Commodity Markets

Lecture series - 4

Regulatory framework of Indian Commodity markets

Ministry of Consumers Affairs, Food & Public Distribition

Forward Markets Commission

Three-tier regulatory framework

National Multicommodity Exchanges

Regional Exchanges

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. By a specific provision, section 19, such agreements are prohibited The Act classifies contracts/agreements into two broad 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 forward contract 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 provides regulatory 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) Edible Oilseeds Food Grains

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

Wheat, Gram, Rice, Dals, Bajra, Maize etc

Metals Spices Fibre Other

Gold, Silver, Copper, Zinc, etc

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 Position Limits

Such limits are applied by the exchange (with prior approval of FMC) on both members and clients Position limits are specified in absolute terms This is used to allow market to cool off during sudden upswing or downswing Like stock exchanges, this is applicable on daily basis Imposed only on one side of trade in case of extreme volatility or requirement of curbing one sided trades Required in order to convince market participants about the credibility of price discovery, especially in case of agricultural products

Circuit filters Special margins Compulsory Delivery

Suspension of Applicable in case of exigencies trading

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 large supply 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 from 11 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 price discovery) 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 on prices of agricultural products. There is a need for a clear and unambiguous regulatory framework. The regulatory authority 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 the government and the regulator to explain to various stakeholders at large any abnormal behavior in the market that might occur as a result of some basic fundamental demand and supply factors

Abhijit Sen Committee report on Future Trading - 2008 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 (Regulation) amendment Bill makes provisions to impose 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

Abhijit Sen Committee report on Future Trading - 2008 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 directed to design their market procedures and contracts such as to enable farmers an easy access to these market and protection against any market malpractices

Abhijit Sen Committee report on Future Trading - 2008 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 the needs of the participants Before listing of new products on futures market, a rigorous examination 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

Abhijit Sen Committee report on Future Trading - 2008 Options in goods can be another hedge instrument suitable 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 the development 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 the commodity 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, Forward Market 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 including farmers to take benefit of `price discovery and `price risk management` The Bill would enhance public accountability of the Regulator by providing for an Appellate Authority

Forward Contracts (Regulation) Amendment Bill Forward Markets Commission (FMC), to be at par with capital 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 recommended in 2003 that there should be a unified regulatory regime for the commodities futures market and the securities market, as is the case in most jurisdictions, whereas this Bill seeks to create a new autonomous body

Forward Contracts (Regulation) Amendment Bill The main objective of this Bill is to permit and regulate a financial instruments which enables buyers and sellers of commodities to effectively manage risk from price fluctuations and open the door for the introduction of new intangible products like options and indices trading in the commodities futures market One of the loop holes in this Bill is that it proposes to levy lower penalty for the same kind of offence in comparison to 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.

Forward Contracts (Regulation) Amendment Bill The Parliamentary standing committee has suggested inclusion of financial institutions and banks, mutual funds and insurance companies to participate in forward markets so as to ensure better price discovery and lower the volatility in the market Some of the major changes which this amendment proposes to make are as follows: the Bill amends the definition of a 'ready delivery contract' to include all contracts 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.

Forward Contracts (Regulation) Amendment Bill The Bill defines 'commodity derivatives' and permits trading 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 Demutualisation means trading rights of members are 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.

Forward Contracts (Regulation) Amendment Bill The number of members of the FMC has also been increased 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 of the Commission, indulging in insider trading or fraudulent and unfair trade practices and in any other case of 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

Forward Contracts (Regulation) Amendment Bill The Bill makes a provision for the transfer of duties and functions 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 notification in some cases to issue directions to the FMC on matters of policy and to supersede it in certain cases

Forward Contracts (Regulation) Amendment Bill Further, the central government is also empowered to suspend a member on appropriate grounds Overall, through this Bill Government is making an effort to regulate the commodities future market and bring more clarity in the existing provisions The main beneficiaries of these reforms will be the companies that either produce commodities or need 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 (i) FII purchases shall be restricted to secondary market only 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 Financial and Administrative Autonomy Market Expansion has put heavy pressure on the FMCs coping 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 the Exchange 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 across exchanges Move towards Compulsory Delivery Restrictions on Proprietary account trading Rationalization of daily price limits, especially in sensitive commodities.

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

Case study: Risk Management Practices in Tea Markets

Plantation Commodities - Black pepper and coffee have 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

Case study: Risk Management Practices in Tea Markets

Is there a need of Futures Contracts in Tea?

Case study: Risk Management Practices in Tea Markets 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 Contracts be restricted to a few volatile high turnover Orthodox and CTC grades, be sold through 2 centres (one in North 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

Case study: Risk Management Practices in Tea Markets Option 2 Index based Futures