Financial Service - Commodity Derivatives
What is a Commodity Market?
A 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, stock futures and index futures, one buys or sells commodities and commodity futures. Commodity markets are mainly exist in tow forms:
- Spot Market
- Future Market.
What is Spot Market ?
Spot Market is a market where delivery based trade of commodities takes place. Forward deals also take place in these markets but they too happen on a delivery basis and hence are restricted to the participants in the spot markets. Spot markets, sometimes also called cash markets, are mostly fragmented Over the Counter markets.
What is Future Market ?
Future Market is primarily intended for Hedging and Speculation. Contracts in Futures Market results mostly in Cash Settlement and do not frequently result in delivery. The Clearing House guarantees trades executed on the exchange. Contracts that are not closed out and are due for delivery will be delivered and settled through the warehouse receipts. All contracts are settled on daily basis at the daily settlement price till the final delivery of commodity on the expiry date.
Futures market is expected to help the market participants through two vital economic functions, viz., Price Discovery and Price Risk Management. With convergence of bids and offers emanating from a large number of buyers and sellers from different parts of the country – and possibly from abroad - futures trading is a very efficient means of forecasting the price for a commodity.
What do we mean by Auction Market ?
Auction Market is meant to close out the positions of the members who have failed to pay-in their obligations. In the Auction market, the trading member can participate in the auctions initiated by the Exchange only. The counter orders can be entered only during Auction period.
What are futures contracts?
A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. These contracts have standardized features. They are normally traded on the exchange. The exchange also provides a mechanism gives the two parties a guarantee to the effect that the contract will be honored.
What are commodity futures?
A commodity futures contract is an agreement between two parties to buy or sell the commodity at a future date at today's future price. Futures are standardized contracts among buyers and sellers of commodities that specify the amount of a commodity, grade/quality and delivery location.
What are forward contracts?
A forward contract is an agreement to buy or sell an asset at a certain future time for a certain price. It is traded over the counter market- usually between two financial institutions or between a financial institution and its clients. They are commonly used to hedge foreign currency risk.
How are forward contracts useful?
Forward contract is very valuable in hedging and speculation. It can help a farmer to hedge himself against any unfavorable movement of the prices of the commodity by forward selling it at a known price. In case of a speculator, if he has information, which forecast an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to raise and then take a reversing transaction. The use of forward market here supplied the leverage to the speculator.
What is the difference between the futures contracts and forward contracts ?
Some of the basic differences between the futures and forward contracts are as follows:
- While futures contracts are traded on the exchange, forwards contracts are traded over-the-counter market.
- In case of futures contracts the exchange specifies the standardized features of the contract, while no per-determined standards are there in the forward contracts.
- Exchange provides the mechanism that gives the two parties a guarantee that the contract will be honored whereas there is no surety/guarantee of the trade settlement in case of forward contract.
What are the benefits in futures trading/investing in commodities?
Benefits of trading/investing in commodity futures :
- Transparency and Fair Price Discovery: Futures trading in commodities results in transparent and fair price discovery on account of large scale participation of entities associated with different value chains and reflects views and expectations of wider section of people related to those commodities. Price discovery and price risk management flow more easily from an Order-driven system rather than Quote-driven system. Anonymity of trading participants and effective risk management system strengthens the trust of the participants in the trading system, which is a precondition for enhancing breadth and depth of the market.
- Online Platform: This also provides effective platform for price risk management for all segments of players ranging from the producers, the traders, processors, exporters/importers and the end users of the commodity. The trading on futures contract on our platform will be facilitated on an online platform for market participants to trade in a wide range of commodity derivatives driven by the best global practices of professionalism and transparencies.
- Hedging: Price Risk Management is very closely related to Hedging, which means transfer of some or all of that risk to those who are willing to accept it, which are in turn called Speculators. Price risk is managed by taking opposite positions on the two legs of the market e.g. spot and futures. The futures prices are linked to the spot prices through carrying cost, which comprises cost of storage, interest, wastage, shrinkage etc. Therefore, the two prices tend to move in parity. Taking opposite positions in the two legs of the market therefore tends to offsets loss in any market on account of adverse price fluctuation. All the participants in the physical markets, like, producers, processors, manufacturers, importers, exporters and bulk consumers can focus on their core activities by covering their price-risk in futures market. Their operations become more competitive since the price-risk involved in procurements, supply is transferred to the futures market.
- No Insider Trading: Dealing in commodities is free from the evils of insider trading. Besides, there are no company specific risks as those seen in stock markets.
- Simple Economics: More the demand for a commodity higher is its price and vice versa.
- Trade on Low Margin: Commodity Futures traders are required to deposit much lower margins compared to other asset classes. The low margin, which again varies across exchanges and commodities, facilitates the taking of large positions at lower capital.
- Seasonality Patterns: Quite often provide clue to both short and long term players.
- No Counter party Risk: Much like the exchanges in the equity market, Commodity Futures market have Clearing Houses, which guarantee that the terms of the contracts are fulfilled, thereby eliminating the counter party risk.
- Wide Participation: The emergence of online trading would enable growth in the commodity market, much akin to the one seen in the equity market. It would also ensure bringing the market closer to both, the user and the trader.
- Evolved Pricing: The rise in participation would decrease the risk of cartelisation, ensuring a holistic view on the commodity. Hence, pricing would be more practical and less irrational leading to Fair Price Discovery Mechanism.
What are the different types of traders/participants in derivatives/futures market ?
There are three types of traders in the Derivative market namely:-
Hedgers: They are in the position where they face risk associated with the price of an asset. They use derivatives to reduce or eliminate risk.
Speculators: Speculators wish to bet on the future movement in the price of an asset. They use derivatives to get extra leverage. A speculator will buy and sell in anticipation of future price movements, but has no desire to actually own the physical commodity.
Arbitrators: They are in the business to take advantage of a discrepancy between prices in two different markets.
Investors: Producers / Farmers, Importers / Exporters, Commodity financers, Agricultural credit providing agencies, Hedgers, speculators, arbitrageurs, Large scale consumers. For e.g. refiners, jewelers, textile mills, Corporate having risk exposure in commodities.
What is the background of the Commodities exchanges/markets in India ?
Commodity derivatives started in India during the later part of 19th century when the first commodity exchange, viz. the Bombay Cotton Trade Association Ltd was set up for organizing futures trading. Forward markets started in Cotton (1875) at Bombay, in oilseeds (1900) at Bombay, in raw jute and jute goods (1912) at Calcutta, in Wheat (1913) at Hapur and in Bullion (1920) at Bombay. Forward markets in Sugar were also functioning at Bombay, Calcutta, Kanpur and Muzaffarnagar.
In the absence of uniform regulations, these markets were regulated by social control of close-knit groups. Meanwhile, steps were taken to regulate these forward markets:
The Govt of India passed Forward Contracts (Regulation) Act, 1952 which empowers the Govt./FMC to notify a commodity for prohibition of forward contract. The Act envisages three-tier regulations:
- Bombay Contract Control (War Provision) Act 1919 was passed by the Govt. of Bombay and Cotton Contract Board was set up.
- The Govt. of Bombay passed Bombay Options in Cotton Prohibition Act 1939.
- In 1943, the Defense of India Act was used extensively for prohibiting forward trading throughout India. Orders were issued to ban forward trading in oilseeds, food-grains, spices, vegetable oils, sugar and cloth.
- The orders were retained in the Essential Supplies Temporary Powers Act 1946, after the Defense of India Act had lapsed
- To have unified systems, Bombay Forward Contracts Control Act 1947 was enacted.
This framework continues to exist even today all over India. A large number of commodities were notified for prohibition during the 1960s which left only a few insignificant commodities open for forward trade. This scenario continued for about four decades.
- The Exchanges which can prepare its own rules, regulations and byelaws.
- The Forward Markets Commission (FMC) approves the rules and byelaws and provides regulatory oversight. The Govt has full control over FMC.
- Ministry of Consumer Affairs, Food and Public Distribution, the Govt. of India - is the ultimate regulatory authority.
During the Post-Liberalization Era since 1990-91 onwards, initiatives were taken for opening up of futures trading in selected commodities, strengthening of FMC, amendments to Forward Contracts Act, 1952, linkage of spot and forward markets, introduction of electronic warehouse receipt system, inclusion of more commodities and promotion of national system of warehouse receipt.
In 2003, a group of 54 prohibited commodities was opened up for forward trading, along with establishment and recognition of 3 new national exchanges with on-line trading and professional management. The new exchanges brought capital, technology and innovation to the markets which notched up phenomenal growth in terms of number of products, participants, volumes and other associated fields, viz. research, education, training, media, collateral management, commodity finance, ware-housing, assaying and certification, software development, electronic spot exchanges etc. Today, forward markets and associated fields attract significant mind-share nationally and internationally.
Which are tradable commodities?
Starting with trade in 7 commodities till 1999, more than 100 commodities have been permitted for trade after liberalization of futures in 2003. But trade could gain liquidity in a few dozen commodities. Futures trading is now available in agro products, metals, oil and oilseeds, food grains, pulses, vegetables, fibres, spices, energy products, polymers, petrochemicals, carbon credits etc.
Precious Metals: Bullion, Gold and Silver
Oil & Oilseeds: Castor Seeds, Soya Seeds, Castor Oil, Refined Soya Oil, Soya meal, Crude Palm Oil, Groundnut Oil, Mustard Seed, Mustard Seed Oil, Cottonseed Oilcake, Cottonseed, Furnace Oil, Light Crude Oil, Mentha Oil,
Spices: Pepper, Red Chilli, Jeera, Turmeric, Cardamom,
Metals: Steel Long, Steel Flat, Copper, Nickel, Tin, Steel, Aluminum Zinc ingots, Zinc.
Fibre: Kapas, Long Staple Cotton, Medium Staple Cotton,
Pulse: Chana, Urad, Yellow Peas, Tur, Yellow Peas, Chana,
Grains: Rice, Basmati Rice, Wheat, Maize, Sarbati Rice, Jeera,
Energy: Crude Oil, Natural Gas, Brent Crude,
Others: Rubber, Guar Seed, Guar gum, Cashew, Cashew Kernel, Sugar, Gur, Coffee, Silk, Sugar. Thermal Coal, Polypropylene, carbon credits.
FMC/the Govt. of India can ban or allow trade of any commodity.
Which commodities are generally suited for trade ?
All commodities are not suited for futures trading. For future trading, a commodity must possess the following characteristics:
- Suitable volume
- Sufficient marketable surplus,
- volatility of price to necessitate hedging,
- Free from Govt. control and regulations,
- Standard grade
Which are the major commodity exchanges in India?
There are three national level commodity exchanges to trade in permitted commodities:
- Multi Commodity Exchange of India Ltd (MCX)
- National Commodity and Derivative Exchange of India Ltd. (NCDEX)
- National Multi Commodity Exchange of India Ltd, (NMCE).
Who regulates the commodity market?
Forward Markets Commission (FMC) is Regulatory Authority which is overseen by Ministry of Consumers Affairs, Food and Public Distribution, Govt. of India. FMC is a Statutory Body set up in 1953 under the provisions of the Forward Contracts (Regulations) Act 1952.
Who can be a Member of the Commodity Exchanges ?
Trading rights on the Exchange can be acquired by Individuals, Registered Firms, Corporate bodies and Companies (as defined in the Companies Act 1956) by complying with the admission norms. Alankit Imaginations Limited, a profit making company of the Alankit Group is a Member of all major commodity exchanges i.e. MCX, NCDEX, NMCE, IEX etc.
What are the trading days and hours?
The Exchanges operate on all days except, Sundays and Exchange specified holidays.
Monday to Friday: 10.00 am - 11.55 pm (except agricommodities upto 5.00 p.m.)
Saturday : 10 am - 2.00 pm (SAT)
The Exchange may vary the above timings with due notice.
How many months contract will be available for futures trading?
At NCDEX, three consecutive calendar month contracts are available. MCX provides different number of contracts for different commodities.
What are the different terms in contract specifications?
The quality specification of each commodity is mentioned in the contract. Each participant will be trading in that particular quality only.
- Trading unit: The Trading unit is the minimum quantity for a contract that can be bought or sold. e.g. If a member is buying 1 lot of cardamom, he has to buy minimum 100kg of cardamom given trading unit of 100kg.
- Quotation / Base value: It is the Quantity in Lot or Weights for which the prices are quoted for online trading e. g. If the quotation or base value for Gold contract is given as 10 grams and the price available for trading is Rs. 16000 for 10 grams of the Gold.
- Maximum order size: Maximum order size is the maximum no. of lots that can be bought or sold in one Single order. The maximum order size of each commodity is given in its contract specifications.
- Tick Size: Tick size is the minimum price difference between the bids and asks for a particular contract. The tick size is given in the contract specifications.
- DPR: Daily Price Limit i.e. circuit filter limit is the percentage of variation allowed in the price of a commodity in a day with respect to the previous day’s close price for the day.
- DDR: Due date rate is final settlement price for particular future contract and calculation process called computation of DDR.
What is base price?
Base price is a reference price used for launching / commencing new futures Commodity/Contract. On the basis of that daily price range gets adjusted.
What does open Interest in the market mean?
The open interest is the number of contracts outstanding in the market (It can be called as outstanding position at any point of time).
Please indicate the permissible brokerage structure and brokerage pattern.
The exchange does not stipulate any directives in this regard and it is free to be bilaterally decided between client and member of the exchange.
What is Initial Margin ?
The initial margin (IM) is levied on all open positions (Buy or sell positions) of the members and their clients. The IM percentage on each commodity varies depending upon its market volatility. The margin so calculated is reduced from the total margin of the member available with the exchange and accordingly further exposure is given on the balance amount. As the IM increases, the exposure shall decrease.
What are Mark to Market (MTM) Margins ?
MTM is a mechanism devised by the exchanges to prevent the possibility of the potential loss accumulating to the level where the participants might willingly or unwillingly commit default. All trades done on the exchange during the day and all open positions for the day are marked to closing price for the respective delivery/contract and notional gain or loss is worked out. Such loss/gain is debited/credited to respective member’s account at the end of each day. The outstanding position of the members is then carried forward the next day at the closing price.
What are Price Bands/Caps ?
Price bands have been imposed on all commodities to prevent extreme volatility and unhealthy practices of cornering the market.
What is circuit filter?
The Exchange notifies a daily circuit filter limit for futures Contract in terms of percentage of intra day variation allowed in a day with respect to the close price of previous day. Circuit filter provides the maximum range within which a contract can be traded during day. Such circuit filter is different for different commodities. The orders, which are in violation of such circuit filter, are rejected by the system.
What do mean by a long position in the market?
Taking a long position means buying futures contracts or owning the cash commodity.
What do mean by a short position in the market ?
Taking a short position means selling futures contracts.
How will the clearing and settlement take place?
The clearing and settlement will take place through institutions/banks arranged by the exchanges. NCDEX has arrange with NSCCL for clearing purpose and the clearing banks are Canara Bank, HDFC, ICICI and UTI Bank. MCX has tied up with HDFC Bank, BOI, UTI Bank, UBI and IndusInd Bank for providing clearing and settlement facilities.
How would contracts settle?
All contracts with open positions not intended for delivery and non-deliverable contracts would be cash settled. All contracts with open position which is intended for delivery would have to be settled by delivery and in case of delivery defaults compensation as per the Exchange norms would be paid to the buyers.
What would be the settlement period?
All contracts settling in cash would be settled on the following day after the contract expiry date. All contracts materializing into deliveries would settle in a period of 2-7 days after the expiry. The exact settlement day would be specified in the settlement calendar released by the Exchange for every expiry month.
Do physical deliveries happen in commodity futures exchanges?
The future contracts are mostly settled in cash. Another method of settling the contracts is by taking or making delivery. For open positions on the expiry day of the contract, the buyer and the seller can give intentions for delivery through the trading system. However, positions, market lots and delivery period vary from exchange to exchange and commodity to commodity. Delivery of the underlying commodities is permitted only through a Central Warehousing Corporation (CWC) receipt, which meets highest contemporary international standards.
In case the seller does not have the materials sold by him in his possession, how will settlement take place? What will be the penalty imposed on the seller by the Exchange?
First of all we have to see the conditions under which the question of making delivery arises. If the price of an expiry month contract gets converged to the spot price, why should seller or buyer hold the position, they would square off. However if the price of expiring contract is lower than spot market, seller must arrange to procure material to tender during expiring month. If sellers fails, then the exchange will fix due date, rate on the basis of spot price of last 3 days of the month and the seller will have to pay the difference between due date rate and contract rate plus penalty prescribed by the exchange for failing to deliver. Also in case of delivery default, compensation is paid to the buyers as per the Exchange norms intimated to market vide various circulars from time to time.
Would additional margins be levied for deliverable positions?
Yes, the Exchange levies delivery margins.
How would a buyer take physical delivery from warehouse?
Any buyer intending to take physical delivery would have to submit Remat request to its Depository Participant, who would pass on the same to the registrar and the warehouse. On a specified day, the buyer would go to the warehouse and pick up the commodity after confirmation from warehouse.
How would a seller get the electronic balance for the physical holdings?
The process is called dematerialization. The seller intending to make delivery would have to take the commodities to the designated exchange accredited warehouse. These commodities would have to be assayed by the Exchange accredited assayer. The assayer report must confirm the quality of commodities to be meeting the contract specifications with allowed variances. If the commodities meet the specifications as required, the warehouse would accept them. Warehouses would then ensure updating the receipt in the warehousing system, then the R&T agent intimates the concerned depository which finally provides the demat credit in the form of electronic balances(ISIN's) into the beneficiary account of the depositor.
How would the seller give an invoice to the buyer?
The seller's would issue and dispatch the respective invoices to its clearing member, who would then dispatch the invoice to the buyer's clearing member.
How would you accredit warehouses?
NCDEX would prescribe the accreditation norms, comprising of financial and technical parameters, which would have to be met by the warehouses. NCDEX would take assayer's/Structural Engineer's certificate confirming the compliance of the technical norms by the warehouses.
Who would decide the warehousing charges?
The respective warehouse service provider would decide the warehousing charges. However the tentative warehouse charges are available on our website. The charges are based on the services provided by respective warehouses.
Would health checks and inventory verification be carried out?
The assayers and or other experts on behalf of NCDEX would carry out surprise health checks and inventory verification/audits at the warehouses.
How will you ensure uniformity in delivered grades / varieties?
The exchange will specify, in its contract specifications, the particular grade / variety of a commodity that is being offered for trade. A range will be specified for all the properties and only those grades / varieties, which fall within the range will be accepted for delivery at the Exchange platform. In case the specifications fall within the range, but differ from the benchmark specifications, the Exchange will specify a premium / discount.
Would there be any premium / discounts for the difference in quality?
Yes, these would be per-defined and made available on the website. The settlement obligation would be impacted on account of the premium / discount in case of deliverable positions. The parameters which would be considered for premium / discount computation as well as the methodology would be specified by NCDEX.
What happens when the commodities reach the validity date?
Those commodities cannot be delivered till it is again revalidated. A revalidation request is to be submitted at the warehouse and once the commodities are certified acceptable by the accredited assayer then a new ISIN no. is allotted. If the commodity fails the revalidation test then such commodities will have to be taken out of the warehouse by remat.
Can commodities be re-deposited in the warehouse after the validity period of the assayer's certificate?
Commodities are only accepted if they pass the assayer test and confirm to NCDEX quality specifications.
What is the procedure for handling bad delivery / part delivery?
Partial delivery as well as bad delivery would be considered as delivery default and appropriate penalties would be levied.
How would disputes be resolved?
Any disputes in regard to the quality / quantity will be referred to the Exchange customer service department for redressal. After verification of the facts a view will be taken on further course of action. The Exchange will take only complaints which have been referred within the FED of the commodity under dispute.
Can a member enter into a common member client agreement with the client for all the Exchanges?
No. Separate member client agreement is to be executed for each of the commodity Exchange for which member is offering broking services to the client.
What are the guidelines for Brokerage to be charged by the member?
Here is no directive or a circular by the Exchange on any limit on the Commission/Brokerage that can be charged by the member. There is no minimum brokerage prescribed by the Exchange till date.
Is Sales Tax applicable on all future contracts/trades in Commodities?
Sales tax is not applicable if the trade is squared off. The sales tax is applicable only if a trade turns into delivery. Normally it’s the seller’s responsibility to collect and pay the sales tax. The sales tax is applicable at the place of delivery.
How sales tax is settled
Prices quoted for the futures contracts would be basis warehouse and exclusive/inclusive of sales tax applicable at the delivery center. For contracts materializing into deliveries, sales tax would be added to the settlement amount. The sales tax would be settled on the specified day after the payout as mentioned in the settlement calendar.
Does the trading / clearing member need to have local sales tax registration?
No. The member need not have a local sales tax registration. However, if the member intends to undertake the delivery, then he needs to have a proper local sales tax registration, where the commodity is located or alternatively he can appoint a C&F agent.
Do the market participants need to have sales tax registration?
The market participants who intend receiving/giving delivery should ensure that they have all the proper local sales tax registration numbers/documents on or before the settlement of the delivery. Deliveries given by market participants who are not registered as per the local sales tax guidelines or whose registration is not valid on the date of settlement / delivery shall not be liable to collect the sales tax from Buyer members.
Further the seller member would be obliged to fulfill any appropriate monetary compensation demanded by the APMC authorities/ sales tax department due to the unregistered sale. Or alternatively they can appoint a C&F agent.
In which state sale tax registration is to be obtained?
Sales tax registration is to be obtained in the State where the delivery is affected.
Who is responsible for payment of sales tax?
It is obligatory on the part of the registered seller to collect the sales tax from the buyer (in case the commodity is covered under the local sales tax) and file the returns as per the defined procedure of the relevant local sales tax laws. However, in the case of commodities which are liable to be taxed on purchases only, the buyer will have to discharge the liability for payment of tax. Further, payment of sales tax to the seller will be the sole responsibility of the Buyer.
When is the sales tax payable by the buyers?
Sales tax has to be paid by the buyer members on the day of sales tax settlement only as specified in the settlement calendar. The local sales tax levied would be based on the Final Settlement Price. The sales tax settlement is generally executed after two (2) days of pay in / pays out day.
How to start trading in Commodities?
To trade in commodities, you need to
- Open a trading account with Alankit Imaginations Limited (AIL)
- Complete required KYC norms.
Why AIL for commodity trading?
AIL is a member of all major Commodity Exchanges i.e. MCX, NCDEX, NMCE and Indian Energy Exchange. AIL provides efficient and effective personalized services and advice for all the commodities.