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Unresolved Issues in Commodity Derivatives Research Team | Posted On Saturday, April 18,2009, 12:21 PM

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Unresolved Issues in Commodity Derivatives



Although the commodity derivatives market has made excellent progress in the last few years, the real issues facing the future of the market have not been resolved. Agreed, the number of commodities allowed for derivative trading have amplified, the volume and the value of business has zoomed, however the objectives of setting up commodity derivative exchanges may not be achieved and the growth rates witnessed may not be sustainable except these real issues are sorted out as soon as possible. Several of the main unresolved issues are discussed below.

Commodity Options

Trading in commodity options contracts has been expelled ever since 1952. The market for commodity derivatives cannot be known to be complete without the presence of this significant derivative. Both futures and options are essential for the healthy growth of the market. Whereas futures contracts help a participant (say a farmer) to hedge against downside price movements, it does not allow him to reap the profit of an increase in prices. No doubt there is an immediate requirement to bring about the necessary legal and regulatory changes to commence commodity options trading in the country. The matter is said to be under the vigorous consideration of the Government and the options trading might be introduced in the near future.

The Warehousing and Standardization

For commodity derivatives market to work capably, it is essential to have a sophisticated, cost-effective, reliable and convenient warehousing system in the country. In addition to this, independent labs or quality testing centers should be established in each region to certify the quality, grade and quantity of commodities with the intention that they are appropriately standardized and there are no shocks waiting for the ultimate buyer who takes the physical delivery. Warehouses also require that it is conveniently located. Central Warehousing Corporation of India (CWC) is operating 500 Warehouses throughout the country along with a storage capacity of 10.4 million tones. This is noticeably not sufficient for a vast country. To resolve this problem, a Gramin Bhandaran Yojana (Rural Warehousing Plan) has been commenced to build new and expand the existing rural godowns. There is also examination of large scale privatization of state warehouses being done.

Cash versus Physical Settlement

It is perhaps due to the inefficiencies in the present warehousing system that just for about 1% to 5% of the total commodity derivatives trade in the country are settled in physical delivery. Hence the warehousing problem apparently has to be handled on a war footing, as a good delivery system is the backbone of any commodity trade. Predominantly difficult problem in cash settlement of commodity derivative contracts is that at present, under the Forward Contracts (Regulation) Act 1952, cash settlement of outstanding contracts at maturity is not acceptable. In other way around, all outstanding contracts at maturity should be settled in physical delivery. To keep away from this, participants square off their positions before maturity. So, in practice, the majority contracts are settled in cash but only before maturity. There is a requirement to modify the law to bring it closer to the widespread practice and save the participants from unnecessary hassles.

The Regulator

As the market activity pick-up and the volumes rise, the market will definitely requires a strong and independent regulator; alike to the Securities and Exchange Board of India (SEBI) that regulates the securities markets. Contrasting SEBI which is an independent body, the Forwards Markets Commission (FMC) is under the Department of Consumer Affairs (Ministry of Consumer Affairs, Food and Public Distribution) and depends on it for funds. It is very important that the Government should grant more powers to the FMC to ensure a systematic development of the commodity markets. The SEBI and FMC also require working closely with each other due to the inter-relationship between the two markets.

Lack of Economy of Scale

There are numerous (3 national level and 21 regional) commodity exchanges. Although over 80 commodities are allowed for derivatives trading, in practice derivatives are popular for just a few commodities. Again, majority of the trade takes place only on a few exchanges. Hence this results in splits volumes and makes some exchanges unviable. This dilemma can possibly be addressed by consolidating some exchanges. In addition to this, the query of convergence of securities and commodities derivatives markets has been part of debated for a long time now. The Government of India has announced its purpose to integrate the two markets. It is felt that convergence of these derivative markets would bring in economies of scale and scope without having to duplicate the efforts, by this means giving a boost to the growth of commodity derivatives market. It would also assist in resolving some of the issues concerning regulation of the derivative markets. Nevertheless, this would necessitate complete coordination among a range of regulating authorities such as Reserve Bank of India, Forward Markets commission, the Securities and Exchange Board of India, and the Department of Company affairs etc.

Tax and Legal bottlenecks

There are at present limitations on the movement of certain goods from one state to another. These require to be removed so that a truly national market could develop for commodities and derivatives. In addition, regulatory changes are required to bring about uniformity in octroi and sales taxes etc. VAT has been practicing in our country since 2005, but has not until now been uniformly implemented by all states.

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