Commodities Exchange and Its Operational Procedure | Forex Management

In a commodity market, the prices undergo considerable degree of fluctuations. The reasons for price fluctuations may be crop failure, bad weather and demand-supply imbalances. These fluctuations in turn lead to price risk. This price risk is largely borne by the farmers and industries where agricultural commodities are used as raw materials.

If the participants hedge against this price risk, they will be able to insulate against the inherent fluctuations associated with agricultural commodities, keeping this in mind, one of the simplest methods to hedge is to use the commodity exchanges as a trading platform.

A commodity exchange is like a stock exchange. It does not buy or sell anything, it only provide a platform to members to buy and sell. It deals with contracts on agricultural commodities besides metals and minerals. Manufacturers, producers, mining companies, traders, brokers and mining companies/processors use the commodity exchange.

On the other hand, a stock exchange is a trading platform for financial products. Manufacturers are those in the metal business and agro processing. Producers are represented by farmers. Mining companies/processors deal with essential minerals such as coal, aluminum.

A trader is a person who buys and sells a commodity and a broker is a member of the market place who represents the trader and in exchange receives a commission for the service.

The commodities provide an efficient and low-cost marketing platform for commodities. Besides, members can get worldwide price information and a means to limit the risk of losing money due to price fluctuation.

The price is determined by demand and supply, and it is not the decision of the commodity exchange. In a commodity exchange actual physical products that are non-financial in nature- agro products such as wheat, castor, groundnut or sesame, industrial products such as aluminum, zinc, nickel and also precious metals like gold and silver are traded.

Commodities derivatives are traded on National Commodity and Derivative Exchange (NCDEX), and the Multi- Commodity Exchange (MCX). Trading in commodity futures is quite similar to equity futures trading. Like in equity markets, long position and short position can be taken by the hedgers and speculators. The SEBI equivalent in the case of the commodity trading markets is the ‘Forward Markets Commission’.

In 1952, Forward Contracts Regulation Act was passed and the Forward Market Commission was established in 1953 under the Ministry of Consumer Affairs and Public Administration. Till the late 1990s, futures trading in all the major commodities was prohibited /suspended.

Liberalization of economy took place in 1991, following which futures trading was permitted in several commodities. The National Agricultural Policy was announced in July 2000. It emphasized the need for allowing futures trading in agricultural commodities for risk management and price discovery. Futures trading were permitted in all the commodities from April 2003.

Accordingly, four national level commodity exchanges were established viz:

1. National Commodity and Derivative Exchange Ltd. (NCDEX), Mumbai

2. National Multi Commodity Exchange of India Ltd. (NMCE), Ahmedabad

3. Multi Commodity Exchange of India Ltd. (MCX), Mumbai

4. Indian Commodity Exchange Ltd., Gurgaon.

Apart from the above four national exchanges, there are number of regional commodity exchanges were established in India namely:

1. Haryana Commodity Exchange, Hissar

2. Bikaner Commodity Exchange, Bikaner

3. Bullion Association, Jaipur

4. Surendranagar Cotton Oil & Oilseeds Association, Surendranagar

5. Rajkot Seeds, Oilseeds and Bullion Merchants Association, Rajkot

6. Ahmedabad Commodity Exchange, Ahmedabad

7. Bombay Commodity Exchange, Mumbai

8. East India Cotton Association Ltd. Mumbai

9. E-Sugar India Ltd., Mumbai

10. Bhatinda Oil Exchange Ltd., Bhatinda

11. Vijay Beopar Chamber, Muzaffarnagar

12. Meerut Agro Commodities Exchange, Meerut

13. Chamber of Commerce, Hapur

14. Rajdhani Oil and Oilseeds Exchange, Delhi

15. E-Commodities, Delhi

16. The East India Jute and Hessian Exchange, Kolkata

17. Central India Commercial Exchange, Gwalior

18. The Spices and Oilseeds Exchange, Sangli

19. India Pepper and Spice Trade Association, Kochi

20. First Commodity Exchange of India Ltd. Kochi.

In all these national and regional commodity stock exchanges there are about 100 commodities available for trading.

Some of them are named as below:

1. Edible oilseed complexes – Groundnut, Mustard seed, Cotton seed, Sunflower, Rice bran, Soya oil etc.

2. Food grains – Cereals, Pulses, Maize etc.

3. Metals – Gold, Silver, Copper, Zinc, Aluminium etc.

4. Spices – Turmeric, Pepper, Cardamom etc.

5. Fibres – Cotton, Jute etc.

6. Energy – Crude oil, Natural gas etc.

7. Others – Cotton seed, Sugar, Jaggery, Rubber etc.

Fluctuations in the commodity prices are a major risk borne by farmers and those engaged in the food processing industry in India. These prices witness fluctuations and volatilities on a large scale.

Volatility in agricultural commodities can be attributed to the following factors:

1. Seasonality of the crops

2. Availability of stocks

3. Weather-related impacts on the crops

4. Supply and demand situation

Need for Regulation of Commodity Derivatives Market:

The regulation of commodity derivatives market is required for the following reasons:

1. To ensure that markets efficiently perform the twin economic fluctuations of price discovery and price risk management.

2. To maintain market integrity and financial integrity across the market, the exchanges and the intermediaries.

3. To maintain financial integrity by ensuring capital adequacy of exchanges and intermediaries and payment of adequate margins by intermediaries.

4. To maintain market integrity by the effective surveillance and monitoring as well as audit of exchanges and intermediaries.

5. To properly integrate spot and future prices.

6. To provide protection against unscrupulous intermediaries.

7. To ensure fairness and transparency in trading, clearing and settlement process.

Reasons for Popularity of Commodity Trading:

Commodity trading is attractive for the following reasons:

1. A good low-risk portfolio diversifier

2. A highly liquid asset class, acting as counter-weight to stocks, bonds and real estates

3. Less volatile, compared with equities and bonds

4. Investors can leverage their investments and multiply potential earnings

5. Better risk adjusted returns

6. A good hedge against any downturn in equities or bonds

7. Little co-relation with equity and bond markets

8. High co-relation with changes in inflation

9. No securities transaction tax levied.

Participants of Commodity Market:

1. Hedgers:

They buy or sell in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. They are producer, farmer, consumers and food processing companies etc.

2. Speculators:

They aim to profit from the very price change that hedgers are protecting themselves against. They are brokerage houses, retail investors and people involved in commodity spot trading.

3. Arbitraguers:

They help to equalize prices and restore market efficiency. They are brokerage houses, warehousing companies and people in commodity spot trading.

Operational Procedure of Commodity Exchanges:

Operational procedures might vary across the exchanges.

The entire operations constitutes of three stages:

(1) Trading,

(2) Clearing,

(3) Settlement.

(1) Trading:

Nowadays, online commodity exchanges usually trade within 10.00 am to 5.00 pm. However, the trade timings differ amongst exchanges. On the first day of the contract the exchange decides the base price of the commodity, which is the sum of notional price based on the spot market price of that commodity on the previous day and a notional carrying cost.

The trading systems provide automated screen based trading for futures on commodities on a nationwide basis with online monitoring and surveillance. The market is order driven, where the orders match automatically on the base of price, time and quantity.

If an entered order finds a match then trace is generated, if not, the active order becomes passive and queues up in the respective outstanding order book. The units of trading, delivery unit, lot size, tick size, expiry date are all specified by the exchange.

At the end of the day, the trading system calculates the closing price as the weighted average price of all the trades executed in the last thirty minutes (usually). During the trading session of the day, the prices are allowed to vary only within a certain specified range, called the daily circuit filter.

It varies from commodity to commodity, orders in violation of the circuit filter are rejected by the system. At the end of the life of the contract, i.e. the expiry date, the contract is settled at the due date rate, usually calculated as the weighted average of the last 1 or 3 or 5 days prices in the spot market (of the market place/where the contracts based) or as prescribed by the exchange in contract specification.

The entities trading system are:

a. TCM:

Trading cum clearing member who can trade on their own account as well as on account of their clients through a unique ID assigned by the exchange.

b. PCM:

Professional clearing members are entitled to clear trades executed by the other members of the exchange.

The membership charges vary between exchanges. They have to pay an initial security deposit, as well as additional security deposits to increase their exposure limits.

(2) Clearing:

Futures contracts are settled either by physical settlement or cash settlement. A clearing house or clearing corporation remains in charge of the clearing and settlement functions. The system of clearing house helps in ensuring fulfillment of all commitments made on the trading exchanges.

A settlement guarantee fund, guaranteeing the settlement of the net settlement liability of clearing members, is maintained with the exchange. However, this liability is limited to the extent of net pay in and pays out, as well as the final settlement amount. Physical settlement (by delivery) or financial settlement (by price difference) of contract is monitored by the clearing house.

(3) Settlement:

Futures contracts are settled by mean of mark to market settlement and final settlement. Under mark to market settlement, the system keeps track of national and booked losses, or gains, incurred by every member up to the last executed trade.

On the day of entering the contract, the profit or loss is determined as the difference of entry value and daily settlement price for that day. On the other day it is the difference between daily settlement price for that day and the previous day’s settlement price. This helps to curb any default in the process of day trading.

On the day of expiry of contract, trades are settled against the final settlement price. Final settlement price is the spot price on the expiry day, but is done by the method of boot strapping. On the date of expiry of future contract, the final settlement price is the spot price on the expiry day.

The spot prices are collected from members across the country through pooling. The bid/ask prices are bootstrapped and the mid of the two bootstrapped prices is taken as the final settlement price.

The responsibility of [final settlement’ in a clearing house is on a trading-cum-clearing member for all trades done on his own account and his client’s trades. A professional clearing member is responsible for settling all the participants’ trade which he has confirmed to the exchange.

Pay-Out Mechanism at Commodity Exchanges:

Commodity:

1. Credit given to the buyer member from Clearing Member Pool A/c

2. Instruction by member to transfer from CM Pool to buyer client’s Demat Account

3. Subsequent Remat of commodities and physical movement handled by buyer

Funds:

Funds pay-out is done into the designated bank account of the member with the clearing house.

The prime difference between a commodity and financial derivative occurs in the settlement process. Financial derivatives are mostly cash settled. However, the commodity derivatives are often settled physically. Due to the weighty nature of the underlying asset, necessity of warehousing comes up.

The problem is the limited storage facilities available, and restrictions on interstate movements of commodities. Besides, the duties and taxes also impact on the cost of goods. The process of deliver)’ might vary among exchanges slightly. However, a generalist process has been discussed here.

The members having outstanding position on the expiry date of the contract have to give intention of tendering or lifting delivery in writing along with the quantity, quality, preferred delivery centre. If a member (buyer or seller) makes the intention but subsequently fails to complete commitment, then his position will be closed out at the due date rate and they also have to pay an additional penalty, major portion of which goes to the other party for compensating their losses.

Prescribed delivery orders have to be filled in by the sellers, clearly stating the quantity, quality, delivery centre. The location mentioned for delivery should not be one where there is a restriction against movement of goods. The quality of goods delivered should be in accordance with the grade permitted by the exchange. The goods should accompany an accredited surveyor or assayer’s certification of quality.

However, some tolerance limits are specified regarding the quality and quantity of goods. When goods come to the authorized warehouse for delivery they are tested and graded, according to some pre-specified parameters. Depending on the outcome or level of variation from the stated quality, quantity, some discount or premium is adjusted with the final price.

This makes the process more rational, since some variations during physical delivery might be out of control. And the price adjustment process protects the buyer from any sudden loss which could incur due to deteriorated quality at time of delivery. The parties involved in the physical delivery process are, therefore, the accredited warehouse, approved registrar and transferred agents, approved surveyor.

Only the approved assayer/surveyor has the capacity to grade the commodities brought to the warehouse, and specify the expiry date of the commodity. Delivery of a commodity post its validity/expiry date would be considered bad delivery. Grade certificates are also provided by the assayer. They also have the right to inspect the warehouses specified by the exchange.

The accredited warehouses should meet the specific standards as set by the exchange. They can accept good only after proper gradation has been done and can store the same till the validity period, after which it has to be kept separately, till the concerned member removes such goods. The process of dematerialization and dematerialization of commodities are done through the registrar and transfer agents in coordination with the warehouse, exchange and depository.

All concerned parties should have their sales tax registration number, or an agent/nominee with such number, through whom goods can be delivered. If due to default in tax payment of one party, loss is suffered by the other, exchange can impose a charge on the defaulting party, and compensate the suffering party with the amount so collected.