Newly Permitted Commodities for Derivatives Trading by MoF

March 4, 2024
Posted by: OptimizeIAS Team
Category: DPN Topics

Newly Permitted Commodities for Derivatives Trading by MoF

Subject: Economy

Section: Financial Market

Recently, derivatives trading in 11 additional commodities, has been allowed by Finance Ministry, based on the recommendation from the Securities and Exchange Board of India (SEBI).

Skimmed Milk Powder
Cement
Apple
Bamboo
Timber
Weather
Freight
White Butter
Cashew
Metal Alloys
Manganese

Key Points:

Date of Notification: The Finance Ministry issued the notification on March 1.
Legislation: These commodities have been added under the Securities Contracts (Regulation) Act, 1956.
Total Number of Commodities for Derivatives Trading: With these additions, the total number of commodities eligible for derivatives trading now stands at 104.
Immediate Effect: The changes are implemented immediately upon the issuance of the notification.

Comments from Industry Experts:

Recommendation by CDAC: The Commodity and Derivatives Advisory Committee (CDAC) of SEBI recommended trading in these 11 commodities. CDAC includes members of the Commodity Participants Association of India (CPAI).
Enabling Provision: While the notification enables trading in these commodities, it does not mean immediate trading will commence. Exchanges will study market potential and submit applications to SEBI. SEBI will then assess demand and market prospects before allowing trading.
Market Participants’ Involvement: Market participant associations need to be on board before a commodity is approved for trading. Some physical market participants have reservations about online derivatives trading, citing concerns about price manipulation.
Ban on Some Commodities: Derivatives trading in seven key agricultural commodities remains banned until December-end to control inflation.

Expert Opinion:

Price Discovery: Allowing derivatives in these commodities will aid in price discovery for widely traded items.
Inflation Concerns: There are concerns about the impact on inflation, with experts noting that the government is cautious about derivatives trading’s role in price inflation.
Policy Certainty: Hedgers and investors are seeking clarity and policy certainty regarding derivatives trading in agriculture commodities.

In summary, the recent move to permit derivatives trading in these 11 commodities aims to enhance market activity, aid in price discovery, and offer new opportunities for investors.

However, considerations about inflation, market demand, and policy certainty remain important factors in the process.

Exploring Derivatives: A Financial Instrument Overview

Derivatives are financial instruments that derive their value from an underlying asset, index, or interest rate. They serve as contracts whose value is linked to the performance of the underlying entity.

Types of Derivatives:

Forwards and Futures:

Description:
- Contracts that obligate the buyer to purchase an asset at a predetermined price on a specified future date.
- Both forwards and futures serve the same purpose, with slight differences in their nature.
Key Points:
- Buyers commit to buy the asset at the agreed-upon price, irrespective of the market price at maturity.
- Commonly used in commodities, currencies, and financial markets.

Options:

Description:
- Offer the buyer the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at a specified price.
- The buyer can exercise the option on the maturity date or at any time before the maturity.
Key Points:
- Provides flexibility to investors based on market movements.
- Two types: Call options (for buying) and Put options (for selling).

Swaps:

Description:
- Contracts facilitating the exchange of cash flows between two parties.
- Involves swapping fixed cash flows for floating cash flows based on a specified underlying asset.
Common Types:
- Interest Rate Swaps:
  - Exchange fixed interest payments for variable (floating) interest payments.
- Commodity Swaps:
  - Exchange cash flows based on commodity prices (e.g., oil, gold).
- Currency Swaps:
  - Exchange cash flows in different currencies, often used to hedge against currency risk.

Benefits and Applications:

Risk Management:
- Derivatives enable hedging against adverse price movements, reducing financial risk.
- Investors use derivatives to protect their portfolios from market volatility.
Speculation:
- Traders utilize derivatives to speculate on price movements without owning the underlying asset.
- Offers potential for higher returns but involves higher risk.
Enhanced Portfolio Diversification:
- Derivatives provide exposure to diverse asset classes without directly owning them.
- Allows investors to spread risk across different markets and instruments.
Price Discovery:
- Derivative markets contribute to price discovery by reflecting market sentiments and expectations.
- Prices of derivatives can indicate future market trends and sentiments.

Considerations and Risks:

Leverage:
- Derivatives often involve leveraging, amplifying potential gains or losses.
- Requires careful risk management and understanding of exposure.
Counterparty Risk:
- Swaps and other derivative contracts involve counterparty risk.
- Parties must assess the creditworthiness of their counterparties to mitigate default risks.
Market Volatility:
- Derivative prices can be highly sensitive to market fluctuations.
- Requires active monitoring and adjustment of positions.

National Commodities and Derivatives Exchange (NCDEX)

The National Commodities and Derivatives Exchange (NCDEX) is an online commodities exchange based in India, specializing in agricultural commodities. Established in 2003, NCDEX plays a crucial role in facilitating trading, price discovery, and risk management in the agricultural sector.

Key Highlights:

Establishment and Legal Structure:
- Founded on: April 23, 2003.
- Legal Status: NCDEX is a public limited company incorporated under the Companies Act, 1956.
Founding Institutions:
- NCDEX was established by a consortium of prominent financial institutions in India.
- Leading Founders:
  - ICICI Bank Limited: One of India’s largest private sector banks.
  - National Stock Exchange of India (NSE): Premier stock exchange in India.
  - National Bank for Agriculture and Rural Development (NABARD): Financial institution focused on rural and agricultural development.
  - Other Institutions: Several other financial entities and institutions also participated in the founding of NCDEX.

Nature of Operations:
- NCDEX primarily deals in agricultural commodities, offering a platform for trading, hedging, and price discovery.
- The exchange provides a transparent and efficient marketplace for farmers, traders, and other stakeholders in the agricultural value chain.
Contracts Offered:
- NCDEX offers a range of futures contracts for various agricultural products.
- Currently, the exchange lists around 25 contracts for different agricultural commodities.
- These contracts allow market participants to hedge against price risks, speculate on price movements, and participate in the agricultural market.
Role in Agricultural Sector:
- The exchange plays a vital role in the agricultural sector by providing farmers with a platform to sell their produce at transparent prices.
- It enables farmers to hedge against price fluctuations, reducing the impact of market uncertainties on their incomes.
- Traders, processors, and other stakeholders benefit from efficient price discovery and risk management tools offered by NCDEX.

About Commodity Derivatives Advisory Committee (CDAC)

Mandate: The Commodity Derivatives Advisory Committee (CDAC) is a committee constituted by the Securities and Exchange Board of India (SEBI) to review the commodity derivatives segment.

Objectives:

Improving Market Depth: CDAC aims to suggest measures to enhance the depth and efficiency of the commodity market in India.
Recommendations:
- Opening to Institutional Investors: CDAC has recommended the phased opening of the commodity derivatives segment to all categories of institutional investors.
- Calibrated Approach for Overseas Investors: SEBI is advised to adopt a careful and phased approach before allowing overseas investors into the commodity derivatives market.
- Phased Approach:
  - Initially, the recommendation is to open the segment to all categories of domestic institutional investors.
  - In the subsequent phase, foreign portfolio investors (FPIs), banks, insurance companies, and pension funds should be allowed to participate.
- Asset Class Diversification: CDAC highlights that commodity derivatives offer a new asset class for investors, which can serve as a hedge against inflation.
- Portfolio Diversification: Investment in commodity derivatives can benefit investors by providing better portfolio diversification, reducing overall risk exposure.

Significance:

Enhancing Liquidity: Opening the commodity derivatives segment to institutional investors is expected to increase liquidity and depth in the market.
Risk Management: Institutional participation allows for better risk management as investors can use commodity derivatives to hedge against price fluctuations.
Investor Benefits: Institutional investors, including foreign entities, gain access to a new avenue for investment diversification, potentially improving overall portfolio performance.
Market Development: These recommendations signify a step towards the development of a more robust and mature commodity derivatives market in India.
Regulatory Oversight: SEBI’s role in overseeing the phased opening ensures a structured approach to market expansion, safeguarding investor interests and market integrity.

The recommendations of the Commodity Derivatives Advisory Committee (CDAC) reflect a strategic approach towards strengthening the commodity derivatives market in India, fostering investor confidence, and promoting market development in line with regulatory standards.