Client / Non Client / Non Registered MemberRegistered Member

Trading Members (TM)Trading Members (TM)

TraderTrader


4. CLEARING & SETTLEMENT MECHANISM

Clearing Bank

Clearing Bank is such bank as the Clearing House of the Exchange may appoint

to act as a funds settling agency, for the collection of margin money for all deals cleared

through the Clearing House of the Exchange and any other funds movement between

clearing members and the Clearing House of the Exchange and between clearing

members as may be directed by the Clearing House of the Exchange from time to time.

A Clearing House

The Exchange shall maintain a Clearing House which shall act as the common

agent of the Exchange Members for clearing contracts between Exchange Members and

for delivering Warehouse Receipts to and receiving Warehouse Receipts from Exchange

Members in connection with any of the contracts and to do all things necessary or proper

for carrying out the foregoing purposes. The functions of the Clearing House may be

performed by the Exchange or any other agency identified by the Exchange for this

purpose.

For efficient clearing & settlement of trades, NMCE has an automated clearing

and settlement system with HDFC Bank as its Clearing Bank. The software automatically

calculates Initial Margins using VAR (Value At Risk) and MTM (Mark to Market)

margins on a daily basis. In the same way, members’ positions are also computed on a

daily basis. The information regarding pay-ins and pay-outs arising in calculations of

positions of members is transferred at the end of trading hours electronically, using flat

files for the clearing banks and members.

5. MARGINS FOR TRADING IN FUTURES

Margin is the deposit money that needs to be paid to buy or sell each contract.

The margin required for a futures contract is better described as performance bond or

35


good faith money. The margin levels are set by the exchanges based on volatility (market

conditions) and can be changed at any time. The margin requirements for most futures

contracts range from 2% to 15% of the value of the contract.

The objective of NMCE is to organize trading in such a way that possibility of defaults is

almost eliminated. To achieve this, NMCE has adopted various margins as follows:-

I. Exposure Limits:

Exchange provides facility in the system enabling the tcms to select the

commodities in which the TM can trade and also fix the trading limits for each TM. TCM

can also monitor the position of tms online.

II. Initial Margin:

The initial margin (IM) is levied on all open positions (Buy or sell positions) of

the members and their clients. The IM percentage on each commodity varies depending

upon its market volatility. The margin so calculated is reduced from the total margin of

the member available with the exchange and accordingly further exposure is given on the

balance amount. As the IM increases, the exposure shall decrease.

III. Mark to Market (MTM) Margins:

MTM is a mechanism devised by the exchanges to prevent the possibility of the

potential loss accumulating to the level where the participants might willingly or

unwillingly commit default. All trades done on the exchange during the day and all open

positions for the day are marked to closing price for the respective delivery/contract and

notional gain or loss is worked out. Such loss/gain is debited/credited to respective

member’s account at the end of each day. The outstanding position of the members is

then carried forward the next day at the closing price.

IV. Special Margins :

Have primarily been introduced not as a risk management tool, but to act as a

speed-breaker for sharply rising or falling price. It is applied when price reaches a

particular level above/below the previous day’s closing price.

36


V. Delivery Margins :

Are applicable to the contracting parties (both, buyer and seller) from the 12th day

of the contract maturity month.

VI. Price Bands: Daily Cap & Life Time Cap:

Have been imposed on all commodities to prevent extreme volatility and

unhealthy practices of cornering the market.

VII. Final Settlement:

On the expiry of the futures contracts, the settlement is by the way of delivery.

The delivery is at seller’s option between 12th to 15th of the delivery month. The pay-

in/pay-out for delivery is by way of debit to the buyer and credit to the seller to the

relevant Clearing Member’s clearing bank account on T+3 day (T=date of allocation of

delivery).

On 15th if seller fails to tender delivery or fails to square-off his position then the highest

price of the contract during its currency is taken for cash settlement in marking all

undelivered outstanding position to final settlement price. Resulting profit/loss settled in

cash. Final settlement loss/profit amount is debited/credited to the relevant Clearing

Member’s clearing bank account on T+1 day. (T=expiry day).

VIII. On-Line Surveillance :

Includes the monitoring of prices, volume & volatility in various series and its

analysis using various methods like real time graphs, queries, alerts etc.

IX. Off-Line surveillance :

Includes margining requirements, procedures in respect of exception handling,

position monitoring, exposure limits, investigation techniques & disciplinary action

procedures.

37


6. DELIVERY MECHANISM

One of the methods of settling the contracts is by taking or making delivery.

Delivery period at NMCE is 12th to 15th of the delivery month. During this period

Members of the exchange are not permitted to create any fresh position in the expiring

contracts. They can either square up their position or take/give delivery to settle their

outstanding contracts. Various steps required to be followed by the participants having

outstanding position on 12th of delivery month are as follows:

Steps to follow:

1) Sellers and buyers have to convey intention on or before 12 th of the delivery

month.

2) The intentions are then matched and assigned by the Exchange with the

corresponding buyers. As is the case universally, seller has freedom to tender delivery

during the delivery period at any approved delivery centers. In other words, buyer cannot

demand delivery at delivery center of his choice. When the seller gives intimation, a call

is made to the corresponding buyer to whom the delivery is assigned by the Exchange.

Delivery margin is collected from both the buyer and seller.

3) After matching the open positions of relevant buyer and seller, the same is

transferred from the system and settled at the closing price of the preceding day, so that

mark to market (MTM) is not levied or paid to the member.

4) Within three days from the position transfer, the buyer has to maintain the

required funds in their clearing & settlement account while the seller has to tender the

warehouse receipts to the exchange along with the computation of warehouse charges.

On the 3rd day, the exchange makes pay-in & payout simultaneously after retaining the

warehouse charges margin and sales tax margin from the buyer and seller respectively.

5) After the completion of pay-in and payout, duly endorsed warehouse receipts

are sent to the buyer immediately.

6) Settlement of warehouse charges, margins and sales tax margins take place

soon after receipt of relevant documents (copies of sales bill, sales tax form) from the

member.

38


DELIVERY MECHANISM OF NMCE

39


7. WAREHOUSE RECEIPT

Sample CWC Warehouse Receipt

40

Exchange looks over the commodities to be delivered from the open positions of members

Open Long Position è Buyers

Open Short Position è Sellers

Exc

han

ge

give

s no

tic

e of

D

eliv

ery

wit

h de

tail

s of

lo

ts

to b

e de

liv

ered

Matching of Open Positions in Between

Buyers & Sellers

5 days prior to the end of the contract month.

On T+3 day

Seller has to tender Warehouse Receipt and

make them available to the exchange

The Buyer has to keep the money ready

Pay

-in P

ay-o

ut

è P

ositi

on

Trans

fer ta

kes

Plac

ec

After Completion of Pay-in & Pay-Out process Warehouse Receipts received from the seller are sent to the buyerOn

Delivery day


The term “Warehousing Receipt” has been defined in The State Warehouses Act.

“Receipt” means a Warehouse Receipt in the prescribed form issued by a Warehouse

Man to a person depositing goods in the warehouse. A licensed warehouseman is

authorized to issue a negotiable or a non negotiable warehouse receipt. It evidences a

contract for storage of goods. It is accepted by the commercial banks as collateral

security for grant of loan against the goods stored in the warehouses. A warehouse receipt

can be negotiated by endorsement and delivery. It is a document of title of goods as per

the Sale of Goods Act, 1930. The goods covered by a negotiable warehouses receipt can

be transferred by an endorsement on the Warehouse Receipt and its delivery to the

endorsee. A person to whom warehouse receipt is negotiated acquires a title to the goods

in respect of which such warehouse receipt has been issued. The endorsee gets a right to

have the possession of goods covered by such warehouse receipt as per the terms and

conditions contained in such receipt. The endorsee also gets a right to have such goods

delivered to him or his authorized agent by the warehouseman.

State Warehouse Act

1) Every warehouseman shall, at the time when goods are received by him for

deposit in a warehouse, issue a receipt in the prescribed form, contained full particulars in

respect of the goods stored in his warehouse by each depositor.

2) A receipt issued by a warehouseman shall, unless otherwise specified on the

receipt, be transferable by endorsement, and shall entitle its lawful holder to receive the

goods specified in it on the same terms and conditions on which the person who

originally deposited the goods would have been entitled to receive them.

Commodity Market Participants

Commodity market is a place where trading in commodities takes place. Markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized Contracts. It is similar to an Equity market, but instead of buying or selling shares one buys or sells commodities.

Commodity market is an important constituent of the financial markets of any country. It is the market where a wide range of products, viz., precious metals, base metals, crude oil, energy and soft commodities like palm oil, coffee etc. Are traded. It is

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important to develop a vibrant, active and liquid commodity market. This would help investors hedge their commodity risk, take speculative positions in commodities and exploit arbitrage opportunities in the market.

In current situation, all goods and products of agricultural (including plantation), mineral and fossil origin are allowed for commodity trading recognized under the FCRA. The national commodity exchanges, recognized by the Central Government, permits commodities which include precious (gold and silver) and non-ferrous metals, cereals and pulses, ginned and un-ginned cotton, oilseeds, oils and oilcakes, raw jute and jute goods, sugar and gur, potatoes and onions, coffee and tea, rubber and spices. Etc.

Commodity Market Structure

The structure of commodity markets dictates that there are several types of participants active in the trading of commodities and commodity derivatives. The structure of the participants and the nature of their activities/motivations are more complex than in other asset classes.

The major participants in commodity markets include:

1. Commodity Producers/Consumers:

These participants have natural underlying outright long (producers) and short (consumers) positions in the relevant commodity. The inherent risk-exposure drives the use of commodity derivatives by producers and users.

The application of commodity derivatives in frequently driven by the pattern of cash flows. Producers must generally make significant capital investments (sometime significant in scale) to undertake the production of the commodity. This investment must generally be made in advance of production and sale of the commodity. This means that the producer is exposed to the price fluctuations in the commodity.

If prices decline sharply, then revenues may be insufficient to cover the cost of servicing the capital investment (including debt service). This means that there is a natural tendency for producers to hedge at levels that ensure adequate returns without seeking to optimize the potential returns from higher returns. This may also be necessitated by the need to secure financing for the project.

Consumer hedging behavior is more complex. Consumer desire to undertake hedges is influenced by availability of substitute products and the ability to pass on higher input costs in its own product market. In many commodities, producer and consumer deal directly with each other. The form of arrangement may include negotiated bilateral long term supply or purchase contracts between the producers and consumers. The contracts may include fixed. Price arrangements to reduce the price risk for both parties.

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These arrangements create a number of difficulties. These include lack of transparency, low liquidity and exposure to counterparty credit risk. The bilateral structure also creates potential adverse performance incentives. This reflects the fact that the contracts combine supply/purchase obligations and price risk elements in a single contract.

2. Commodity Processors:

These participants have limited outright price exposure. This reflects the fact the processors have a spread exposure to the price differential between the cost of the input and the cost of the output. For example, oil refiners are exposed to the differential between the price of the crude oil and the price of the refined oil products (diesel, gasoline, heating oil, aviation fuel, etc.). The nature of the exposure drives the types of hedging activity and the instruments used.

3. Commodity Traders:

Commodity markets have complex trading arrangements. This may. Include the involvement of trading companies (such as the Japanese trading companies and specialized commodity traders). Where involved, the traders act as an agent or principal to secure the sale/purchase of the commodity. Traders increasingly seek to add value to pure trading relationship by providing derivative/risk management expertise. Traders also occasionally provide financing and other services. Commodity traders have complex hedging requirements, depending on the nature of their activities.

A trader as a pure agent will generally have no price exposure. Where a trader acts as a principal, it will generally have outright commodity price risk that requires hedging. Where traders provide ancillary services such as commodity derivatives as the principal, the market risk assumed will need to be hedged or managed.

4. Financial Institution/Dealers:

Dealer participation in commodity markets is primarily as a provider of finance or provider of risk management products. The dealers’ role is similar to that in the derivative market in other asset classes. The dealers provide credit enhancement, speed, immediacy of execution and structural flexibility. Dealers frequently bundle risk management products with other financial services such as provision of finance.

5. Investors:

This covers financial investors seeking to invest in commodities as a distinct and a separate asset class of financial investment. The gradual recognition of commodities as a specific class of investment assets is an important factor that has influenced the structure of commodity derivatives markets.

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Benefits to Commodity Trading Participants

Hedging the price risk associated with futures contractual commitments. Spaced out purchases possible rather than large cash purchases and its storage.

Efficient price discovery prevents seasonal price volatility.

Greater flexibility, certainty and transparency in procuring commodities would aid bank lending.

Facilitate informed lending.

Hedged positions of producers and processors would reduce the risk of default faced by banks.

Lending for agriculture sector would reduce the risk of default faced by banks.

Commodity exchanges to act as distribution network to retail agri-finance from Banks to rural households.

Provide trading limit finance to traders in commodities exchanges.

Players in Commodity Market :

Players of commodities market have been classified into three broad categories. They are Hedgers, Speculators and Arbitrageurs.

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Hedgers:

Hedging is an investment strategy used for minimising a risk and hedgers are the practitioners of this strategy. Generally, hedgers are producers or consumers who want to transfer the price-risk on to the market. Commodities derivatives market provide them an effective hedging mechanism against adverse price movements. They protect themselves from risk associated with the price of commodity by using derivatives. For example, an airline company faces the risk is price rise of fuel. So they will go for a long position (buy an oil futures contract) to hedge, just to cover the amount of fuel they expect to buy. Similarly, gold is the best hedge against inflation.

Commercial hedgers are corporations that seek to ensure the stability of a given commodity by taking a position in the commodities market. The exact nature of the stake or position will vary, depending on the type of influence the corporation wishes to exert on the commodity. Generally, the goal of the commercial hedger is to create a situation where the price of the commodity remains at a level considered to be desirable by the corporation.

One of the main motivating factors for employing this type of strategy is the use of the commodity in production. The commercial hedger will often make use of the commodity in the manufacture of goods and services sold by the corporation. From this perspective, it should come as no surprise that the hedger would wish to keep the price for the commodity at a level that is affordable to the corporation. This action can help to keep production costs for the company within budget, and thus improve the potential for realizing a net profit.

When a corporation chooses to employ a hedging strategy, the commercial hedger becomes both investor and consumer. This can help the bottom line. First, by securing a futures option on the commodity, the corporation can claim valuable production materials at a desirable price. Second, the company can benefit from the stable performance and trade of the commodity on the open market. At it’s best, this approach places the commercial hedger in a win-win situation that transfers the bulk of the market risk to speculative investors who are also participating in the market.

Many different types of companies function as hedgers. In today’s market, one of the more common examples of a commercial hedger would be a business that relies on petroleum products in order to operate. The hedger would buy futures while the per barrel price for crude oil is relatively low, thus hedging against market risk involved with elevated prices in the long term.

Speculator

Speculators are sophisticated leading players in commodities futures market. They are basically risk takers and are never associated with any commodity. They generally bet against the price movement in the hope of making gains. They undertake

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speculative position with respect to anticipating future price movements with a small margin and square-off anytime during trading hours. They do either by going long or going short positions. Buying a futures contract in anticipation of price increase is known as 'going long". Selling a futures contract in anticipation of a price decrease is known as 'going short".

In terms of financial markets, a speculator is a person, or more likely an institution, that purchases or sells commodities, stocks and/or bonds based on factors other than simply analysis. Investors, on the other hand, focus, by and large, on detailed analysis.

An oil speculator, for instance, will buy shares of “paper” or “future” barrels of oil from an oil producer and sell or broker this future oil to a user for an inflated price based on speculation that prices will rise even further. This is where the term “oil futures” originates. This future oil is either untapped (reserves) or is sitting un-contracted in a supplier’s tanks waiting to be sold. Therefore, the supplier or oil company actually owns the oil and the investor or speculator buys shares of this oil on the expectation that the value of the share will rise.

Oil users, in order to make a profit, have to be financially prudent. One method whereby the petroleum users can increase effective operation is to “hedge” on oil supply purchases. This means that they will purchase a long-term contract for oil at a price determined, in part, by the speculator. The user, thereby, expects that this contracted price will remain lower than prices over the long run, while the speculator expects a more lucrative return on his next contract since he is driving prices higher with an inflated price for his last contract.

Oil speculators have been blamed some say unfairly by politicians and consumers for driving oil prices unnaturally high through hoarding, price gouging and collusion with suppliers. Other analysts maintain that supply and demand is the true culprit, primarily because of the underestimation of the impact that the exploding Asian oil markets have had on the available oil reserves. Still others blame OPEC (Organization of Petroleum Exporting Countries). OPEC, at one time the single most influential force in the oil market, is now only one third of the driving force behind oil price increases. Supply and demand, rampant speculation and profit taking on the part of the petroleum industry are, arguably, the major factors contributing to what many call the artificially inflated price of oil.

The oil speculater, meantime, expects that the intricacies involved in the production and distribution of this important source of energy are so internationally diverse and resistant to regulation and so deeply in flux as to be virtually impossible to decipher or control.

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Arbitrageur :

Arbitrageurs are investors who earn from discrepancy in prices between the two exchanges or between different maturities of the same commodity. A simple example of arbitraging is simultaneously buying a gold at lower price from one exchange and selling it on another exchange for higher price. So they make profit from price difference.

An arbitrageur is essentially a practitioner of what is known as arbitrage. In finance, arbitrage mainly involves the act of buying assets in one place and then quickly selling them in another. This is done in order to benefit from the price difference in the two places. That is, a particular financial asset may trade at a low price in one location compared to others, at one given time. Then an arbitrageur would buy it at the low price and sell it in the location where it is priced higher.

Typically, arbitrageurs trade in financial instruments like stocks, bonds, currencies and commodities. Generally, an arbitrageur will find opportunities when one of several conditions is present. One of these is the price discrepancy in two or more locations. For instance, any particular asset is expected to trade at the same price in all markets, though at times prices may diverge in different places for various reasons. In such cases, an arbitrageur would make his or her move to take advantage of the price discrepancy.

Another condition would be when two assets that are pretty much similar have different prices. Thus, arbitrage opportunities are not only confined to the same asset. For example, two different bonds with similar characteristics may only differ in prices. Arbitrage would then be feasible in such an occurrence.

To illustrate, it helps to consider a hypothetical stock trading at $30 US Dollars (USD) on the New York Stock Exchange (NYSE). Say the same stock is trading at $31 USD on the London Stock Exchange (LSE). Then an arbitrageur would buy a given amount of the stocks on the NYSE and simultaneously sell the same amount of stocks on the LSE, making $1 USD in profits per stock minus any fees. Arbitrage transactions such as these may provide a handsome profit, especially since the typical arbitrageur deals in large volumes. Information in the financial markets travels very fast; therefore, arbitrage opportunities vanish quickly, meaning arbitrage traders have to act fast as well.

In the foreign exchange market, there is what is referred to as triangular arbitrage, which essentially involves the buying and selling of three currencies virtually at the same time. For transactions such as this, an arbitrageur would exchange one currency for another, then exchange it again for a third, and finally exchange it back to the original currency. Basically, this is done when there are exchange rate mismatches between the three currencies in two or more locations, such as London and New York.

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Commodity Risk

Commodity risk is a term that is used to describe the level of volatility or risk that is associated with the trading of commodities in the futures market. Investments in commodities like electricity, metals, or grains can and do fluctuate in value based on factors such as supply on hand, the demand for those products, and even events such as the outcome of political elections or shifts in the general economy. The goal of investors is to consider the potential for future events to adversely affect the price of the commodities associated with the futures contracts and structure those contracts so that the level of risk is kept within a reasonable range.

There are several different types of commodity risk that investors will consider very closely before actually entering into a futures contract. One of the more common issues to address is the degree of risk associated with the unit price of the commodity. Here, the investor will weigh the potential for shifts in exchange rates or downward trends in local or world prices that could cause the investment to perform poorly, and determine if the futures contract is likely to yield sufficient returns to justify taking on the risk.

Assessing commodity risk also calls for considering the degree of quantity risk that is inherent with the deal. The potential for some type of interruption in production will be considered, including the impact of that reduction in available product on the market and the commodity price. At the same time, the possibility of a sudden increase in production that exceeds demand and causes the commodity price to slump is also an important aspect to consider.

Political risk is a third component that must be included when assessing commodity risk. Here, the goal is to accurately project the outcome of elections on the performance of the commodity in the marketplace, at least for the duration of the futures contract. This includes allowing for upsets in which a candidate that was highly unlikely to be elected actually does capture the popular vote as well as determining what would likely happen to the commodity price if favored candidates were to win the elections.

As with any type of investment, commodity risk requires that investors look closely at any factors that could negatively impact the performance of the asset at any point during the futures contract. By accurately assessing the degree of risk and accurately forecasting the outcome of the contract once it is called or reaches maturity, investors can realize a health return for their efforts. Should those projections be faulty or fail to include consideration of relevant information, the potential for failure is increased and the chances of losing money rather than earning a return are higher.

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CONCLUSION

India is one of the top producers of a large number of commodities, and also has a long history of trading in commodities and related derivatives. The commodities derivatives market has seen ups and downs, but seem to have finally arrived now. The market has made enormous progress in terms of technology, transparency and the trading activity. Interestingly, this has happened only after the Government protection was removed from a number of commodities, and market forces were allowed to play their role. This should act as a major lesson for the policy makers in developing countries, that pricing and price risk management should be left to the market forces rather than trying to achieve these through administered price mechanisms.

Commodities offer exciting opportunities for investors to diversify their investment portfolios beyond stocks, bonds and mutual funds.

Like any other investment, commodities carry some risk. However, what makes them particularly attractive is leverage. You can trade them on very low margin.

There are more than a dozen major commodity exchanges around the world, reflecting the globalization of the markets.

Grains include wheat, oats, corn, rice, soybeans and other agricultural products.

Softs include coffee, cocoa, sugar, oats, cotton and similar products. Frozen concentrated orange juice (FCOJ) has been actively traded since the creation and widespread use of inexpensive refrigeration (post World War II).

Energies cover a range of products used to provide energy to heat and power homes and businesses. The most common are petroleum and its byproducts: crude oil, heating oil, natural gas and others.

Meats like live cattle, pork bellies and feeder cattle are traded on various exchanges. Pork belly prices can be dependent on the price of grain, since the pigs are fed mostly corn.

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