lecture series 4
TRANSCRIPT
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Commodity Markets
Lecture series - 4
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Regulatory framework of Indian Commodity markets
Ministry of Consumers Affairs,
Food & Public
Distribition
Three-tier
regulatory
ForwardMarkets
Commission
National Multi-commodity
Exchanges
RegionalExchanges
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Other acts and regulations that affect functioning of
Commodity Markets
Essential Commodities Act
The Stamp Act
The Companies Act
Agriculture Produce Market Committee (APMC)
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Brief synopsis of FCRA 1952
• The Act applies to goods, which are defined as any movable
property other than security, currency and claims
• In the preamble of the Act itself, the intention of the
legislature to prohibit options in goods is made explicit. Bya specific provision, section 19, such agreements are
prohibited
•
categories, viz., ready delivery contracts and forward
contracts. Ready delivery contract are those where delivery
of goods and full payment of price therefore is made within
a period of eleven days• It is further clarified that notwithstanding the period of
performance contract, if the contract is performed by
payment of money difference (cash settlement), it would
not be a ready delivery contract
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Brief synopsis of FCRA 1952 (Cont.)
• The Act provides for either regulation of the forwardcontract in specified commodities or prohibition of
specified commodities. Such contracts in the commodities,
which do not figure in, regulated or prohibited categories
are outside the purview of the Act, except when they are
organized by some exchange
• The Act envisages a three-tier regulation. The exchange
which organizes forward trading in regulated commodities,can prepare its own rules (articles of association) and
byelaws and regulate trading on a day-to-day basis
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Brief synopsis of FCRA 1952 (Cont.)
• The FMC approves those rules and byelaws and providesregulatory oversight. It also acquires concurrent powers of
regulation either while approving the rules and byelaws or
by making such rules and byelaws under the delegated
powers
• The Central government – Department of Consumer Affairs,
Ministry of Consumer Affairs, Food and Public Distribution
– is the ultimate regulatory authority• Only police authorities have powers to enforce illegal
trading in prohibited commodities and options in goods.
FMC can merely forward information and render technical
assistance to police. The penalties provided under the Act
are nominal and does not have deterrent effect
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Classification of Goods
Section 15 – Regulated Commodities
Section 17 – Prohibited Commodities
- Presently Futures Trading is not prohibited in
any commodity
Free Goods – Other than those u/s 15 and 17
- FMC may permit futures trading
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Regulated Commodities (Section 15)
• Groundnut, mustard seed, cottonseed, sunflower,rice bran, soy oil, etc
EdibleOilseeds
• Wheat, Gram, Rice, Dals, Bajra, Maize etcFood Grains
• Gold, Silver, Copper, Zinc, etcMetals
Spices
Fibre
Other
• Turmeric, Pepper
• Cotton, Jute etc
• Castorseed, Gur, Natural Gas, Crude Oil etc
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Role of Forward Markets Commission
Regulate the market
Development of the market
Creation of awareness
Increasing market participation
Effective dissemination of price information
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Tools available with Forward Markets Commission
• Such limits are applied by the exchange (with priorapproval of FMC) on both members and clients
• Position limits are specified in absolute termsPosition Limits
• This is used to allow market to cool off duringsudden upswing or downswing
• Like stock exchanges, this is applicable on daily basisCircuit filters
• mpose on y on one s e o tra e n case o extremevolatility or requirement of curbing one sided tradesmargins
Compulsory
Delivery
Suspension of trading
• Required in order to convince market participantsabout the credibility of price discovery, especially in
case of agricultural products
• Applicable in case of exigencies
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Genesis - Shroff Committee (1950)
• Draft Bill for Forward Markets Regulation was made
• Inputs received from different commercial organizations
• Led to passage of the Forward Contract Regulation Act of
1952
• Forward Market Commission (FMC) was established in
1953, dedicated to regulation of forward markets
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Dantwala Committee (1966)
• Review of previous 10 years of FMC
• Suggest amendments to FCR(A), 1952
• Recommended that FMC be made autonomous
• Futures in export commodities to be allowed
• Futures contracts to be defined
• Options trading not recommended
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Khusro Committee (1979)
• Review role of FMC and analyze commodities markets
- Not all commodities were to be allowed for futures
trading
- Laid down the possibilities for specific commodities such
as Sugar and Silver
- Condition for trade: Homogeneity of commodity and largesupply and demand
- Exporters to be allowed to hedge
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Kabra Committee (1993)
• Exchanges to enlist more members and be demutualised
• Ensure Capital adequacy norms
• Encourage Computerization
• Vigilance Committee and Panel of surveyors
• Arbitrators (dispute settlement mechanism)
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Kabra Committee (1993)
• Options and range forwards to be allowed
• Recognition to exchanges to be permanent (or at least for 5
years)
• Time limit for ready delivery contracts to be made 30 days
• Futures trading to be allowed for more commodities
• Allow Indian companies to hedge abroad (accepted)
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World Bank and UNCTAD (Joint Study) - 2009
• Opening of Agricultural markets would lead to greater
exposure to price volatility
• Requirement of Price Risk Management
• Price fluctuations to be sufficiently large (to ensure pricediscovery)
• Efficient transfer of risk from Hedgers to Speculators and
Arbitragers• Standardization of trading practices
• Storage facilities to be enhanced
•
Encourage participation of large institutional investors• Improve internal management of exchanges
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Abhijit Sen Committee report on Future Trading - 2008
• Minimize the potential adverse impact of futures trading onprices of agricultural products. There is a need for a clearand unambiguous regulatory framework. The regulatoryauthority should have the capacity and the power to
discipline the market
• Once these pre-requisite are in place they will not only help
in controlling aberrations in the market but also help thegovernment and the regulator to explain to variousstakeholders at large any abnormal behavior in the marketthat might occur as a result of some basic fundamental
demand and supply factors
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Abhijit Sen Committee report on Future Trading - 2008
• Reasons for abnormal market behavior to be thoroughly
probed to take remedial action to protect market and
financial integrity
• Currently, errant participants can only be suspended or
debarred from trade. But the Forward Contract
monetary penalty for violations
• The autonomous status envisaged for the regulator by
Amendment Bill is designed to provide it powers and
capacity to intervene in the market
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Abhijit Sen Committee report on Future Trading - 2008
• FMC should frame regulations on various aspects of market
operations for transparent and efficient functioning of the
market
• Care should be taken to enable farmers and small operators
to take benefit of these markets. Exchanges should be
recte to es gn t e r mar et proce ures an contracts
such as to enable farmers an easy access to these market
and protection against any market malpractices
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Abhijit Sen Committee report on Future Trading - 2008
• The most important enabler of the market is to upgrade the
quality of regulation both by the FMC and by the Exchanges
• Exchanges must act as self regulatory organizations and to
demonstrate fair play, objectivity and customer orientation• The contract designs, delivery mechanism such as assaying,
availability and accreditation of warehousing should meet
• Before listing of new products on futures market, a rigorousexamination is required. These efforts need to be
strengthened further, particularly at the level of regulatory
approval of contract design
• In this context, particular emphasis needs to be put in
avoiding approval of such contracts where basis risk is likely
to exceed spot price
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Abhijit Sen Committee report on Future Trading - 2008
•‘Options in goods’ can be another hedge instrumentsuitable for farmers’ needs
• However, complex options products may be difficult to
comprehend and not suitable for farmers’ needs till market
attains maturity of operations and regulations
• Moreover, since the premium on option may be quite high,
this can be subsidized to some extent by using the
collection from proposed CTT exclusively for thedevelopment of agricultural markets and to improve access
of the farmers to them
• In the longer run, it is also worth exploring the possibility of
MSP implementation agencies such as FCI operating in thecommodity market as an option writer in respect of goods
it needs to procure for the operation of PDS
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Forward Contracts (Regulation) Amendment Bill
• Once the Bill is passed and enacted by Parliament, ForwardMarket Commission (FMC) as a regulator will get autonomy
and power to regulate the market effectively
• New products like `options’ will be allowed in the
commodity market. This will benefit various stakeholders
` ’
`price risk management`
• The Bill would enhance public accountability of the
Regulator by providing for an Appellate Authority
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Forward Contracts (Regulation) Amendment Bill
• Forward Markets Commission (FMC), to be at par withcapital markets regulator Sebi, making it an autonomous
regulator which currently is overseen by the Ministry of
Consumer Affairs, Food and Public Distribution
• Contradiction - The Wajahat Habibullah Committee had
regulatory regime for the commodities futures market andthe securities market, as is the case in most jurisdictions,
whereas this Bill seeks to create a new autonomous body
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Forward Contracts (Regulation) Amendment Bill
• The main objective of this Bill is to permit and regulate afinancial instruments which enables buyers and sellers of
commodities to effectively manage risk from price
fluctuations and open the door for the introduction of newintangible products like options and indices trading in the
commodities futures market
•
lower penalty for the same kind of offence in comparisonto the penalty levied in the Sebi Act
• While the FMC is to regulate all commodity derivatives, the
markets for the underlying goods will be regulated by state
governments, which could lead to duplication in regulation.
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Forward Contracts (Regulation) Amendment Bill
• The Parliamentary standing committee has suggestedinclusion of financial institutions and banks, mutual funds
and insurance companies to participate in forward markets
so as to ensure better price discovery and lower thevolatility in the market
• Some of the major changes which this amendment
definition of a 'ready delivery contract' to include allcontracts that provide for the delivery of goods and
payment of the price within 30 days
• Currently, ready delivery contracts needs to be delivered
and paid for immediately or within 11 days but this
legislative piece extends this period of the ready (spot)
delivery to 30 days.
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Forward Contracts (Regulation) Amendment Bill
• The Bill defines 'commodity derivatives' and permitstrading in them
• the Bill requires all exchanges to be corporatised and
demutualised by a date to be decided by FMC• Corporatisation means the exchange will have to convert
from being a body of individuals or a society to a company
•
separate from ownership and management of the company• The Bill proposes to empower the FMC to issue franchisee
registration certificates to sub-brokers of member-brokers
of commodity exchanges and to take decisions of increasing
salaries of its member-directors and other office bearers.
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Forward Contracts (Regulation) Amendment Bill
• The number of members of the FMC has also beenincreased from four to nine, including one chairperson, of
which eight members will be selected by the central
government, and one by the Reserve Bank of India• The Bill allows the FMC to impose penalties in case of
failure to furnish information or comply with the directions
,
fraudulent and unfair trade practices and in any other caseof contravention of the provisions of the Principal Act
• All sums collected by way of penalties shall be credited to
the Consolidated Fund of India and appeals shall lie from
the order of the FMC to the Securities Appellate Tribunal
established under the Sebi Act
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Forward Contracts (Regulation) Amendment Bill
• The Bill makes a provision for the transfer of duties andfunctions presently performed by a clearing house to a
clearing corporation
• The central government has the power to prohibit forward
contracts or options in goods or commodity derivatives by
matters of policy and to supersede it in certain cases
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Forward Contracts (Regulation) Amendment Bill
• Further, the central government is also empowered tosuspend a member on appropriate grounds
• Overall, through this Bill Government is making an effort to
regulate the commodities future market and bring moreclarity in the existing provisions
– The main beneficiaries of these reforms will be the
raw materials to produce them – Options would provide useful price signals to producers
and farmers which in turn would gain more security in
the volatile markets
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Foreign Investment in Commodity Exchange
• Limit of Foreign investment - 49%• Registered FII under Portfolio Investment Scheme (PIS) is
limited to 23%
•
Investment under FDI Scheme is limited to 26%
Other conditions
and(ii) No non-resident investor/ entity, including persons acting
in concert, will hold more than 5% of the equity in these
companies
While it is not clear, however, it is presumed that for an
increase in FII investment within the 49 per cent cap,
approval would be under the automatic route
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Present Limitations of FMC
• Option trading prohibited
• Functions as a Government department with limited
autonomy with respect to :
– Recognition / de-recognition of Exchanges
– Regulation of Intermediaries
–
– Market Expansion has put heavy pressure on the FMC’scoping capacity
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Summary of proposed regulatory measures
• Registration of brokers / intermediaries
• Audit of brokers / intermediaries.
• Penalties for violation of limit on open position
• Contract designs being made broad based – Urad,
Tur, Potato
•
Clubbing of Open Interest to prevent Cartelization
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Summary of proposed regulatory measures (Cont.)
• Review of non operative / illiquid contract at theExchange
• Stringent Norms for client Code Modifications
• Permanent Account Number made mandatory
• Portfolio Management Scheme prohibited
•
Uniformity in Transaction Cost
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Summary of proposed regulatory measures
• Harmonization of Regulatory measures acrossexchanges
• Move towards Compulsory Delivery
• Restrictions on Proprietary account trading
• Rationalization of daily price limits, especially in
sens ve commo es.
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Case study: Risk Management Practices in Tea Markets
Types of variability of in Asset Price• Random noncyclical
• Random cyclical
• Intra year pattern cyclical
• Inter year pattern cyclical
• Monotone trend
Conclusion of various studies• Positive relation between trading volume and volatility and
also a strong negative relation between time to maturity
and trading volume• Increased financial speculation in commodity index futures
was highly destructive for the market, mainly because
speculators would never take delivery of the commodity
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Case study: Risk Management Practices in Tea Markets
• Plantation Commodities - Black pepper and coffeehave futures market in India
– International Pepper and Spice Trade Association (IPSTA) in
Cochin since 1958 – Coffee Futures Exchange of India (COFEI) based in
Bangalore, since 1998
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Case study: Risk Management Practices in Tea Markets
• Is there a need of Futures Contracts in Tea?
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Case study: Risk Management Practices in Tea Markets
• Option 1 – • Challenge – Heterogeneous nature of tea
• Damodaran suggested a framework for developing
commodity based futures contracts in tea
• Useful for tea packers, importers’ agents and bulk tea
merchandisers’ agents
•
Orthodox and CTC grades, be sold through 2 centres (one inNorth India and one in South India), be sold over a time
cycle of 14 months and delivered from certified
warehouses
• Methods to provide Liquidity
• Settlement