INDEX

Section TOPIC PAGE NO.

I. Evolution of Derivatives Parties Involved Commonly Used Derivatives

II. Commodity and Commodity Market Difference Between Commodity and Financial

Derivatives Commodities Traded Evolution of the commodity market in World

Evolution of the commodity market in IndiaIII. Trading Exchanges in India

MCX NCDEX NMCE

IV. Trading and Settlement Procedure Trading Procedure Clearing and Settlement Procedure

V. Commodity Analysis Gold Guar Seed

VI. Impediments in development of commodity exchanges

VII. Possible Recommendations

VIII. Conclusion

IX. Bibliography

1

Evolution to Derivatives

The origin of derivatives can be traced back to the need of farmers to protect themselves

against fluctuations in the price of their crop. From the time it was sown to the time it

was ready for harvest, farmers would face price uncertainty. Through the use of simple

derivative products, it was possible for the farmer to partially or fully transfer price risks

by locking in asset prices. These were simple contracts developed to meet the needs of

farmers and were basically a means of reducing risk.

A farmer who sowed his wheat in rainy season, faced uncertainty over the price he would

receive for his produce i.e. wheat. If there is scarcity of commodity he has produced, he

would probably obtain attractive prices. And if the supply is more, he would have to sale

off his harvest at a very low price. This means that the farmer was exposed to a high risk

of price uncertainty.

At the same time, a merchant trading in wheat, with high demand of wheat would face a

price risk that of having to pay exorbitant prices during this period, although he will

receive high prices. Under such situation it would be good if farmer and merchant come

together and enter under a contract where they would decide the price at which they want

to settle. This way they can eliminate any price risk.

In 1848, CBOT (Chicago Board of Trade), was established to bring farmers and

merchants together. A group of traders got together and created the ‘to-arrive' contract

that permitted farmers to lock in to price upfront and deliver the grain later. These to-

arrive contracts proved useful as a device for hedging and speculation on price changes.

These were eventually standardised, and in 1925 the first futures clearing house came

into existence.

2

Definition of Derivative

Securities Contracts (Regulation) Act, 1956 (SCRA) defines derivatives as:

“A security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or contract for differences or any other form of

security.”

“A contract which derives its value from the prices, or index of prices, of

underlying securities.”

In simple words a derivative is a product whose value is derived from the value of

one or more underlying variables or assets in a contractual manner. The underlying asset

can be equity, forex, any commodity or any other asset. As mentioned earlier, that wheat

farmers may wish to sell their harvest at a future date to eliminate the risk of a change in

prices by that date. Such a transaction is an example of a derivative. The price of this

derivative is driven by the spot price of wheat, which is the “underlying” in this case.

Derivatives markets

Derivative markets can broadly be classified as commodity derivative market and

financial derivatives markets. As the name suggest, commodity derivatives markets trade

contracts for which the underlying asset is a commodity. It can be an agricultural

commodity like wheat, soybeans, rapeseed, cotton, etc or precious metals like gold,

silver, etc. Financial derivatives markets trade contracts that have a financial asset or

variable as the underlying. The more popular financial derivatives are those which have

equity, interest rates and exchange rates as the underlying. The most commonly used

derivatives contracts are forwards, futures and options which discussed in detail later.

3

Derivative products initially emerged as hedging devices against fluctuations in

commodity prices, and commodity-linked derivatives remained the sole form of such

products for almost three hundred years. Financial derivatives came into spotlight in the

post-1970’s period due to growing instability in the financial markets. However, since

their emergence, these products have become very popular and by 1990’s, they accounted

for about two-thirds of total transactions in derivative products. In recent years, the

market for financial derivatives has grown tremendously in terms of variety of

instruments available, their complexity and also turnover. In the class of equity

derivatives the world over, futures and options on stock indices have gained more

popularity than on individual stocks.

Parties involved in derivativesDerivative contracts are of different types. The most common ones are forwards, futures,

options. Participants who trade in the derivatives market can be classi_ed under the

following three broad categories hedgers, speculators, and arbitragers.

1. Hedgers: Hedgers face risk associated with the price of an asset. They use the futures

or options markets to reduce or eliminate this risk. The farmer's example that we

discussed about was a case of hedging.

Derivatives

Commodity DerivativesE.g.: wheat, soyabean guar seed, gold etc

Financial DerivativesE.g.: equity interest rate etc

4

2. Speculators: Speculators are participants who wish to bet on future movements in the

price of an asset. Futures and options contracts can give them leverage; that is, by putting

in small amounts of money upfront, they can take large positions on the market. As a

result of this leveraged speculative position, they increase the potential for large gains as

well as large losses.

3. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy

between prices of the same product across different markets. If, for example, they see the

futures price of an asset getting out of line with the cash price, they would take offsetting

positions in the two markets to lock in the profit.

Some commonly used derivativesHere we define some of the more popularly used derivative contracts. Some of

these, namely futures and options will be discussed in more details at a later stage.

Forwards: As we discussed, a forward contract is an agreement between two entities to

buy or sell the underlying asset at a future date, at today's pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell the

underlying asset at a future date at today's future price. Futures contracts differ from

forward contracts in the sense that they are standardised and exchange traded.

Options: There are two types of options - calls and puts. Calls give the buyer the right

but not the obligation to buy a given quantity of the underlying asset, at a given price on

or before a given future date. Puts give the buyer the right, but not the obligation to sell a

given quantity of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of upto one year, the majority of options traded

on options exchanges having a maximum maturity of nine months. Longer-dated options

are called warrants and are generally traded over-the-counter.

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Baskets: Basket options are options on portfolios of underlying assets. The underlying

asset is usually a weighted average of a basket of assets. Equity index options are a form

of basket options.

Swaps: Swaps are private agreements between two parties to exchange cashflows in the

future according to a prearranged formula. They can be regarded as portfolios of forward

contracts. The two commonly used swaps are:

Interest rate swaps: These entail swapping only the interest related cashflows between

the parties in the same currency.

Currency swaps: These entail swapping both principal and interest between the parties,

with the cashflows in one direction being in a different currency than those in the

opposite direction.

Commodity and Commodities market

INTRODUCTION

6

Derivatives as a tool for managing risk first originated in the commodities markets. They

were then found useful as a hedging tool in financial markets as well. In India, trading in

commodity futures has been in existence from the nineteenth century with organized

trading in cotton through the establishment of Cotton Trade Association in 1875. Over a

period of time, other commodities were permitted to be traded in futures exchanges.

Regulatory constraints in 1960s resulted in virtual dismantling of the commodities future

markets. It is only in the last decade that commodity future exchanges have been actively

encouraged. However, the markets have been thin with poor liquidity and have not grown

to any significant level.

COMMODITY

Commodity is defined as any bulk good traded on an exchange or in the cash market.

One of the first forms of trade between individuals began by what is called the barter

system wherein goods were traded for goods. Lack of a medium for exchange was the

sole initiator of this system. People sold what they had in excess and bought what they

lacked. Animals were the first few commodities to be exchanged.

Some examples of commodities include grain, oats, gold, oil, beef, silver, and natural gas.

These markets are the meeting places of buyers and sellers of an ever-expanding list of

commodities that today includes agricultural goods, metals and petroleum, but also

products such as financial instruments, foreign currencies and stock indexes that trade on

a commodity exchange.

Commodity Exchange is a platform where different types of market participants trade in

wide spectrum of commodity derivatives. In other words, prices of contracts can be

determined at present for goods to be delivered in future. This helps people to avoid wide

fluctuations in the prices of the commodities. The Government issued notifications on

1.4.2003 permitting futures trading in the commodities, with the issue of these

notifications futures trading is not prohibited in any commodity. Options trading in

commodity are, however presently prohibited.

7

In fact, the size of the commodities markets in India is also quite significant. Of

the country’s GDP of Rs 13, 20,730 crore (Rs 13,207.3 billion), commodities related

(and dependent) industries constitute about 58 per cent.

Currently, the various commodities across the country clock an annual turnover of Rs 1,

40,000 crore (Rs 1,400 billion). With the introduction of futures trading, the size of the

commodities market grows many folds here on.

Difference between commodity and financial derivatives

The basic concept of derivative contract remains the same whether the underlying

happens be a commodity or a financial asset. However there are some features which are

very peculiar to commodity derivative markets. In the case of financial derivatives, most

of these contracts are cash settled. Even in the case of physical settlement, financial assets

are not bulky and do not need special facility for storage. Due to the bulky nature of the

underlying assets, physical settlement in commodity derivatives creates the need for

warehousing. Similarly, the concept of varying quality of asset does not really exist as far

as financial underlying are concerned.

However in the case of commodities, the quality of the asset underlying a contract can

vary largely. This becomes an important issue to be managed. We have a brief look at

these issues.

Physical settlement

Physical settlement involves the physical delivery of the underlying commodity, typically

at an accredited warehouse. The seller intending to make delivery would have to take the

8

commodities to the designated warehouse and the buyer intending to take delivery would

have to go to the designated warehouse and pick up the commodity. This may sound

simple, but the physical settlement of commodities is a complex process. The issues

faced in physical settlement are enormous. There are limits on storage facilities in

different states. There are restrictions on interstate movement of commodities. Besides

state level Octroi and duties have an impact on the cost of movement of goods across

locations. The process of taking physical delivery in commodities is quite different from

the process of taking physical delivery in financial assets.

We take a general overview at the process flow of physical settlement of commodities.

Later on we will look into details of how physical settlement happens on the NCDEX.

Delivery notice period

Unlike in the case of equity futures, typically a seller of commodity futures has the option

to give notice of delivery. This option is given during a period identified as `delivery

notice period'.

Such contracts are then assigned to a buyer, in a manner similar to the assignments to a

seller in an options market. However what is interesting and different from a typical

options exercise is that in the commodities market, both positions can still be closed out

before expiry of the contract. The intention of this notice is to allow verification of

delivery and to give adequate notice to the buyer of a possible requirement to take

delivery. These are required by virtue of the fact that the actual physical settlement of

commodities requires preparation from both delivering and receiving members.

Typically, in all commodity exchanges, delivery notice is required to be supported by a

warehouse receipt. The warehouse receipt is the proof for the quantity and quality of

commodities being delivered. Some exchanges have certified laboratories for verifying

the quality of goods. In these exchanges the seller has to produce a verification report

from these laboratories along with delivery notice. Some exchanges like LIFFE, accept

warehouse receipts as quality verification documents while others like BMF-Brazil have

independent grading and classification agency to verify the quality.

In the case of BMF-Brazil a seller typically has to submit the following documents:

9

A declaration verifying that the asset is free of any and all charges, including

fiscal debts related to the stored goods.

A provisional delivery order of the good to BM&F (Brazil), issued by the

warehouse.

A warehouse certificate showing that storage and regular insurance have been

paid.

Assignment

Whenever delivery notices are given by the seller, the clearing house of the exchange

identifies the buyer to whom this notice may be assigned. Exchanges follow different

practices for the assignment process. One approach is to display the delivery notice and

allow buyers wishing to take delivery to bid for taking delivery. Among the international

exchanges, BMF, CBOT and CME display delivery notices. Alternatively, the clearing

houses may assign deliveries to buyers on some basis. The Indian commodities

exchanges have alsoadopted this method.

Any seller/ buyer who has given intention to deliver/ been assigned a delivery has an

option square off positions till the market close of the day of delivery notice. After the

close of trading, exchanges assign the delivery intentions to open long positions.

Assignment is done typically either on random basis or first-in-first out basis. In some

exchanges, the buyer has the option to give his preference for delivery location.

The clearing house decides on the daily delivery order rate at which delivery will be

settled. Delivery rate depends on the spot rate of the underlying adjusted for discount/

premium quality and freight costs. The discount/ premium for quality and freight costs

are published the clearing house before introduction of the contract. The most active spot

market is normally taken as the benchmark for deciding spot prices. Alternatively, the

delivery rate is determined based on the previous day closing rate for the contract or the

closing rate for the day.

Delivery

10

After the assignment process, clearing house/ exchange issues a delivery order to the

buyer. The exchange also informs the respective warehouse about the identity of the

buyer. The buyer required to deposit a certain percentage of the contract amount with the

clearing house as margin against the warehouse receipt. The period available for the

buyer to take physical delivery is stipulated by the exchange. Buyer or his authorised

representative in the presence of seller or his representative takes the physical stocks

against the delivery order. Proof of physical delivery having been effected forwarded by

the seller to the clearing house and the invoice amount is credited to the seller's account.

In India if a seller does not give notice of delivery then at the expiry of the contract the

positions are cash settled by price difference exactly as in cash settled equity futures

contracts.

Warehousing

One of the main differences between financial and commodity derivatives are the need

warehousing. In case of most exchange-traded financial derivatives, all the positions are

cash settled. Cash settlement involves paying up the difference in prices between the time

the contract was entered into and the time the contract was closed. For instance, if a

trader buys futures on a stock at Rs.100 and on the day of expiration, the futures on that

stock close Rs.120, does not really have to buy the underlying stock. All he does is take

the difference of Rs.20 cash. Similarly the person who sold this futures contract at

Rs.100, does not have to deliver the underlying stock. All he has to do is pay up the loss

of Rs.20 in cash.

In case of commodity derivatives however, there is a possibility of physical settlement.

Which means that if the seller chooses to hand over the commodity instead of the

difference in cash, the buyer must take physical delivery of the underlying asset. This

requires the exchange to make an arrangement with warehouses to handle the settlements.

The efficacy of the commodities settlements depends on the warehousing system

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available. Most international commodity exchanges used certified warehouses (CWH) for

the purpose of handling physical settlements.

Such CWH are required to provide storage facilities for participants in the commodities

markets and to certify the quantity and quality of the underlying commodity. The

advantage of this system is that a warehouse receipt becomes good collateral, not just for

settlement of exchange trades but also for other purposes too. In India, the warehousing

system is not as efficient as it is in some of the other developed markets. Central and state

government controlled warehouses are the major providers of agri-produce storage

facilities. Apart from these, there are a few private warehousing being maintained.

However there is no clear regulatory oversight of warehousing services.

Quality of underlying assets

A derivatives contract is written on a given underlying. Variance in quality is not an issue

in case of financial derivatives as the physical attribute is missing. When the underlying

asset is a commodity, the quality of the underlying asset is of prime importance. There

may be quite some variation in the quality of what is available in the marketplace. When

the asset is specified, it is therefore important that the exchange stipulate the grade or

grades of the commodity that are acceptable. Commodity derivatives demand good

standards and quality assurance/ certification procedures. A good grading system allows

commodities to be traded by specification.

Currently there are various agencies that are responsible for specifying grades for

commodities. For example, the Bureau of Indian Standards (BIS) under Ministry of

Consumer Affairs specifies standards for processed agricultural commodities whereas

AGMARK under the department of rural development under Ministry of Agriculture is

responsible for promulgating standards for basic agricultural commodities. Apart from

these, there are other agencies like EIA, which specify standards for export oriented

commodities.

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Different commodities traded in commodity market

In all there are around 40 forty commodities traded in the different commodity markets.

These commodities are basically divided in four main types, namely:

Agricultural commodities which consist of all agricultural products like cotton,

wheat, jowar, coffee, guar gum, soyabean, seas am, mustard oil, etc

Precious metals which include gold and silver

Base metals include other metals like tin copper, magnesium

Energy includes commodities like crude oil, brent crude oil, furnace oil.

All these commodities have different set of features different characteristics, different

dealing methods, and different margins. Due to these differences these commodities

require different contracts which some extra rules relating to delivery, trading, quality

specifications, warehousing requirements, settlement procedure, etc.

13

Evolution of the commodity market in World

Early forward contracts in the US addressed merchants' concerns about ensuring that

there were buyers and sellers for commodities. However “credit risk” remained a serious

problem. To deal with this problem, a group of Chicago businessmen formed the

Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to

provide a centralised location known in advance for buyers and sellers to negotiate

forward contracts. In 1865, the CBOT went one step further and listed the first

“Exchange traded” derivatives contract in the US, these contracts were called “futures

contracts”. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganised

to allow futures trading. Its name was changed to Chicago Mercantile Exchange

(CME). The CBOT and the CME remain the two largest organised futures exchanges,

indeed the two largest ” financial” exchanges of any kind in the world today.

The first stock index futures contract was traded at Kansas City Board of Trade.

Currently the most popular stock index futures contract in the world is based on S&P 500

index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures

Commodity Markets

Precious Metals Others Metals

Agriculture Energy

14

became the most active derivative instruments generating volumes many times more than

the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the

three most popular futures contracts traded today. Other popular international exchanges

that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE

in Japan, MATIF in France, Eurex etc. Some of the oldest and most famous stock

exchanges in the world are as follows:-

COUNTRY EXCHANGE

United States of America

 

 

 

 

 

Chicago Board of Trade (CBOT)

Chicago Mercantile Exchange

New York Cotton Exchange

New York Mercantile Exchange

New York Board of Trade

The Winnipeg Commodity Exchange

Canada The Winnipeg Commodity Exchange

Brazil

Brazilian Futures Exchange Commodities

and Futures Exchange

Australia Sydney Futures Exchange Ltd.

China

 

Beijing Commodity Exchange Shanghai

Metal Exchange

Hong Kong Hong Kong Futures Exchange

Japan

 

 

Tokyo International Financial Futures Exchange

Kansai Agricultural Commodities Exchange

Tokyo Grain Exchange

Malaysia Kuala Lumpur commodity Exchange

Singapore Singapore Commodity Exchange Ltd.

France Le Nouveau Marche MATIF

Russia

 

The Russian Exchange

MICEX/ Relis Online St. Petersburg Futures Exchange

Spain The Spanish Options Exchange

15

 

Citrus Fruit and Commodity Futures Market of

Valencia

United Kingdom

The London International Financial Futures

Options exchange

Evolution Commodity Market In India

The organized trading in commodity futures markets has a long history in India. In 1875,

the first commodity futures exchange was set up in Mumbai under the guidance of

Bombay Cotton Traders Association. During 1900-1920 many futures markets were set

up including raw jute futures market in Kolkata (1912) and wheat futures market in

Hapur (1913). A number of other exchanges appeared between 1920 and 1940 trading

such commodities as raw jute, jute products, pepper, turmeric, potatoes, sugar, castor

seed, groundnuts, groundnut oil, rice, wheat, etc. With the outbreak of World War II and

in its aftermath trading in forward and futures contracts as well as options was either

outlawed, as part of the Government's drive to contain inflation, or made impossible

through price controls. This situation persisted until 1952, when the Government

introduced the Forward Contracts (Regulation) Act, which to this day controls all

transferable forward contracts and futures. Through this act Forward Market Commission

(FMC) was established to oversee the working of future exchanges in India. The Act

allowed futures market trade in a number of commodities (but excluded some which were

seen as essential foods, such as sugar and food grains). During 1960s, the government

either banned or suspended futures trading in several commodities, including cotton, raw

jute, edible oilseeds and their products. Futures' trading in pepper, turmeric, castor seed,

linseed, etc. was, however still permitted. In 1977, futures' trading in non-edible oilseeds

like castor seed and linseed was forbidden. The reason for this crackdown on futures

markets was that, in Government's view, these markets helped driving up prices for

commodities, by giving free rein to speculators. The Government's policies underwent a

change in the late 1970s, when futures trade in gur and potato was allowed on the

16

recommendations of Khusro Committee. This committee recommended the revival of

futures trading in a wide range of commodities, but little action resulted.

As on August 2003, there are 21 commodity exchanges in operation in India dealing in

futures trading in 35 commodities (FMC website). Out of these, two exchanges viz.,

Indian Pepper and Spice Trade Association (IPSTA), Cochin and the Bombay

Commodity Exchange (BCE) Ltd. have the status of international exchange and deal in

international contracts (transacting party could be a foreign national also) in pepper and

castor oil respectively. The commodities in which futures trading is done by other

exchanges are: pepper, turmeric, gur, castor seed, hessian, jute sacking, cotton, potato,

castor oil, soya bean and its oil and cake, coffee, mustard seed and its oil and oilcake,

groundnut and its oil, sunflower oil, copra/coconut and its oil and oilcake, cottonseed and

its oil and oilcake, kapas, RBD palmolein, rice bran and its oil and oilcake, sesame seed

and its oil and oilcake, safflower seed and its oil and oilcake, and sugar.

Commodity Trading Exchanges in India

17

Forward Market Commission

In India commodity markets are governed by Forward Market Commission The

Forward Contract (Regulation) Act was enacted in 1952. this act passed in the

parliament to regulate the futures markets and avoid the exploitation of farmers by

middlemen and cruel landlords. In 1966, in the aftermath of a severe drought and

escalating food prices, forward trading was banned in most commodities to make it easier

for the government to impose price controls. A long settled over the commodity markets.

That was unfortunate. Futures and forward contracts allow market participants to

transfer risks from those wary of it to those who are hungry for it. Those most vulnerable

Ministry of Consumer affairs

Forward Market

Commission

Commodity Exchanges

National Level Stock

Exchange

Regional Level Stock

Exchange

NCDEX MCX NMCE20 Regional Exchanges

18

to risk-the farming community-have suffered over the subsequent decades. Not only was

the economics of the ban suspect, but also turned a blind eye to a natural dispensation

among Indians to trade in commodities. Forward trading in commodities is mentioned in

Kautilya’s Arthashastra. The Bombay Cotton Trade Association set up a futures market

for cotton in 1875, a mere decade after the Chicago Board of Trade opened for business.

Subsequently, India developed vibrant forward markets in a host of commodities.

In November 2003, Mukesh Ambani, was speaking at the inauguration of

MCX, a spanking new national, multi- commodity exchange. The government has

decided to clear the way for forward trading in commodities once again. Mukesh says

that MCX and the other exchanges are sitting on a market worth $ 600 billion a year

(or Rs 30 lakh crore).

Currently, the annual value of all commodity futures traded in India is $ 135

billion, far less than the potential 4600 billion. What is significant, however, is the

speed at which the gap is being narrowed. “Volumes in commodity futures have perked

up from Rs 20,000 crore- 30,000 crore per annum before the liberalization of futures

trading, to around Rs 5.71 lakhs crore per annum today. The natural instinctive genius of

the Indian trader has come into play”, says S. Sundereshan, Chairman, FMC (forward

market commission), which regulates commodity futures market in India

Commodities’ trading is now one of the latest trend in the town. Volumes grew by

over 900 % between financial years 2002-03 and 2004-05. “The growth of the

commodities business has been beyond what was originally projected. With new

commodity contracts getting launched sequentially, the average daily futures volumes

could scale upwards of Rs 140,000 crore”, says Vineet Bhatnagar, country manager of

Refco (India), one of the largest non- bank futures players globally. With national level

exchange of India (MCX) and the National commodities Derivatives Exchange

(NCDEX) yet to complete two years of full- fledged commercial operations, the growth

in commodity futures trading is almost as spectacular as India’s success in business

process outsourcing.

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Commodity Exchanges

In India there are about 25 commodity exchanges, these include exchanges at national

level and regional level commodity exchanges. Of all these exchanges there are only

three national level commodity exchanges. And these are National Commodity And

Derivatives Exchange (NCDEX), Multi Commodity Exchange (MCX), National

Commodity Exchange (NMCE). But among these NCDEX and MCX are quite functional

in the country. The basic difference between the national level and regional level

exchanges is their area of their operations and the technology used by the exchanges.

1. Multi Commodity Exchange of India Limited (MCX):

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MCX an independent multi commodity exchange has permanent recognition from

Government of India for facilitating online trading, clearing and settlement operations for

commodity futures markets across the country. It was inaugurated in November 2003 by

Mr. Mukesh Ambani. It is headquartered in Mumbai. The key shareholders of MCX are

Financial Technologies (India) Ltd., State Bank of India, NABARD, NSE, HDFC Bank,

State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI Life

Insurance Co. Ltd., Union Bank of India, Bank of India, Bank of Baroda, Canara Bank,

Corporation Bank.

MCX offers futures trading in the following commodity categories: Agri

Commodities, Bullion, Metals- Ferrous & Non-ferrous, Pulses, Oils & Oilseeds, Energy,

Plantations, Spices and other soft commodities.

Today MCX is offering spectacular growth opportunities and advantages to a

large cross section of the participants including Producers / Processors, Traders,

Corporate, Regional Trading Centers, Importers, Exporters, Cooperatives, and Industry

Associations.

In a significant development, National Stock Exchange of India Ltd. (NSE),

country’s largest exchange and National Bank for Agriculture and Rural Development

(NABARD), country’s premier agriculture development bank announced their strategic

21

participation in the equity of MCX on June 15, 2005. This new partnership of NSE and

NABARD with MCX makes MCX consortium the largest distribution network across the

country.

MCX is an ISO 9001:2000 online nationwide multi commodity exchange. It has

over 900 members spread across 500 centers across the country, with more than 750

VSAT’s and leased line connections and 5,000 and more trading terminals that provide a

transparent robust and trustworthy trading platform in more than 50 commodity futures

contract with a wide range of commodity baskets which includes metals, energy and

agriculture commodities. Exchange has pioneered major innovations in Indian

commodities market, which has become the industry benchmarks subsequently.

MCX is the only Exchange which has got three international tie-ups which is with

Tokyo Commodity Exchange (TOCOM), the 250 year old Baltic Freight Exchange,

London, Dubai Metals & Commodity Centre (DMCC) & Dubai Gold & Commodity

Exchange (DGCX), the strategic initiative of Government of Dubai. MCX has to its

credit, setting up of the National spot exchange (NSEAP), which connects all India

APMC markets thereby contributing in the implementation of Government of India’s

vision to create a common Indian market

The trading system of MCX is state-of-the-art, new generation trading platform

that permits extremely cost effective operations at much greater efficiency. The Exchange

Central System is located in Mumbai, which maintains the Central Order Book.

Exchange Members located across the country are connected to the central system

through VSAT or any other mode of communication as may be decided by the Exchange

from time to time. The controls in the system are system driven requiring minimum

human intervention. The Exchange Members places orders through the Traders Work

Station (TWS) of the Member linked to the Exchange, which matches on the Central

System and sends a confirmation back to the Member Settlement: Exchange maintains

electronic interface with its Clearing Bank. All Members of the Exchange are having

their Exchange operations account with the Clearing Bank.

22

All debits and credits are affected electronically through such accounts only. All

contracts on maturity are for delivery. MCX specifies tender and delivery periods. A

seller or a short open position holder in that contract may tender documents to the

Exchange expressing his intention to deliver the underlying commodity. Exchange would

select from the long open position holder for the tendered quantity. Once the buyer is

identified, seller has to initiate the process of giving delivery and buyer has to take

delivery according to the delivery schedule prescribed by the Exchange Players involved

in commodities trading like commodity exchanges, financial institutions, and banks have

a feeling that the markets are not being fully exploited. Education and regulation are the

main impediments to the growth of commodity trading. Producers, farmers and agri-

based companies should enter into formal contracts to hedge against losses. The use of

commodity exchanges will create more trading opportunities; result in an integrated

market and better price discoveries.

MCX offers trading in various Products which include Gold, Silver, Castor

Seeds, Soy Seeds, Castor Oil, Refined Soy Oil, Soymeal, RBD Palmolein, Crude Palm

Oil, Groundnut Oil, Sesame Seed, Mustard /Rapeseed Oil, Cottonseed, Mustard Seed

(Hapur), Mustard Seed (Jaipur), Soy Seeds, Castor Oil, Refined Soy Oil, Soymeal, RBD

Palmolein, Groundnut Oil, Sesame Seed, Mustard Seed (Jaipur), Pepper, Red Chilli,

Jeera, Turmeric, Copper, Nickel, Tin, Aluminium , Chana, Rice, Wheat, Maize, Crude

Oil, Rubber, Cashew, Guar Seed, Polypropylene (PP), High Density Polyethylene

(HDPE).

2. National Commodity and Derivatives Exchange

(NCDEX)

23

NCDEX is a public limited company incorporated on April 23, 2003 under

the Companies Act, 1956. It obtained its Certificate for Commencement of Business

on May 9, 2003. It has commenced its operations on December 15, 2003.

National Commodity & Derivatives Exchange Limited (NCDEX) is a

professionally managed online multi commodity exchange promoted by ICICI Bank

Limited (ICICI Bank), Life Insurance Corporation of India (LIC), National Bank for

Agriculture and Rural Development (NABARD) and National Stock Exchange of

India Limited (NSE). Punjab National Bank (PNB), CRISIL Limited (formerly the

Credit Rating Information Services of India Limited), Indian Farmers Fertiliser

Cooperative Limited (IFFCO)  and  Canara Bank    by subscribing to the equity

shares have joined the initial promoters as shareholders of the Exchange. NCDEX is

the only commodity exchange in the country promoted by national level institutions.

This unique parentage enables it to offer a bouquet of benefits, which are currently in

short supply in the commodity markets. The institutional promoters of NCDEX are

prominent players in their respective fields and bring with them institutional building

experience, trust, nationwide reach, technology and risk management skills.

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NCDEX is regulated by Forward Market Commission in respect of futures

trading in commodities. Besides, NCDEX is subjected to various laws of the land like

the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation)

Act and various other legislations, which impinge on its working.

NCDEX is located in Mumbai and offers facilities to its members in more

than 390 centres throughout India. The reach will gradually be expanded to more

centres. 

NCDEX is a nation-level, technology driven de-mutualized on-line

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 best global practices, professionalism

and transparency.

NCDEX currently facilitates trading of thirty six commodities - Cashew, Castor

Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller

Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel

25

Ingot, Mulberry Green Cocoons, Pepper, Rapeseed Mustard Seed ,Raw Jute, RBD

Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds,  Silk, Silver, Soy Bean,

Sugar, Tur, Turmeric, Urad, Wheat, Yellow Peas, Yellow Red Maize & Yellow

Soybean Meal.  At subsequent phases trading in more commodities would be

facilitated.

3. National Multi Commodity Exchange (NMCE)

26

NMCE is the first to get the ‘National’ status and be fully operational

Demutualised Corporate Structure leading to a reliable, effective, impartial and

rule-based management by professionals having no trade interest.

Convergence of all the offers and bids emanating from all over the country in a

Single Electronic Order Book of the Exchange ensuring equal access to all

intermediaries.

Participation of diverse interests like Importers, Exporters, Growers, Brokers,

Traders, etc., using an electronic trading system providing a fair, efficient and

transparent commodities market.

Fair Trading Practice ensured through inbuilt checks and balances in the System.

Use of LEMDA based margining at 99.9% VAR (Value at Risk) system for the

initial margin.

Warehouse Receipt System based Delivery of Underlying Commodities meeting the

current international standards; its endeavor is to fulfill its mission in letter and

spirit.

First to establish a Trade Guarantee Fund, thereby offering guaranteed clearing

and book entry settlements by assuming counter-party risks.

Real Time Price & Trade Data Dissemination

NMCE Market Surveillance Program

NMCE would bring about the convergence of large-scale processors, traders,

and farmers along with banks. NMCE would provide a common ground for

fixation of future prices of a number of commodities enabling efficient price

discovery/forecast. In addition, hedging using different and diverse commodities

would also be possible with help of NMCE. In short, NMCE is leading

27

transition of highly fragmented, controlled and restricted commodity

economy to globally integrated, efficient and competitive environment in the

21st Century.

Trading and Settlement Procedure At

Commodity Market

TRADING

28

The various aspects in trading are as follows:

a) Placing the order

b) Methods of trading

c) Kinds of orders

d) Kinds of margins

e) Pricing of futures

f) Closing out the positions

a) Placing the order In futures market an order should contain specifications such as buy or sell, the number

of contracts, the month of contract, type and quality of the commodity, the exchange, the

price specifications and the period of validity. Usually, orders are placed by telephone,

with brokers representing users and producers. If an order is executed the client receives

a confirmation. The Investor who agrees to buy assumes a long futures position and the

investor who agrees to sell assumes a short futures position.

b) Methods of Trading The trading in future exchanges is carried out through two methods. They are

i. Open outcry

ii. Electronic trading

i. Open Outcry

Open outcry trading is a face to face and highly activated form of trading used on the

floors of the exchanges. In open outcry system the futures contracts are traded in pits. A

pit is a raised platform in octagonal shape with descending steps on the inside that permit

buyers and sellers to see each other. Normally only one type of contract is traded in each

pit like a Eurodollar pit, Live Cattle pit, etc.

29

The trading process consists of an auction in which all bids ad offers on each of the

contracts are made known to the public and everyone can see the market's best price. To

place an order under this method, the customer calls a broker, who time-stamps the order

and prepares an office order ticket. The broker then sends the order to a booth on the

exchange floor called broker's floor booth. There, a floor order ticket is prepared, and a

clerk hand delivers the order to the floor trader for execution. In some cases, the floor

clerk may use hand signals to convey the order to floor traders. Large orders typically go

directly from the customer to the broker's floor booth. The floor trader, standing in a

central location i.e. trading pit, negotiates a price by shouting out the order to other floor

traders, who bid on the order using hand signals. Once filled, the order is recorded

manually on the order parties in the trade. At the end of each, the clearing house settles

trades by ensuring that no discrepancy exists in the matched-trade information.

ii. Electronic Trading

Electronic trading systems have become increasingly popular in the past decade. The

driving factor for the rise in the popularity of these systems is their potential to improve

efficiency and lower the cost of transactions. In addition, electronic trading systems

make exchanges available to remote investors in real time, which is an important benefit

in the present situation of increased trading from remote locations.

Electronic trading is an automated trade execution system with three key components.

1. Computer terminals, where customer orders are keyed in the and trade confirmations

are received.

2. A host computer that processes trade.

3. A network that links the terminals to the host computer.

30

Customers may enter orders directly into the terminal or phone in the order to a broker.

With electronic order matching systems, the host computer matches bids with offers

according to certain rules that determine an order's priority. Priority rules on most

systems include price and time of entry. In some cases, priority rules may also include

order size, type of order and identity of the customer who placed the order.

In the simplest case, matching occurs when a trader places a buy order at a price equal to

higher than the price of an existing sell order for the same contract. The host computer

automatically executes the order, so that trades are matched immediately. Trades are

then cleared immediately, as long as the host computer is lined to the clearing house.

After hours Electronic trading System

After-hours electronic trading first began in 1992 at CME (Chicago Mercantile

Exchange). This was introduced to meet the needs of an increasingly integrated global

economy and to have an access to the currency price protection around the clock.

Electronic trading system is used in the open outcry exchanges after the day trading is

over.

c) Kinds of orders The orders (under an open outcry / electronic system) can be placed in different ways,

including:

Market Order

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This is the most common type of order. No specific price is mentioned. Only the

position to be taken-long/short is stated. When this kind of order is placed, it gets

executed irrespective of the current market price of that particular asset.

Market on open

The order will be executed on the market open within the opening range. This trade is

used to enter a new trade, or exit an open trade.

Market on Close

The order will be executed on the market close. The fill price will be within the closing

range, which may, in some markets, be substantially different from the settlement price.

This trade is also used to enter a new trade, or exit an open trade.

Limit Order

An order to buy or sell a stated amount of a commodity at a specified price, or at a better

price, if obtainable at the time of execution. The disadvantage is that the order may not

get filled at all if the price for that day does not reach the specified price.

Stop-Loss Order

A stop-loss order is an order, placed with the broker, to buy or sell a particular futures

contract at the market price if and when the price reaches a specified level. Futures

traders often use stop orders in an effort to limit the amount they might lose if the futures

price moves against their position. Stop orders are not executed until the price reaches

the specified point. When the price reaches that point the stop order becomes a market

order. Most of the time, stop orders are used to exit a trade. But, stop orders can be

executed for buying/selling positions too. A "buy" stop order is initiated when one wants

to buy a contract or go long and a "sell" stop order when one wants to sell or go short.

The order gets filled at the suggested stop order price or at a better price.

Example: A trader wants to purchase a crude oil futures contract at Rs.750 per barrel. He

wishes to limit his loss to Rs.50 a barrel. A stop order would then be placed to sell an

32

offsetting contract if the price falls to Rs.700 per barrel. When the market touches this

price, stop order gets executed and the trader would exit the market.

Day order

Day orders are good for only one day, the day the order is placed.

Example: A trader wants to go long on September 1, 2003 in Refined Palm Oil in a

commodity exchange. A day order is placed at Rs. 340/10 kg. If the market does not

reach this price the order does not get filled even if the market touches Rs.341 and closes.

In other words, day order is for a specific price and if the order does not get filled that

day, one has to place the order again the next day.

Good Till Cancelled (GTC) Order

It is an open order to buy or sell that remains active until the order gets filled in the

market, or is cancelled by the person who placed the order.

Example: A trader wants to go long on Refined Palm oil when the market touches

Rs.400/10 kg. The order exists until it is filled up, even if it takes months for it to

happen. The order is always open until the order is cancelled or the contract expires.

Fill or Kill order

This order is a limit order that is sent to the pit to be executed immediately and if the

order is unable to be filed immediately, it gets cancelled.

All or None order

All or None order (AON) is a limit order, which is to be executed in its entirety, or not at

all. Unlike a fill-or-kill order, an all-or-none order is not cancelled if it is not executed as

soon as it is represented in the exchange. An all-or-none order position can be closed out

with another AON order.

Spread Order

A simple spread order involves two positions, one long and one short. They are taken in

the same commodity with different months (calendar spread) or in closely related

33

commodities. Prices of the two futures contract therefore tend to go up and down

together, and gains on one side of the spread are offset by losses on the other. The

spreaders goal is to profit from a change in the difference between the two futures prices.

The trader is virtually unconcerned whether the entire price structure moves up or down,

just so long as the futures contract he bought goes up more (or down less) than the futures

contract he sold.

OCO Order

It is called One cancels the Other (OCO) order. The order placed so as to take advantage

of price movement, which consists of both a Stop and a Limit price. Once one level is

reached, one half of the order will be executed (either Stop or Limit) and the remaining

order cancelled (either Limit or Stop). This type of order would close the position if the

market moved to either the stop rate or the limit rate, thereby closing the trade and at the

same time, cancelling the other entry order.

Example: A trader has a buy position at Rs.14, 000/tonne on Soybean. He wishes to have

both stop and limit orders in order to fill the order in a particular price range. A stop

order is placed at Rs. 14,100/tonne and a limit order at Rs.13, 900/tonne. If the market

trades as Rs. 13,900/tonne, the limit order gets filled and the stop order immediately gets

cancelled. The trader exists the market at Rs.13, 900/tonne.

d) Kinds of Margin Margin is the deposit money that needs to be paid to buy or sell each contract. The

margin required for a futures contract is better described as performance bond or good

faith money. The margin levels are set by the exchanges based on volatility (market

conditions) and can be changed at any time. The margin requirements for most futures

contracts range from 2% to 15% of the value of the contract.

34

The different types of margins in futures that a trader has to maintain are as under:

Initial Margin

The amount that must be deposited by a customer at the time of entering into a contract is

called initial margin. This margin is meant to cover the largest potential loss in one day.

The margin is a mandatory requirement for parties who are entering into the contract.

Maintenance Margin

A trader is entitled to withdraw any balance in the margin account in excess of the initial

margin. To ensure that the balance in the margin account never becomes negative, a

maintenance margin, which is somewhat lower than the initial margin, is set. If the

balance in the margin account falls below the maintenance margin, the trader receives a

margin call and is requested to deposit extra funds, to bring it to the initial margin level

within a very short period of time.

Additional Margin

In case of sudden higher than expected volatility, the exchange calls for an additional

margin, which is a preemptive move to prevent breakdown. This is imposed when the

exchange fears that the markets have become too volatile and may result in some

payments crisis, etc.

Mark-to-Market Margin

At the end of each trading day, the margin account is adjusted to reflect the trader's gain

or loss. This is known as marking to market the account of each trader. All futures

contracts are settled daily reducing the credit exposure to one-day's movement. Based on

the settlement price, the value of all positions is marked-to-the-market each day after the

official close i.e. the accounts are either debited or credited based on how well the

positions faired in that day's trading session. If the account falls below the maintenance

margin level the trader needs to replenish the account by giving additional funds. On the

other hands, if the position generates a gain, the funds can be withdrawn (those funds

above the required initial margin) or can be used to fund additional trades.

35

e) Pricing of Futures In futures contract the price is predetermined. The seller knows how much he is going to

be paid and the buyer knows how much he is going to pay at a future date. As futures

contracts are standardized according to quantity, quality and location, it is price that is the

only factor on which buyers and sellers can bargain. The price in futures market is

determined by a mechanism called Price discovery.

Price discovery

It is the process of arriving at a figure in which one person buys and another sells a

futures contract for a specific expiration date. In an active futures market, the process of

price discovery continues from the market's opening until its close. The prices are freely

and competitively derived. Future prices are therefore considered to be superior to the

administered prices or the prices that are determined privately. Further the low

transaction costs and frequent trading encourages wide participation in futures markets

lessening the opportunity for control by a few buyers and sellers.

In an active futures markets the free flow of information is vital. Futures exchanges act

as a focal point for the collection and dissemination of statistics on supplies,

transportation, storage, purchases, exports, imports, currency values, interest rates and

other pertinent information. Any significant change in this data is immediately reflected

in the trading pits as traders digest the new information and adjust their bids and offers

accordingly. As a result of this free flow of information, the market determines the best

estimate of today and tomorrow’s prices and it is considered to be the accurate reflection

of the supply and demand for the underlying commodity. Price discovery facilitates this

free flow of information, which is vital to the effective functioning of futures market.

Interpretation of Price charts and tables

Example: NCDEX Cotton Futures Prices on Thursday, September 4, 2005.

36

Contract

Month

Open High Low Settle Lifetime

High

Lifetime

Low

Open

Interest

Sept 262.75 263.50 261.50 262.00 270.50 238.00 33922

Dec 266.25 267.50 264.75 266.75 268.00 235.50 141307

Estimated Volume 38,000; volume Wed 38592; open interest 348967+987

The first line of the table: Cotton 5,000 Kg; Rs per 10 Kg. This indicates that the table

applies to the NCDEX Cotton contract, the contract size is 5,000 Kg, and the prices

shown in the table are in units of Rs per Kilograms.

Opening Price : The open or opening price is the price or range of prices for the day's

first trades, registered during the period designated as the opening of the market or the

opening call.

Closing Price : The closing price is the price or range of prices at which the commodity

futures contracts are traded during the brief period designated as the market close or on

the closing call (i.e. last minute of the trading day).

Highest Price: The word high refers to the highest price at which a commodity futures

contract is traded during the day.

Lowest Price: Low refers to the lowest price at which a commodity futures contract is

traded during the day.

Settlement Price: This is abbreviated as settle in most of the pricing tables. There will be

many trades occurring in the last few minutes. Settlement price is computed from the

range of closing prices. Settlement price is important to calculate the daily gains, losses

and margin requirements. It is used by the clearing house to calculate the market value of

outstanding positions held by its members.

37

Change: The change refers to the change in settlement prices from the previous days

close to the current day's close.

Lifetime high and low: They refer to the highest and lowest prices recorded for each

contract from the first day it traded to the present.

Open Interest: It refers to the number of outstanding contracts for each maturity month.

In the line at the bottom of the table, Est. vol. indicates the estimated volume of trading

for that day. Vol. Wed. indicates the trading volume for the previous day. Open interest

refers to the total open interest for all contract months combined at the end of the day's

trading session. Then the figure +987 indicates an increase of 987 contracts from the

open interest of the previous day.

Patterns of Futures Prices

As the maturity date approaches the futures prices show different patterns. Based on

these patterns the markets can be predicted.

Normal Markets: Markets where the prices increase as the time to maturity increases.

Inverted Markets:Markets where the price is a decreasing function of the time to

maturity.

Convergence of futures price to spot price

As the delivery month of a future contract approaches the futures prices converges to the

spot price of the underlying asset. When the delivery period is reached the futures price

equals or is very close to the spot price. This happens because if the futures price is

above the spot price during the delivery period it gives rise to a clear arbitrage

38

opportunity for traders. In case of such arbitrage the trader can short his futures contract,

buy the asset from the spot market and make the delivery. This will lead to a profit equal

to the difference between the futures price and spot price. As traders start exploiting this

arbitrage opportunity the demand for the contract will increase and futures prices will

fall leading to the convergence of the future price with the spot price. If the futures price

is below the spot price during the delivery period all parties interested in buying the asset

will take a long position. The trader would buy the contract and sell the asset in the spot

market making a profit equal to the difference between the future price and the spot

price. As more traders take a long position the demand for the particular asset would

increase and the futures price would rise nullifying the arbitrage opportunity.

f) Closing out the Positions The futures contracts are squared-off before the delivery date. Most of the traders choose

to closeout their positions prior to the delivery period specified in the contract. Closing

out means taking opposite positions of trade from the original one.

Continuing from Example 1 : The Mumbai investor who bought the December soybean

futures on September 2, 2005 can close out the position by selling (i.e. going short) one

December futures contract on any date before the agreed upon delivery date. The Indore

investor who sold the Soybean futures can closeout by buying one December contract at

any time before the Delivery date. The investor's total gain or loss is determined by the

change in the futures prices between the date of entering in to the contract and date of

closing out the contract.

CLEARING AND SETTLEMENT

INTRODUCTION

39

Most of the futures contracts do not lead to the actual physical delivery of the underlying

asset. The settlement is by closing out, physical delivery or cash settlement. All these

settlement functions are taken care of by an exchange-clearing house, called clearing

house / corporation, in futures transactions.

Clearing HouseA clearing house is a system by which exchanges guarantee the faithful compliance of all

trade commitments undertaken on the trading floor or electronically over the electronic

trading systems. The main task of the clearing house is to keep track of all the

transactions that take place during a day so that the net position of each of its members

can be calculated. It guarantees the performance of the parties to each transaction. It is

responsible for:

Effecting timely settlement

Trade registration and follow up

Control of the evolution of open interest

Financial clearing of the payment flow

Physical settlement (by delivery) or financial settlement (by price difference) of

contracts.

Administration of financial guarantees demanded by the participants.

Functions of the clearing houseClearing house has a number of members, who are mostly financial institutions

responsible for the clearing and settlement of commodities traded on the exchanges. The

margin accounts for the clearing house members are adjusted for gains and losses at the

end of each day (in the same way as the individual traders keep margin accounts with the

40

broker). In the case of clearing house members only the original margin is required (and

not maintenance margin). Everyday the account balance for each contract must be

maintained at an amount equal to the original margin times the number of contracts

outstanding. Thus depending on a day's transactions and price movement the members

either need to add funds or can withdraw funds from their margin accounts at the end of

the day. The brokers who are not the clearing members need to maintain a margin

account with the clearing house member through whom they trade in the clearing house.

Provisions Regarding Members Of The Clearing House

REGULATION OF CLEARING HOUSEExchanges shall prescribe the process from time to time for the functioning and

operations of the Clearing House and to regulate the functioning and operations of the

Clearing House for the settlement of non-depository deals.

CLEARING HOUSE TO DELIVER COMMODITIES AT

DISCRETIONThe Clearing House is entitled at its discretion to deliver commodities, which it has

received from a member under these Regulations to another member who is entitled

under these Regulations to receive delivery of commodities of a like kind or to instruct a

member to give direct delivery of commodities which he has to deliver.

41

Processes of a clearing house

NO LIEN ON CONSTITUTUENT'S COMMODITIESWhen a member is declared a defaulter neither the Exchange nor the creditor of the

defaulter shall be entitled to any lien on the commodities delivered by him to the Clearing

House on account of his Constituents.

CLEARING CODE AND FORMS

42

Member Trading Report Statement of commitments

Checking

Trading Roo Price information Commitments information

Clearing Section-Report on Margins In-out

Input

Computer Processing

OutputStatement of account for daily Settlement Daily clearing account (Mark to Market) Exchange Trading fee Exchange Tax Liability Reserve

Statement of Margines Margin Required - Margin

PaymentMargin required or refundable

Amount to be paid or received

Margin required is to be paid by cash or substitutable securities. Margin refundable is to

To be made through account transfer at the contracted bank by noon of 2 business days after

A member shall be allotted a Clearing Code, which must appear on all forms used by the

member connected with the operation of the Clearing House. The Clearing Forms and

Formats to be used by the members shall be prescribed by the Clearing House.

SIGNING OF CLEARING FORMSThe member or his Clearing Assistant shall sign all Clearing Forms

SPECIMEN SIGNATURESA member shall file with the Clearing House specimens of his own signature and of the

signatures of his Clearing Assistants. The member and his Authorised Representative in

the presence of an officer of the Exchange or of the Clearing House shall sign the

specimen signatures card.

CLEARANCE BY MEMBERS ONLYClearing members including professional Clearing Members only shall be entitled to

clear and settle contracts through the Clearing House.

CHARGES FOR CLEARINGThe Exchange shall from time to time prescribe the scale of clearing charges for the

clearance and settlement of transactions through the Clearing House.

CLEARING HOUSE BILLSThe Clearing House shall periodically render bills for the charges, fees, fines and other

dues payable by members to the Exchange which would also include the charges for the

use of the property as well as the charges, fines and other dues payable on account of the

business cleared and settled through the Clearing House and debit the amount payable by

members to their accounts. All such bills shall be paid within a week of the date on

which they are rendered.

LIABILITY OF THE CLEARING HOUSE

43

The only obligation of the Clearing House shall be to facilitate the delivery and payment

in respect of commodities, transfer deed and any other documents between members.

SETTLEMENT METHODSA contract can be settled in three ways:

By physical delivery of the underlying asset.

Closing out by offsetting positions.

Cash settlement.

Closing Out

Most of the contracts are settled by closing out. In closing out, the opposite transaction is

effected to close out the original futures position. A buy contract is closed out by a sale

and sale contract is closed out by a buy.

Cash Settlement

When a contract is settled in cash it is marked to the market at the end of the last trading

day and all positions are declared closed. The settlement price on the last trading day is

set equal to the closing spot price of the underlying asset ensuring the convergence of

future prices and the spot prices.

Commodity Physical settlement schedule for

pay in/payout’s

Soyabean T+7

Refined soyabean oil T+7

Rapeseed mustard seed T+7

Rapeseed mustard seed oil T+7

RBD Palmolein T+7

Crude palm oil T+7

44

Medium staple cotton T+10

Long staple cotton T+10

Gold T+2

Silver T+4

T’ is the date of expiry of the contract.

Cash settlement on T+1 for all contracts.

Process of Dematerlization:-

Dematerlization refers to issues of an electronic credit, instead of vault/

warehouse receipt, to the depositor against the deposit of commodity. Any person (a

consultant) seeking to dematerialize a commodity has to open an account with an

approved depository participant.

In case of agri commodities the constituent delivers the commodity to the

exchange-approved warehouses. The commodity brought by the constituent is checked to

the quality by the exchange-approved assayers before the deposit of the same is accepted

by the warehouse. If the quality of the commodity is a per the norms defined and notified

by the exchange from time to time, the warehouse accepts the commodity and sends

conformation in the requisite form to the R&T agent who upon verification, confirms the

deposit of such commodity to the depository for giving credit to the demat account of the

said constituent.

In case of precious metals, the commodity must be accompanied with the

assayers’ certificate. The vault accepts the precious metal, after verifying the contents of

assayers’ certificate with the precious metal being deposited. On acceptance, the vault

issues an acknowledgement to the constituent and sends confirmation in the requisite

45

format to the R&T agent who upon verification, confirms the deposit of such precious

metal to the depository for giving credit to the demat account of the said constituent.

Process of re-materialization:-

Seller client of member

Warehouse

R & T AgentAccepts Goods

NSDL

Submits commodities & Demat Request Form

Sends data to NSDL via R & T Agent

46

Re-materialization refers to issue of physical delivery against the credit in the demat

account of the constituent. The constituent seeking to rematerialize his commodity

holding has to make a request to his DP then routes his request through the depository

system to the R& T agent issues the authorization addressed to the vault/warehouse to

release physical delivery to the constituent.

Commodity AnalysisStudy on some commodities that are traded in the commodity markets. Commodities

selected are which are traded widely in the market. So commodities like gold and guar

are selected. This analysis contains brief description if product, factors affecting its

supply and demand,

1. Gold

For centuries, gold has meant wealth, prestige, and power, and its rarity and natural

beauty have made it precious to men and women alike. Owning gold has long been a

safeguard against disaster. Many times when paper money has failed, men have turned to

gold as the one true source of monetary wealth. Today is no different. While there have

been fluctuations in every market and decided downturns in some, the expectation is that

gold will hold its own. There is a limited amount of gold in the world, so investing in

gold is still a good way to plan for the future. Gold is homogeneous, indestructible and

fungible. These attributes set gold apart from other commodities and financial assets and

tend to make its returns insensitive to business cycle fiuctuations. Gold is still bought

(and sold) by different people for a wide variety of reasons ñ as a use in jewellery, for

industrial applications, as an investment and so on.

47

Traditionally South Africa has been the largest producers of gold in the world accounting

for almost 80% of all non communist output in 1970. Although it retained its position as

the single largest gold producing country, its share had fallen to around 17% by 1999

because of high costs of mining and reduced resources. In contrast other countries like

US, Australia, Canada and China have increased their output exponentially with output

from developing countries like Peru and other Latin American countries also increasing

impressively.

Global and domestic Demand-Supply

The demand for gold may be categorized under two heads consumption demand and

investment demand. Consumption of gold differs according to type, namely industrial

applications and jewellery. The special feature of gold used in industrial and dental

applications is that some of it cannot be salvaged and thus is truly consumed. This is

unlike consumption in the form of jewellery, which remains as stock and can reappear at

future time in market in another form.

Consumer demand accounts for almost 90% of total gold demand and the demand for

jewelry forms 89% of consumer demand.

1996 1997 1998 1999 2000

--------------------------------------------------------------------------------------------

India 506.98 736.84 814.91 838.86 855.34

USA 331.56 362.04 428.29 459.71 387.55

China 374.48 406.83 314.45 343.38 329.38

SE Asia 329.69 204.04 51.63 265.62 267.18

Saudi 184.75 199.06 208.39 199.37 221.14

Turkey 153.03 201.86 172.00 139.03 207.15

World Markets

48

Today's gold market is a round-the-world, round-the-clock business, played out largely

on dealers' trading screens. The core of the business, however, remains in the key markets

of London, as the great clearing house, New York as the home of futures trading, Zurich

as a physical turntable, Istanbul, Dubai, Singapore and Hong Kong as doorways to

important consuming regions and Tokyo where the Commodity Exchange (TOCOM) sets

the mood of Japan. Even Paris still has a small market, a reminder of the days when the

French were great hoarders, while Mumbai has increasing importance under India's

liberalised gold regime that permits official imports through local markets.

Domestic ScenarioIndia is the world's largest consumer of gold. According to Gold Field Minerals Service,

in 2001 it absorbed around 700 tons from the world market, compared to just 320 tons in

1994; that is without taking into account the recycling of scrap from the immense stock

of close to 10,000 tons built up on the sub-continent in the last few hundred years, or gold

imported for jewellery manufacture and re-export.

During 1990-95, India’s share in global gold demand is placed at about 402 tons (16.4

per cent) a year, including imports into India. This should be viewed against its share of

0.6 per cent in world trade. On the other hand, India exported about 23 tons in 1995

accounting for a negligible part of world trade.

Gold is valued in India as a savings and investment vehicle and is the second preferred

investment behind bank deposits. India is the world’s largest consumer of gold in

jewellery (much of which is purchased as investment). However, gold has to compete

with the stock market, investment in internet industries, and a wide range of consumer

goods. In the rural areas 22 carat jewellery remains the basic investment.

Jewellery

India is the world's foremost gold jewellery fabricator and consumer with fabricator and

consumption annually of over 600 tons according to GFMS. Measures of consumption

49

and fabrication are made more difficult because Indian jewellery often involves the re-

making by goldsmiths of old family ornaments into lighter or fashionable designs and the

amount of gold thus recycled is impossible to gauge. Estimates for this recycled jewellery

vary between 80 tons and 300 tons a year. GFMS estimates are that official gold bullion

imports in 2001 were 654 tons.

Factors affecting the price of Gold

Uncontrolled and uncertain supply

Besides new mining supply, the available supply of gold in the market is made up of

three major ‘above-ground sources’. In recent years, the growth in gold supply has come

from these ‘aboveground’ sources.

Reclaimed scrap, or gold reclaimed from jewelry and other industries such as

electronics

and dentistry;

Official, or central-bank, sales

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Gold loans made to the market from official gold reserves for borrowing and

lending purposes.

The supply from these sources is not determined easily, so it is not possible to estimaye

the total supply.

Fluctuating and uncertain demand

The deregulation of the Indian gold market during the 1990s brought about a dramatic

change. Jewellery demand increased from 208 tons in 1991 to peak at 658 tons in 1998,

while demand for investment bars grew from 10 tons in 1991 to 116 tons in 1998, and

registered 85 tons in 2002. India in 2001 it absorbed around 700 tons from the world

market compared to just 320 tons in 1994; that is without taking into account the

recycling of scrap.

In India the rural population accounts for approximately 70% of national gold demand.

Thus India’s annual gold consumption is dictated both by the monsoon, with its effect on

the harvest, and the marriage season. Between 1998-2001 annual Indian demand for gold

in jewellery exceeded 600 tons, however in 2002, due to rising and volatile prices and a

poor monsoon season, this dropped back to 490 tons.

The major factors influencing demand for gold in India are,

Generation of large market surplus in rural areas as a result of all round increase

in agricultural production

Unaccounted income/wealth generated mainly in the service sector

Domestic gold prices relative to those of ordinary shares and international gold

prices

Wide and unforeseen price variation

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Economic forces that determine the price of gold are different from, and in many cases

opposed to, the forces that influence most financial assets.

Econometric studies indicate that the price of gold is determined by two sets of factors:

‘supply’ and ‘macro-economic factors’.

Supply and the gold price are inversely related. In the case of ‘macro-economic factors’,

the U.S. dollar tends to be inversely related to gold, while inflation and gold tend to move

in tandem with each other. Also, high low-interest rates are generally a positive factor for

gold. Overall, the impact of all of these determinants on the gold price is judged to be

neutral-to-positive at this time. Also there is low to negative correlation between returns

on gold and those on stock markets

An Article from ‘The Hindu’

Demand for gold set to remain strong

World price likely to reach $500 an ounce by the end of 2005.

Oil-dollar-gold price link broken Alternative for speculative investors Nine-

month sale in India exceeds that of whole of 2004.

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MUMBAI 7 th November, 2005 :World Gold Council (WGC) data reveal that in the first

nine months of 2005, Indian demand was up at 645 tonnes (470 tonnes) and Indians

bought 642 tonnes of the metal more than the whole of last year. Besides, it is expected

that with the festive and wedding seasons in full swing, the full year figure could well

break the previous record of 795 tonnes in 1998. According to the WGC, following the

astonishing growth witnessed in the first half of 2005, when total consumer demand rose

55 per cent.

With the U.S. dollar at a two-year high and oil prices having peaked, the alternative to

investors seems to have been gold. Madhusudan Daga, Bullion Analyst and Consultant,

Goldfield Mineral Services, attributed the spectacular rise to open speculative positions

in the U.S. "This time the link between gold, oil and the U.S. dollar seems to have been

broken. While gold has traditionally had a direct link with oil prices and an inverse one

with the U.S. dollar, this time, gold has moved up in consonance with falling oil and

rising dollar."

In India, investment demand in the first nine months of 2005 was up 50 per cent at 105

tonnes (71 tonnes) and in the July-September period, it was up 56 per cent. Globally, the

price moved up to $488 per ounce from $458 per ounce in July. Mr. Daga was confident

that prices would cross the $500 per ounce mark by the year-end.

Sanjeev Agarwal, Managing Director, Indian Subcontinent, World Gold Council, "Gold

has been on the up because over the last few years, with the U.S. dollar weakness and the

huge deficit in the U.S., the investors have been looking at other options like housing,

hedge funds and gold. Also, oil prices have moved up in last six months. So gold has been

seen as a means of diversification of portfolio."

"The underlying prospects for gold in India remain very good. The economy continues to

perform." according to the WGC.

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Trading system NCDEX's Trading System

Trading Hours

Monday to Friday

Trading Hours - 10.00 a.m. to 4.00 p.m. & 5.00 p.m. to 11.00

p.m.

Closing session – 11.15 p.m. to 11.30 p.m. or as may be decided

and notified by the Exchange from time to time

Unit of trading 1 kg

Delivery unit 1 kg

Quotation/Base Value Rs per 10 Grams of Gold with 999.9 fineness

Tick size Re 1 or as may be notified by the Exchange from time to time

Price band Limit 10%. Limits will not apply if the limit is reached during

final 30 minutes of trading

Quality specification

Not less than 995 fineness bearing a serial number and

identifying stamp of a refiner approved by NCDEX. List of

approved refiners will be available with the Exchange and also

on its web site: www.ncdex.com

Quantity Variation None

No. of active contracts 3 concurrent month contracts or as may be notified by the

Exchange from time to time

Delivery center Mumbai as also other centers as may be notified by the Exchange

from time to time

Opening Date The first 3 contracts will be launched on March 31, 2004.

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Subsequently, trading in any contract month will open on the

21st day of the month or as may be decided by the Exchange

from time to time.

Due date 20th day of the delivery month, if 20th happens to be a holiday

then previous working day

Position limits Member-wise: Max (Rs 200 Crores, 15% of open interest)

Client-wise: Max (Rs 100 Crores, 10% of open interest)

Premium/Discounting

The price adjustment will be given for the fineness below 999.9.

The settlement price for less than 999.9 fineness will be

calculated as: (actual fineness / 999.9) Settlement Price

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2. Guar Seed

Introduction:-

Guar, or cluster bean, (Cyamopsis tetragonoloba (L.) Taub) is a drought-tolerant

annual legume crop. Guar is being grown in India since ancient time and the Tender

Green Guar is an important source of nutrition to animals and humans and is consumed

as a vegetable and cattle feed The Guar legume plant is an agricultural product grown in

arid zones of west and North West India and parts of Pakistan.

India accounts for 80% of the total guar produced in the world and 70% is

cultivated in Rajasthan. Apart from Rajasthan, it is being grown mainly in Gujarat,

Haryana and Punjab. It is also grown in some parts of Uttar Pradesh and Madhya

Pradesh.

Global Scenario:-

56

Pakistan, Sudan and parts of USA are the other major Guar growing countries.

75% of the Guar Gums or their derivatives produced in India are exported mainly to USA

and European countries. The value added derivatives of Guar Powder are used by the

various industries in India as well as abroad.

Geographic/Agronomic suitability:

Guar grows best in sandy soils and it needs moderate, intermittent rainfall with

lots of sunshine. Too much precipitation can cause the plants to become leafier, thereby

reducing the number of pods and/or the number of seeds per pod which affects the size

and yield of the seeds. Guar is a rain fed monsoon crop, which requires 8-15 inch of rain

in 3-4 spell and is generally sown after the monsoon rainfall in the second half of July to

early August and is harvested in October - November. Guar requires 2 rainfalls before

sowing, one when the crop buds, and one rainfall when the crop comes up well and the

blossoming starts.

The Guar has the properties to regenerate soil nitrogen and the endosperm of guar

seed is an important hydrocolloid widely used across a broad spectrum of industries.

Rajasthan accounts for 70% of the Guar Seed cultivation.

Pricing Pattern:-

Guar seed has shelf life of more than 3 years without losing out on any of its

properties or qualities. It requires the barest minimum maintenance and handling

environment. The price range of Guar seed ranges from Rs 850/- per qtl to Rs 6500/- qtl.

57

The Value Chain:-

Farmer

Agent (mandi) stockist

Broker

Split Processing Units

Broker

Powder Processing Units

Industrial use (local/export)

Consumer

Various Industrial applications of Guar Powder:-

Food, pet-food, nutritional products and pharmaceuticals.

Personal care products.

Household products.

Paints.

Textiles and carpets.

58

Mining and flocculation.

Oils, gas and other deep well operations.

Paper.

Impediments in development of commodity exchanges

Agricultural commodity Futures exchanges in India are still not developed as compared

to other countries. The dominant political ideology during early years after independence

dealt a severe blow to development of futures exchanges in India. It is only after the onset

of liberalization during 1990s that attitude towards futures trading has changed and its

potential benefits are now being acknowledged in the policy circles. However, there are

still a number of impediments in their growth many of which are on account of regulatory

provisions while others relate to the practices of trade prevalent in these exchanges. As a

result of these impediments membership of commodity exchanges and volume of futures

transactions have remained low.

The membership of a majority of agricultural commodity exchanges have either remained

stagnant or declined during last few years. Small and stagnant number of members proves

that the business of trading in futures is not considered attractive. Examples of a few

exchanges will illustrate this point. The number of active members in Kochin pepper

exchange declined from 55 in 1999 to 33 in 2001. In castor oil exchange at Mumbai it

declined from 8 to 5, in Potato exchange at Hapur, it declined from 36 to 21 and in

Cotton exchange it declined from 15 to 7 during the same period. In most of the

agricultural commodity exchanges, less than 10 per cent of the registered members are

actually actively trading.

These are definite pointers to deep malaise afflicting the futures trading business in India.

Similarly, the volume of transactions in agricultural commodity exchanges have been

very low except in pepper exchange at Cochin, Gur exchange at Hapur, Castor seed

exchange at Ahmedabad, Gur exchanges at Bhatinda and Muzaffarnagar, Soya exchange

at Indore and Jute exchange at Kolkata where the annual transaction exceeded Rs. 2000

Crores during 2000-01. The average volume of transaction of other exchanges was less

59

than Rs. 100 Crores during 2000-01. Some of the reasons for low membership and low

volume of transactions in agricultural commodity exchanges are discussed below:

o Most of the exchanges still follow open outcry system. This stystem is not

considered to be efficient and transparent. The chances of manipulations are quite

high in open outcry system. This is the reason why the Forward Market

Commission has been emphasizing on the need for automation and has made it

mandatory to have on-line trading system for all the commodity exchanges that

are set up newly. There is a global trend towards electronic trading; even the

exchanges that have a legacy of open outcry (and the concomitant problem of

floor brokers keen on defending their turf) are now moving towards electronic

trading.

o Most of the agricultural commodity exchanges in India are beset with the problem

of poor infrastructure. They even lack basic infrastructure like modern trading

ring, warehousing facilities. independent clearing house

o Under the existing system, users of exchange, i.e. traders, hedgers, speculators,

etc need to register their full details with Forward Market Commission. This is not

in tune with foreign exchanges norms. This adds unrequired regulatory costs. This

becomes a significant issue in India where there is large expandable economy.

o Due to history of ban on futures trading a “Havala” or unorganized marketwas

built and they continue to exist now. A large portion of future is diverted to this

market. Due to there long existence they have built up good reputation in terms of

liquidity and integrity some of these markets trade as much as 20-30%higher than

registered markets.

o There is widespread lack of awareness the role and technique of trading among

the potential beneficiaries. Only traditional players who have been participating in

60

such trading either in formal markets or gray markets. This acts as a barrier to the

growth of futures trading in India.

o Currently, Indian tax law does not permit losses on a futures transaction to

be treated as a business expense to be offset against, say, a profit on the

underlying physical trade (unless there is a definite underlying contract).

o A major flaw in Indian commodities futures market is the practice of having an

exclusive futures exchange for each commodity. This has happened due to

historical reasons. Futures exchanges got set up in specific regions in which there

was an active spot market for a particular agricultural commodity. As a result the

volumes available at each exchange are so miniscule that it does not permit large

investments required to create a modem derivative exchange.

o No futures market can exist in the absence of variability in the prices. Through a

host of diverse measures such as price controls, price support operations,

procurement and distribution schemes, buffer stock operations, restriction on

storage and movement, etc. the government has tried to virtually eliminate price

risks. There are also commodity based specialized government agencies like

NAFED, Cotton Corporation of India, Jute Corporation of India, etc. which

control supplies of some farm products. In the presence of these restrictions the

futures markets can't be expected to develop and play any meaningful role in price

discovery of agricultural commodities.

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Recommendations

Electronic/Modern Technique

Markets in are traditional type, so there are huge amount of manipulations in it. So it’s

necessary for the governing body to use modern technique for trading in futures to avoid

such manipulations and provide its members with fair trading.

Create Awareness among Farmers

In India many farmers, traders are not aware about the existence of commodity markets.

Inspite of efforts taken by the government to create awareness it is still not enough to

attract farmers and traders towards the commodity and regulated markets. This is due to

lack of educational facilities to farmers.

Permitting FII and mutual-fund participation :-

Currently, regulations do not permit FIIs and mutual funds to participate in

commodity trading in India. Removal of these restrictions is likely to provide further

depth to the commodity markets as FIIs are likely to trade actively across various

commodity markets and asset classes globally to take advantage of arbitrage

opportunities.

Increasing corporate and retail participation :-

Commodity trading in India is still at a nascent stage, with the majority of volume

attributable to traders, industry associations and speculators. Corporate and retail

62

participation is negligible. However, I believe this will change once the contracts mature

and there is sufficient liquidity. Up to now only a few companies have used commodity

exchanges to hedge on a trial basis. Their full entry will boost liquidity and trading

volume.

Create Infrastructure

Commodity markets lack proper infrastructural facilities which are necessary for

conducting trading smoothly. So it is necessary to have good infrastructural facilities to

improve commodity markets. It should have proper ordering, filling , processing, storage,

dispatching facilities.

Contract of Smaller Value

Exchanges should come with concept like contract of smaller value. A contract of smaller

would be able to attract the small investors to play in the markets. This could enable to

abolish the monopoly of few existing members. This can also help these exchanges to

increase the number of their members.

Introduction of options Transaction volume will rise further if the regulator opens up the commodity

exchanges for commodity option trading. Currently, only trading in commodity futures is

permissible. Globally, trading volume from options is 20-30 % of the futures volume,

implying that India exchanges could get a further 20-30 % boost in commodity trading

volume.

63

Warehousing Facility

All the exchanges have their warehouses at a particular place i.e. the place where it is

traded in huge numbers or place where it is produced. So it is necessary for the exchanges

to locate heir warehouses at various places as it is possible to deliver and collect the

goods. This could help in increasing percentage of delivery.

Compulsory Delivery

Exchanges can also try with compulsory delivery contracts. This contract can be helpful

basically for farmers through which they can sell off their produce at reasonable prices.

64

ConclusionIn spite of the best efforts of the government and the banks, the credit off take for

agricultural sector is not increasing to the desired extent. For this to happen, deepening of

agricultural credit market is necessary. If farmers have access to market-based price

insurance through futures markets, they will be able to benefit from higher income by

commercial farming and the potential profitability of specialization. The higher

investment required for commercial and hi-tech farming will boost the demand for farm

credit. The policy environment governing the Indian agricultural sector is rapidly

evolving. Several measures have been adopted which suggest that international price and

competition is likely to intensify in agriculture sector in near future. In order to enable the

Indian farmers to meet these challenges comprehensively, the policy environment will

have to be suitably changed. The market forces will have to be given a much greater

freedom to discover prices. It is in this context that futures markets assume a very

important role in facilitating discovery of prices and devising new and effective risk

management tools for the benefit of farming economy. The opening of futures trading in

several commodities, after an almost 40-year gap, is a welcome step. Futures trading is

employed in all major global commodities markets as an effective hedge against

fluctuating prices. However, in India a great deal of groundwork, such as strengthening

Forward Market Commission, amending Forward Contract Act, 1952 and modifying

Essential Commodities Act, Minimum Support Price Mechanism, etc., needs to be done

if the futures markets are to efficiently carry out their function as a mechanism of price

discovery and risk management. There is a need to put in place a strong, but not

excessive, regulatory regime that will ensure transparency and efficient trading and

encourage development of futures trade. Efficient futures markets will stabilize the

incomes of the farmers and provide an incentive to go for capital-intensive cash crops.

This, in turn, will increase the demand for agricultural credit. Higher and stable income

of the farmers will help in emergence of a sustainable credit market in rural areas with

high demand for credit coupled with high percentage of repayment of loans.

65

Bibliography

Books/ magazine: - NCFM Form National Stock Exchange.

Bank Quest

Websites: - www.mcxindia.com

www.ncdex.com

www.ficci.com

www.iibf.org

www.motilaloswal.com

Newspapers: - Hindustan Times

The Economic Times

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