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What is “Commodity”?
“The term refers to a whole range of natural resources that are used to create the
goods that people buy and the food they eat.” Says Jeremy Baker, USB's Zurich-
based head of Commodity Research'.
Retail investors, who claim to understand the equity markets, may find commodities an
unfathomable market. But commodities are easy to understand as far as fundamentals
of demand and supply are concerned. Retail investors should understand the, risks and
advantages of trading in commodities futures before taking a leap. Historically, pricing in
commodities futures has been less volatile compared with equity and bonds, thus
providing an efficient portfolio diversification option.
What is a commodity Market?
In fact, the size of the commodities markets in India is also quite significant. Of
the country's GDP of Rs 13, 20,730 crores (Rs 13,207.3 billion), commodities related
(and dependent) industries constitute about 58 per cent. Currently, the various
commodities across the country clock an annual turnover of Rs 1, 40,000 crores (Rs
1,400 billion). With the introduction of futures trading, the size of the commodities
market grows many folds here on.
Commodities future trading was evolved from need of assured continuous supply
of seasonal agricultural crops. The concept of organized trading in commodities evolved
in Chicago, in 1848. But one can trace its roots in Japan. In Japan merchants used to
store Rice in warehouses for future use. To raise cash warehouse holders sold receipts
against the stored rice. These were known as “rice tickets”.
This kind of as why Chicago Board of Trade (CBOT) was established in 1848. In
1870 and 1880s the New York Coffee, Cotton and Produce Exchanges were born.
Agricultural commodities were mostly traded but as long as there are buyers and
sellers, any commodity can be traded. In 1872, a group of Manhattan dairy merchants
got together to bring chaotic condition in New York market to a system in terms of
storage, pricing, and transfer of agricultural products. In 1933, during the Great
Depression, the Commodity Exchange, Inc. was established in New York through the
merger of four small exchanges – the National Metal Exchange, the Rubber Exchange
of New York, the National Raw Silk Exchange, and the New York Hide Exchange.
Commodities futures trading have evolved from the need for ensuring continuous
supply of seasonal agricultural crops. In Japan, merchants stored rice in warehouse for
future use. In order to raise case warehouse holders sold receipts against the stored
rice. These were known as rice tickets.
Nature of Commodities –
For example, zero or negative price may occur in electricity markets where
generators seek to ensure that their plants are dispatched for contiguous blocks
of time longer than a simple slot for which separate time bids are accepted. This
is driven by the desire of the generator to shed excess output as electricity
cannot be stored.
The structure of commodity markets dictates that there are several types
of participants active in the trading of commodities and commodity derivatives.
The structure of the participants and the nature of their activities/motivations are
more complex than in other asset classes.
Commodity Exchange
Definition
• Bullion:-
Gold KG, Silver, Brent
• Minerals:-
Electrolytic Copper Cathode, Aluminum Ingot, Nickel
Cotton seed, Oil cake, Crude Palm Oil, Groundnut (in shell),
seed oil cake, Refined soya oil, Rape seeds, Mustard seeds,
• Pulses:-
Urad, Yellow peas, Chana, Tur, Masoor,
• Grain:-
Wheat, Indian Pusa Basmati Rice, Indian parboiled Rice (IR-
red maize
• Spices:-
Jeera, Turmeric, Pepper
• Plantation:-
• Energy:-
Crude Oil, Furnace oil
MCX started of trade in Nov 2003 and has built strategic alliance with Bombay
Bullion Association, Bombay Metal Exchange, Solvent Extractors Association of India,
pulses Importers Association and Shetkari Sanghatana. MCX deals wit about 100
commodities.
• Bullion:-
• Minerals:-
• Pulses:-
Chana, Masur, Tur, Urad, Yellow peas
• Grains:-
Rice/ Basmati Rice, Wheat, Maize, Bajara, Barley,
• Spices:-
Pepper, Red Chili, Jeera, Cardamom, Cinnamon, Clove,
Ginger,
• Plantation:-
Coffee,
Sacking,
• Petrochemicals:-
• Energy:-
Brent Crude Oil, Crude Oil, Furnace Oil, Middle East Sour
The act provides that the commission shall consist of not less than two but
not exceeding four members appointed by the Central Govt. out of them being
nominated by the Central Govt. be the chairman thereof.
2. To keep forward markets under observation and to take such action in relation to
them, as it may consider necessary, in exercise of the powers assigned to it by or
under the Act.
5. During shortages, extreme steps like skipping trading in certain deliveries of the
contracts, closing the markets for a specified period and even closing out the
contracts to overcome the emergency situations are taken
International Commodity Exchanges
Recent years have witnessed a steep rise in the creation of the commodity
exchanges along with a consistent expansion of the existing ones. The United States,
Japan, United Kingdom, Brazil, Australia, Singapore are homes to leading commodity
futures exchanges in the world.
The New York Mercantile Exchange is the world's biggest exchange for trading in
physical commodity futures. It is the primary trading forum for energy products and
precious metals. The Exchange has been in existence for 132 years and performs
trades through two divisions, the NYMEX divisions, which deals in energy and platinum
and the COMEX division which trades in all the other metals.
A major contribution of the Exchange has been to develop and launch energy futures
and options contract in 1978 to facilitate price transparency and risk management in this
key market. Exchange has become a significant part of the commercial, civic and
cultural life of New York. Exchange also clears trades for market participants who which
to avoid counter-party credit risk by using standardized contracts for Natural Gas, Crude
Oil, Refined products and Electricity.
Commodities traded – Light Sweet Crude Oil, Natural gas, Heating Oil, Gasoline,
RBOB Gasoline, Electricity, Propane, Gold, Silver, Copper, Aluminum, Platinum,
Palladium, etc.
The Exchange was formed in 1877 as a direct consequence of the industrial revolution
witnessed in Britain in the 19th Century. The primary focus of LME is providing a market
for participants from the non-ferrous base metals related industry to safe guard against
risk due to movements in base metal prices and also arrive at a price that sets the
benchmark globally. The exchange trades. 24 hours a day through an inter-office
telephone market and also through an electronic trading platform. It is famous for its
open-outcry trading between ring dealing members that takes place on the market floor.
Commodities Traded – Aluminum, Copper, Nickel, Lead, Tin, Zinc, Aluminum Alloy,
North American Special Aluminum Alloy (NASAAC), Polypropylene, Linear Low Density
Polyethylene, etc.
The LME metal futures contracts run a daily basis for a period of three months, unlike
other commodity markets that are primarily based on a monthly prompt dates. The
Exchange thus combines the convenience of settlement dates tailored to individual
needs with the security of a clearinghouse for its clearing members, The LME also
offers options contracts based on each of these futures contracts together with Traded
Average Price Options contracts (TAPOs) based on the monthly average settlement
price (MASP) for all metals futures contracts.
The first commodity exchange established on the world was the Chicago
Board of Trade (CBOT). During the year 1848 by a group of Chicago merchants who
were keen to establish a central market place for trade. This was situated in the
premises of a flour store during its first four years, Prior to this farmers often found no
buyers for the grain they had transported to Chicago. Given the high transport cost, they
have been left with little choice but to dump the unsold produce in the near by lake.
Commodities traded Corn, Soybeans, Soybean Oil, Soybean Meal, Wheat, Oats,
Ethanol, Rough Rice, Gold, and Silver etc.
] Like any other commodity exchange the primary role of CBOT is to provide
transparency and liquidity in its contracts to its members, clients and market participants
like farmers, corporate, small business men, financial service providers, international
trading firms and speculators for price delivery, risk management and investment.
In January 2003, in a major overhaul over its computerized trading system, TOCOM
fortified its clearing system in June by being the first commodity Exchange in Japan to
introduce an in-house clearing system. TOCOM launched options on gold futures, the
first options contract in Japanese market, in May 2004.
There are two kinds of trades in commodities. The first is the spot trade,
in which one pays cash and carries away the goods. The second is futures trade. The
underpinning for futures is the warehouse receipt. A person deposits certain amount of
say, good X in a ware house and gets a warehouse receipt which allows him to ask for
physical delivery of the good from the warehouse but some one trading in commodity
futures need not necessarily posses such a receipt to strike a deal.
person can buy or sale a commodity future on an exchange based on his expectation of
where the price will go. Futures have something called an expiry date, by when the
buyer or seller either closes (square off) his account or give/take delivery of the
commodity. The broker maintains an account of all dealing parties in which the daily
profit or loss due to changes in the futures price is recorded. Squiring off is done by
taking an opposite contract so that the net outstanding is nil.
For commodity futures to work, the seller should be able to deposit the
commodity at warehouse nearest to him and collect the warehouse receipt. The buyer
should be able to take physical delivery at a location of his choice on presenting the
warehouse receipt. But at present in India very few warehouses provide delivery for
specific commodities.
Following diagram gives a fair idea about working of the Commodity market.
- Order receiving
- Execution
- Matching
- Reporting
- Supervision
- Price limits
- Position limits
- Matching
- Registration
- Clearing
- Clearing limits
- Notation
- Margining
- Price limits
- Position limits
- Clearing house.
- Marking to market
- Reporting
Every market transaction consists of three components i.e. trading, clearing and
settlement.
TRADING
All contracts expire on the 20th of the expiry month. Thus a January
expiration contract would expire on the 20th of January and a February expiry contract
would cease trading on the 20th of February. If the 20th of the expiry month is a trading
holiday, the contracts shall expire on the previous trading day. New contracts will be
introduced on the trading day following the expiry of the near month contract.
The
CLEARING
The cash settlement is only for the incremental gain/loss as determined on the basis of
final settlement price.
SETTLEMENT
On the date of expiry, the final settlement price is the spot price on the
expiry day. The responsibility of settlement 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’ trades, which he has confirmed to the
exchange. On the expiry date of a futures contract, members submit delivery
information through delivery request window on the trader workstations provided by
NCDEX for all open positions for a commodity for all constituents individually. NCDEX
on receipt of such information matches the information and arrives at delivery position
for a member for a commodity. The seller intending to make delivery takes the
commodities to the designated warehouse.
Bikaner commodity Exchange Ltd., Mustard seeds its oil & oilcake,
23. Bikaner Gram. Guar seed. Guar Gum
An investor can transact a business with the approved clearing member of previously
mentioned Commodity Exchanges. The investor can ask for the details from the
Commodity Exchanges about the list of approved members.
When investor approaches Clearing Member, the member will ask for identity proof.
For which Xerox copy of any one of the following can be given
b) Driving License
c) Vote ID
d) Passport
What statements should be given for Bank Proof?
The front page of Bank Pass Book and a canceled cheque of a concerned bank.
Otherwise the Bank Statement containing details can be given.
In order to ascertain the address of investor, the clearing member will insist on
Xerox copy of Ration card or the Pass Book/ Bank Statement where the address of
investor is given.
The above things are only procedure in character and the risk involved and only
after understanding the business, he wants to transact business.
While selecting a commodity broker investor should ideally keep certain aspects
in mind to ensure that they are not being missed in any which way. These factors
include
• The clientele.
• The kind of service provided- back office functioning being most important.
• Credit facility.
These are amongst the most important factors to calculate the credibility of
commodity broker.
Broker:-
Types of Traders:-
Hedgers
Speculators
Speculators are some what like a middle man. They are never interested
in actual owing the commodity. They will just buy from one end and sell it to the other in
anticipation of future price movements. They actually bet on the future movement in the
price of an asset. They are the second major group of futures players. These
participants include independent floor traders and investors. They handle trades for their
personal clients or brokerage firms. Buying a futures contract in anticipation of price
increases is known as ‘going long’. Selling a futures contract in anticipation of a price
decrease is known as ‘going short’. Speculative participation in futures trading has
increased with the availability of alternative methods of participation.
Speculators have certain advantages over other investments they are as follows:
If the trader’s judgment is good, he can make more money in the futures
market faster because prices tend, on average, to change more quickly than real estate
or stock prices. Futures are highly leveraged investments. The trader puts up a small
fraction of the value of the underlying contract as margin, yet he can ride on the full
value of the contract as it moves up and down.
Arbitrators
To become a commodity trader one needs to complete certain legal and binding
obligations. There is routine process followed, which is stated by a unit of Government
that lays down the laws and acts with regards to commodity trading. A broker of
Commodities is also required to meet certain obligations to gain such a membership in
exchange. To become a member of Commodity Exchange the broker of brokerage firm
should have net worth amounting to Rs. 50 Lakhs. This sum has been determined by
Multi Commodity Exchange.
How to become a Member of Commodity Exchange?
There are two types of TCM, TCM-1 and TCM-2. TCM-1 refers to
transferable non-deposit based membership and TCM-2 refers to non-transferable
deposit based membership.
A PCM entitled to clear and settle trades executed by other members of the
exchange. A corporate entity and an institution only can apply for PCM. The member
would be allowed to clear and settle trades of such members of the Exchange who
choose to clear and settle their trades through such PCM.
Rs. 50 Rs. 50
ITCM
Rs. 10 Lakhs Lakhs Rs 50,000 Lakhs N.A. N.A.
Rs. 50 Rs.
PCM
Nil Lakhs Rs 1,00,000 5Crores N.A. N.A.
Dematerialization and Rematerialization in
commodity markets
Introduction
Need for splitting the warehouse receipt in case the depositor has an obligation
to transfer only a part of the commodities. A single warehouse receipt is
generally issued to the depositor for the goods deposited by him at one time
hence he faces this difficulty in case of part transfer.
Need to physically move the warehouse receipt from one place to another with
the risk of theft, mutilation, loss in transit etc. if the transferor and the transferee
are at two different locations.
Issuer: The issuer is an entity, which floats the physical paper document. It
would be a company in case of the share certificate or warehouse in case of
warehouse receipt.
The Registrar and Transfer Agents: It acts on behalf of the issuer as an
interface between the issuer and the depository for converting the physical
warehouse receipt in the demat form.
The Depository: The Depository maintains the records of the beneficial owner in
its books. Presently there are two depositories in India i.e. National Securities
Depository Limited (NSDL) and Central Depository Services Limited (CDSL)
and warehouse receipt to the warehouse and receives acknowledgement of the same.
The warehouse management then initiates the process of demat credit in co-ordination
with the Exchange, Registrar and Transfer Agent and the Depository. The depositor is
required to check the holding statement (which can be obtained from his depository
participant) after a day or two to see whether the commodity deposited has been
credited to his account under proper Commodities Identifier – ICIN.
Commodity.
Warehouse Location.
Change in any of the above parameters will result in the generation of new ICIN. For
example, suppose there are four designated Vaults for Gold delivery and 2 qualities of
gold are tendered for delivery then a total of 8 ICINs will be generated for Gold. The
ICIN description provides the name of the commodity, grade of goods, the unit of
measurement and the validity date of the ICIN.
If the futures contract on its expiry results into delivery, then the member having delivery
obligation is required to give delivery of the commodity to the exchange on or before the
respective pay-in date. This is done by transferring commodity from the Clearing
Member Pool Account to the Clearing House Account of the Exchange; the member is
required to give the delivery instruction to his Depository Participant before the pay-in
deadline. On Payout, the exchange credits the commodity to the Buying Member Pool
Account.
The depositor approaches the DP and makes request for withdrawal of commodity in
the prescribed form called Remat Request Form (RRF). The acknowledgement copy of
RRF is given to the depositor. The depositor will approach the vault / warehouse along
with the following documents for withdrawal of commodity.
All agricultural commodities have a shelf life and cannot be stored indefinitely. The “final
expiry” of commodity refers to the maximum time period for which the particular
commodity has shelf-life. "Validity / Revalidity Duration" refers to the number of times
and the corresponding duration for which the quality certification is valid. After the
validity date, ICIN is considered to have expired and the same would not be acceptable
as good delivery at the exchange.
Thus in case of revalidation of commodity, the depositor needs to submit the fresh
quality certificate as revalidation form. The relevant quantity will be credited on the new
ICIN.
Participation of FII and Mutual Funds in Commodity
Markets
Mutual Funds and Foreign Institutional Investors are presently not allowed
to trade in commodity markets. The Government is considering the proposal to allow
these entities to trade in commodity future markets.
Unlike the financial derivatives market, one can enter the commodity
derivatives market with a much lower investment, since margins are lower in the range
of 5-10%. The leverage that can be obtained in the commodity futures market is much
higher. In case mutual funds are allowed to participate in commodity markets by
structuring commodity funds for retail investors, this would prove to be an added
advantage for the lay investor, who may not have the knowledge and wherewithal to
trade in such markets. The commodity futures exchange remain largely in the shadows
of the booming equity market exchanges due to low awareness levels.
Yet the other set of challenges in front of the exchanges are creating
awareness and information dissemination. While volumes are important for commodity
exchanges, what is probably more critical is awareness. There is a need for exchanges
to keep relentlessly pursuing an awareness creation strategy. Awareness at the
grassroots will be essential to materialize and sustain the success it is foreseeing.
Disseminating market discovered prices to the farmer level calls for a mammoth
structural framework and massive investments.