Term Paper_ Evolution Of Derivatives In India 432y62

Evolution of Derivative in India

1. Introduction Derivative products initially emerged as hedging devices against fluctuations in stock and commodity prices, and financial and commodity-linked derivatives remained the sole form of such products for almost three hundred years. By defining the term precisely, a derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets1. However, since their emergence, these products have become very popular and by 1990s, they ed for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in of variety of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major s of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with index derivatives vis-à-vis derivative products based on individual securities is another reason for their growing use.

2. Financial Derivatives in India A liquid market for forward foreign exchange contracts has existed in India for several decades now. This product is still the main instrument for hedging foreign exchange risk in India, although foreign currency options are also getting increasingly popular. Over the last 10 years or so, several other types of derivatives have begun trading in India. As you are aware, efforts are on for introduction of credit derivatives in India. Feasibility probes for foreign exchange futures have begun. Efforts are also on for an appropriate design for interest rate futures. In the recent years, the regulatory ecosystem for financial derivatives has been sought to be made more effective and straight forward. Insertion of a new Chapter IIID to the RBI Act, 1934 by way of an amendment in 2006 has been a milestone in this regard, since this has provided legal clarity as regards OTC derivatives and has also defined regulatory domain and scope. ing treatment of financial derivatives in banks is also being streamlined so as to be broadly in tune with international standards. L. C. Gupta committee (1998) came out with the major recommendations on the parlance of financial derivative in India. In post-liberalization, the committee was in favour of that futures trading through derivatives should be introduced in phased manner starting with stock index 1

To mitigate the three risks, precisely, exchange rate risk, interest rate risk, and equities/market risk (systematic risk).

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futures, which will be followed by options on index and later options on stock. This, in turn, will expedite the efficiency and liquidity of cash markets in equities through arbitrage process. In continuation of the report, there should be two-level regulation, i.e. one at exchange level and other is at SEBI level (for financial derivatives). Further there must be considerable emphasis on self regulatory competence of derivative exchanges under the overall supervision and guidance of SEBI. The derivative trading should be initiated on a separate segment of existing stock exchange having an independent governing council. The number of the trading should be limited to 40 percent of the total . The chairman of the governing council will not be permitted to trade on any of the stock exchange. The settlement of derivatives will be through an independent clearing corporation (e.g. National Securities Clearing Corporation of India Limited, (NSCCL) looks after the settlement issue in India) house, which will become counter-party for all trades or alternatively guarantees the settlement of all trades. The clearing corporation will have adequate risk containment measure (four-sigma level at Value at Risk, 99% level of Confidence of Interval) and with collect margins through electronic fund transfer (EFT). The derivatives exchange will have on line trading and adequate surveillance system. It will disseminate trade and price information on real time basis through two information vending networks which should inspect 100 percent of every year. There will be complete segregation of client money at the level of trading/clearing member level and even at the level of clearing corporation. The clearing should deposit minimum Rs 50 lakhs with clearing corporation (both for trading cum clearing member (TCM) and permanent clearing member (PCM) and should have a net worth of rs.3 crore. Committee raised the point for the removal of the regulatory prohibition on the use of derivatives by mutual funds while making the trustees responsible to restrict the use of derivatives by mutual funds only to hedging and portfolio balancing and not for restriction. The operations of the cash market on which the derivatives market will be based, needed improvement in many areas. The committee asked for the creation of a derivative cell, a Derivative Advisory Committee, and Economic Research wing by SEBI and the declaration of Derivatives as „securities‟ under Section 2 (h) of the SC(RA) and suitable amendments in the notification issued by the central Government in June, 1969 under Section 16 of the SCRA (Gupta, 2005, pp.121-122).

2.1. Categories of Derivatives Traded in India Commodities futures for coffee, oil seeds, and oil, gold, silver, pepper, cotton, jute and jute goods are traded in the commodity futures. FMC regulates the trading of commodities futures and controls the trading nuances for 21 regional level exchanges including 3 national level multi commodity exchanges. Index futures based on Sensex and NIFTY index are also traded under the supervision of SEBI. The RBI has permitted banks, and primary dealers (PD‟s, although before 2007 regulation being ratified on futures market, financial institutions were permitted) to enter into forward rate agreement (FRAs)/interest rate swaps in order to facilitate hedging of interest rate risk and ensuring orderly development of the derivatives markets. The National Stock Exchange (NSE) became the first exchange to launch trading in options on individual securities apart from index futures/options. Trading in options on individual securities commenced from July, 2001. Options contracts are American style and cash settled and are available in about 40 securities stipulated by SEBI. The NSE commenced trading in futures on individual securities on November 9, 2001. The futures contracts are available in about 31 securities stipulated by SEBI. The BSE also started trading in stock options and futures (both index and stocks) around at the same time as the NSE.



The NSE commenced trading in interest rate future on June 2003. Interest rate futures contracts are available on 91-day T-bills, 10-year bonds, and 10-year zero coupon bonds as specified by the SEBI. There are other schemes and categories of derivatives like exchange traded bonds, options and currency futures to be introduced subsequently on futures trading platform. A notable change observed in the year of 2008 is about currency futures which were commenced on August 29, 2008. CME (Chicago Mercantile Exchange) created the first financial futures in 1972 when it offered a futures contract between the dollar and seven currencies. It is, therefore, interesting to notice that Indian Commodity Exchanges have also lined up to offer currency derivatives trading. But the success of the trading will depend on the market microstructure and how it evolves over time…the first issue is the link between the existing OTC market and the exchange-traded futures market that is about to kick off soon. While the OTC market will understandably continue to dominate in volume , the first-cut structure of the futures market seems to indicate that fetters have already been put on its growth. The nuance behind it is participants in the exchange can‟t keep an open position larger than $5 million, a small limit compared to the typical hedging needs of those with currency exposures. While speculators provide the liquidity and efficient price discovery to any market, their role will be constrained by the predominance of the OTC market and the apprehension of illiquidity in the futures market. Second, the report of technical committee on exchange traded currency futures ahs prescribed that trading hours be restricted between 9 am to 5 pm. Apart from raising financial questions about why the committee should be bothering about this issue, and not leaving it to the discretion of exchange, it also displays the regulators‟ determination to keep its control over even the futures market. The OTC market is largely a telephone-quote driven market, dominated by banks. The RBI typically uses one of the large public sector banks to send its currency signals through this market, despite all claims of allowing the rupee to float freely. With markets closing simultaneously and the OTC market‟s signaling role dominating, the futures markets will have to necessarily follow, and not lead…third, the market has forbidden entry to non-resident Indians and foreign institutional investors (FIIs). Most overseas investors, especially portfolio investors, have turned to the Singapore-based nondeliverable forwards market to hedge their investments in India. The regulators have looked as this offshore market has grown in size. That begs the question: is there a future for the currency futures market, without full convertibility or without round-the-clock trading? (Singhal, 2008: adapted from ET, under the editorial column, „„Future of Currency Futures: Serendipity‟‟)

TABLE 1: Calendar of Introduction of Derivatives Products in Indian Financial Markets OTC Exchange traded June, 2000-Equity index futures 1980s-Currency forwards 1997-Long term foreign currency, rupee June, 2001-Equity index options swaps July, 2001-Stock option July, 1999-Interest rate swaps and FRAs June, 2003-Interest rate futures July, 2003-FC-rupee options August, 2008-Currency futures Source: www.derivativesportal.com

TABLE 2: Financial Derivatives in India: A Chronology Date Progress NSE asked SEBI for permission to trade 14 December, 1995 futures SEBI setup L.C.Gupta committee to draft a 18 November, 1996 policy framework for index futures L.C.Gupta committee submitted report 11 May, 1998 Page 3 of 20 CIS -TERM PAPER//FPRM/IRMA (2008-09)


7 July, 1999 24 May, 2000 25 May, 2000 9 June, 2000 12 June, 2000 31 August, 2000 July, 2001 June, 2003 July, 2003 August, 2008

RBI gave permission for OTC forward rate agreement (FRAs) and interest rate swaps SIMES chose NIFTY for trading futures and options on an Indian index SEBI gave permission to BSE and NSE to do index futures trading Trading of BSE sensex futures commenced at BSE Trading of NIFTY futures commenced at NSE Trading of futures and options on NIFTY to commence at SIMES Trading on equity futures commenced at NSE on 31 securities Trading on interest rate futures commenced at NSE Trading on FC-rupee options started Currency Futures derivatives- mooted on the platform of SEBI, RBI, BSE, and NSE

3. Evolution of Financial Derivatives in India The most praiseworthy development in the history of secondary segment of the Indian Stock market is the commencement of derivatives trading in June, 2000. The SEBI approved derivatives trading based on futures contract at National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) in accordance with bye-laws/rules and regulations of the stock exchanges. To begin with, the SEBI permitted equity derivatives named stock index futures, which was introduced on BSE on 9 June, 2000 based on the sensitive index (also referred to as SENSEX comprising 30 scripts) named BSX, and NSE started on June 12, 2000 stock index future based on its S&P 500, CNX, NIFTY (comprised 50 scripts) in the name of NFUTIDXNIFTY. Further the details are furnished as under (Gupta, 2005; Sinha, and Nath, 2001). TABLE 3: Salient features of Index Futures Contract at BSE and NSE S. No. Particulars BSE Date of commencement 9 June 2000 1 Name of Security BSX 2 Underlying asset BSE Sensitive index 3 (SENSEX) Contract size Sensex value×50 4 5

Tick size/price step

6 7

Minimum Price fluctuation Price bands

NSE 12 June 2000 N FUTIDX NIFTY S&P CNX NIFTY

200 or multiples of 200 0.1 point of Sensex Rs.0.05 (equivalent to Rs.5) Rs.5 Not applicable NA Not applicable Page 4 of 20

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8 9

Expiration months Trading cycle

10

Last trading/Expiry day

11

Settlement

Index closing price on last trading day which is computed on the basis of the weighted average of last 15 min. trading. Daily Settlement price (DSP) Closing of futures 13 contract which is computed on the basis of weighted average of the last 5 min, or if the no. of weighted average of the last 5 trades. Trading hours 9:30 am to 3:30 pm 14 Margin Upfront margin on 15 daily basis Source: NSE and BSE weblinks, www.nseindia.com and www.bse.com 12

Final Settlement price (FSP)

3-near months A maximum of 3 months, the near month (1), the next month (2), the a month (3) Last Thursday of the month or the preceding day In cash on T+1 basis

3-near months As in previous column

As in column

previous

As in previous column Index closing price on 1st trading day which is weighted average for the last half an hour‟s trade. Closing contract

of

As in column

futures

previous

4. Commodity Derivatives in India The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty.



On the other hand, a merchant with an ongoing requirement of grains too would face a price risk; that of having to pay exorbitant prices during dearth, although favorable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into a contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be a futures-type contract, which would enable both parties to eliminate the price risk. The Forwards Contracts (Regulation) Act, 1952, regulates the forward/ futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity forward/ futures contracts. However when derivatives trading in securities was introduced in 2001, the term „security‟ in the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the purview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets.

5. History of commodity derivatives: world sketch Early forward contracts in the US addressed merchants' concerns about ensuring that there were buyers and sellers for commodities. However „credit risk‟ remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first „exchange traded‟ derivatives contract in the US-these contracts were called „futures contracts‟. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest financial exchanges of any kind in the world today. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in , SGX in Singapore, TIFFE in Japan, MATIF in , Eurex etc.

6. Evolution of commodity derivatives in India: a time line Commodity Derivative markets were set up in India in cotton in 1875 and in oilseeds in 1900 at Bombay. Forward trading in raw jute and jute goods started at Calcutta in 1912. Forward Markets in Wheat had been functioning at Hapur since 1913, and in bullion at Bombay, since 1920. In 1919, the government of Bombay ed Bombay Contract Control (War Provision) Page 6 of 20 CIS -TERM PAPER//FPRM/IRMA (2008-09)


Act and set up the Cotton Contracts Board. With a view to restricting speculative activity in cotton market, the Government of Bombay issued an Ordinance in September 1939 prohibiting option business. Bombay Options in Cotton Prohibition Act, 1939, later replaced the Ordinance. In 1943, the Defence of India Act was utilized on a large scale for the purpose of prohibiting forward trading in some commodities and regulating such trading in others on an all India basis. In the same year oilseeds forward contracts prohibition order was issued and forward contracts in oilseeds were banned. Similarly orders were issued banning forward trading in food-grains, spices, vegetable oils, sugar and cloth. These orders were retained with necessary modifications in the Essential Supplies Temporary Powers Act 1946, after the Defence of India Act had lapsed. With a view to evolving the unified systems of Bombay enacted the Bombay Forward Contract Control Act, 1947.

6.1. Committee on Forward and Futures Markets: Review (1952-2001) The Government of India appointed various committees at different time to look into the regulatory framework of futures trading in the country. Tracing to different committees, in 1950, the Indian Government appointed the A.D. Shroff committee whose report formed the basis of Forward Contracts (Regulations) Act, 1952. In 1966, the M.L. Dantwala Committee reviewed the SCR Act and the functioning of the Forward Markets (FMC, 1953). Further, in 1993, GOI constituted the committee, K.N.Kabra Committee which submitted its report in September, 1994 with the noted recommendations. The commodity exchanges should enroll more . Capital adequacy norms must be ensured for smooth functioning. The commodity exchanges should be computerized to accommodate on-line trading other than open outcry. Internal vigilance mechanism of the exchanges should be strengthened (circuit breakers). Non-transferable specific delivery forward contracts should be freed from restrictions. Option and range forward contracts may be introduced. However, this was not agreed by the Chairman of the committee. The exchanges should be recognized on permanent basis. The exchanges should be developed into self-regulatory organizations. The Forward Markets Commission should be strengthened with more powers including formation of statutory body of board of Directors. More commodities should be included in futures trading like basmati rice, cotton seed, ground nut, rapeseed, linseed, copra, sesame seed, mustard seed, soybean, etc. (Gupta, 2005: pp.156).

At the same time, in 1994, another committee was constituted under the chairmanship of O.P.Sodhani on foreign exchange markets functioning. The reason behind the formation owing to the forward contracts and options on foreign exchange are conducted through over-the-counter (OTC) markets and regulated by RBI. The companies should be given permission to book, cancel, and rebook options on foreign currencies. Banks should offer range forward contracts. There should be no withholding taxes on derivatives transactions. More liberty should be given to banks to use derivatives. More derivatives instruments like caps, dollars, floors, FRAs, swaps should be allowed to offer by the banks to the traders without approval of RBI. Different specific dealers should be allowed to offer derivatives instruments. Proper documentation and market practices should be evolved for better functioning of the markets (Gupta, 2005: pp.157).



After almost three years, RBI set up a committee under the aegis of R.V.Gupta (1997) to review „Hedging‟ through International Commodity Exchanges and other related issues. The committee‟s main recommendations are as under. All the Indian companies with genuine commodity price risk exposures are to be allowed to hedge through off shore commodity futures and option markets. The Central Government should grant permission for such hedging transactions and the RBI should grant the necessary exchange control permission. Only hedging contracts for genuine price exposure through international markets should be allowed, not the speculative or profit seeking objectives. OTC instruments like vanilla swaps would only be permitted where they have only efficient means of hedging. Use of options would not be allowed. The committee recommended a phased manner approach. In Phase-I, the hedging should ordinarily be through exchange traded commodity futures. Phase I would be a period of acclimatization. At this stage prior approval would be required to ensure existence of genuine underlying risk, the appropriateness of the hedging instrument, and adequateness of risk management procedures. In Phase-II, no prior approval, as recommended in Phase-I should be needed. Only periodic scrutiny of actual transactions and auditor‟s adequacy of control are sufficient. The committee further recommends that hedging should be allowed through foreign derivatives markets (Gupta, 2005: pp.157).

In India, stock index futures are available for one-month, two month and three month maturities. All the open positions in these contracts are settled daily. Further, the buyers and sellers are required to deposit margin (initial and maintenance margin if required) with the respective stock exchanges as per the SEBI guidelines. To facilitate the effective risk management in the derivatives segment, all the important measures like minimum net worth (50 lakh to 25 lakh including PCM and TCM, NCDEX, 2003) requirement for the broker, determination of margin based on value at risk model, position limit for various participants, mechanism for collection and enforcement of margin, etc. have been put in place. Subsequently, the derivative products range had been increased by including options and futures on the indices and on several highly traded stocks. In an estimate, the product wise turnover of derivatives on the Indian stock markets as on July 6, 2002 is stock futures (50%), index futures (21%), stock options (25%), and index options (4%) showing that stock futures are most popular derivative traded at the stock market of India. During the last decade, to make stock market functioning effective for futures trading, the SEBI has adopted several internationally tested and accepted mechanisms for implementation at the Indian stock exchanges. For this, surveillance and risk containment like the circuit breaker, price bands, value at risk (VaR) based margin collections, etc. have been introduced. The SEBI set up a „Technical Group‟ headed by Prf. J.R. Verma, IIM-Ahmedabad (1996) to prescribe risk containment measures for new derivative products. The group recommended the introduction of exchange traded options on indices which is also conformity with the sequence of introduction of derivatives products recommended by the standing committee. The following are the salient features of the risk containment framework for the trading and settlement of both index futures and index options contracts. European style options will be permitted initially. These will be settled in cash. Index option contracts will have a minimum contract size of Rs. 2 lakh, at the time of its introduction. The risk containment measures described hereunder are only for style European option. Index option contract will have a



maximum maturity of 12 months and a minimum of three strikes, i.e. in the money, near the money and out of the money. A portfolio based margining approach, which would take an integrated view of the risk involved in the portfolio of individual client, will be adopted. It is for the first time that such an approach is introduced in the Indian Stock market. It is inconsistent with the practices followed in the countries. This approach will not only cover the risk but also help in reducing the transaction costs in derivatives. The initial margin requirements will be based on worst case loss of a portfolio of an individual client to cover a 99% value at risk (VaR) over a one day horizon. The initial margin requirement will be netted at level of individual client and it will be on gross basis at the level of trading/clearing member. Further, the initial margin requirement for the proprietary position of trading/clearing member will also be on net basis. The short option minimum margin equal to 30% of the notional value of all short index options will be charged if sum of the worst scenario loss and the calendar spread margin is lower than the short option minimums margin. Net option value (strike price minus exchange rate minus or option price, St-K-P or K-StP) will be calculated the option times the number of options (positive for long position and negative for short position) in the portfolio. The net option value will be added to the liquid net worth (LNW) of the clearing member (TCM and PCM). For option positions, the will be paid in by the buyer in cash and paid out to the seller in cash on T+1 day until the buyer pays in the due shall be deducted from the available LNW on real time basis. In case of index futures contracts, the mark-to-market (MTM) gains-losses for index futures positions will continue to be settled…SEBI‟s technical group on new derivatives products has recently examined this issue and recommended the following measures for the development of derivatives market. The systems of sub-brokers are to be used for increasing the volume of trading in this market. Financial institutions and mutual funds should be permitted to sell short in the cash market for facilitating the free arbitrage between cash and derivatives market. However, such short sale may be restricted to the extent of corresponding exposure in the derivative market. Arbitrage between cash and derivatives markets will assist in better price discovery in both the markets (Gupta, 2005: pp.129).

However, the futures markets experts observed that due to lack of experience of the Indian corporate sector regarding the functioning of international commodity exchanges‟ (CME, CBOT, LME, NYBoT2 etc.) derivatives and inadequate experience amongst auditors, a longer „acclimatization‟ period of at least three years is desirable instead of one year as recommended by the committee. Policy initiatives in commodity markets. The expert committee (Shankarlal Guru committee, 2001) was set up by the Govt. of India, MoA to suggest measure for strengthening and developing of agricultural marketing system in the country, had made several important recommendations in the year of 2001 to initiate policy, legal and market infrastructure related reform programs. MoA constituted an inter-ministerial task force to examine the recommendations of the above expert committee and to suggest measures to be initiated for implementation within a period of three months. The inter-ministerial force constituted nine different sub groups on different aspects to examine the feasibility of implementing recommendations made by the expert committee. One of the groups was dealt with forward and futures market (Raipuria et al, 2001; Economic Advisory Group). The salient features of presented report are as under. Some insights drawn from the report is a reform packages suggested by Govt. of India and the FMC on the commodity exchanges, furnished below. (Prior to establishment of electronic auction-traded exchanges in India) 2

CME-Chicago Mercantile Exchange, CBoT, Chicago Board of Trade, LME, London Mercantile Exchange, NYBoT, New York Board of Trade (Commex)



The system of daily mark-to-market (MTM) margining (based on contract specified maintenance margin) is to improve financial integrity of the markets. The system of simultaneous reporting under which /brokers are required to put the transaction slips in a sealed box within fifteen minutes of execution of transaction. This measure facilitates audit trail and ensures that clients‟ contracts are executed at a correct price. Trading ring discipline to be ensured by appointing a ring inspector, issuing of badges, prohibiting the entry of unauthorized persons in pit, surprise checks is to be ensured by exchanges. The exchanges are to appoint a qualified secretary to look after its day-to-day operation. Representation of diverse groups like growers, processors, exporters, and importers are included in commodity futures market. The commodity exchanges are to introduce a system of guaranteeing performance of the contract. However, the manner in which the contracts would be guaranteed by the exchange or a separate clearing house/corporation is left to the individual exchanges. Exchanges like IPSTA, BCE have set up independent clearing houses, which guarantee performance of the contract. Other exchanges have set up, or are in process of setting up, of „Trade Guarantee Fund (TGF) within exchange to guarantee performance of contracts. The commodity exchanges are to amend their rules/Articles of Association so as to provide alteast one third of the total strength of Board of Directors to be independent and non-trading directors. The measure has been taken to professionalize the Board of exchanges in public interest and in the general trade interest. The exchanges should be run as public institutions. Adoption of an online trading platform has been a necessary condition for the exchanges recognized for futures trading in edible oil seed complex (FMC Bulletin, 2002: pp.211-212).

From trading statistics during the latter half of the nineties volumes (VOT) and value of trading (NOP) in some of the exchanges had reached reasonable levels while others had been striving and the summary position is as follows. TABLE 4: Volume of Trading and Net Open Position of consolidated regional exchanges (Commodities) Year 1996-97 1997-98 1998-99 1999-00 2000-01

VoT (Rs. in bn) 313.56 314.79 326.50 228.593 273.80

Source: FMC Bulletin, Vol. XLIV (1), Jan 2002

6.2. Progress in Indian Commodity Markets (1999-2001): Summing Up The four exchanges which were recognized for edible oil seed complex like BCE, Mumbai, NBoT, Indore, Kanpur commodity exchange, Kanpur, First commodity exchange, Kochi have assured to go online in stipulated time-frame. The commission has been adopting a persuasive approach by impressing them the need of switching over to online trading platform. BCE has already introduced online trading, East India Cotton Association (EICA), and India Pepper and Spice trade association (IPSTA) have made substantial progress in this direction (shown in Annexure 1 & 2).

3

The drastic decline in value of trading in 1999-2000 was mainly on of the reduced trading at the Jute Exchange at Kolkata (dropped from Rs. 5022 to Rs.1234 mn) and castor seed exchange at Ahmedabad (decreased from Rs. 6854 to Rs. 5220mn); refer to FMC Bulletin, Vol. XLIV (1), Jan 2002.



Many exchanges have developed software for their back office operations and provided e-mail connectivity. All the commodities are not suited for futures trading, for a commodity to be suitable for futures trading it must possess the following characteristics, the commodity should have a suitable demand and supply conditions, i.e. volume (production) and marketable surplus should be large; price should be volatile to necessitate hedging through future trading, in this case persons with spot market commitment face a price risk. Resulting there would be demand for hedging facilities. The commodity should be free from substantial control from Govt. regulations (or other bodies) imposing restrictions on supply, distribution, and prices of the commodity. The commodity should be homogeneous (assaying quality, quantity) or alternately it must be possible to specify standard grade and to measure deviations from the grade. This condition is necessary for the futures trading in standardized contract. The commodities should be storable and in absence of this condition arbitrage would not be possible and there would be no relationship between spot and futures market. Based on the above criteria and as a follow up of the recommendations of the Kabra committee (1994) the Government has permitted futures trading in various commodities. However, the current practice in USA and other Western countries is to allow futures trading in a range of commodities including live cattle, feeder cattle, hogs, pork bellies, fluid milk, rubber, tea, wool, and industrial metals like copper, gold, lead, aluminium, silver, zinc and even in a number of „non-commodities‟ such as weather index and pollution permits (FMC, 2002-03). TABLE 5: Trends in volume trade on Futures Exchange Turnover (Rs. in Cr) Growth (%)

2002-03 66,530

2003-04 1,29,363

2004-05 5,71,759

2005-06 21,34,471

2006-07 33,27,633

92.8

94.4

342.0

273.3

55.9

Source: Annual Report, Ministry of Consumer Affairs, Food and Public Distribution, 2007, Delhi

TABLE 6: Trends in Exchange-wise Turnover Value (Rs Crore) 2005 2006 MCX(market share) Metals Energy Agriculture Total NCDEX(market share) Metals Energy Agriculture Total NMCE(market

(Jan- 2005

Share (%) 2006

41.7

59.9

2007 Mar) 74.1

2007 (JanMar)

3,91,693 1,41,327 1,00,303 6,33,324 57.5

16,87,759 1,68,319.8 1,69,589.7 20,25,668 36.8

5,30,345 97,653 43,027 6,71,027 24.7

61.8 22.3 15.8 100.0

83.3 8.3 8.4 100.0

79.0 14.6 6.4 100.0

1,04,654 3,560 7,66,712 8,74,927 0.8

2,26,741 4,042.3 10,12,555 12,43,339 3.3

26,884 1,323 1,95,018 2,23,226 1.2

12.0 0.4 87.6 100.0

18.2 0.3 81.4 100.0

12.0 0.6 87.4 100.0



share) Metals Agriculture Total Grand Total

12,133 12,133 15,20,385

8,116 1,03,226 1,11,343 33,80,350

3,689 7,379 11,068 9,05,322.7

100.0 100.0

7.3 92.7 100.0

33.3 66.7 100.0

Source: Market Review, Forward Markets Commission (www.fmc.gov.in)

7. Growth of Commodity Futures Market: Review (2003-2007) The year 2003 is a watershed in the history of commodity futures market. The last group of 54 prohibited commodities was opened up for forward trading, along with establishment and recognition of three new national exchanges with on-line trading and professional management. Not only was prohibition on forward trading completely withdrawn, including in sensitive commodities such value of trading since 2004-05. Although agricultural commodities led the initial spurt, and constituted the largest proportion of the total value of trade till 2005-06 (55.32%), this place was taken over by bullion and metals in 2006-07. The growth in 2006 as wheat, rice, sugar and pulses which earlier committees had reservations about, the new exchanges brought capital, technology and innovation to the market. These markets notched up phenomenal growth in of number of products on offer, participants, spatial distribution and volume of trade. Starting with trade in 7 commodities till 1999, futures trading is now available in 95 commodities out of 103 allowable commodities for participation in trading (Nath and Lingareddy, 2008). There are more than 3000 ed with the exchanges. More than 20,000 terminals spread over more than 800 towns/cities of the country provide access to trading platforms. The volume of trade has increased exponentially since 2003- 04 to reach Rs. 36.77 lakh crore in 2006-07. Almost all of this (97.2%) of this is now ed for by the three national exchanges. The other 21 Exchanges have a miniscule share in the total volume. (Sen et al., 2007, FMC) The growth in commodity futures trade has spawned an upsurge of interest in a number of associated fields, viz. research, and education and training activities in commodity markets, commodity reporting for print and visual media, collateral management, commodity finance, ware-housing, assaying and certification, software development, electronic spot exchanges etc. Markets and fields almost non-existent four years ago now attract significant mind-share nationally and internationally.

7.1. Major breakthrough in commodities’ futures Futures contracts are available for major agricultural commodities, metals and energy. Commodity group-wise -07 was almost wholly (88.7%) ed for by bullion and metals, with agricultural commodities contributing a small fraction (10.7%). This was partly due to the stringent regulations, like margins and open interest limits, imposed on agriculture commodities and the dampening of sentiments due to suspension of trade in few commodities. Futures market growth in 2006-07 appears to have byed agriculture commodities.



TABLE 7: Commodity-wise Trends in Volume-traded 2005 Share 2006 Share January- (%) January- (%) December December 4,87,333 32.1 16,81,220 49.7 Precious metals: 2,06,398 13.6 10,45,573 30.9 Gold 2,80,935 18.5 6,35,647 18.8 Silver 0.3 2,33,449 6.9 Basemetals: 3916 5,072 0.2 Aluminium 31 3,544 0.2 1,76,941 5.2 Copper 337 Lead 230 946 Nickel 111 193 Tin 49,960 1.5 Zinc 5,099 0.3 7,947 0.2 Ferrous 1,44,888 9.5 1,72,362 5.1 Energy: 1,44,288 9.5 1,37,372 4.1 Crude oil 32,625 1.0 Natural gas 489 1,229 Polymers 8,79,149 57.8 12,85,372 38.0 Agri: 10,664 0.7 34,543 1.0 Cereal 9,327 0.6 7,602 0.2 Fibre 1,04,548 6.9 1,28,854 3.8 Oil Complex 3,00,699 19.8 5,16,137 15.3 Pulses 0.3 6,944 0.2 Plantations 4,828 27,606 1.8 1,46,482 4.3 Spices 4,21,477 27.7 4,44,808 13.2 Others 15,20,385 100 33,80,350 100 Total

2007 JanuaryMarch 3,86,523

Share (%)

2,04,261 1,82,263 1,73,353 3,966 99,909 1,110 11,996 335 56,037 1,043 98,978 87,181 11,793

22.6 20.1 19.1 0.4 11.0 0.1 1.3 0.0 6.2 0.1 10.9 9.6 1.3

42.7

Growth in 2006 (%) 245 407 126 5,861 16,181 4,893 311 74 56 19 -5

2,45,426 2,749 2,401 46,971

27.1 0.3 0.3 5.2

151 46 224 -18 23

45,713 4,005 87,972 60,615 9,05,323

5.0 0.4 9.2 6.7 100

72 44 431 6 122

Source: Forward Markets Commission, NCDEX, and MCX, Mumbai, 2007

TABLE 8: Commodity Group-wise value of trade (Rs. in lakh Crore) Commodity 2004-05 2005-06 2006-07 Groups ((Rs. in lakhs Cr) 7.79 (36.15) 21.29 (57.90) Bullion and 1.80 (31.47) other metals Agriculture

3.90 (68.18)

11.92 (55.31)

13.17 (35.82)

2007-08

26.24 (64.55) 9.41 (23.15)



Energy

0.02 (0.35)

1.82 (8.45)

2.31 (6.28)

5.00 (12.30)

Others

0.00 (0.00)

0.02 (0.09)

0.001 (0.00)

0.00 (0.00)

Total

5.72 (100.00)

21.55 (100.00)

36.77 (100.00)

40.65 (100.00)

Source: Sen, 2008: FMC Expert Committee Report “the impact of futures trading on agricultural commodity prices”

TABLE 9: Trends in turn-over of Agricultural Commodities (Rs. Crore) JanuaryShare (%) JanuaryShare (%) JanuaryDecember December March 2005 2006 2007 8,79,149,1 100 12,85,372.0 100 2,45,426 Agriculture: 3,37,844.9 38.4 3,26,344.4 25.4 35,766 Guarseed 1,66,587.5 18.9 3,41,035.7 26.5 40,145 Gram 1,06,012.3 12.1 1,45,333.9 11.3 3,004 Urad 2.2 63,041.6 4.9 11,241 Mentha Oil 19,354.3 24,055.8 2.7 25,696.7 2.0 2,529 Tur 67,204.2 7.6 85,861.6 6.7 28,331 Soy oil 35,301.8 4.0 15,980.5 1.2 1,458 Guragum 14,493.9 1.6 22,145.4 1.7 8,620 Soy seed 9,213.0 1.0 60,905.8 4.7 31,891 Peeper 10,879.8 1.2 33,124.5 2.6 38,241 Jeera 9,072.7 1.0 28,828.8 2.2 1,409 Wheat 3,431.3 0.4 35,432.6 2.8 6,805 R Chillies

Share (%)

100 14.6 16.4 1.2 4.6 1.0 11.5 0.6 3.5 13.0 15.6 0.6 2.8

Source: Market Review, FMC (www.fmc.gov.in) (adapted from the article “Impact of Futures Trading on Commodity Prices”, (Nath and Ligareddy, 2008), published in Economic and Political Weekly.

Moreover, there has been a very significant decline in volume of futures trade in agriculture commodities during the year 2007-08, by 28.5%. The overwhelming bulk of this decline is ed for by Chana, Maize, Mentha Oil, Guar seed, Potato, Guar Gum, Chillies and Cardamom. Trade in these eight commodities, which ed for 57.9% of total futures trade in agricultural commodities in 2006-07, declined by over 66.4% during 2007-08 compared to previous year. The decline in these eight commodities exceeded the decline of futures trading volumes in all agricultural commodities taken together. Four commodities (wheat, rice, urad and tur) were de-listed for futures trading towards the end of financial year 2006-07. This de-listing has been held responsible in many circles for the recent general downturn in futures trading in agricultural commodities. But these four de-listed commodities together ed for only 6.65% of the total value of futures trading in all agricultural commodities in 2006-07. Thus, although this may have affected market sentiments



adversely, the delisting did not have any major direct contribution to the decline in trading observed during 2007-08. In fact, except chana and urad, the share of sensitive commodities in total value of futures trade in agricultural commodities has so far been quite insignificant. The combined share of other food grains (i.e. wheat, rice, maize and tur) peaked at 5.0% in 2005-06 and of sugar at only 2.2%. This is in line with what various Committees mentioned earlier had foreseen regarding prospects of futures trading in commodities with significant government intervention. If, nonetheless, de-listing has adversely affected market sentiment regarding futures trading more generally, this must be because of the “go-stop” nature of government policy on the matter (Sen et al, FMC, 2007).

7.2. Price Volatility issue of commodities We have come across to witness the recent phenomena that futures prices of the commodities leads to increase the spot or ready cash prices of the commodities owing to unscrupulous trading, speculation and also enormous pressure on inventory functions and consumption functions coupled with underlying market conditions. It has shown that 35.56 percent increase in minimum price (MSP) of rice, wheat, chana, and urad resulting into imposition of ban on futures trading of the four commodities (Sen, 2008: FMC Expert Committee report) Kamara (1982) found that the introduction of commodity futures trading gene rally reduced or at least did not increase cash price volatility. The study compared cash market volatility before and after the introduction of futures trading; thus, implicitly focused on the paradigm of introducing futures trading. Singh (2000) investigated the Hessian cash (spot) price variability before and after the introduction of futures trading (1988-97). Results of a multiplicative dummy variable model indicated that the futures market has reduced the price volatility in the Hessian cash market. On the other hand, Dasgupta (2004) found that there is a co-movement among futures prices, production decisions and inventory decisions. The results showed that the futures price elasticity of inventory is inversely related to the carrying cost. Therefore, an unnecessary hoarding will increase the carrying cost, leading to a lower responsiveness of inventory to futures prices. This paper also determines the effect of expected production shocks on the futures price elasticity of supply. Yang et al (2005) examined the lead-lag relationship between futures trading activity and cash price volatility for major agricultural commodities. Granger causality tests and generalized forecast error variance decompositions showed that an unexpected and unidirectional increase in futures trading volume causes an increase in cash price volatility. Further, they found a weak causal association between open interest and cash price volatility. Sahi (2006) studied the impact of introducing futures contracts on the volatility of the underlying commodity in India. Empirical results suggest that the nature of volatility has not changed with the introduction of futures trading in wheat, turmeric, sugar, cotton, raw jute and soy oil. However, a weak destabilizing effect was found from futures to spot in the case of wheat and raw jute. Further, results of Granger causality tests indicated that the unexpected increase in futures activity in of increases in volumes and open interest has led to an increase in cash price volatility in all the commodities listed. The study has confirmed the conception of the destabilizing effect of futures trading on agricultural commodity prices. Thus, recent studies have shown mixed results indicating that futures trading has either driven up or brought down volatilities in spot prices depending on the commodities and underlying market conditions (Nath and Lingareddy, 2008:pp. 18-19 (2).



8.0 Concluding notes: Price Stability and Futures Trading We need to understand the efficacy of the markets from the point of large stakeholders including growers or producers who want to hedge the commodities either for buying or for selling, processors, investors including wholesale and retail. Indian derivatives market has been undergoing rapid changes in of policy implications and world economy. Even the price volatility and price discovery are two important issues being addressed by today‟s economy. Precisely, conclusion lies in the line of the followings. A market mechanism that is more efficient and viable for risk management and price discovery is the use of futures, if there is wide participation by stakeholders. From a macro-development angle, this should happen with appropriate measurement of risk. The present emphasis and reporting on trading turnover, be it the stock or commodity market, lacks a macro-development framework. For example, resource mobilization by capital markets has not kept pace with the increased turnover handled by the two monoliths, BSE and NSE at all. On the other hand, small towns with meagre resources and small investors have suffered all along, mainly due to the lack of any risk measurements and especially with liberalization. This has indeed narrowed down market developments and SEBI recently set up a Market Development Committee to look into this matter. The macro-development approach demands that the market performs financial inter- mediation such that saving and investment rates rise and faster growth rates of GDP and employment are achieved. Similarly in commodity futures, risk measurement, risk management and price discovery are expected to affect macro-developments insofar as agricultural market reforms take place so that agricultural growth in of GDP is achieved through the realization of higher value added and employment. The speculative nature of futures however, is the Achiles heel of the market, as are illegal trade and round tripping practices that are intended to avoid transparency and taxes. Such phenomena persist and traders unabashedly claim that re- ported trade is only a fraction of the trading activity taking place outside the regime. This subverts regulation, undermines macro-development and thus public interest. An ideal framework of growth is that in which tensions between micro- and macro-level frameworks are known and avoided in time and, where their compatibility is taken to maximize the value added to GDP growth and employment. Know- ledge of tensions between micro- and macro-level frameworks requires crafting of certain indicators, besides a symmetric perfect system for dissemination of information on trading and prices, for both spot and futures which makes full use of the latest ICT. The ways in which combining micro- macro development frameworks brings advantage to the economy are listed below:

TABLE 10: Micro-Macro development framework for Price Stability and Futures Market

Feasibility Test

Present Micro and Short-term development framework Being done

Best practices/services Focus

Being developed

Impact

Comparison with spot prices

On trading turnover

Desired Macro and Long-term development framework To include GDP contribution and employment valuetrading services Value-adding services Illegal and roundtripping in trading to be stopped Real time information dissemination

Advantage

Income and employment growth A „virtuous circle‟ of expansion of futures Increased revenues to exchanges and state Grower‟s knowledge and efficient produce management Page 16 of 20

CIS -TERM PAPER//FPRM/IRMA (2008-09)


Indicators Final result

None Narrow-based growth

Futures Prices Index Broad-based growth

Trend awareness Increased interest of growers at large

Source: Raipuria, K (2003), „Price Stability and Futures: Need for Macro-development framework‟, published in Economic and Political Weekly. Given the ‘noisy’ nature of Indian wholesale and retail markets particularly in essential items like wheat, rice, oilseeds and edible oils, symmetry in dissemination of real time spot and future prices will help consumers at large. (Raipuria 2003: pp. 5330(1)



References FMC (2002), Market Review, Vol. XLIV (1). Forward Markets Commission, Mumbai. www.fmc.gov.in Gupta, S.L. (2005). Financial Derivatives: Theory, Concepts and Problems, Prentice-Hall of India Pvt. Ltd. Publication, New Delhi Kolamkar, D.S. (2003) „Regulation and Policy issues for Commodity Derivatives in India‟. Retrieved from URL www.nmce.com/publication/dsk.jsp MCX (2007): „Market data‟, Multi Commodity Exchange of India Limited, www.mcxindia.com Naik, Gopal & Jain, Sudhir (2002), „Indian Agricultural Commodity Futures Market‟, Vol. 37 (30), pp.3161-3173, Economic and Political Weekly Nath, Golaka & Lingareddy, Tulsi (2008) „Impact of Futures Trading on Commodity Prices: A Performance Survey‟, Vol. 43 (3), pp.18-23, Economic and Political Weekly National Stock Exchange of India Limited (2004). NCFM: Commodities Market Module Work Book, pp. 11-27, Mumbai. www.nseindia.com, www.bse.com NCDEX (2007): „Market data‟, National Commodities & Derivatives Exchange of India Ltd. www.ncdex.com Raipuria, Kalyan (2003), „Price Stability and Futures: Need for Macro-Development Framework‟, Vol. 38 (51-52), pp. 5330, Economic and Political Weekly. Sen, Abhijit (2008). Expert Committee report „The study of Impact of Futures Trading on Agricultural Commodity Prices‟, pp. 4-20, Ministry of Consumer Affairs, Food & Public Distribution, New Delhi. Thomas, Susan & Shah, Ajay (2003), „Equity Derivatives in India: the State of the Art‟ Derivatives Markets in India, Published by Tata McGraw Hill. New Delhi. Retrieved from www.igidr.ac.in



ANNEXURE-1 Details of the association conducting forward/futures trading are shown as under. S. No Name of the association (recognized under Section(6) of FCRA, 1952 The Ahmedabad Commodity Exchange, Ahmedabad 1

Commodity

Castorseed (permanent recognition w.e.f. 16th May 1959 The Bombay Commodity Exchange ltd. Mumbai Castorseed (08.09.1959), 2 castor oil international, RBd palmolin, sunflower oil, and groundnut oil Rajkot seeds Oil and Bullion Merchants Assn. Rajkot Castorseed 3 The East India Cotton Association Ltd. Mumbai Cotton 4 The Ahmedabad Cotton Merchants Assn. Ahmedabad Cotton (NTSD) 5 The Central Gujarat Cotton Dealers Assn., Vadodara Cotton (NTSD) 6 The South India Cotton Association, Coimbatore Cotton (NTSD) 7 Bhatinda Om & Oil Exchange Ltd., Bhatinda Gur 8 The Chamber of Commerce, Hapur Gur and potatoes 9 The Meerut Agro Commodities Exchange Ltd., Meerut Gur 10 Rajdhani Oils & Oilseeds Exchange Ltd., Delhi Gur 11 Vijai Beopar Chambers Ltd., Muzzafarnagar Gur 12 The East India Jute & Hessian Exchange Ltd., Calcutta Jute & Jute goods (Hessian 13 Sacking) India Pepper & Spice Trade Assn., Kochi Pepper (both domestic and 14 international), recognized from 02.04.1960 The Kanpur Commodity Exchange Ltd., Kanpur Rapeseed/Mustardseed, its Oil 15 and oilcakes The National Board of Trade Ltd., Indore Rapeseed/Mustardseed, 16 oilcake, Soyabean, its Oil and Oilcake The Spices & Oilseeds Exchange Ltd., Sangli Turmeric 17 First Commodity Exchange India Ltd., Kochi Copra, Coconut Oil and Copra 18 cake Keshav Commodities Exchange Ltd., Delhi Potatoes 19 The Coffee Futures Exchange India Ltd., Bangalore Coffee: raw, Arabic 20 (the Associations ed under Section 14 (B) of parchment, Robusta cherry, Forward Contracts (Regulation) Act, 1952 Cured: Plantation A & Robusta Cherry AB Source: FMC Bulletin, Vol. (), 2003



ANNEXURE 2 Reform initiatives have also reached other stake holders association with futures trading, besides as the regulatory body (FMC), warehouse agencies, clearing corporations, trade guaranteeing agencies, settlement bodies, all need to adapt to the emerging situation in order to make commodity futures trading vibrant. The regulatory set up of various markets is presented below. S. No. 1

2 3

4 5

6

Institution Reserve Bank of India

Major Regulatory Functions Public debt, foreign exchange interest and financial structure (FRBM) Ministry of Finance (department of Economic Capital markets, Public debt Affairs) related policy measures Department of company affairs Company Act and related issues of registration, reporting etc. Department of consumer affairs Policy issues related to commodity futures trading Securities and Exchange board of India Regulator for securities market including securities derivative market Forward Markets Commission Regulator for commodity derivatives market


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