A Beginner’s Guide to Indian Commodity Futures Markets Neeraj Mahajan and Kaval
A Beginner’s Guide to Indian Commodity Futures Markets Neeraj Mahajan and Kavaljit Singh A BEGINNER’S GUIDE TO INDIAN COMMODITY FUTURES MARKETS NEERAJ MAHAJAN AND KAVALJIT SINGH MADHYAM Madhyam is a non-profit policy research institute based in New Delhi, India. Kavaljit Singh is Director of Madhyam. Neeraj Mahajan is an independent journalist based in New Delhi. Published in 2015 by: Madhyam 148, Maitri Apartments Plot No.28, Patparganj New Delhi: 110092, India Phone: 91-11-43036919 Email: madhyamdelhi@gmail.com Website: www.madhyam.org.in Creative Commons Attribution Non Commercial No Derivatives 3.0 Since this publication is meant for nonprofit, research and educational purposes, you are welcome to reproduce it provided the source is acknowledged. We will appreciate if a copy of reproduced materials is sent to us. Designed by KS Designers, New Delhi. CONTENTS Acronyms ix Data Notes x Acknowledgements xi Introduction xiii How This Guide is Organized xv PART I 1. Understanding Commodities 3 What is a commodity? Which kinds of commodities are traded in the world? Why are commodities important? What are the main differences between commodity spot and derivatives markets? Why are prices in global commodities markets volatile? 2. Understanding Derivatives and Commodity Futures Trading 7 What is a derivative contract? What are exchange-traded derivatives? What are over-the-counter (OTC) derivatives? Why are derivatives considered a double-edged sword? What are the key functions of commodity futures trading? Which commodities are suitable for futures trading? What is an “underlying” and how is it different from a “contract”? What is convergence? 3. Understanding Commodity Derivatives Exchanges 17 What is a commodity derivatives exchange? What were the historical reasons behind setting up commodity exchanges worldwide? How does a commodity derivatives exchange function? What is the role of an exchange in futures trading? How are futures prices on the exchange determined? Which are the biggest global commodity derivatives trading exchanges? 4. The Market Participants 23 Who are the main players in commodity futures market? Why is farmer participation in the Indian commodity futures markets very low? ( vi ) Are foreign investors allowed to trade in the Indian commodity markets? Are banks and financial institutions allowed to trade in commodity futures markets in India? 5. The Financialization of Commodities 27 What is financialization of commodities? Why are financial players interested in commodity derivatives? What has been the impact of financial players? 6. A World Full of Manipulated Markets 33 Silver Thursday and the Hunt Brothers Scandal Crude Oil Price Fixing Scandal The Enron Scandal The Copper King Scandal PART II 7. Commodity Futures Markets in India 39 Are commodity derivatives new in India? What was the rationale behind setting up commodity futures exchanges in India? What are the major commodity exchanges in India? What is the status of regional commodity exchanges? Which commodities are allowed in the Indian futures markets? Are options allowed in commodity derivatives trading in India? Are deliveries compulsory in Indian commodity futures markets? What is staggered delivery? 8. How are the Indian Commodity Futures Markets Manipulated? 45 What are the common fraudulent business practices? What is circular trading? How does it contribute to market manipulation? What is open interest and what does it reveal? What are the international best practices on open interest? How does profit and loss accounting in commodity futures trading lead to tax evasion? What is dabba trading? What is wash trading? What is client code modification (CCM) and how is it used to evade taxes? 9. The Guar Futures Trading Scandal 49 What is guar? What led to steep rise in guar futures prices? How were the guar futures prices manipulated? Did guar farmers benefit from the steep hike in prices? What was the regulatory response to the guar trading scandal? ( vii ) 10. The NSEL Payment Scam 53 How did the NSEL payment scam unfold? What was the modus operandi? What was the regulatory response? What happened to the settlement guarantee fund? How were warehouse receipts forged? Is weak regulatory framework responsible for the NSEL scam? 11. The Regulatory Issues in India 59 Why should commodity futures markets be regulated? Who regulates the commodity futures markets in India? What are the key regulatory tools used by FMC in the recent past? What are the key regulatory and governance gaps in Indian commodity futures markets? Should FMC be given more powers and greater administrative autonomy? Should FMC encourage independent research for evidence-based policymaking? 12. The Commodity Transaction Tax 63 What is a commodity transaction tax? What are the main benefits of CTT? Can CTT trigger a sharp fall in futures trading? Is CTT a panacea? PART III 13. Policy Issues and Challenges 67 Is speculation good for commodity futures markets? Why is there so much excessive speculation in the Indian futures markets? Are futures markets performing the two important functions of price discovery and price risk management in India? What policy reforms are needed to encourage the participation of farmers and commercial hedgers? To what extent should algorithmic trading be allowed in commodity futures markets? Should banks be allowed to trade in commodity futures markets in India? Do futures markets aggravate rise in commodity prices? What should be the government’s policy towards regional commodity exchanges? Should large companies disclose their positions in commodity futures markets? Should India implement international regulatory reforms initiated by the G20? Glossary 83 Useful Links 91 ( viii ) LIST OF BOXES Box 1 : Commodity Physical Forward Contracts 8 Box 2 : Exotic Derivatives Trap Small Exporters in India 14-15 Box 3 : US Senate report: Banks Had “Unfair Advantage” in Physical Commodities Business 30-32 Box 4 : NSEL Debacle has Damaged the Prospects of Fungibility of Warehouse Receipts 75-76 LIST OF TABLES Table 1 : Billion-Dollar Losses in Commodity Derivatives Deals 10 Table 2 : Top 15 Derivatives Exchanges Worldwide 20 Table 3 : Top 12 Most Active Banks in Commodities Derivatives 27 Table 4 : Group-wise and Commodity-wise trading in the Indian Futures Market 42 Table 5 : Futures Trade Multiples of Various Agricultural Commodities 68 ( ix ) ACRONYMS BIS Bank for International Settlements CDS Credit Default Swap CFTC Commodity Futures Trading Commission CME Chicago Mercantile Exchange CTT Commodity Transaction Tax FII Foreign Institutional Investor FMC Forward Markets Commission GDP Gross Domestic Product ICE Intercontinental Exchange Inc. ICEX Indian Commodity Exchange IFFCO Indian Farmers Fertilizer Cooperative Limited IOSCO International Organization of Securities Commissions ISIN International Securities Identification Number MCA Ministry of Corporate Affairs MCX Multi Commodity Exchange of India NAFED National Agricultural Co-operative Marketing Federation of India Limited NBOT National Board of Trade NCDEX National Commodity and Derivatives Exchange of India NMCE National Multi Commodity Exchange NYMEX New York Mercantile Exchange OCEIL Online Commodity Exchange India Limited OTC Over-the-counter PDS Permanent Account Number PDS Public Distribution System RBI Reserve Bank of India SEBI Securities and Exchange Board of India SGF Settlement Guarantee Fund UCC Unique Client Code UNCTAD United Nations Conference on Trade and Development ( x ) DATA NOTES 1 US$ = Rs.62 (as of March 2015) Dollars are US dollars unless otherwise specified 1€ = Rs.70 (as of March 2015) 1 lakh is 100,000 1 crore is 100 lakh (or 10 million) 1 million is 10,00,000 (10 lakh) 1 billion is 1,000 million 1 trillion is 1,000 billion 1 quintal is 100 kilogram, or Kg 1 tonne is 1,000 kg ( xi ) ACKNOWLEDGEMENTS We express our thanks to all those individuals and organizations who provided support in the research and publication of the Guide. In particular, we would like to thank Tarun Soni for his immense contribution in the early stages of research and the glossary section. We are thankful to Myriam Vander Stichele (Senior Researcher, SOMO, Amsterdam),G. Chan drashekhar (Commodities Editor, The Hindu Businessline, Mumbai), Dilip Kumar Jha (Commodities Editor, Business Standard, Mumbai), and Dr. R. Sendhil (Scientist, Directorate of Wheat Research, Karnal) for providing valuable inputs and comments on the draft manuscript besides sharing a number of articles, documents and books with us. Special thanks to Kaveri Nandan for copy editing the manuscript. Thanks are also due to all those experts whose writings and data we have drawn upon in the preparation of the Guide. However, the authors remain responsible for any errors. ( xii ) ( xiii ) INTRODUCTION When food prices rose dramatically worldwide during the 2007-2008 period, food riots broke out in many poor countries and there were fears of high price volatility and inflation in the developed countries. The food price spike created a global food crisis. Concerns over the social unrest and economic instability compelled the policymakers to examine the factors behind the worldwide increases in food prices. Apart from analyzing developments in the spot markets, the policymakers also turned their attention to the commodity derivatives markets, which had been undergoing major changes since 2000. In India, too, the role of futures trading in aggravating the price hike was hotly debated when the government banned futures trading in several agricultural commodities in 2008 to control food inflation. Commodity trading in food and other agricultural products, metals and energy products is uploads/Finance/ commodity-guide.pdf
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