Commodity Derivative Trading : A Unified Exchange Regime

[Vaidehi Soni]

 

Vaidehi is a 4th year student of NUALS , Kochi

Background

The Securities and Exchange Board of India (SEBI) announced to have a unified exchange regime from October 1, 2018, wherein stock exchanges would be allowed to offer to trade in commodity derivatives. Pursuant to the said approval, Bombay Stock Exchange (BSE) is set to launch commodity derivatives segments for the delivery-based futures contract in Gold (1 kg) and Silver (30 kg) and later add metals, energy products following by agricultural commodities such as processed/Un-processed farm produce whereas NSE apart from gold and silver will begin with mini gold (100 grams) contracts so as to attract small investors from October 12, 2018. Additionally, considering the fact, Multi Commodity Exchange (MCX) being the market leader, dominates in the trade volumes in non-agricultural commodities derivatives, BSE has decided to waive off the transaction charges for the first year of commodities market operations in order to encourage more participants to join commodity markets.

Understanding Commodities market

Commodities markets, globally and in India can be broadly categorised into two segments, namely, the market for spot transactions and the market for derivative transactions. The former market deals with the purchase (or sale) of commodities and the settlement of the transaction takes place simultaneously i.e. trade in commodity takes place either on a physical market place or on an electronic platform whereas the latter market deals with the exchange-traded commodity futures markets, which offer a highly standardized platform for trading financial instruments which derive their value from underlying physical commodities including settlement of trade at a future date. The commodity derivative market provides a platform for discovery of future prices of a commodity and also offer an opportunity to the participants in the spot market to hedge themselves against fluctuations in future prices of the underlying commodities. A sound derivative market through hedging delivers price discovery and price risk management by stakeholders including commodity traders, farmers, and market participants.

Derivative trading in India takes place either on a separate segment of an existing Stock Exchange or on a separate and independent Derivative Exchange. The settlement & clearing of all trades on the Derivative Exchange/Segment would have to take place through a Clearing Corporation/House, which is unimpeded in governance and membership from the Derivative Exchange/Segment.

Legal Framework for Derivative Market

The derivatives market is governed by a central legislation, viz., Securities Contracts Regulation Act, 1956 (SCRA) which provides for the legal framework for organized derivatives trading and SEBI acts as the oversight regulator.

In pursuance of recommendations made by the commodities derivatives advisory committee (CDAC), vide circular dated September 28, 2016, certain amendments/omissions were made to Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2012 (SECC) so as to enable commodity derivatives exchanges to deal in Options.

As per section 2(bc) of The Securities Contracts (Regulation) Act, 1956 (SCRA)

a commodity derivatives contract can either be:

• Physical delivery of goods (not being a ready delivery contract) as notified by Central Government or
• For differences, which derives its value from prices or indices of prices of such underlying goods or activities, services, rights, interests and events, as may be notified by the Central Government, but cannot have securities.

As per section 2(1) (fa) of SCRA, the commodity derivative exchange means a recognized stock exchange which assists, regulates or controls the business of buying, selling or dealing only in commodity derivatives.

Since the Commodity derivative exchange cannot deal in any other product except for commodity derivatives, an option contract with commodity futures may not be eligible for trading on commodity derivatives exchanges.

To overcome such legal hurdle, multifarious amendments are made including omission of the category of “Commodity Derivatives Exchange” under SECC regulation” with effect from October 1, 2018 so as to enable commodity derivatives exchanges to also organise trading in option contracts with commodity futures and accordingly  all norms issued for commodity derivative exchanges till date shall be applicable to commodity derivative segments of recognised stock exchanges/recognised clearing corporations to the extent of its applicability.

Need for Integration of Spot and Derivative Markets

With increasing commercialisation and changing demands of consumers, traders and other market participants; BSE’s foray into commodities derivatives The need for integration is more felt for the overall benefit to the primary producers and value chain participants as:

Firstly, A comprehensive mechanism for integration would improve cohesion between futures and physical markets.

Secondly, in case, the commodity is assayed before trading, it may also lead to lead to the standardization and assurance regarding the quality of commodity to the buyers.

Thirdly, on an electronic spot exchange, as the price of a commodity would be determined by a wider cross-section of people from across the country in contrast to the present scenario where price discovery for commodities takes place only through local participation, such platform will bring about efficient price determination and will ensure transparency in price discovery.

Fourthly, A single market may also lead to lower operational cost, reduction in timelines, wider market penetration as technological advancement would result in amelioration of accounting of all the transactions that are taking place in the market.

Additionally, the Derivative market would achieve better convergence pursuant to development of a regulated electronic spot platform and/or regulated commodity spot exchanges as is evident from the success achieved by the securities market or the commodity derives market after moving to the electronic platform.

Since the derivatives market assures that the future and spot price of a commodity converges on the day the derivative contract lapse for settlement, the discovery of real-time spot prices of a commodity on a pan-India electronic spot exchange will unequivocally strengthen the convergence of future and spot prices of a commodity thereby increasing efficiency of both spot and derivatives market. Thus, the functioning of these two markets could help Indian commodity markets improve its efficiencies and enhance the effectiveness of the overall functioning of the commodity ecosystem so as to benefit all the stakeholders.[1]

Challenges and Recommendations

Such integration poses a big challenge to Farmer’s participation in agricultural commodity derivative contracts on account of speculation in the market.  Other issues are pertaining to the Legal, operational and technical aspects where there is no specific central law in the country for setting-up of or regulation of pan-India electronic spot market platform or spot exchanges in agricultural or non-agricultural Commodities. Also, there is a dearth of warehousing and development of storage infrastructure including the absence of an integrated data management system for which fundamental reforms are required to be introduced in the two-market setup. Such a multipronged approach would require the market:

Firstly, to exist within a robust and consistent legal and regulatory framework,

Secondly, create a diverse and liquid market in both the spot and the derivatives segments,

Thirdly, create a seamless linkage between the two markets both in terms of information about prices as well in terms of the deliveries of the underlying commodity, and

Fourthly, enable a wide variety of participants to effectively access the market and create a governance framework to resolve any contradictions that may adversely affect this linkage.

Conclusion

So as to align the transaction avenues of commodities with the changing demands of  traders and consumers, SEBI announced the kick off of unified exchange regime, wherein stock exchanges would be allowed to offer to trade in commodity derivatives and such regulatory framework would permit the foreign entities to have an actual exposure to participate in the domestic commodity derivatives markets thereby strengthening the existing institutions regulating the physical market, which tend to be fragmented and geographically dispersed vis-à-vis derivative markets.

 

 

 

 

[1] Report of Expert Committee on Integration of Commodity Spot and Derivative Markets, Dept of Economic Affairs, Ministry of Finance, Government of India, New Delhi, February 2018