Commodities

A fundamental economic definition states that a commodity is a tangible product derived from a natural resource, tradable, and available to the general public without significant differentiation. Grains, Gold, Crude Oil, Copper, Natural Gas are some examples of commodities.

Types of Commodities Derivatives 

Typically, commodities in the commodity derivatives market are broadly categorized into two main groups: Agricultural Commodities and Non-Agricultural Commodities.

History of Commodities Trading

Commodity trading, an ancient economic activity, has transitioned from barter systems to spot markets and eventually to derivatives markets. In spot markets, goods were exchanged directly, and over time, commodities were exchanged for precious metals like gold and silver. The introduction of money transformed commodity trading into a monetary expression. Commodity spot markets emerged where goods were immediately sold based on demand and supply. Forward contracts were later introduced, but they faced challenges due to non-compliance. To address this, futures contracts emerged with Exchange guarantees. Contracts standardized in terms of quantity and quality, allowing trading before delivery. Speculators entered, betting on price movements, contributing to the development of the futures market. Hedgers, like commodity producers, transferred market risk efficiently to speculators in futures exchanges.

In India, Commodities trading has a long history, with references in ancient texts like Kautilya's 'Arthasastra.' Organized commodity derivatives trading began in 1875 with the Bombay Cotton Trade Association Limited, focusing on cotton. Other centers emerged in cities like Hapur, Amritsar, and Delhi. Controls were imposed at times due to speculation, hoarding, wars, and disasters. Post-independence, the Forward Contracts Regulation Act of 1952 regulated forward contracts, and in 2015, SEBI took over the regulation of commodity derivatives. Indian exchanges now provide sophisticated electronic platforms, enhancing efficiency. Globally, exchange-traded commodity derivatives, including exotic products like weather and power derivatives, have gained popularity among various investor groups.

Global Evolution of Commodities Exchange 

Commodity exchanges have a rich history, with Japan hosting the first organized futures market, the Osaka Rice Exchange, in 1730. Osaka became a prominent trading center for rice in the 17th century. The rice bills, certificates of title issued during auctions, marked the early stage of futures, allowing merchants to make quick profits. The Chicago Board of Trade (CBOT) and the London Metal Exchange (LME) began operations in 1848 and 1877, respectively. Numerous exchanges, including those in Argentina, China, Egypt, Russia, Hungary, Turkey, and India, were established in the following decades. Post-1990s, global market liberalization and information technology growth led to the proliferation of commodity exchanges worldwide.

Derivatives

Derivatives are financial instruments whose value is derived from the value of an underlying asset, such as equities, currency, other financial assets, or commodities. The most prevalent types of derivative instruments include forwards, futures, options, and swaps.

Commodity Derivatives

A derivative contract that uses a commodity as its underlying asset is referred to as a 'commodity derivatives' contract. This includes agreements for the delivery of goods, which are not ready delivery contracts, or for differences. The latter derives its value from prices or indices of prices related to the underlying goods, activities, services, rights, interests, and events.

Features of Commodities Derivative Market

The basic features of derivative market are 

• The underlying asset is a tangible physical asset. The underlying market is distributed nationwide, with significant trading activity focused in major production/consumption centers.

• The supply of the underlying asset is uncertain and subject to estimation. Participants in this market include farmers, traders, manufacturers, brokers, FPOs, etc.

• The period of life of the underlying asset is standardized according to Stock Exchange contract specifications and includes an expiry date.

• Since September 28, 2015, the Securities and Exchange Board of India (SEBI) has been regulating the commodity derivatives market. Prior to this date, the market was overseen by the former Forward Markets Commission (FMC).

• Trading occurs anonymously between two parties on the Stock Exchange platform. The contracts are standardized, requiring an initial margin before trading.

• At the end of the day, a mark-to-market settlement in cash is conducted, and final settlement, either in cash or physical delivery, takes place at the contract's expiry.

• The clearing corporation is responsible for ensuring the performance guarantee of the contract.

Functions of Commodities Derivative Market

• Facilitating trading in a transparent manner

• Recording trading transactions, including circulating price movements and market news, to the participating members

• Ensuring execution of contracts

• Providing a system of protection against default of payment (clearing)

• Providing a dispute settlement mechanism

Commodities Derivatives Trading

Commodity derivatives trading encompasses the exchange of standardized derivative contracts, such as futures and options, for both agricultural and non-agricultural commodities. This activity takes place on the electronic platforms of recognized stock exchanges, contingent upon approval from SEBI and compliance with existing regulations and laws governing the commodity derivatives market.

Which commodities are suitable for futures trading?

There are 91 commodities officially designated by the Central Government for commodity derivative trading. These commodities meet the following criteria:

• The commodity should demonstrate a relatively large demand and supply.

• No individual or group of persons acting together should have the ability to significantly influence the demand or supply.

• Prices should exhibit adequate volatility.

• The commodity should be free from substantial government regulations concerning supply, distribution, and prices.

• The commodity should be capable of standardization and gradation.

• The commodity should have a long shelf-life.

Futures trading can be conducted in any of the commodities meeting these requirements, pending approval or recognition from the regulator.

Commodities Derivatives Exchanges

The commodity derivatives segment is facilitated by the following recognized stock exchanges in India:

Multi Commodity Exchange of India Ltd. (MCX)

National Commodity & Derivatives Exchange Ltd. (NCDEX)

National Stock Exchange of India Ltd. (NSE)

BSE Ltd.

Indian Commodity Exchange Ltd. (ICEX)

Functions Of Commodity Exchange

Operating within SEBI's regulatory framework, the Stock Exchange facilitates commodity derivatives trading. On its trading platform, the Stock Exchange provides SEBI-approved standardized derivatives contracts. These contract specifications, developed in collaboration with stakeholders, are designed to meet industry standards. The trading platform efficiently consolidates bids and offers from diverse geographic locations, facilitating their matching.

Commodities Derivatives Clearing Corporations

Multi Commodity Exchange Clearing Corporation Limited (MCXCCL)

National Commodity Clearing Limited (NCCL)

Metropolitan Clearing Corporation of India Limited (MCCIL)

NSE Clearing Limited (NCL)

Indian Clearing Corporation Limited (ICCL)

Commodity Index

A commodity index is a compilation of prices from constituent commodity futures contracts. Unlike stock indices like Nifty or Sensex, which are based on underlying stock prices, commodity indices derive their value from commodity futures. Since these futures contracts have expiry dates, it is essential to regularly transition from expiring contracts to new ones, a process known as 'roll-over,' to maintain the integrity of the commodity index.

Types of Commodity Derivatives 

In India, there are two types of commodity derivative contracts traded:

• Forwards

• Futures

• Options

• Swaps

Futures Contract

A futures contract on a Stock Exchange is an agreement between a buyer and seller to trade a specified amount of an underlying asset at a predetermined future time and agreed-upon price. The contracts are standardized in terms of size, quantity, grade, and time. Commodity index futures involve prices of constituent commodity futures contracts, requiring regular roll-over as these contracts have expiry dates.

Options Contract

An option is a derivative contract providing the buyer the right (but not the obligation) to buy or sell an underlying asset. The buyer pays an option premium for this right, while the seller bears the obligation if the option is exercised. There are two types:

• Call Option: Gives the right to buy at a specified strike price by a certain expiration date.

• Put Option: Gives the right to sell at a specified strike price by a certain expiration date.

Options on commodity futures allow the holder to buy or sell a specific futures contract at a strike price before the option's expiration. SEBI permits options on commodity futures traded on its platform. Options in Goods, settled based on spot prices, enable farmers to sell crops in the future at a predetermined price, minimizing risk.

Risk Management Mechanisms in Derivatives Exchanges

Implementing Effective Risk Management: Utilizing a clearinghouse, often owned by the exchange or another operator, to assess the creditworthiness of contract parties and ensure contract execution. This entity, known as a central counterparty (CCP), acts as a legal intermediary between buyers and sellers of derivatives contracts on the exchange. Additionally, exchanges maintain a Settlement Guarantee Fund (SGF) for robust protection against trader defaults. The CCP or SGF steps in to settle defaults by buyers or sellers, ensuring payment to the affected party. To secure contract execution and create reserves for potential defaults, the clearinghouse or SGF requires parties to provide collateral (margin) in cash or securities. Margin amounts fluctuate daily based on contract prices, and traders receive margin calls during adverse price movements, prompting an increase in their margin amount.

Key Features of Modern Electronic Commodity Exchanges

Modern electronic commodity exchanges provide rapid, secure, transparent, and regulated platforms for transactions, along with public displays of prices and trading activities.

The exchange formulates standardized contracts for trading, ensuring that neither party can modify them.

Offering a seamless trading platform, the exchange facilitates competitive trading and provides services for clearing, settlement, and arbitration.

Crucially, the exchange ensures a financially secure environment for effective risk management and guaranteed contract performance.

Price fluctuations occur based on the balance of purchase and sale volumes.

Bargaining for commodity derivatives contracts takes place on the trading floor, reflecting stakeholders' expectations regarding future prices of a particular commodity on the specified maturity date.

Futures market prices result from the bargaining process, involving the interaction of buy and sell quotes from participants with diverse expectations from both physical and financial markets.

The buying and selling activities of speculators, especially when engaged in excessive speculative trading unrelated to the physical market, influence futures prices.

Frequently Asked Questions

What is a commodity derivatives market?

A commodity derivatives market is a financial marketplace where standardized contracts for buying or selling commodities at a future date are traded.

Which commodities are typically traded in commodity derivatives markets?

Commodities such as agricultural products (wheat, rice, etc.), metals (gold, silver, copper), energy resources (crude oil, natural gas), and others are commonly traded in commodity derivatives markets.

What is the role of a clearinghouse in the commodity derivatives market?

A clearinghouse ensures the execution of contracts by acting as an intermediary between buyers and sellers. It assesses creditworthiness and manages risk, providing a secure trading environment.

What is the significance of standardized contracts in commodity derivatives?

Standardized contracts have uniform specifications, including quantity, quality, and expiry date. They promote transparency, liquidity, and ease of trading on the exchange.

How are price fluctuations managed in commodity derivatives trading?

Price fluctuations are managed through risk management mechanisms, including margin requirements, clearinghouses, and settlement guarantee funds.

Who participates in the commodity derivatives market?

Participants include farmers, traders, manufacturers, brokers, and financial institutions. Each plays a role in the buying or selling of commodity derivatives.

What is the impact of global events on commodity derivatives markets?

Global events such as geopolitical tensions, natural disasters, and economic changes can influence commodity prices, leading to fluctuations in the derivatives market.

How can one get involved in commodity derivatives trading?

To participate, individuals typically need to open trading accounts with brokerage firms like Enrich Money that provide access to commodity derivatives trading on recognized stock exchanges.

What are the key factors influencing commodity prices in derivatives markets?

Factors such as supply and demand dynamics, geopolitical events, weather conditions, and economic indicators can significantly impact commodity prices in the derivatives market.