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About Commodity Insights The Multi Commodity Exchange of India (MCX) and PricewaterhouseCoopers (PwC) joint effort — Commodity Insights — is a first-of-its-kind yearbook on commodities aimed at giving its readers rare insights into the entire commodity ecosystem. Commodity Insights will have a plethora of useful databases on commodity markets arranged in a novel way so that it is extremely useful to virtually all the ecosystem stakeholders as a one-point source for quick and easy reference. Additionally, this unique publication attempts to deliberate on issues and concerns (with suggested solutions) that ought to be resolved for a healthy development of the domestic commodity market. This will be in the form of articles authored by change agents and thought leaders to provide a rich repertoire of analytical articles. Thus, Commodity Insights promises to be truly useful to not only all the commodities market stakeholders, such as traders, processors, consumers, banks, policymakers, analysts, and industry observers, but also others who matter in this industry, giving them a year-long reference book that is both fascinating and engaging. The yearbook aspires to be a benchmark resource for spreading knowledge about the commodity market.
About PricewaterhouseCoopers PricewaterhouseCoopers (PwC), which measures its success by its clients, provides industry-focused advisory and tax services to build public trust and enhance value for its clients and their stakeholders. PwC professionals work collaboratively using connected thinking to develop fresh perspectives and practical advice. Complementing its depth of industry expertise and breadth of skills is PwC’s sound knowledge of the local business environment in India, with offices in Mumbai, New Delhi, Kolkata, Chennai, Bangalore, Gurgaon, Hyderabad, Ahmedabad, Bhubaneshwar and Pune. PwC is committed to working with its clients to deliver the solutions that help them take on the challenges of the ever-changing business environment.
About Multi Commodity Exchange of India Multi Commodity Exchange of India (MCX) is a demutualised commodity exchange with permanent recognition from the Government of India to facilitate online trading, clearing and settlement operations for commodity futures markets across the country. Since its inception in November 2003, millions of small and medium enterprises, corporate houses, exporters, importers and traders have benefitted from this nationwide electronic trading platform through its efficient and transparent price discovery and price risk management. MCX ranks No. 1 in silver, No. 2 in gold, and No. 3 in crude oil, natural gas, copper and zinc futures trading (by the number of contracts traded in 2008-09), according to FIA and data put up on exchanges’ websites.
2 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS
Gopal Naik Commodity Futures in India – A Product of Globalisation and Liberalisation By Mr. 65 10. 69 11. Prashant Vikram Singh Commodities Derivative Hedging: Portfolio and Effectiveness By Mr. B. Kumar Dasgupta and Dr. 30 4. V. Dipankar Chakrabarti and Ms. 42 6 49 7. 62 9. Lamon Rutten Role of Mutual Funds in Commodity Markets By Mr. Banks on Commodities Futures Platform – A Win-Win Situation By Mr. Chiragra Chakrabarty Role of Brokerage Industry in linking Ecosystem with the Futures Markets By Ms. Priti Gupta Role of Banks in Indian Commodity Derivative Markets By Mr. Nachiket Mor and Dr. 81 DATA FOR READY REFERENCE Non-Agricultural Commodities Agricultural Commodities 87 171 .G. P. 53 8. An Integrated Approach to Agriculture Marketing and Financing By Prof.Content FOREWORD FROM THE EDITORIAL DESK MARKET COMMENTARY EXPERTS’VIEWS 1. Venkateswaran R. Ananthakrishnan Warehouse Receipt Finance for Farmers – A Glimpse By Mr. 34 5. 75 12. Kshama Fernandes Carbon and Clean Energy Markets – the Potential in India By Ms. Rachna Nath India Needs to Usher in the Next Agricultural Revolution By Mr. Amitabh Jaipuria 5 7 9 14 2. Narendra Rathore Commodity Exchange Technology Concepts – Looking Forward By Mr. 22 3. Venkatesh Tagat and Mr. Ramola and Mr. Shailesh Sukhthankar Agriculture Financing under OTC Products By Mr.
communication and technology (ICT) as well as connecting them with it through the creation of forward and backward linkages. In just about six years since then the sector has embarked upon a remarkable journey of rapid growth and national outreach. The hallmark of these exchanges lies in the level of efficiency of market mechanism. and building up of rational expectations in the market. processors. such as producers. The domain knowledge and expertise of the previous generations which was largely lost in the decades of trading ban has been built back to a large extent in this short span of time. because of which the Indian commodity futures market has scaled the heights of global reckoning. Information on commodities that constantly flows into and out of the commodity markets remains the key driver of the price discovery and risk management process for which they were brought into being in the Indian economy. However. hedgers and arbitrageurs. The market was opened up for futures trading in any commodity without any restrictions. It is the promotion of market research and knowledge management through generation and maintenance of market information.Dated 6th October. And this was largely achieved through the sustained awarenesscreation and outreach efforts taken by both the exchanges and the Forward Markets Commission besides coming up with innovative products. It also makes the exchange platforms useful and effective for participation by various stakeholders from within the ecosystem. What lay behind this whole turnaround — from the hitherto status of the Indian commodity markets as a ‘price taker’ to be on the path of being a ‘price setter’ — has been the increased streamlining and convergence of diversified information on the market fundamentals of commodities through transparent interaction of various stakeholders of the ecosystem on the organized platform. integrating the asymmetrically informed or ill-informed. the maturity and the globallycompetitive edge that they have managed to build into them in this short span of time. dynamically aligned from time to time in keeping with the changing market/stakeholders’ needs. This market which was known for its innovations including creation of a revolutionary trading and risk mitigation concept called “options” is rising from the ashes like a Phoenix once again and will certainly occupy a place of pride in the global comity of commodity markets within the next decade or so. has staged a spectacular comeback with the total turnover increasing by a compounded annual rate of over 100 percent during this period. FOREWORD |5 . fragmented domestic physical markets through effective application of information. the commodity futures market came really into its own with the advent of national electronic futures exchanges in 2003. The Indian commodity futures market. which are of paramount importance to put it on the right path towards becoming the ‘price setters’ for the global markets in many commodities. comprising 19 commodityspecific regional exchanges and three national-level multi-commodity electronic exchanges. 2009 FOREWORD Commodity markets in India have had a chequered but long history with the futures markets remaining in virtual hibernation — a large part of them in the unorganized form — for over four decades before they were resurrected in 1999-2000 as part of various reform measures initiated by the government.
traders. 6 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . This. ready source for all kinds of references by various stakeholders including industry players. businesses.In this context. I wish the publication all success. the initiative of the Multi Commodity Exchange of India (MCX) and PricewaterhouseCoopers (PwC) to bring out a yearbook on data and information related to the commodity markets and their fundaments is both timely and a very welcome one. Happy reading. will not only nurture and strengthen the commodity markets to bring greater economic benefits to the stakeholders but also benefit the national development strategy for the economy as a whole. I congratulate them for this initiative. becoming a constant. I am sure. researchers and students. academicians. I am confident that this inspiring effort of theirs will go a long way in encouraging extensive and intensive research into the Indian commodity markets as well as pave the way for transforming the country’s commodity database management towards excellence. market analysts.
Since the Indian commodity markets came into being. various sectors including infrastructure and financial services have their own examples that led us on our way to providing a shape to this product. it was time for MCX to join hands with PricewaterhouseCoopers to bring in yet another global benchmark practice into the Indian commodity markets. FROM THE EDITORIAL DESK |7 . We did our best to include all the related variables and flag the growth process and issues impeding the market growth. Standing (L-R): Mr. Carol Daver. Dr. In the process. Dr. Mr. to analyse them and put them in an appropriate perspective for researchers and policymakers to fall back on them whenever the need arises which would otherwise be missing. through a number of technical and nontechnical articles authored by the invited experts. Dhruv Madeka. Nazir Ahmed Moulvi. As a result. Ms. However. Participants and followers of global commodity exchanges keenly await publication of such material covering all the global fundamentals year-wise in order to empower them to achieve their objective of better decision making. those whoever succeeded in garnering the necessary data were enabled to achieve their objective while others who did not had to leave their objective behind due to this lack of information. Mr. Global commodity exchanges such as CME and CBOT. periodically publish information on markets which is avidly followed by those to whom it matters most. Sarvesh Ramachandran. Ankan Mondal Seated (L-R): Mr. not only media and policymakers but also traders themselves have been scrambling for data that they could use to put prices and the market into an appropriate perspective. in respective domains connected with commodity futures. Mr.From the Editorial Desk It is our pleasure to come together on a joint platform to bring ‘Commodities Insights’ yearbook to enrich the whole ecosystem consisting of varied stakeholders ranging from policymakers to academicians/researchers to media. in our endeavour to flag the market growth and related issues we approached experts. Vidya Shintre Standing (L-R): Mr. along with the potential that it holds for the future. Sujan Bhattacharyya. the commodity markets lacked appropriate scrutiny by the stakeholders to prove the worth for their existence even though they had started making inroads into the lives of both consumers and producers besides effectively linking them with the financial markets. we gave our best to think innovatively to compile and publish various useful and related variables in such way that the collection shall remain a one-stop shop for information that would be needed by all the stakeholders. Having reached several milestones in its journey to become India’s largest exchange. Chiragra Chakrabarty While the raw market data was a key part of the endeavour. V. we are fully aware that improvement of this once-in-a-year effort will be a continuous affair and we assure users that we will take a giant leap to make the yearbook a far more enriched product when it is released from our desk next year. despite their impressive growth performance. Mr. driven by its strategic partnerships with various other ecosystem players. among others. Niteen Jain Seated (L-R): Ms. Kumar Dasgupta. fulfilling the role of empowering the market participants and perfecting the process of price discovery on its platform. Domestically. Besides the datasets related to commodities and their ecosystem. Shunmugam.
Niteen Jain. We would also like to thank Ankan Mondal. who efficiently marketed this initiative of ours and got the much needed financial as well as knowledge support towards its accomplishment. Nazir Ahmed Moulvi. Mr. Shunmugam Chief Economist Multi Commodity Exchange of India Dr. Chiragra Chakrabarty Associate Director PricewaterhouseCoopers 8 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . Kumar Dasgupta. this message from the desk will not be complete without thanking Ms. Mr. Lamon Rutten. V. for their continuous encouragement and support towards this initiative of ours without which it would have been only half done. without which this book would have remained just a concept. Sarvesh Ramachandran and Dhruv Madeka from PwC and Sujan Bhattacharya. Partner – Price Waterhouse. And finally.We would like to thank Mr. day in and day out. Dr. Ritambhara Singh and Dhiraj Pandya from MCX for the enormous efforts they put in. Vidya Shintre. Jignesh Shah. Joseph Massey. Dr. MD and CEO – MCX-SX. Vice Chairman – MCX. Carol Daver and Ms. and Mr. MD and CEO – MCX.
Market Commentary Indian Commodity Futures Markets – Still Evolving… Futures trading plays a key role in the marketing of a number of important agricultural and nonagricultural commodities as it provides the industrial and farming communities with a transparent price discovery platform. This was followed. The yesteryears… Forward/futures markets have come a long way since the days of the “rice tickets” in Japan and the first organised futures market in the form of the Chicago Board of Trade (CBOT) in the US. thus developing the overall infrastructure of agricultural commodities marketing in the country. which also enables them to hedge their price risk and price volatility. vegetable oils. Besides the primary benefits of its twin economic functions of price discovery and price risk management. soon there were widespread fears that derivatives trading fuelled unnecessary speculation in essential commodities and was therefore detrimental to healthy functioning of the markets for the underlying commodities and. by a ban on forward trading in oilseeds and some other commodities such as food-grains. the Indian commodity futures market slipped into virtual extinction. The growth of Indian commodities futures trading towards an efficient. In India. organised commodity derivatives trading began with the Cotton Trade Association’s debut in futures in 1875. and the trade shot into prominence in the mid-nineteenth century when trading in agricultural commodity futures in the US became organised. However. transparent and well-organised market has thrown open a window of benefits and opportunities to Indian producers and traders. to farmers. the Government of Bombay barred options trading in cotton in 1939. Cotton merchants of Bombay took cues from the US and the UK. To curb speculative activity in the cotton market. After the first recorded instance of futures trading in “rice” in 17th century Japan. In India. Forward contracts were the earliest form of commodity derivatives. only to continue negligibly in the form of over-the-counter (OTC) contracts. Futures trading in oilseeds was organised with the setting up of Gujarati Vyapari Mandali in 1900 in Bombay. sugar and cloth. spices. Metals followed suit with contracts traded on the London Metal Exchange (LME) in 1878. It disintegrated and went into a hibernation. in 1943. which was soon (1919) replaced by Cotton Contract Board. wheat in Hapur (1913) and then bullion in Bombay (1920). Almost a MARKET COMMENTARY |9 . post-World War II. And. As. commodity futures trading has also played an instrumental role in integrating various fragmented components of the commodity ecosystem. over the years. and to regulate futures trading the government in 1918 set up Cotton Contracts Committee. the derivatives market developed in several other commodities in the country: raw jute and jute goods in Calcutta (1912). Thereafter a number of commodity exchanges facilitating futures trading in numerous agriand non-agri commodities sprang up the world over. therefore. the Great Depression had its devastating effects on economies around the world during 1939-45 and the British rulers imposed controls over the financial markets. the earliest reference to “futures’ can be found in Kautilya’s Arthashastra. it took off in the US with “grain” contracts on CBOT (the first exchange to start there in 1848). and futures contracts have existed for centuries in one form or the other.
the bulk of trading has been taking place on the three national exchanges.1. Despite being a late starter. from the four decades of restrictive government policies.226 crore in 2006-07. As it agreed to and acted upon most of these recommendations. In the current fiscal.65. MCX overtook other domestic exchanges and continues to be the No.40. which shot up by 53. 405.40 crore.20 crore. which include 21 regional bourses and the three national-level players.14 trillion).27. the total trade accounted for 97. After significant declines in the trade volumes of agricultural commodities in the previous two consecutive fiscals i. the Prof. the growth in trade volumes slowed down to Rs. aviation turbine fuel (ATF). 1952 (FCRA) to regulate commodity futures trading in the country.e.48 trillion ($1. 2007-08 and 2008-09. total turnover of commodity futures trading is expected to cross Rs. with another three proposed exchanges on the cards. notwithstanding the ban. secure and efficient operational infrastructure these national exchanges are creating a near-perfect market situation with a much wider participation from the ecosystem stakeholders in a large number of domestic and global commodities during local and international timings. a y-o-y jump of 31%. 2009 period.decade later. what began with a notional value of Rs. the National Commodity and Derivatives Exchange Ltd (NCDEX) and the National MultiCommodity Exchange Ltd (NMCE) were born. and so on.364 crore in 2003-04 increased to Rs. the Government allowed futures trading in all the commodities recommended. which only marginally slipped to 94.983 crore in 2007-08.671. (MCX).52.48. The trade came into being after remaining in hibernation for nearly four decades. provided the FCRA amendment Bill is passed.22. the cumulative value of trade stands at Rs. made several recommendations including cer tain amendments to Forward Contracts (Regulation) Act 1952 and strengthening of the Forward Markets Commission (FMC).956 crore. and three national-level online exchanges — the Multi Commodity Exchange of India Ltd. Kabra-headed committee. Parliament passed the Forward Contracts (Regulation) Act. And a major part of it was due to a surge in the trade volumes of agricultural commodities futures. turned out to be spot on.1% in 2007-08 but shot up to 106.36. 1 commodity futures exchange in the country (by numbers/lots of contracts traded) with a market share of 85% as on August 31. set up by the Government in 1993 to examine the role of futures trading.29. globally. The Indian commodity futures market has emerged as one of the fastest growing markets with a combined trade turnover of around Rs.29. followed by the trade in the energy and industrial metals complex. However. following a Given the growth in trading volumes and increasing integration of Indian economy with the rest of the world. 2009.5% to Rs. as realization that derivatives do perform a role in risk management dawned. which includes launches of a slew of new products suitable to the fast-changing market dynamics and needs such as certified emission reduction (CER).4% in 2008-09. FMC and the Government. The timing of this revival effort. As the percentage of Gross Domestic Product (GDP) at market prices. K.3% in 2006-07. encouraged the idea of setting up commodity exchanges with state-of-the-art infrastructure and global best practices. and the phenomenal growth (110% compounded annual average growth since the market’s resurrection in 2003) is largely attributed to continuous outreach efforts and all-round innovation by its national-level electronic commodity futures exchanges. Nevertheless. the rise in agricultural commodities’ trade in the current year is noteworthy. The current scenario At present. ban on some commodities in January 2007 and then in May 2008 as well as imposition of higher margins and stringent norms for trading. the Indian commodity futures market has begun to be recognized among the top derivatives exchanges of the world. 10 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS .N. Since the reintroduction of commodity futures trading in India in 2003. 24 commodity futures exchanges are operational in India.80 crore.89. With the process of liberalisation and globalisation of the Indian economy and consequent reforms in its financial markets in the early 1990s.5% to Rs. With the state-ofthe-art technology-powered modern.100 lakh crore by 2010-11.248. for the April 1-August 31.316.60 lakh crore in the current fiscal (2009-10) and Rs. on a fast-track mode. the Indian commodity futures market staged a comeback in 2008-09 with a sharp increase in the turnover to Rs. gold guinea contracts. which jumped by 27. As per FMC estimates. Speaking of the combined turnover of domestic commodities exchanges.77.52. as the 1990s heralded an upswing in the commodity cycle.
Maize. had it been implemented. Rice. Rice. currently being awaited. while globally the corresponding figure is 5 to 10 times. would have stunted the growth and maturity of a still-nascent market whose turnover is less than even half (only 40% in 2008) the country’s equity market turnover. 2008 citing the same reason. and Zinc futures (by the number of contracts traded). During 200708. According to Futures Industry Association (FIA) and data put up by benchmark international exchanges. While the trade in non-agricultural commodities. MARKET COMMENTARY | 11 . mutual funds. Drop in agricultural commodities trading volume There had been a significant decline in the volumes of futures trade in agriculture commodities.5% and the trend continued in 2008-09 as well. MCX retained its leadership position with 85% of the total turnover of all the 24 exchanges.Given the growth in trading volumes and increasing integration of Indian economy with the rest of the world. by becoming ‘price setters’ in many commodities (India is currently a ‘price taker’ despite being one of the world’s largest producers/impor ters/expor ters of about 17 commodities) through much wider participation. No. The passage of the FCRA amendment Bill. Copper. especially bullion and crude. 2 in Gold (followed by NYMEX and TOCOM) and No. Guar Gum. 3 in Natural Gas. The move will also help mobilise the resources that would have otherwise been diverted to CTT towards enhancing expertise and skills of domestic commodity futures markets to international standards. The trade in these eight commodities. plummeted by over 66. And a major part of this fall in the trade volumes of agricultural commodities was accounted for by Chana. due to the continued ban on several commodities. which will deepen the market through wider participation of entities like banks. 2008 as four other agri-commodities — Chana. Prevailing prices of banned agricultural commodities and the volatility that existed in their cash markets clearly indicate that their trading in organised and wellregulated markets would have kept the volatility in their prices under control than otherwise. 2009. 1 in Silver. though later the Abhijit Sen committee appointed to find out the truth. Crude Oil. for the year ended March 31. Lately. 2009. The proposed tax.4% during 2007-08 compared with the previous year level. FIIs. Futures trading in Wheat.017% proposed in the Budget 2008-09. Potato. Potato and Rubber — were banned for four months until December 3. The agricultural commodities vertical suffered another shock on 7 May. found no direct link between the price rise and futures trading. will clear the deck for introduction of long-awaited instruments in commodity derivatives such as options and index-based trading. This will help Indian commodity futures markets not only become globally competitive but also develop into benchmark markets. at the international level. 2009 following a shortage and the associated increase in its price. while the ban on what futures was lifted on May 15. Soy Oil. has increased in the past two financial years. and Guar seed. The share of agricultural commodities almost halved during 2008-09. which accounted for 57. the same in agricultural commodities has declined. it fell by 28. Sugar was also banned on May 27. Further. Tur and Urad was banned in March 2007 by the government following pressure from many quarters blaming the futures market for an unprecedented surge in retail prices of food commodities. Until August 31 of the current fiscal. Mentha Oil. the Indian commodity futures market has begun to be recognized among the top derivatives exchanges of the world. this fall (in the eight commodities) exceeded the overall drop in futures trading volumes in all agricultural commodities together. Regulatory and market developments Abolition of CTT – The Union Budget 2009-10 did away with the Commodity Transaction Tax (CTT) of 0. Tur and Urad are still under ban. Chilly and Cardamom.9% of total futures trade in agri-commodities in 2006-07. MCX fares as the world No.
48. 12 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS .10 lakh will attract no charges. cash transactions up to Rs. these state-of-the-art exchanges have also crossed several policy hurdles to grow in stature equivalent to their international counterparts. mutual funds. During this small yet remarkable journey. A large number of risk-averse economic stakeholders will likely be attracted towards the market with increased information about commodities enabling hedging of price risk at much lower costs (driven by increased liquidity). besides nurturing the ecosystem delivering both the felt and the unfelt benefits of their existence to one and all in the commodities supply chain right from the producer to the consumer. FIIs.1% of commodities’ transaction value if they wish to settle in cash. these modern commodity exchanges have also enabled the Indian industry manage risks as they flow from their origins crossing economic borders. taking the erstwhile turnover of Rs.66. Conclusion Indian commodity exchanges have come a long way. which will deepen the market through wider participation of entities like banks. It is a further policy boost and socio-economic-institutional change as discussed above that will take the Indian commodity markets to a much higher level of growth to help the economy allocate its resources effectively as with the developed economies. This will also guarantee fair returns to farmers. spread the risks thinly among all the stakeholders. they also took along with them the stakeholders. As these exchanges grew over the past six years. The three national online exchanges came into being. It has also directed commodity exchanges to levy non-compliance charges on high-value cash dealings. The move obviously aims to discourage cash dealing in commodities. seamlessly integrating with the entire financial markets architecture. Regulatory measures: FMC has recommended a reduction in central value added tax (cenvat) from 8% to 5%. while traders will have to pay 0. This will help India emerge as a price taker with a transparent flow of market information converging from a highly increased number of domestic and international participants. They also did help spread risks in major commodities ecosystems across several stakeholders thereby making the economy more competitive in the current rapidly globalising world. The passage of the FCRA amendment Bill. However. and wade through the fear of globalisation affecting our economic and political stability.52. will clear the deck for introduction of long-awaited instruments in commodity derivatives such as options and index-based trading. currently being awaited.956 crore in 2008-09. Being online with extended hours of operation. it stated.530 crore to Rs. with an impressive growth during the last six years since 2002-03 when the government embarked upon policy liberalisation.Amendment to FCRA: The proposed amendment to FCRA will make FMC an autonomous regulator with functional and financial autonomy to play its regulatory role more effectively alongside its developments responsibilities.
EXPERTS’ VIEWS .
these markets have become inefficient over a period of time. and Kisan Credit Cards. All these factors are interrelated and unless changes in them are made in an integrated manner. as well as ensure better prices and timely payment for their produce. scientific warehousing and collateral management. infrastructure and institutions. set up in major production and arrival centres across the country. In addition. These efforts will have to be in the form of policy instruments in the area of technology. various policies of the government weakened the performance of these institutions creating a major vacuum in financing agriculture. Though the APMCs were set up to protect farmers from exploitation of intermediaries and traders. in India. This has enormously affected agriculture sector growth in the country. a large gap still remains between provisioning and the requirement. infrastructure and institutions in order to leapfrog development of the agriculture sector. reduction in interest rates. will help solve current problems in these functions. perform the crucial function of organising agriculture trade and providing a meeting point for buyers and sellers. The world over agricultural marketing and financing developed together as complementary to each other. leaving behind equally important marketing finance. which creates a situation where a large number of households have too small an income to sustain their life. Institutional conditions perform an important function of providing easier financing to the agricultural sector through creating appropriate processes.An Integrated Approach to Agriculture Marketing and Financing By Prof. While considerable efforts have been made in recent years to improve agriculture financing through measures such as loan wavers. infrastructure and institutional conditions for effective adoption. forcing farmers to fall back on the informal sector. Any effort to improve rural conditions on a sustainable basis hinges to a large extent on how agriculture income can be increased. Agriculture sector financing has so far mainly concentrated on production financing. in which efficient systems of e-spot trading. grading and quality certification. This Act helped in establishing nearly 7. they are dealt separately ignoring this attribute of complementariness. there are also serious questions raised about food security in the country. cooperative institutions played a major role in providing production financing in many parts of India. However. . and futures-benchmarked OTC offered forward contracting can exploit complementarities between agricultural marketing and financing. markets. crop/weather insurance. among others. over the years. during the past 50 years. India has had a very successful technology development in the past in agricultural production in general and particularly in crops such as cotton.500 regulated markets throughout the country and stipulating how agricultural trade should take place. Agricultural Marketing and Financing in India During the Green Revolution. maize and vegetables recently. Even now. However. India has certainly lagged behind in terms of bringing appropriate changes in markets. a major reform was initiated when almost all the states brought in legislation the Agriculture Produce Market Committee (APMC) Act to ensure an efficient system of trading 14 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS agricultural commodities. they will not help in creating an enabling environment for faster growth. mandating banks to increase the share of loans to the sector. Agriculture sector development in India is very critical today than ever before as the sector still supports nearly two-thirds of the country’s population even though its share in national gross domestic product is less than one-fifth. no significant improvement has taken place in the functioning of agricultural markets. During the Green Revolution. Gopal Naik An integrated approach. a number of technology options seem to be available at the laboratory level waiting for appropriate market. However. The APMCs.
and also risks are reduced. At the time of planting. This insurance may be given by the same agency as the crop yield insurance which may facilitate faster processing. And this challenge has been accentuated because there has hardly been any worthwhile reform undertaken in the country’s agricultural marketing for a long time now.In recent years. With the crop-acreage decision. gets a warehouse receipt and forward sells it using the forward market and delivers on the contract maturity. sells using the forward market. liberalisation of agriculture trade in India as part of the globalization process has created enormous pressure to reform the agricultural marketing system to be in tune with the rest of the world both in terms of quality and efficient handling of agricultural produce. sells in the spot market. In fact. which will help increase the price realised by the grower and decrease the price paid by the consumer. The forward contracting system will be tagged on to the futures market. The farmer buys back the contracts he has sold during the planting time and uses any one of the above three options — keeps in the storage for a sale at a later date. Farmers should be able to sell the crop to the extent of insured quantity. For the development of such marketing and financing systems. The ultimate objective is to develop marketing and financing systems where price discovery takes place in an efficient manner. The forward contract buyer may have reinsurance arrangement to meet the financial obligations in the event of a crop loss which should not be recovered from the claim of the farmers from the agency that had provided them with crop insurance. especially that of information and communication. quality of produce improves. once the farmer takes his decision on the crop and acreage. Wait for the better prices in the future: if the current prices are not attractive and the farmer expects the prices to go up in the coming weeks/months. the farmers can check the quantity and quality of the produce. gets a warehouse receipt. he has an estimate of crop yield that he should be able to sell forward through a forward contracting arrangement to be established at an APMC. Based on the forward contract and yield insurance. the farmer should be able to take additional loans if he intends to do so. Sell it in the forward market: The farmer feels that one or more forward prices are attractive. Once the harvest is done. He keeps the produce in the warehouse. he keeps the produce in a warehouse. while elsewhere technology development. In addition to technology development. contributing significantly to the economy. enables farmers to get bank credit in addition to the crop loan. a farmer will be able to get both production and marketing credit as well as sell his produce efficiently. The Food Corporation of India should buy the contract in case farmers are prepared to sell at the announced minimum support prices. organised by private players and are based on the prevailing futures prices. sells in the current spot market. several process improvements need to be brought in to reduce the cost of transaction. With these systems in place. thus. A farmer can use the forward contracting facility at any time during the crop production period. farmers are able to receive payments as well as production and marketing credit in time. has been effectively used for improving the agricultural marketing system. 2. New System for Agricultural Marketing and Finance Complementarities between agricultural marketing and financing help evolve an integrated approach to address the current problems in these functions. Deliver the contracted amount to the forward contract seller and sell the remaining amount in one of the following ways: a. This will be essentially retailing futures contracts to farmers. along with the crop yield insurance. These forward contracts are the over-the-counter (OTC) transactions available at APMCs. If the current prices are attractive. b. he should be able to avail of crop loan and crop yield insurance. with the contract price derived from futures prices. And they will have the following options (see flowchart): 1. the following requirements have to be met: • • • • • • An efficient spot trading system An efficient grading system An efficient forward market An efficient insurance market An efficient warehouse receipt system An efficient Government support system the crop-acreage and forward contracting decisions simultaneously based on the prices offered in the forward contracting arrangement. A good marketing system facilitates easier financing and a good financing system improves efficiency in marketing. This futures contract. may or may not go for a pledge loan from the bank counter. cost of marketing reduces. the farmer can make 16 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . benefiting both consumers and producers and. sells at a later date and realises the remaining value. Lower prices at the consumer level increases demand and higher prices at the farm level increases supply. transaction cost is reduced. and these two changes together result in large volumes of production and consumption. c.
forward selling and warehousing. there will be a better estimate of the supply of commodities that would be used in the futures market as forward contract sellers hedge in the futures market to cover their risks. the transaction costs in this mechanism are likely to be low. At present. Efficient Spot Trading System In the current marketing system. without going for forward contracting. However. And this will require participation of both the public and private players as well as government support. Risks are covered: Farmers can cover the yield risk through crop yield insurance and the market risk through forward contracting. forward transaction and insurance will facilitate transactions at a lower rate. farmers should be able to get more credit through forward contracting. Price stability: With the forward contracting arrangements. this provides comprehensive revenue insurance to farmers. Some of the deficiencies in the existing agricultural marketing system are: EXPERTS’ VIEWS | 17 . Farmers will still have the option of going for crop loan in the existing arrangements. This integrated system will work well if each one of its components is made to work efficiently.A NOVEL AGRICULTURAL PLEDGE FINANCING MODEL This integrated system will provide the following advantages to the farmer: Easy financing of crop production and marketing: Farmers can get crop production credit and marketing credit through insurance. However. but credit limits are low. APMCs play a pivotal role in spot trading. Thus. A large volume of handling in grading. crop production loan is available. Low transaction costs: As systems develop and reach a steady state. warehousing. these primary markets have not kept pace with the developments taking place in the international markets. The additional information flow into the system will lead to stability in the prices.
The e-trading will also remove the problem of information asymmetry. direct marketing. Further. making farmers neglect the quality aspect of their produce. which makes farmers rely mainly on the prices quoted by local traders. putting it far below international standards. anywhere. This will connect local markets nationally and will effectively do away with information arbitrage that exists in today’s APMC markets. Encouraging alternative marketing systems such as contract farming. which gets built up at the consumer end. Lack of effective information transmission: This leaves very high information arbitrage possibilities among the markets. Thus. and end-users can buy electronically through competitive bidding. which would While many of these initiatives are yet to be implemented. Therefore. Adoption of ICTs for agricultural trade. the e-spot exchange is a marketplace where local farmers and traders can sell farm produce. while upcountry buyers. Absence of a good grading system: This makes farmers unaware of the quality requirement of agricultural produce at the user end. Poor handling also results in substantial loss in quality during marketing of the produce. No post-harvest guidance system: Absence of any extended system to guide farmers on post-harvest care results in substantial losses of value of the agricultural produce. Poor handling of agriculture produce: This practice in the market yard results in large losses of the farm produce. Lack of price information: Price information about other markets is not available on right time. E-spot trading is an effective method which enables farmers to sell their produce to anybody. farmers have restricted selling options. exporters. E-Spot Trading The developments in ICT that have already taken place can facilitate agricultural marketing functions and processes. processors. and quality certification of agricultural produce. ICT can also play a pivotal role in disseminating and using trade information. the anonymous nature of the system will ensure pricing transparency and reduce possibilities of speculation. ‘farmers markets’ for direct sales Promoting PPP (public-private partnership) in the management and development of agricultural markets in the country • • • Setting up ‘special markets’ for perishable commodities such as onions. the government. fruits. • 18 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . processors. No access to warehouse receipt financing: This pushes farmers to distress sales and lower price realizations. Poor knowledge of packing and scientific storage: This leads to losses in the supply chain. vegetables. importers. In recent years. in the form of electronic spot trading. The trading will help the producer get the best possible price for his commodity/produce. corporate. ‘direct purchase centres’. exporters. and flowers. including buying and selling. and movement of produce Permitting the establishment of ‘private market yards’. This screen-based trading will help small and marginal farmers participate as it will be possible to do trading in small quantities. APMCs need to redefine their role in the context of present era of Information and Communication Technology (ICT) and globalization. etc. payment.Absence of a good quality assessment system: This often result in lower price realization for the seller (farmer). • Limitation of selling options: The system of marketing through APMCs with only a few registered traders who often buy in collusion among themselves. which in turn helps farmers realize a better share of consumers’ rupee. certain policy changes have been announced to improve the agricultural marketing system and they are: • • • Encouraging procurement of agricultural commodities directly from farmers’ field Removing all restrictions on production. a significant initiative that can be taken up immediately is the setting up of and enabling of “electronic spot trading” (e-spot trading) for agricultural produce. wholesalers. and transportation and logistics. standardization. without any dependence on middlemen to sell their small marketable surpluses. and farmers markets Promoting grading. Price realization by sellers will also be faster. supply. will benefit farmers enormously. farmers’ associations/co-operatives. storage. Potential participants/traders on the exchange platform can be farmers. as price information will be available instantaneously in any terminal and quality assessment will be done before the transaction. anytime in a transparent way. while the buyer takes advantage of the state of affairs to offer lower prices to the farmers. This can not only reduce transaction costs and make intermediation in commodity markets cost-effective but can also effectively mitigate problems of lengthy supply chain through the elimination of middlemen connecting farmers through the shortest possible value chain.
While APMCs provide a backward integration. they can make export commitment and cover themselves immediately by buying at NESE. coupled with grading facilities at market yards where farmers’ produce can be graded and stored. This can be done at the state level by organizations like State Marketing Boards. imports of good quality produce are taking place to meet the needs of the emerging qualityconscious section of Indian population. offers efficient warehousing and logistics support. Efficient Grading System • • • • • APMCs and spot trading – the PPP model of transformation Though the e-spot trading is a good alternative to traditional marketing. APMCs will have better realization of market fees. This also has led to a larger gap between the quality of domestically traded produce and internationally traded produce. EXPERTS’ VIEWS | 19 . Traders will have a big and liquid market. It is a facilitator that undertakes delivery and payment responsibility and. Hassles relating to procurement of material in physical markets can completely be avoided. The infrastructure and quality of manpower needed are also deterrents to setting up of an e-trading platform in agriculture. More importantly. end-users and upcountry Formal grading of agricultural commodities is very rarely done for internal transaction in India. Exporters can save brokerage or commission payable to procurement agents. base value. delivery specifications (delivery unit and centre) and quality specifications (grades. with the elimination of counterparty risk. availability of finance and absence of counterparty risk under the NESE system. tolerance limits. the synergy between APMCs and NESEs will complete the chain and make it most efficient. they can expand their activities to multiple commodities. etc). Using the price available at NESE. Exporters can buy certified quality material through a secured platform. price quote. APMCs stand guarantee to the quality specified in the auctioned lots. a viable model is to have a PPP with NESEs. they can effectively use the futures market for managing their risk. leased lines. This can be effectively facilitated by introducing grading at the primary wholesale market level. Setting up of trader work stations. as well as be able to pledge produce for warehouse receipts. Reversing this trend necessitates development of a value chain that is conscious of quality. Good warehousing facilities. greater outreach and timely transaction. maximum order quantity. lower transaction cost. Hence. Arrangement with transporters who can ensure delivery of the goods sold. It allows desktop monitoring of trade. it prevents information arbitrage from getting added to consumers’ rupee. This has caused the ‘lemon problem’ in agricultural markets where bad quality produce drive away good quality produce in the market as there is no price incentive for farmers to supply better quality produce.Requirements for successful implementation of espot trading: • • Amendment of the APMC Act that gives recognition to these electronic spot exchanges. NESE is neither a buyer nor a seller nor a commission agent. credit risk. thus. internet facilities. being online and accessible to traders located across the nation. Synergy between APMCs and NESEs Synergy in this PPP is feasible due to the complementary nature of the two entities — APMC and NESE. NESEs provide a forward integration linking processors. while electronic spot exchanges have pan-India reach with a robust delivery and payment mechanism. standards. Farmers will have better price realization. guarantees quality. This model of marketing of produce has advantages for farmers. knowledge and catchment of commodities. In addition. rejection at the buyer’s godown at the time of delivery and easier access to bank finance against warehouse receipts. APMCs have physical infrastructure. where they can sell a large quantity. facilitates timely disbursement of commodities and funds while ensuring transparency in transaction and settlement. clarity on quality requirements and quicker transaction. easy access to credit. functions as a complementary market to derivative traders. unit of trade. traders and exporters. linking farmers to market yards. etc Establishment of contract specifications that include particulars such as opening of contracts. buyers to local delivery points. which will link each APMC with the existing NESE. exporters. which can create an effective combination to transform agriculture marketing. power backups. the investment needed to set up national-level electronic spot exchanges (NESE) by every APMC is likely to be a deterrent. With operational ease. Therefore. APMCs. Setting up grading laboratories at market yards for establishment of uniform grading/quality standards. functions like a national-level APMC facilitating trade between the buyer and the seller. With the grading system in place. NESE is a new distribution channel with trade guarantee that offers advantages to the overall marketing system. making exports of agricultural produce difficult. Removal of restrictions on interstate movement of agricultural produce. This will enable farmers to get easy financing.
cost of marketing reduces. There are private sector companies which are already providing scientific warehousing facilities including collateral management. Also. which prevents deterioration in quality and quantity during storage. Nevertheless. A formula can be established to retail futures contracts to farmers in the form of forward contracts. crop/weather insurance. will give financial institutions the confidence to extend easy financing. The extent of finance that the market participants can obtain through pledging will also increase. warehousing. forward price contract may require a yield insurance to be obtained as a prerequisite. These companies can have franchises so as to create enough facilities for grading and certification at all APMCs. financing and forward contracting. which will enable the farmer to obtain credit easily. Efficient Insurance Market Yield insurance has been existence in India for more than three decades for crops such as rice and wheat. But then the pressing need for a good system of grading to bring in quality consciousness among various participants in the agricultural value chain can hardly be overstated. for commodities. a farmer can either sell his qualit y certified/graded produce immediately through an espot exchange or defer the sale. Indian Institute of Management – Bangalore. While the government should set standards and continuously undertake research to upgrade and harmonise. As more and more agencies come up to retail forward contracts. its reputation has not helped produce quality crop in India. farmers can effectively address both yield and price risk. farmers are able to get their payment in time. the warehouse receipt system will become easier to implement. financing at the farm level and. With the warehouse system available at the APMC level. transaction costs are reduced and risks are minimised. Once the decision on planting certain acres of a particular crop is made. With yield insurance and forward contracting. Gopal Naik is Professor. he can obtain insurance and then forward sell at an APMC. Conclusions An integrated approach. in which efficient systems of e-spot trading. This could be achieved effectively with participation of both the public and private sectors. and futures-benchmarked OTC offered forward contracting could exploit complementarities between agricultural marketing and financing. a few national-level companies can be accredited for grading and certification of agricultural produce. credit access to farmers becomes easier. grading and quality certification. the private sector can develop a system to implement it effectively. This protects farmers from distress sales. While steps should be taken to update Agmark standards to reflect consumer preferences and technical needs of processors. Since there is a problem of uncertainty about the amount of yield. thus. The commodities futures exchanges already have already a grading system in place.Although Agmark standards and labelling has been in existence for nearly half a century. continuous upgrading of standards and harmonising with international standards. grading is hardly practised in the country. Views expressed by the author are personal and not of the institution. In case there is a shortfall of yield. with increasing sophistication in the data collection methodology. the insurance can be used to make up the losses. they are offered on an area basis. a much needed healthy competition to provide this service will be created at the APMC yard. quality of produce improves. This will help in facilitating e-spot trading. A scientific method of storage. individual assessment-based insurance will become a reality. grading and warehousing system in place. but a robust grading system can be set up only when the government too pays adequate attention to the development of standards and grading systems. 20 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . However. as there are no effective ways of dealing with moral hazard and adverse selection problems. With a good insurance market. Prof. In case of deferment he may go for pledge financing to meet immediate financial requirements. private companies can offer retailing of commodity futures contracts at the APMC level. The ultimate objective is to develop marketing and financing systems wherein price discovery takes place in an efficient manner. This will also make transactions over long distances easier. Such an insurance system will address the risk management needs of farmers effectively. Efficient Warehouse Receipt System An efficient warehousing receipt system can go a long way in helping reduce transaction costs in the supply chain and facilitate financing of agricultural commodities. With appropriate backup of legislation. Efficient Forward Market With the futures market. scientific warehousing and collateral management. will help address current problems in these functions. farmers get both production and marketing credit in time. A good grading system ought to have unquestionable integrity and standards in line with the requirement of trade.
a process of deregulation and privatisation initiated. These exchanges are offering the benefits of liberalisation and globalisation directly to the industry and consumers by empowering them to influence the global prices of commodities they deal in. traders trade their products. After decades of decay. and this is where an efficient commodity futures market plays a primordial role not only in facilitating price/volatility risk mitigation but also catalysing near-perfect price discovery. of key importance to many. Like in many countries. The Enabler of Efficient Price Risk Management and Price Discovery The price discovery process should not be left to just a handful of traders in asymmetrically informed or illinformed. And this will make the Indian markets a force to reckon with on the global commodity map. In 2007. Stakeholders have still not reaped the fruits of greater competition in financial markets. is commodity price volatility. turning them into a‘price setter’indeed. and the financial sector has been lagging behind many parts of the real economy. International trade and investment were opened up. policymakers. and banks lend against commodities or those with exposure to commodity price risk. the tax regime reviewed. Economic liberalisation took off in the early 1990s in India. This opens a window of opportunity to Indian companies but also. and aviation. resulting in widening and deepening of the market through increased participation by various ecosystem players. and a new-found ebullience surrounding emerging markets. It is time the markets were made much more vibrant and efficient by allowing participation of a larger number of new categories of economic stakeholders and introduction of innovative derivative instruments. the best price discovery comes when a large number of various categories of market players with a wide range of 22 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS .Commodity Futures in India – A Product of Globalisation and Liberalisation By Mr. But now. practitioners and academics responded to the growth of financial markets worldwide. As it matures over time. by advocating wide-ranging reforms. banking. insurance. India's economy greatly benefitted. This is to plug risks at the roots rather than when they finally sneak into the prices of end products. its backward and forward linkages will strengthen. India's organised futures industry was revived in 2003. The ultimate results will be 'Financial Inclusion' and 'Market Inclusive' growth. Rather. unlike what has been seen in sectors such as telecom. exposes them to a whole new world of risks. Indian financial markets are poised to scale to the next growth orbit. However. India increasingly integrates with markets around the world. This in turn is changing the ways producers make their cropping decisions. with the national online commodity futures exchanges taking the lead. Among these risks. from its current status of being a ‘price taker’ to a ‘price setter’. the country clocked its highest ever GDP growth rate of 9% the second-fastest in the world after China and a far cry from its annual GDP growth in the three decades postIndependence. the reform process is still incomplete. segmented markets. Companies need to be able to manage these risks if they are to be globally competitive. Lamon Rutten A beginning has been made towards transforming the Indian commodities sector.
The efficiency and transparency of price discovery depends on the robustness of the trading platform. In the case of MCX. That is to gauge the capability of its futures contracts to predict its maturity prices more accurately (indicated by the percentage deviation between the first traded price and the last traded price of a given contract). the national commodity futures exchanges in India performed better than the policymakers expected in terms of catching up with their age-old global counterparts on most of the aforesaid parameters.1. Table 1: MCX vis-à-vis global parameters Domestic Exchanges Particulars Commodity Stock exchange (MCX) exchange (NSE) Global Exchanges COMEX and CBOT Remarks Position limit is significantly lower than that of global benchmark exchanges indicating that the domestic futures market cannot be distorted by single/a few players.2 crore). Risk management tools on a futures platform include margining.0. creating awareness. Rs. last but not the least. Ref.18. Such a platform and the Multi Commodity Exchange of India Ltd.2.60% COMEX Gold . limits on open positions.1.9% - COMEX Gold . The efficiency of price discovery is also indicated by the nearness of the spot and futures price movements. For the same period.1% Impact cost Gold . the right mix of its participants with relevant price information.1. and bringing in world-class technology and global best practices are some worth mentioning. The lower impact cost on MCX at par with global exchanges reflects better liquidity in terms of market depth and width. (MCX) is one ensures that all relevant information is absorbed in the price formation process. NIFTY .7% Avg. right contract design. EXPERTS’ VIEWS | 23 . taking them to appropriate participants. A lot of efforts delivered from a base of strong domain knowledge and technical skills went behind this spectacular growth. e f fe c t i ve management of the participants' varied risks and.0.027% NIFTY . This reflects how efficient the Indian futures market is in capturing global cues. COMEX gold futures contract. and the “right price” is discovered.2 crore. COMEX Gold and Nifty Futures. MCX gold contract's correlation with the global benchmark. Price volatility of commodities traded on an exchange is an indicator of how effectively these tools are used by the exchange managers to improve the efficiency of price discovery. Selection of commodities relevant to the stakeholders. The lower price volatility on MCX compared with global exchanges reflects that price discovery on the domestic platform is happening with more price stability.0.019% Note: In the case of price discovery. Position limit to physical market size (%) Gold . is around 99. making participation costeffective vis-à-vis alternatives available for risk m a n a g e m e nt a n d / o r i nve s t m e nt .2% in January 2007 MCX Comdex to August 2009 . which indicates a strong inter-linkage between domestic spot and futures markets. The more efficient the discovered prices on a futures platform is.2 crore sourced from NSE website on September 9.4%. Impact cost of COMEX Gold calculated for a portfolio of USD4 lakh (app. Impact cost for Nifty was calculated based on trading happened on a regular trading day. it is necessary that various risks to the participants be effectively managed. 2009.5% CBOT Soybean Oil . To make these markets more relevant and useful to different categories of stakeholders and thus their participation more effective. keeping ears and eyes to market needs.objectives and interests converge on an organized futures platform. its regulations.16% COMEX Gold . we considered August 2009 contracts – MCX Gold contract.3%. expanding infrastructure. In just about six years.1. daily volatility Gold .8% (from January 2007 to August 2009).9% (the rupee adjusted). a robust and transparent clearing policy.1. Soy Oil .0. the correlation between its gold futures contract and gold spot prices is around 99. and effective surveillance (see table 1). the more effective are the business and policy decisions that are taken based on these prices. Impact cost of MCX gold calculated for a portfolio size of Rs. Impact cost of the S&P CNX Nifty for a portfolio size of Rs.
innovative applications of technology. participation of commercial banks.the Road So Far The introduction of commodity derivatives has remained one of the most significant developments in the Indian commodity market sector. most of these commodities are largely governed by their fundamentals (the supply and demand conditions) at the global level and partly by developments on the domestic front.1 billion) in 2008-09 at 74. functional transparency based on sound regulation. on an average) with the international benchmarks (see table 2) despite the high volatility in USDINR in the recent past. These exchanges’ efforts and performance helped make Indian companies and economy globally competitive. The prices efficiently and transparently discovered on these exchanges are gradually being transmitted to the physical markets. If the margin utilization crosses 100%. For globally traded commodities. they have performed well. Global commodities traded on these Indian exchanges. and so on. However. The exchanges clocked this robust growth despite continuance of various restrictions. the second option may not be workable due to lack of clear participation norms for international exchanges. Table 2: Price correlation – MCX vs.5. trading on exchanges having the right mix of arbitragers between the domestic and global benchmark exchanges will also serve the hedging purpose.7 lakh crore ($127.0 Data Source: Exchanges' websites 24 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . steel. such as bullion. the prices discovered on MCX have very high correlation (96%. and speculators on to a single platform. while the option of indirect participation will be costly for most of today’s corporate hedgers. etc) and energy (crude oil and natural gas). particularly metals and crude oil. aluminium. Such users may participate in exchange-traded contracts with their underlying physicals being the same as their raw materials and whose prices are linked to the prices discovered on the international benchmark exchanges. Therefore. This innovative risk management system has been adopted to prevent any spread of financial contagion. The robust growth numbers reflect the stakeholders’ strong faith in these exchanges’ functional efficiency and transparency.143. and this will lead to increased competitiveness both in the manufacturing and services sectors. MCX follows strict vigilance with an automated system in place.8 Copper 94. The lower volatility on the Indian commodity exchanges is due to the close monitoring and the robust margining system adopted by them. etc. What helped these exchanges to leap forward and attain higher levels of efficiency and trade volumes are their innovative products. aimed at improving the software through telecom technology. It has a constant collaboration with FTIL.52. global benchmark exchanges in globally-linked commodities from Apr ‘05-Mar ’09 (in %) Gold 94.4 Crude oil 97. This also shows that the prices of MCX’s futures on globally traded commodity follow efficiently — and in tandem — the combined forces of domestic and international fundamentals. arbitragers. provides automated alerts when a member’s margin utilization crosses various levels. and this works towards cost-effectively connecting the stakeholders to the market. And this makes the domestic online exchanges a cost-effective and superior alternative to their international counterparts. being successful in bringing various ecosystem participants such as producers. for example.Again. These commodities are largely linked to the global markets as their imports and exports are allowed subject to a marginal tariff incidence. The system. the parent company. Commodity Derivatives . MCX gold contract is more efficient than COMEX gold contract in terms of price discovery. the technological robustness (both hardware and software) also adds value to the MCX participants by enabling cost reduction. Obviously. For example. In the span of just six years. The three national online exchanges brought in revolutionary changes in this sector by bringing in spatial integration and temporal price discovery of commodities at the national level. effective adoption of global best practices. hedgers.10% CAGR.48 lakh crore ($1. as well as indicate the commodity markets’ growing influence over the Indian economy.6 Average 96. But in the absence of such an arrangement. ferrous and non-ferrous metals (copper. as the same table shows. on instruments such as options and indices. it is necessary for the users of these commodities to take positions on a futures platform with global linkages in order to hedge their risk. mutual funds and FIIs. account for more than 80% of their average daily turnover.3 Silver 94.6 billion) during 2004-05 to about Rs. Besides the functional efficiency of trading. The annual turnover of domestic commodity exchanges increased from Rs. the member in question is put automatically on a “square off” mode.
the coming up of the national commodity exchanges. Besides the price risk. And this not only means having competitive manufacturing and services sectors but also necessitates promotion of markets to make them globally-competitive. such as farmer-friendly weather derivatives. the weather risk has a profound impact on a farmer’s income under the predominantly rainfed farming (about 70% of net cultivated area) conditions prevalent in India. once effective.The Way Forward At this juncture when the Indian markets are on their way to the heights achieved by the global benchmark markets. It is the functioning of the domestic commodity exchanges which will strengthen the market-based trading system in India making it useful for Government procurement. it is essential that they are allowed to have the right mix of participants —and products — to have the necessary liquidity depth and width. armed with their global alliances. An increased participation of such players will go a long way in streamlining commodity trading in India by bringing in relevant information about the fundamentals into the markets and. The exchanges will create an environment where farmers have multiple selling options (for their produce) such as the spot market. Although India has a long way to cover in harnessing the potential in the major commodities. the story of its bullion market is bright. has provided industrial users of primary commodities with easy access to an alternative platform to trade on. and the futures market-referred over-the-counter forward market. this will also help corporate best practices percolate into the markets to fine-tune their functioning and efficiency. Besides. Effectiveness of participation in global exchanges can only be replicated if the domestic exchanges meet the efficiency of trading in the global benchmark exchanges. The Indian bullion market has demonstrated its resilience to remain the “price setter” for gold and silver in the Euro-Asian time zone. The multi-faceted benefits will include introduction of a number of innovative instruments. The futures market in electronic format being executable at the national level. Corporates and physical market players in India are gradually realising the importance and need to participate on commodity exchanges. which can be mitigated by trading in relevant commodity derivatives. The domestic exchanges offering such an opportunity to the industry ought to be effectively harnessed to efficiently manage their profit margins and safeguard their investor and consumer interests by infusing efficiency and economy into their procurement operations. neither the automobile/ancillary industries manage their input costs effectively nor do the suppliers of their raw materials. in I ndia. especially in the globally traded commodities (with least trade distortions). Gone are those days when policymakers successfully used MSP as an instrument to influence the cropping pattern and production of farmers. And if there could be a single most positive and defining step that can be taken towards solutions to such problems as mentioned above it shall be the passage of the longpending amendment to For ward Contracts (Regulation) Act. will work towards an efficient and vibrant commodity market in India (both on the physical and futures fronts) and bring a world of good to the entire commodity market ecosystem. India is a land of billions that consume a large portion of most primary commodities produced in the country. Indian (MCX) bullion prices have strong correlation with those of the international benchmark markets. Further. competitiveness remains one of the most defining factors for developing economies. of late. To cite an example. making the price discovery process more efficient. thus. once allowed options will help farmers lock in their prices on the commodity exchanges in a more efficient way than they can currently do with the existing instruments. For the domestic exchanges to rise to the challenge of turning the country into a ‘price setter’ it is necessary that India has strong and transparent markets with robust infrastructure for efficient transactions. The Act. Given the current trend of globalisation of economies. integration of banks and institutional traders into the market will create several institutional options for farmers. This is partly due to lack of policy guidelines allowing and promoting them to effectively participate in the market and partly because of lack of awareness on their part. However. EXPERTS’ VIEWS | 25 . the futures market.
is committed to transforming the Indian rural economy to international standards by providing the last mile connectivity to rural areas and developing the required infrastructure. intangibles like weather derivatives. Besides the revenue earned from scientific stock management. As the WR draws its power under the act. issuance of WRs and collateral management services will enable earning of higher revenues than the plain-vanilla storage charges levied on their clients. Therefore. the FCRA will clear the deck for introduction of long-awaited instruments such as options. And the deepening of the commodity market. as their holding power will be enhanced. reflect the sentiments of the entire producing. intermediaries. enhanced income of the farmer. the overall economy. discovered on the MCX platform. standardization. thus. and marketing. trading and consuming community representing a one-India market. This in turn necessitates that Indian commodity exchanges have an upright regulatory framework under a robust regulator. communication and technology (ICT). The WDRA will also create efficient linkages between producers and markets. It launched two major infrastructure projects . and effective nurturing of the linkages will go a long way in creating a healthy warehousing system in the country. thus achieved. Second. strengthening FMC through the FCRA will be a momentous step towards strengthening the commodity futures market as a whole. once amended. innovative solutions to practical constraints. along with its strategic partners. which through value additions will attract risk-averse participants. Availability of liquid futures contracts on various key commodities on the MCX platform has dramatically changed the spot market scenario. Warehouses and the related institutions (quality testing. availability of credit through warehouse receipts (WR) etc. NSEL and NBHC. And this will eventually result in fairer returns to farmers. The futures market is also increasingly acting as a guiding light for the physical markets to assess the upcoming underlying fundamentals and sentiments. the coming into force of the Warehousing (Development and Regulation) Act. First. standardization. these benchmark prices. The fact that these prices are arrived through collective participation of the stakeholders from various parts of the ecosystem and the country makes it suitable to be benchmarked for the commodities underlying the futures contracts for the spot markets. MFs and FIIs in the commodities market. Thus. (NBHC). Efficient warehousing creates efficient linkages among the participants in a value chain resulting in improved efficiency with which the produce is being marketed. commodity indices and freight indices. and marketing yards) form a vital cluster in the logistics sector linking the producers of agricultural commodities with their end-users ensuring effective carryover of the commodity from the farm gate to the consumers’ table. will enhance the market’s efficiency of price discovery and efficacy of risk management. This will not only democratise the price discovery process on the exchange platform but will also stabilise the market forces and. Development of the warehousing sector — through the linkages to be created between the players and the institutions in the agricultural supply chain ecosystem — will help achieve the ultimate objective of creating win-win supply chains for producers. 26 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . and provide price signals to the physical markets. This is despite the standardised nature of contracts and terms and conditions of futures trading. MCX – Unrelenting in Its Endeavour Since its inception in 2003 MCX has taken a number of initiatives to help the farming community to realize a better value for their produce. the amended FCRA will pave the way for participation of banks. 2007 (WDRA) and setting up of the authority will create an efficient warehousing ecosystem that will include quality testing and certification. the value to it is added by the linkages that the warehousing institution creates with the funding institutions and the strength of the collateral management services for the funding agencies and their clients at a cost which would keep both the financial institutions and clients happy.? National Spot Exchange Ltd (NSEL) and National Bulk Handling Corporation Ltd. For the domestic exchanges to rise to the challenge of turning the country into a ‘price setter’ it is necessary that India has strong and transparent markets with robust infrastructure for efficient transactions. The combined strengths of MCX. This has ensured emergence of benchmark prices of various commodities representing the most prevalent varieties in the most active physical markets in India. Following this. and consumers. Application of information.India is a land of billions that consume a large portion of most primary commodities produced in the country. which in turn will lead to the benefits of price discovery flowing down even to small farmers. Participation of financial institutions on exchanges will also enable lending at market-linked prices.
developed increasingly opening up and integrating with markets its own sustainable business model and came out of around the world. in which MCX’s shadow. which rose to a cumulative figure of over Rs. bulk handling. NBHC. facilitated in its first year of table 3). benchmark futures prices of the standardised contracts. They have EXPERTS’ VIEWS | 27 .500 crore. have started influencing the global counterparts. as discovered on the MCX platform.5 lakh million tonnes demand as a dominant player in the world market (see by the end of 2008-09.Creating a silent revolution… Why Can India Not Be a ‘Price Setter’? A pre-WDRA entity.869 in 2007-08 — markets of those commodities. And this has partly effective. with its robust relevance and priority with the Indian markets standardisation and quality-testing facilities. BP Statistical review number of agric o m m o d i t y producers/farmers hitherto unreached through its To transform the country into a 'price setter' the first unique Gramin Suvidha Kendra (GSK) model.897 as has started emitting price signals to the linked global on March 31. One such business opportunity that it is either one of the largest producers or consumers or evolved was collateral management undertaken to both.determination of commodity prices. which was floated by MCX Despite the fact that it is fast developing into a major with the felt need for delivering the underlying at the ‘economic powerhouse’ in the global arena India maturity of contracts.2 6th largest producer remarkable success in Aluminium reaching out to a large Source: USDA. is an end-to-end solutions continues to look up at other markets to decide the provider in the entire gamut of collateral management.007 Rice milled tonnes of rice and wheat by 3rd largest producer behind EU-27 Wheat 12. across five states. is it not just logical that the Indian management. pesticides/fungicides/weedicides penetration of the online electronic exchanges and fertilizers. Taking the market to the masses… Soybean Oil Gold Coal 3. India has immense potential to have a domestic facilitate trading against collaterals (warehouse market that is strong enough to set global market receipts). grading and largest producer and consumer of a large number of quality certification. In fact. price setter in 17-odd commodities.1 22.8 7.34. commodity care and pest commodities. As for commodity markets.5 (cumulative of 5. 2009 vis-à-vis 2.6 6.800 Table 3: India's share in global production and consumption crore in the current fiscal.1 12.7 7 6th largest producer and 5th largest consumer Largest consumer MCX has achieved 3. To a large extent. traditional modes of communications for been taken care of by the modern national-level price dissemination and providing other services like commodity exchanges. The logical step would be to democratize its markets to innovative outreach network in tie-up with India Post enable an efficient flow of information for effective to leverage the latter’s vast rural infrastructure in cost.8. accreditation and commodity markets upgrade to the level of ‘price setter’ from their valuation. In just a few years.0 and China 2008-09).4 2nd largest producer behind China 20.1. contracts in many of the aforesaid commodities. local prices of commodities. awareness. NBHC. With the development of liquid futures benefiting over 3. thanks to policy liberalization redressal of technical queries and supplies of farm of 2002-03.800 registered farmers more directly. GFMS. has now spread over 768 villages served through reduced participation costs and increasing by about 160 branch post offices. Share (%) in Share (%) in total Global rank in total global NBHC also facilitates Commodities global consumption production/consumption output government procurement 19. such testifying the growing popularity of the model. NBHC. the country has the potential to become the operation (2006-07) collateral funding of Rs. warehousing. The rapid ICT developments helped inputs such as seeds. audit. given its share in global supply and 18 states with a total capacity of 16. trade consultancy and disposal of current tag of a ‘price taker’? And this assumes more commodities. with about 437 warehouses spread over prices. With the country being the procurement.1 3. India Farmer registration with GSK shot up by 34% to 3.
in many global commodities the participants tended to discount the global pricemoving factors rather than domestic information. and the national online commodity exchanges are already helping various categories of participants get all such available information to converge. besides carrying out other next-level reforms. For example. in terms of influencing or setting the prices. With increased accuracy of the prices discovered and more effective price risk management. the efficiency of the Indian industries and commodity markets will increase significantly. of which it is the world's largest importer and consumer. turning them into a 'price setter' indeed. with the national commodity futures exchanges taking a lead. It is time these markets were made much more vibrant and efficient by allowing participation of a larger number of new categories of economic stakeholders and introduction of more innovative derivative instruments. of which it is the largest producer and consumer.started discounting the Indian fundamentals and sentiments in Indian time zone. a beginning has been made towards transforming the country's commodities sector from being a price taker to a price setter. is slowly gaining the rightful place among the world markets. This is to plug risks at the roots rather than when they finally sneak into the prices of end products. Although it is still a long way to go. India. Laman Rutten is MD & CEO of Multi Commodity Exchange of India Ltd. And this will make the Indian markets a force to reckon with on the global commodity map. While proliferation of products and participants is evident from the phenomenal 110% annual compounded growth rate at which the trade on the domestic commodity futures exchanges grew between 2003-04 and 2008-09 (source: FMC and Economic Survey data). 28 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . Views expressed in this article are personal. Mr. on the strength of its futures market. in commodities such as gold. Indian markets have to enable cost-effective participation of all those with information to effectively discover prices. They are offering the benefits of liberalisation and globalisation directly to the Indian industry and consumers by empowering them to influence the global prices of the commodities they deal in. And this will result in a “multiplier effect” on the national economy. and chana.
In fact. Close-ended: 196 and Interval Funds: 48) to the investors. Of the open-ended schemes. entry of new fund houses. viz. often can't be counted. 2009. Venkateswaran R. ETFs had 0. Equity oriented schemes. relaxation of investment restrictions. the AUM stood at 14. adoption of robust risk management system covering all operational aspects. The worldwide total net assets under management of mutual funds as at end-2008 were $ 18. Things that count. posting of consistent better returns. minerals.975 trillion.23% share in AUM and fund of funds investing overseas 0. the number of folios with the domestic mutual funds totaled 4. abolition of entry load (initially for direct applications and now for all) and investor awareness and distribution initiatives. discusses the investment objectives and restrictions applicable to a domestic mutual fund and concludes with a brief overview of the commodity funds. The Indian Mutual Fund Industry An overview As at end-August.51. globally. and is very limited or absent in emerging markets.487. growth of assets under management (AUM). who offered a total of 852 schemes (Open-ended: 608. Growth/Equity Schemes. mutual funds’ role in commodity markets is of very recent origin. introduction of new products.. six were Gold ETFs and 12 were other ETFs. As a percentage of GDP at market prices at current prices. 2009.26% of the AUM. close-ended schemes 8. The assets under the management of the mutual funds stood at Rs. open-ended schemes accounted for 91.56. Individual investor accounts 30 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS .10% of the AUM. The Article describes the current state of the domestic mutual fund industry. domestic mutual funds are not allowed to invest in commodity markets. Liquid/Money Market Schemes and Gilt Schemes.Role of Mutual Funds in Commodity Markets By Mr. accounted for only 26.12% of the AUM. With increased demand of a growing world population.53% as at end-2007). Nevertheless.Albert Einstein At present. the prospects for commodity markets.42% of the AUM.. the growth so far has been good.17 crore as on August 31. Income Schemes. look bright. More than 56% of the AUM was contributed to by corporates and institutions. and agricultural commodities. . precious metals. The Indian mutual funds industry is older than the Indian public sector banks (other than the SBI Group). in particular. with $ 85.48% of the AUM and interval funds 0.638. Indian mutual funds. 7. viz.45% (down from 0. The AUM of mutual funds in developed markets range between 20% and 70% of GDP. Hence. there were 43 mutual funds registered with SEBI. 2009.22% as at end-August. accounted for 0. As on August 31. While debt oriented schemes. buoyed by surging prices of crude oil. and food items. As on August 31. Things that can be counted. made up for 73. The industry has made remarkable progress in terms of some parameters like opening up of the sector in stages to all sorts of players. Balanced Schemes and ELSS. 2009. in general. reduction of fees and other expenses.83. 2009.32 billion AUM as at end-2008. often don't count.39% share in AUM. expansion in the number of unitholders.
mutual funds have seen net inflows of Rs. debentures and units of mutual funds. 12. Internationally. Also. the growth of the domestic mutual fund industry is dependent upon the networth and profitability of the asset management companies. i. 89. The funds of a gold ETF scheme of a domestic mutual fund are currently invested only in gold. as may be specified by SEBI from time to time. The Regulatory Framework The domestic mutual funds are registered with. 1996. This is on account of commodity prices responding directly to changes in the economy that tend to produce inflation. privately placed debentures. investments in traditional avenues like equity shares and non-inflation indexed bonds alone cannot protect the real value of the portfolios. Regulation 45 further permits a mutual fund to enter into derivatives transactions and short selling transactions on a recognized stock exchange. During April – August. Thus. and regulated by. Then. several new products have been made available over the years.349 crore to investments in shares. Role of Mutual Funds in Commodity Markets On account of high unpredictability of long term inflation rates. The emergence of a self-regulatory organization (SRO) (a reincarnation of the Association of Mutual Funds in India (AMFI)) can further strengthen the regulatory framework. Prospects There is a need to widen the reach of the domestic mutual fund industry to the retail individual investors.. 1996. the funds track the movement of an underlying index so designed to track the trend in the price of the underlying asset. investments in units of mutual funds comprised 26% of the gross financial saving of the household sector. The global financial and economic crisis had affected the Indian financial markets and the Indian household sector preferred safe havens in the midst of uncertainty and high volatility. In the United Kingdom. There are some funds that own the commodities that the fund represents. but that own futures contracts and undertake trading strategies so that the assets of the fund and the net asset value (NAV) mirror the trends in the price of the underlying commodity. During 2008-09. A gold ETF has been defined as a mutual fund scheme that invests primarily in gold or gold related instruments. SEBI was established as a statutory autonomous regulator to protect the interests of investors in securities. The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive and revised SEBI (Mutual Funds) Regulations. 2.4% of the total gross financial saving and 1.36% of the GDP at current market prices (Rs. From a financial point of view. in spite of the increase in gross financial saving of the household sector. 2009. under which all mutual funds. there is scope for the industry to tap the technological prowess that has transformed the Indian secondary market microstructure. especially to those outside of the Tier 1 and Tier 2 cities. 2. this trend is contrary to the inverse relationship between inflation and equity share prices (A high rate of inflation is usually associated with a high rate of interest and high interest expense means low earnings per share). the moneys may be invested only in securities. except Unit Trust of India. were to be registered and governed. Accordingly. securities debt instruments (which are either asset backed or mortgage backed securities). money market instruments. gold or gold related instruments or real estate assets.96 crore.56.6% of the total gross financial saving and 0. Though.754. investment in commodities has proved to be a rewarding option for those investors diversifying their portfolios beyond equity shares and bonds. there is scope for further product innovation. to promote the development of the securities market and to regulate the same. Securities and Exchange Board of India (SEBI). A domestic mutual fund can invest moneys collected under any of its schemes in accordance with the investment objectives specified in Regulation 43 and the investment objective of the relevant mutual fund scheme.89% of the GDP at current market prices during 2007-08). which are held under the custody of a SEBI-registered EXPERTS’ VIEWS | 31 . The first case is similar to the gold ETF scheme of a domestic mutual fund in India. SEBI came out with the first Mutual Fund Regulations in 1993. And. The investments permissible under Regulation 43 are subject to the restrictions on investments specified in the Seventh Schedule to SEBI (Mutual Funds) Regulations. A gold related instrument refers to such instrument having gold as its underlying.made up about 96% of the total investor accounts. Commodities are often seen as a hedge against inflation. there are different ways in which mutual funds invest in commodity markets. there are other funds that do not own the underlying commodity at all. 19.e. In most of these cases.134 crore. A mutual fund has been defined as a fund established in the form of a trust to raise monies through the sale of units to the public or a section of the public under one or more schemes for investing in securities including money market instruments or gold or gold related instruments or real estate assets. the household sector allocated only Rs.
the prospects for the commodity markets in general and agricultural commodities in particular appear to be bright. ( Jim Rogers) had said that one thing everyone could count on. Jr. minerals and food articles. It is worth noting that commodity based ETFs in the United States. it is clear that the domestic mutual funds are currently not permitted to invest in commodity markets. the growth so far has been vibrant. seeking the protection of regulated asset managers. 904 crore. like metals and oil and gas. gold and silver. 2009. about three-quarters of commodity ETF assets tracked the price of two precious metals.. Also. This strategy is also in vogue in India. According to EPFR Global and Gardner Finance AG. Oppenheimer Real Asset Fund. indexes having companies in the commodities sector as their constituents. commodity ETFs grew from just over $ 1 billion to $ 36 billion by the end of 2008. through the spot and futures markets in 2008. It is estimated that the assets of SPDR Gold Trust. through overseas funds which in turn invest in the shares. no matter what happened in other sectors. the biggest exchange-traded fund backed by gold.e. 2009. As at end-2008. PIMCO Commodity Real Return Strategy and Rogers International Commodities Index. precious metals. the commodity assets under management of institutional and retail investors at the end of March 2009 amounted to $ 172 billion. there is the commodity pool. where many high networth individual investors combine their moneys and trade in futures contracts or commodity options as a single entity. are not registered or regulated by the Securities and Exchange Commission (SEC). accounting for about 7% of the ETF assets. the strategy paid off well. With reference to Macquarie and Rogers China Agricultural Index. Back home. investors favour mutual funds over hedge funds for investments in commodity markets. The commoditybased ETFs that invest in commodity futures are regulated by the Commodity Futures Trading Commission (CFTC). According to Barclays Capital. the share of the Indian demand in the global demand for gold. operated by the commodity pool operator. are among the popularly tracked ones. noted financial investor James Beeland Rogers.custodian of securities. The Investment Company Institute (ICI) estimated that commodity ETFs accounted for 19% of the number and 38% of the total assets of sector and commodity ETFs. viz. or the managed futures fund. there were 231 sector and commodity ETFs with $ 94 billion in assets. Some of the commodity mutual funds/index funds that have become the favourites of investors on the basis of their performance are Deutsche Bank Liquid Commodities Index. of late (in the first quarter of 2009). With the larger demands of a growing world population. buoyed by the surging prices of crude oil. This has prompted the launch of many new ones in the stable. Several estimates are available regarding the size of the AUM of commodity funds. As on August 31. making agriculture a key part of any commodity investment portfolio. Some of the investments are through feeder funds. Goldman Sachs Commodities Index. Lastly. the demand for gold ETF schemes will grow exponentially with increased investor awareness. The growing demand for ETFs in the United States prompted sponsors to offer more funds with a great variety of investment objectives. But the role of mutual funds in commodity markets is of very recent origin globally and is very limited or absent in emerging markets. Dow Jones AIG Commodities Index. Since their introduction in 2004. the socio-cultural factors affecting the demand for gold in India and the additional benefits of a gold ETF like absence of storage cost and insurance premium and no fear of theft. the AUM of gold ETF schemes stood at Rs. The year-to-date returns of gold ETFs and commodity-oriented schemes of domestic mutual funds are also quite impressive. Given gold’s status as a safe haven. while those that invest solely in physical commodities are not regulated by the CFTC. Gardner Finance estimated that commodity hedge funds’ assets under management ranged between $ 190 billion and $ 210 billion as at end-March. Notwithstanding the losses in 2008. was people would continue to eat. are more than the amount of bullion held by Switzerland’s central bank. 32 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . Nevertheless. There are now more than half-a-dozen domestic mutual funds in India too which invest in shares of Indian and foreign companies in the commodities sector. Conclusion Thus. i. The brighter growth prospects of the emerging economies and search for yield (often buying into the risk premium story) in the developed economies resulted in the launch of many commodity index funds blending the emerging markets and the commodity asset class.. Another category of funds own the shares of companies that are into the commodities sector.
Venkateswaran R.celent. McKinsey & Company (August. simplicity and safety. is Assistant Director. 1996 Annual Report 2008 ? 09. In this milieu. Prof. 2009) Future of Investment: The Next Move?. References: ? ? SEBI (Mutual Funds) Regulations.com www. High networth individuals would venture back into active long only space as well as alternatives.In the aftermath of the global financial crisis. 2009) 2009 Investment Company Factbook. the global asset management industry has explored how the market dynamics would change and how the business models would reshape. with periodic opportunistic forays into absolute returns or cash products.in www. Retails investors would be drawn into products that offer capital protection and tax efficiency. Amin Rajan (CREATE-Research. EXPERTS’ VIEWS | 33 . it is all the more imperative that the asset managers underscore what they stand for and what they can deliver. which wiped out 15 years of capital gains in 15 months.amfiindia.com ?? ??? ??? ??? ??? ??? ??? ??? ?? Mr. 2009) www. Outlook for 2015 (CII ? KPMG.ici. with a strong opportunistic slant.gov.org ? www. 2009) Business Impact of Regulations in the Indian Asset Management Industry: Playing in the New Market Place. Reserve Bank of India (August. Investment Company Institute Indian Mutual Fund Industry ? The Future in a Dynamic Environment.sebi. Securities and Exchange Board of India (SEBI). Views are personal and do not necessarily reflect those of the SEBI. June. Investment goals over the next three years would be conspicuous by the flight to quality.
banks do not even need to assume all the risks associated with their core business of lending and borrowing. just logical to believe that with growing penetration.Banks on Commodities Futures Platform – A Win-Win Situation By Mr. What followed as a corollary is that businesses and entrepreneurs in large numbers joined the bandwagon and this brought in the necessary investments as well as global best practices for all these industries to flourish. and setting up units overseas. In India. the phenomenon has thrown open huge opportunities to various industries. Also. banks do need to absorb some risks that are inherent in their operations and smartly avoid others that can be effectively passed on to other participants in the financial marketplace. on the one hand. and better compliance. both public sector and private sector banks have. a key component of the financial services industry. They can mitigate such risks through a combination of business practice. especially the financial sector – being critical to economic growth and stability of any economy. are getting increasingly exposed to a whole lot financial risks. like their global counterparts. commodity/equity price risk. In fact. In other words. By now everybody knows what happened to several frontline international banks in the recent past. efficiently transferring a part of the risks to other financial market participants. has remained one of the major beneficiaries of the current era of ‘globalisation and liberalisation’. and incentive-based remuneration to employees who are made accountable. Indian banks are getting increasingly exposed to various risks such as interest rate risk. Second. They can manage these risks by sharing them with other economic stakeholders. Ananthakrishnan With gradual liberalisation. Indian commercial banks. As economies and markets around the world opened up amid rapid globalisation. they can transfer risks that are not complex and can be easily shared with other participants in the financial domain. banks absorb a part of the risks associated with individual/institutional borrowers. V. and pricing. They not only reported enormous losses but went on to collapse in the wake of a number of their credit exposures having met up with default deadlock. so that they can continue to expand their business and flourish. primarily by participating in commodity derivatives markets. to operate efficiently. product design. Associated Risks and How Banks Usually Deal with Them… Risks that banks carry while discharging their services are of various types. making rapid inroads beyond urban India into the country’s heartland. experts lay great emphasis on banks’ ability to provide market information and have funding capability and transaction efficiency. systematic procedures eliminating chances of unscrupulous lending. It is. forex risk. banks can stave off risks associated with their business through sound banking practices that include efficient por tfolio management. but they do not necessarily absorb all kinds of risks. through the use of advanced technology and global best practices. How Should Banks Go about Managing the Risks? First. It is time one looks forward to further policy liberalisation to allow banks’ participation in commodity futures exchanges given that these are equally well regulated as their equity counterparts. As banks play a key role in both economic growth and dissemination of the benefits of economic development cutting across social strata and geographies. by participating in derivative markets. Interest rate risk is one such risk that banks can mitigate through 34 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . The banking sector. P. made a phenomenal progress in recent years. What banks require is managing these risks with tighter rules and regulations. therefore. and credit risk. on the other hand. by way of providing credit.
and other derivative instruments.024 15. in Rs. Third. Banks have to manage such risks at their end itself. WRs. They not only got new business opportunities but also a shot in the arm in terms of being able to mitigate various risks associated with their business./Crore) Sectors Gems & Jewellery Metal & metal products (including iron & steel) Agri & allied activities Industry (small. forwards. as lenders to various players in all the three sectors of the economy. In most developed countries.1 (MCX Metal index) 09.900 Annualised volatility (Percent) (3) 20. futures. In India too. medium and large) Outstanding credit by banks (2) 24.6 (NSE Nifty) Risk exposure (2) X (3) 5. there are certain risks with financial assets which are complex. the underlying assets in the case of WRs are commodities which would carry known price volatility risk (accordingly a haircut can be taken) in most cases unlike equity prices which at times can go down to even zero level. the banking system received a windfall in terms of enabling transactions on these exchanges along with their clearing functions on the exchange. with the arrival of national-level commodity futures exchanges. cannot be shared by banks in their business interests and are proprietary in nature (the risk inherent with any business activity as it is carried on the back of expectations of returns). and swaps to mitigate various systemic risks to a certain extent. wherein wellestablished commodity markets act as an effective cushion. While to reduce interest rate they usually participate in interest rate swaps. their inability to meet the priority sector lending target. warehousing companies and commodity exchanges. Also.1 (MCX Agri index) 25. are widely used and form the core of their funding to the agricultural commodities sector. They do actively participate in various derivatives markets such as OTC (over-the-counter). In India. EXPERTS’ VIEWS | 35 . in the case of warehouse lending — is however mitigated largely through futures market participation. In case of collateral financing.1 (MCX Gold futures) 15. banks are yet to be allowed to participate in the commodity futures market. This could serve as a model to emulate for the Indian financial and economic structure. activity in commodity derivatives is rapidly growing and is increasingly being looked as an investment/business opportunity by many of international financial services providers including banks and their investment arms.813 17. however. being a negotiable instrument.399 871. A failure in effectively managing such risks not only means a reduction in the opportunities for banks’ expansion but also reflects poorly in their ability to reach performance targets. Credit risk — for example. assume certain risks associated with the business or the firm and its inherent business risks. globally. Opportunities in the Wake of Financial Reforms In most developed economies. etc. 2008. Also. bond markets. which as a collateral-based product for farmers is finding increasingly more favour with banks for various reasons such as high risk associated with other types of lending to the farming sector. which threw open a new efficient and transparent platform for players in the commodity or primary sector ecosystem to mitigate their risks. Table 1: Risk exposure arising out of outstanding funds of banks (approx. in order to mitigate foreign exchange risk banks participate in the forward market (to a much more extent than in the futures market).719 197.interest rate swaps and other derivatives such as the forthcoming exchange traded plain vanilla futures derivatives while continuing to retain market competiveness in their lending products. Globally. A popular example of this type would be lending against warehouse receipts (WR) or WR financing. corporate.206 262.963 223. banks tend to carry the price risk associated with the underlying asset (see table 1). banks participate in the equity and commodity futures markets to mitigate risks or exploit business opportunities by establishing trading desks. with commonly followed trading mechanism involving banks. Banks and financial institutions. banks and individuals do help each other through the participatory sharing of risks and benefits.006 Total annual price risk exposure of banks in commodities Note: Outstanding figures as on March 31.995 104. which assumes greater importance in an increasingly competitive world of banking post-consolidation through mergers and acquisitions.
perception of risk due to uncertainty over agricultural yield. as central bank regulations and guidelines already streamline and monitor their participation in the equity market.Some participants on the sidelines of the derivatives market may tend to believe that participating in this market is risky because of the uncertainty of the information that flows into this market. low prices are limiting their incomes and. the subsequent launch of rainfall and weather derivatives will enable banks to hedge against price risk or help farmers cover themselves against nature as there will be participants in these markets ready to take the risks. Further. the necessary investment in the overall farming process. allocate resources efficiently and obtain credit from organised sector. Of late. This enables them to take efficient farming decisions — and improve their economic conditions. Besides. Of late. lack of effective collaterals among farmers. In this scenario. with more than a billion mouths to feed and agriculture providing the livelihood of more than two-thirds of the total national workforce. Besides. banks providing credit facilities to companies indirectly assume price risk related to commodities that are used in various business processes of these companies operating in various sectors. Why Should Banks Rrade in Commodities Futures Market? Commodities. Price Risk and Foreign Exchange Risk Corporate India is being increasingly exposed to global markets as the Indian markets began integrating with their international counterparts rapidly amid the globalisation since the early 1990s. therefore. Reasons are many: banks’ poor penetration in rural areas. on the one hand. Given its total earnings. banks’ lending to the priority sector remained low leading to low value realisation in adhering to the norms set by the central bank. In India. with the value of INR against benchmark foreign currencies becoming 36 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . and so on. in the price discovery and price risk management mechanism that an organised platform of commodity futures exchanges provides. etc. The robust growth of India’s merchandise trade. Now. banks can be similarly allowed to operate in the commodity derivatives market within a given set of regulations and could counter the force of unilateral market direction at times of crisis. For example. Even then. options. with the amendments to the Forward Contracts Regulation Act. On the other hand. use of price risk management instruments provides them with some sort of certainty about the minimum prices that their produce will likely fetch at a future point in time. like other asset classes whose prices are determined by all the various information that flow into the markets about their fundamentals. This reduces the exposure risk perception of lenders which in turn enhances small farmers’ access to credit and its terms. This reform initiative resulted in market-based instruments for commodity risk management including futures. risk perception of banks can partially be mitigated if they are allowed to participate in the organised commodity futures market to hedge their exposure to agricultural lending arising out of price fluctuations that their debtors would face in their incomes. As for agricultural commodities in India. As for producers. The opportunity will lend more balance and support to banks’ portfolio of investments and also help spreading risks across various asset classes. gradual liberalisation of domestic markets left this direct intervention limited and allowed market forces to decide the prices as well as private players to engage in providing farmers with assured prices through routes such as contract farming. etc aimed at protecting buyers was not so successful. This win-win situation can be a reality only with further liberalisation of the markets ensuring appropriate opportunities to both public and private players. commercial banks are traditionally mandated to maintain an adequate credit flow to the agriculture sector. of around 30% to US$396 billion in FY08 (R) over the previous fiscal. From farmers’ standpoint. use of price risk management instruments nullifies the main reason behind producers’ loan default: the unanticipated price movement or inability to reap a better price that may prevail at a future point of time. is a clear reflection of the opportunities that are being reaped by India Inc. direct government intervention in the form of floor price. inherently carry price volatility. Fluctuations in commodity prices simply adds to this risk exposure of Indian companies denting their bottom-lines. being professional and organized banks can have researchbased information flowing into the market compared with a research arm of a broking house. guaranteed price. lack of development of collateral-based credit products. Risk arising out of volatility in foreign exchange rate movement is borne by exporters and importers of goods and services themselves who build that into the prices of their end-products or take that into their balance sheets making their business or product uncompetitive in the market. marketrelated factors. this produces a win-win situation for both producers and lenders/banks. banks holding gold or in physical trade of gold are exposed to the same amount of risk as in table 1. So. including banks. the average annualised forex volatility of around 11% works out to forex risk exposure worth around US$44 billion for India Inc. price volatility is making it difficult for them to plan their production activities. However. minimum support price.
4 20.33% movement.1% 25.00 50. Under such conditions. a 1% rise in crude oil prices has led to a 0. The Reserve Bank of India.4% Source: MCX & NSE. banks with such large price risk exposure need be allowed to participate in an efficient market to effectively hedge their position by transferring the risk to those participants who are willing to assume.1 22.7 12. we considered BSE Sensex and MCX crude oil prices as respective benchmarks.2 price fluctuations that also makes their debtors vulnerable to potential default.17% drop in the Sensex as it cuts bottom lines of India Inc. is much lower (0. which is often marred by poor recovery that leads to building up of scepticism in the minds of organised lenders. Banks’ Risk Exposure in Agriculture Lending and Primary Sector Outstanding Increasingly realising how crucial the contribution of agriculture to the country’s economic growth is.3 2. comparative data in table 2 indicate that commodities are a much more stable asset class than equities. is issuing various guidelines from time to time to make sure that formal lenders give top priority to the agriculture sector in terms of credit advances. This is reflected in its various measures aimed at boosting the sector in successive budget proposals.9 1.5 9.9%) than the overall volatility in the equities market. In other words. Therefore. EXPERTS’ VIEWS | 37 . It is obvious that sharing this price risk with the economic stakeholders ready to take it for a cost will create balance in the economic engagement.8% 36.3 1. of late.5% 25.9% 19. the Indian government has been laying added emphasis on the sector. thereby reflecting appropriately discovered prices to the spot markets and thus help in efficient allocation of resources among various sectors of the economy. *Jan-June 2009 Table 3 shows that based on the total exposure outstanding to various sectors of the primary economy and the annualised volatility worked out for the sectors mentioned above. on its part.6% 44.1 2. which is vindicated by the fact that volatility of MCX Agri Index. the rupee on March 29. for the one-year period Table 4: Correlation analysis Company Sterile Industries Apollo Tyre Associated Commodity Copper Rubber Correlation (%) 74. 2007 had seen an intra-day high-low difference of Rs.9% Metal Index 30.2 0. Complied from spot prices of MCX and BSE closing prices of companies. Over the years. the forex risk situation has become even worse. it is less risky for banks to trade in commodities than in equities. The quantum of price risk in the credit exposure will go further up if the services sector and other industries are included in the analysis.2 25.highly volatile. what will be viable for banks is to lend against commodity collaterals enabled by modern collateral management agencies backed up by the credible warehouse receipt system that they had developed.9 1.3 11. there was only one loan that was effectively utilised by the farm sector — production credit. For example. This lays a strong case for banks to be allowed to operate in commodity markets when they are already allowed to participate in equity markets.0 2. Appropriate positions in the futures market can help them mitigate such risk. A regression analysis was done by taking the Sensex as a function of MCX crude oil prices. Table 3: Annualised volatility (%) MCX Year 2006 2007 2008 2009* Comdex 17. Further.2 Energy Index 21.4% NSE Nifty 26.2% 15.9% 42.3 Agri Index 12.5 2. Table 2: Comparison of price volatility of various commodities traded on MCX and NSE Nifty index Commodities & indices Gold Silver Copper Crude Oil MCX Comdex MCX Agri Index MCX Energy Index MCX Metal Index NSE Nifty Average daily volatility (%) 1. Demystifying a Mystical Relationship In order to identify the relationship between the Indian equity market and domestic crude oil prices — one of the major influencing factors behind inflation and generally in an economy. which is not healthy for either companies or banks that finance their operations or imports/exports. By hedging their exposure on this platform banks can safely lend and enhance their credit exposure to these players.01 — over 2. which covers several essential commodities.5% 20.1. The analysis showed that for the last two years. The basic reason is lack of effective collateral that can take care of the risk of default and/or an effective mechanism to share their risks in markets arising out of Note: The period considered is from the date of launch of respective commodities contracts on MCX to June 2009.8% 40. including an unprecedentedly large loan waiver. Significantly.45 Note: Prices of commodities and indices are taken from January 2006 to June 2009.
most international (multi-national) banks deal in commodity derivatives to add value to their customers that include public sector and private sector Indian Commodity Exchanges – Not Far Behind companies and individuals. them value for money.1% drop in the Sensex.China. Incidentally. They do also bring in other value-added services such as aiding local companies and clients participate in both the domestic and global markets to hedge their exposures in various markets across platforms. coffee. ICICI commodities. in the first instance. including banks and funds. Empowered with varied and innovative products. Specialists Despite several restrictions. these banks have research desks not only to help infuse appropriate domestic fundamentals into the markets but also carry international fundamentals across borders into different markets that are open to them.com. CRDB Bank’s adopted Position limits as prescribed collateral management system to exercise tighter control in commodities in India are Delivery of various over the lending to these high-risk sectors rather than pulling much tighter than those in services offered by out altogether.11 indicating a 1% rise in crude oil prices leading to a 1. interestingly. tobacco. options and several other structured transactions. domestic America. such as on the products working with such banks. which offers online trading facility to its customers as a plain vanilla offering. come Tanzania-based CRDB Bank with one of the country’s largest in the space of just six years up with high level of share in cotton and coffee financing and agricultural — their turnover growing s e r v i c e f o r t h e i r commodities. such as OTC and structured hybrid products. For example. basis swaps. and the bank was facing considerable problems of turnover (see table 5). It The overall growth of the a c r o s s n a t i o n s implemented price risk management in two ways – hedging Indian commodities market d e p e n d s o n t h e the overall portfolio related to coffee and cotton by using risk has remained constrained by necessary regulatory management instruments and hedging the exposure by way many such strict regulatory of acting as a market intermediary in carrying hedging controls that prevent large approvals acquired by transactions on behalf of borrowers. carried heavy risk — and more so due to price from a negligible amount to customers even for volatility in the commodities market. The bank’s lending to about half of the total equity cotton. These activities of large international banks play an instrumental role in integrating domestic economy with the global markets. CRDB Bank of Tanzania – A case study made remarkable headway Standard Chartered etc among others. Standard Chartered Bank . with an opportunity to hedge their risk by taking appropriate positions in both the equity and commodity futures markets simultaneously. This lending against warehousing receipt global commodity markets. capable of catering to a wide range of different market needs and reach to various markets the world over. Commodity Derivatives and Banks – International Experience operations. for example. Further. and cashew verticals was more than small exposures to give 50%. default in the cotton and coffee sector. it shows a value of -1. Table 4 clearly indicates a strong relationship between the prices of commodities and those of stocks in the case of commodity-intensive industries. which include Bank of and participatory limitation to individuals and corporate. such global banks additionally provide arbitrage opportunities across the globe and enable customers to hedge risks ranging from forex risk to interest rate risk and commodity/equity price risk — all at one go.between February 2006 and February 2007. the adjusted R-squared (strength of the indicated relationship) is 98%. exchanges in India have D e u t s c h e B a n k . With their connectivity banks can additionally act as commodity derivatives market access providers for the common man and small producers. to hedge their own risks rather than those of their customers. wide use of derivatives by banks in the US is a recent phenomenon and the reason behind the bulk of derivatives holdings by large US banks is. received an approval to offer commodity derivative products to cater to even a group of investors who are highly ambitious yet risk-averse. such global banks enhanced its capability to lend to farmers in rural areas. Today. companies from them for such 38 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . while in the second instance it was 94% (and statistically significant as well). Their offerings cover Global Peers products such as OTC swaps. can additionally offer customised products to create models of aggregation for both consumers and producers of commodities and enable their participation in the futures market. thereby adding value to customers and economies they are operating in on a continuous basis. BNP Paribas. The high correlation between equity prices and the prices of the underlying commodities (in which these companies primarily deal in) on MCX (see table 4) provides equity market players. In fact.
1 Crore Turnover (April 1March 31. on MCX (as expressed by Comdex) — has been much lower than volatility in both the domestic stock market and global commodity markets with equally comparable regulatory practices (table 5). Funds. Funds. Conclusion It is evident that by the very nature of their operations Indian banks are exposed to several risks ranging from interest rate risk to forex risk to commodity/equity price risk to credit risk.participating due to their huge exposure size. which include companies as well as high net-worth individuals. Corporate. Moreover. keeping sensitivity of the prices of the underlying commodities in view.e. Options. Mutual Funds Members Brokers/Sub-brokers Clients Almost the entire population (family heads/individuals) of the country who in one way or the other would be related to the consumption of the commodity. Indian commodity derivative markets are much more relevant to the physical markets at this nascent stage of their growth. trading in derivatives on a variety of underlying assets. Brokers. Options. Furthermore.VAR adjusted Price Circuits Position Limits . based on the annualised volatility in the commodities which are used by these sectors in their production processes. stock market Commodities & indices Stock Markets Commodity Markets International Commodity Exchanges Potential Investors/Operators Affluent few with income level to invest in the secondary/tertiary growth sector i. Corporate.Member and Client Level Penalties Exchange Participating Banks Members Brokers/Sub-brokers Clients Futures. contracts in the domestic commodity markets have been made deliverable compared with financially-settled nature of stock market contracts. Participants Institutions. an analysis of the global scenario indicates that major global banks participate in various products in several countries not only to hedge their risks but also to add value to their customers.1 Crore Those in developed markets reaches out to almost those who are affected by the volatility in the commodity exchanges -NA- Futures Individuals. Spot Individuals. Banks. and the sellers or buyers on the opposite side. FIIs Single or Separate Regulators for Similar regulation with variable position limits Exchange. Thus. not more than 45 lakh investors with sufficient flow of money Average Daily Market Rs. there is an inverse relationship in their price movements indicating an opportunity for banks which had invested in those stocks to hedge their exposure in appropriate commodity derivatives traded on exchanges. Indices.e. the volatility in the commodity market — for example. 45. Banks. An analysis of outstanding credit to various industries shows that banks tend to lose an average of 23% of their aggregate lending to these sectors. 2009) Spot. Banks can manage all these risks in some way or the other by sharing them with various economic stakeholders — largely by participating in the derivative market i. Clearing House. Clients EXPERTS’ VIEWS | 39 . 17. Rs. FIIs Stock Exchange Board of Regulators India Margins – VAR adjusted Regulatory tools Index Circuits Position Limits – Company level and Market Valuation Level Penalties Institutional Structure Exchange Participating Banks FIIs. Further. Futures. in select stocks of companies with extensive exposure to primary commodities that are traded on the commodity exchange platform.359. Also.042. Corporate Forward Markets Commission Margins . Table 5: Commodity market vs. Institutions. Members. Products Available Indices Individuals. Banks. Numbering around 200-250mn.
This would rather help our policymakers achieve the two primary objectives that they had aimed for while paving the way for national online electronic commodity exchanges: efficient price discovery and taking the hedging process closer to producers. these international banks have not just taken these as a mere risk management practice but put in their best efforts in response to the intense and rising competition and came up with some marvellous results in terms of quality market research by their analysts. P. This not only helped these banks’ own treasury and customers but also the markets to discover efficient prices with increased flow of accurate i n fo r m at i o n a b o u t co m m o d i t i e s a n d t h e i r fundamentals into the ecosystem. Mashreq Bank – India. there are no reasons why the regulators should stop banks from participating in the commodity markets.Trade Timings Cross margining Index trading Delivery logic (derivatives market) Electronic trading Demutualization Denomination of contracts Stage of Development (derivatives market) Only one session (morning session) In the planning stages (between cash market and futures market) Existing Financial settled contracts Yes Demutualized exchanges Single currency denomination contracts Both morning and evening session Not existing Not existing Delivery based contracts Yes Demutualized exchanges Single currency denomination contracts Just passed nascent stages Somewhere between growth and maturity stages Limited. Mr. a comparison of the regulatory principles and business practices of Indian stock markets and commodity exchanges makes it amply clear that the domestic commodity exchanges are as efficiently regulated as their equity counterparts. Foreign banks that have entered India are also most likely to seek an entry into Indian commodity markets in line with their global operational principles to help them remain profitable in the market. V. 40 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . extended and 24 hours Existing not only between spot and futures but even between two exchanges Existing Both financial and delivery based contracts Yes Demutualized exchanges Single currency and multiple currency denomination contracts Maturity stage In the process. commercial banks with strong connectivity with rural areas and domestic commodity exchanges can facilitate participation of all stakeholders in the value chain from the producer to the end-consumer. Therefore. thus preventing risk from being priced to be shared among others besides ensuring shrinkage of the product value chain through the transparency exuded by these markets. Ananthakrishnan is Country Head & CEO. making this not only a business opportunity for banks but a tool in linking these various participants with the markets and help them discover efficient prices. Views expressed in this article are personal. Formerly as Executive Vice-President of HDFC Bank. he started the commodity business for the bank. in India. which is also confirmed by commodity price volatility on the exchanges as a measure. Therefore. Also.
Physical collateral. is greatly enhanced when producers and commercial entities can convert inventories of agricultural raw materials or finished products into a readily tradable device. quantity and grade deposited in accredited warehouses. small and marginal farmers find themselves in dire need of liquidity. According to a report by the Reserve Bank of India Working Group on Warehouse Receipts & Commodity Futures (2005).Warehouse Receipt Finance for Farmers – A Glimpse By Mr. Nachiket Mor and Dr. swapped. the overall efficiency of markets. small and marginal farmers have been virtually left out of it. used as collateral to support borrowing. Being negotiable instruments. goods stored in a warehouse are used as collateral against a loan. these receipts can be traded. these receipts can be traded. quantity. concluding with a brief on IFMR Trust’s agricultural commodity pilot in Gujarat. or accepted for delivery against a derivative instrument such as a futures contract. used as collateral to enable borrowing. Producers receive a receipt against goods of a given quality. sold. Warehouse receipts finance can play an important role in smoothening income for farmers by providing liquidity at times when cash flows dry out. This paper discusses the advantages and disadvantages of WR financing in India from small farmers’ point of view. Agricultural production. to obtain finance for agriculture can be really difficult and often expensive. It also lays stress on some key requirements for implementing a successful WR finance programme. immensely improves when producers and commercial outfits are able to convert inventories of agricultural raw materials or finished products into a readily tradable instrument. farmers face two major problems — lumpy cash flows and nonavailability of intermediate finance. Producers deposit goods of a certain quality. In light of this. Kshama Fernandes While warehouse receipt (WR) finance has been in existence in India for a long time. processing and trade are often considered low-margin. The simple demand and supply equation results in prices falling to their lowest during harvest and gradually rising during 42 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . No wonder. warehouse receipt finance has emerged as an attractive alternative for farmers and processors in the developed world. or accepted for delivery against a derivative instrument such as a futures contract. Under a warehouse receipts financing scheme. and traders and large farmers do benefit by availing of the mechanism. particularly in the agribusiness sector. and are perceived as risky investments by financiers. It also says that being negotiable instruments. This has become a fairly mainstream method of financing in most industrialised countries. and there is evidence that the overall efficiency of markets. given the risk premium charged by financiers. while citing examples of how this mechanism has been used globally. WR financing as a means of extending the sales period beyond the harvest season: As the harvest season approaches. These goods could be agricultural or nonagricultural in nature. Broadly speaking. and grade in accredited warehouses and receive a receipt for it. Warehouse Receipt Finance for Farmers Despite growth projections. swapped. high-uncertainty operations. such as land and real estate or machinery and agriculture implements. particularly in the agribusiness sector. sold. is often of little use in mitigating financiers’ risks as such collateral tends to either be very difficult to enforce or of very little resale value. what remains the reality of the agriculture-related business is its high dependence upon seasonality.
collateralisation of agricultural inventories using warehouse receipts will lead to increased credit availability and reduced cost of credit. the contention that farmers should not engage in speculative activity because it is not their core competence is something that must be looked into in the light of alternatives available. a part of the price benefit could accrue to them. In their study on the use and impact of warehouse receipts in developing and transition economics. Two alternate directions however look promising: commodity forward contracts to be offered to farmers at the time of sowing (so that they may “square off” the “long” position that they create as soon as they commit themselves to planting a particular crop and thereby lock in their profit margins) and an options contract or least a delta hedge (since options contracts on commodities are not legal in India) which allows the farmer to buy protection against a further drop in commodity prices but retain the right to benefit from a rise in prices.the lean season1 . Warehouse receipt financing is profitable only when the expected rise in the value of the stored product is actually more than the cost of storage plus that of the borrowed funds (i. Lacroix and Varangis (1996) concluded that warehouse receipts are an important addition to the store of negotiable instruments in a country’s financial sector. WRs as secure collateral for obtaining finance: Most banks are uncomfortable in extending pre-harvest loans to farmers. then one wonders if availability of warehouse receipt finance for the small farmer is a boon or a curse (discussed later in the note). the Indian farmer is a speculator in any case. futures or options market. in the absence of a readily accessible hedging mechanism. This provides banks and financiers with the comfort to lend to the farmer without lengthy documentation and long processing delays. on their part. etc). In the event of default. in general. can avail of loans either to overcome immediate liquidity requirements or to finance future crop/investments on farm equipment or alternative businesses. it should have led to more aggressive “calendaring” (more distributed production throughout the year). Although farmers are aware of this seasonal trend. Besides. by providing farmers with a mechanism to store and hold on to their produce. the seasonal variation in castor seed prices during 2008 was almost Rs. Most farmers who sell their standing crop to traders and other local financiers before harvest do so at suboptimal rates under tremendous liquidity pressure and not from the point of view of hedging their exposure. EXPERTS’ VIEWS | 43 . Farmers.200 per 20kg which translates into a profit of Rs. on notion of reduced risk premia. it will lead to mobilisation of mainstream financial resources into the agricultural sector. which he has no access to in India. wherever possible. Availing of the facility simply extends farmers’ already existing price exposure beyond the harvest. So. 1 The persistence of this arbitrage is a conundrum. Warehouse receipts form sound collateral whose market value can be easily estimated and whose liquidity is much higher than conventional collateral such as land and machinery. According to the RBI Working Group report. the return from this arbitrage should have been lower than the cost of financing and storage costs. This crop is often bought by traders or village-level aggregators who hold the stock through the harvest season till prices pick up and then sell it at a profit. So. there are concerns about its inherent speculative nature. In perishables. it allows him to do price averaging (thus reducing his exposure to “impact” cost) by selling his harvest gradually instead of being forced to sell the entire quantity on a single day. However.750 a bag of castor seed (which translates into an annualised return of 88. However. at least for non-perishables. loan principal plus interest payments. A typical small farmer sells his crop when its prices are at their lowest. Is There a Downside for the Farmer? While availing of finance against warehouse receipts appears to be an attractive option for the farmer. If indeed that is the case. they not only provide important long-term economic benefits but also have immediate positive impact on the farmer’s life. If indeed this pattern was risk-less and the large traders or buyers were not credit constrained then. Many would argue that farmers ought to confine their activity to the area of their core competence — farming — and not indulge in speculation. According to them. even if the farmer wishes to sell in the spot market. And. It is possible that the existence of the “peso problem” (the risk of a sudden.e. If farmers are enabled to hold on to their crop beyond harvest. warehouse receipts finance enables the extension of the sales period beyond the harvest season. unless he hedges his long spot exposure by selling his produce in a forwards. completely unexpected precipitous fall in value that is rationally anticipated by the market – first pointed out by Rogoff (1980)) makes this arbitrage both persistent and highly risky. the holder of the warehouse receipt has the first call on the underlying goods or its value. To cite some numbers. From the point of time he sows the seed till the point of time he sells the crop in the market the farmer is long on the commodity. they cannot take advantage of this and benefit from it as they are hard put to organise immediate cash. Warehouse receipt financing is in essence a speculative activity. bank fees. in almost all commodities this arbitrage persists.. providing him with a readily available cash flow and a potential upside. One must seriously look into a likely adverse outcome: this financing avenue may encourage farmers to take speculative positions having the potential of resulting in losses beyond their risk-taking ability.9 %).
made it possible for cattlemen to receive strong financing support to feed their cattle – at rates determined through the competition among institutional investors on the country’s stock and commodity markets. introduced in mid-2000. and duties of each party to a warehouse receipt (for example a farmer.Warehouse Receipt Financing – International Experience Experiences around the world suggest that warehouse receipt financing can be a profitable avenue for both the farmer and the financier. risk management and finance at United Nations Conference on Trade and Development). And this enabled the firm to attract huge investment to finance maize stocks. they have the flexibility to exercise one of the following options: • can decide to sell the produce through the group. They must be freely transferable by delivery and endorsement and the holder of a warehouse receipt must be first in line to receive the stored goods or their fungible equivalent on liquidation or default of the warehouse. PTA Bank in Kenya finances coffee exporting farmers by accepting warehouse receipts as collateral. Participating farmers usually form groups of 20-50 members to store their produce and carry it into the lean season when prices are at their peak — much higher than harvest time price levels. At the same time. Warehouse receipts must be functionally equivalent to stored commodities with well-defined rights. This will give farmers the confidence to store their produce and banks the comfort to accept warehouse receipts as secure collateral for financing agricultural inventories. At preset. constituting 60% of Ghana’s farming population. In a similar effort. It also offers them a put option. warehouse receipts require a recognised foundation in law ensuring that the ownership established by the receipts is not challenged. which guarantees sellers a minimum price for the coffee in storage. quantity and storage of commodities. in Venezuela. • TechnoServe has refined the model of inventory credit and expanded its application to other areas in Ghana. TechnoServe in Ghana has achieved considerable success in its inventory credit programme over the past two decades. According to Lamon Rutten (then Coordinator – commodity marketing. the firm believes that only the confidence of being able to sell the produce at a reasonable profit to buyers can be the incentive for small and marginal producers. Again in Colombia. or a warehouseman). Hicks says. liabilities. under a system developed by private firm Induservices. significantly improved their incomes and agricultural production. purchased at the London Commodity Exchange. To improve their conditions. provided capital enhancement to warehouse receipts on seasonal maize stocks. the RBI Working Group report says. For nearly two decades now the participating farmers have maintained a cent per cent on-time loan repayment record. TechnoServe ushered in the concept of inventory credit in Ghana in 1989. to augment both production and productivity. Rutten said. using the proceeds to repay the bank for its credit and the group for the use of storage facilities. a more complex structure. A robust legal framework is a prerequisite to warehouse receipts being treated as secure collateral. According to TechnoServe’s Inventory Credit Programme in Ghana by Frank Hicks. thus assuring that the quantities of goods stored match those specified by the warehouse receipt and also their quality is the same as stated on the receipt. As in most agricultural markets including India. a bank. small farmers remain the classic “price takers”. Keys to Successful Implementation of a Warehouse Receipts Programme According to the RBI Working Group report. PTA Bank can provide finance for a higher percentage of the value of coffee than it could justify in the absence of the floor price. By assuring a floor price for the stored coffee. cut down post-harvest losses and accumulated capital to invest in other agricultural activities. 44 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . and supply to local industries and exporters. and still saving a substantial amount by avoiding high lean season food prices. earning a net profit of 40 to 100%. it is offering facilitating over 100 farmers’ groups access inventory credit. Also essential is a warehouse infrastructure. The idea was to create an opportunity for these farmers to take advantage of seasonal price swings (used smartly by local traders) to mitigate risks for banks that were hesitant about lending in the rural belt and to increase food security for farmers who can buy back (or “redeem”) their produce rather than sell it. to work effectively. grading and collateral management system that provides guarantees on quality. They can take back the produce from the group to consume as food. repaying the bank loan and the group’s storage costs. cut off from information flowing into and out of the market and profitable market opportunities.
From the farmer’s end. weight adjustments are made and the commodity is packed in 75 kg bags and stacked away. It is largely perceived to be non-applicable to or non-viable for the small and marginal farmer. 2. the proposed Warehousing (Development and Regulation) Act. hidden charges. IFMR Holdings provides warehouse receipt finance. and IFMR Capital are working together on a pilot with the following objectives: • To provide price discovery to farmers for their crops in a fair and transparent manner (ATMNE). The first crop to be traded was castor seed. helping farmers wait out the low price realisation period during harvest. and agricultural extension services (ATMNE and IFMR Holdings). As part of the servicer agreement. Farmers come to the warehouse with their commodities which are then put through a standard weighing and quality testing process.000 acres under castor production and a population of 3. it should provide a sound basis for developing and promoting warehouse receipt-backed trade and finance activity in the country. the exchange provides guarantee on quality. This is in line with IFMR Trust's mission of ensuring complete access of financial services to every individual and every enterprise. So far castor seed worth Rs. IFMR Holdings. three of its entities. Over the last four months. enabling both farmers and banks to value and sell warehouse receipts at short notice if need be. The collateral manager issues a receipt of weight and quality. and storage of commodities in the warehouses managed by it. IFMR Holdings has ventured into the agricultural space. village level warehousing capability. Barriers to participation from the financiers’ side include reluctance on their part to deal with small-size transactions due to operational reasons. Agricultural Terminal Markets Network Enterprise (ATMNE).And finally what is required is a combination of fair and transparent spot and futures markets that provide liquidity and price discovery. The electronic exchange market provides nationwide access to buyers and sellers. existence of multiple layers of intermediaries. Dharampur. there are issues concerning non-availability of reliable price information. a village 20 km from Kadi town. EXPERTS’ VIEWS | 45 . In the Indian context. with 1. • • • • As part of this pilot. and high transportation costs. To provide commodity-backed finance to farmers who would like to avail of finance against the commodity as collateral (IFMR Holdings). Once the trade goes through. quantity. 18 a bag possibly in response to a credible price discovery mechanism being provided to small farmers through the exchange. IFMR Trust’s Pilot in Kadi Taluka (Gujarat) In pursuit of its mission for financial inclusion. the farmer is handed over the cash and receipt for the same. Dealing exclusively with small and marginal farmers in the Kadi Taluka of Mehasana in Gujarat. To develop tradable Asset-Backed Warehouse Finance Receipts (ABWFRs) so that they may be sold to mutual funds and other financial institutions (IFMR Capital). following which the farmer places a sell trade through the ATMNE agri-broker sitting at the trading terminal at the warehouse. Trading operations: The trading facility is located at Kadi in the exchange-managed warehouse premises. its volumes have been encouragingly large. 75 to Rs. To explore other services required but not available to small farmers currently such as transportation from the village to the market/buyer.000. Depending upon the quality. documentation challenges. Financing operations: Warehouse receipt finance in India is typically used by traders and affluent farmers. lack of storage space. To explore other financial products and services required but not available to small farmers currently such as commodity forward contracts and deltahedging (IFMR Holdings and ATMNE). ATMNE is an institutional trading and clearing member and provides trading access to small and marginal farmers. The market caters to farmers from around 125 villages around Kadi. (NSEL) to help farmers realise the best possible price for their agricultural commodities. price differentials between the mandi and the electronic exchange have dropped from Rs.5 crore has been traded by over 500 farmers based in 25 different villages surrounding Kadi. the three IFMR Trust entities are working with the National Spot Exchange Ltd. Towards this. the smallest trade being one bag and the largest 70 bags. inefficient quality testing procedures. While the market is still at its nascent stage. 2007 incorporates almost all the aforesaid legal and warehouse infrastructure related requirements. Once approved and implemented. has been identified as an ideal village to operate the pilot from. after extensive survey.
loans are being given to farmers coming from five villages. benefit from higher profitability being able to delay sales. Reluctance to store commodity in warehouse Perishability of castor seed is almost negligible. which involves fulfilling the KYC (Know Your Client) process that includes biometric identification and physical verification of address proof. The Ghana experience shows that these schemes can dramatically reduce inter-seasonal price fluctuations. IFMR Holdings provides loan against commodities as collateral. and wheat. Conclusions The contribution of warehouse receipt systems in developing agricultural markets has been well recognised across the world. from improved price transparency. While farmers’ response to the warehouse receipt finance mechanism has so far been a cautious one. trading on an electronic exchange and availing of finance against the stored commodities has been a new experience. By interacting with farmers in their local settings. After charging appropriate margins to cover price fluctuations. Rigour of the quality testing process . benefiting small and marginal farmers who otherwise have no choice but to resort to distress sales (sell immediately after harvest). The exchanges arrange for collateral management services and act as a service provider. the farmer is given a smart card which henceforth is used as a single source of identification and data capture for all transactions done by the farmer. on their part. Reasons for their initial inhibitions could be: Lack of awareness . it is explaining to them the concept of an electronic exchange that provides a transparent price discovery process. as well as the documentation. mustard seed. On completion of the process. The maximum loan amount they can avail of against a particular commodity is Rs. Prior advances taken from traders . Currently. Financial institutions benefit from reduced risks and from liquidity due to ready collateral to guarantee or reimburse defaulted loans. process. among others. they are definitely gradually becoming aware of this facility and coming forward to avail of loans through this route. Farmers can also sell some of their stored products to finance future crop. Instead of storing it in a warehouse and incurring storage costs. loan is given against the warehouse receipt for the commodity stored by the farmer in the NSEL-managed warehouse. Farmers who initially took a while to understand the quality testing process now feel the process is more fair and transparent than the one they were used to.In our experience. thereby obviating or reducing the need for borrowing from moneylenders and traders. A value reduction is applied if the commodity does not meet the set parameters. the biggest challenge in terms of giving farmers access to warehouse receipt finance has been awareness creation. Farmers. 46 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . farmers prefer to store it in their backyards.1 million). and from increased bargaining capacity through working in farmers’ groups. The branch through which the IFMR Holdings finances farmers against commodities is located at Dharampur village such that it would serve a cluster of villages that cultivate in large quantities crop such as castor seed.The exchange follows a rigorous quality-testing procedure unlike regular mandis where quality is gauged simply by picking up a handful of commodity. 10 lakh (Rs. It goes like this: a farmer visits the branch and registers himself. IFMR Trust has been putting in a lot of efforts at farmer education. Warehouse receipt finance can offer farmers a marketing and credit option that spurs productivity and thus increases their incomes.For farmers used to centuries of trading through adhathiyas on the mandi and availing of loans from them. Farmers can avail of finance against a single bag of castor seed placed in a warehouse. The purpose of the loan product is to provide short-term finance to farmers collateralised by commodities for which warehouse receipts are issued by a collateral management company. risks and returns from availing commodity-backed finance through IFMR Holdings.Almost 30-40% of farmers around Kadi have already taken loans from traders against commitments to sell their existing commodities to these traders.
United Nations Conference on Trade and Development 4. “Local market opportunities with respect to warehouse receipt finance tapping into the local capital market”. Views are personal. 2001. and Dr. “Warehouse receipts: financing agricultural producers” 2. 1996. When properly designed and managed. No. “TechnoServe inventory credit programme in Ghana”. Finance & Development 5. Hicks. Lewis. Rutten. 2005. Martin D. 2004. EXPERTS’ VIEWS | 47 . IFMR Trust. 2001. References: 1.. Rutten. The World Bank (Agricultural Investment sourcebook series). ESCAP-ADB Joint Workshop 7. 5).However. Richard. 1992. Frank. The Reserve Bank of India 6. 1998. “Report of the Working Group on Warehouse Receipts & Commodity Futures”. Lamon. Lamon. NBER Working Paper Series. Nachiket Mor is President. “Ghana: Inventory Credit for Small-Scale Farmers” Mr. Kshama Fernandes is Vice-President. The mechanism can also provide rural entrepreneurs with a route to capital accumulation that can be invested in more diversified and sustainable ventures capable of stimulating long-term rural economic growth and development. and Karen K. a warehouse receipt finance programme can allow small farmers to graduate from the status of “price takers” to that of “price negotiators” in the local market economy. ICICI Foundation. which in turn can contribute significantly to the overall economic growth in line with national aspirations. Lacroix. Bamako (Technical Note No. “Financial engineering techniques for directly linking domestic capital markets and the agricultural sector – a short note”.D. Evans. “Using warehouse receipts in developing and transition economies”. warehouse receipt finance is essentially a speculative activity and requires serious monitoring of grain quality as well as market price trends and fluctuations. Panos. and Varangis. 2000.4003 3. ESCAP-ADB Joint Workshop 8.
at the minimum. in Copenhagen summit in December 2009. policies. Addressing jurisdictional and market participation issues will remain crucial even as we consider market mechanisms for achieving strategic clean energy objectives in the country so that our commodity markets can perform their role of risk mitigation in this important sector of the economy effectively. This article looks at the potential of clean energy and GHG emission reduction for commodity markets as many of these initiatives have relied on domestic and. Bart Chilton.072 million in 2008. Trade in primary CERs (Certified Emission Reductions). the developing world’s instrument of access to the global carbon markets. This is 5. Even as the debate intensifies on whether or not there will be a global climate agreement on reducing greenhouse gas (GHG) emissions post-2012. and on the contours of such an agreement. binding GHG emission reduction targets. EXPERTS’ VIEWS | 49 . clean energy and. can read as a first sign of rapid growth of emissions trading with high volatility in other energy markets in the last three years. which would inevitably translate into a trading scheme and the trading of underlying targets or commitments as commodities on exchanges. and if this growth continues. Rise of Global Carbon Commodity Global carbon markets have been growing at 100% a year. The EU ETS (European Union Emission Trading Scheme) saw 3. There is a momentum building as several of these legislations. sometimes. Spot trading in EUAs jumped significantly to 250 million out of total 2. while that in secondary CERs (CERs traded among developed economy banks. gas and emissions markets in the Euro Zone. Bharti Gupta Ramola and Mr.2 billion exchange-traded EUAs in the first half of 2009. at the other end. opined that “the potential size and scope of a structured carbon emissions market in the US is unequivocally vast. but it is interesting that some analysts predict that the emissions market may one day overtake the energy market (electricity and gas). and utilities) witnessed a significant jump in volumes at 1. The linkage between the energy and the carbon emissions markets is obvious. Estimates of the size of the global carbon market in 2020 are in the range of US$1 trillion to US$3 trillion.Carbon and Clean Energy Markets – the Potential in India By Ms.3 times the underlying physical market of 275 million issued CERs up to 2008. Last year." while estimating emissions futures to reach US$2 trillion in five years. one of the largest electricity. several developed and developing countries have embarked on a number of initiatives conveyed in pending and approved legislations. Data on transactions in the UK. and measures have been set on course in the last 12-18 months. global market mechanisms. touching US$126 billion in 2008.7 billion exchange-traded EUAs in 2008 and further increased to 850 million out of total 3. We should see greater volumes of EUA and CER trades as the carbon commodity markets deepen and reach the level of other energy markets such as electricity and natural gas markets where the total financial market is 10 to 20 times the underlying physical market or crude oil where it is more than 30 times. It is certainly possible that the emissions markets could overtake all other commodity markets. exceeding the annual allocation for 2008 of 1.09 billion EUAs (European Union Allowances) traded in 2008. traders.8 billion. The explosive growth in the EUA market and the significant increase in spot trading imply a deepening of the EUA market. US Commissioner of the Commodities Futures Trading Commission. and measures aimed to deal with. was below the 2007 level at 389 million in 2008. policies. the year 2009 could end up with the financial market volume for carbon in excess of 6 billion or more than 3 times the underlying physical market. Prashant Vikram Singh Traditional energy and clean energy hold significant potential in the Indian commodity market.
risk mitigation. in the event no international agreement takes place. which is one of the actively traded contracts. a third power exchange. Calls for exclusion of industrial gases have also been raised.2 billion. It provides for allowable limits of two billion tons annually from domestic and international offsets.5 2006 30 108 147 11 107 5. Multi Commodity Exchange of India Ltd (MCX) inter alia trades in natural gas. The US is not yet a significant player in the global carbon market. The power exchanges deepen the existing bilateral electricity trading by embedding the transmission availability within the day-ahead contract in addition to the standard benefits of a trading platform — access.9 TWh (terawatt hour or billion kWh) in 2008-09. In its absence. A carbon market of US GHG emissions of this magnitude will increase the global emissions market multiple times. The ACES does not automatically allow all CDM/JI credits but calls on the US EPA (Environment Protection Agency) to develop its own process for approving offset projects. it will take a 20% reduction below 1990 by 2020. If one were to use the 10-20 multiple benchmark of financial markets to the underlying physical markets. has kept the momentum to Copenhagen summit (the 15th Conference of Parties in December 2009). this shows a huge growth potential in terms of electricity trade volumes and the share of exchange-traded electricity. On an annualised basis. the key parameters set out in the Bali Action Plan. at the very least.5 2007 30 134 193 11 46 8. has received approval from CERC (Central Electricity Regulatory Commission). On the other hand. The demand for CDM/JI (Clean Development Mechanism/ Joint Implementation) credits is restricted.Contracts transacted by UK brokers – notional value of markets in £ billion. to the allowances unused during the period 2008-2012. The ACES proposes 17% emissions reduction between 2005 and 2020 (3% below 1990 levels) and 80% by 2050. 50 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . clearing and settlement processes. The total US emissions in 2005 were at 7. This implies allocation/auction of 2 billion EUAs for 2013 decreasing to 1. There are calls for the existing (improved) CDM scheme to be applicable only to ‘least developed countries’ in future and making sectoral CDM applicable for major economies. Around 2 TWh was traded on the power exchanges in FY09 (part year operation of both the exchanges). the developing countries have been raising the issue of financing and technology transfer. In the event of an international agreement on emissions. they have not come in the way of developing the exchangetraded electricity market.4 billion (without international agreement) and an additional 300 million in the event of an international agreement being secured. the CDM scheme is expected to change significantly from the one that exists today — both internally.8 2008 63 176 178 27 111 36 Source: Financial Services Authority (FSA) survey of the energy derivatives market Projections by EPA show that this would require an emissions reduction (against the business as usual) of 366 mtCO2e (million tons of carbon dioxide equivalent) per annum during the period 2012-2020. the limit on use of CDM/JI credits will automatically be increased up to half the additional reduction effort. in scope and coverage. electricity exchanges have been a recent entrant in the commodity market. approximately 3% of the total electricity generation in India. While these issues are being deliberated. in the event of an international agreement on emission reductions. However. Crude oil and fuel oil are traded on both The European Union has agreed to take a 30% reduction below 1990 by 2020. the recent passage of the American Clean Energy & Security Act (ACES) through the US House of Representatives is expected to change that dramatically and. valued at approximately US$3 billion (given the high traded prices in the range of US$150/MWh). Estimates put the total limit of CDM/JI credits during the period 20082020 at 1. Recently. there are indications that term capacity contracts and intraday contracts would be allowed to be traded on the exchange. which translates into a 21% reduction between 2005 and 2020 in the EU ETS sectors. and externally. National Power Exchange Ltd. and international allowance trading. Energy Markets in India In India. in terms of improving the existing mechanism. 2005 UK power UK gas Euro power Euro gas Coal Emissions 25 54 77 7 45 1. There are some issues relating to the appropriate regulatory agency that has primary jurisdiction over the electricity commodity market. However. while National Commodity & Derivatives Exchange Ltd (NCDEX) has recently introduced trading in thermal coal. the electricity traded by the trading licensees stood at 21.7 billion EUAs for 2020 valuing the physical market at US$ 50 billion a year. with Indian Energy Exchange Ltd (IEX) and the Power Exchange India Ltd (PXIL) becoming operational last year. Currently a day ahead market.
primary CER sellers were seen as an important segment of the market but the anticipation was that very significant interest from speculators. In the absence of buyers and sellers in the Indian market. However. liquidity and trading volumes are likely to continue to be low (affecting the price discovery process) until some elements of this equation are modified. When CER prices began to decline. OTC transactions generally involve longer lead times and more complex and largely bespoke emissions reduction purchase agreements with extensive provisions to deal with credit risk issues. an entire suite of energy and emission products is being traded on the two exchanges and is expected to grow significantly in volumes. which is intended to promote renewable energy development and provide flexibility to electricity distribution utilities that have renewable purchase obligations (RPO) fixed for more than 10 states in the country and to the states that have abundant resources for renewable energy generation. As with any trading scheme. At times. traders and arbitrageurs would provide the needed liquidity. Significant opportunities could emerge for compliance and voluntary carbon for commodity exchanges if there is continued use of market mechanisms for reducing GHG emissions in the global context post-2012. However. We anticipate that. Importantly. the world’s largest carbon exchange. speculators and arbitrators vanished. Carbon Markets in India Carbon instruments were launched in India in 2008 in anticipation of significant growth in the global carbon markets and India’s position as the second-largest supplier of emission reductions. And this resulted in the drying up of trades on the Indian exchanges. The initial trades and growth in the volumes of exchange-traded carbon instruments on MCX and NCDEX were encouraging. Exchange-traded carbon instruments were aimed to infuse greater liquidity and depth to a market that was being serviced by the over-the-counter (OTC) market. Indian commodity exchanges do not allow direct participation by foreign institutions. banks etc. NCDEX launched CER futures contract with expiry December 2008. the states with renewable energy resources will have EXPERTS’ VIEWS | 51 . The price fall was further fuelled by companies in Europe selling surplus EUAs to raise much needed finances.MCX and NCDEX. there will be opportunities for commodity trading products in the Indian clean energy space. agreed in Copenhagen summit. MCX initially launched futures linked to EUA and later launched CER futures contracts (expiry December 2008-2012). as energy markets are further liberalised. which was expected to rise. exchange-traded carbon instruments were intended to give the treasuries of large carbon sellers in India the ability and the flexibility to actively manage the company’s carbon portfolio and price risks as commodity hedging on overseas carbon markets requires regulatory approvals not many companies are willing to pursue. In the absence of the tradable REC scheme. which largely comprised compliance buyers. As there are no compliance buyers in India and foreign traders and institutions are not allowed to participate on NCDEX and MCX. This may not impact price discovery for domestic commodities but CERs are different as their primary use is by Annex 1 countries. Apart from market participation regulations. The Indian government and power regulators are in the process of defining the tradable REC scheme. the demand for the EUAs — and hence for CERs — began to decrease. Exchange-traded carbon instruments were seen capable of addressing all these issues. Emissions trading (see section below) got underway at both the exchanges last year. A renewable energy certificate (REC) trading programme is on the anvil. That is. traders. Clean Energy Commodities on the Horizon Negotiations at Copenhagen notwithstanding. the prices of CER futures contracts on these exchanges were at a premium over those of the European Climate Exchange (ECX). Indian sellers preferred to wait and watch rather than transact at lower prices. it was generally understood that the premium was on the account of speculation over the exchange price (Euro Vs INR). the development of carbon markets in India will also depend on the contours of global carbon markets post2012. and there was a lot of interest. new products in the form of spark and dark spreads with and without embedded emissions will also emerge as hedging tools. as the global recession and economic slowdown hit Europe in the latter half of 2008. The 2008 preliminary verified emissions data released in 2009 showed that EU ETS was overall short in spite of the economic slowdown but this did not cause any significant market movements as this was generally expected. international brokers. The exchange-traded market’s role in price discovery and transparency was of particular relevance to Indian sellers as there was a general perception of lack of transparency in the OTC market.
railways. The potential for trade in RECs and ESCs. is significant. Nine energy intensive industries have been notified as ‘designated consumers’ under the Energy Conservation Act. the designated consumers will have to reduce their specific energy consumptions to the target level or purchase Energy Saving Certificates (ESC) from others who have improved on their targets. Ms. 2001. The goal setting. This will be an interesting and relevant extension to the electricity trading schemes already operational at the commodity exchanges including the possibility of trading electricity with embedded emission reductions. Achieve and Trade (PAT) Scheme under the National Mission on Enhanced Energy Efficiency. Given the expectation of 25 GW (gigawatt) of renewable energy capacity targeted by 2012. These are thermal power stations. 52 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . The REC trading is expected to be on the same platform as the electricity trading. Prashant Vikram Singh are both Executive Directors – PricewaterhouseCoopers Pvt. chlor-alkali. Over the next three-four years. The Bureau of Energy Efficiency (BEE) has established the Perform. Let us assume that the potential gains for industry energy efficiency are 50 TWh/yr and assuming that two-thirds of this expected energy efficiency gains are covered under the PAT scheme. textile and pulp & paper firms having energy consumption over certain thresholds. However. including trading of derivatives of these commodities. the energy commodities markets in India can grow considerably with the inclusion of carbon. Looking ahead The conclusion we can draw is that there is significant trading potential for traditional energy and clean energy in the Indian commodity market. aluminium. involving the setting up of specific energy consumption benchmarks. while those that do not have access to renewable energy resources will be hard pressed to meet their RPO. the underlying physical ESC market is expected to be 33 TWh/yr or US$ 3 billion/yr. iron & steel. Bharti Gupta Ramola and Mr. The ESCs may be made fungible with the RECs. Views expressed by the authors are personal and not of PricewaterhouseCoopers Pvt. If a global carbon agreement that relies on market mechanisms comes into being at Copenhagen summit. this creates an underlying physical renewable energy market equivalent of 50 TWh/yr or US$4 billion/yr. thus expanding the depth of the market. it will be important to sort out jurisdictional and market participation issues even as we consider market mechanisms for achieving strategic clean energy objectives in India so that the commodity markets can perform the role of risk mitigation in this important sector of the economy. fertilizers. is in progress. Ltd. cement. Ltd.little incentive to promote renewable energy generation beyond their RPO.
Iron Age. Ever since we arrived. gold. presenting both challenges and opportunities in their wakes. and yet again with the advancement in electronic transfer of credits called dematerialisation. Introduction to Commodity Derivatives Markets vehicles for accumulation of significant wealth for individuals. trade was revolutionised by the introduction of money. mine metals. Civilisations rise and fall.3. | 53 1. While it is true that commodities have dictated the economic passions of sovereign and nonsovereign nations. Commodities derivatives markets are deep and broad. with metals and energy playing a crucial role in the growth and development of the industrial sector of the Indian economy and agricultural products. (b) enable wider participation by different segments of the economy. “how do we give or take delivery of commodities?”.Commodities Derivative hedging: Portfolio and Effectiveness By Mr. Chiragra Chakrabarty “Commodities have been the bedrock of civilization. Rockefeller created the first true corporate. and economies prosper based on their ability to harness energy. and (d) make India a potential “price setter” for many commodities.. the founding father of Saudi Arabia. as we know them today. commodities trading has come a long way. Mayer Rothschild singlehandedly built the banking empire by providing vault facilities for storing bullion during World War II. With a growing population of over one billion (2001 census).2. institutional development of commodity markets will: (a) create a “near-perfect” market situation. Among the stars in the galaxy. has determined the fate and wealth of nations for eons and would continue to do so in future…” 1. John D. Interesting to note: the progress of mankind has been marked through the ages with different commodities – Stone Age. and so on. Andrew Carnegie conglomerated the steel industry in the United States to form US Steel. Jim Rogers. we are still perplexed by questions such as: “what should we trade in?”. created one of the most influential nations on energy products. These asymptomatic behaviours of intermediaries and investors have given naissance to the major commodity markets. “when is the ideal time to enter and exit the market”. by exploring crude oil. the Tatas and Laxmi Mittal have all become legends because they had the foresight to invest in commodities. and cultivate agricultural produce. Man has undertaken treacherous expeditions and fought battles to discover and conquer commodities. our existence has been defined by a quest for control over geological resources – call it oil. India would remain one of the largest markets for traders in global commodities. copper or even exotics like uranium. 1. Abdel-Aziz-Al-Saud. It has been the experience of participants that they have been besieged by the vastness of the market and the types of underlying assets available. “how much do we buy or sell?”. Some of the most enduring fortunes have been built with commodities. The mode of exchange of the value of commodities has also seen a transformation over the ages — from the rudimentary barter system. called commodities. Kumar Dasgupta and Dr. The enigma. 1. Despite millennia of commerce in commodities. Standard Oil Co.1. Bronze Age. At this juncture. and now Nuclear Age. they have also acted as the EXPERTS’ VIEWS . (c) create a global hub for trading in commodities due to its strategic geographical location. From the mandis in Asia and Africa to the sophisticated electronic platforms in the Western world. the Ambanis.
22 36.945 77.1: Turnover of the Indian Commodity Derivative Exchanges Year 2002-03 2003-04 2004-05 2005-06 2006-07 2007 -08 2008-09 (Nov.706 55.2% of GDP in 1999. Mumbai (www.nmce. has estimated that the contribution of commodity derivatives exchanges would be as high as 10% of Gross Domestic Product (GDP) by the year 2007 compared with a nominal of 1. The volumes in terms of USD or INR are not considered within the scope of this study. Indian Markets vs. overtaking longestablished and mature institutions such as the Tokyo Commodity Exchange and New York Board of Trade.869.271. Billion) 665.397 Source: Industry Analysis 1 2 3 Multi Commodity Exchange of India Limited.086 25. 2. (erstwhile New York Board of Trade) Tokyo Commodity Exchange (TOCOM) Country USA China China China USA Belgium.233.30 1. Further. And interestingly.149 83. International Markets – Where We Stand Rs.736 78.mcxindia.551.2. The figures include the volumes in terms of contracts traded in the first half of 2009.com) 54 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . Ahmedabad (www.1.59 21. While section 2 draws a comparison of Indian markets with international markets. Table 1.350 billion in 2001-02 to 2. Indian market participants have had the experience of trading in commodity derivatives for ages. While in 2001-02 futures trading was allowed only in eight commodities. The growth charted by the Indian commodity exchanges can be summarised in Table 1.1.162. nine of the world’s top 22 major commodity derivatives exchanges are in developing countries. in 2002. The question which was.3.com) National Multi Commodity Ex change of India Limited.1.293.769. 2008) Source: MCX. one of these exchanges (MCX) features in the world’s top 10. the use of commodity derivatives in portfolio management is explained in section 3.472 93. the Indian commodity market took a quantum jump. there were reports of parallel markets in commodity derivatives. The Group on Forward and Futures Markets.127 151. The paper has been divided into five sections.33. Europe Multi Commodity Exchange of India (MCX) London Metal Exchange (LME) ICE Futures U. Even during the long period of ban.162. If we look at our history. both in terms of commodities allowed for futures trading and volumes of the trade. Section 4 depicts the methodology and issues related to the measurement of hedge effectiveness.659.2. Table 1.ncdex.544. just after the ban was lifted and the Government approved the launch of national-level trading platforms.4.643. NCDEX2 and NMCE3).07 2.64 5.27 40.010. Industry observers were left wondering as to how India could pull off a coup d’état in such a short time.07 billion in 2008-09. S.2: Turnover of Global Commodity Derivatives Exchanges Rank 1 2 3 4 5 6 7 8 9 10 Exchange New York Mercantile Exchange (NYMEX) Dalian Commodity Exchange (DCE) Shanghai & Hong Kong Futures Exchange (SHFE) Zhengzhou Commodity Exchange (ZCE) Chicago Board of Trade (CBoT) ICE Futures. India UK USA Japan Turnover (number of contracts traded) 206. and perhaps still lingers (even after five years of operation) is: Is such a progress sustainable and what are the obstacles that need attention if the market has to realise its full potential? 2. It is interesting to note that.742. three of them are based in India (MCX1. Let us consider some statistics. A figurative assessment is given in Table 1.213. NMCE & NBOT Turnover (in Rs. NCDEX.717. Section 5 is devoted to conclusion.89 33.185. the count jumped to 109 in 2008-09.205 170.245 14. Mumbai (www.com) National Commodity and Derivatives Exchange Limited.372. The value of trading in Rupee-denominated terms saw a quantum jump from about Rs. Compared by volumes (the number of contracts traded). 2001. Since 2002 there has been a revival of commodity derivatives markets in India.
2. The government's approval to the amendment of Forward Contracts (Regulation) Act. A snapshot of the global volumes of futures and options contracts traded across the asset classes will ingrain an impression of what we are looking at. some of which have ratios in excess of 200%.3: Comparison of MCX Comdex with major global commodities indices Indices RJCRB DJAIG Comdex Source: Industry Analysis Table 1. 2. India is still in the fifth position. EXPERTS’ VIEWS | 55 . The derivatives segment of the historically more mature Indian equity markets ranks seventh (S&P CNX Nifty Futures) and tenth (S&P CNX Nifty Options). it must be hailed as one of the most pragmatic pieces of economic legislation. we have recalibrated the base period of all the indices to 100 from June 2005. For a comparative analysis of MCX Comdex with the other global indices. we find that there is a need for elevating the products base of the exchanges in India. through an ordinance. Table 1.7.83 580. Levels are calculated as in January 2009. 2.7972 128. There is a need for strengthening the regulatory framework of the market. Singapore.4. we find that India ranks quite high among all countries. the existing national-level exchanges support a strong and advanced technology-driven platform. The ratio of India’s market capitalisation to GDP touched a historical high of 165% in early 2008. Table 1. are among the top 10 in terms of volumes generated.40 577.5218 Note: Prices of commodities and indices are taken from January 2006 to June 2009.70 Levels in June 2005 100 100 100 Levels in January 2009 128. While this is a substantially sharp rise. If the move is symptomatic of the government's softening stance towards commodity exchanges and commodity futures.6% and Reuters/Jefferies Commodity Research Bureau (RJCRB) at 36%.860. Clocking an impressive growth within five years.6.50 17.7134 102. The Indian commodity derivatives exchanges.62 5.4 shows the sectoral break-up of volumes in terms of million contracts traded and/or cleared on 69 exchanges worldwide for the year ended March 2008.204. In a comparison of the Indian commodity derivatives market with the international markets.652. In the new economy paradigm. 2. Even if we undertake a comparison of the share of equity market investors’ wealth in GDP with that of the commodity futures markets.84 888.3. respectively. Switzerland and Taiwan.16 180. behind Hong Kong.75 billion in 2008-09 (excluding assets under management of fund management houses). 2.79 45. with the participation of banks. The value of investors’ wealth in Rupee-denominated spot market turnover terms is approximately Rs.488. make them more mature and spur wider participation in derivatives trading on the domestic commodity exchanges. The move will certainly deepen commodity markets. banks are engaging in warehouse receipt financing and collateral management. In retrospect.5.8. Now. MCX Comdex fell by 24% during 2008 — somewhat lower compared with the decline in international commodity futures indices of Dow Jones AIG Commodity Index Cash Index (DJAIG) at 36. Limited commodities are limiting industry participation. this transformation has expanded the breadth and intensity of potential impacts that a commodity derivatives exchange can make on underlying commodity sectors as well as the economy.19 3.511. on the other hand.30. paves the way for introduction of long-awaited ‘options’ trading in commodity derivatives.4: Global Sector-wise Futures & Options Volume Sector Sector Equity Index Individual Equity Interest Rates Agriculture Energy Foreign Currency Precious Metals Non – Precious Metals Other TOTAL Contracts Traded in Millions 6. tabulated in Table 1. Moreover. in terms of turnover ratio when compared to the top 20 derivatives exchanges globally. this industry is bound to flourish.37 175.
It was observed that the improvement is more pronounced for the 1970s than the 1980s due to the high inflation of the 1970s with commodities acting as a natural inflation hedge.08 Inflation 1. on examining the correlations of oil-based futures contracts with energy-related and non-energy-related stock.6. we present our case by demonstrating that during a same period analysis. A few studies have been cited.5. many traditional forms of indirect energy investments such as natural resource mutual funds and energy-based common stocks are not correlated with energy price movements. But the principal thought lingers: why should the investor think about diversifying the portfolio through investments in commodity-linked instruments? The answer lies in the fact that direct or indirect investments in the commodities market actually increase the Sharpe ratio of the portfolio and significantly reduce the annualized volatility. This is as expected.01 MCX Comdex 1. 3. except in periods of extreme energy price movement. Academicians have identified business cycle component in the variation of spot and futures prices of industrial metals. 1983. The theory of storage splits the difference between the futures price and the spot price into the forgone interest from purchasing and storing the commodity. commodity-linked assets have increased the number of available commodity-based products. bond. MCX Comdex and Inflation BSE Sensex 1. and across the continents.000 (-)0. results confirm that. Futures prices were also found to have little value in predicting inflation. as well as the potential to capture a positive ‘roll return’. It was also confirmed that in addition to energybased “passive” long-only commodity indices offering returns not available in traditional equity investments. In recent times.1. 3. The studies have spanned across years of high inflation such as 1978. 3. 3.210 (-)0. We have compared MCX Comdex with the BSE Sensitive Index and inflation respectively for a period spanning June 2005 to January 2009. direct commodity investment has not been a major part of the investors’ pool. real estate and commodity markets. unless the price change in the underlying commodity is structural and long lasting. Furthermore. short-term changes in commodity prices may have little impact on a firm's equity performance. W h y Yo u r Po r t f o l i o S h o u l d I n c l u d e Commodities Derivatives 3.2. This contradicts the popular belief that commodity derivatives put inflationary pressures on the economy.5: Comparative Analysis of BSE Sensex. Commodities indices have shown a greater independence from inflation. The question of whether commodities represent a separate asset class has been extensively debated.000 BSE Sensex MCX Comdex Inflation Source: Industry Analysis 56 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . “active” long/short energy traders offer returns (positive returns in markets with declining energy prices) not available in longonly commodity indices or traditional commodity-based equity investments. Given the risk management and firm diversification abilities of most corporations. The diversification benefits of commodities have been studied in length and breadth. 1998 and 2000. convenience yields increase for a wide variety of metals prices. equities show a n e g at i ve co r re l at i o n w i t h i n f l at i o n .3. Studies have found that the inclusion of portfolios of long commodity futures contracts (CRB and GSCI) improves the risk and return performance of stock and bond portfolios for the period 1970 through 1990. Empirical studies have shown that investment in commodities results in significant diversification benefits. storage costs and the convenience yield on the inventory.5 Table 1.3. These benefits are traced to the unique exposure of commodity investment to macroeconomic variables. and CPI. the findings of which are tabulated in Table 1. however.000 0. Tests were performed on the theory of storage and present empirical evidence that in periods of increasing volatility and risk. In continuation with the evidences presented.4. The principal argument for investing in commodities is that investing in assets that rise in price with inflation provides a natural hedge against losses in equity and debt holdings that typically lose value during periods of unexpected inflation. 3. In our country.
4. in a given period. a fund manager investing in equities may give higher returns. These standardise the accounting treatment for derivative instruments by requiring all entities to report derivatives as assets and liabilities on the balance sheet at their fair value. the variability-reduction method. grading and technology infrastructure. the impression of the company management may have its effects on the financial statements during the same period. If a derivative qualifies for hedge accounting and the hedge is deemed to be “highly effective”. 4. and expand access to cheaper sources of finance.4. Normally there are three common methodologies for testing and analysing hedge effectiveness — the dollar-offset method. they are a perfect contender for reducing downside risks.3. the standard permits entities to match the timing of the gains and losses on the hedged item and with the gains and losses on the derivative positions in their profit or loss account. in other words. and document by statistical or other means the basis for expecting the hedge to be highly effective in offsetting the designated risk exposure.3. valuations. 4. To qualify a derivative position for hedge accounting. Commodity derivative exchanges can yield other critical impacts: b ro a d e n a cce s s to m a r k e t s .8. and it must be done to justify continuing hedge accounting. The return from the equity is subject to company policies. the accounting captures the economics of the hedge whereby an entity has mitigated its exposure to commodity price risks through commodity derivative instruments. As commodities have the ability to react favourably to economic downturns or macroeconomic conditions unfavourable to equities. e m p owe r participants to take better decisions. reduce information asymmetries that have previously advantaged more powerful market actors. industry-wide conditions and management styles. upgrade procurement. 3. Perhaps the major advantage of diversifying an equity portfolio using commodities is the mitigation of management risk. The above methods to an extent have also been enshrined in the new accounting norms dealing with such types of instruments. investing in commodities automatically mitigates the abovementioned risks. Adding commodities to an equity portfolio can minimise the damage during economic crises or downturns. risk seeps in from the style incorporated by the fund manager. these exchanges enable entities to create a hedge against their exposures to the vagaries of commodity price movements.9. How Effective is “Highly Effective” – An Accounting Perspective 4. A fair value hedge offsets the price risk of a recognised asset or liability or an unrecognised firm commitment. These are systemic risks associated with the equity market. a cash flow hedge model and a net investment hedge model — with the first two being most commonly used. the hedging entity must specify the hedged item. The ability to protect the value of investment in chaotic markets is the key to any diversification. however. A cash flow hedge offsets the variability of the cash flows of a balance sheet item or a forecasted transaction. In a nutshell. The hedger must also regularly perform retrospective testing to determine how effective the hedging relationship has actually been. The new accounting norms for derivative instruments and hedging activities were issued because the effects of the increasing quantity and variety of derivatives used by companies were not always transparent in their financial statements. This documentation step is called prospective testing. and the regression method. The macroeconomic variables determine the prices and the behaviour of commodities. a hedge is highly effective if the changes in the fair value or the cash flow of the hedged item and the hedging derivative offset each other. In principle. In any portfolio management. However. Last but not the least. it is also emphasised that price risk management may not always be the most important benefit. However. 3.2. the new accounting norms also recognise hedges that are put in place by entities and try to reflect the economics of such hedges in the financial statements. identify the hedging strategy and the derivative. Even though. the prices are dependent purely on demand and supply conditions. EXPERTS’ VIEWS | 57 . 3. But the moot question is: how effective is the hedge created by commodity derivatives? The next section tries to answer this question. In the commodity market. storage.10.7.1. 4. Or. It basically allows for three accounting models for hedges — a fair value hedge model.
4. then there is some range of decline in values of the hedge that can be defined as substantially offsetting this change. the ratio of the cumulative sum of the periodic changes in the value of the derivative and the cumulative sum of the periodic changes in the value of the hedged item will equal one in a perfect hedge (after multiplying the ratio by negative one to adjust for the two sums having opposite signs in a hedging relationship).110.25.000–110. The dollar-offset method can be applied either period by period or cumulatively. Anyone choosing this test should be aware that researchers question its reliability because of its excessive sensitivity to small changes in the value of the hedged item or the derivative.0. the change in value of the derivative were (–)USD.5. the slope of this regression equation should be negative and close to (–)1. 58 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . 4. Therefore. The variability-reduction method compares the variability of the fair value or the cash flows of the hedged (combined) position to the variability of the fair value or the cash flows of the hedged item alone.e. Highly effective hedge substantially offsets the change in the fair value (or the cash flow) of the hedged item.11. The interpretation of the intercept term is also important. the accounting literature explicitly allows for a hedge ratio that differs from 1. if the hedged item in a fair value hedge appreciates by $100.7.000.80.000) = (–)USD. This idea of offsetting has found its way into the hedge effectiveness testing literature in the form of the dollar-offset method of testing.10. This method places greater weight on larger deviations than on smaller ones by using the squared changes in value to measure ineffectiveness. The dollar-offset method compares the changes in the fair value or the cash flow of the hedged item and the derivative. Given the definitions of X and Y. Canabarro (1999) showed that under reasonable assumptions about the distribution of changes in prices. 4.12. the change in the value of the derivative exactly offsets the change in the value of the hedged item. by which the change in value of the hedged item differs from the change in value of the derivative.10.6. Defining and testing a measure of hedge effectiveness represents an important and potentially challenging aspect of hedge accounting. That is. Failure to meet the challenges hedge accounting presents may introduce substantial volatility into reported earnings.125. for the hedge to be considered effective it should lie between -0. the 80/125 standard rejects as ineffective 36% of all hedges when the coefficient of determination (correlation squared) R2 is 0.00. on an average. for example. 4. Then the acceptable range of the change in value for the derivative will be between (–)USD.9. The difference is that the variabilityreduction method assumes that the riskminimising derivative position is equal and opposite to the hedged item in a one-to-one hedge.000. 4. because this change in value falls within the specified range and hedge accounting would report an effect on income of USD. there could be an impact on current earnings when there is not an exact offset of the hedged risk.0.4.8. 4. If. For a perfect hedge.00. The preferred test statistic for this method is the proportion of the hedged item’s mean-squared deviation from zero that the hedge eliminates.8 and -1. If a one-to-one hedge performs perfectly. The other two methods of assessing hedge effectiveness i. Defining this range is a matter of subjective judgment. the change in the value of the derivative exactly offsets the change in the value of the hedged item. To calculate the test statistic.00. It is the amount per (data measurement) period.000.00 and (–)USD. 4. However.000. subtract from one the ratio of the sum of the squared periodic changes in the hedge and the hedged item to the sum of the squared changes in the hedged item. even when a hedge is determined to be highly effective. A highly effective hedge has been defined in literature as one that offsets at least 80% of this change and no more than 125%. However.000. Consequently.98. The measure of hedging effectiveness using regression analysis is based on the regression line in which the change in the value of the hedged item is the dependent variable and the change in the value of the derivative is the independent variable or vice versa. the variability-reduction method and regression analysis are closely related. Ederington (1979) showed that the estimated slope coefficient is the variance-minimising hedge ratio. then the hedge would be highly effective.(+100.
which is essential for the long-term growth of our economy. What is also required is more detailed guidance from a risk management perspective by the Reserve Bank of India on the use of such products. 5. It is only a combined approach that will lead to the establishment of stable and deep markets for commodities in India. Concluding Remarks 5. As the recent global experience has exhibited. it is difficult to argue for other than an expansion of the availability of such products in the arena of exchange-traded instruments.5.2. growth in derivative products without corresponding development in regulation — both from a macroeconomic perspective and a risk management perspective — is neither desirable nor advantageous from the viewpoint of long-term stability. Price Waterhouse. ‘portfolio diversification’ or to provide access to our producers to the most efficient markets in commodities. EXPERTS’ VIEWS | 59 . as the above article demonstrates. Be it for ‘risk management’. Chiragra Chakrabarty is Associate Director. In this arena. The need for commodity derivatives is multifarious in a growing economy like India. ‘investment’. Kumar Dasgupta is Partner and Dr. there has been unprecedented growth in this area over the last few years.1. the new literature on the accounting for such instruments is a welcome addition. Views expressed are personal. Mr. However.
a n a n d r a t h i . We bring customized financial planning to you. fixed income and life and non-life insurance. understand his risks and offer unbiased investment management strategies. The Anand Rathi team. We provide a range of financial solutions divided across distinct client groups instead of product groups.000 professionals and 20% of the group’s equity is currently held by Citigroup Venture Capital. We have grown from a base group of 15 people in 1994 to the current strength of over 4000 people globally and continue to be the firm of choice for the best people from the widest available pools of talent. NMCE. Be it differentiating different kinds of wealth. we analyze the client’s financial profile and goals. Pradeep Gupta in 1994. identify the commodity price risk and suggest optimal solutions in consultation with our dedicated product research team. Corporates and Institutions Anand Rathi works closely with Corporates and Institutions to understand their needs and create investment banking and hedging solutions according to their requirement. The people are the prime reason we consistently deliver strong results year after year. Private Clients Each one of our Relation Managers is dedicated to providing superior financial solutions to affluent individuals including NRIs. views and trade. We have. over the years. These underpin the value the Company delivers to all its clients. investment need and approach. We recently ranked as the “Best Domestic Private Bank” in Asia Money 2009 polls. We fulfill the client’s capital raising needs through equity markets (IPO/FPO/QIB). Our membership with MCX. These include: • • Brokerage in equities. underwriting. DGCX and LME provide the client a strong trading platform. c o m w a s c r e a t e d a s a comprehensive. We operate at over 739 locations through 260 branches and 479 business associates. given your lifestyle and family size. distribution of assets or creation of safety nets for clients as well as their successors. relationship-led. gathered expertise across various investment platforms – equity. we believe in your individuality and your individual financial. 60 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . enabling us to understand the client better and giving us an added advantage. A client-centric focus. Anand Rathi today has a strong domestic presence as well as international reach. NCDEX. We believe private clients need to be treated like corporates. interactive platform for all your financial information. What makes us compelling is that we are unbiased. w w w. Hedging solutions are largely provided to Corporates that would be exposed to commodity risk. private placements and other activities associated with debt and equity products. The other is to marry this expertise to the individual risk profile understanding your financial status and investment needs.ANAND RATHI GROUP PROFILE Anand Rathi is a full service. Our Investment Banking services include solutions in raising debt and equity in the private markets. derivatives and commodities Third-party-product distribution of mutual funds. Our holistic wealth management solutions are focused entirely on the client. an open architecture. Just as in the case of a corporate. life and general insurance Investment banking Wealth management Financial Planning. Anand Rathi and Mr. financial intermediation company with sole focus on providing longterm value to its clients. one of the 11 members of the LME is another added advantage. identifying strategic alliances and M&A opportunities. news. helping us to achieve excellence in each of our business verticals. We provide the insight and the expertise clients require and deliver all the resources of our retail brokerage network. Our exclusive tie-up with Natixis Commodities Markets. as this is known in India was hitherto restricted to large HNI and select corporate houses. amongst the most highly regarded in the nation. mutual fund. We understand the client’s physical business. and acting as strategic advisors. Anand Rathi helps them capitalize on every opportunity. a group of highly motivated and professional people. form the cornerstone of the Company’s philosophy. That’s just one part. • • Individual Clients At Anand Rathi. Our presence in Dubai. t r a d e. third-party-product based platform and quality fundamental research across asset classes. selling only third-party products. We employ close to 4. is our principal asset. Founded by Mr. Anand Rathi’s competitive advantage comes from its network and the strength and breadth of its relationships in the business. Bangkok and New York largely caters to Non Resident Indians (NRIs) and Corporates and Institutions looking to invest in India.
Creation and Spread of Awareness The commodity market itself is a complex area with a plethora of fundamentals influencing or determining its direction and is. The next challenge was to take it to the target clients or users such as hedgers. On the other hand. have. in this short span of six years. However. etc — to these markets. So it was like starting from ground zero! The commodity brokerage industry has come a long way over the last five years. On top of that. there was no reliable historical database — even of basic data or data on fundamentals like production and consumption — to carry research on commodities. An entirely new breed of people capable of handling this commodity space had to be developed and made competent by means of exhaustive training. a massive education drive had to be taken up. The majority of India’s population — as high as 60% — depends on agriculture for its living. It connects all the players of the ecosystem — producers. Broking Firm – A Broader Perspective General perception about a brokerage firm is that it is a facilitator of ‘buy’ and ‘sell’ of commodities. unlike in the developed world where a small number of people produce large quantities of agricultural commodities. setting up an in-house research desk was a daunting task indeed. Priti Gupta A brokerage firm is the key link in the chain of commodity markets. firms. arbitrageurs. they had a challenging task ahead of them mainly because the segment was absolutely new and practically diverse. The first challenge was to acquire the necessary resources or manpower. from the advantage of price movement. played a commendable role in integrating the country’s fragmented commodity markets and improving the overall conditions of the agricultural marketing infrastructure. In the Indian markets. leave alone a novice. as such. However. this would be mere understatement of the true importance of a commodity broking firm. etc. commodity futures markets. And the most critical part. it is necessary that both hedgers and investors in commodities should be aware of the advantages and disadvantages. A brokerage house acts as a key link connecting these markets to all categories of physical market participants.Brokerage Industry: Key Link between Ecosystem Players and Exchanges By Ms. traders. consumers. when commodities brokerage firms were set up with the advent of national-level commodity exchanges. which are currently at a nascent stage since their revival by the government in 2002-03. a very difficult subject for a common man to understand. This makes Indian commodity markets radically different from their counterparts across the world and extremely price-sensitive. This in turn makes the role of the government in power very critical in regulating the prices as well as the entire commodity ecosystem truly complex. But given the kind of role a commodity broker actually plays. traders. but a long road yet needs to be traversed. in India a much larger number of people produce little. Since over more than four decades people in the country had no idea about what commodity futures were all about. The last but not the least. The commodity ecosystem consists of corporations. and traders who do not directly deal in commodities but have information on the fundamentals specific to those commodities and want to get the same converged on an efficient trading platform to get a nominal return. and make the 62 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . the concept of a derivatives market makes the commodity market no less than a maze even to the seasoned trader.
which in turn helps in bring an increased number of various categories of commodity market players on to the exchange platform and. which started a completely automated trading system paving the way for the Indian commodity markets to be globally competitive. As brokers. we were taken aback to see how counterparty risk was discounted by these risk-mitigating practices! Here brokerages play a very important role of identifying the risks involved in the indigenous systems and off market transactions. as they strongly believed that their risks were already well taken care of. For healthy market ecology. Taking Innovation to a New Height! Today. broking firms are equipped with state-of-theart infrastructure and cutting-edge technologies for risk management and trade execution and.trading process on the exchange platform a healthy one. In a short time. Converging the Entire Spectrum on the Exchange The commodity ecosystem consists of two different sects: the one who always intends to ‘sell’ (the producer) and the other who always intends to ‘buy’ (the consumer). Transparency in the operations of a broking house takes it a long way in establishing a strong bond with its clients. Transparency – the Essence of Markets Transparency is the essence of electronic commodity markets and kudos to the initiatives and innovations made by our home-born national-level commodity futures exchanges. commodity futures are generally high-valued contracts and as such put huge amounts of money at stake. thus. and make them see the benefit of trading on the exchange platform where there is a clean and transparent process of risk mitigation. The broking house plays a crucial role in reaching out and facilitating both the ends of the spectrum. Less human intervention means lower transaction cost. A broking firm must ensure that all the trades it executes for its client should be communicated in a transparent manner and its interests be kept open to the client. aided by the exchanges. to define the risks in these preset mechanisms. As most commodity deals/transactions are settled through delivery of the underlying commodity on expiration of a given contract it warrants making traders/investors understand the procedure as well as the risks involved in making or taking a physical delivery. Most commodity broking houses in the years 2004 and 2005 spent a very large chunk of their time. This put the onus on brokerages as well — alongside the exchanges — to perform this crucial task of creating awareness about this market among both the hedger and the investor who look to this market with completely opposite objectives. at a mandi with higher cost of transaction. Trade and industry had survived in India without commodity futures markets for a long time and that forced them to evolve several mechanisms in order to take care of their hedging requirements. In addition to the reach the exchanges and regulators have had. balanced participation of both the parties is essential. efforts and resources on creating awareness among the participants as well as undertaking training for their own staff. From the perspective of the exchange broking houses have brought in the much-needed liquidity and depth to the markets by leveraging their customer reach. This makes transparency in the operations of brokerage houses extremely important for users. and thus slowly move on to this format. Even though awareness development has been considered to be the prime responsibility of commodity futures exchanges and the regulators. capable of minimising human intervention and manual error components. brokerages have remained the connecting link reaching out to both the ends of the commodity chain and thus carrying the benefits from end to end. hence. EXPERTS’ VIEWS | 63 . Apart from mere trading side of it. And this adds another dimension making training and spreading of awareness all the more important.e. integrate them with a much larger market system than where they would have otherwise be trading i. we have seen major global commodity markets realise the importance of the electronic platform — and technology — for enhancing transparency. the supplier itself accepting a periodical average price (for metals) or farmers getting into agreements with buyers at the time of sowing itself. It took a great deal of effort on the part of commodity brokers. such as forward booking of the commodity. These well-entrenched practices and habits were the primary hurdles for any player to move on to the futures markets. broking firms cannot escape their share of this responsibility of knowledge development and sharing among the participants of the commodity ecosystem.
and we converted a lot of manuscripts into software-powered systems by manually punching them in. but this does not in any way lessen the responsibility of brokerage houses of keeping their clients updated on a regular and consistent basis. In fact. 64 | A PUBLICATION BY MCX AND PRICE WATERHOUSECOOPERS . A few data providers have popped up. given the time-consuming verification and documentation needed to be carried out. making a fair estimate of the crop and keeping records of daily spot prices prevalent in various mandis. a lot of hard work goes into research. Unlike in the developed economies. they were utterly amazed to see how flawlessly we were able to manage tedious compliance as well as real-time risk management for such a large numbers of our private and individual clients. Priti Gupta is Executive Director of Anand Rathi Group. This may sound a fairly simple task but it is not. for example. At present. To take the responsibility of ensuring that each of its clients is eligible and authorised to use the exchange platform is a daunting task. This change is welcome. and weather updates have turned more frequent and more accurate. and mandi traders used to get only limited information in the geographical area of their activity. statistics on agricultural commodities was really scarce in India. Ms. which helps in bringing transparency and efficiency in both price discovery and risk management. research in commodities and their fundamentals was an alien subject in India before the advent of commodity futures exchanges. government sites are getting updated regularly. a brokerage plays a vital role in the integration of obligations and requirements of all the parties. the picture is slightly changed. We believe it is the entrepreneurial instinct in Indians that help them carry out sensitive tasks in such innovative ways. To sum it up all. A few broking houses like ours took upon the task of conducting research and take the benefits of information to all the parties in the system and continue to do so now. the participants and the regulator. On various occasions when foreign brokerage houses visited us. Today. Having access to all the stakeholders. A few corporations had their own internal research setups that used to advise their top brass on their exposure to commodities. and government websites were not updated month after month. This was extremely challenging in the commodity space where most of the participants from upcountry or mandis were not merely sceptic but were practically averse to sharing information. there are some broking firms which advise even the government on decisions with regard to imports. We on our own initiated crop surveys. Views expressed are personal. which is an integral part of a full-fledged broking house and a key to bringing the various ecosystem players together on a single platform. a broking house is a key link between the exchanges. There was no proper dissemination of the data that lay with the government. Research and Market Intelligence Last but not the least.Technology-enabled Smooth Compliance The broking fraternity takes on itself the responsibility of compliance on its own behalf as well as on the behalf of its customer.
It will be especially attractive for banks when they offer a combination of multiple derivatives products to satisfy the requirements of their customers. wherein daily settlement of trades/obligations. and use of technology are the key parameters to doing this business. etc. Shailesh Sukhthankar As and when allowed to enter it. Commodity derivatives in India have had a chequered history. the need has been felt for various players in the commodities market ecosystem to be permitted to participate in commodity derivative markets. The clearing bank services are a highly time critical activity as delays directly impact the members/exchange. Settlement is a two-way process that involves legal transfer of the title to funds and securities/other assets on the settlement date. after which the obligations are discharged by settlement. custodians. Multi Commodity Exchange of India. EXPERTS’ VIEWS | 65 . members. the strategically important institution in the overall growth and development of the economy. ability to manage fund flows in volatile days. The advent of national-level multicommodity exchanges viz. etc contribute towards effective functioning of the exchange mechanism. With the gradual withdrawal of the government from various sectors in the post-liberalisation era. Some banks are already carrying out some vital functions such as clearing and funding. earn revenues through float funds. Apart from clearing services. except trading in a few regional commodity exchanges. can play various important roles in this market as well. coordination with exchanges and members. trained manpower. Bank. while regulatory approvals are required for considering other roles such as hedging and serving as an aggregator: • • • • • • • Clearing Bank Services Depository Services Broking Services Professional Clearing Member Structured Finance Aggregator Trading & Investments • • • Hedging credit exposure Information Dissemination Advisory Services Clearing and Settlement Services Clearing is the process of determination of obligations.Commodity Derivatives – An Opportunity for Banks to Diversify Risks By Mr. banks also provide fund and non-fund based facilities to the members of the exchange for managing their working capital requirements and. etc. Dedicated infrastructure. which can help in nurturing and developing the commodity derivative market in India. as outlined below. This article dwells on some of these roles. thus. This is highly transactional nature of the business. interest earned on overdrafts/loans. National Commodity & Derivatives Exchange and National Multi Commodity Exchange provided a much needed impetus to the growth of this market. Until 2002 the market was virtually nonexistent. The banking settlement system plays a crucial role in the overall risk management of the exchange mechanism. commission income. clients. the commodity derivatives business holds enormous potential for banks. Banks can play an important role in settlement of obligations in the overall ecosystem including exchanges.
and helps banks go beyond the normal balance-sheet lending by structuring the cash flows/collateral. This mechanism is accomplished through the National Securities Depository Ltd (NSDL) and Central Depository Services Ltd (CDSL). The existing depository system/processes (subject to appropriate regulatory approvals/modifications) may be utilised providing an impetus to holding and transacting in electronic warehouse receipts. customised MIS. etc. banks can also offer broking services by leveraging their existing customer base. etc. integration with their lending/credit assessment and generation of fee-based income. broking account and depository account of investors. Professional Clearing Member A professional clearing member (PCM) is one who can only clear trades but cannot trade on one’s own account. Banks can benefit from economies of scale. additional float funds. Institutions and corporates prefer clearing the trade through PCMs to avoid being exposed to brokers who may lack adequate capital. professionalism. The Warehousing (Development & Regulatory) Act 2007 also has provisions for issuance of electronic warehouse receipts. As they already play a key role in financial intermediation. Depending upon the regulatory structure/requirement. Large corporates and institutions may trade through various brokers for their execution/advisory capabilities. Banks are ideal to serve as PCM too. for the settlement of trades. Structured Finance Products Structured finance is a very exciting development. among others. as they have necessary attributes such as adequate capital. strict regulatory structure and strong internal controls. Banks can empanel as Depository Participants of NSDL and CDSL and provide this service to the members. and general investors. It involves tailoring of a product according to the requirements of the borrower and the lender. with faster turnaround time. Banks can leverage the exchange infrastructure in integrating the 66 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . This will also throw open another opportunity for banks to lend against electronic warehouse receipts in a seamless and efficient manner. branch network. they may prefer PCMs due to less counterparty risk. which will be of great convenience to customers. They can add value to market participants by designing appropriate lending products. dedicated service. banks can integrate this product into their overall offering of retail products and also technological initiatives such as online banking-broking account — similar to the existing 3-in-1 account in equity markets interlinking the bank account. clients. and so on. However. Broking Services The sheer growth in the commodity futures volumes and interest among the investor community will boost the growth of broking services.EXCHANGE CLEARING BANK CLEARING BANK MEMBER MEMBER INVESTOR INVESTOR Depository Services Commodity exchanges have revolutionised Indian markets by enabling holding of warehouse receipts in electronic form.
The borrower can store his produce in an exchange-accredited warehouse and get a warehouse receipt issued to him from the warehouse. Banks can play a very important part in this context by acting as an aggregator i. enable trades in spot and futures markets. trade structure. The buyer deposits the margin money with the bank. On the due date. Here are two examples of structured finance product that can help the farmer and the end user industry. the bank shall deliver the commodity and receive the funds. wherein the borrower can hedge his price risk and deliver the commodity on the exchange. A bank can perform the function of an entire value chain for its customer by providing the crop finance. Aggregator Since the Indian farming sector is characterised by small and marginal holdings. the borrower can sell the commodity on an exchange using the PCM services of the bank and mark the commodity for delivery. it will provide the upside benefits as well. He then enters into buy contract with the bank acting as a PCM. Thereafter he can take loan from a bank at a competitive interest rate against this warehouse receipt. pooling the individual farmer’s requirements to create the necessary volume and then hedge on the exchange. The conventional warehouse receipt lending can be integrated with the exchange mechanism. Subsequently. With these funds. individually farmers do not have the volume and expertise to hedge on the exchange platform. the bank takes the delivery by making the payin of funds. Once options are allowed. (a) Payout funding: Normally agricultural commodity prices tend to be lower during the season and increase during the offseason. On settlement. This mode of funding is very helpful to a producer/farmer as it provides them with a one-stop solution to storage.traditional lending products with the exchange mechanism and develop products such as financing against warehouse receipts and settle (receipt/payment of funds) through exchanges. funding through collateral management structure. hedge the price risk on the exchange and then EXPERTS’ VIEWS | 67 . liquidity.e. Warehouse receipt lending provides the borrower/owner of the commodity with an opportunity to avail of financing to meet his liquidity requirements and thereby avoid distress sale. The same is then converted to pledge finance by releasing the loan to the borrower. Payout Funding: BORROWER DEPOSIT OF COMMODITY HEDGE THE UNDERLYING COMMODITY PLEDGE THE WAREHOUSE WAREHOUSE RECEIPT BANK LENDING AGAINST WAREHOUSE RECEIPT & ALSO COMMODITY EXCHANGE PCM SERVICES (b) Payin funding: The buyer can also opt for payin funding from the bank. and so on. the bank will close the loan and release the balance funds to the borrower. and hedging of the price risk.
This can greatly facilitate the financial inclusion and general awareness process and empowerment of farmers. Trading and Investments Commodities have become an important asset class in recent times. etc. banks. in India. The concerned bank can ask the borrower to either hedge his position on a commodity exchange or have a process of directly hedging the underlying credit exposure himself. Banks can also mobilise the savings accounts of these customers with their relevant products and services under their financial inclusion agenda. HDFC Bank Ltd. especially agriculture-related products such as crop loan. as per their credit policy. 68 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . Advisory Services Banks are already providing advisory services to their high net-worth customers. Hedging credit Exposure While lending to customers. This initiative provides additional comfort to the banker. banks can provide/assist in overall wealth management of individual customers. land development loan.FARMER FARMER FARMER FARMER Pool individual quantity to get exchange traded lot BANK Hedge on Exchange EXCHANGE This provides a huge opportunity to various sections of the society including farmers. Currently. traders. he has an exposure/associated risk on the underlying commodities. processors. appraise the credit worthiness of the borrower. banks are not allowed to trade in commodity futures. Information Dissemination Information is knowledge. there is enormous potential for banks in the commodity derivatives business. tractor loan and so on. helping in: • • • • Higher amount of facility Longer tenor of the facility Competitive margin Competitive rate of interest. especially when a multiple of above products will be combined to satisfy the requirements of their customers. Views expressed are personal and not of HDFC Bank Ltd. especially as a hedge against inflation. and knowledge is power! A bank’s vast network of branches across the country can act as additional information dissemination centres for spot and futures prices of commodities and other related information. Shailesh Sukhthankar is Senior Vice President & Head – Capital & Commodity Markets. With commodities gaining the prominence as a separate asset class and a natural hedge against inflation. etc to participate in commodity exchanges and hedge their exposure at an optimal cost. In case the borrower is from the commodity sector. Commodity price information in this mode will also likely attract target customers to avail of other banking products. Mr. As and when regulations allow. Once allowed to invest/trade in various commodity derivatives they can contribute significantly towards creating depth in the market.
Later. regional rural banks (RRBs). illiquidity and inability of rural banks to transfer credit risk. this kind of system may be structured on a pilot basis for interbank transfer of risks without compromising on the capital adequacy standards. While the informal sector has the flexibility of structuring its products to meet financing requirements of both the borrower and the lender. etc. Some of the major areas of concern in the cooperative sector are low resource base.1 crore. other agencies such as insurance firms. Cooperative banks accounted for 19% of the total disbursement of Rs. This paper discusses the benefits of development of credit derivatives markets for rural banks and corporates such as diversification of the risk-reward profile. Rural Banking and Credit Derivatives The investment in agriculture to total national Gross Domestic Product (GDP) was in the 1.25. cooperative banks. Initially. portfolio imbalances. It also discusses the conditions necessary for the development of such markets. high dependence on financial agencies. 2. which in turn is dependent on the performance of financial products of the agencies involved. Health of formal financial institutions. absence of structure that can attract new investment risk capital into assumption of credit risks1 . 2008 the total erosion in the value of assets of 127 district central cooperative banks (DCCBs) aggregated to Rs. concentration of credit risks on a few agricultural activities. the formal sector has restrictions despite the fact that the informal sector has to deal with fewer and smaller risks and has a better control on its portfolio of loans and advances compared to the formal sector. non-banking financial corporations (NBFCs). and corporates may be included after due diligence.Agriculture Financing under OTC Products By Mr.9-2. mutual funds. has been a major concern. Gross capital formation in agriculture is a function of investment and financing in agriculture through institutions such as commercial banks. Once the systems are grounded exchange-traded products may also be introduced to induce liquidity and wide-ranging participation. and so on. especially cooperative banks. The share of cooperative banks and RRBs in overall financing has also been decreasing over the years.384 crore in 2007. Narendra Rathore Over-the-counter (OTC) products for agriculture financing may be seen in the light of strong recommendations made in 2008 by the Reserve Bank of India working group on introduction of credit derivatives. and local money lenders. optimal utilization of resources. hedge funds.998. Taking cues from various recommendations made by the International Securities and Derivatives Association (ISDA) and Reserve Bank of India (RBI) draft guidelines on credit derivatives.14. Venkatesh Tagat and Mr. apex development financing institutions (DFIs) can be identified to introduce various risk management systems and infrastructure for using credit derivatives to help rural banks. Purpose of this paper is to pursue with the policymakers to reinitiate the debate on the use of credit derivatives as OTC products to address problems of rural and agricultural banking through credit derivatives at least at the interbank level and while dealing with corporates on a pilot basis. microfinance institutions. As on March 31. . poor business diversification and recoveries.2 percent range between 2003 and 2007.
51 4316. MACH) OWNERSHIP BANKRUPTCY.03.29 1783. RATING DECLINE OF ASSEST OR ISSUER REF.07) 2005 2006 2007 NPA (31. The credit event usually includes bankruptcy. are usually defined as ‘off-balance sheet financial instruments’ that are designed to transfer credit risk from the person exposed to that risk (the protection buyer) to a person willing to take that risk (the protection seller) by means of payment of fees from the protection buyer to the protection seller.06.13 7648. obligation acceleration.44 6704. Area of Concern . It is a protection against risk of financial loss due to counterparty failure to perform its obligation. These are contracts where the protection seller receives premium in quarterly installments throughout the life of the contract or till the credit event occurs. etc. PROTECTION SELLER/CREDIT RISK/ BUYER/GUARANTOR (PERSON WILLING TO TAKE RISK) PREMINIUM/FEES/INTEREST 2. RESTRUCTURING. MERGER. to another party without actually selling the asset.41 16494. which are OTC financial contracts. DELINQUENCY.13 2511.Page 82.34 2471. CROSS DEFAULT. price decline or rating downgrade of the underlying asset or the issuer. failure to pay (principal or interest).42 1310. OBLIGATION (LOAN. are bilateral contracts designed to meet the specific requirement of the counterparties to the contract.G. Total Default Swaps. credit derivatives allow one party to shift credit risk of a reference asset. According to RBI draft guidelines on credit derivatives in India./crore) Year Accumulated losses (31March) and % recovery (30. In return of these premia. Credit Linked Notes. PRICE DECLINE. CROSS ACCELERATION. PLANT. the protection buyer will receive a payment from the protection seller upon the occurrence of a credit event in respect of the reference obligation. generally. which it owns. ADVANCES) LOAN REPAYMENT 1. The value of a credit derivative is derived from the credit quality of an obligation. CASH SETTLEMENT: PAR LESS RECOVERY VALUE FIXED AMOUNT) 1 2 Annual Report of NABARD (2007-08).03 305 276 389 86 87 86 4776 5298 5712 72 69 71 1039 876 946 44 46 44 2466 2725 2870 54 48 52 Loss %Rec Loss %Rec Loss %Rec Loss %Rec SCBs DCCBs SCARDBs PCARDBs Source: NABARD Annual Report (2007-08) Credit derivatives. Most commonly used credit derivatives are Credit Default Swap2.23 21.05 2624. 70 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . from the protection buyer as compensation for assuming the credit risk of a specialized reference obligation. COUNTER PARTY (LOAN BENEFICIARY) CREDIT DERIVATIVES LOAN CREDIT RISK NO 3. ‘credit event’ is defined as the scenario or the condition agreed between the contracting parties that will trigger the credit event payment from the protection seller to the protection buyer. Thus. REPUDIATION. merger. FAILURE TO PAY. OWNERSHIP UNDERLYING ASSET(S) (LAND. PROTECTION BUYER/ CREDIT RISK SELLER (PERSON EXPOSED TO RISK E. INSOLVENCY.25 17. That is. cross default.Accumulated losses and recovery (Rs. The credit risk is transferred between market participants without the underlying assets changing hands.88 4315. moratorium or restructuring.51 1122. BANK) OR CREDIT RISK YES CREDIT EVENT PAYMENTS (PHYSICAL DELIVERY.00 6375.46 5643. repudiation. it “unbundles” credit risk from the credit instruments and trades it separately. Credit derivatives.07) Sub-standard Doubtful Loss assets Total 2957. insolvency.
landowners and local adatiyaas (kachha adatiyas) provide short-term credit and protection to farmers against their contingent financial requirements in exchange of collateral or higher premium (interest) in cash or kind. DBOD.103/2002-03 dated 26 March 2003. and constitution of Committee for Regulatory Framework for Derivative Trading in India (chaired by Dr LC Gupta) and RBI Draft Guidelines for Introduction of Credit Derivatives in India6 in March 2003. Although there is no comprehensive risk management tool deployed for effective management of credit risks.04. besides providing flexibility to hierarchy of borrowers and lenders. RBI circular No. Notification No. In the process kachha adatiyas seek protection from pacca adatiyas against risk of default from farmers/peasants in exchange of part of the premium received from the farmers.Use f credit derivatives as OTC products has gained support especially after the release of second consultative document on New Basel3 Capital Accord in January 2001.BC.rbi. The credit default of the farmers is settled either through physical delivery of reference assets or in cash (see the adjoining figure). BP.04.in/rdocs/PublicationReport/Pdfs/35293. Its new accord has provide more risksensitive standardized approach on capital adequacy of banks so as to ensure soundness of banks in globally networked financial system.103/2001 dated 20 September 2001. http://rbidocs. FEMA 25/RB-2000 dated 3 May 2000 RBI circular No. RBI guidelines on Credit Risk Management 4 . PHYSICAL DELIVERY / CASH SETTLEMENT AGRI/RURAL ACTIVITIES FINANCING UNDER INFORMAL SECTOR FARMER REFERENCE ASSET (LAND. the system works fairly well in rural areas. measurement. and control of credit risk exposures with proper documentation and registration of such transaction. A working group on credit derivatives7 was also constituted by the RBI in 2008 which recommended introduction of credit derivatives in the country.26/21. Foreign Exchange (Derivative Contracts) Regulations Act 20005. Given that more than 70% of banks’ assets are loans and advances and credit risk has a major impact on banks’ financial performance.pdf EXPERTS’ VIEWS | 71 .BP.1057/21. it is important to take a look at certain financial OTC products that have performed well in the informal sector. These kachha adatiyas take long-term loan pacca adatiyas (bigger adatiyas) at a lower rate of interest for lending to farmers. ANIMALS ETC) DEFAULT EVENT LOAN FOR AGRI-RURAL ACTIVITY HIGH PREMINUM/ COLLATERAL PROTECTION BUYERKACHCHA ADDATIYA DELIVERABLE OBLIGATION/ REFERENCE ASSET PRE AGREED AMOUNT OR PAR VALUE OF ASSET AT START DATE PROTECTION SELLERPUCCA ADDATIYA INFORMAL CREDIT DERIVATIVES SYSTEM 3 4 5 6 7 Basel Committee on Banking Supervision sets global standards and benchmarks on regulatory and supervisory practices.org. albeit under different forms and names and even without much documentation and other formalities. In rural areas. monitoring. Formal systems when introduced will definitely require comprehensive risk management systems through identification.
credit derivatives have the potential to succeed where the traditional methods of adjusting exposure (e. Commercial banks can provide protection to sponsored RRBs through these derivative instruments while isolating credit risk from other risks (interest rate/currency risks / regulatory / political / business / sovereign) and from the asset itself. return requirement. In doing so it can fully utilise the available credit capital and even increase the return on capital over the full term of credit lines by suitably pricing forward default swap. banks that are falling short of their lending targets for the priority sector can be allowed to assume sector-specific credit risks of other banks that have exceeded their targets. otherwise. Returns from customisation: Institutions can use credit-derivative structures for developing a system for transferring credit risks with customised risk-reward profiles. etc. non-availability of required currency. These banks can manage their concentration-risk by optimally diversifying within their credit portfolio by reducing overexposed risks while increasing exposure to the industrial/agricultural segments where it is sub-optimal. This concentration increases their credit risk and reduces return on capital with in a restricted risk-return framework. In the process commercial banks will themselves be able to diversify their credit portfolio and ensure a regular flow of revenue in the form of premium paid by RRBs that are currently seen as a burden rather than a source of revenue and liquidity. Capital optimisation: Banks can minimise their forward gaps in utilisation of credit lines by selling or buying credit protection. Credit derivatives provide hierarchy of rural banks with an opportunity not just to manage their own credit risk but also to expand their business as discussed below. The ability to churn assets can possibly bring higher return on capital. expensive or difficult in view of regulatory/legal constraints or higher transaction cost. they have to forgo otherwise lucrative oppor tunities. therefore. political pressures. and hedge funds may be included. It is felt that risk premium in the form of interest charged by banks. the ability of banks to customise credit risks on a spatial and temporal framework through credit derivative instruments provide them access to investments that would otherwise be difficult to secure. Banks can also seize trading opportunity by structuring their risk-reward profile. mutual funds. 72 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . Hedge credit risk: Banks are often concerned with the credit quality of an individual loan or a group of loans and want to hedge the credit risk. and horticulture. In the process they will release their capital that is otherwise blocked in assets which they have to maintain till maturity. prohibitive. animals. Margins of banks are also at risk with loss of value of traditional collaterals (e. having securities with maturity different from that of the bank’s credit lines. and inability to originate assets from non-traditional markets. Using credit derivatives. is inadequate to cover the credit risk.g. Under this system there is no need for rural banks to assume credit risk and sell/hold assets to be able to hedge their credit risks. etc. which. This can be done by selling protection on an underexposed geographical/industrial segment and purchasing protection on the segment to which the bank is overexposed. Current exposure norms restrict banks from concentrating certain credit risks in their books and. high switchover costs. adopting different credit exposures and defining credit events that trigger default payouts. especially on priority sector loans. Initially.). Credit derivatives enable a rural bank to transfer the credit risk associated with a loan to another party through a bilateral and confidential contract without selling the asset and without the knowledge/consent of the borrower. lack of liquidity. this kind of system may be structured for interbank transfer of risks on a pilot basis and later other agencies such as insurance firms. Synthetic means of credit exposure can enhance portfolio returns. A bank can match its willingness to acquire a credit exposure to a particular issuer. by investing in a structured credit derivative where default risks of the two are linked. With the help of credit derivatives their risk profile can be changed without the need to either purchase new assets or dispose of existing assets. Benefits to Banks Diversification of business opportunities: Rural banks tend to have geographic or sectoral concentration of their credit portfolio because of lack of expertise and knowledge of new credit markets. O ff-balance -sheet nature of transactions can help banks avail of such opportunities and maintain client relationships. Besides. Thus. sticky client relationships.Indian banks are increasingly becoming vulnerable to credit risk. thereby diversifying portfolio risk and optimising capital of both types of banks. are not directly available. regulatory restriction. industrial/sectoral biasness of the management.g. especially if that involves long-term financing such as forestry. participation in the secondary loan market) cannot provide an equivalent protection as they suffer from problems of high transaction costs. land.
insurers. but with low risk appetite. Opportunities for new business: Corporate investors can not only arbitrage the pricing of credit risks in and between separate market sectors but also participate in the loan market which till date eluded them because of the absence of required loan administrative infrastructure. and ensuring best practices. This may be done for domestic reference assets with minimal exposure to foreign exchange risks. Also. default of major suppliers or customers. corporates that have business exposure in the rural economy can benefit from the use of credit derivatives for managing financial and project risks. Although it is important to aim at increasing participation of various sectors of the economy such as banks. and corporate in the credit derivatives market they may be permitted in a cautious. hedge funds. debtors. The high level of certainty provided under the system can help companies plan their future business expansion besides deciding pricing with pre-defined contribution margins. Under these systems banks are not permitted to assume risks of other banks and write guarantees in favour of other banks even to manage their own risk portfolio. can purchase an asset and then transfer the credit risk of that asset using a credit derivative to another institution that has high funding cost but higher risk-taking capacity. purchase of credit-risk protection will free up capital that can be used in core business activities. Later. If required banks may hedge their associated interest rate and currency risk on the exchange trading platforms. and reputation. for increasing their range of business counterparties and for covering default by major suppliers and purchasers in the following manner. may be allowed to assume one-way credit risks of cooperative banks and RRBs. commercial banks. In the process the institution selling the protection need not make an outright investment in the asset to be able to gain from credit arbitrage opportunities and there is also no need to incur cost of building and maintaining relationship with reference to that asset. The RBI working group for introduction of credit derivatives has observed that credit derivatives are not fundamentally different from convention credit risk management tools such as guarantees. Corporates with surplus funds can use credit derivatives to invest in Credit Default Swaps and provide credit protection and earn premium on diversified portfolio on credit exposures. Once the market matures other agencies may also be permitted in two-way transfer and management of risks.Accessing credit exposure without funding or relationship costs: RRBs have to invest a lot of time and resources in maintaining relationship with regard to advance agricultural loans. mutual funds. However. the protection buyer will pay a lower premium for the protection than the return that he earns on the purchased asset. Similarly. foreign exchange. the group has laid down policies and procedures for credit risk valuation and control such as development of adequate systems. conventional systems such as insurance. and unfunded sub-participation as credit default events are protected by the ‘protection seller’ under credit derivatives instead of the ‘guarantors’ who stand guarantee under conventional systems. good RRBs and state cooperative banks may enter the scenario. price. Initially. guarantees. legal (compliance). business losses. On the other hand. step-by-step manner. Cost-efficient protection for business operations: Credit exposures related to day-to-day operations of any company in terms of receivables. Credit derivative protection can possibly be used for determining new credit lines or freeing up the existing lines for exploring new business opportunities without having the need for maintaining rigorous client relationships. Therefore. capturing of credit risk acquired through credit derivatives within banks’ normal credit monitoring regime. sovereign credit risks incurred in cross-border investments can be hedged by payment of premium for protection against default and rating downgrade on the sovereign’s outstanding debt. These instruments can help them diversify their portfolio and seek protection from banks at a lower cost than the current economic cost of maintaining the exposure through provisioning. under the supervision of apex DFIs. letter of credit. Funding arbitrage/warehousing risk: A corporate with low funding cost and available capital. necessitate use of credit derivatives as a cost-effective protection against risks. development of an appropriate mathematical model to incorporate fair economic value of assets and liabilities. EXPERTS’ VIEWS | 73 . Companies can even choose a short-term protection for continuously adjusting their exposures vis-à-vis changes in the risks involved. Protection against political and sovereign risks: Companies willing to make investments in politically volatile states can isolate the political risk from other risks of planned investments and consider appropriate protection. and securitisation are less liquid and involve increased intermediation and transaction costs. The RBI working group has however come up with a caveat that an unbridled approach may expose banks to other associated risks related to liquidity. Synthetic lending swap provides them with an opportunity to participate in the bank markets without having created an infrastructure of a bank. Benefits to Corporates Besides banks. approval of policy by the board of directors. etc. advance contract payments.
insolvency laws. Venkatesh Tagat is Chief General Manger. standardisation of back office operations and movement of funds. Development of credit risk models: Most credit risk management models. access to information. tax laws. accounting standards. presume availability of default data and adequate expertise. etc. state specific registration and stamp duties requirements. lack of standardised pricing practices etc. explicit. Efficient regulatory environment: Organisations transferring/covering the risk must gain confidence in the market with respect to its ability to enable them to hedge trade risks with an efficient regulatory environment. lack of term yield curve and proper identification of mismatches on account of poor asset liability management systems. have also been discussed in detail by the RBI working group on credit derivatives9. Bangalore. Trained human resources are required to give regulatory treatment of credit derivatives vis-à-vis materiality of the expected outcome and expectations of clients. Views expressed by the authors are personal and not of the institutions. National Bank for Agriculture & Rural Development. rating and surveillance system. credit administration and monitoring system. Securities Contracts (Regulation) Act. capital adequacy. amendments and restructuring of obligations etc. Any confusion on the provisions of various regulations and their applications on the credit derivatives market must be addressed in the beginning itself. infrastructure.pdf Mr. representation in case of default. development of relationships. It must address the issues of training and skill upgrades. online trading. advice. distress.in/rdocs/PublicationReport/Pdfs/35293.rbi. BIS interventions etc. etc. Complex models to suite Indian conditions need to be developed for enabling an integrated risk management system and encompassing associated uncertainties in the credit derivatives market. the Indian financial markets are marred by difficulty in estimation of default probabilities. Issues related to exposure norms. 74 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . Bangalore. ISDA Master Agreement. Other conditions necessary for the development of a robust credit derivatives market are: Synergy of laws: Development of the credit derivatives market requires synergistic assimilation of governing laws and regulations such as RBI guidelines relating to FEMA. Issues related to confidentiality. irrevocable and unconditional8 . regulation relating to forex derivatives contracts. It must ensure that due care with the consent of the top management of the bank is taken and it is ensured that transactions are direct. should to be adequately addressed by the regulator. and Mr. However. dispute. 8 9 Recommendation of the RBI Working Group on Credit Derivatives http://rbidocs. Securities Exchange Board of India regulations and provisions for derivative trading.Identified DFIs will be required to standardise documents and registration system for use of credit derivatives by rural financial institutions. An apex financial institution will be better placed to train the required human resources with requisite skills sets.org. Transfer of Property Act. credit-risk models and techniques. created in the developed financial markets. Narendra Rathore is a freelance consultant. Development of internal systems and procedures with trained human resources: Derivatives business requires strong internal systems and procedures in conformation with international standards.
• • • • • A stream of innovations in products. banks. the government. collateral managers. Commodity exchanges should utilise the new wave of technology innovations to create a differentiator for themselves. EXPERTS’ VIEWS | 75 . In this discussion note our emphasis would be on elaborating on the concept of futuristic technologically utilization to have an integrated platform for a commodity exchange which will be more customer-centric. This is because when the portal was down there was no business. Rachna Nath Technology is and will remain pivotal for any commodity exchange in the near future. A forward looking technology strategy could include the use of innovative concepts for cost-optimised communication. easy information dissemination. better market information management. more self service enablement. exchanges. it is essential that we look into the holistic picture of the information flow among all the actors of the exchange. clearinghouses.futuristic customer service on an integrated voice. In fact. platforms and functionalities. regulators. as well as a fundamental restructuring of the relations between market actors — hedgers. assayers. infrastructure providers and technology vendors — is creating the challenges. warehouse. a central integrated exchange platform. This will enable them to foster ever closer relations with their users. Likewise information technology plays a key role in the success of the business of an exchange helping it run efficiently and effectively. speculators. etc Value added services . The Current Need To make technology act as an enabler for all actors of a commodity exchange and thus leverage the maximum benefit from it. mobile enablement. faster learning kit for users. The day the portal “eBay” went down it realized that it was not in the business of selling but in the business of information technology. spot markets. mail and internet platform. management of risks. brokers. Emerging technologies can add to the “customer delight” through: • Faster enablement of trading of newer & innovative products – adding flexibility to the system to meet new requirements Faster go-to-market from the conceptualization state – reducing time between conceptualization and actual trading Improved user experience – availability of information of major requirement for commodity trading Integrated system – seamless integration of all stakeholders including clearing house. collaborative and self-service-oriented. Dipankar Chakrabarti and Ms. provide transparency and build trust. agile. etc Proactive decision support system – easy modification of contracts. and proper usage of technology can help resolve these issues to a large extent and create a differentiator that is getting increasingly important as the number of players increases in this market and globalization changes the way of business. The adjoining figure shows a conceptual information flow among the different actors with the “central integrated commodity exchange platform”. technology can become a huge differentiator. and increased service levels towards customers with algorithms-embedded customer relationship management (CRM).11 Commodity Exchange Technology Concepts – Looking Forward By Mr.
If we judiciously use the communication technology. during the winter. banks I need a ‘value adding’ decision support system to modify contracts fast according to the market need I should be able to manage risk online – automate futuristic price movement management My system should give me an integrated view of all actors of the marketplace including warehouses and assayers I need better spot market simulation I need a framework that will help me with better customer retention. Electronic trading has led to the emergence of many globalised exchanges. Warehouse lin On e Buyers – Brokers Agents Risk Management Automated fast On li ne Assayers Clearing House Banks Need of the day is to have an agile system to support the customer need immediately and reduce the time from conceptualization to production. 76 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . better reach to supplier/producer and buyers and faster go-to-the market strategy. Developed market knowledge is getting fed back to the emerging market to create an efficient risk-resilient market. commodity exchanges have been in existence since 17th century.Possible technology-enabling pieces Contracts DS S Market Analysis Cont. accounting for three-quarters of the volume of futures traded. & Batch Info Analysis & t. Every exchange is looking forward to innovative products. The globalized exchange market has intensified the competition as well. It is imperative to say that only running the platform for bid-ask-rollover will not suffice as the horizon of opportunity is waiting to open. who. In ancient literature we find the mention about commodity futures trading. Not surprisingly. The first recorded account of derivative contracts can be traced to the ancient Greek philosopher Thales of Miletus. More communication improvements are on the cards. What Does the Future Look Like? If we look back. The wish list today looks something like: • • • I need innovative products to take to the market I need to take these faster to the market My system should be flexible. Modern commodity exchanges date back to the trading of rice futures in the 17th century Osaka. Since then we have matured a lot and commodity exchanges are enjoying around 12% CAGR growth where technology is the main enabler. Raw Data Entry EWR WMS Central Integrated Exchange Platform Intrgtd. • • • • • • Given this scenario. technology enablement with innovation is becoming fast the theme of the day. negotiated what were essentially call options on oil presses for the spring olive harvest. E-Com a D at Trad in Market Makers/ Spot Price Finders g Stn . The Reach New communication technology breakthrough has changed the landscape of reaching out to the exchange players in the recent past. agricultural products have the highest growth rate followed by metals and energy. Japan. Concepts like a pan-African commodity market are possible only with assurance of better connectivity. it will help us tap into the rural market easily and thus make till-date-unearthed huge resources available to us. Si et i s k ar s M n al y A Info Dissemination Producers/ Suppliers KYC. Satellite communication has improved the reach by manifold. robust and fault tolerant to adopt these new products and opportunities I should be able to integrate seamlessly all my stakeholders including clearing house.
but the cost of such support will only go up as the exchange scales. IIT-Kanpur has propagated the concept of Info-Thela which can empower village farmers to connect to national/international commodity exchanges. Despite the increase in penetration of information technology. There is no time and cost for creating another platform to support a new product. and we began to see the power of distributed computing realised on a large scale. reliable. Scaling up of hardware is one way of supporting the need. In the 1990s. without access charges. EXPERTS’ VIEWS | 77 . and networking. Time has come to look for innovative solutions for a faster and better delivery mechanism at a lower cost. who declared long back “the network is the computer”. distributed computing environments within the confines of the internet. It is basically a pedal-driven vehicle just like a common cycle rickshaw with a personal computer onboard which will be connected to internet using wireless technology. to benefit the community. Hence. Using clouds. Newer concepts are emerging to reach end-users directly. the world was introduced to the internet. The costs usually revolve around managing equipment (operational) and not just buying it (capital). and open source implementations. cloud computing seems to be better positioned in terms of economic viability. In the recent past. are becoming increasingly popular. costeffective approaches to scale and reliability. users have a myriad of virtual resources for their computing needs. A cooperative model. MPLS is one such solution that has been standardised by the Internet Engineering Task Force ( I E T F ) . By prioritising internet traffic and the core network more efficiently. Compared to its predecessors. early adoption of inter faces. This simple but innovative mechanism may change the way reach to the villages can be increased. It is designed keeping in mind the village conditions in the country where electricity is not available all the time. and customisable with guaranteed quality of service. There are a few concerns about the security of the environment. anywhere. Internet enablement of the trading platform has made it possible to trade anytime. in both industry and academia. storage. Multi Protocol Label Switching (MPLS) networking is increasing the quality of services at a lesser cost. innovative methods of expanding reach. there has been a lack of communication instrument availability in semi-urban and rural areas of developing nations. Cloud computing is one of today’s most hotly discussed/debated topics. Initially. a second of “service-out” makes people move out from the marketplace. Within this system. the model will work on VSAT but slowly. Researchers are working to eliminate the lacuna. can extend the reach of the exchange. cloud computing appears to be catching on. quality of service (QoS) and traffic engineering functions can address the performance issues related to emerging internet applications. This environment strives to be dynamic. we have the ability to utilise scalable. Today. Network equipment manufacturers are constantly developing new solutions that solve many of the problems associated with today’s internet applications. and they do not need a complete understanding of the infrastructure. a much lower cost communication protocol can be adopted to minimise the cost and make information available to the remotest rural areas. The Info-Thela can provide an internet Wi-Fi network in a radius of about 20 km around the nearest internet access point. through cloud computing. It reminds us of Sun Microsystems founder Scott McNealy. So a pedal generator is designed in such a way that while pedalling the battery will keep on charging for running the onboard computers and equipment. high hardware and network demanding organisations have more options to fully understand the costs associated with owning versus renting CPUs. This demands that the technical platform of the exchange is such that it can launch any combination of products fast. The system should be robust and scalable enough to go for a new product without evoking any customer dissatisfaction. Th i s w i l l c h a n g e t h e l a n d s c a p e o f communications as this is creating a network that increases the reach manifold. as the demand-supply scenario changes. In the online scenario. such as Kiosks. Faster Go-to-Market It is very important for the commodity exchanges of today to look for innovative complex products to stay ahead of competition within the framework of the existing regulations of the country. Despite the relative decline of grid computing and unfulfilled promises of utility computing. Amazon and other providers are relying on consolidating resources with automated management to make it cheaper for customers to rent resources than buy them. where the reach can be extended to a pool of people through creation of Kiosks through a private-public handshaking.The cost of broadband is going southward fast making internet more accessible and changing the way exchanges perform. and this should be an adaptable platform for cost-effective online service provision.
Technologies like in-process data mining and auto learning inference system are making the changes and are providing a different level playing field for risk management. Technological road map to align with the exchange business strategy has to be developed to utilize the wave of technological innovations and thus creating an integrated platform for trading encompassing all the stakeholders. The continuing shift of market volume to the electronic trading environment poses new data processing challenges to regulatory bodies. New technologies with mobile workforces operating in dispersed mode. Focus is more on proper data management. up-tothe-moment risk mitigation mechanism which will make the system robust and yet user-friendly. The internet is rapidly evolving into an always-on. governance. enhanced network resilience. Users will be more tech-savvy and will use more and more algorithmic trading tools. Integrated Platform The central tendency of future exchanges is taking shape on an integrated platform where all actors’ demands and needs are taken care of by robust usage of an internet-enabled technology platform. cloud computing will be excellently poised for information dissemination to users. Data dissemination over cloud will depend to a great extent on the security of data and how that is being tackled. Change in trading pattern affected the working of market regulatory commissions to maintain a robust-yetflexible regulatory framework as market participants have an increasing number of choices available to them as to where. and deployment of cutting-edge security software and high available systems. and appellate work. The focus of risk management is also changing for regulatory bodies — not the exchanges only. regulators are typically in a “catch-up” mode to identify policy. This is changing the way traditional exchanges were looking at the business strategy. there has been a large increase in the number of contracts being traded. Faster adoption of innovative technology will build the differentiation. when. software as a service (SaaS). and likelihood assessment of risk to auto-enable safety mechanisms to have a sound system. rich internet applications (RIAs) and Web 2. auto-learning risk management system. The programming technique is also getting changed to suit faster demand where programming is becoming elastic with the highest level of scalability from a few users/nodes to a large number of them. always-connected. and there will be an optimised model to have availability. Robust online risk management is the call of the day. To facilitate the emergence of such policy and governance. internet-based trading can only be mitigated by a highly sophisticated online. Major opportunities for integration lie in the following areas. Risk Management Technology has opened up new opportunities in commodity exchanges. 78 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . Given the situation. security and cost in balance. but it has also increased the system risk. straight-through processing as standard. As with most technological advances. We can very well see that the threat posed by the changing pattern of technology due to online. This medium allows exchanges to gather and transmit much more information about trading activity and hence warrants increase in overall capacity for processing and storage. a much focused data mining tool will be required to manage the huge volume of data pursing the information out of these and creating a repository which is easily accessible and understandable and can be easily d i s s e m i n a t e d. In addition.0 make enterprises think differently. delivered ondemand without significant dependencies on hardware and with run-time composable screens. It may take some more time to move the base platform to cloud computing mode. This is highly suitable for a commodity exchange to dish out new products from test bed to actual contracts. All these will make the exchange more efficient. inference drawing from data. and law. trial. device independent environment for commodity exchange. This group envisions its role as promoting “the effective and secure use of the technology within the government and industry by providing technical guidance and promoting standards. Therefore. the US created a cloud computing security group. Th i s c h a n g e a l s o b r i n g s i n modernisation of regulatory legal system and efforts should be put in to seamlessly integrate technology and work processes to support investigation. more technologically complex environments including service-oriented architecture (SOA). Mobile workforces may be deployed at different remote mandis to provide online information feed for spot market data which is essential for creation of a better futures and option market. integrated value-added clearing services into the trading platform. Technology will enable creation of a virtual spot market scenario for the exchanges.Many models will emerge — from provisioning the core system on cloud to information dissemination over cloud. Demands of key liquidity providers and institutional investors will include fast execution speeds. and how to trade. Exchanges should possess an online. Proper algorithm can be used to deduce the spot value from a set of large data points which will be provided to the system online multiple times in a day.
technology-enabled customer-focused complaint and suggestion handling system takes an exchange to a long way. it will be also possible using technology to create a common clearing house across the country from which services will be used by individual exchanges.Clearing house integration is another new concept which can provide straight-through faster processing of transactions. Customer Service Innovative customer service will be the major differentiator for these exchanges. Commodity exchanges should utilise the new wave of technology innovations to create a differentiator for themselves. Algorithms embedded in CRM systems can maximise the impact of an exchange’s marketing efforts. on the other hand. efficient. The major need will be less upfront investment and ongoing management through a lean IT organisation structure. and technology will be the major enabler for the integrated system. These will be the basis for ‘data mining’ of trading information. Warehouse management system can be implemented at warehouses and data can be integrated with the exchanges to have real-time data availability. For smaller exchanges facing far tighter resource constraints. this will be a real help to the exchanges. CRM systems can be used by exchanges as a mechanism to increase the service levels. mail. EXPERTS’ VIEWS | 79 . Information dissemination to users in a targeted and measured manner is very important and should be looked into so that the system is costeffective and content self-sufficient. This will make the supply chain more efficient and transparent to users. Warehouses and assayers can also be integrated with the exchange platform. The technology framework must have ‘rapid customisation and deployment’ capability to enable the exchange to respond to market demands and requirements in the shortest possible time. miscommunication. Integration of information flow of all the actors will be the future of commodity exchanges. Customer relationship . make users feel at home and special. hence. fax and walk-in system will give users a very special experience. An integrated voice. It is also to be noted that convergence of media and better packaging of video and audio enable delivery of good quality media over less bandwidth. It is necessary to calculate the ROI for each investment and treat each of such improvement as projects which will be managed professionally. and more robust with increased liquidity. This will. the development of close. This will make the system faster. While choosing a technology platform it is to be noted that the solution must ensure that operations can seamlessly scale up and scale out to handle growing business. and transaction needs.Finally. identifying the client’s product focus and analysing his trading strategies. which will be essential to delivery of training to the remotest places. save cost and will. Auto-learning Web pages will make users feel that the exchange understands their particular need and will thus give a large stickiness factor. Personalisation and self service – This will be another major differentiation factor for the exchanges. if the exchanges target the rural market. As speed is the essence of the delivery mechanism. Technology can help in converging these and in faster retrieval of users’ nature and queries for the past few cases. Self-service modules will empower users and will eliminate a majority of human intervention and. Complaint and suggestion handling – A smooth. connectivity. targeted to those areas where it will generate maximum returns. on one hand. Epilogue Technology is and will remain pivotal for any commodity exchange in the near future. This will enable them to foster ever closer relations with their users. Technology Investment Investments must be highly selective. Moreover. provide transparency and build trust. Suggestions will then be generated to help greater client participation. collaborative partnerships with technology developers will be the key to surviving — and thriving — in the technology era. The solution must provide a fault-tolerant trading environment delivering the highest levels of availability and continuity in trading operations. Even banks through their payment gateways will be integrated with the exchange platform to do seamless and fast transactions. A concept of clearing house as a distribution portal can also be thought of through the usage of modern Web-based technology. technology can provide the means for exchanges to foster ever closer relations with their users. Alignment of broader strategic approach to the technology deployment need will be the key. Electronic warehouse receipts (EWR) can be utilised for financing seamlessly through the exchanges. A few differentiation factors to be enabled by technology will be: Better training tools – An online simulation-based training kit with voice over in vernacular will be a dream come true for users — more so.
We want to reiterate that technology deployment is only a means to an end, and success in the future will depend on meeting the foundational value propositions on which investor participation is premised: well-defined contracts in line with the requirements of market users; a smooth functioning delivery system; liquid, efficient and transparent markets built on a robust, scalable, highly available and risk resilient approach. In this note, we have provided some concepts of usage of new technology for efficient, fast and smooth operation of any commodity exchange. These will take a firm shape depending upon the nature of the exchange and will need customisation as per the business strategy and needs.
References 1. United Nations Conference on Trade and Development (UNCTAD) 2. PricewaterhouseCoopers’ internal analysis 3. Food and Agriculture Organization (FAO)
Mr. Dipankar Chakrabarti is Managing Consultant and Ms. Rachana Nath is Executive Director, Performance Improvement, PricewaterhouseCoopers Pvt. Ltd. Views expressed by the authors in this article are personal and not of PricewaterhouseCoopers Pvt. Ltd.
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India Needs to Usher in the Next Agricultural Revolution
By Mr. Amitabh Jaipuria
We need to produce more using less, earn more per unit of it and improve farmers' lives
The 1965 slogan of 'Jai Jawan, Jai Kisan' coined by Late Shri. Lal Bahadur Shastri, rightfully hailed the soldier and the farmer as icons of patriotism and hard work. The Green Revolution of the 1970s with Indian famers at the forefront led to a sharp rise in food grain production enabling the country to achieve selfsufficiency and overcome the threat of famine. The Green Revolution, increasing food production through agricultural intensification, played a significant role in reducing poverty, is undoubtedly a great Indian success story. Today, however, the world and our nation face tremendous challenges poverty, hunger, climate change, amongst others. Experts estimate that between now and 2050, agriculture will need to produce as much food as was produced in the last 10,000 years. Land resources are shrinking, area under agriculture has witnessed a decline and water resources are depleting. We're talking about having to double world food production in just forty years and doing it without much more land. This means that almost all of it has to come from increased output on every acre, without using more water - that means getting a lot more out of the rain that is still free. Forty per cent of world production of food comes from 18 per cent of land that needs irrigation. Leading this agricultural revolution are the farmers - majority of who live on less than Rs. 48 ($ 1) per day. According to a recent report drafted for ministers of the G-8 nations, the world faces “a permanent food crisis and global instability unless countries act now to feed a surging population by doubling agricultural output”. The world needs to increase food
production while conserving land, water and energy, and inclusively improve farmer lives. Two-thirds of Indian agriculture is monsoon dependent, and we are witness to the fact that this kharif season had deficient or scanty rainfall. It is unfortunate that large areas of our country are facing a drought-like situation. Agriculture contributes 18 per cent to the GDP and the overall growth for 2008-09 was a modest 1.6 per cent. In India, important food crops with wide consumption including wheat, rice, maize, soybean and others, continue to grow in the low single-digit range. The Plan document also speaks of yield fatigue and technology gaps as the two main constraints in the development of Indian agriculture. Seeds with superior genetics and state-of-the-art technology coupled with quality inputs are most important for productivity-led growth in agriculture improving the economic fate of the farmers as well. Today's demand-supply challenge presents an incredible opportunity for all those engaged in agriculture business to unite to help agriculture unleash its potential and solve one of the biggest challenges facing developed and developing nations. We need to take the Green Revolution further- It's time for ushering in the next revolution Agriculture has a history of making dramatic productivity improvements due to the deployment of numerous innovations, better genetics and better farming practices keeping up with growth in population
defying the famous Malthusian theory. Innovation in agriculture provides the greatest hope for solutions. Agricultural research and extension systems need to be strengthened to improve access to productivityenhancing technologies. Indian agriculture has the potential to augment the process of the country's economic development and has immense potential to alleviate millions of households out of poverty. With a stable Government and strong visionary leadership determined to make a difference to the lives of the farmer, Indian agriculture is at an inflection point. Agricultural innovations can make farm families and rural India prosperous Today, Indian farmers have better access to technology in agriculture in the form of enhanced seeds, inputs and infrastructure. Amidst the challenges in agriculture, India's success story with insect-protected cotton seed stands out as a beacon of hope and pride. Farmers cultivating Bt cotton seeds have made India the world's second largest producer and second largest exporter of cotton by doubling India's cotton production within six years of its launch in 2002 to 2007; thus contributing Rs. 20,400 crores in foreign exchange to the Indian exchequer, taking India from the position of a net cotton importer at the time of its launch to a strong exporter in the world markets. In 2008, farmers adopted this technology on 82 per cent of India's total cotton acres - probably the fastest technology adoption across all product categories. This is testament to the benefits and superior value farmers derive from agriculture technology. Figure 7.7 Area Production
35 30 25 20 15 10 5
1990-01 1991-02 1992-03 1993-04 1994-05 1995-06 1996-07 1997-08 1998-09 1999-00
Rapid adoption of insect-protected bt cotton technology has helped farmers increase yields and earn an additional income Rs. 20,400 crores a direct contribution to India's GDP from 2002 to 2008. Additionally, India's Bt cotton farmers reduced pesticide usage by 80%, which resulted in savings of Rs. 1,127 crores in 2007 alone (IMRB). Research among bt cotton farmers has indicated that 87% are enjoying better lifestyles, 84% felt more peace of mind, 72% invested in children's education, and 67% repaid long-pending debts (IMRB). Farmer Dyneshwar Buibhand from Antargaon village, Yavatmal in Vidarbha, Maharashtra, recently purchased a new motorcycle. Income from his 14-acre cotton farm has increased to Rs. 21,000 per acre, in addition to per acre savings of Rs. 7,500 from reduced pesticide usage from using Bollgard II BT cotton seeds. Mr. Buibhand is proud to be able to educate his son in an Englishmedium convent school and to build a brick home worth Rs. 550,000 for his family. Bollgard II BT cotton seed's higher yield of 12 quintals per acre (compared with only 7 quintals per acre with conventional seeds) has proven successful for him and for cotton farmers across India who have adopted the technology. In fact, in 2008 alone, yields from BT Cotton in India increased by 31%, pesticide usage decreased by 39%, and profitability increased by 88% equivalent to US $250 per hectare.
All India area, production and yield of cotton
430 380 330 280 230 180
2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 (AE)
Area: Million Hectares; Production: Million Bales of 170 kgs. each; Yield: Kg./Hectare Source: Economy Survey 2007-08
India’s robust regulatory system has made this possible. Superior technology in a single crop has benefited over four million farmers across the country. This success can be, and needs to be replicated across other crops. The potential of innovative agriculture technologies for India and Indian agriculture representing 57 per cent of our population is tremendous.
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The farmer-led white gold revolution should be replicated – We could witness a ‘yellow revolution’ in corn Corn is India’s third largest cereal crop after rice and wheat, and is the fastest growing cereal amongst all food grains, directly contributing Rs. 15,500 crores to the agricultural GDP. India is sixth largest producer and fifth largest consumer of corn in the world. Corn production in India has grown by over 60 per cent to 19.31 MMT in 2008 compared with 12.04 MMT in 2000, even though the area under corn cultivation grew only by approx. 7 per cent (2008: 7.09 Mha vs. 2000: 6.61 Mha). This rapid increase can be attributed to increased hybridization and launch and adoption of superior corn hybrids by the Indian farmers. Farmers across India, with better access to high-quality seeds through public and private sectors are adopting improved hybrids at a fast pace, thus experiencing higher productivity and adopting good agronomic practices. Demand for corn has increased significantly too. Over 30 user industries produce more than 1000 products from corn for textile, paper, medicinal and other allied industries. Higher incomes, better standards of living and changing consumption patterns have led to increased demand for poultry and cattle products. India needs to increase growth rate of corn to 5.91 per cent from 4.2 per cent in 1995-2005 to meet the increasing domestic demand of 22.73 million tons by 2011-12. Corn constitutes 50 per cent of the poultry feed industry. India’s poultry sector consumes 7.5 million metric tons of corn today and is estimated to increase to 16.5 million metric tons by 2015. According to IMDA Vision 2025 Report, for sustained growth of the poultry sector, corn production needs to be doubled in the next five years. Production growth is highly dependent on yield growth as land under corn cultivation is largely stagnant at 7.2 million hectares. With only 46 per cent of acreage under hybrid corn, and the average corn productivity at less than one metric ton per acre as compared to global average of two metric tons per acre, there is an opportunity to increase productivity through the most important input which can dramatically alter yields, i.e. high-yielding corn hybrid seeds. With its potential yet to be realized fully, increasing corn productivity can be one of the solutions to tackle the food security issue along with rice and wheat.
Monsanto is committed to addressing these increasing needs. Through our diversified seed production, world class breeding and manufacturing processes, and extensive market outreach, we are ensuring that the Indian farmer has access to best-in-class products, enabling him to produce more per acre on his farm. Monsanto’s Dekalb™ high-yielding corn hybrid seeds, cultivated across 18 Indian states are available in 13 high-yielding hybrids to suit India’s diverse agronomic and climatic conditions. In 2008, Monsanto also started research and regulatory work in India to introduce our biotech-improved corn technology offering farmers solutions to the two key yield impacting factors: insects and pests, and weeds. Biotechenhanced corn technology has tremendous relevance and potential to enhance corn productivity in our country. One of our noteworthy projects includes ‘Project Sunshine’ - A Public Private Partnership of Monsanto with the Government of Gujarat’s Tribal Development Department (TDD), aimed at improving economic selfsufficiency and quality of life of tribal farmers of Gujarat. Under the aegis of their 10-point program ‘Van Bandhu Kalyaan Yojana’, TDD set up a goal of ‘Increasing income of tribal farmers by 100 per cent within five years’ and amongst its various programs partnered with Monsanto on Project Sunshine. Monsanto partnered via its Dekalb™ high-yielding corn hybrid seeds (supplied to 30,000 tribal farmers across 535 villages through TDD). Additionally, we also committed resources to conduct farmer education programs on agronomy, pest management, post harvest care and more, to increase productivity; and also partnered with TDD to provide critical project management. Due to better quality and timely supply of inputs (seeds, fertilizers, etc.) farmers experienced a healthy crop. Project Sunshine generated outstanding results: A three-fold increase in yield (15 quintals per acre vs. only five quintals per acre with conventional seeds) and a cumulative incremental income of over Rs. 20 crores for the 30,000 beneficiary tribal farmers. Farmer Ramabhai Khoyabhai Maaliwaad is one of the many corn farmers who are experiencing the benefits of higher productivity. A resident of Nava Muvada village, his family of nine members had seen tough
880 daily leading to a diversification in his farming income as well. Monsanto has announced three commitments to help farmers increase global food production in the face of growing demand. In our quest to improve yields sustainably. in addition to the private sector. soybeans and cotton by 2030. To provide irrigation to his fields. With the objective of ensuring food security for the burgeoning population through sustainable agricultural practices. or reduction in post-harvest losses – there is a clear and important role for agricultural technology in improving productivity. was creating a challenge for his large family getting caught into a vicious cycle which was in operation. They have moved from being below-poverty-line to being self-sufficient and empowered. An example of the positive impact through a single input. Our opportunity to help make a difference lies at the intersection of demand. high-yielding seeds and the power of public-private partnership. in the Indian context. At Monsanto. 84 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS . Improve farmers’ lives – Monsanto will help improve the lives of farmers. he is investing in a 40-feet deep well. and execution Monsanto’s worldwide three-point commitment to develop Indian Agriculture to put the Indian Economy on a high growth path and to spread its benefits among the farming community includes: Produce more – Monsanto will develop better seeds that will double yields in its three core crops of corn. stress tolerance. thereby improving farmers’ lives. Effective enforcement of intellectual property rights (IPR) that encourages private investment in agricultural research. A strong science-based Regulatory framework. we perceive that four factors can positively influence the future of agriculture and need attention from Government and Policy Makers: • A supportive environment and free market system that encourages competition.e. i. With his income. His family now has a mobile phone connecting them better with market opportunities outside their farm and an electricity connection in their house to improve their personal productivity in various ways.times growing corn although it partially met their food needs. it is heartening to note that the Public Sector R&D institutions in India are conducting extensive research on the benefits of agricultural biotechnology. Whether it is high-yielding seeds with better inherent genetic potential combined with biotech-enabled insect protection. that remains the focus. compared to a base year of 2000 in countries where farmers have access to current and anticipated new seed choices offered by us. Helping farmers produce more with less. limited natural resources and a changing climate. Monsanto established the ‘Beachell’ Borlaug International Scholars Program to accelerate breakthrough public sector research in wheat and rice yield. • • This will help in providing farmers with a choice of world’s best technologies and encourage investment in research to develop new higher-yielding products. Recognizing the importance of wheat and rice as key food crops. • There is a unique role for technology in agriculture in the Indian scenario. a n d b e t te r we e d m a n a g e m e nt to p ro te c t productivity/yields. and have also pledged to work in new partnerships with other businesses. and will build a pipeline to link it to his farm. He saved 12 quintals for the consumption of his family and sold the remaining produce in the market. Rigorous promotion of Public-Private Partnership and collaborative research. His son Mahesh is pursuing a vocational course to be an electrician. Conserve more – Develop seeds that will reduce by one-third the amount of key resources like land. However. Under Project Sunshine. Shri Ramabhai Khoyabhai Maaliwaad’s family has prospered. Monsanto will also undertake a series of partnerships to address key environmental issues. including an additional five million people in resource-poor farm families by 2020 through innovative public-private partnerships including creation of effective market linkages. innovation. fertilizer and water required to grow crops by the year 2030. In a single season. building effective linkages and partnerships. Low yields of not more than six quintals from conventional corn seeds and resultant low income thereof. citizen groups and Governments. cultivation of MIL’s Dekalb™ high-yielding corn hybrid seeds produced three times more than he could earlier produce with conventional seeds – 20 quintals in his one acre farm. he has setup a small dairy farm with eight buffaloes that generates an additional income of Rs. better agronomic practices. and. research investment and innovation. energy.
empowered with seeds that enhance yields.and pest-protection and better weed management via eight unique technologies in a single corn seed. We envision a prosperous rural India that is both self-sufficient in food. We believe. We are optimistic about the role of agriculture in driving India’s economic development in the next decade. we are researching innovative products that will enable corn farmers to reap higher crop productivity from the combined benefits of insect. The success of Indian IT can be repeated in agriculture. Amitabh Jaipuria is Managing Director of Monsanto India Limited. the potential of each entrepreneurial farmer.Monsanto has been a historically trusted partner of Indian farmers for over four decades and are committed to further improving their lives We are committed to strengthening communities and doing what we can to help people lead safer. we have the capability to compete in the global market with agricommodity powerhouses like Brazil and Argentina. infrastructure and market linkages. To cite an example. and more productive lifestyle. and to evaluate the need and potential of future technologies. We are optimistic that the time has come for a new slogan for Indian agriculture. For this to happen. is tremendous. modernize. and also becomes a major player in global agricultural commodity trade Imagine the potential for Indian farmers to replicate the Indian cotton success story in other crops to contribute to meeting the world’s needs. As a pure agriculture company. helping farmers succeed is at the core of all we do. make agriculture accessible to markets and sustainable to empower India to seek its rightful place on the global map. It can be Jai Ho all the way! Mr. We believe the visionary political leadership in our country and our robust regulatory system will accelerate this further. Since two out of every three Indian’s livelihood is linked to agriculture. healthier. We are also partnering with the Government and other stakeholders to make our products more accessible to farmers. they need to have access to cutting-edge agriculture technologies to help them remain globally competitive and to take their rightful place in the global commodity trade. EXPERTS’ VIEWS | 85 . We need to revive. As the world’s largest investor in farmer-focused agricultural research and India’s leading agriculture company – Monsanto. Our commitments represent the beginning of a journey that we will expand on and deepen in the years ahead. feed and fibre. Views expressed are personal. its people and partners are working to meet these needs playing an important role in providing solutions to the challenges that we face today.
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