Commodity Future Markets in India

As human civilization progressed, mankind started to feel the requirement of a large number of
goods. This necessitated the exchange of goods through the barter system. However, with the
invention—arguably one of the greatest in human civilization—and gradual acceptance of
money, the barter system gave way to monetized commodity trade, that is, exchange of goods
for a fixed monetary value. Thereafter, trading in different commodities grew in leaps and
bounds, eventually leading to the standardization of trade contracts. The earliest instance of
standard contracts is believed to be from Sumer, where Sumerians used standardized trade
contracts to trade in sheep and goats. In due course the standardized traded contract, that is
the forward contract, led to the development of today’s futures contract. Thus commodity
futures have emerged, primarily out of the need to deal with the risks associated with
agricultural production, storage, trade, and processing; further they have also evolved in
response to the counterparty default risks associated with forward contracts1. Initially
concentrated in a small number of developed economies, commodity futures markets are now
emerging and gaining prominence across newly liberalizing, developing economies and
economies in transition, such as China, India, Brazil, and South Africa.

1. History of commodity futures

Commodity markets are one of the oldest markets in human history. The first recorded
organized trading of futures or futures-like contracts was reported from Japan. The 17th
century feudal landlords or samurais stored surplus rice in warehouses in the cities and sold
them by issuing rice tickets. These rice tickets were commitments for delivery of a certain
quantity of rice at a future date and at a specified price, thereby locking in prices and reducing

1
UNCTAD, “Development Impacts of Commodity Exchanges in Emerging Markets”, 2009
risks. The holder of these rice tickets could sell these tickets on the Dojima Rice Exchange near
Osaka2 if they did not wish to take delivery.

The seasonal nature of agricultural production was the main reason behind the development of
derivatives in the 19th century in Chicago. Farmers brought their harvest to the market during
the season and created a seasonal glut that drove down prices, and in the off season, the
shortages drove up prices. The situation was aggravated by the shortage of storage facilities in
cities and difficulties of transportation from rural areas. This led to forward arrangements—
recognized as ‘to arrive’ contracts—in the early 1800s. It involved an agreement or contract
between a buyer and a seller for the future delivery of grain. The contracts specified the
quantity and grade of the grain as well as the delivery date and an agreed-upon price. Soon
contracts started trading in anticipation of changes in the market price3. The realization of the
benefits of standardization increased trading volumes and hastened the need for an organized
exchange. This led to the setting up of the Chicago Board of Trade (CBOT) in 1848, the world’s
first modern futures exchange.

Being located in the grain bowl of the country and facilitated by well-developed railroad network
and telegraph lines connecting it with the rest of the country, Chicago attracted grain producers
from far and near and emerged as a commercial hub. Gradually, more and more farmers and
traders started to make commitments to exchange their produce for cash, at an agreed upon
price and a future delivery date. However, the absence of a uniform weighing and grading
system often restrained the growth and development of futures markets. This led to the
evolution of a ‘standardized contract’ that clearly defined the quantity, grade, and quality
parameters of the traded commodity.

The standardized contract helped both the seller and the buyer—the farmer, since he knew in
advance what he was expected to produce/deliver; and the trader, what grade or quality to

2
‘The Origin of Derivatives’, www.people.brandeis.edu;
3
Markham J W, 1987, as quoted in ‘The Origin of Derivatives’ in people.brandeis.edu;
expect. Only unknown was the price of the contract, which was decided at the time of getting
into the contract. Prices were arrived at based on prevailing prices in the spot market,
transportation costs, and so on. Because of convenience, the trade in standardized commodity
contracts became popular. The contracts even started changing hands before the contract
delivery date, that is, a trader/dealer not interested in taking physical delivery of the produce
would sell his contract to someone who wanted to take delivery. Similarly, a farmer who had a
contract to deliver but did not intend to deliver would pass on the contract to another farmer
who wanted to deliver. Thus, in a couple of decades, CBOT emerged as a major marketplace
where farmers and traders transacted in spot and futures grain. The first ever ‘standardized
exchange-traded’ forward contracts were introduced by CBOT in 1864.

However, there were risks for participants trading on exchanges. During periods of supply
shortage due to adverse weather conditions, the farmers having contracts to sell wanted to
hold on (because the value of the commodity had gone up); and, conversely, during periods of
oversupply, the traders were not keen on taking delivery (because the contract value had
declined). With the entry of speculators, both the farmers and the traders found a party willing
to take on the risk. This made selling and buying of futures a beneficial activity, and soon the
success of grain futures encouraged futures trade in several other commodities. Other local
markets catering to specific commodities started to establish trade bodies that would facilitate
dealing in futures contracts. In 1872, a group of Manhattan Dairy merchants created the Butter
and Cheese Exchange of New York. Later, with additional commodities, the name of the
exchange was changed to the New York Mercantile Exchange (NYMEX) in 1882. Over time,
several other commodity exchanges were set up in the U.S., Europe, and other parts of the
world.

2. Current status of global commodity futures market

With liberalization and globalization, the international trade in commodities has been increasing.
Countries and industries are taking steps to secure or maintain a year-round supply of all types
of commodities/products, including seasonal commodities. The derivatives trade or futures
platform has opened up a more efficient and effective way of doing this. With greater
transparency and better communication and logistics than ever before (these supported by
friendly international trade policies), the importance of price discovery and price risk
management has received considerable attention of the stakeholders. Today, the inter-linked
markets across the continents are driving towards a global market.

In this global development, the role played by many of the commodity derivative markets is
quite obvious. There are benchmark markets and benchmark prices that set prices of
commodities in many parts of the world. Some of the leading international exchanges that set
benchmark prices or reference prices for a number of key commodities are given below.

Leading international commodity exchanges and commodities traded on them

Commodity Exchange Commodities Traded

Chicago Mercantile Exchange light sweet crude oil, natural gas, heating oil, gasoline,
(CME) Group, which Includes RBOB gasoline, electricity, propane, gold, silver, copper,
NYMEX, CBOT, COMEX, and Kansas aluminium, platinum, palladium, corn, soya beans, soya
City Board of Trade bean oil, soya bean meal, wheat, oats, ethanol, rough
rice, gold, silver, and so on.
International Continental Exchange Brent crude oil, coal, electricity, emissions, gas oil,
(ICE) Group, which includes former heating oil, gasoline (RBOB), natural gas, WTI crude oil,
International Petroleum Exchange cocoa, canola, robusta coffee, corn, potato, rapeseed,
(IPE), London International Financial white sugar, feed wheat, milling wheat, cotton,
Futures and Options Exchange ethanol, sugar, frozen concentrated orange juice, pulp,
(LIFFE), NYBOT, Winnipeg western barley, and so on.
Commodity Exchange (ICE Canada)
and Singapore Mercantile Exchange
London Metal Exchange (LME) aluminium, copper, nickel, lead, tin, zinc, aluminium
 alloy, and so on.

Tokyo Commodity Exchange gasoline, kerosene, crude oil, gold, silver, platinum,
(TOCOM) palladium, aluminium, rubber, and so on.
Australian Securities Exchange (ASX) wool, sorghum, wheat, natural gas, and so on.
Bursa Malaysia Derivative Exchange refined bleached deodorized palmolein, crude palm oil,
(BMD) palm kernel oil, and so on.
Dalian Commodity Exchange corn, soya bean, soya bean meal, soy oil, and so on.
Shanghai Futures Exchange (SHFE) copper, aluminium, gold, natural rubber, fuel oil, and so
on.
Zheng Zhou Commodity Exchange wheat, cotton, sugar, and so on.
(CZCE)

3. Evolution of Indian Commodity Futures Markets

Although it has passed through a turbulent time in the past, the history of commodity futures
markets in India is almost as old as that of the U.S. The first organized commodities futures
market for cotton, the Bombay Cotton Trade Association Ltd., was set up in 1875. Subsequently,
a number of trade associations for futures trade came up at regular intervals in various parts of
the country. Key among them include: the Gujarati Vyapari Mandali in 1900 to facilitate futures
trade in oilseeds; association to trade in gold futures in 1920; and exchanges for facilitating
futures trade in commodities like jute, pepper, turmeric, potato, gur (jaggery), and sugar.

4. Current status of commodity futures market in India

Commodity futures trading have come a long way ever since they resumed after nearly a four-
decade ban. Three demutualized, national-level exchanges were established during 2002 and
2003. Later, more national-level exchanges were approved by the regulator. Presently, there
are five active national-level exchanges operating in India.
The biggest driver of the exchange business in India has been the application and
operationalization of information technology, which changed the entire face of the industry.
This was as opposed to its historical tradition of an open outcry platform. The growth of online
commodity futures trading and the development of an efficient, transparent, and well-
organized market, over the past few years, have thrown open a number of opportunities and
enormous benefits to various stakeholders, ranging from producers to processors and
consumers.

Indian commodity futures volume has increased exponentially since 2003 and the Multi
Commodity Exchange of India Ltd or MCX is the largest commodity exchange in India with a
market share of 95% of commodities traded on Indian exchanges (comprising gold and silver;
energy, consisting of crude oil and natural gas; base metals, covering copper, aluminum, lead,
zinc, and nickel; and agro commodities, such as edible oil, natural rubber and cotton.) The
Securities and Exchange Commission (SEBI) is the regulator of the markets.

National Exchanges IN INDIA

No Name and Location of the Exchange
1 Multi Commodity Exchange of India Ltd. (MCX), Mumbai
2 National Commodity and Derivatives Exchange Ltd (NCDEX), Mumbai
3 Indian Commodity Exchange Ltd (ICEX),
4 National Stock Exchange (NSE)
5 Bombay Stock Exchange (BSE)- Mumbai

The Government of India and the SEBI are laying a strong emphasis on spreading awareness
among stakeholders in commodity markets, which is especially aimed towards greater financial
inclusion and thus focuses on small producers (farmers), small traders, and SMEs across the
country. Growth and development in this sector would contribute significantly to the
strengthening of the Indian economy, and agriculture in particular, given the challenges of
globalization.
 5. Key Benefits of Commodity Futures Markets

The key benefits of the futures markets are price discovery and price risk management.
Moreover, the functioning of these markets brings in innumerable benefits to the various
stakeholders in the value chain and numerous eco-system partners of the futures exchanges.

Price Discovery
The prices of commodities are discovered on commodity futures exchanges, which are seamlessly
disseminated through various mediums.

Price discovery is based on the interaction of supply and demand forces. In addition to this,
several interrelated factors affect price discovery. These could include quantity, location, and
competitiveness of buyers and sellers; and market information and price reporting (amount,
timelines, and reliability of information). Moreover, efficiency of price discovery necessitates
knowledge of players on commodities, easy entry and exit, and availability of fungible trading
instruments. Notably, commodity futures market enables trading in fungible commodity futures
contract to a diverse mix of players (beyond just commercial participants), and hence bring in
high liquidity. Consequently, price discovery in futures market is more efficient than that in
physical markets.

Thus when the participants on futures exchanges put in their bid and ask prices based on their
assessment of demand and supply at that time, their orders are a composite reflection of
specific market-related information, expert views and comments, government policies,
international trade, inflation, weather forecasts, hopes and fears, market dynamics, and so on.
The successful execution of trades between buyers and sellers indicates an assessment of an
‘unbiased fair value’ of the particular commodity. An unbiased price, thus evolved, is the
discovered price that is freely available for uninterrupted dissemination real time through
trading terminals. The discovered price on an exchange is the rational market price agreed upon
by both the buyer and the seller. Hence, the last traded price is considered to be the discovered
price. The market participants and commodity traders view the futures prices as a leading ‘price
indicator’. The price discovered on a futures exchange gives an idea today about the price that is
likely to prevail at a future point in time. Importantly, the price discovered is continuously
disseminated to all commodity stakeholders through various mediums, such as ticker-boards,
newspapers, and television. This helps in bringing about the much-desired price transparency in
physical market transactions.

Equipped with this knowledge, the farmer/producer can decide on which crop to sow when and
whether to postpone or sell his produce or to simply use that price as a fair reference price for
negotiations with traders.

Price Risk Management or Hedging

Unprecedented volatility in commodity prices has been a source of great risk, greatly affecting
economies and stakeholders. To tackle this, price risk management through hedging has
emerged as a well-established trade mechanism that protects business from adverse effects of
temporal price volatility. It is somewhat comparable with the concept of insurance in the sense
that insurance offers financial cover against specified risks just as hedging offers cover against
price risk fluctuations in commodities that impact cash-flows.

Hence, in commodities, hedging through futures market has emerged as one of the popular
market-mediated price risk management mechanism. It is used as a preferred instrument to
manage price risk by a large number of stakeholders who have an exposure to the physical
commodity. In fact, the first-ever organized commodity futures exchange in Chicago was set up
in 1848 as a platform for hedging in grains by farmers and traders in the U.S.

Hedging is actually a strategy to offset price risk that is inherent in the spot market by taking an
equal but opposite position in the futures market. The idea is to offset the loss in one market
with profit in the other market, that is, the futures market as against the physical/spot market.
The futures market is used by hedgers to protect their businesses from adverse price
movements which could dent their profitability. Producers like farmers, manufacturers, and
mining companies; and consumers like processors, merchandisers, manufacturers, exporters,
and importers benefit from hedging. An illustration of hedging follows.

Hedging by a Wheat Miller

A miller enters into an agreement to sell wheat flour to a bread manufacturer. He agrees to
deliver an agreed quantity at an agreed price on an agreed date, say in four months. The miller is
apprehensive that the price of wheat may increase in the interim, that is, from the date of
signing the agreement to the date of delivery.

To manage his price risk, the wheat miller decides to take a buy position or going long4 on the
futures platform. He buys the number of wheat contracts on the exchange that are equal to his
requirement four months hence. When the deadline for the supply of wheat flour nears, he finds
that wheat prices have gone up in the spot market. He ends up paying more for the wheat. This
increases the cost of wheat flour, squeezing his margins.

However, the loss in the spot market is offset in the futures market as the miller has hedged on
the futures exchange. By squaring off his position, that is, by selling an equal amount on the
exchange, he makes a profit (because spot and futures prices converge at the time of expiry of
the contract). Thus the miller offsets his loss in the spot market by making a profit in the futures
market. This enables the miller to protect his margin to a great extent.

4
Going long: buying a futures contract; going short: selling a futures
Figure 1. Flow chart of hedging mechanics

April
o Agrees to sell flour to bread
manufacturer
o Buys wheat futures contract
Wheat Miller

o Sells wheat futures contract

July o Buys wheat in the physical
market

Spot price Futures price (Rs per quintal)

April Rs 1,000 Rs 1,300
July Rs 1,200 Rs 1,500
Rs 200 Rs 200
Note: On the date on which the futures contract expires, spot and futures price will converge.

The wheat miller goes long and buys a futures contract at Rs 1,300 in April and subsequently
squares up his position in July by selling the contract at Rs 1,500, making a profit of Rs 200 per
contract.
In the spot or physical market, he could have purchased wheat at Rs 1,000 but ends up buying at
Rs 1,200 in July. By not buying in the physical market in April at Rs 1,000 he has incurred a loss of
Rs 200, which has been compensated by the Rs 200 he makes in the futures market.

Other Benefits of Futures Trading

 Protecting Market Share through Predictable Pricing
The demand for certain commodities like edible oils is highly price elastic. The manufacturers
have to ensure that the prices are stable over an extended period so as to protect their
market share. By buying on the exchange (going long), the manufacturers and processors are
assured of stable and uniform prices over a fairly long period. This predictability allows them
to get into forward sale contracts at fixed prices with their stockists, wholesale buyers, and
 distributors, bringing in predictability in domestic prices. Thus hedging helps reduce the
effects of losses in input prices on the price of their final product. Without futures market,
the processors/manufacturers would have found it difficult to balance severe short-term
price movements of raw materials and the necessity to maintain price stability. In the
absence of futures, this would have meant buying and storing raw material in bulk, incurring
more financial outgo and adding to the cost of production. It would also have meant fewer
funds for other profitable ventures or investments.

 Stable Markets Benefit Farmers/Agriculture

The futures market brings in price stability that is beneficial to farmers and farming (even to
farmers who do not directly participate on futures exchanges). Price stability is important to
the farm economy as unstable market means unpredictability in the income of farmers.
Income unpredictability would also mean less farm-related investments and poor planning of
agricultural activities. The free and wide dissemination of futures price information to
farmers will empower them in negotiating and extracting a ‘fair’ or better price for their
produce from traders/buyers. Moreover, as there is a time lag between planning and
production, the futures market-discovered price information will encourage farmers to make
investment decisions based on market demand.

 Processors Benefit from Reduced Interest Rates and Premiums

Hedging mitigates the need for processors to buy in advance large quantities of raw material
(in season when prices are generally low) to ensure reasonable raw material prices and
protect against adverse price movements over time. Thus, it reduces expenses, such as
working capital requirement, interest on capital, premiums associated with marketing risks,
and processing margins, and ensures greater returns to the processor.
 Benefits to Value Chain Operators
The following are a few key ways in which futures exchanges are helping value chain
operators:
o Enabling price stabilization (reduces the amplitude of price variations).
o Enabling an integrated national and international price structure.
o Facilitating operation of lengthy and complex production and manufacturing activities.
o Helping in balancing supply and demand position throughout the year.
o Acting as a price barometer to farmers and other stakeholders.
o Encouraging competition.

 Import–Export Competitiveness
Futures markets help importers and exporters hedge their price risks and improve their
competitiveness. Many physical traders involved in international trading hedge their risks on
futures exchanges through futures, forwards, and options. For instance, a textile mill needs
to get into contractual export, at least three months forward, since their buyers need to
have an undisrupted supply. In the oilseeds sector, international buyers prefer to buy at least
a year forward.

Normally, exporters who enter into such forward contracts do not possess the entire
committed stocks. They may have to purchase the shortfall from the physical market. This
exposes them to price risks resulting in potential losses. Exporters manage such risks in three
ways: a) refuse demand for long period contracts; or b) hold more-than-required inventory
(hurting their own competitive position); or c) hedge their risk in proposed purchase (which
temporarily substitutes for an actual purchase till the time is ripe to buy in the physical
market). Without hedging through futures market, such risks can only be managed through
meticulous, time-consuming, and costly planning to time the physical transactions. Importers
too go through a similar ordeal if they do not hedge.
 Thus, futures markets allow exporters and importers to cut down their marketing costs,
safeguard processing margins, and compete internationally.

 Improved Accessibility to Bank Credit

Without proper risk management tools, the marketing and processing of commodities
become high-risk business for banks to finance. Even a small movement in price can negate a
huge proportion of the margins, thus, at times, making it virtually impossible to pay back the
loan. Due to this, banks are extremely reluctant to fund the commodity trade. In such a
situation, many banks insist that borrowers hedge their risk on exchanges. Even if banks fund
borrowers who have not hedged their risks, they tend to charge high interest rates besides
forcing stringent terms and conditions of repayment.

6. Documented benefits of commodity futures market in India

Commodity futures market has been fulfilling the key objective of price risk management, or
hedging, for millions of stakeholders exposed to price volatility, which has been increasing as
the Indian economy gets globalized. The rapid growth of the commodity futures market over
the last few years is a reflection of the huge unmet demand for an effective price risk
management tool. Thus, this market has been fulfilling this requirement for which national
commodity trading was permitted by the government in 2003.

Various independent studies and surveys (for example, IIM Lucknow, United Nations
Conference on Trade and Development (UNCTAD), Economic Survey of India, Tata Institute of
Social Sciences, and many others) have confirmed that the commodity futures market has
brought about benefits to its users, which include small stakeholders like the SME sector and
farmers. Such tangible benefits contain avoidance of distress sale, reduction of intermediaries
in the value chain, reduction in price volatility, and so on. Some of the studies are as follows:
 a) IIM Calcutta and NISTADS, New Delhi (2012). MCX Mentha Oil futures facilitated the
rise of India as a major exporter of processed mentha crystals—a transition from raw
material exports.
b) Tata Institute of Social Sciences (2012). The MCX platform has ensured stable and fair
prices for SMEs. Fair prices reduce the cost of production and import bill, boosting
growth of SMEs and providing them with accurate demand–supply signals that reduce
their risks.
c) UNCTAD (2009). Number of intermediaries in the mentha value chain has reduced
after the introduction of futures market, reducing the price spread in the marketing
channel from 11–12% to 7.5–10.5%. For cardamom, it has helped in stabilizing prices
in the spot market.
d) IIM Lucknow (2007). After the introduction of futures, the potato and mentha oil
markets showed marked improvements in increased price realization to farmers.

7. The way forward for commodity futures market in India

Despite the commodity futures market bringing in substantial benefits to the various stakeholders,
institutional constraints have hampered its growth, which must be removed to unleash its full potential.
Topping the list of these bottlenecks is the amendment to the Forward Contracts (Regulation) Act, 1952,
or FCRA, which sets the legal framework for the functioning of the futures market in India. The
amendment will pave the way for a slew of reforms in the legal/regulatory structure, which can be
placed under two broad heads: empowerment of the regulator, SEBI; and permission to introduce new
products.

Moving forward: The regulator SEBI, has now allowed the following categories/changes in the
exchange traded commodity markets
These are:

 Unification of exchanges
 Entry of banks and other financial institutions
 Category III Hedge Funds
  Option Instruments
 Eligible foreign entities (Foreign companies that import/export commodities can hedge their risk
on the commodity platform.
 Mutual Funds
 Introduction of deliverable contracts
 Index Futures

Thus, the participation of banks and other financial institutions in the commodities market would now
ensure greater penetration of an efficient commodity market-based or warehouse receipt-based lending
and bring in commodity exchanges-linked risk management services to the masses.

8. Conclusion

During the short yet remarkably successful journey in the past few years, state-of-the-art online
commodity exchanges have crossed several hurdles to grow in stature that equals their international
counterparts, seamlessly integrating with the entire financial markets architecture. As the commodity
exchanges grew, they have taken the stakeholders along the way and nurtured the commodity
ecosystem. They have delivered both the felt and the unfelt benefits of their existence to all the
participants in the commodities supply chain, from producers to consumers. These exchanges have also
helped spread risks across several stakeholders, thus making the economy more competitive in this
rapidly globalizing world with its interconnected financial markets. Being online with extended hours of
operation, modern commodity exchanges have also enabled the Indian industry manage risks that flow
from their origins crossing economic borders.

Though the commodity futures market have proved their mettle over the years, there are huge
benefits for the economy waiting to be reaped, if a more liberalized environment is permitted
for this market to operate in. Ultimately, new measures can potentially alter the face of the
commodity derivatives economy in India given the long-term benefits that flow to all sections
of the economy.
Disclaimer: The Contents do not constitute professional advice or provision of any kind of
services and should not be relied upon as such. MCX does not make any recommendation and
assumes no responsibility towards any investments / trading in commodities or commodity
futures done based on the information given in the website/contents and any such investment
/ trade are subject to investment / commercial risks for which MCX shall not be responsible. If
financial, investment or any other professional advice is required, please seek advice of
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