Indian Commodity Futures Markets – Still Evolving…

Futures trading plays a key role in the marketing of a number of important agricultural and nonagricultural commodities as it provides the industrial and farming communities with a transparent price discovery platform, which also enables them to hedge their price risk and price volatility. The growth of Indian commodities futures trading towards an efficient, transparent and well-organised market has thrown open a window of benefits and opportunities to Indian producers and traders. Besides the primary benefits of its twin economic functions of price discovery and price risk management, commodity futures trading has also played an instrumental role in integrating various fragmented components of the commodity ecosystem, thus developing the overall infrastructure of agricultural commodities marketing in the country.

The yesteryears…

Forward/futures markets have come a long way since the days of the “rice tickets” in Japan and the first organised futures market in the form of the Chicago Board of Trade (CBOT) in the US. Forward contracts were the earliest form of commodity derivatives, and futures contracts have existed for centuries in one form or the other.In India, the earliest reference to “futures’ can be found in Kautilya’s Arthashastra, and the trade shot into prominence in the mid-nineteenth century when trading in agricultural commodity futures in the US became organised. After the first recorded instance of futures trading in “rice” in 17th century Japan, it took off in the US with “grain” contracts on CBOT (the first exchange to start there in 1848). Metals followed suit with contracts traded on the London Metal Exchange (LME) in 1878. Thereafter a number of commodity exchanges facilitating futures trading in numerous agri- and non-agri commodities sprang up the world over. In India, organised commodity derivatives trading began with the Cotton Trade Association’s debut in futures in 1875. Cotton merchants of Bombay took cues from the US and the UK, and to regulate futures trading the government in 1918 set up Cotton Contracts Committee, which was soon (1919) replaced by Cotton Contract Board. Futures trading in oilseeds was organised with the setting up of Gujarati Vyapari Mandali in 1900 in Bombay. And, over the years, the derivatives market developed in several other commodities in the country: raw jute and jute goods in Calcutta (1912), wheat in Hapur (1913) and then bullionin Bombay (1920). However, soon there were widespread fears that derivatives trading fuelledunnecessary speculation in essential commodities and was therefore detrimental to healthy functioning of the markets for the underlying commodities and, therefore, to farmers. To curb speculative activity in the cotton market, the Government of Bombay barred options trading in cotton in 1939. This was followed, in 1943, by a ban on forward trading in oilseeds and someother commodities such as food-grains, spices, vegetable oils, sugar and cloth. As, post-World War II, the Great Depression had its devastating effects on economies around the world during 1939-45 and the British rulers imposed controls over the financial markets, the Indian commodity futures market slipped into virtual extinction. It disintegrated and went into a hibernation, only to continue negligibly in the form of over-the-counter (OTC) contracts. Almost a decade later, Parliament passed the Forward Contracts (Regulation) Act, 1952 (FCRA) to regulate commodity futures trading in the country. With the process of liberalisation and globalisation of the Indian economy and consequent reforms in its financial markets in the early 1990s, the Prof. K.N. Kabra-headed committee, set up by the Government in 1993 to examine the role of futures trading, made several recommendations including certain amendments to Forward Contracts (Regulation) Act 1952 and strengthening of the Forward Markets Commission (FMC). As it agreed to and acted upon most of these recommendations, the Government allowed futures trading in all the commodities recommended. The trade came into being after remaining in hibernation for nearly four decades, as realization that derivatives do perform a role in risk management dawned. The timing of this revival effort, from the four decades of restrictive government policies, turned out to be spot on, as the 1990s heralded an upswing in the commodity cycle, globally. FMC and the Government, on a fast-track mode, encouraged the idea of setting up commodity exchanges with state-of-the-art infrastructure and global best practices, and three national-level online exchanges — the Multi

Commodity Exchange of India Ltd. (MCX), the National Commodity and Derivatives Exchange Ltd (NCDEX) and the National Multi- Commodity Exchange Ltd (NMCE) were born.

The current scenario

At present, 24 commodity futures exchanges are operational in India, which include 21 regional bourses and the three national-level players, with another three proposed exchanges on the cards. With the state-of the- art technology-powered modern, secure and efficient operational infrastructure these national exchanges are creating a near-perfect market situation with a much wider participation from the ecosystem stakeholders in a large number of domestic and global commodities during local and international timings.

Since the reintroduction of commodity futures trading in India in 2003, the bulk of trading has been taking place on the three national exchanges. Despite being a late starter, MCX overtook other domestic exchanges and continues to be the No. 1 commodity futures exchange in the country (by numbers/lots of contracts traded) with a market share of 85% as on August 31, 2009.

Speaking of the combined turnover of domestic commodities exchanges, what began with a notional value of Rs.1,29,364 crore in 2003-04 increased to Rs.36,77,226 crore in 2006-07. However, following a ban on some commodities in January 2007 and then in May 2008 as well as imposition of higher margins and stringent norms for trading, the growth in trade volumes slowed down to Rs.40,65,983 crore in 2007-08. Nevertheless, the Indian commodity futures market staged a comeback in 2008-09 with a sharp increase in the turnover to Rs.52,48,956 crore, notwithstanding the ban. As the percentage of Gross Domestic Product (GDP) at market prices, the total trade accounted for 97.3% in 2006-07, which only marginally slipped to 94.1% in 2007-08 but shot up to 106.4% in 2008-09. In the current fiscal, for the April 1-August 31, 2009 period, the cumulative value of trade stands at Rs.27,29,248.80 crore, a y-o-y jump of 31%. And a major part of it was due to a surge in the trade volumes of agricultural commodities futures, which shot up by 53.5% to Rs. 405,671.40 crore, followed by the trade in the energy and industrial metals complex, which jumped by 27.5% to Rs.22,89,316.20 crore. After significant declines in the trade volumes of agricultural commodities in the previous two consecutive fiscals i.e. 2007-08 and 2008-09, the rise in agricultural commodities’ trade in the current year is noteworthy.

. Given the growth in trading volumes and increasing integration of Indian economy with the rest of the world, the Indian commodity futures market has begun to be recognized among the top derivatives exchanges of the world.

The Indian commodity futures market has emerged as one of the fastest growing markets with a combined trade turnover of around Rs.52.48 trillion ($1.14 trillion), and the phenomenal growth (110% compounded annual average growth since the market’s resurrection in 2003) is largely attributed to continuous outreach efforts and all-round innovation by its national-level electronic commodity futures exchanges, which includes launches of a slew of new products suitable to the fast-changing market dynamics and needs such as certified emission reduction (CER), aviation turbine fuel (ATF), gold guinea contracts, and so on. As per FMC estimates, total turnover of commodity futures trading is expected to cross Rs.60 lakh crore in the current fiscal (2009-10) and Rs.100 lakh crore by 2010-11, provided the FCRA amendment Bill is passed.

Given the growth in trading volumes and increasing integration of Indian economy with the rest of the world, the Indian commodity futures market has begun to be recognized among the top derivatives exchanges of the world. According to Futures Industry Association (FIA) and data put up by benchmark international exchanges, for the year ended March 31, 2009, MCX fares as the world No. 1 in Silver, No. 2 in Gold (followed by NYMEX and TOCOM) and No. 3 in Natural Gas, Crude Oil, Copper, and Zinc futures (by the number of contracts traded). Until August 31 of the current fiscal, MCX retained its leadership position with 85% of the total turnover of all the 24 exchanges.

Drop in agricultural commodities trading volume

There had been a significant decline in the volumes of futures trade in agriculture commodities. During 2007- 08, it fell by 28.5% and the trend continued in 2008-09 as well. And a major part of this fall in the trade volumes of agricultural commodities was accounted for by Chana, Maize, Mentha Oil, and Guar seed, Potato, Guar Gum, Chilly and Cardamom. The trade in these eightcommodities, which accounted for 57.9% of total futures trade in agri-commodities in 2006-07, plummeted by over 66.4% during 2007-08 compared with the previous year level. Further, this fall (in the eight commodities) exceeded the overall drop in futures trading volumes in all agricultural commodities together.

While the trade in non-agricultural commodities, especially bullion and crude, has increased in the past two financial years, the same in agricultural commodities has declined. The share of agricultural commodities almost halved during 2008-09, due to the continued ban on several commodities. Futures trading in Wheat, Rice, Tur and Urad was banned in March 2007 by the government following pressure from many quarters blaming the futures market for an unprecedented surge in retail prices of food commodities, though later the Abhijit Sen committee appointed to find out the truth, found no direct link between the price rise and futures trading. The agricultural commodities vertical suffered another shock on 7 May, 2008 as four other agri- commodities — Chana, Soy Oil, Potato and Rubber — were banned for four months until December 3, 2008 citing the same reason. Rice, Tur and Urad are still under ban, while theban on what futures was lifted on May 15, 2009. Lately, Sugar was also banned on May 27, 2009 following a shortage and the associated increase in its price.

Prevailing prices of banned agricultural commodities and the volatility that existed in their cash markets clearly indicate that their trading in organised and well regulated markets would have kept the volatility in their prices under control than otherwise.

Regulatory and market developments

Abolition of CTT – The Union Budget 2009-10 did away with the Commodity Transaction Tax (CTT) of 0.017% proposed in the Budget 2008-09. This will help Indian commodity futures markets not only become globally competitive but also develop into benchmark markets, at the international level, by becoming ‘price setters’ in many commodities (India is currently a ‘pricetaker’ despite being one of the world’s largest producers/importers/exporters of about 17 commodities) through much wider participation. The move will also help mobilize the resources that would have otherwise been diverted to CTT towards enhancing expertise and skills of domestic commodity futures markets to international standards. The proposed tax, had it been implemented, would have stunted the growth and maturity of a still-nascent market whose turnover is less than even half (only 40% in 2008) the country’s equity market turnover, while globally the corresponding figure is 5 to 10 times.

The pa s s age of the FCRA amendment Bill, currently being awaited, will clear the deck for introduction of long-awaited instrument s in commodity derivatives such as options and index-based trading, which will deepen the market through wider participation of entities like banks, mutual funds, FII’s.

Amendment to FCRA: The proposed amendment to FCRA will make FMC an autonomous regulator with functional and financial autonomy to play its regulatory role more effectively alongside its developments responsibilities. The passage of the FCRA amendment Bill, currently being awaited, will clear the deck for introduction of long-awaited instruments in commodity derivatives such as options and index-based trading, which will deepen the market through wider participation of entities like banks, mutual funds, FIIs. A large number of risk-averse economic stakeholders will likely be attracted towards the market with increased information about commodities enabling hedging of price risk at much lower costs (driven by increased liquidity). This will help India emerge as a price taker with a transparent flow of market information converging from a highly increased number of domestic and international participants. This will also guarantee fair returns to farmers.

Regulatory measures: FMC has recommended a reduction in central value added tax (cenvat) from 8% to 5%. It has also directed commodity exchanges to levy non-compliance charges on high-value cash dealings. However, it stated, cash transactions up to Rs.10 lakh will attract no charges, while traders will have to pay 0.1% of commodities’ transaction value if they wish to settle in cash. The move obviously aims to discourage cash dealing in commodities.

ConclusionIndian commodity exchanges have come a long way, with an impressive growth during the last six years since 2002-03 when the government embarked upon policy liberalisation. The three national online exchanges came into being, taking the erstwhile turnover of Rs.66,530 crore to Rs.52,48,956 crore in 2008-09. As these exchanges grew over the past six years, they also took along with them the stakeholders, besides nurturing the ecosystem delivering both the felt and the unfelt benefits of their existence to one and all in the commodities supply chain right from theproducer to the consumer. During this small yet remarkable journey, these state-of-the-art exchanges have also crossed several policy hurdles to grow in stature equivalent to their international counterparts, seamlessly integrating with the entire financial markets architecture. They also did help spread risks in major commodities ecosystems across severalstakeholders thereby making the economy more competitive in the current rapidly globalising world. Being online with extended hours of operation, these modern commodity exchanges have also enabled the Indian industry manage risks as they flow from their origins crossing economic borders. It is a further policy boost and socio-economic-institutional change as discussed above that will take the Indian commodity markets to a much higher level of growth to help the economy allocate its resources effectively as with the developed economies, spread the risks thinly amongall the stakeholders, and wade through the fear of globalisation affecting our economic and political stability.

Commodity Futures in India – A Product of Globalisation and Liberalisation

A beginning has been made towards transforming the Indian commodities sector, from its current status of being a ‘price taker’ to a ‘price setter’, with the national online commodity futures exchanges taking the lead. These exchanges are offering the benefits of liberalisation and globalisation directly to the industry and consumers by empowering them to influence the global prices of commodities they deal in. It is time the markets were made much more vibrant and efficient by allowing participation of a larger number of new categories of economic stakeholders and introduction of innovative derivative instruments. This is to plug risks at the roots rather than when they finally sneak into the prices of end products. And this will make the Indian markets a force to reckon with on the global commodity map, turning them into a ‘price setter’ indeed.

Economic liberalisation took off in the early 1990s in India. Like in many countries, policymakers, practitioners and academics responded to the growth of financial markets worldwide, and a new- found ebullience surrounding emerging markets, by advocating wide-ranging reforms. International trade and investment were opened up, a process of deregulation and privatization initiated, the tax regime reviewed.India's economy greatly benefitted. In 2007, the country clocked its highest ever GDP growth rate of 9% the second-fastest in the world after China and a far cry from its annual GDP growth in the three decades post- Independence. However, the reform process is still incomplete, and the financial sector has been lagging behind many parts of the real economy. Stakeholders have still not reaped the fruits of greater competition in financial markets, unlike what has been seen in sectors such as telecom, banking, insurance, and aviation. But now, Indian financial markets are poised to scale to the next growth orbit.India increasingly integrates with markets around the world. This opens a window of opportunity to Indian companies but also, exposes them to a whole new world of risks. Among these risks, of key importance to many, is commodity price volatility. Companies need to be able to manage these risks if they are to be globally competitive, and this is where an efficient commodityfutures market plays a primordial role not only in facilitating price/volatility risk mitigation but alsocatalysing near-perfect price discovery.After decades of decay, India's organised futures industry was revived in 2003. As it matures over time, its backward and forward linkages will strengthen, resulting in widening and deepening of the market through increased participation by various ecosystem players. This in turn is changing the ways producers make their cropping decisions, traders trade their products, and banks lend against commodities or those with exposure to commodity price risk. The ultimate results will be 'Financial Inclusion' and 'Market Inclusive' growth.

The Enabler of Efficient Price Risk Management and Price Discovery

The price discovery process should not be left to just a handful of traders in asymmetrically informed or ill-informed, segmented markets. Rather, the best price discovery comes when a large number of various categories of market players with a wide range of objectives and interests converge on an organized futures platform. Such a platform and the Multi Commodity Exchange of India Ltd. (MCX) is one ensures that all relevant information is absorbed in the price formation process, and the “right price” is discovered. The more efficient the discovered prices on a futures platform is, the more effective are the business and policy decisions that are taken based on these prices.The efficiency and transparency of price discovery depends on the robustness of the trading platform; its regulations; the right mix of its participants with relevant price information; making participation cost effective vis-à-vis alternatives available for risk management and/or investment; effective management of the participants' varied risks and, last but not the least, a robust and transparent clearing policy.In just about six years, the national commodity futures exchanges in India performed better than the policymakers expected in terms of catching up with their age-old global counterparts on most of the aforesaid parameters. A lot of efforts delivered from a base of strong domain knowledge

and technical skills went behind this spectacular growth. Selection of commodities relevant to the stakeholders; right contract design; keeping ears and eyes to market needs; taking them to appropriate participants; creating awareness; expanding infrastructure; and bringing in world-class technology and global best practices are some worth mentioning.To make these markets more relevant and useful to different categories of stakeholders and thus their participation more effective, it is necessary that various risks to the participants be effectively managed. Risk management tools on a futures platform include margining, limits on open positions, and effective surveillance . Price volatility of commodities traded on an exchange is an indicator of how effectively these tools are used by the exchange managers to improve the efficiency of price discovery. That is to gauge the capability of its futures contracts to predict its maturity prices more accurately (indicated by the percentage deviation between the first tradedprice and the last traded price of a given contract). The efficiency of price discovery is also indicated by the nearness of the spot and futures price movements. In the case of MCX, the correlation between its gold futures contract and gold spot prices is around 99.8% (from January 2007 to August 2009), which indicates a strong inter-linkage between domestic spot and futures markets. For the same period, MCX gold contract's correlation with the global benchmark, COMEX gold futures contract, is around 99.9% (the rupee adjusted). This reflects how efficient the Indian futures market is in capturing global cues.

Mahesh Jadhav

Capmatrix Consultants Pvt LtdUnique Finvestwww.capmatrix.co.inmahesh@unifinvest.com+91 9011 877899