TRADING IN COMMODITY MARKET - STOCK AND COMMODITY MARKET

Notes 10 Pages

Bengaluru City University

Bachelor of Business Administration

Contributed by

Tabeed Malpani

1

FACULTY NAME: Mrs NALINI.N
COLLEGENAME: MES INSTITUTE OF MANAGEMENT
SUB:STOCK AND COMMODITY MARKET

CHAPTER-V

TRADING IN COMMODITY MARKET

History of the Commodity Futures Market in India

The Commodity Futures market in India dates back to more than a century. The first organized
futures market was established in 1875, under the name of ’Bombay Cotton Trade Association’
to trade in cotton derivative contracts. This was followed by institutions for futures trading in
oilseeds, food grains, etc. The futures market in India underwent rapid growth between the
period of First and Second World War. As a result, before the outbreak of the Second World
War, a large number of commodity exchanges trading futures contracts in several commodities
like cotton, groundnut, groundnut oil, raw jute, jute goods, castor seed, wheat, rice, sugar,
precious metals like gold and silver were flourishing throughout the country. In view of the
delicate supply situation of major commodities in the backdrop of war efforts mobilization,
futures trading came to be prohibited during the Second World War under the Defence of India
Act. After Independence, especially in the second half of the 1950s and first half of 1960s, the
commodity futures trading again picked up and there were thriving commodity markets.
However, in mid-1960s, commodity futures trading in most of the commodities was banned and
futures trading continued in two minor commodities, pepper and turmeric.
Current Scenario

Currently 5 national exchanges, viz. Multi Commodity Exchange, Mumbai; National
Commodity and Derivatives Exchange, Mumbai and National Multi Commodity Exchange,
Ahmedabad, Indian Commodity Exchange Ltd., Mumbai (ICEX) and ACE Derivatives and
Commodity Exchange, regulate forward trading in 113 commodities. Besides, there are 16
Commodity specific exchanges recognized for regulating trading in various commodities
approved by the Commission under the Forward Contracts (Regulation) Act, 1952.
The commodities traded at these exchanges comprise the following:

Edible oilseeds complexes like Groundnut, Mustard seed, Cottonseed, Sunflower, Rice bran oil,
Soy oil etc.
Food grains – Wheat, Gram, Dals, Bajra, Maize etc.
Metals – Gold, Silver, Copper, Zinc etc.
Spices – Turmeric, Pepper, Jeera etc.
Fibres – Cotton, Jute etc.
Others – Gur, Rubber, Natural Gas, Crude Oil etc.
MEANING OF FORWARD MARKET COMMISSION (FMC)

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FMC is a regulatory authority which is overseen by the Ministry of Consumer Affairs and Public
Distribution, Government of India. It is a statutory body set up in 1953 under the Forward
Contracts (Regulation) Act, 1952. This is the regulating authority for all Commodity Derivatives
Exchanges in India.
Forward Markets Commission (FMC) headquartered at Mumbai, is a regulatory authority for
commodity futures market in India.
FUNCTIONS OF FMC

(a)

To advise the Central Government in respect of the recognition or the withdrawal
of recognition from any association or in respect of any other matter arising out of the
administration of the Forward Contracts (Regulation) Act 1952.
(b)

To keep forward markets under observation and to take such action in relation to
them, as it may consider necessary, in exercise of the powers assigned to it by or under the Act.
(c)

To collect and whenever the Commission thinks it necessary, to publish
information regarding the trading conditions in respect of goods to which any of the provisions
of the Act is made applicable, including information regarding supply, demand and prices, and to
submit to the Central Government, periodical reports on the working of forward markets relating
to such goods;
(d)

To make recommendations generally with a view to improving the organization
and working of forward markets;
(e)

To undertake the inspection of the accounts and other documents of any
recognized association or registered association or any member of such association whenever it
considers it necessary.
TRADING AND SETTLEMENT IN COMMODITY MARKET

Process Flow in Commodity Futures Trading

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After the process of opening account is done the investor may want to trade in commodity. IT is
important to understand the process after the trade is placed.
An investor places a trade order with the broker (at the dealing desk) on phone. The dealer puts
the order in exchange trading system. At the initiation of the trade, a price is set and initial
margin money is deposited in the account. At the end of the day, a settlement price is determined
by the clearing house (Exchange). Depending on if the markets have moved in favor or against
the investors' position the funds are either being drawn from or added to the client's account. The
amount is the difference in the traded price and the settlement price. On next day, the settlement
price is used as the base price. As the spot market prices changes every day, a new settlement
price is determined at the end of every day. Again, the account will be adjusted by the difference
in the new settlement price and the previous night's price in the appropriate manner.
Trading and Settlement in Commodity Market

Every market transaction consists of three components. Trading, clearing and settlement.
This section provides a brief overview of how transaction happen on the commodity market /
commodity exchanges.

1
Trading

The trading system on the commodity exchanges, provides a fully automated screen based
trading for futures on commodities on a nationwide basis as well as an online monitoring and
surveillance mechanism. It supports an order driver market and provides complete transparency
of trading operations. The trade timings of the commodity exchanges
are 10.00 am to 4.00 p.m. After hours trading has also been proposed for implementation at a
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later stage.
The commodity exchanges system supports an order driven market, where orders match
automatically. Order matching is essentially on the basis of commodity, its price, time and
quantity. All quantity fields are in units and price in rupees. The exchange specifies the unit of
trading and the delivery unit for futures contracts on various commodities. The exchange notifies
the regular lot size and tick size for each of the contracts traded from time to time. When any
order enters the trading system, it is an active order. It tries to find a match on the other side of
the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes
passive and gets queued in the respective outstanding order book in the system. Time stamping is
done for each trade and provides a possibility for a complete audit trail if required.
Commodity exchanges trades commodity futures contracts having one, month, two
month and three month expiry cycles. All contracts expire on the 20
th
of the expiry month. Thus
a January expiration contract would expire on the 20
th
of January and a February expiry contract
would cease trading on the 20
th
February. If the 20
th
of the expiry month is a trading holiday, the
contracts shall expiry on the previous trading day. New contracts will be introduced on the
trading day following the expiry of the near month contract.

Clearing

National securities clearing corporation limited (NSCCL) under takes clearing of trades executed
on the commodity exchanges. The settlement guarantee fund is maintained and managed by
commodity exchanges. Only clearing members including professional clearing members (PCMs)
only are entitled to clear and settled contracts through the clearing house. At commodity
exchanges, after the trading hours on the expiry date, based on the available information, the
matching for deliveries takes place firstly, on the basis of location and then randomly keeping
view the factors such as available capacity of the vault/ warehouse, commodities, already
deposited and dematerialized and offered for delivery etc. matching done by this process binding
on the clearing members. After completion of the matching process, clearing members are
informed of the deliverable / receivable positions and unmatched positions. Unmatched positions
have to be settled in cash. The cash settlement is only for the incremental gain/ loss as
determined on the basis of final settlement price.
Settlement.

Futures contracts have two types of settlements, the MTM settlement which happens on a
continuous basis at the end of each day, and the final settlement which happens on the last
trading day of the futures contracts. On the commodity exchanges, daily MTM settlement and
final MTM settlement in respect of admitted deals in futures contracts are cash settled by
debiting/ crediting the clearing accounts of CMs with the respective clearing bank. All positions
of a CM,
either brought forward, credited during the day or closed out during the day, are market to
market at the daily settlement price or final settlement price at the close of trading hours on a
day.
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On the date of expiry, the final settlement price is the spot price on the expiry day. The
responsibility of settlement is on a trading cum clearing members for all traders done on his own
account and his client’s trades. A professional clearing member is responsible for selling all the
participants traders trades which he has confirmed to the exchange. On the expiry date of a
futures contracts members submit delivery information through delivery request window on the
traders workstations provided by commodity exchanges for all open positions for a commodity
for all constituents individually commodity exchanges on receipt of such information, matches
the information and arrives at a delivery positions for a member for a commodity .
The seller intending to make delivery takes the commodities to the designated warehouse.
These commodities have to be assayed by the exchange specified assayed. The commodities
have to meet the contracts specifications with allowed variances. If the commodities meet the
specifications, the warehouse accepts them. Warehouse then ensures that the receipts get updated
in the depository system giving a credit in the depositors’ electronic account. The seller then
gives the invoice to his clearing member, who would courier the same to the buyer’s clearing
member. On an appointed date, the buyer goes to the warehouse and takes physical possession of
the commodities.
Trading System of Commodity Exchanges.

The trading system at commodity exchange is as follows
a)

The entire trading operation at commodity exchange shall be conducted under the automated
screen based Trading system, which is called as ‘commodity exchanges Trading system’. The
Exchange will provide such Automated Trading Facility in all contracts permitted to commodity
exchange by FMC
b)

Trading on the exchange shall be allowed only through approved workstation (s) located at
approved locations for the office (s) of a Members. If an approved workstation of a Trading
Members is connected by LAN or any other way to other workstations at any place it shall be in
advance.
c)

Each members shall have a unique identification number which shall be provided by the
Exchange and which shall be used to log on (sign on) to the system

d)

A member shall have a non-exclusive permission to use the Trading system as provided by the
exchange in the ordinary course of business as Trading member / Participant.

e)

A member shall not any title, rights or interested with respect to Trading System, its facilities,
software and information provided by MCX. The permission to use the Trading System shall be
subject to payment of such charges as the Exchange may from time to Time prescribe in this
regard.

f)

A member shall not, permit itself or any other person(s) to: use the software provided by
exchange for any purpose other than the purpose as approved and specified by the Exchange.
Use the software provide by exchange on any equipment other than the workstation approved by
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the exchange copy, alter, modify or make available to any other person the software provided by
the exchange use the software in any manner other than the manner as specified by the exchange.
Attempt directly or indirectly to decompile, dissemble or reverse engineer the same.

g)

A Member shall not, by itself or through any other person on his behalf, publish, supply, show or
make available to any other person or reprocess, retransmit, store or use the facilities of the
Trading System or the information provided by the Trading System except with the explicit
approval of the Exchange

h)

The exchange will provide the application software for installation of TWS. However, the
member has to arrange at his own cost the system software required for installation of trading
application. Besides, he has to arrange for installation of trading applications software at his
TWS at his own cost.

Margins for trading in commodity derivatives.

Margin is the deposit money that needs to be paid to buy or sell contract. The margin
required for a futures contract is better describe as performance bond or good faith money. The
margin levels are set by the exchanges based on volatility (market conditions) and can be
changed at any time. The margin requirements for most futures contracts range from 2% to 15%
of the value of the contract.
In the futures market, there are different types of margins which are discussed as follows

1

Initial margin: The amount that must be deposited by a customer at the time of
entering into a contract is called initial margin. This margin is meant to cover the largest
potential loss in one day. The margin is a mandatory requirement for parties who are entering
into the contract.
2

Maintenance margin: A trader is entitled to withdraw any balance in the margin
account in excess of the initial margin. To ensure that the balance in the margin account never
becomes negative, a maintenance margin, which is somewhat lower than the initial margin, is
set. If the
balance in the margin account falls below the maintenance margins the traders receives a margin
call and is requested to deposit extra funds to bring it to the initial margin level within a very
short period of time. The extra funds deposited are known as a variation margin. If the traders
does not provide the variation margin, the broker closes out the positions by offsetting the
contract.
3

Additional margin: In case of sudden higher than expected volatility the
exchange calls for an additional margin, which is a pre-emptive move to prevent breakdown.
This is imposed when the exchange fears that the markets have become too volatile and may
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results in some payment crisis etc.
Mark-to-Market margin (MTM): At the end of each trading day, the margin account is adjusted
to reflect the trader’s gain or loss. This is known as marking to market the account of each trader.
All futures contracts are settled daily reducing the credit exposure to one day’s movement. Based
on the settlement price. The value of all positions is marked-to-market each day after the official
close i.e. the accounts are either debited or credited based on how well the positions are fared in
the day’s trading session. If the account falls below the maintenance margin level the trader need
s to replenish the account by giving additional funds can be withdrawn (those funds above the
required initial margin) or can be used to fund additional trades.

Challenges faced by commodity markets- Efficiency of commodity markets.

Despite a long history of commodity markets, the Indian commodity markets remained
under developed, partially due to intermediate ban on commodity trading and more due to the
policy interventions by the government. Being agriculture –based economy, commodity markets
plat vital role in the economic development of the country. Well the agricultural liberalization as
provide way for commodity trading, India as to still go on long way in achieving the benefits of
commodity markets. Towards the development of the commodity markets, it is improved to
understand the growth constraints and address those issues in the right perspective.
Commodity markets play an important role in the development of an economic,
especially those economics that are depended to a large extent on the agriculture sector. Owing
to its dependence on agriculture sector, Indian economy to a large extent would benefit from
commodity markets. Despite the fact, that Indian economic as witnessed robust growth in the last
decade on account of service sector; agricultural sector still remain the back bone of Indian
economic. Roughly around 60% of the Indian population is dependent on agriculture. Vibrant
commodity markets in India well not only benefit the farmers but also the manufacturing sectors
that is dependent on it to gain significant price gains.
The following are challenges faced by Indian commodity markets currently. These are
the explained and also conclusion is provided at the end of it:
Legal challenges
Regulatory Challenge
Infrastructural challenges
Awareness among investors and producers.
Legal Challenges
Right from the beginning of commodity markets there has been several bottlenecks
regarding the products being in the essential commodities list because of which the often got
banned. Also there were times when because of hoarding and black marketing there were famine
for a very long time, so the market needed an efficient regulator which led to the formation of
PMC. Moreover, many efficient in commodity markets. Also weather and rainfall indexes are
also banned from trading on the commodity exchanges because of the clauses of the banking
regulations act, which defines that anything that could be obtained in physical form only can be
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traded at the exchange. These inefficiencies must be eradicated by amending these acts. Several
amendments have been introduced in these acts and also accepted by the government but only
some of them has been passed. Rests are in the queue.

1 Regulatory challenges
As the market activity pick –up and the volumes rise, the market will definitely need a strong and
independent regulatory body, similar to the Securities And Exchange Board of India (SEBI) that
regulates the securities markets unlike SEBI which is an independent body, the forwards markets
commission (FMC) is under the department of consumer Affairs (Ministry of consumers Affairs,
food and Public Distribution) and depends on it for funds, it is imperative that the government
should grant more power to the FMC to ensure that there is orderly development of the
commodity markets. The SEBI and FMC also need to work closely with each other due to inter-
relationship between the two markets.

2 Infrastructural Challenge:The main Infrastructural Challenges includes

a)

The Warehousing and Standardization:
For commodity derivatives market to work efficiently, it is necessary to have sophisticated, cost
effective, reliable and convenient warehousing system in the country .A Sophisticated
warehousing industry has yet to come in India further, independent labs are quality testing
centers should be set up in each region to certify the quality, grade quantity and commodities so
that they are appropriately standardized and there are no shocks waiting for the unlimited buyers
who takes the physical delivery. Warehouse also need to be conveniently located.

b)

Cash versus Physical Settlement:
It is probably due to the inefficiencies in the present ware housing system that only about 1% to
5% of the total commodity derivatives trade in country is settled in physical delivery. Therefore
warehousing problem obviously has to be handled on a war footing, as a good delivery system is
the backbone of any commodity trade. A particularly difficult problem in cash settlement of
commodity derivative contracts is that at present, under the forward contracts (regulation) act
195, cash settlement of outstanding contacts at maturity is not allowed. In other words, all
outstanding contracts at maturity should be settled in physical delivery. To avoid these,
participants square off their positions before maturity. So, in practice, most contract are settled in
cash but before maturity. There is a need to modify the laws to bring it closer to the widespread
practice and save the participants from unnecessary hassles.

c)

Lack of Economy of scale
There are too many (5 national level and 22 regional) commodity exchanges, though over 113
commodities are allowed for derivatives trading, in practice derivatives are popular only for few
commodities. Again, most of the trade take place only on a few exchanges. With so much of
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volume of trade makes some exchanges unviable. This problem can possibly be addressed by
consolidating some more exchanges. Also, the questions of convergence of securities and
commodities derivatives markets has been debited for a long time known. The government of
India has announced its intention to integrate the two markets. It is felt that convergence of these
derivative markets would bring in economies of scale and scope without having to duplicate the
efforts, thereby giving a boost to the growth of commodity derivatives market. It would also help
in resolving some of the issues concerning withthe regulation of the derivative markets.
However, this would necessitate complete co-ordination among various regulating authorities
such as reserve bank of India, forward markets commission, the securities and exchange board of
India, and the department of company affairs etc.

d)

Tax and legal Bottlenecks
There are at present restrictions on the movement of certain goods from one state to another.
These need to remove such restrictions so that a true national market could develop for
commodities and derivatives. Also, regulatory changes are required to bring about uniformity in
octroi and sale taxes act. VAT has been introduced in the country 2005, but has not yet been
uniformly implemented by all states.

3 Awareness among investors and producers:
Creation of awareness amongst the farmers, related bodies and organizations including the once
which could be potential hedgers / aggregators and other market constituents has been one of
major activities of the commission. During 2010-11, 829 awareness programs were organized for
various stockholders of the commodity features market. Of this, 486 programs were held
exclusively for farmers. In the previous year 515 awarenessprograms were held, of which 423
were exclusively for the farmers. The programs were conducted at different locations all over the
country. These awareness programs were attended by different category of market participants
from farmers, traders and member s of commodity exchanges to bankers, co-operative personnel
staff and students of university , government functionaries ware house professional agricultural
extensions workers, makers etc.. These awareness programs have resulted in creating awareness
among the various constituents about commodity futures trading and benefits thereof. The
programs were organized in associate with various organization/ university having
connectivitywith the farmers,via agricultural universities, NABCONS farmer’s cooperatives and
federations GSKs national & Regional Base commodity exchanges

BENEFITS OF COMMODITY MARKETS

1.

A safe investment during crisis – Investing in precious metals like silver, gold & platinum offer
a clear protection during inflation and times of economic uncertainty.
2.

Diversified investment portfolio – An ideal asset allocation plan means having a diversified
portfolio. Thus an investor who has invested in stocks is suggested to invest in commodities so
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that in case of a stock crash he has some safety from commodity sector.
3.

Transparencies in the process – Trading in commodity is a transparent process. The course of
action leads to fair price discovery which is controlled by large scale participation.
4.

Profitable returns –
Commodities have huge swing in prices which can provide profitable
returns in investments are planned correctly and calculated risks are taken.

5.

Protection against inflation – the price of commodities usually go up during high inflation,
accordingly price of raw materials also sees an upward trend , which will help those who have
invested in such commodities.
6.

Trading on lower margin – Commodity traders need to deposit a margin with broker which can
be close to 5-10% of the total value of the contract , which is much lower considering other asset
classes.Such low margins allow traders to take larger positions at a lesser capital.
7.

Managing the risk – Exchanges have well structured settlement procedures and prudent risk
management practices , which reassures an investor. The absence of counter party risk and
existence of clearing house as a legal counter party increases the faith of investors and risk is
manged well.
8.

Beneficial to farmers – India is a traditionally agricultural economy and price fluctuations
during harvest season has always been a major concern for the farming community. Thus futures
trading has emerged as a beneficial option for providing a greater degree of assurance on the
price front. Also, using the futures platform farmers can store their produce in the exchange
provided warehouse till the time that their produce fetches reasonable returns.

IMPORTANT QUESTIONS

SECTION B

1.

Types of margins in commodity market
2.

Benefits of commodity market

SECTION C
1.

Explain trading and clearing process
2.

Challenges of commodity market or Efficiency of commodity markets.

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