Commodities market, commodities trading, commodity futures. . .

These terms are not very commonly understood

by many. However, commodity markets offer as much an opportunity to investors as does the stock market.

Here is an FAQ on what is the commodity futures market all about. What is the commodity market? Commodity market is a place where trading in commodities takes place. It is similar to an equity market, but instead of buying or selling shares one buys or sells commodities. How old are the commodities market? The commodities markets are one of the oldest prevailing markets in the human history. In fact, derivatives trading started off in commodities with the earliest records being traced back to the 17th century when rice futures were traded in Japan [ Images ]. What are the different types of commodities that are traded in these markets? World-over one will find that a market exists for almost all the commodities known to us. These commodities can be broadly classified into the following:

Precious Metals: Gold, Silver, Platinum, etc. Other Metals: Nickel, Aluminum, Copper, etc. Agro-Based Commodities: Wheat, Corn, Cotton, Oils, Oilseeds, etc. Soft Commodities: Coffee, Cocoa, Sugar, etc. Live-Stock: Live Cattle, Pork Bellies, etc. Energy: Crude Oil, Natural Gas, Gasoline, etc.

What are the different segments in the commodities market? The commodities market exists in two distinct forms, namely, the Over the Counter (OTC) market and the exchangebased market. Also, as in equities, there exists the spot and the derivatives segment. The spot markets are essentially over-thecounter markets and the participation is restricted to people who are involved with that commodity, say, the farmer, processor, wholesaler, etc. A majority of the derivative trading takes place through exchange-based markets with standardised contracts, settlements, etc. What are the characteristics of Over The Counter (OTC) commodity markets? The OTC markets are essentially spot markets and are localised for specific commodities. Almost all the trading that takes place in these markets is delivery based. The buyers as well as the sellers have their set of brokers who negotiate the prices for them. This can be illustrated with the help of the following example:

A farmer, who produces castor, wishing to sell his produce would go to the local 'mandi.' There he would contact his broker who would in turn contact the brokers representing the buyers. The buyers in this case would be wholesalers or refiners. In event of a deal taking place, the goods and the money would be exchanged directly between the buyer and the seller. Thus, it can be seen that this market is restricted to only those people who are directly involved with the commodity. In addition to the spot transactions, forward deals also take place in these markets. However, they too happen on a delivery basis and hence are restricted to the participants in the spot markets. What are the characteristics of the Exchange Traded markets? The exchange-traded markets are essentially only derivative markets and are similar to equity derivatives in their working. That is, everything is standardised and a person can purchase a contract by paying only a percentage of the contract value. A person can also go short on these exchanges. Also, even though there is a provision for delivery most of the contracts are squared-off before expiry and are settled in cash. As a result, one can see an active participation by people who are not associated with the commodity. Do the commodity exchanges facilitate delivery? The commodity exchanges do facilitate delivery, although it has been observed world-over that only 2 per cent of all the trades result in actual delivery. Why is the percentage of delivery ratio very low in the exchange-based commodity derivatives? Many people who participate in the exchanges are those who are not involved with the physical trading of the commodity. Thus they would not like receiving delivery and would not be in a position to give delivery. Standardised contracts make an unfeasible proposition for any trader to give or take delivery. E.g. if the size of 1 soya contract is 10 MT, a trader cannot buy / sell 15 MT of soya through the exchange. Also one cannot avail a credit facility in the exchanges that may be available in the local market. These and other factors deter a person from giving / receiving delivery through the exchanges. What is the size of the commodities market as compared to the equity market? In the developed markets the volumes on the exchange-based commodity derivates markets are about five times more than that of the equity markets. What is the history of commodities markets in India [ Images ]? India, being an agro-based economy, has markets for most of the agro-based commodities. India is the largest consumer of gold in the world, which implies a huge market for the yellow metal. India has huge spot markets for all these commodities. For instance,. Indore has a huge market for soya, Ahmedabad [ Images ] for castor seeds and Surendranagar for cotton, etc.

During the pre-Independence era, India also had a thriving futures market for commodities such as gold, silver, cotton, edible oils, etc. In mid-1960s, due to wars, natural calamities and the consequent shortages, futures trading in most commodities was banned. Currently, the futures markets that exist in India are localised for specific commodities. For example, Kerala [ Images ] has an exchange for pepper; Ahmedabad for castor seeds, and Mumbai [ Images ] is the major center for gold, etc. These exchanges, however, have only a regional presence and are dominated by people who are involved with the physical trade of that commodity. What are the current developments in this market? The government has now allowed national commodity exchanges, similar to the Bombay Stock Exchange [ Images ] and the National Stock Exchange, to come up and let them deal in commodity derivatives in an electronic trading environment. These exchanges are expected to offer a nation-wide anonymous, order-driven, screen-based trading system for trading. The Forward Markets Commission (FMC) will regulate these exchanges. Consequently four commodity exchanges have been approved to commence business in this regard. They are:

Multi Commodity Exchange of India Ltd (MCX), located at Mumbai National Commodity and Derivatives Exchange Ltd (NCDEX), located at Mumbai National Board of Trade (NBOT), located at Indore National Multi Commodity Exchange (NMCE), located at Ahmedabad.

What is the need for the exchange-traded commodity derivatives market? The biggest advantage of having an exchange-based platform is reach. A wider reach ensures greater participation, which results into a more efficient price discovery mechanism. In fact, it comes to a stage where the derivative market guides the spot market in terms of pricing. This can be well understood by looking at the following example: Imagine a soy wholesaler in Madhya Pradesh [ Images ], who -- having bought the crop from the farmer -- wishes to sell it to the oil refiners. To sell his crop he has to go to the local market at Indore. The price that he will get for his crop would be solely dependent upon the demand supply condition prevailing at that point of time at that market place. Also as the number of players is less there are chances of the prices being biased. In contrast the prices in the futures market are determined not only by the local demand supply conditions but also by the global scenario. Add to that the view taken on a commodity by various sets of people depending upon different parameters such as technical analysis, political news, exchange rates, etc. The price that is thus quoted can be safely regarded as the most efficient price. Thus, looking at the futures price the trader can price his crop appropriately. What opportunities do the commodity derivatives provide for investors?

Futures contract in the commodities market, similar to equity derivatives segment, will facilitate the activities of speculation, hedging and arbitrage to all class of investors. Speculation: It facilitates speculation by providing opportunity to people, although not involved with the commodity, to trade on the views in the movement of commodity prices. The speculative position is taken with a small margin amount that is paid to the exchange, and the contract can be squared-off anytime during the trading hours. Hedging: For the people associated with the commodities the futures market can provide an effective hedging mechanism against price movements. For example an oil-seed farmer may go short in oil-seed futures, thus 'locking' his sale price and in the process hedging against any adverse price movements. On the other hand a processor of oil seeds may buy oil-seed futures and thus assure him a supply of oil-seeds at a pre-determined price. Similarly the oil-seed processor may go short in oil futures, which may be bought by a wholesaler of oil. Also, there is a saying that 'gold shines when everything fails.' Thus, gold can be used as a hedging tool against other investments. Arbitrage: Traders may exploit arbitrage opportunities that arise on account of different prices between the two exchanges or between different maturities in the same underlying.

The history of organized commodity derivatives in India goes back to the nineteenth century when Cotton Trade Association started futures trading in 1875, about a decade after they started in Chicago. Over the time datives market developed in several commodities in India. Following Cotton, derivatives trading started in oilseed in Bombay (1900), raw jute and jute goods in Calcutta (1912), Wheat in Hapur (1913) and Bullion in Bombay (1920). However many feared that derivatives fuelled unnecessary speculation and were detrimental to the healthy functioning of the market for the underlying commodities, resulting in to banning of commodity options trading and cash settlement of commodities futures after independence in 1952. The parliament passed the Forward Contracts (Regulation) Act, 1952, which regulated contracts in Commodities all over the India. The act prohibited options trading in Goods along with cash settlement of forward trades, rendering a crushing blow to the commodity derivatives market. Under the act only those associations/exchanges, which are granted reorganization from the Government, are allowed to organize forward trading in regulated commodities. The act envisages three tire regulations: (i) Exchange which

organizes forward trading in commodities can regulate trading on day-to-day basis; (ii) Forward Markets Commission provides regulatory oversight under the powers delegated to it by the central Government. (iii) The Central Government- Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution- is the ultimate regulatory authority. The commodities future market remained dismantled and remained dormant for about four decades until the new millennium when the Government, in a complete change in a policy, started actively encouraging commodity market. After Liberalization and Globalization in 1990, the Government set up a committee (1993) to examine the role of futures trading. The Committee (headed by Prof. K.N. Kabra) recommended allowing futures trading in 17 commodity groups. It also recommended strengthening Forward Markets Commission, and certain amendments to Forward Contracts (Regulation) Act 1952, particularly allowing option trading in goods and registration of brokers with Forward Markets Commission.

The Government accepted most of these recommendations and futures trading was permitted in all recommended commodities. It is timely decision since internationally the commodity cycle is on upswing and the next decade being touched as the decade of Commodities. Commodity exchange in India plays an important role where the prices of any commodity are not fixed, in an organized way. Earlier only the buyer of produce and its seller in the market judged upon the prices. Others never had a say. Today, commodity exchanges are purely speculative in nature. Before discovering the price, they reach to the producers, end-users, and even the retail investors, at a grassroots level. It brings a price transparency and risk management in the vital market. A big difference between a typical auction, where a single auctioneer announces the bids and the Exchange is that people are not only competing to buy but also to sell. By Exchange rules and by law, no one can bid under a higher bid, and no one can offer to sell higher than someone elses lower offer. That keeps the market as efficient as possible, and keeps the traders on their toes to make sure no one gets the purchase or sale before they do. Since 2002, the commodities future market in India has experienced an unexpected boom in terms of modern exchanges, number of commodities allowed for derivatives trading as well as the value of futures

trading in commodities, which crossed $ 1 trillion mark in 2006. Since 1952 till 2002 commodity datives market was virtually non- existent, except some negligible activities on OTC basis. In 2002-03, Prime Minister, Shri. A. B. Vajpayee, in his Independence Day address to the nation on 15th August 2002, demonstrated its commitment to revive the Indian agriculture sector and commodity futures markets. The GOI in that very year took two steps that gave a fillip to the commodity markets. The first one was setting up of nation wide multi commodity exchanges and the second one was expansion of list of commodities permitted for trading under (FC(R) A). In India there are 25 recognized future exchanges, of which there are three national level multicommodity exchanges. After a gap of almost three decades, Government of India has allowed forward transactions in commodities through Online Commodity Exchanges, a modification of traditional business known as Adhat and Vayda Vyapar to facilitate better risk coverage and delivery of commodities. The three exchanges are: National Commodity & Derivatives Exchange Limited (NCDEX) Mumbai, Multi Commodity Exchange of India Limited (MCX) Mumbai and National Multi-Commodity Exchange of India Limited (NMCEIL) Ahmedabad. There are other regional commodity exchanges situated in different parts of India.