Lecture Series 4

7/27/2019 Lecture Series 4

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Commodity Markets

Lecture series - 4



Regulatory framework of Indian Commodity markets

Ministry of Consumers Affairs,

Food & Public

Distribition

Three-tier

regulatory

ForwardMarkets

Commission

National Multi-commodity

Exchanges

RegionalExchanges



Other acts and regulations that affect functioning of

Commodity Markets

Essential Commodities Act

The Stamp Act

The Companies Act

Agriculture Produce Market Committee (APMC)



Brief synopsis of FCRA 1952

• The Act applies to goods, which are defined as any movable

property other than security, currency and claims

• In the preamble of the Act itself, the intention of the

legislature to prohibit options in goods is made explicit. Bya specific provision, section 19, such agreements are

prohibited

•

categories, viz., ready delivery contracts and forward

contracts. Ready delivery contract are those where delivery

of goods and full payment of price therefore is made within

a period of eleven days• It is further clarified that notwithstanding the period of

performance contract, if the contract is performed by

payment of money difference (cash settlement), it would

not be a ready delivery contract



Brief synopsis of FCRA 1952 (Cont.)

• The Act provides for either regulation of the forwardcontract in specified commodities or prohibition of

specified commodities. Such contracts in the commodities,

which do not figure in, regulated or prohibited categories

are outside the purview of the Act, except when they are

organized by some exchange

• The Act envisages a three-tier regulation. The exchange

which organizes forward trading in regulated commodities,can prepare its own rules (articles of association) and

byelaws and regulate trading on a day-to-day basis



Brief synopsis of FCRA 1952 (Cont.)

• The FMC approves those rules and byelaws and providesregulatory oversight. It also acquires concurrent powers of

regulation either while approving the rules and byelaws or

by making such rules and byelaws under the delegated

powers

• The Central government – Department of Consumer Affairs,

Ministry of Consumer Affairs, Food and Public Distribution

– is the ultimate regulatory authority• Only police authorities have powers to enforce illegal

trading in prohibited commodities and options in goods.

FMC can merely forward information and render technical

assistance to police. The penalties provided under the Act

are nominal and does not have deterrent effect



Classification of Goods

Section 15 – Regulated Commodities

Section 17 – Prohibited Commodities

- Presently Futures Trading is not prohibited in

any commodity

Free Goods – Other than those u/s 15 and 17

- FMC may permit futures trading



Regulated Commodities (Section 15)

• Groundnut, mustard seed, cottonseed, sunflower,rice bran, soy oil, etc

EdibleOilseeds

• Wheat, Gram, Rice, Dals, Bajra, Maize etcFood Grains

• Gold, Silver, Copper, Zinc, etcMetals

Spices

Fibre

Other

• Turmeric, Pepper

• Cotton, Jute etc

• Castorseed, Gur, Natural Gas, Crude Oil etc



Role of Forward Markets Commission

Regulate the market

Development of the market

Creation of awareness

Increasing market participation

Effective dissemination of price information



Tools available with Forward Markets Commission

• Such limits are applied by the exchange (with priorapproval of FMC) on both members and clients

• Position limits are specified in absolute termsPosition Limits

• This is used to allow market to cool off duringsudden upswing or downswing

• Like stock exchanges, this is applicable on daily basisCircuit filters

• mpose on y on one s e o tra e n case o extremevolatility or requirement of curbing one sided tradesmargins

Compulsory

Delivery

Suspension of trading

• Required in order to convince market participantsabout the credibility of price discovery, especially in

case of agricultural products

• Applicable in case of exigencies





Genesis - Shroff Committee (1950)

• Draft Bill for Forward Markets Regulation was made

• Inputs received from different commercial organizations

• Led to passage of the Forward Contract Regulation Act of

1952

• Forward Market Commission (FMC) was established in

1953, dedicated to regulation of forward markets



Dantwala Committee (1966)

• Review of previous 10 years of FMC

• Suggest amendments to FCR(A), 1952

• Recommended that FMC be made autonomous

• Futures in export commodities to be allowed

• Futures contracts to be defined

• Options trading not recommended



Khusro Committee (1979)

• Review role of FMC and analyze commodities markets

- Not all commodities were to be allowed for futures

trading

- Laid down the possibilities for specific commodities such

as Sugar and Silver

- Condition for trade: Homogeneity of commodity and largesupply and demand

- Exporters to be allowed to hedge



Kabra Committee (1993)

• Exchanges to enlist more members and be demutualised

• Ensure Capital adequacy norms

• Encourage Computerization

• Vigilance Committee and Panel of surveyors

• Arbitrators (dispute settlement mechanism)



Kabra Committee (1993)

• Options and range forwards to be allowed

• Recognition to exchanges to be permanent (or at least for 5

years)

• Time limit for ready delivery contracts to be made 30 days

• Futures trading to be allowed for more commodities

• Allow Indian companies to hedge abroad (accepted)



World Bank and UNCTAD (Joint Study) - 2009

• Opening of Agricultural markets would lead to greater

exposure to price volatility

• Requirement of Price Risk Management

• Price fluctuations to be sufficiently large (to ensure pricediscovery)

• Efficient transfer of risk from Hedgers to Speculators and

Arbitragers• Standardization of trading practices

• Storage facilities to be enhanced

•

Encourage participation of large institutional investors• Improve internal management of exchanges



Abhijit Sen Committee report on Future Trading - 2008

• Minimize the potential adverse impact of futures trading onprices of agricultural products. There is a need for a clearand unambiguous regulatory framework. The regulatoryauthority should have the capacity and the power to

discipline the market

• Once these pre-requisite are in place they will not only help

in controlling aberrations in the market but also help thegovernment and the regulator to explain to variousstakeholders at large any abnormal behavior in the marketthat might occur as a result of some basic fundamental

demand and supply factors




• Reasons for abnormal market behavior to be thoroughly

probed to take remedial action to protect market and

financial integrity

• Currently, errant participants can only be suspended or

debarred from trade. But the Forward Contract

monetary penalty for violations

• The autonomous status envisaged for the regulator by

Amendment Bill is designed to provide it powers and

capacity to intervene in the market




• FMC should frame regulations on various aspects of market

operations for transparent and efficient functioning of the

market

• Care should be taken to enable farmers and small operators

to take benefit of these markets. Exchanges should be

recte to es gn t e r mar et proce ures an contracts

such as to enable farmers an easy access to these market

and protection against any market malpractices




• The most important enabler of the market is to upgrade the

quality of regulation both by the FMC and by the Exchanges

• Exchanges must act as self regulatory organizations and to

demonstrate fair play, objectivity and customer orientation• The contract designs, delivery mechanism such as assaying,

availability and accreditation of warehousing should meet

• Before listing of new products on futures market, a rigorousexamination is required. These efforts need to be

strengthened further, particularly at the level of regulatory

approval of contract design

• In this context, particular emphasis needs to be put in

avoiding approval of such contracts where basis risk is likely

to exceed spot price




•‘Options in goods’ can be another hedge instrumentsuitable for farmers’ needs

• However, complex options products may be difficult to

comprehend and not suitable for farmers’ needs till market

attains maturity of operations and regulations

• Moreover, since the premium on option may be quite high,

this can be subsidized to some extent by using the

collection from proposed CTT exclusively for thedevelopment of agricultural markets and to improve access

of the farmers to them

• In the longer run, it is also worth exploring the possibility of

MSP implementation agencies such as FCI operating in thecommodity market as an option writer in respect of goods

it needs to procure for the operation of PDS



Forward Contracts (Regulation) Amendment Bill

• Once the Bill is passed and enacted by Parliament, ForwardMarket Commission (FMC) as a regulator will get autonomy

and power to regulate the market effectively

• New products like `options’ will be allowed in the

commodity market. This will benefit various stakeholders

` ’

`price risk management`

• The Bill would enhance public accountability of the

Regulator by providing for an Appellate Authority




• Forward Markets Commission (FMC), to be at par withcapital markets regulator Sebi, making it an autonomous

regulator which currently is overseen by the Ministry of

Consumer Affairs, Food and Public Distribution

• Contradiction - The Wajahat Habibullah Committee had

regulatory regime for the commodities futures market andthe securities market, as is the case in most jurisdictions,

whereas this Bill seeks to create a new autonomous body




• The main objective of this Bill is to permit and regulate afinancial instruments which enables buyers and sellers of

commodities to effectively manage risk from price

fluctuations and open the door for the introduction of newintangible products like options and indices trading in the

commodities futures market

•

lower penalty for the same kind of offence in comparisonto the penalty levied in the Sebi Act

• While the FMC is to regulate all commodity derivatives, the

markets for the underlying goods will be regulated by state

governments, which could lead to duplication in regulation.




• The Parliamentary standing committee has suggestedinclusion of financial institutions and banks, mutual funds

and insurance companies to participate in forward markets

so as to ensure better price discovery and lower thevolatility in the market

• Some of the major changes which this amendment

definition of a 'ready delivery contract' to include allcontracts that provide for the delivery of goods and

payment of the price within 30 days

• Currently, ready delivery contracts needs to be delivered

and paid for immediately or within 11 days but this

legislative piece extends this period of the ready (spot)

delivery to 30 days.




• The Bill defines 'commodity derivatives' and permitstrading in them

• the Bill requires all exchanges to be corporatised and

demutualised by a date to be decided by FMC• Corporatisation means the exchange will have to convert

from being a body of individuals or a society to a company

•

separate from ownership and management of the company• The Bill proposes to empower the FMC to issue franchisee

registration certificates to sub-brokers of member-brokers

of commodity exchanges and to take decisions of increasing

salaries of its member-directors and other office bearers.




• The number of members of the FMC has also beenincreased from four to nine, including one chairperson, of

which eight members will be selected by the central

government, and one by the Reserve Bank of India• The Bill allows the FMC to impose penalties in case of

failure to furnish information or comply with the directions

,

fraudulent and unfair trade practices and in any other caseof contravention of the provisions of the Principal Act

• All sums collected by way of penalties shall be credited to

the Consolidated Fund of India and appeals shall lie from

the order of the FMC to the Securities Appellate Tribunal

established under the Sebi Act




• The Bill makes a provision for the transfer of duties andfunctions presently performed by a clearing house to a

clearing corporation

• The central government has the power to prohibit forward

contracts or options in goods or commodity derivatives by

matters of policy and to supersede it in certain cases




• Further, the central government is also empowered tosuspend a member on appropriate grounds

• Overall, through this Bill Government is making an effort to

regulate the commodities future market and bring moreclarity in the existing provisions

– The main beneficiaries of these reforms will be the

raw materials to produce them – Options would provide useful price signals to producers

and farmers which in turn would gain more security in

the volatile markets



Foreign Investment in Commodity Exchange

• Limit of Foreign investment - 49%• Registered FII under Portfolio Investment Scheme (PIS) is

limited to 23%

•

Investment under FDI Scheme is limited to 26%

Other conditions

and(ii) No non-resident investor/ entity, including persons acting

in concert, will hold more than 5% of the equity in these

companies

While it is not clear, however, it is presumed that for an

increase in FII investment within the 49 per cent cap,

approval would be under the automatic route



Present Limitations of FMC

• Option trading prohibited

• Functions as a Government department with limited

autonomy with respect to :

– Recognition / de-recognition of Exchanges

– Regulation of Intermediaries

–

– Market Expansion has put heavy pressure on the FMC’scoping capacity



Summary of proposed regulatory measures

• Registration of brokers / intermediaries

• Audit of brokers / intermediaries.

• Penalties for violation of limit on open position

• Contract designs being made broad based – Urad,

Tur, Potato

•

Clubbing of Open Interest to prevent Cartelization



Summary of proposed regulatory measures (Cont.)

• Review of non operative / illiquid contract at theExchange

• Stringent Norms for client Code Modifications

• Permanent Account Number made mandatory

• Portfolio Management Scheme prohibited

•

Uniformity in Transaction Cost



Summary of proposed regulatory measures

• Harmonization of Regulatory measures acrossexchanges

• Move towards Compulsory Delivery

• Restrictions on Proprietary account trading

• Rationalization of daily price limits, especially in

sens ve commo es.



Case study: Risk Management Practices in Tea Markets

Types of variability of in Asset Price• Random noncyclical

• Random cyclical

• Intra year pattern cyclical

• Inter year pattern cyclical

• Monotone trend

Conclusion of various studies• Positive relation between trading volume and volatility and

also a strong negative relation between time to maturity

and trading volume• Increased financial speculation in commodity index futures

was highly destructive for the market, mainly because

speculators would never take delivery of the commodity




• Plantation Commodities - Black pepper and coffeehave futures market in India

– International Pepper and Spice Trade Association (IPSTA) in

Cochin since 1958 – Coffee Futures Exchange of India (COFEI) based in

Bangalore, since 1998




• Is there a need of Futures Contracts in Tea?




• Option 1 – • Challenge – Heterogeneous nature of tea

• Damodaran suggested a framework for developing

commodity based futures contracts in tea

• Useful for tea packers, importers’ agents and bulk tea

merchandisers’ agents

•

Orthodox and CTC grades, be sold through 2 centres (one inNorth India and one in South India), be sold over a time

cycle of 14 months and delivered from certified

warehouses

• Methods to provide Liquidity

• Settlement




• Option 2 – • Index based Futures

Documents

Lecture Series 4