Roadmap for opening Commodity Derivatives in India

Over two decades, commodity futures have become a popular asset class for portfolio investors, just like other financial assets classes -- stocks and bonds. The investment inflows have only increased to several commodities such as energy, metal and agriculture and also their indices.

Jul 20, 2021 07:07 IST India Infoline News Service

The commodity sector will be one of the key drivers for India’s to achieve its objective of becoming a USD 5-trillion economy. Concomitant growth in the commodity derivatives market is of utmost importance and needs immediate attention. Although the underlying nature of the commodity derivatives market is a physical asset, and not merely a financial asset, but financialization of commodities globally has changed the dynamics of the derivatives market.

Over two decades, commodity futures have become a popular asset class for portfolio investors, just like other financial assets classes -- stocks and bonds. The investment inflows have only increased to several commodities such as energy, metal and agriculture and also their indices.

Let’s quickly discuss commodity derivates, their need, the economic functions they serve and the orientation to risk by the participants in the derivatives market.

The Commodity derivatives market provides various direct and indirect benefits to commodity value chain participants. The key benefits of commodity derivatives market include providing a nationwide platform for discovery of prices and enabling physical market participants to hedge their price risk. Besides, in the absence of futures trading, various value chain participants like small producers and end users lose an invaluable tool for hedging their price risk, getting advance price signals of the commodity and for making informed decision on cropping, timing of sales etc. Also, a successful futures contract in any commodity catalyzes the development of marketing infrastructure like warehousing, assaying facilities which in turn facilitates pledge financing through warehousing and banks network.

Derivatives markets perform two economic functions; they facilitate the transfer of risk from those who do not want it to those who are more willing to accept it, and they provide price discovery signals to the various stakeholders. The commodity derivatives perform two important roles- Price Discovery and Hedging. Therefore, the participation of each stakeholder is an imperative for the development of an efficient derivatives market.

The players in the commodity derivatives market can be classified into two major categories - risk givers and risk - takers. Risk givers or hedgers refer to those who have a risk due to physical exposure to the commodity, and are looking to pass on their risk by taking a sell or buy position on Stock Exchange. Risk takers or investors refer to those who do not have physical exposure to the commodity, but who are willing to take a buy or sell position or risk with the aim of making gains from inequalities in the market. Financial investors and arbitrageurs are the investors in this market.

The various stakeholders in the commodity derivatives markets are- Farmers, processors, stockists/wholesalers/retailers, brokers, importers, exporters, traders/merchants, Financial investors, arbitragers, financial institutions such as Mutual Funds, Alternative Investment Funds (AIFs) Category III, Eligible Foreign Entities (EFEs) having actual exposure to Indian commodity markets, Portfolio Managers.

Ever since SEBI assumed the role of regulation and development of Commodity Derivatives in 2015, it first overhauled the risk management, margin system, and enhanced & most stringent norms for Settlement Guarantee Fund (SGF), positional limits, surveillance measures. More importantly, it has taken numerous steps to widen the market by allowing introduction of various products like Options in Futures, Options in Goods and Commodity Indices and deepen the market by allowing the participation of institutional players.  SEBI permitted the participation of some categories of institutional investors in the Exchange Traded Commodity Derivatives (ETCD), for improving the quality of price discovery, thereby leading to better price risk management.

Category III Alternative Investment Funds (AIFs) (various types of funds such as hedge funds, PIPE (Private Investments in Public Equity) Funds, etc. are registered as Category III AIFs),  eligible Foreign Entities (EFEs) having actual exposure to Indian commodity market, mutual funds, and portfolio managers are some class of investors allowed in the sector.

Banks and FPIs, though, are still not allowed though Banks can offer broking services to their clients to trade commodity derivatives.

Importance of increased institutional participation

Eligible Foreign Entities are, as per the current provision, allowed to take only one side exposure and that is limited to the extent of their exposure to physical market demonstrable through export or import of commodities with Indian Party. Several industry experts have opined that this requirement of linking it to exposure in the Indian physical market constrains their participation in ETCD. With the repeal of FCRA and amendment in SCRA to include Commodity Derivatives as securities, SEBI only has to change few regulations to have position limits that are beyond the domestic exposure and allow freely sell or buy of commodity derivatives by foreign entities.

SEBI has already notified sensitive commodities. Foreign entities may be allowed to trade only in non- sensitive commodities.

It is important to understand the fundamental reasons why foreign entities, especially foreign portfolio investors (FPIs) would increase inflows in ETCD. They would do so to primarily diversify their portfolio and not to hedge. The financial year 2020-21 witnessed strong FPI investment inflows into the Indian equity markets of Rs 2,74,034 crore. The increase in aggregate FPI investment limit in Indian companies from 24% to the sectoral cap has been a catalyst for the increase in weightage of Indian securities in major equity indices, thus mobilising massive equity inflows, both passive and active, into Indian capital markets. The Government and regulators had also undertaken major policy initiatives directed at improving ease of access and investment climate for FPIs in the recent past.

Commodity Derivatives can also see a major change and that would be positive. The ease of access, deregulation, enhancing limits beyond hedging purpose and primarily a fundamental change in perspective is required and the foreign players including FPI and also Banks should be allowed to participate. The hedgers will also find that our own Exchanges provide more liquidity for them to hedge their quantities and markets will be truly vibrant. Export of hedging to exchanges in other country jurisdictions will gradually halt.

However it is important for India to have predictable and stable regulations. A well thought out and measured approach that is attuned to protecting the physical market from undue influence, as well opening up the futures market to foreign participation to non- sensitive commodities is the need of the hour.

The author of this article is Narinder Wadhwa, Founder & MD, SKI Capital Services Ltd and SKI Group

The views and opinions expressed are not of IIFL Securities,

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