Aipr

1. Understanding Commodity Markets &
Derivatives
COMMODITY EXCHANGES
Class 8
TUSHAR PANDEY
ISAB, Gr Noida
Tushar.pandey@gmail.com

2. History
• The development of modern futures trading began in the US in the 1800s.
• The earliest recorded forward contract was on March 13, 1851. As the grain trade expanded, a group of
82 merchants gathered over a flour store in Chicago to form the Chicago Board of Trade (CBOT).
• By the mid 19th century, futures markets had developed into effective mechanisms for managing
counterparty and price risks.
• The clearinghouse of the Exchange guaranteed the performance of contracts and started collecting
margins to ensure contract performance.
• New Exchanges were formed in the late 19th and early 20th centuries as trading started in non-
agricultural commodities like precious metals and processed products, among others.
• Commodities’ trading in some developing economies also has a long history.
• The Buenos Aires Grain Exchange in Argentina (founded in 1854) is one of the oldest in the world.
• In India, futures’ trading was introduced in 1875.
• Africa’s most active and important commodity Exchange is the South African Futures Exchange (SAFEX).
• China’s first commodity Exchange was established in 1990, followed soon after by the setting up of as
many as 40 Exchanges. Subsequent consolidation has resulted in three commodity Exchanges - Dalian
Commodity Exchange (DCE), Zheng Zhou Commodity Exchange and the Shanghai Futures Exchange.
The Bursa Malaysia Derivatives Exchange (MDEX) was established in 1980.

3. History
• Taiwan Futures Exchange (TAIFEX) was established in 1998.
• The Jakarta Futures Exchange (JFX) was launched in 1999.
• The merger of two well–established Exchanges in Singapore - the Stock Exchange of Singapore (SES) and Singapore
International Monetary Exchange (SIMEX) led to the formation of the Singapore Exchange (SGX) in 1999.
• Thailand’s Agricultural Futures Exchange of Thailand (AFET) was launched in 2004.
• In India, organised trading in commodity derivatives started in 1875 with the setting up of the Bombay Cotton Trade
Association Ltd.
• This led to the establishment of the Bombay Cotton Exchange Ltd. in 1893.
• Following Cotton, trading was introduced in other agricultural commodities.
• In 1900, the Gujarati Vyapari Mandali was established.
• Futures trading in Raw Jute and other Jute goods began at Kolkata with the setting up of the Calcutta Hessian
Exchange Ltd. in 1919.
• Futures trading in bullion began in Mumbai in 1920 and later in Rajkot, Jaipur, Jamnagar, Kanpur, Delhi, and Kolkata.
• In December 1952, the Forward Contracts (Regulation) Act (FCRA) was enacted that was regulating forward contracts
in commodities in the country until it was repealed on September 29, 2015.
• In due course, several Exchanges and registered associations were set up to trade in a range of commodities.
• During the 1970s however, most of these became inactive as trading in futures and forwards of commodities for which
they were registered was either suspended or totally prohibited.

4. The History & Structure of Indian Commodity Exchanges
• There are SIX national commodity futures Exchanges and around 20 regional commodity
exchanges in India.
• Indian commodity market faced a tough time during 2012 -2015 when introduction of Commodity
Transaction Tax (CTT)
• resulted in a squeeze of the trading volume on the stock market.
• While, the SEBI, initiated a series of initiatives to widen the market and increase the depth, the
response from the market participants remained slow. Universal Commodity Exchange Limited
(UCX), the latest entrant, was the sixth national level commodity exchange that started its operation
in 2012. It has surrendered its license in 2014. It was allowed by SEBI to exit in 2017-18.
• National Multi Commodity Exchange of India Ltd. (NMCE), Ahmedabad was merged with Indian
Commodity Exchange Limited (ICEX), New Delhi.
• Ace Derivatives and Commodity Exchange Limited (ACE), Mumbai, has exited from Exchange
business.

5. The History & Structure of Indian Commodity Exchanges
• National Multi Commodity Exchange of India Ltd. (NMCE), one of the oldest commodity exchanges
in India, merged with Indian Commodity Exchange Limited (ICEX) in 2018.
• Apart from national commodity exchanges, there were regional commodity exchanges
• Hapur Commodity Exchange Limited
• Spices and Oilseeds Exchange Limited (SOE)
• Rajkot Commodity Exchange Limited
• India Pepper and Spice Trade Association (IPSTA)
• SEBI, in order to make commodity market more efficient, has prescribed the minimum criteria of
turnover and also specified various terms and conditions that exchanges have to comply failing,
which exchanges need to surrender their recognition.
• Being commodity specific exchanges and unable to comply with these compliance requirements
specified by SEBI, such as 100 crore capital for commodity- specific regional exchanges forced
them to pull down the shutters for futures trading.
• Accordingly, Spice and Oilseeds Exchange Limited, Rajkot Commodity Exchange Limited, and India
Pepper Spice Trade Association were allowed by SEBI to exit during 2017-18.
• In a recent reform, the market regulator SEBI allowed convergence of stock and commodity bourse
from October 2018.
• major equity exchanges like BSE, NSE to introduce commodity- backed financial instruments on their platforms
• commodity exchanges such as MCX and NCDEX are allowed to list equities and equity derivatives.
• On October 1, 2018, BSE became the first stock exchange in the country to launch the commodity derivative
contracts in gold and silver while planning to launch crude oil, copper and agri commodities subsequently.

6. History
Presently following Exchanges are offering commodity derivatives at the national level:
1. National Commodity and Derivatives Exchange Ltd. (NCDEX), Mumbai
2. Multi Commodity Exchange of India Ltd. (MCX), Mumbai
3. Indian Commodity Exchange Limited (ICEX), New Delhi
4. Bombay stock Exchange (BSE), Mumbai
5. National Stock Exchange (NSE), Mumbai

7. Regulatory Framework
• In India, the spot market and the forward markets are not governed by the same regulatory system.
• The spot markets are generally controlled by the State governments through the APMC Acts.
• The responsibility for regulation of forward and futures contracts rests with the Central government
• The subject “Stock Exchanges and Futures Markets” is in the Union List.
• A comparison of the regulation of spot and forward markets is presented in Figure

8. Commodity Exchanges
• The need to manage a variety of risks in agriculture led to the evolution
and establishment of commodity Exchanges
• Derivative Exchanges lower transaction costs and offer a platform to
market participants with different risk preferences to exchange risks.
• The major functions of an Exchange are
• price discovery
• price dissemination
• risk management
• market surveillance
• clearing and settlement (though handled by clearing houses).

9. Commodity Exchanges
• Price discovery is the process of arriving at the price at which the buyer buys and a seller sells a
futures contract on a specific expiration date.
• In active futures markets, free flow of information is vital.
• In commodity Exchanges, price dissemination occurs through ticker bands, print, audio and visual
media (various TV channels).
• The key objective of an Exchange is to organise trading in such a way that risk of default (counter
party credit risk) is almost eliminated.
• Exchanges adopt various measures such as capital adequacy for its members, margin
requirements, marking to market, setting price bands etc.
• Exchanges use market surveillance to instil market confidence and increase liquidity and turnover.
• Clearing and settlement is another important function for which clearinghouses are used.
• A clearinghouse is a system by which Exchanges guarantee faithful compliance of all trade
commitments undertaken on the trading floor or electronically over electronic trading systems.

10. Commodity Exchanges
• Settlement in the commodities derivatives market can be done (depending upon the type of
contract)
• closing out
• physical delivery
• cash settlement.
• These settlements are carried out through the Exchange’s clearinghouse or clearing corporation.
• The roles of an Exchange are manifold and include:
• standardisation
• guarantor of all trades
• provider of an anonymous auction platform for creditable price discovery
• neutrality
• risk transfer platform
• provider of long-term price signals
• market linkages
• infrastructure

11. Commodity Exchanges
• The contracts designed by specific Exchanges are standardised and cannot be modified by
participants.
• The clearinghouse becomes the legal counterparty to every contract made, regardless of its origin.
• Exchanges provide an anonymous auction platform, where bids and offers coming from
geographically dispersed locations converge.
• Exchanges maintain absolute neutrality toward market movements and price changes.
• Their rules apply to both sides of a transaction.
• One of the primary roles an Exchange performs is to act as a platform that transfers risk.
• Exchanges act as providers of long-term price signals.

12. Spot Polling Process at NCDEX
• The Exchange through polling agencies, who randomly call up about 25 or
so market participants from a panel of 40 market participants and asks
them for the spot prices thrice a day.
• After collecting the raw prices, the Exchange carries out a process called
bootstrapping
• a scientific procedure for removing the outliers of raw prices (i.e. prices
that are too far away)
• averaging the remaining prices.
• To avoid any manipulation list of polling participants is constantly revised
and updated and price quotes from those participants who have significant
open positions are not considered

13. Spot Polling Process at NCDEX

14. Risk Management at Exchanges
Price Risk Management
• Buyers and sellers of commodities use the futures market for risk management.
• They use futures to protect themselves against adverse price changes.
• Commodity Exchanges provide a market for all participants to manage price risks by locking prices
of fixed delivery dates, in advance.
• Last class we learnt how traders, hedgers, and speculators use various derivative products to cover
potential losses and make gains, if possible, through the market mechanism.

15. Risk Management at Exchanges
Credit Risk Management
• The objective of any exchange is to organise trading in such a way that risk of default (counterparty credit
risk) is almost eliminated.
• Capital adequacy (minimum net worth, security deposits) requirement
• Stringent requirements ensure financial soundness of Members of the Exchange eg the members of NCDEX
broadly fall into following categories:
1. Trading cum Clearing Member (TCM):
• Members can carry out the transactions (Trading, clearing and settlement) on their own account and also on their clients’ accounts.
Applicants accepted for admission as TCM are required to pay the requisite fees/ deposits and also maintain net worth as explained in
the later section.
2. Professional Clearing Members (PCM):
Members can carry out the settlement and clearing for their clients who have traded through TCMs or traded as TMs. Applicants accepted
for admission as PCMs are required to pay the requisite fee/ deposits and also maintain net worth.
3. Trading Member (TM):
• Member who can only trade through their account or on account of their clients and will however clear their trade through
PCMs/STCMs.
4. Strategic Trading cum Clearing Member (STCM):
• This is up gradation from the TCM to STCM. Such member can trade on their own account, also on account of their clients. They can
clear and settle these trades and also clear and settle trades of other trading members who are only allowed to trade and are not allowed
to settle and clear.

16. Risk Management at Exchanges
Credit Risk Management

17. Market monitoring and surveillance system
• A good market monitoring and surveillance system has the following features:
• An adequate framework for regulation and compliance
• Proper controls over trading practices
• A well enforced regulation for brokers and other members of the Exchange
• A well-functioning clearing and delivery system
• Capacity for timely detection and prevention of attempts at market manipulation.
• At NCDEX, most of the surveillance is done online
• margining and monitoring of members’ positions.
• A team of professionals is engaged in monitoring on a regular basis.
• Members of Surveillance teams also regularly visit mandis to get themselves updated with ground realities
• This is significant as physical market prices in case of Agri commodities play important roles in price discovery process.
• The mandi visits are apart from regular phone contacts with active traders on day-to-day basis.