Commodity Derivatives 2.0

While 2.0 fever is raging in the tinsel town, the commodity market is not far behind. While on the one hand, the Centre has been striving hard to integrate the fragmented physical mandis, on the other, the SEBI has been working overtime to clean up the commodity derivatives market and bring new products and players.

It was in 1875 that futures trading in commodities started in India, but it’s been more than a century and the commodity derivatives market is still small. The absence of institutional players and lack of product innovation have checked growth. The levy of transaction tax on commodity derivatives in 2013 and the scam at the National Spot Exchange in the same year, were setbacks too.

Volumes at the commodity derivative exchanges have dropped to a third over the last five years — from about ₹170 lakh crore in 2012 to under ₹70 lakh crore in 2017.

However, the next few years look promising.

With the Forward Markets Commission merging with SEBI and the latter regulating the commodity derivatives market since September 2015, many things have changed.

The minimum net worth required for commodity derivative exchanges has been increased to ₹100 crore. These exchanges have transferred the function of clearing and settlement to a separate entity, and the grievance redressal mechanism has improved. Further, the commodity derivatives space has been opened to the Big Daddy stock exchanges — the NSE and the BSE.

Here’s a look at the reforms initiated by SEBI in the commodity derivatives space in recent times, their impact, and further changes required.

Regulatory clean-up

SEBI has been formulating new rules and amending existing ones to benefit the participants of commodity derivative contracts.

In September 2017, it allowed broking activities in equity and commodity derivatives market of a single entity to be integrated, by amending the Securities Contract Regulation Rules. This improved the ease of transaction and made investors’ margin-money fungible across equities and commodities. Previously, a stock broker trading in securities other than commodity derivatives was not allowed to transact in commodity derivatives or vice-versa , except by setting up a separate entity.

SEBI, in 2017, also released norms on risk management at exchanges and laid down disclosures that exchanges had to make on deliverable supply and open interest. It also released comprehensive guidelines for IPF, Liquidity Enhancement Schemes and amended the grievance redressal mechanism.

The new rule on disclosure by listed companies, recently, is a positive from the exchanges’ perspective. Listed companies, henceforth, will have to disclose their commodity risks and the risk management policy in the ‘Corporate Governance Report’ section of the annual report, SEBI said through a circular. Another key change that happened outside SEBI, but holds significance for commodity derivatives market, is the RBI’s revised directions on ‘Hedging of Commodity Price Risk and Freight Risk in Overseas Markets’ in March that closed the option for domestic companies in the business of gold (and gems) of hedging outside India.

Impact: Positive. SEBI has brought back the lost trust in the commodity derivatives market. The new regulations will attract more participation from the corporate and retail segments. However, until transaction costs on the exchange remain high, financial players may only keep away.

New participants

SEBI has been very keen to bring more participants into the commodity derivatives space. In 2017, it showed the green flag to hedge funds (Alternative Investment Funds category III). Further, this October, it opened the space to foreign entities with exposure to the Indian physical market. Sources say that SEBI is now considering allowing MF and PMS entities. Once these institutions step in, it will give a fillip to volumes. It will bring liquidity in options and far-month futures and attract corporate hedgers.

Impact: Positive. When PMS and MF entities step in, there will be new products that use arbitrage strategy on commodities. Retail investors can invest in commodities through these products without the hassle of dealing with daily mark-to-market margins and roll overs.

New products

a) Options

In June 2017, SEBI gave the nod to launch commodity options. Options are derivatives instruments that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price. For example, if you wish to buy 10 gm of gold after three months and worry that prices may go up from ₹3,000 a gm to ₹3,200/3,500 in the interim period, you may want to lock-in at the current price. This can be done by entering into an ‘option’ agreement with the seller by paying a fee (referred as premium) that gives you the right to buy gold at ₹3,000 a gm after three months.

Now, two scenarios can emerge.

One, gold prices may go up at the end of three months, say to ₹3,300. Since you have locked into the price earlier and paid a ‘premium’ to validate the contract, you need to pay the seller only ₹3,000 a gm.

Alternatively, if gold prices drop in those three months, say, to ₹2,700 a gm, you can let the contract expire and forego the premium. Since market prices are now much cheaper, you can buy gold from the market. Your loss is only to the extent of the premium you paid.

Undeniably, options are good hedging tools. Globally, a third of the commodity options market is made of agri commodity contracts. But in India, agri commodity options haven’t picked up since their launch.

NCDEX launched its first options contract in guar seed in January and has since introduced four more commodities — guar gum, chana, refined soya oil and soyabean, in options.

However, volumes in this segment are still negligible, at about ₹15-20 crore a month. The complicated product design is to be blamed for this. Every commodity option contract, if not squared off before the expiry day, converts itself into a futures contract.

For instance, if a farmer had bought a ‘put’ option, on the expiry day, his position will convert to ‘sell’ in the underlying commodity futures contract.

The farmer then becomes liable to pay margin money on the futures contract and faces the risk of market price volatility.

Impact: Positive. Options are low-cost hedging tools, but to make them more attractive, SEBI needs to tweak the product design. It also needs to make sure that it does not put-off arbitrageurs and financial market players. Without them, the option contracts will not generate sufficient liquidity.

b) Contracts with differentiation

The talk in Dalal Street is that SEBI has been pushing exchanges to come up with differentiating features in their new futures contracts.

BSE, which ventured into commodity derivatives in October with gold and silver futures, launched its crude oil futures contract in the same month. The contract tracks the Oman Crude Oil contract in Dubai Mercantile Exchange. In MCX, it is the WTI crude that is traded. There was no change in lot size (100 barrels), though.

Earlier in the year, MCX launched brass futures contract, eyeing physical market participants in the metal parts industry. It was the first compulsory deliverable contract in the non-ferrous metals space for the exchange, and the first in brass, globally.

NSE, on the other hand, is now preparing to launch a Brent Crude futures contract. In Copper, its planning launch of a contract with smaller lot size.

Impact: Positive. New products will expand the market and grow volumes. But SEBI has to open up the space to institutional players. Otherwise, these contracts may not see liquidity. For awareness to increase, both exchanges and the SEBI need to put in more effort. BSE Oman Crude Oil futures saw trading only for one day after launch.

c) Contracts with compulsory delivery in base metals

SEBI has also been pushing exchanges to make all metal contracts compulsorily deliverable. In aluminium, copper and zinc, where there is good domestic production, physical settlement appears possible. However, note that even at the LME, less than 1 per cent of traded contracts are delivered.

Commodity derivative contracts in India work on different settlement models – cash settlement, intention matching and compulsory delivery.

While crude and natural gas contracts are cash settled and agri-commodity futures and bullion contracts are compulsory deliverable, the base metal futures are intention-matching contracts.

In these contracts, the intention from both the parties should match on quantity and warehouse location. Only then will delivery of the commodity happen. Otherwise, the contract is cash-settled. (Usually, all metal futures contract on the exchange are only cash-settled as intentions never match).

BSE’s first metal futures contract in copper, that was launched recently, is a compulsory deliverable contract — meaning, all the open positions on the expiry date will be settled through physical delivery. The rationale behind ‘compulsory deliverable’ contracts is that it will check speculation. It will bring in only players who want to give/take delivery. But the problem with this new rule is that it will be squeeze out arbitrageurs from the market.

In deliverable contracts, those not intending to take delivery have to square up the position much before the expiry date; it creates liquidity crunch for others in that period. A market veteran explains: “When there is compulsory delivery, the roll over to next month contract begins early, and the current month contract sees contraction in open interest much before expiry. In a globally-linked commodity, it then becomes complex for traders to create strategies linked to their international prices…”

Impact: Neutral. It may initially push arbitrageurs out of market, as a result of which volumes may dry up, but will slowly bring in SMEs/MSMEs who wish to take delivery on the exchange platform. The move will ensure that derivative and physical market prices converge. SEBI, however, needs to soon bring out warehousing regulations for non-agri commodities.

Domestic price polling

SEBI is now insisting that exchanges put in place a price-polling mechanism for metal contracts as they will be compulsorily deliverable. Currently, all metal contracts in MCX are cash settled at the LME price.

When exchanges put in place a price-polling mechanism, the price of the contract will reflect the local demand/supply and the SMEs that wish to take delivery can do so at the exchange discovered price. However, one needs to note that for hedgers, this is not going to make any difference.

All they need is protection against price risk and this can be done by taking a hedge at global reference prices also, since the trend in both domestic and global markets is largely similar. For instance, spot prices of aluminium in domestic market currently trade at a premium of $80-100/tonne over the LME prices. But since prices move in the same direction in both markets, price risk can be hedged with either of the prices.

One also needs to understand that metals, including aluminium, copper and zinc, are globally traded and domestic players such as Nalco, Hindalco and Vedanta export significant volume of their production; they may want to hedge their risks on LME-based price.

Impact: Neutral. While in agri commodities, domestic price discovery makes sense and is being done in metals, it might not help much. Since these are globally-traded commodities, the global benchmark should ideally be the settlement price. Price polling may help SMEs, but we should not be oblivious to the needs of the larger players. Exchanges could consider pricing contracts in an innovative manner that takes global price as the base and adjusts it to reflect domestic market conditions.

 

 

 

"The existing commodity exchanges in the country have done a lot of work over the last 15 years, but we believe the commodities market has not covered the entire spectrum yet. There are lots of gaps

 

both in terms of products as well as reach. We believe we will be able to significantly add value on both counts because our reach is significantly larger. We will be launching new contracts in metals and crude oil, soon. In agri commodities, we are now doing research. We will probably be introducing our first agri product in the next five-six months… "

Ravi Varanasi

Chief Business Development Officer, NSE

 

 

 

"We have 4.11 crore customers registered with us, and, if we take out duplication, it may come to 2.75 crore separate pan-holders. So, our reach is large, and, we are hopeful of doing well in commodities. We

 

will soon be launching more base metal contracts. On the agri front, we have already tied up with seven to eight associations and are planning contracts in cotton and guar seed. We want to focus on product differentiation the way we have done in our crude contract. We are purely going by what trade bodies want. We are willing to take extra effort to bring small customers on-board…"

Ashish Chauhan

MD & CEO, BSE

 

 

 

"We always welcome competition. We genuinely believe that for the potential and size of the Indian market, it is still fairly under-exploited. Therefore, there is no need for anybody to start fearing that

 

competition means business going from A to B. As long as the pie is growing, all players will get their market share. Also, I think, not just in India, but globally too, it has been well-demonstrated that liquidity does not move away purely based on change in transaction prices. So, we are very confident of our liquidity remaining as it is. And, as a player born and bred in commodities, we are very well committed to this market. So, tomorrow, we don’t see ourselves diluting our focus by trying to get into another asset class".

Mrugank Paranjape

MD & CEO, MCX