Future & Option

Futures and options represent two of the most common form of “Derivatives”. Derivatives are financial instruments that derive their value from an ‘underlying’. The underlying can be a stock issued by a company, a currency, Gold etc., The derivative instrument can be traded independently of the underlying asset. The value of the derivative instrument changes according to the changes in the value of the underlying.

Derivatives are of two types – exchange traded and Over the Counter.
Exchange traded derivatives, as the name signifies are traded through organized exchanges around the world. These instruments can be bought and sold through these exchanges, just like the stock market. Some of the common exchange traded derivative instruments are futures and options.

Over the counter (popularly known as OTC) derivatives are not traded through the exchanges. They are not standardized and have varied features. Some of the popular OTC instruments are forwards, swaps, swaptions etc., 

FUTURES 

A ‘Future’ is a contract to buy or sell the underlying asset for a specific price at a pre-determined time. If you buy a futures contract, it means that you promise to pay the price of the asset at a specified time. If you sell a future, you effectively make a promise to transfer the asset to the buyer of the future at a specified price at a particular time. Every futures contract has the following features

• Buyer
• Seller
• Price
• Expiry

Some of the most popular assets on which futures contracts are available are equity stocks, Indices, Commodities and Currency.

The difference between the price of the underlying asset in the spot market and the futures market is called ‘Basis’. (As ‘spot market’ is a market for immediate delivery) The basis is usually negative, which means that the price of the asset in the futures market is more than the price in the spot market. This is because of the interest cost, storage cost, insurance premium etc., That is., if you buy the asset in the spot market, you will be incurring all these expenses which are not needed if you buy a futures contract. This condition of basis being negative is called as “Contango”. Sometimes it is more profitable to hold the asset in physical form than in the form of futures. For eg: if you hold equity shares in your account you will receive dividends, whereas if you hold equity futures you will not be eligible for any dividend. When these benefits overshadow the expenses associated with the holding of the asset, the basis becomes positive (i.e., the price of the asset in the spot market is more than in the futures market). This condition is called ‘Backwardation’. Backwardation generally happens if the price of the asset is expected to fall.

It is common that, as the futures contract approaches maturity, the futures price and the spot price tend to close in the gap between them ie., the basis slowly becomes zero. 

OPTIONS 

Options contracts are instruments that give the holder of the instrument the right to buy or sell the underlying asset at a predetermined price. An option can be a ‘call’ option or a ‘put’ option.

A call option gives the buyer, the right to buy the asset at a given price. This ‘given price’ is called ‘strike price’. It should be noted that while the holder of the call option has a right to demand sale of asset from the seller, the seller has only the obligation and not the right. For eg: if the buyer wants to buy the asset, the seller has to sell it. He does not have a right.

Similarly a ‘put’ option gives the buyer a right to sell the asset at the ‘strike price’ to the buyer. Here the buyer has the right to sell and the seller has the obligation to buy.

So in any options contract, the right to exercise the option is vested with the buyer of the contract. The seller of the contract has only the obligation and no right. As the seller of the contract bears the obligation, he is paid a price called as ‘premium’. Therefore the price that is paid for buying an option contract is called as premium.

The buyer of a call option will not exercise his option (to buy) if, on expiry, the price of the asset in the spot market is less than the strike price of the call. For eg: A bought a call at a strike price of Rs.500. On expiry the price of the asset is Rs.450. A will not exercise his call. Because he can buy the same asset from the market at Rs.450, rather than paying Rs.500 to the seller of the option.

The buyer of a put option will not exercise his option (to sell) if, on expiry, the price of the asset in the spot market is more than the strike price of the call. For eg: B bought a put at a strike price of Rs.600. On expiry the price of the asset is Rs.619. A will not exercise his put option. Because he can sell the same asset in the market at Rs.619, rather than giving it to the seller of the put option for Rs.600

Commodit Derivatives

A commodity derivative derives its value from an underlying asset which is necessarily a commodity. To understand the commodity derivatives markets it’s necessary to clear about ‘commodities’.

Commodities, in simple words are any goods that are common and unbranded. Gold, silver, rubber, pepper, jute, wheat, sugar, cotton etc., are some of the common commodities. For e.g. apple juice can be a commodity whereas the ‘Real’ apple juice cannot be called a commodity. You may be surprised to know that in the US commodities markets there are futures available even on cattle. Another feature of commodities is that they are commonly available.

Commodity markets represent the formal system for the interplay of demand for and supply of commodities. These markets can be broadly classified into spot market and futures market. Commodities for immediate delivery are traded through the spot market. The players in the spot market are the actual producers and the consumers of the commodities.

The other type of market called the ‘Futures market’ is for facilitating contracts for future delivery. (Please go through the material on ‘Futures and Options’ to understand about futures) These markets make available for trading, the various derivatives based on commodities. Usually traded ones are the futures and options. However in India options on commodities are not available and are expected to be introduced soon. The players in the futures markets are Hedgers, Arbitragers and investors.

Hedgers are those who hold simultaneous positions in the spot market also. These are generally the actual consumers or the producers of the commodities. For eg: A wheat farmer who expects his harvest to be over in 3 months time may sell a futures contract with an expiry of three months, so that even if the prices happen to fall after three months, he can still manage to sell at the price at which the contract was struck.
The large scale consumers of the products can also make use of the futures to secure their purchase. For eg: A cooldrinks can manufacturing company may buy tin futures, so that even if the prices happen to rise later, thy can be assured of the supply of raw materials at the pre-determined price.

The other major group of participants in the commodity futures market are the importers and the exporters. Since they have confirmed obligations to export/import fixed quantity of commodities at a particular period of time, they can take opposite positions in the futures market.

Arbitrage is a process of making profits using the price differences between two markets without exposing oneself to any risk. Arbitraging is a very profitable business. It is possible to arbitrage between two different futures markets or between the futures market and the spot market. However in an ‘efficient’ market arbitraging is not possible, because any price gap is closed immediately as soon the arbitragers enter the market.

Investors are those who participate in the market for profits and are ready to face the risk involved in the market. An investor can be anyone from an individual who has a small surplus income to the treasury desks of banks and corporate.

Most commonly traded derivatives around the world are futures, options and option futures. Some of the most popular commodity exchanges in the world are listed below:

London Metals Exchange, London

New York Mercantile Exchange, New York

Chicago Mercantile Exchange, Chicago

Chicago Board of Trade, Chicago

London International Financial Futures and Options Exchange (LIFFE), London

Tokyo Commodity Exchange, Tokyo

Winnipeg Commodity Exchange, Canada

Indian Commodity Market

In India commodity markets have been in existence for decades. However in 1975 the Government banned forward contracts on commodities. Later in 2003 the Government of India again allowed forward contracts in commodities. There have been over 20 exchanges existing for commodities all over the country. However these exchanges are commodity specific and have a strong regional focus. The Government, in order to make the commodities market more transparent and efficient, accorded approval for setting up of national level multi commodity exchanges. Accordingly three exchanges are there which deal in a wide variety of commodities and which allow nation-wide trading. They are

• Multi Commodity Exchange (MCX)
• National Commodities Derivatives Exchange (NCDEX))
• National Multi Commodity Exchange (NMCE)

The MCX is Mumbai-based and is promoted by Financial Technologies Pvt Ltd. MCX allows trading on a host of commodities ranging from bullion to grains. Please check the ‘Commodities traded’ menu’. MCX has become the first exchange in the world to launch futures on steel. Recently on 11th August 2004, MCX crossed a peak daily turnover of Rs.950 Crores

NCDEX is promoted by an elite group of financial institutions including NSE, LIC, SBI, UBI etc., NCDEX also allows trading of futures on a host of commodities.

The following tables indicate the various commodities traded in both exchanges and also the critical information regarding the various contracts.

National Commodities and Derivatives Exchange, NCDEX

Multi-Commodity Exchange, MCX

Note: NCDEX introduced trading on Saturdays in all eligible contracts with effect from May 15, 2004.

Commodities FAQ

Q- What are Commodity Futures?
A- Commodity Futures are contracts to buy specific quantity of a particular commodity at a future date. It is similar to the Index futures and Stock futures but the underlying happens to be commodities instead of Stocks and indices.

Q- Commodity Futures are recently introduced in India. Aren’t they?
A- Commodity futures market has been in existence in India for centuries. The Government of India banned futures trading in certain commodities in 70s. However trading in commodity futures has been permitted again by the government in order to help the Commodity producers, traders and investors. World-wide, commodity exchanges originated before the other financial exchanges. Infact most of the derivatives instruments had their birth in commodity exchanges.

Q- What are the major commodity Exchanges?
A- The Government of India permitted establishment of National-level Multi-Commodity exchanges in the year 2002 and accordingly three exchanges have come into picture. They are

– Multi-Commodity Exchange of India Ltd, Mumbai (MCX).
– National Commodity and Derivatives Exchange of India, Mumbai (NCDEX).
– National Multi Commodity Exchange, Ahmedabad (NMCE).

However there are regional commodity exchanges functioning all over the country. Karvy Comtrade Ltd has got membership of both the premier commodity exchanges i.e. MCX and NCDEX.

At international level there are major commodity exchanges in USA, Japan and UK Some of the most popular exchanges around the world are given below along with the major commodities traded:

Q- Commodity markets are small. Aren’t They?
A- This is the biggest myth about the commodities market. Commodities (spot) Markets in India are about Rs.11 trillion worth per annum. Internationally the futures market in commodities is 5- 20 times that of the spot market. Look at the table given below. Even if we assume a 5 times multiple the commodity futures markets can grow up to become Rs.55 trillion.

Q- What are the volumes in commodity exchanges recently?
A- The two exchanges (NCDEX & MCX) have seen tremendous growth in less than two years. The daily average on these two exchanges put together has now grown to a healthy Rs.3700 Crores. It has been believed by experts that the volumes on these exchanges would overtake the stock market volumes in the days to come.

Q- What are the working hours for the commodity exchanges?
A- Commodity Exchanges (MCX and NCDEX) function from 10.00 Am to 11.55 PM with a break of 30 minutes between 5.00 PM and 5.30 PM. However some specific commodities with strong international price linkages (such as Gold, Silver, Soy oil, Crude Oil etc) are allowed to be traded after 8.00 PM.

Q- Who regulates the commodity exchanges?
A- Just as SEBI regulates the stock exchanges, commodity exchanges are regulated by Forwards Market Commission (FMC); Forwards Market Commission is under the purview of the Ministry of Food, Agriculture and Public Distribution.

Q- Who benefits from dealing in commodity futures and how?
A- Commodity futures are beneficial to a large section of the society, be it farmer, businessmen, industrialist, importer, exporter, consumer et all.

If you are an investor, commodities futures represent a good form of investment because of the following reasons:
– Diversification-The returns from commodities market are free from the direct influence of the equity and debt market, which means that they are capable of being used as effective hedging instruments providing better diversification.
– Less Manipulations-Commodities markets, as they are governed by international price movements are less prone to rigging or price manipulations by individuals.
– High Leverage-The margins in the commodity futures market are less than the F&O section of the equity market.

If you are an importer or an exporter, commodities futures can help you in the following ways:
– Hedge against price fluctuations-Wide fluctuations in the prices of import or export products can directly affect your bottom-line as the price at which you import/export is fixed before-hand. Commodity futures help you to procure or sell the commodities at a price decided months before the actual transaction, thereby ironing out any fluctuation in prices that happen subsequently.

If you are a producer of a commodity, futures can help you as follows:
– Lock-in the price for your produce-If you are a farmer, there is every chance that the price of your produce may come down drastically at the time of harvest. By taking positions in commodity futures you can effectively lock-in the price at which you wish to sell your produce.
– Assured demand-Any glut in the market can make you wait unendingly for a buyer. Selling commodity futures contract can give you assured demand at the time of harvest.
– Increase in holding power-You can store the underlying commodity in exchange approved warehouse and sell in the futures to realize the future value of the commodity.

If you are a large scale consumer of a product, here is how this market can help you:
– Control your cost-If you are an industrialist, the raw material cost dictates the final price of your output. Any sudden rise in the price of raw materials can compel you to pass on the hike to your customers and make your products unattractive in the market. By buying commodity futures, you can fix the price of your raw material.
– Ensure continuous supply-Any shortfall in the supply of raw materials can stall your production and make you default on your sale obligations. You can avoid this risk by buying a commodity futures contract by which you are assured of supply of a fixed quantity of materials at a pre-decided price at the appointed time.

Q- How risky are these markets compared to stock & bond markets?
A- Commodity prices are generally less volatile than the stocks and this has been statistically proven. Therefore it’s relatively safer to trade in commodities. Also the regulatory authorities ensure through continuous vigil that the commodity prices are market-driven and free from manipulations. However all investments are subject to market risk and depends on the individual decision. There is risk of loss while trading in commodity futures like any other financial instruments.

Q- Are the trades/ settlement guaranteed by the exchanges?
A- YES, the commodity exchanges have got some of the most high profile corporate as their promoters. Multi Commodity exchange of India, promoted by Financial Technologies Ltd has got on board institutions such as SBI, HDFC Bank, Canara Bank, Corporation Bank, Bank of India, Union Bank of India, Bank of Baroda. The National Commodity and Derivatives Exchange (NCDEX) has got NSE, ICICI, NABARD, CRISIL, LIC, PNB, Canara Bank as the major share-holders. Such a high profile share-holding provides these exchanges valuable experience, knowledge and also high standards of operations . Also the exchange guarantees the settlement of trades and so eliminates the counter-party risk in the transactions. The exchange for this purpose maintains a Settlement –Guarantee fund akin to the stock exchanges.

Q- Are there physical deliveries in commodity futures exchanges?
A- YES, the exchanges, in order to maintain the futures prices in line with the spot market, have made available provisions of settlement of contracts by physical delivery. They also make sure that the price of futures and spot prices coincide during the settlement so that the arbitrage opportunities do not exist.

Q- How the deliveries are made possible?
A- The exchange has enlisted certain cities for specific commodities as the delivery centres. The seller of commodity futures, upon expiry of the contract may choose to deliver physical stock instead of settling the positions by cash, in which case he would be required to deliver the stocks to the specified warehouses. The buyer of the commodity futures, if he is interested in physical delivery would be matched with a seller and would be required to take delivery of the specified quantity of stock from the designated warehouse. World-wide commodity futures are generally used for hedging and speculation and hence physical deliveries are negligible. However the possibility of physical delivery has made these markets more attractive in India. Both NCDEX and MCX have successfully completed physical delivery in bullions and various agro-commodities. 
In case of NCDEX it is mandatory to open a Demat account with an approved DP by the buyer and seller if they wish to take/ give delivery of goods. 
Please note the delivery and settlement procedure differs for each exchange and commodity. Read the delivery/ settlement procedure carefully or contact us before deciding to give/ take physical delivery.

Q- Do I need to pay sales tax on all trades? Is registration mandatory?
A- NO. If the trade is squared off no sales tax is applicable. The sales tax is applicable only in case of trade resulting into delivery. Normally its seller’s responsibility to collect and pay the sales tax. The sales tax is applicable at the place of delivery. Those who are willing to opt for physical delivery need to have sales tax registration number.

Q- Are any transaction duty charges imposed on commodity futures contracts, as in case of stocks?
A- Although FMC does not levy any transaction charges as of now, the respective commodity exchanges levy transaction charges. Transaction charges are in the range of Rs 4 to Rs 6 per lakh/per contract, which may differ for each commodity/ exchange.

Q- What is the date of expiry?
A- At NCDEX the contracts expire on 20 th day of each month. If 20 th happens to be a holiday the expiry day will be the previous working day. 
At MCX the expiry day is 15 th of every month. If 15 th happens to be a holiday the expiry day will be the previous working day. The expiry day also differs for different commodities in both the exchanges.

Q- What are the commodities on which futures trading take place?
A- At Present futures are available on the following commodities.

Q- How much are the margins on these Commodity futures?
A- Generally commodity futures require an initial margin between 5-10% of the contract value. The exchanges levy higher additional margin in case of excess volatility. The margin amount varies between exchanges and commodities. Therefore they provide great benefits of leverage in comparison to the stock and index futures trade on the stock exchanges. The exchange also requires the daily profits and losses to be paid in/out on open positions (Mark to Market or MTM) so that the buyers and sellers do not carry a risk of not more than one day.

Following is a table showing the details # regarding major commodities traded on MCX & NCDEX

* MCX Initial margins are shown above. NCDEX follows SPAN margins which could be between 5-10% depending on volatility.
# The specifications are subject to change by the exchanges / FMC
The list given above covers only the popular commodities and not exhaustive.

Q- Are options also allowed in commodity derivatives?
A- No. Options in goods are presently prohibited under Section 19 of the Forward Contracts (Regulation) Act, 1952. No exchange or person can organise or enter into or make or perform options in goods. However the market expects the government to permit options trading in commodities soon.

101 FAQ from FMC

I – DERIVATIVE CONTRACTS (“VAYADA KABALA”) AND THEIR BENEFITS

Q- What is a Derivative contract?
A- A derivative contract is an enforceable agreement whose value is derived from the value of an underlying asset; the underlying asset can be a commodity, precious metal, currency, bond, stock, or, indices of commodities, stocks etc. Four most common examples of derivative instruments are forwards, futures, options and swaps/spreads.

Q- What is a forward contract?
A- A forward contract is a legally enforceable agreement for delivery of goods or the underlying asset on a specific date in future at a price agreed on the date of contract. Under Forward Contracts (Regulation) Act, 1952, all the contracts for delivery of goods, which are settled by payment of money difference or where delivery and payment is made after a period of 11 days, are forward contracts.

Q- What are standardized contracts?
A- Futures contracts are standardized. In other words, the parties to the contracts do not decide the terms of futures contracts; but they merely accept terms of contracts standardized by the Exchange.

Q- What are customized contracts?
A- Forward contracts (other than a futures) are customized. In other words, the terms of forward contracts are individually agreed between two counter-parties.

Q- Is delivery mandatory in futures contract trading?
A- The provision for delivery is made in the Byelaws of the Associations so as to ensure that the futures prices in commodities are in conformity with the underlying. Delivery is generally at the option of the sellers. However, provisions vary from Exchange to Exchange. Byelaws of some Associations give both the buyer and seller the right to demand/give delivery.

Q- What is the n.t.s.d. contracts ?
A- Non-Transferable Specific Delivery Contracts is an enforceable bilateral agreement under which the terms of contract are customized and the performance of the contract is by giving specific delivery of goods. The rights or liabilities under this contract cannot be transferred by transferring delivery order, railway receipt, bill of lading, warehouse receipts or any other documents of title to the goods.

Q- Are n.t.s.d. contracts regulated by the Forward Markets Commission?
A- Though the Forward Contracts (Regulation) Act, 1952, contains enabling provisions to regulate or prohibit such contract in notified goods, the Government have freed n.t.s.d. contracts from regulation or prohibition by issue of notification No.369(E) dated 1.4.2003.

Q- What is the t.s.d. contracts ?
Transferable Specific Delivery contracts is an enforceable customised agreement where unlike known transferable specific delivery contracts, the right or liabilities under the delivery order, railway receipt, bill of lading, warehouse receipts or any other documents of title to the goods are transferable. The contract is performed by delivery of goods by first seller to the last buyer. The parties, other than the first seller and the last buyer, perform the contract merely by exchanging money differences.

II – FUTURES CONTRACTS

Q- What is a futures contract?
A- Futures Contract is specie of forward contract. Futures are exchange – traded contracts to sell or buy standardized financial instruments or physical commodities for delivery on a specified future date at an agreed price. Futures contracts are used generally for protecting against rich of adverse price fluctuation (hedging). As the terms of the contracts are standardized, these are generally not used for merchandizing propose.

Q- What are the commodities suitable for futures trading?
A- All the commodities are not suitable for futures trading and for conducting futures trading. For being suitable for futures trading the market for commodity should be competitive, i.e., there should be large demand for and supply of the commodity – no individual or group of persons acting in concert should be in a position to influence the demand or supply, and consequently the price substantially. There should be fluctuations in price. The market for the commodity should be free from substantial government control. The commodity should have long shelf-life and be capable of standardisation and gradation.

Q- How many commodities are permitted for futures trading?
A- With the issue of the Notifications dated 1.4.2003 futures trading is not prohibited in any commodity. Futures trading can be conducted in any commodity subject to the approval /recognition of the Government of India. 91 commodities are in the regulated list i.e. these commodities have been notified under section 15 of the Forward Contracts (Regulation) Act. Forward trading in these commodities can be conducted only between, with, or through members of recognized associations. The commodities other than those listed under Section 15 are conventionally referred to as ‘Free’ commodities. Forward trading in these commodities can be organized by any association after obtaining a certificate of Registration from Forward Markets Commission.

Q- How are futures prices determined?
A- Futures prices evolve from the interaction of bids and offers emanating from all over the country – which converge in the trading floor or the trading engine. The bid and offer prices are based on the expectations of prices on the maturity date.

Q- How professionals predict prices in futures?
A- Two methods generally used for predicting futures prices are fundamental analysis and technical analysis. The fundamental analysis is concerned with basic supply and demand information, such as, weather patterns, carryover supplies, relevant policies of the Government and agricultural reports. Technical analysis includes analysis of movement of prices in the past. Many participants use fundamental analysis to determine the direction of the market, and technical analysis to time their entry and exist.

Q- How is it possible to sell, when one doesn’t own commodity?
A- One doesn’t need to have the physical commodity or own a contract for the commodity to enter into a sale contract in futures market. It is simply agreeing to sell the physical commodity at a later date or selling short. It is possible to repurchase the contract before the maturity, thereby dispensing with delivery of goods.

Q- What are long position?
A- In simple terms, long position is a net bought position.

Q- What are short position?
A- Short position is net sold position.

Q- What is bull spread (futures)?
A- In most commodities and financial derivatives market, the term refers to buying contracts maturing in nereby month, and selling the deferred month contracts, to profit from the wide spread which is larger than the cost of carry.

Q- What is bear spread (futures)?
A- In most of commodities and financial derivatives market, the term refers to selling the nearby contract month, and buying the distant contract, to profit from saving in the cost of carry.

Q- What is ‘Contango’?
A- Contango means a situation, where futures contract prices are higher than the spot price and the futures contracts maturing earlier.

Q- When is futures contract in ‘Contango’?
A- It arises normally when the contract matures during the same crop-season. In an well-integrated market, Contango is equal to the cost of carry viz. Interest rate on investment, loss on account of loss of weight or deterioration in quantity etc.

Q- What is ‘Backwardation’? 
A- When the prices of spot, or contracts maturing earlier are higher than a particular futures contract, it is said to be trading at Backwardation.

Q- When is futures contract at ‘Backwardation’?
A- It is usual for a contract maturing in the peak season to be in backwardation during the lean period.

Q- What is ‘basis’?
A- It is normally calculated as cash price minus the futures price. A positive number indicates a futures discount (Backwardation) and a negative number, a futures premium (Contango). Unless otherwise specified, the price of the nearby futures contract month is generally used to calculate the basis.

Q- What is cash settlement?
A- It is a process for performing a futures contract by payment of money difference rather than by delivering the physical commodity or instrument representing such physical commodity (like, warehouse receipt)

Q- What is offset?
A- It refers to the liquidation of a futures contract by entering into opposite (purchase or sale, as the case may be) of an identical contract.

Q- What is settlement price?
A- The settlement price is the price at which all the outstanding trades are settled, i.e, profits or losses, if any, are paid. The method of fixing Settlement price is prescribed in the Byelaws of the exchanges; normally it is a weighted average of prices of transactions both in spot and futures market during specified period.

Q- What is convergence?
A- This refers to the tendency of difference between spot and futures contract to decline continuously, so as to become zero on the date on maturity.

Q- Can one give delivery against futures contract?
A- Futures contract are contracts for delivery of goods. But most of the futures contracts, the world over, are performed otherwise than by physical delivery of goods.

Q- Why the proportion of futures contracts resulting in delivery is so low?
A- The reason is, futures contracts may not be suitable for merchandising purpose, mainly because these are standardized contracts; hence various aspects of the contracts, viz., quality/grade of the goods, packing, place of delivery, etc. may not meet the specific needs of the buyers/sellers.

Q- Why delivery of good is permitted when futures contract by their very nature not suitable for merchandising purposes?
A- The threat of delivery helps in dissuading the participants from artificially rigging up or depressing the futures prices. For example, if manipulators rig up the prices of a contract, seller may give his intention to make a delivery instead of settling his outstanding contract by entering into purchase contracts at such artificially high price.

Q- How can one avoid delivery being imposed against outstanding purchase contracts?
A- All the Exchanges give option to the participants to liquidate their outstanding position by entering into offsetting contract, before the “delivery period” commences. There is no delivery if the contracts are so liquidated. The threat of delivery – whether in terms of physical goods or by warehouse receipts – becomes a reality once delivery period commences.

Q- Can a buyer demand delivery against futures contract?
A- The Byelaws of different Exchanges have different provisions relating to delivery. Some Exchanges give the option to seller, i.e., if the seller gives his intention to give delivery, buyers have no choice, but to accept delivery or face selling on account and/or penalty. Some Exchanges, particularly the northern Exchanges trading contracts in “gur”/jaggery provide the option both to buyer and seller. In some Exchanges, if the sellers do not give intention to give delivery, all outstanding short and long position are settled at the “Due Date Rate”.

Q- What is “Due Date Rate”?
A- Due Date Rate is the weighted average of both spot and futures prices of the specified number of days, as defined in the Byelaws of Associations.

Q- What is delivery month?
A- It is the specified month within which a futures contract matures.

Q- What is delivery notice?
A- It is a written notice given by sellers of their intention to make delivery against outstanding short open futures positions on a particular date.

Q- What is Warehouse Receipt?
A- It is a document issued by a warehouse indicating ownership of a stored commodity and specifying details in respect of some particulars, like, quality, quantity and, some times, indicating the crop season.

Q- Are futures markets “satta” markets?
A- Participants in futures market include market intermediaries in the physical market, like, producers, processors, manufacturers, exporters, importers, bulk consumers etc., besides speculators. There is difference between speculation and gambling. Therefore futures markets are not “satta markets”.

Q- Why do we need speculators in futures market?
A- Participants in physical markets use futures market for price discovery and price risk management. In fact, in the absence of futures market, they would be compelled to speculate on prices. Futures market helps them to avoid speculation by entering into hedge contracts. It is however extremely unlikely for every hedger to find a hedger counterparty with matching requirements. The hedgers intend to shift price risk, which they can only if there are participants willing to accept the risk. Speculators are such participants who are willing to take risk of hedgers in the expectation of making profit. Speculators provide liquidity to the market, therefore, it is difficult to imagine a futures market functioning without speculators.

Q- What is the difference between a speculator and gambler?
A- Speculators are not gamblers, since they do not create risk, but merely accept the risk, which already exists in the market. The speculators are the persons who try to assimilate all the possible price-sensitive information, on the basis of which they can expect to make profit. The speculators therefore contribute in improving the efficiency of price discovery function of the futures market.

Q- Does it mean that speculation need not be curbed?
A- Informed and speculation is good for the market. However over-speculation needs to be kerbed. There is no unanimity about what constitutes over-speculation.

Q- How is over-speculation kerbed?
A- In order to curb over-speculation, leading to distortion of price signals, limits are imposed on the open position held by speculators. The positions held by speculators are also subject to certain margins; many Exchanges exempt hedgers from this margins.

Q- How should a futures contract be designed?
A- The most important principle for designing a futures contract is to take into account the systems and practices being followed in the cash market. The unit of price quotation, unit of trading should be fixed on the basis of prevailing practices. The “basis” – the standard quality/grade – variety should generally be that quality or grade which has maximum production. The delivery centers should be important production or distribution centers. While designing a futures contract care should be taken that the contract designed is fair to both buyers and sellers and there would be adequate supply of the deliverable commodity thus preventing any squeezes of the market.

Q- What are the benefits from Commodity Forward/Futures Trading?
A- Forward/Futures trading performs two important functions, namely, price discovery and price risk management with reference to the given commodity. It is useful to all segments of the economy. It enables the ‘Consumer’ in getting an idea of the price at which the commodity would be available at a future point of time. He can do proper costing and also cover his purchases by making forward contracts. It is very useful to the ‘exporter’ as it provides an advance indication of the price likely to prevail and thereby helps him in quoting a realistic price and secure export contract in a competitive market It ensures balance in supply and demand position throughout the year and leads to integrated price structure throughout the country. It also helps in removing risk of price uncertainty, encourages competition and acts as a price barometer to farmers and other functionaries in the economy.

Q- What is hedging?
A- Hedging is a mechanism by which the participants in the physical/cash markets can cover their price risk. Theoretically, the relationship between the futures and cash prices is determined by cost of carry. The two prices therefore move in tandem. This enables the participants in the physical/cash markets to cover their price risk by taking opposite position in the futures market.

Q- Illustrate hedging by a stockist by using futures market?
A- To illustrate the concept of hedging, let us assume that, on 1st December, 2002, a stockist purchases, say, 10 tonnes of Castorseed in the physical market @ Rs. 1600/- p.q.. To hedge price-risk, he would simultaneously sell 10 contracts of one tonne each in the futures market at the prevailing price. Assuming the ruling price in May, 2003 contract is Rs.1750/- p.q., the stockist is able to lock in a spread/“badla” of Rs. 150/- p.q., i.e., about 9% for about 6 months. The stockist would, in the first instance, take the decision to purchase stock only if such a spread covers his cost of carry and a reasonable profit of margin. Assuming that the stockist sells his stock in the month of April when the spot price is Rs. 1500/- p.q.. The stockist would incur a loss of Rs. 100/- p.q. on his physical stocks. He would also make a loss of expenses incurred for carrying the stocks. However, since the spot and futures prices move in parity, futures price is also likely to decline, say, from Rs. 1750/- p.q. to, say, Rs. 1625/- p.a. The stockist can liquidate his contract in the futures market by entering into purchase contract @ Rs. 1625/- p.q. He would end up earning a profit of Rs. 125/- in the futures segment. Looking at the gain/loss in the two segments, we find that the stockist is able to hedge his price risk by operating simultaneously in the two markets and taking opposite positions. He gains in the futures market if he loses in the spot market; but he would lose in futures market if he gains in the spot market. Similarly, processors, exporters, and importers can also hedge their price risks.

Q- How does futures market benefit farmers?
A- World over, farmers do not directly participate in the futures market. They take advantage of the price signals emanating from a futures market. Price-signals given by long-duration new-season futures contract can help farmers to take decision about cropping pattern and the investment intensity of cultivation. Direct participation of farmers in futures market to manage price risk –either as members of an Exchange or as non-member clients of some member – can be cumbersome as it involves meeting various membership criteria and payment of daily margins etc. Options in goods would be relatively more farmer-friendly, as and when they are legally permitted.

Q- Can the loss incurred on the futures market be set off against normal business profit?
A- Loss incurred in futures market by entering into contracts for hedging purposes can be set off against normal profit. The loss incurred on account of speculative transactions in futures market cannot be set off against normal business profit. This loss is however allowed to be carried forward for eight years, during which it can be set off against speculative profit.

Q- How can futures trading be successful when the cash markets of the underlying commodities are fragmented?
A- It is true that in order to attract wide participation, the cash market of commodities should be geographically integrated and free from Government restrictions on production, marketing and distribution, like limit on stock-holding, movement of goods across state borders etc. Differential inter-state tax structure as well as the APMC Acts introduced by various State Governments restraining direct purchase from farmers also comes in the way of developing nationwide market. It is however not a bad idea to introduce futures trading in commodity without waiting for the cash market in the commodity to become geographically integrated. The number of commodities attracting Essential Commodities Act, as well as the restrictions imposed on production, marketing and distribution of the commodities under the Essential Commodities Act have declined rapidly. Existence of futures/derivatives market as well as wide use of derivatives in commodities to manage price risk would create conditions for the Government to consider dilution/withdrawal of Administered price mechanism.

III. PARTICIPANTS IN DERIVATIVES MARKETS

Q- Who can be a member of the Exchange?
A- The Bye-laws and Articles of the Association prescribed the criteria for being a member of the Exchange. Any person desirous of being a member of the Exchange may approach the contact persons whose names, telephone numbers, fax numbers, email addresses etc. are available on the website of fmc: www.fmc.gov.in. They may also refer to the Bye-law and Articles of Association of the concerned Exchange which contain various criteria for the membership of the Exchange.

Q- Who are the participants in forward/futures markets?
A- Participants in forward/futures markets are hedgers, speculators, day-traders/scalpers, market makers, and, arbitrageurs.

Q- Who is hedger?
A- Hedger is a user of the market, who enters into futures contract to manage the risk of adverse price fluctuation in respect of his existing or future asset.

Q- What is arbitrage?
A- Arbitrage refers to the simultaneous purchase and sale in two markets so that the selling price is higher than the buying price by more than the transaction cost, so that the arbitrageur makes risk-less profit.

Q- Who are day-traders?
A-Day traders are speculators who take positions in futures or options contracts and liquidate them prior to the close of the same trading day.

Q- Who is floor-trader?
A- A floor trader is an Exchange member or employee, who executes trade by being personally present in the trading ring or pit floor trader has no place in electronic trading systems.

Q- Who is speculator?
A- A trader, who trades or takes position without having exposure in the physical market, with the sole intention of earning profit is a speculator.

Q- Who is market maker?
A- A market maker is a trader, who simultaneously quotes both bid and offer price for a same commodity throughout the trading session.

Q- What kinds of risks do participants face in derivatives markets?
A- Different kinds of risks faced by participants in derivatives markets are:
• credit risk 
• market risk 
• liquidity risk 
• legal risk 
• operational risk

Q- What is credit risk?
A- Credit risk on account of default by counter party: This is very low or almost zeros because the Exchange takes on the responsibility for the performance of contracts.

Q- What is market risk?
A- Market risk is the risk of loss on account of adverse movement of price.

Q- What is liquidity risk?
A- Liquidity risks is the risk that unwinding of transactions may be difficult, if the market is illiquid.

Q- What is Legal risk?
A- Legal risk is that legal objections might be raised, regulatory framework might disallow some activities.

Q- What is operational risk?
A- Operational risk is the risk arising out of some operational difficulties, like, failure of electricity, due to which it becomes difficult to operate in the market.

IV. EXCHANGES AND THEIR ROLE

Q- How many recognized/registered associations engaged in commodity futures trading?
A- At present 21 Exchanges are recognized/registered for forward/ futures trading in commodities.

Q- Why are associations required to get recognized?
A- Under the Forward Contracts (Regulation) Act, 1952, forward trading in commodities notified under section 15 of the Act can be conducted only on the Exchanges, which are granted recognition by the Central Government (Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution).

Q- Which associations are recognized?
A- The list of the Exchanges and the commodities in which they are recognized is given at Annex-I.

Q- Are the associations organizing forward trading required to get themselves registered?
A- All the Exchanges, which deal with forward contracts, are required to obtain certificate of Registration from the Forward Markets Commission.

Q- What is the difference between Registered Associations and Recognized Associations?
A- All the associations concerned with regulation and control of business relating to forward contracts in goods, including recognized associations, are required to obtain Certificate of Registration from the Forward Markets Commission. Such business can be conducted only in accordance with the conditions of Certificate of Registration. All the Associations concerned with the regulation and control of business relating to forward contracts in commodities, which are notified u/sec. 15 of the Act have to obtain recognition from the Central Government. The associations organizing trading in commodities other than those notified under section 15, need not seek recognition; they merely have to obtain certificate of registration.

Q- What is the procedure for obtaining recognition for an Association?
A- The application for grant of recognition will have to be made in triplicate in a prescribed form to Secretary, Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution, Krishi Bhavan, New Delhi – 110 00. Form A prescribed for application for the recognition is placed on the web site of the FMC www.fmc.gov.in .The application for grant of recognition should be forwarded through Forward Markets Commission, Everest, 3rd Floor, 100, Marine Drive, Mumbai – 400 002.. The Government may grant recognition to the applicant association on the basis of recommendations made by the Forward Markets Commission. A fee of Rs. 2500/- will have to be paid by the applicant association for grant of recognition. The fee could also be deposited in the nearest Government Treasurery or the nearest branch of State Bank of India; provided that at Mumbai, Kolkatta, Delhi, Kanpur and Chennai, the amount has to be deposited in the Reserve Bank of India. The fee can also be remitted by crossed Indian Postal Order drawn in favour of Secretary, Forward Markets Commission. The application has to be accompanied by 3 copies of Memorandum and Articles of Association and Byelaws. 

Q- What is the procedure for obtaining certificate of registration from the Forward Markets Commission? 
A- Application in triplicate for grant of certificate of Registration in Form B – placed on the web site of the FMC < www.fmc.gov.in > – should be sent to Forward Markets Commission, Everest, 3rd Floor, 100, Marine Drive, Mumbai – 400 002. A fee of Rs. 50/- will have to be paid by the applicant association for grant of registration certificate. The fee could also be deposited in the nearest Government Treasurery or the nearest branch of State Bank of India; provided that at Mumbai, Kolkatta, Delhi, Kanpur and Chennai, the amount has to be deposited in the Reserve Bank of India. The fee can also be remitted by crossed Indian Postal Order drawn in favour of Secretary, Forward Markets Commission. The application has to be accompanied by 3 copies of Memorandum and Articles of Association and Byelaws.

Q- What is “National” Commodity Exchange?
A- Government identified the best international systems and practices in respect of trading, clearing, settlement and governance structure and invited applications from associations – existing and potential – to set up National Commodity Exchanges by introducing such systems and practices. The term, “National” used for these Exchanges does not mean that other Exchanges are restricted from having nationwide operations.

Q- How do National Commodity Exchanges differ from other Commodity Exchanges?
A- National Commodity Exchanges would be granted recognition in all permitted commodities; the other exchanges have to approach the Government for grant of recognition for each futures contract separately. Also, National Commodity Exchanges would be putting is place the best international practices in trading, clearing, settlement, and governance.

Q- Which are the approved National Commodity Exchanges?
A- The Government of India identified four commodity exchanges – two existing and two at proposal stage for setting up of Nation-Wide Commodity Exchanges. One of these existing Exchanges, Online Commodity Exchange of India Ltd. – now renamed as National Multicommodity Exchange of India Ltd. – completed the preconditions for grant of national status, and was granted permanent recognition in all commodities, permitted from time to time. National Board of Trade, Indore is also an existing Exchange, recognised in Soya Complex, Mustard Complex and Palm Derivatives. Three Exchanges, including National Board of Trade, Indore, were given ten months’ time to complete the preconditions. They are expected to be operational by October, 2003.

Q. What is the role of an Exchange in futures trading?
A- An Exchange designs a contract, which alone would be traded on the Exchange. The contract is not capable of being modified by participants, i.e., it is standardized. The Exchange also provides a trading platform, which converges the bids and offers emanating from geographically dispersed locations. This creates competitive conditions for trading. The Exchange also provides facilities for clearing, settlement, arbitration facilities. The Exchange may also provide financially secure environment by putting in place suitable risk management mechanism (margining system etc.), and guaranteeing performance of contract through the process of novation.

Q- Why does Exchange collect margin money?
A- The aim of margin money is to minimize the risk of default by either counter party. The amount of initial margin is so fixed as to ensure that the probability of loss on account of worst possible price fluctuation, which cannot be met by the amount of ordinary/initial margin is very low. The Exchanges fix rates of ordinary/initial margin keeping in view need to balance high security of contract and low cost of entering into contract.

Q- What are the different types of margins payable on futures?
A- Different margins payable on futures contracts are:
Ordinary/initial margin, mark-to-market margin, special margin, volatility margin, and delivery margin.

Q- What is initial/ordinary margin?
A- It is the amount to be deposited by the market participants in his margin account with clearing house before they can place order to buy or sell a futures contracts. This must be maintained throughout the time their position is open and is returnable at delivery, exercise, expiry or closing out.

Q- What is Mark-to-Market margin?
A- Mark-to-market margins (MTM or M2M or valan) are payable based on closing prices at the end of each trading day. These margins will be paid by the buyer if the price declines and by the seller if the price rises. This margin is worked out on difference between the closing/clearing rate and the rate of the contract (if it is enterned into on that day) or the previous day’s clearing rate. The Exchange collects these margins from buyers if the prices decline and pays to the sellers and vice versa.

Q- Why is Mark-to-Market margin collected daily in commodity market?
A- Collecting mark-to-market margin on a daily basis reduces the possibility of accumulation of loss, particularly when futures price moves only in one direction. Hence the risk of default is reduced. Also, the participants are required to pay less upfront margin – which is normally collected to cover the maximum, say, 99.9%, of the potential risk during the period of mark-to-market, for a given limit on open position. Alternatively, for the given upfront margin the limit on open position would have to be reduced, which has the effect of restraining the trade and liquidity.

Q- What is Volatility?
A- It is a measurement of the variability rate (but not the direction) of the change in price over a given time period. It is often expressed as a percentage and computed as the annualized standard deviation of percentage change in daily price.

Q- What is a Client Account?
A- Client Account is an account maintained for any individual or entity being serviced by an agent (broker, members), for a commission. A customer’s business must be segregated from the broker’s/member’s/principal’s own business and clients’ money should be kept in segregated accounts.

Q- What is a client agreement?
A- It is a legal document entered into between the broker and the client setting out the conditions of their relationship and meeting the requirements of the relevant self-regulatory organization and the Regulator.

Q- What is the ‘Trade Guarantee Fund’?
A- The main objectives of Trade Guarantee fund are (a) to guarantee settlement of bonafide transactions of the members of the Exchange (b) thereby, to inculcate confidence in the minds of market participants’ (c) to protect the interest of the investors. All the members of the Exchange are required to make initial contribution towards trade guarantee fund of the Exchange.

Q- What is the role of Clearing House?
A- Clearing House performs post trading functions like confirming trades, working out gains or losses made by the participants during the course of the clearing period – usually a day-collecting the losses from the members and paying out to other who have made gains.

Q- What is novation?
A- Some Clearing Houses interpose between buyers and sellers as a legal counter party, i.e., the clearing house becomes buyer to every seller and vice versa. This obviates the need for ascertaining credit-worthiness of each counter party and the only credit risk that the participants face is the risk of clearing house committing a default. Clearing House puts in place a sound risk-management system to be able to discharge its role as a counter party to all participants.

Q- How does an exchange ensure the guarantee of the performance of the contract?
A- The performance of the contracts registered by the exchange are guaranteed either by the exchange or its clearing house. The exchange interposes itself between each buyer and seller thereby becoming a seller to every buyer and a buyer to every seller. The Exchange In order to safeguard its interest by imposing mark to market margin (which is clearing all the transactions at the closing price of the day. All the profits and losses are either paid in or paid out). This minimises the chances of default as buyer or seller is exposed to one day of price movements. The Exchange also maintains its own TGF / SGF which can be used in case of a default. The Exchange also puts in place a membership criteria and some of the new Exchanges have also prescribed certain minimum capital adequacy norms.

V. MEMBERSHIP OF EXCHANGES

Q- Does a member / broker need to register with the Forward Markets Commission?
A- No, but the Forward Contracts (Regulation) Act, 1952 is proposed to be amended to provide for registration of brokers with the Forward Markets Commission.

Q- At what rate does the Forward Markets Commission charge its fee on the turnover of the members/brokers?
A- Forward Market Commission does not charge any regulatory fee from the Exchanges or its members and users. It is an office of the Government of India and sources its finances from the budget.

Q- Can a security broker obtain the membership of a Commodity Exchange?
A- The Forward Contracts (Regulation) Act, 1952 does not prohibit security broker from obtaining membership of a Commodity Exchanges. Certain restrictions are however, imposed on a security broker from participating in the Commodity Exchanges under Securities Contracts (Regulation) Rules, 1952. Notification is being/has been issued removing such a restriction. The security broker will however have to set up a subsidiary – a separate legal entity – with separate capital adequacy and minimum networth for being able to trade on a commodity exchange.

Q- Can a member enter into the options in goods?
A- Options in goods are presently prohibited under Section 19 of the Forward Contracts (Regulation) Act, 1952. No exchange or no person – whether he is a member of any recognized association or not – can organize or enter into or make or perform options in goods; it constitutes cognizable offence, which is punishable under section 20(e) of the Act.

VI. REGULATION

Q- What is the present system of regulation in commodity forward/future trading in India?
A- At present, there are three tiers of regulations of forward/futures trading system exists in India, namely, Government of India, Forward Markets Commission and Commodity Exchanges.
The FC(R) Act, 1952 prohibits options in commodities. For the purpose of forward contracts in certain commodities can be regulated by notifying those commodities u/s 15 of the Act; forward trading in certain other commodities can be prohibited by notifying these commodities u/s 17 of the Act.

Q- What is the need for regulating futures market?
A- The need for regulation arises on account of the fact that the benefits of futures markets accrue in competitive conditions. The regulation is needed to create competitive conditions. In the absence of regulation, unscrupulous participants could use these leveraged contracts for manipulating prices. This could have undesirable influence on the spot prices, thereby affecting interests of society at large.. Regulation is also needed to ensure that the market has appropriate risk management system. In the absence of such a system, a major default could create a chain reaction. The resultant financial crisis in a futures market could create systematic risk. Regulation is also needed to ensure fairness and transparency in trading, clearing, settlement and management of the exchange so as to protect and promote the interest of various stakeholders, particularly non-member users of the market.

Q- What is Forward Markets Commission and where is it located?
A- Forward Markets Commission is a regulatory body for commodity futures/ forward trade in India. This was set up under the Forward Contracts (Regulation) Act of 1952. It is responsible for regulating and promoting futures/ forward trade in commodities. The Forward Markets Commission’s Head Quarter is located at Mumbai and Regional Office at Kolkata. The Address of the contact person is as follows:
The Chairman, Forward Markets Commission, Ministry of Consumer Affairs, Food and Public Distribution, (Department of Consumer Affairs), Government of India, “Everest”, 3 rd floor, 100, Marine Drive, Mumbai – 400 002 . Tel : (022) 22811262/22811429, Fax : (022) 22812086, E-mail :- fmc@bom5.vsnl.nic.in , Web-site :- www.fmc.gov.in

Q- What are the functions of the Forward Markets Commission?
A- • FMC advises Central Government in respect of grant of recognition or withdrawal of recognition of any association.
• It keeps forward markets under observation and takes such action in relation to them as it may consider necessary, in exercise of powers assign to it.
• It collects and publishes information relating to trading conditions in respect of goods including information relating to demand, supply and prices and submit to the Government periodical reports on the operations of the Act and working of forward markets in commodities.
• It makes recommendations for improving the organization and working of forward markets.
• It undertakes inspection of books of accounts and other documents of recognized/registered associations.

Q- What are the powers of the Commission?
A- The Commission has powers of deemed civil court for (a) Summoning and enforcing the attendance of any person and examining him on oath; (b) Requiring the discovery and production of any document; (c) Receiving evidence on affidavits, and (d) Requisitioning any public record or copy thereof from any office.
The following powers are vested in the Central Government, most of which are delegated to the Commission: 
The powers of approving memorandum and articles of association and Bye-laws; powers to direct to make or to make articles (Rules) or Bye-laws; powers to suspend governing body of recognised association, and, powers to suspend business of recognised association.

Q- Why and what are the regulatory measures prescribed by Forward Markets Commission?
A- Forward Markets Commission provides regulatory oversight in order to ensure financial integrity (i.e. to prevent systematic risk of default by one major operator or group of operators), market integrity (i.e. to ensure that futures prices are truly aligned with the prospective demand and supply conditions) and to protect & promote interest of customers /non-members.
The Forward Markets Commission prescribes following regulatory measures: 
(a) Limit on net open position as on the close of the trading hours. Some times limit is also imposed on intra-day net open position. The limit is imposed operator-wise, and in some cases, also member-wise.
(b) Circuit-filters or limit on price fluctuations to allow cooling of market in the event of abrupt upswing or downswing in prices.
(c) Special margin deposit to be collected on outstanding purchases or sales when price moves up or down sharply above or below the previous day closing price. By making further purchases/sales relatively costly, the price rise or fall is sobered down. This measure is imposed only on the request of the Exchange. 
(d) Circuit breakers or minimum/maximum prices: These are prescribed to prevent futures prices from falling below as rising above not warranted by prospective supply and demand factors. This measure is also imposed on the request of the Exchanges.
(e) Skipping trading in certain derivatives of the contract, closing the market for a specified period and even closing out the contract: These extreme measures are taken only in emergency situations.

Q- What are the legal and regulatory provisions for customer protection?
A- The F.C(R) Act provides that client’s position cannot be appropriated by the member of the Exchange, except a written consent is taken within three days’ time. Forward Markets Commission is persuading increasing number of Exchanges to switch over to electronic trading, clearing and settlement, which is more customer-friendly. Commission has also prescribed simultaneous reporting system for the Exchanges following open out-cry system. These steps facilitate audit trail and make it difficult for the members to indulge in malpractices like, trading ahead of clients, etc. The Commission has also mandated all the Exchanges following open outcry system to display at a prominent place in Exchange premises, the name, address, telephone number of the officer of the Commission who can be contacted for any grievance. The website of the Commission also has a provision for the customers to make complaint, send comments and suggestions to the Commission. Officers of the Commission have been instructed to meet the members and clients on a random basis, whenever they visit Exchanges, to ascertain the situation on the ground, instead of merely attending meetings of the Board of Directors and holding discussions with the office-bearers.

VII. ILLEGAL DERIVATIVE TRADING

Q- What is FMC doing to curb illegal forward trading?
A- Under the Forward Contracts (Regulation) Act, 1952 most of the contravention of the provisions of the Act constitutes cognizable offences. The powers of search, seizure and investigation are therefore with the State Police Authorities. The role of Forward Markets Commission is confined to communication of information relating to offences under the Act to the police authorities and assist such authorities in scrutinising documents referred to by them in rendering such expert advice as may be required by them (Please see Rule 13 of the Forward Contracts (Regulation) Rules, 1954).
Since the offences under the Act are technical in nature and it is difficult to prove the charges in accordance with the rules of evidence contained in the Evidence Act, beyond any reasonable doubt, the Forward Markets Commission periodically conducts training progammes, Seminars, Workshops etc. for the benefit of Police Officers/ Prosecutors and also Judicial Magistrates First Class/Metropolitan Magistrates. The officers of the Commission also accompany the police in conducting searches to assist in sifting incriminating documents. Commission also exhorts the office bearers and the members of the recognized exchanges to share information in respect of illegal forward trading.

Q- What types of contracts are illegal?
A- The following contracts are illegal.
– Forward Contracts in the permitted commodities, i.e., commodities notified under S.15 of the Forward Contracts (Regulation) Act, 1952, which are entered into other than: a) between the members of the recognised Association or b) through or c)with any such members.
– Forward contracts in prohibited commodities, i.e., commodities notified under S. 17 of the Forward Contracts (Regulation) Act, 1952 (Presently no commodity has been notified under S. 17 of the Act.
– Forward Contracts in contravention of the provisions contained in the Bye-laws of the Exchange, which attract S. 15(3) of the Act.
– Forward Contracts in the commodities in which such contracts have been prohibited.Options in goods.

Q- Who can be arrested and prosecuted under the Forward Contracts (Regulation) Act? For what offences?
A- The following persons attract penal provisions under the F.C.(R) Act, 1952:
– Owner or tenant of a place which is used, with the knowledge of such owner and tenant, for entering into or making or performing, whether wholly or in part, illegal forward contracts;
– A person who, without permission of the Central Government, organizes or assists in organizing or becomes a member of any association other than recognized association for the purpose of assisting in, entering into, or making, or, performing; whether wholly or in part, in illegal forward contract;
– Any person who controls, manages, or assists in keeping any place, other than recognized association for entering into, or making, or performing illegal forward contract, or for clearing or settlement of such contracts;
– Any person who willfully misrepresents or induces any person to believe that he is a member of a recognized association or that forward contract can be entered into or made or performed, whether wholly or in part through him.
– Any person who is not a member of a recognized association canvasses, advertises or touts in any business connected with forward contracts in contravention of the Forward Contracts (Regulation) Act, 1952.
– Any person who joins, gathers, or assists in gathering at any place other than the place of business specified in the bye-laws of the recognized associations for making bids or offers or for entering into illegal forward contracts.
– Any person who makes publishes or circulates any statement or information, which is false and which he either knows, or believes to be false, affecting or tending to affect the course of business in forward contracts in permitted commodities.
– Any person who manipulates or attempts to manipulate prices of forward contracts in permitted commodities are liable for punishment under the Act on conviction.

Q- What is bucketing?
A- Broker is said to be indulging in bucketing, when he takes directly or indirectly, the opposite side of a customer’s order either on his own account or into on account in which he or she has an interest, without executing the order on an Exchange. Appropriation of clients’ trade without written consent constitutes contravention of S. 15(4) of the Act and is punishable under S. 20(e).

Q- What is Options in goods?
A- Options in goods is an agreement by whatever name called, like, Teji-Mandi, Jota Fatak, Najrana, under which buyer of the option (called as applier) pays a premium to the seller of option (called as writer of the option) for acquiring from him right to buy or sell the goods at a mutually agreed rate (called as strike price), in respect of which the premium amount is paid. When the buyer acquires right to buy, it is called as a “call” (Teji) and when he acquires right to sell it is called a “put” (Mandi) option. It is possible to acquire a rights both to buy and to sell the goods; but in this case higher premium amount would have to be paid. The buyer acquires only right, i.e., he is under no obligation to buy or sell, as the case may be, at the mutually agreed price. Options in goods are presently prohibited under section 19 of the Act. There is a proposal to amend the Act to allow options in goods under regulated conditions.

Membership

Q- What are the benefits in futures trading in commodities?
A- Futures trading in commodities results in transparent and fair price discovery on account of large scale participations of entities associated with different value chains and reflects views and expectations of wider section of people related to that commodities. This also provides effective platform for price risk management for all segments of players ranging from the producers, the traders, processors, exporters/importers and the end users of the commodity. The trading on futures contract on our platform will be facilitated on an online platform for market participants to trade in a wide range of commodity derivatives driven by the best global practices of professionalism and transparencies. We have provided with more details on the entire gamut of commodity trading in India in general and on NCDEX in particular in our website under “Presentations”. Please visit our website www.ncdex.com.

Q- Who can become member of NCDEX?
A- An individual, partnership firm, Private limited company, public limited Company, co-operative societies are eligible to become members of NCDEX.

Q- Can we apply for the membership under the HUF account? 
A- No, HUF is currently not permitted for NCDEX membership.

Q- Is NCDEX a separate legal corporate entity?
National Commodity and Derivatives Exchange Ltd (NCDEX) is a public limited company registered under The Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23,2003. The registration no of NCDEX is U51909 MH 2003 PLC 140116

Q- What are the membership charges?
A- For trading cum clearing member (TCM) the criteria is as follows:
– Net worth of Rs 50 lacs
– Interest free deposit of Rs 15 lacs towards base capital
– Collateral deposit of Rs 15 lacs in form of bank guarantees, fixed deposit. GOI securities.

Q- How is the net worth calculated for a new subsidiary?
A- Net worth of the new entity should be Rs 50 lacs. Please follow the procedure explained in detail in Annexure C-1A of the application form to calculate the networth.
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Q- Whether the networth of the holding company will be taken into consideration for the same?
A- No, the networth of the holding company is not taken into consideration for reckoning the networth of the entity applying for membership.

Q- How could a new company submit the 3 years balance sheet?
A- In case of newly formed companies, only current balance sheet needs to be submitted.

Q- Who will certify the various certificates, which are required to be certified by the auditor of the company?
A- The certificate and statements need to be certified by a Qualified Chartered Accountant who has audited the same.

Q- Is it a must that the individual should be a graduate?
A- It is desirable, however, we will consider waiving the same in case of persons having adequate experience in commodity market, financial markets.

Q- What is the lock in period for the interest free security deposit?
A- The lock in period for the interest free security deposit fee is three years.

Q- When is the security deposit eligible for refund in case of surrender?
A- The interest free security deposit will be refunded to the TCM, when they express their intention to relinquish their membership rights after a cooling period of 6-12 months of surrendering the membership rights. The minimum lock in period for membership is three years.

Q- What is the essential requirement for collateral?
A- Collateral security could be in the form of bank guarantee, RBI Bonds, fixed deposits and Government of India Securities. These certificates have to be deposited with the NCDEX and the same will be refunded on relinquishment of the membership.

Q- Are the course materials available for the proposed exam to be undertaken by the core dealer?
A- The course module and the study materials is being complied and the same will be made available on our website. The core dealer is expected to pass the exam on or before the date stipulated by NCDEX.

Q- Whether we can apply for the membership of NCDEX in the same name in which we are holding the membership of NSEIL?
A- The existing stock broking company cannot apply in the same and need to form separate entity for seeking membership of NCDEX.

Q- Whether exposure will be allowed against base capital and collateral?
A- Exposure will be permitted against base capital and collateral however a portion of the same will utilized for formation of Settlement Guarantee Fund.

Q- What are the trading hours?
A- The trade timings of the exchange are 10.00 a.m. to 4.00 p.m. It is also proposed to have after hours trading also.

Q- Please indicate the permissible brokerage structure and brokerage pattern.
A- The exchange does not stipulate any directives in this regard and it is free to be bilaterally decided between client and member of the exchange.

Q- Whether Regulators, i.e., Forward Market Commission, levy any turnover fee?
A- Currently, there is no provision to charge any fee.

Q- Is there any additional cost towards acquiring membership in addition to what has been specified in the application form?
A- There are no additional costs other than what is stated in the application form.

Q- Are the memberships to be taken afresh for each of the products to be traded in NCDEX from time to time?
A- No, the membership availed at the first instance is composite one and will be valid for all the products which are to be traded on NCDEX.

Q- Can one use the NSE terminal to trade in NCDEX?
A- Separate VSat connectivity is required.

Q- Whether one can use the idle NSE terminal for trading on NCDEX?
A- One can use the dish and other hardware with concurrence of NSE and service provider.

Q- What is the meaning of dominant promoter group?
A- The dominant promoter group stipulation is applicable in case of partnership firms, private limited companies and unlisted public companies. As per this stipulation, a group of not more than 4 individuals (who directly / indirectly hold more than 51% of capital in the firm / company) need to be identified as the key promoters of the entity. This exercise is an effort by NCDEX to identify and understand the individuals, who are the driving forces of the entities applying for membership on NCDEX.

Q- What are the commodities identified for trading?
A- Subject to Forwards Market Commission approval, 9 commodities, viz, Gold, Silver, Cotton, Soyabean, Soyaoil, Rape/Mustardseed, Rape/Mustard oil, Crude Palm Oil and RBD Palmolein are the commodities that will be traded in the first phase. NCDEX proposes to trade in all the major commodities approved by FMC.

Q- Which are the other multi commodity exchanges in the country?
A- Forward Markets Commission has accorded in principle approval for the following national level multi commodity exchanges in the country apart from NCDEX 
(1) National Board of Trade
(2) Multi Commodity Exchange of India
(3) National Commodity & Derivatives Exchange of India Ltd

Q- How NCDEX is different from other exchanges?
A- NCDEX is a professionally managed, nation wide, on-line multi-commodity exchange promoted by ICICI Bank Ltd, National Bank for Agriculture and Rural Development (NABARD), Life Insurance Corporation of India (LIC), and National Stock Exchange (NSE).
NCDEX is a technology driven de-mutualised commodity exchange with an independent board of directors and professionals not having any vested interest in commodity markets. It is committed to provide a world class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by the best global practices of professionalism and transparency.
The four institutional promoters of NCDEX are prominent players in their respective fields and bring with them institutional building experience, trust, nation wide reach, technology and risk management skills.

Q- Will the exchange plan to have market makers?
A- We are in dialogue with large scale players in commodity market for voluntary market making like in case of gold and silver major bullion importing banks have agreed fro market making. Similarly large commodity trading houses have agreed to do market making in commodities they are dealing in.

Q- What is your membership scrutiny process?
A- The membership forms will be processed at our end and in case of any additional information, the same will be called for. If found in order, the applicants will be subsequently called for personal interaction with the membership committee of NCDEX. Successful applicants will be intimated by NCDEX.

Q- What should be the main objective clause in the Memorandum of Association to aid in trading in commodity futures?
A- The main objective clause to be inserted in the Memorandum of Association is:
To carry on the business of trading in agricultural products, metals including precious metals, precious stones, diamonds, petroleum and energy products and all other commodities and securities, in spot markets and in futures and all kinds of derivatives of all the above commodities and securities.
To carry on business as brokers, sub brokers, market makers, arbitrageurs, investors and/or hedgers in agricultural products, metals including precious metals, precious stones, diamonds, petroleum and energy products and all other commodities and securities, in spot markets and in futures and all kinds of derivatives of all the above commodities and securities permitted under the laws of India.
To become members and participate in trading, settlement and other activities of commodity exchange/s (including national multi – commodity exchange/s) facilitating, for itself or for clients, trades and clearing/settlement of trades in spots, in futures and in derivatives of all the above commodities permitted under the laws of India.

Q- Whether a designated director in an entity having membership of BSE assume similar responsibility /designation in the new subsidiary formed for taking membership of NCDEX.
A- While taking membership of BSE the designated directors have executed undertaking to following effect “We hereby undertake that on starting business in the Stock Exchange, Bombay, we shall cease to do any other business or render professional services in any other capacity or work as an employee”.
In view of undertaking as above it is suggested that designated director on entitiy having membership of BSE does not assume responsibility as qualifying director in corporate entity seeking membership of NCDEX. However entity having membership of BSE can seek membership of NCDEX through subsidiary route.

Q- Whether qualifying director in entity being member of NSE assume similar responsibility /designation in the new subsidiary formed for commodity exchange?
A- Yes, in case of NSE there is no such bar.

Q- At what point of time one has to comply with the Net worth requirements?
A- Upon the provisional admission as NCDEX member and being advised on the same by NCDEX, the prospective members are required to comply with the networth requirements in 2-3 weeks time.

Settlement

Q- Is NCDEX going to have its Clearing Corporation?
A- NCDEX has tied-up with NSCCL for clearing the trades.

Q- Who maintains and the Settlement Guarantee Fund?
A- Settlement guarantee fund would be maintained and managed by NCDEX.

Q- How would contracts settle?
A- All open contracts not intended for delivery and non-deliverable positions at client level would be cash settled.

Q- What would be the settlement period?
A- All contracts settling in cash would be settled on the following day after the contract expiry date. All contracts materializing into deliveries would settle in a period of 2-7 days after the expiry. The exact settlement day would be specified for each commodity.

Q- Would you be providing for deliveries?
A- Yes

Q- Are deliveries compulsory?
A- No. The buyer and the seller have to express their intention for delivery. Deliveries would be matched randomly at client level. Contracts not assigned delivery would be settled in cash.

Q- Would additional margins be levied for deliverable positions?
A- Yes

Q- How would the settlement take place in commodity futures market?
A- For open positions on the expiry day of the contract, the buyer and the seller can give intentions for delivery. Deliveries would take place in electronic form. All other positions would be settled in cash.

Q- How would a buyer take physical delivery?
A- Any buyer intending to take physicals would have to put a request to its Depository Participant, who would pass on the same to the registrar and the warehouse. On a specified day, the buyer would go to the warehouse and pick up the physicals.

Q- How would a seller get the electronic balance for the physical holdings?
A- The seller intending to make delivery would have to take the commodities to the designated warehouse. These commodities would have to be assayed by the Exchange specified assayer. The commodities would have to meet the contract specifications with allowed variances. If the commodities meet the specifications, the warehouse would accept them. Warehouses would then ensure updating the receipt in the depository system giving a credit in the depositor’s electronic account.

Q- How would the seller give an invoice to the buyer?
A- The seller would give the invoice to its clearing member, who would courier, the same to the buyer’s clearing member.

Q- How many warehouses would be there?
A- To start with, we are looking at only one delivery center for each commodity and only one warehouse in that location. Over a period of time, we would be adding warehouses to the list.

Q- How would you accredit warehouses?
A- NCDEX would prescribe the accreditation norms, comprising of financial and technical parameters, which would have to be met by the warehouses. NCDEX would take assayer’s/Structural Engineer’s certificate confirming the compliance of the technical norms by the warehouses.

Q- Whether the accredited warehouses would be dedicated warehouses?
A- In case of grains/seeds, warehouses would earmark a definite storage capacity within the warehouse premises for members of NCDEX, while in case of oils, specified tankers would be earmarked for NCDEX participants.

Q- Who would decide the warehousing charges?
A- The warehouse concerned would decide the warehousing charges. However the warehouse charges would be made available on our website.

Q- Would health checks and inventory verification be carried out?
A- Yes. The assayers and or other experts on behalf of NCDEX would carry out surprise health checks and inventory verification.

Q- What happens to the sales tax?
A- Prices quoted for the futures contracts would be basis warehouse and exclusive of sales tax applicable at the delivery center. For contracts materializing into deliveries, sales tax would be added to the settlement amount. The sales tax would be settled on the specified day after the payout.

Q- How would the buyer give a declaration for re-sale in case of last point collection of tax?
A- The buyer intending to take delivery would give declaration for re-sale at the time of giving intention for delivery. Accordingly the seller would issue the invoice, exclusive of sales tax. The declaration form duly signed by the buyer would be forwarded through the buyer’s clearing member to the seller’s clearing member within a specified time after pay-in and payout.

Q- How will you ensure uniformity in delivered grades / varieties?
A- The exchange will specify, in its contract description, the particular grade / variety of a commodity that is being offered for trade. A range will be specified for all the properties and only those grades / varieties, which fall within the range, will be accepted for delivery.
In case the properties fall within the range, but differ from the benchmark specifications, the Exchange will specify a premium / rebate.

Q- Would there be any premium / rebates for the difference in quality?
A- Yes. These would be pre-defined and made available on the website. The settlement obligation would be impacted on account of the premium / rebates in case of deliverable positions. The parameters which would be considered for premium / rebate computation as well as the methodology would be specified by NCDEX.

Q- Who will be certifying / assaying agencies. Will they also give the time validity for the commodities certified?
A- We are looking at following assayers: SGS India Pvt. Limited, Geo-Chem Laboratories, Dr. Amin Superintendents & Surveyors Pvt Ltd., Calib Brett and Stewart. Only certificates given by specified assayers by NCDEX will be accepted. All the certificates issued will have time validity.

Q- What happens when the commodities reach the validity date?
A- Those commodities will not be available for delivery on the clearing corporation. Hence the deliverable electronic balance would be automatically reduced. Warehouse would place the commodities in a separate area, indicating that they are not available for electronic trading.

Q- Would commodities be accepted without assayer’s certificate?
A- No

Q- Can commodities be re-deposited in the warehouse after the validity period of the assayer’s certificate?
A- Yes, provided they are re-validated by the assayer.

Q- What would be transaction charges?
A- Rs.6/- per Rs100, 000/- i.e. 0.006% of the trade value.

Q- What is the procedure for handling bad delivery / part delivery?
A- Partial delivery as well as bad delivery would be considered as default. Penalties would be levied.

Q- How would disputes be resolved?
A- Any disputes in regard to the quality / quantity will be referred to the Arbitration committee set up for the purpose.

Q- Who would be the clearing bankers?
A- Following banks have agreed to act as clearing bankers:
– Canara Bank
– HDFC Bank
– ICICI Bank
– UTI Bank

Q- Who would be the depository participants?
A- We have approached
– Bank of Baroda
– Canara Bank
– Global Trust Bank
– HDFC Bank
– ICICI Bank
– IDBI Bank
– Indusind Bank
– UTI Bank

Technology

Q- Would the same technology infrastructure of NSE be used?
A- No

Q- Why is the same network of NSE not being considered?
A- There is no additional capacity available. As the operations are time critical, we thought it prudent to have a separate network.

Q- Are VSATs compulsory?
A- No. NCDEX is proposing an option of either two lease lines or one lease line backed by V-SAT

Q- Which protocol is being used?
A- We would be operating on TCP / IP protocol

Q- Who would provide the services?
A- NCDEX has tied up with HCL Comnet for VSAT services. The services would be provided as a package deal at the price agreed. The cost approximately works out to be Rs.140, 000/- in year 1. The total cost over a period of 5 years works out to be approx. Rs200, 000/-. The member would directly deal with the vendor. However, NCDEX would monitor the service levels of the vendor. Member is free to approach NCDEX for problems faced and NCDEX would intervene.

Q- When would the payment be made?
A- The member would have to directly make the payment to the vendor. As soon as NCDEX confirms the membership, NCDEX would intimate the service provider. The member would approach the service provider, along with the one time payment.

Q- Is there a facility of buy back of VSAT in case of surrender of membership?
A- Yes, the service provider would buy back the VSAT at a price, which would be dependent on the year of surrender and the condition in which it is surrendered. The rates for buy back would be specified.

Sales Tax

Q- Does the trading / clearing member need to have sales tax registration?
A- No. The member need not have a sales tax registration. However, if the member wants to undertake proprietary trading and take the delivery of the commodities, then he needs to have sales tax registration under the provisions of the relevant State sales tax law.

Q- Do the clients/participants need to have sales tax registration?
A- Those clients who trade with the intention of taking/giving delivery should have sales tax registration before settlement of the delivery based trades. Deliveries given by clients/participants who are not registered under the relevant State sales tax law or whose registration is not valid on the date of sale / delivery, will amount to defaults.

Q- In which state sale tax registration is to be obtained?
A- Sales tax registration is to be obtained in the State where the delivery center for the commodity is located.

Q- What is rate of sales tax applicable?
A- Rate of sales tax for the commodities differs from State to State. In the case of settlements culminating into delivery, sales tax at the rates applicable in the State where the delivery center is located will be payable. Many States’ sales tax laws, also provide for levy of additional tax, turnover tax, resale tax, etc. which may or may not be recoverable from the buyer depending on the provisions of the local State sales tax law.

Disclaimer: The rates given above are only for reference, are as per the information available and should be verified from independent sources. The Exchange will not be responsible for accuracy of the same.

Q- Who is responsible for payment of sales tax?
A- It is obligatory on the part of the seller to collect the sales tax from the buyer and deposit the same into the Government Treasury. However, in the case of commodities which are liable to tax on purchases only and not on sales, the buyer will have to discharge the liability for payment of tax. In all other cases, payment of taxes will be the sole responsibility of the seller.

Q- When is the sales tax payable by the buyers?
On the day of settlement the sales tax incidence on the trades settled would be notified to the clearing members, which will be settled on the supplemental settlement day, which is normally two (2) days after the actual settlement day.

Q- Can sales tax exemptions be availed? How?
A- Yes. The participants can avail of the exemptions, if any entitled to them. The buyers will have to indicate their ability to give supporting documents / certificates / declarations prescribed under the respective State sales tax laws at the time of giving requests for taking delivery and will have to be submitted before the supplemental settlement day. Submission of incomplete or invalid declarations / certificates would amount to defaults on the part of the seller.

Q- What are the procedure for submission of the support documents /certificates / declarations for availing the sales tax exemptions?
A- At the time of supplemental settlement the buyers will have to confirm their eligibility for availing exemption from payment of sales tax. The party will have to physically deliver the support documents to their respective clearing members within 5 business days and the clearing members will forward the same to the relevant parties within the next two days thereafter.

Q- If a client/participant trades in more than one commodity having delivery centers in different States does he need sales tax registration in each of such states?
A- Yes, the client/participant will have to register in all those states where the delivery center for the commodities is located.

Q- How should the client/participant move the commodities into the designated warehouses?
A- The client / participant are responsible to move the commodities from their warehouse into the warehouses designated by the Exchange. Such movement may be by way of stock transfers from place outside the State for which the client / participant will be responsible for issuance of certificate in Form F under the Central Sales Tax Act, 1956 to his dispatching branch. The client / participant will also be responsible for payment of octroi, entry tax, cess, etc. on entry of the goods into the local areas in the State where the designated warehouse is located and for obtaining check post declaration forms from the sales tax department.
If the client / participant move the commodities from another State pursuant to a fructified sale transaction, there could be liability for payment of Central sales tax in the State from where the inter-State movement of the commodities commences. The client/participant will be responsible for the payment of the Central sales tax in such cases. The clients/participants are being advised to move the commodities into the designated warehouses well in advance and ensure compliance of provisions of law.

Education Series I

India has long history of commodity futures trading, extending over 125 years. Still, such I trading was interrupted suddenly since the mid-seventies in the fond hope of ushering in an elusive socialistic pattern of society. As the country embarked on economic liberalization policies and signed the GATT agreement in the early nineties, the government realized the need for futures trading to strengthen the competitiveness of Indian agriculture and the commodity trade and industry. Futures trading began to be permitted in several commodities, and the ushering in of the 21 century saw the emergence of new National Commodity Exchanges with countrywide reach for trading in almost all primary commodities and their products.

A commodity futures contract is essentially a financial instrument. Following the absence of futures trading in commodities for nearly four decades, the new generation of commodity producers, processors, market functionaries, financial organizations, broking agencies and investors at large are, unfortunately, unaware at present of the economic utility, the operational techniques and the financial advantages of such trading. The Multi Commodity Exchange of India (MCX) the premier New Order Exchange in the country is, therefore, launching this Commodity Futures Education Series to provide valuable insights into the rationale for such trading, and the trading practices and regulatory procedures prevailing at the Exchange.

For easy understanding and simplification of various issues and nuances involved in commodity futures trading, a convenient question-answer approach is adopted.

PHYSICAL AND FUTURES COMMODITY MARKETS

Q- What kind of statutory framework for regulating commodity futures exists in India?
A- Commodity futures contracts and the commodity exchanges organizing trading in such contracts are regulated by the Government of India under the Forward Contracts (Regulation) Act, 1952 (FCRA or the Act), and the Rules framed thereunder. The nodal agency for such regulation is the Forward Markets Commission (FMC), situated at Mumbai, which functions under the aegis of the Ministry of Consumer Affairs, Food & Public Distribution of the Central Government.

Q- What is “Commodity”?
A- Commodity includes all kinds of goods. FCRA defines “goods” as “every kind of movable property other than actionable claims, money and securities”. Futures’ trading is organized in such goods or commodities as are permitted by the Central Government. At present, all goods and products of agricultural (including plantation), mineral and fossil origin are allowed for futures trading under the auspices of the commodity exchanges recognized under the FCRA. The national commodity exchanges have been recognized by the Central Government for organizing trading in all permissible commodities which include precious (gold & silver) and non-ferrous metals; cereals and pulses; ginned and un-ginned cotton; oilseeds, oils and oilcakes; raw jute and jute goods; sugar and gur; potatoes and onions; coffee and tea; rubberand spices, etc.

Q- What is “Commodity Exchange”?
A- A commodity exchange is an association, or a company or any other body corporate organizing futures trading in commodities.

Q- What is the meaning of “Futures Contract”?
A- A futures contract is a type of “forward contract”. FCRA defines forward contract as “a contract forthe delivery of goods and which is not a ready delivery contract”. Underthe Act, a ready delivery contract is one, which provides for the delivery of goods and the payment of price therefor, either immediately or within such period not exceeding 11 days after the date of the contract, subject to such conditions as may be prescribed by the Central Government. A ready delivery contract is required by law to be fulfilled by giving and taking the physical delivery of goods. In market parlance, the ready delivery contracts are commonly known as “spot” or “cash” contracts.
All contracts in commodities providing for delivery of goods and/or payment of price after 11 days from the date of the contract are “forward” contracts. Forward contracts are of two types – “Specific Delivery Contracts” and “Futures Contracts”. Specific delivery contracts provide for the actual delivery of specific quantities and types of goods during a specified future period, and in which the names of both the buyer and the seller are mentioned.
The term ‘Futures contract’ is nowhere defined in the FCRA. But the Act implies that it is a forward contract, which is not a specific delivery contract. However, being a forward contract, it is necessarily “a contract for the delivery of goods”. A futures contract in which delivery is not intended is ab initio void (i.e., not enforceable by law), and is, therefore, not permitted for trading at any commodity exchange.

Q- What are the salient features of a “Commodity Futures Contract”?
A- A commodity futures contract is a tradable standardized contract, the terms of which are set in advance by the commodity exchange organizing trading in it. The futures contract is for a specified variety of a commodity, known as the “basis”, though quite a few other similar varieties, both inferior and superior, are allowed to be deliverable or tenderable for delivery against the specified futures contract.
The quality parameters of the “basis” and the permissible tenderable varieties; the delivery months and schedules; the places of delivery; the “on” and “off” allowances forthe quality differences and the transport costs; the tradable lots; the modes of price quotes; the procedures for regular periodical (mostly daily) clearings; the payment of prescribed clearing and margin monies; the transaction, clearing and otherfees; the arbitration, survey and other dispute redressing methods; the manner of settlement of outstanding transactions after the last trading day, the penalties for non-issuance or non-acceptance of deliveries, etc., are all predetermined by the rules and regulations of the commodity exchange.
Consequently, the parties to the contract are required to negotiate only the quantity to be bought and sold, and the price. Everything else is prescribed by the Exchange. Because of the standardized nature of the futures contract, it can be traded with ease at a moment’s notice.

Q- What are the main differences between the physical and futures markets?
A- The physical markets for commodities deal in either cash or spot contract for ready delivery and payment within 11 days, or forward (not futures) contracts for delivery of goods and/or payment of price after 11 days. These contracts are essentially party to party contracts, and are fulfilled by the seller giving delivery of goods of a specified variety of a commodity as agreed to between the parties. Rarely are these contracts forthe actual or physical delivery allowed to be settled otherwise than by issuing or giving deliveries. Such situations may arise when unforeseen and uncontrolled circumstances prevent the buyers and sellers from receiving or taking deliveries. The contracts may then be settled mutually.
Unlike the physical markets, futures markets trade in futures contracts which are primarily used for risk management (hedging) on commodity stocks or forward (physical market) purchases and sales. Futures contracts are mostly offset before their maturity and, therefore, scarcely end in deliveries. Speculators also use these futures contracts to benefit from changes in prices and are hardly interested in either taking or receiving deliveries of goods.

Q- What is price risk management? How does a commodity futures market perform this economic function?
A. The two major economic functions of a commodity futures market are price risk management and price discovery. Among these, the price risk management is by far the most important, and is the raison d’etre of a commodity futures market.
The need for price risk management, through what is commonly called “hedging”, arises from price risks in most commodities. The larger, the more frequent and the more unforeseen is the price variability in a commodity, the greater is the price risk in it. Whereas insurance companies offer suitable policies to cover the risks of physical commodity losses due to fire, pilferage, transport mishaps, etc., they do not cover similarly the risks of value losses resulting from adverse price variations. The reason forthis is obvious. The value losses emerging from price risks are much larger and the probability of the recurrence is far more frequent than the physical losses in both the quantity and quality of goods caused by accidental fires and mishaps, or occasional thefts.
Commodity producers, merchants, stockists and importers face the risks of large value losses on their production, purchases, stocks and imports from the fall in prices. Likewise, the processors, manufacturers, exporters and other market functionaries, entering into forward sale commitments in either the domestic or export markets, are exposed to heavy risks from adverse price changes.
True, price variability may also lead to windfalls, when prices move favorably. In the long run, such gains may even offset the losses from adverse price movements. But the losses, when incurred, are, at times, so huge that these may often cause insolvencies. The greater the exposure to commodity price risks, the greater is the share of the commodity in the total earnings or production costs. Hence, the need for price risk management or hedging through the use of futures contracts.
Hedging involves buying or selling of a standardized futures contract against the corresponding sale or purchase respectively of the equivalent physical commodity. The benefits of hedging flow from the relationship between the prices of contracts (either ready or forward) for physical delivery and those of futures contracts. So long as these two sets of prices move in close unison and display a parallel (or closely parallel) relationship, losses in the physical market are offset, eitherfully or substantially, by the gains in the futures market. Hedging thus performs the economic function of helping to reduce significantly, if not eliminate altogether, the losses emanating from the price risks in commodities.

Watch out for Part – II :
– Price Discovery & Price Risk Management
– Role of Commodity Exchange

Education Series II

Q- How does a Commodity Futures Exchange help in Price Discovery & Price Risk Management?
A- Unlike the physical market, a futures market facilitates offsetting the trades without exchanging physical goods until the expiry of a contract. As a result, futures market attracts hedgers for risk management, and encourages considerable external competition from those who possess market information and price judgment to trade as traders in these commodities. While hedgers have long-term perspective of the market, the traders or arbitragers, prefer an immediate view of the market. However, all these users participate in buying and selling of commodities based on various domestic and global parameters such as price, demand and supply, climatic and market related information. These factors, together, result in efficient price discovery, allowing large number of buyers and sellers to trade on the exchange. MCX is communicating these prices all across the globe to make the market more efficient and to enhance the utility of this price discovery function.
Price Risk Management: Hedging is the practice of off-setting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market. This technique is very useful in case of any long-term requirements for which the prices have to be firmed to quote a sale price but to avoid buying the physical commodity immediately to prevent blocking of funds and incurring large holding costs.

Q- Who uses Futures market and how MCX members serve their needs?
A- The Futures market participants comprises of farmers, traders, producers, processors, exporters, importers and industries associated with commodities. The futures market is used for hedging the price risk and for trading or arbitrage. Brokers of MCX, who are located all across the country, serve the futures market users directly through their own branch offices’ network or through the network of their franchisees or sub-brokers.

Q- How does one trade on MCX?
A- Only exchange members and their authorized users are entitled to trade on MCX. Those who are not members of MCX can trade through MCX members or their authorized users.

Q- How does one Clear the Trades on MCX?
A- All trades on MCX are supported by an initial margin. At the End-of-day MCX does mark-to-market of all the open positions. This activity results into final position of all members in respect to booked losses or losses on open positions. Members make the shortfalls good by way of pay-insto MCX by next day and the members in profit on such positions are given the necessary credits. These payments are processed electronically through a country-wide network of clearing banks, like-Bank of India, HDFC Bank, IndusInd Bank, Union Bank of India and UTI Bankwherein members maintain theiraccounts.

Q- How settlement happens at the end of the contract? Is delivery compulsory?
A- A contract has a life cycle of one month or longer. At MCX, two weeks before the expiry of a contract, the contract enters into a tender period. At the start of the tender period, both the parties must state their intentions to give or receive delivery, based on which the parties are supposed to act or bear the penal charges for any failure in doing so. Those who do not express their intention to give or receive delivery at the beginning of tender period are required to square-up their open positions before the expiry of the contract. In case they do not their positions are closed out at ‘due date rate’. The links to the physical market through the delivery process ensures maintenance of uniformity between spot and futures prices.

Q- How does a seller at MCX tender delivery to a buyer?
A- Sellers at MCX intimate the exchange at the beginning of the tender period and get the delivery quality certified from empanelled quality certification agencies. They also submit the documents to the Exchange with the details of the warehouse within the city, chosen as a delivery center. Sellers are free to use any warehouse, as they are responsibleforthe goods until the buyer picks up the delivery, which is a practice followed in the commodities market globally. Seller would receive the money from the exchange against the goods delivered, which happens when the buyer has confirmed its satisfaction over quality and picked up the deliveries within stipulated time.
MCX has tied up with State Level Warehousing Corporations of Kerala, Gujarat, Tamil Nadu and Uttar Pradesh and is in the process of finalizing the arrangements with CWCand other State level Warehousing Corporations.

Q- How does a buyer at MCX receives delivery?
A- Buyers intending to take delivery will receive it, if there are sellers willing to give delivery. The Buyer will have to make the payment within three days after the delivery is allotted. The buyer will take actual delivery from the warehouse at the designated delivery centers on the designated delivery days. There are commission agents who help the brokers with handling of the delivery, logistic support, associated quality certification through empanelled agencies and associated billings due to tax implications. This support is required as the buyer may be in a different city than the place where the delivery is being received.

Q- What does a client of a buyer do with the physical delivery in the warehouse?
A- The client of a buyer may use this delivery for his consumption in the industry, or for exports, or he may sell in the spot market or may sell in futures market in the subsequent contract, if he is a regulartrader. Generally the commodities available in the physical form are consumed by the industry and, rarely, commodities, are stored in the warehouse for a longer period.

Q- What is the percentage of delivery in the futures market?
A- The percentage is fairly low. Generally, the futures markets all over the world are used for hedging where actual delivery percentage is about 1%. Any user in the commodities ecosystem unlike the physical spot or forward market does not use these markets for regular consumption.

Q- Is it possible to officially operate a futures market under FC(R)A, 1952 on cash settlement basis as seen in the Futures Market in Securities? What is the position at MCX?
A. No, the FC(R) Act, 1952 does not permit any exchange to create a market where settlement of contract happens only on cash basis, without giving the seller an option to tender deliveries. MCX permits the sellers to tender delivery if they chose to. This has to be followed by any commodity exchange recognized under FC(R) Act.

Q- How is the quality of a commodity given by a seller ensured?
A- MCX has specified the deliverable grades in the contract specifications, which are notified before commencement of trading in a contract. The seller is required to submit the quality certification issued by MCX’s empanelled quality certification agencies, like, SGS, Geo Chem, Dr. Amins, among others.

Q- What is the role of a Warehouse in Futures Market?
A- In India, vibrant spot markets, in various commodities, exists for 100s of years. In these markets, there are farmers, industrialists, warehouses, consumers, dealers and traders, who buy and sell commodities. There are warehouses, which stores commodities and there are consumers, who consume them eventually. MCX or, for that matter, any other Futures Exchange do not aim to replace, replicate or substitute such spot markets, rather the only value added service of MCX is to support the spot market players by developing their price risk efficiency through providing hedging tools. Therefore, a Futures Exchange has to base its delivery process on the basis of existing physical market practices and use existing warehouse infrastructure, which is capable of handling billion dollars worth of physical market trades. So the same infrastructure can properly take care of minuscule delivery tendered in a futures market.

Q- When is the role of a Warehouse most necessary?
A- The role of a warehouse is most necessary in the spot market where a farmer after having harvested his crop sells them to commission agents who in turn sells them to a Mandi. The Traders in Mandi may then sell it to a large consumer or to a trader who in turn will sell it to some other consumer, industry, exporter or miller at the right time and right price. The Goods during this period are stored in the warehouse. It is seen that today 80% of the warehousing capacity is used by the Government for storing various commodities under the Public Distribution System and for storing fertilizers.

Q- What is a Demat Electronic Warehouse receipt?
A- Demat Electronic Warehouse Receipts are expected to be electronic records created by an approved agency after dematerialisation of the physical receipt issued by a Warehouse. In securities market the physical shares of the company are dematerialized by their Registrar and Transfer Agents using a Depository empowered under the Depositories Act. Also, the total shares of a company are monitored by the Registrar of Companies and the Stock Exchanges. In commodities market, there is no standardization of monitoring of warehouse receipts issued by a warehouse by any regulatory body. Similarly, the transfer of ownership also gets affected under a mutual agreement and not as per any Statutory Act. It remains to be seen whether such transfer will be considered good transfer under Negotiable Instruments Act and whether electronic records will be good title considering the above shortcomings. And also the fact that commodity is perishable and may not be a good delivery if the buyer finds out that it has deteriorated beyond the specifications mentioned in the contract.

Q- Are Demat electronic warehouse receipts necessary for futures trading like the demat shares in the securities market?
A- No. As 99% of the trading does not result in delivery, demat electronic warehouse receipts are not mandatory. Further, in futures market, since this 1 % delivery also happens only once in a month or perhaps once in two months, it may not be economically viable to create such an elaborate system forfutures market only.
In the securities market also, demat deliveries were useful only in the spot segment where the delivery percentage is 15-20% and it occurs on a daily basis across the country. Further, the demated shares in securities market are perpetual in nature and, therefore are rarely required to be used in the physical form. Whereas, in the commodities market such an elaborate system is pointless initially as commodities traded on the futures markets are consumed regularly and are rarely available in abundance for extended storage.
As far as commodities are concerned, there is no law, which regulates dematerialisation of warehouse receipts. Availability of a commodity at any point of time is a direct derivative of total production, carried forward stocks, imports and consumption. Equity shares are off the market if the issuing company buys them back. Commodities, on the other hand, are extinguished due to consumption, the perishable nature and exports.
Currently, 80% of the warehousing in India is used primarily for wheat, rice and fertilizers, among others. The import of commodities is spaced out at regular intervals to reduce storage cost and commodities produced seasonally are used completely, by the next season Therefore, it may not be a feasible business proposition to recommend market participants to use electronic warehouse receipts without first providing fora legal secured framework, which guarantees the quantity, quality, title and ownership of the commodities held by a genuine buyer and covers issues like sales tax concerning sale and movement of goods.

Q- How efficiency is measured in commodities market? How efficient is MCX?
A- Efficiency in commodities market is measured in terms of bid ask spread, direct and indirect cost of trading and holding such positions. MCX has started trading last month and is witnessing a bid ask spread of Rs 2-3 at a price quote of around Rs. 6000 (10 Grams) and the buyers and sellers are available in the system at all times at such a narrow range. Moreover, the cost of trading in MCX is very optimal i.e. all you need is an initial deposit ofRs. 2.5 Lakhs only.
To understand this better, we shall observe a comparative analysis between deposit amounts required in MCX (i.e. Rs. 2.5 Lakhs) versus a deposit amount of Rs. 25 Lakhs (a hypothetical figure).
An optimum deposit amount does not mean a compromise on margin requirements and risk management checks, additional margins/ deposits required will bethe same to hold open position as in any other Exchange as at MCX. But the difference at MCX is that you need to block money only when you create a position in the Exchange. Thus it ensures thatthere is no idle money or in other words, its utilization is most optimal as the interest (vyaj) meter runs for all 24 hours and 365 days.
At MCX, the margin % in case of Gold is 5 %. Hence, with an initial deposit of Rs. 2.5 Lakhs, a member can create open outstanding position of Rs. 50 Lakhs. It is observed that normally 15 % of daily turnover remains as open position, which is a good beginning and once the market matures this normally goes up proving the effectiveness of hedging. Hence, in this example, if the open position is Rs. 50 Lakhs, his daily business should be Rs. 3.30 Crore. If there are 100 members in the Exchange, then total turnover of exchange should be Rs. 330 Crore. Similarly, if there are 500 brokers then exchange daily turnover is Rs. 1650 Crore. Thus it is very clear that initial deposit justifies the ground reality of achievable turnover as commodity futures market in India, is starting after 40 years of gap. So lot of awareness and education is required to be invested by all the stakeholders before this market starts witnessing substantial volumes.
For further clarity & understanding purpose, lets assume that MCX’s initial deposit was Rs. 25 Lakhs, then to derive the real value of money invested, the total daily turnover on the exchange from day one has to be Rs.3300
Crore if there are 100 brokers. And Rs 16500 Crore if there are 500 brokers. Conclusively, from the detailed analysis of cost, we realize idle money in commodities futures market is a crime especially since interest cost makes a tremendous difference even up to two digits after the decimal point. In short, the difference between a winner and a loser is determined by whose cost of interest is more efficient.
Another fact that adds to this analysis is that since commodities markets are seasonal, the users of commodities markets prefer to bring in capital when they have large business during the crop season and would like to maintain very low idle money during slack season.
This equation suits the traders as a result of which, three large trade associations have already joined MCX.
Efficient utilization of capital in MCX as explained above permits a Trading Member or user to hedge his risk better and at a lower cost. Hedging is like insurance and, therefore, at higher costs there is tendency to avoid insurance and instead carry the risk which is what the industry has been doing till date. At MCX, an Exchange member uses his deposits optimally at Rs. 3.3 Crore of business per day. In case the member’s business commitment requires more money seasonally, then the memberwill bring more money when needed. Thus, MCX prevents any idling of money during slack seasons and facilitates a low level of turnover requirement for 100% utilization of deposits. This means a low breakeven level and early profitability. Therefore, MCX with 100 members will have to only do a daily turnover of Rs. 330 Crore (both sides) and Rs 1650 Crore (both sides), in case of 500 brokers to enable all brokers to operate at the most optimal level. This is a realistic target to achieve. MCX is about 10 times (1000%) more efficient than an Exchange with Rs. 25 lakhs or so as the entry norm. Beyond this level of turnover, the members will bring capital only when needed and do business as per the market demand and MCX is all set to do a turnover of Rs.10,000 Crore a day and above. However on MCX, due to quick breakeven level, the members will have early and higher profitability due to efficient use of money and windfall gains.
Thus MCX provides the most attractive entry route to a $ 600 billion opportunity into the global commodities sector.

Education Series III

The government, after prolonged prohibition, has finally approved futures trading in all commodities. In order to activate the futures market, the government has mandated four commodity exchanges to establish national level multi-commodity exchanges.
There have been various incorrect perceptions about the commodities market founded on experiences in the securities market. These have hindered the development of the commodities market and the protection of real trading interests. Multi Commodity Exchange of India Limited (MCX) believes that the commodities market would be successful only if the commodities’ eco-system partners use the exchange for its economic function of price discovery and price risk management.

Busting some of the myths about the commodities market-

Myth: Commodities markets are small due to the transaction size and number of players.
Reality: Securities cash : Rs. 12,00,000 Crore Derivatives: Rs. 25,00,000 Crore Commodities cash: Rs. 4,00,000 Crore Derivatives: 20 times internationally and assumed to be 10 times in India. Possible commodity futures market size: Rs. 40,00,000 Crore

Myth: Commodities markets are very complex to understand.
Reality: The markets are not complex as the products are natural and therefore cannot be artificially manipulated. The demand and supply also depends on economic factors. It is easier to understand commodities, as in our everyday life we are familiar with commodities, we know the ruling prices of these commodities in the market, while in the stock market, we are not fully aware about the internal affairs of a company.

Myth: Only farmers are interested in trading and only they should be trading.
Reality: It is incorrect to say that only the farmers would use this market. Actually, the farmers only use the commodity futures prices as a tool to decide which crop to grow and some large farmers would use this market to hedge their price risk through an intermediary. These intermediaries would normally be the same commission agents who help the farmers to sell their crop in the cash market.

Myth: These markets are not really required and they only serve the need of speculators.
Reality: Commodities markets are needed for the most important economic function of price discovery and price risk management, Speculators constitute only one dimension of the market. They can work only because someone is hedging their risk in the market.

Myth: The economy does not need futures market.
Reality: A Futures Exchange provides price signals to producers and consumers based on which they meet their long terms requirements. These price signals are not available to the user unless there is a commodity futures exchange and in its absence, the markets have large price fluctuations. This is not in the interest of the producers and consumers. Price stabilisation comes from the price discovery process when market participants react positively to the information available to decide a price.

Multi Commodity Exchange

Myth: A Commodity Futures Exchange must have large capital.
Reality: A Commodity Futures Exchange has to be run and managed efficiently with optimal costs as the commodities markets does not provide listing fees as in the securities market and therefore all costs have to be recovered from revenues earned through transactions. Large infrastructure costs may translate into large costs to traders and which would have direct implications on hedging making it expensive. If real users of the commodities market use this market as insurance and discover that the cost of hedging is considerably high, they would prefer not to hedge but bearthe risk instead.

Myth: A Commodity Futures Exchange is represented by the size of its real estate.
Reality: No, its not true that the Commodity Futures Exchange is known by the size of its real estate. The new order Commodity Futures Exchanges may not necessarily require large conventional real estate. In fact in the new era the real estate is defined by the power of processors deployed to handle system driven trading and post trading operations.
Further, the Exchanges need an efficient team of professionals who thoroughly understand the intricacies of the commodities market, state of the art technology support partners and dynamic members.

Myth: A Commodity Futures Exchange must have large number of members to be successful.
Reality: The Commodity Futures Exchange should focus on good and wel-spread brokerage houses to penetrate the market. The market would soon move over to many intermediaries with separate trading rights and have few members with clearing rights like banks.

Myth: An Exchange must have cash settled contracts to avoid the pains of delivery handling process.
Reality: Cash settled market would be no different than an online lottery system. In such markets, the priMyth: The Depository system of electronic transfer of commodities is covered in the Depositories Act. Reality: It is incorrect.

Myth: The regulatory framework covers agencies in the chain of the Demat Process for commodities
Reality: No, it is merely an understanding being reached within the trade and industry.

Myth: The Depository/Warehouse guarantees the quality.
Reality: Quality of delivery is not guaranteed by anyone. Until the standards in warehousing management improves to ensure preservation of the quality of goods stored no exchange or depository will be able to guarantee quality of the commodity in a warehouse. If the quality is not assured no benefit accrues to the actual user. Therefore, the Exchange should provide a system, whereby the sellers must ensure quality certification before tendering delivery and the buyers must have option to recheck the quality at the time of collecting delivery and in case of any discrepancies compared to the contract specifications, they should have an option to reject it. Worldwide, no Demat delivery is operational in commodities.

Myth: There is no guarantee of quality in a physical settlement between memberto memberthrough a warehouse.
Reality: The seller guarantees the quality to the buyer and therefore he takes care of storing the commodity, as it may be rejected by the buyer. He keeps it in a warehouse where he ensures preservation of quality and quantity of the commodity. Further, the buyer also has the option to recheck the quality at the time of delivery. For performing all such checks, there are professional firms of international repute, which are experts in certification. India is exporting a large number of agro-based commodities to Europe and America on the basis of such certification. Therefore, a commodity Exchange has to educate the members about the effective prevailing systems and to implement a settlement process based on a similar infrastructure.

Myth: The operators can manipulate commodity futures prices and so it is not safe to operate in this system.
Reality: It is incorrect that commodities prices can be manipulated because all these commodities are under OGL and in case somebody tries to corner stocks of a commodity to manipulate price, some importer will import that commodity from any other country and deliver in India nullifying the attempt to manipulate the price. In the stock markets, the floating stocks are limited so if an operator buys a large number of shares, prices will rise, which is not the case in commodities, because supply and floating stocks are virtually unlimited. In terms of fundamentals and technical analysis commodity prices follow the trends with more accuracy than as compared to scrip, because the commodity markets truly reflect the demand and supply factors.

• Myth: Commodity futures markets are more risky and so it is not advisable to trade in commodities
  Reality: While a scrip price can go down even by 30-40 percent in a single trading session, it cannot happen in commodity futures as the commodity futures price is based on the intrinsic value of the commodity. For instance, a scrip future can go down from Rs.4000 to Rs. 2800 in a single trading session, but Gold Feb 2004 contract would never come down from Rs. 6100 to Rs. 4100 in a single trading session, because the inherent value of gold would never fall so drastically. Therefore, it is always safe to operate in the commodity futures market as against the stockfutures market.
  It is only an issue of in depth understanding of the real market and anticipating and delivering what the commodity industry actually requires.