How does the Commodity Market Work in India
One of the most interesting things to understand is how the commodity market works. When we talk of the working commodity market, we must understand that there are two distinct markets viz. the spot market and the derivatives market. The spot market is a market for delivery of commodities on spot or that is normally 4-5 days. The futures markets will be delivered after a specific period; normally 1 month, 2 months, or 3 months. The working of commodity markets in India is basically about the futures market but the spot market is equally important.
How does the commodity market work in spot and futures? The spot market is controlled by specific states and does not come under SEBI purview. It is only the commodity futures, and that too the exchange-traded futures, that come under SEBI purview. There is still a thriving commodity forward market that is on an OTC basis and where contracts are customized to the specific requirements of the individual parties. So in a nutshell; there is the commodity spot market, the commodity forwards market, and the commodity futures market with SEBI regulating only the third aspect of commodities.
Commodity Market Work in India
Commodities were permitted in 2001 and in 2002, the MCX and the NCDEX started functioning. However, the volumes picked up very sharply only in select commodities. To begin with, the commodity exchanges were only offering futures on commodities. However, being a commodity market, the commodity futures offered speculation-based trading and delivery-based trading. That means the exchange had tie-ups with warehouses to supply the underlying commodity at an assured price to the two parties. The risk belonged to the two parties and the exchange was only a facilitating platform.
In terms of regulation, the commodity markets were regulated under the aegis of the Forward Market Commission or FMC till 2015. After the National Spot Exchange (NSEL) scam in 2013, there was a major furor over the functioning and regulation of the FMC and subsequently, the regulation of the commodity futures market was fully transferred to SEBI. Since 2015, it is the Securities and Exchange Board of India (SEBI) has been regulating the commodity markets. Commodity trading in these exchanges requires standard agreements as per the instructions so that trades can be executed without visual inspection. In general. Like in any futures exchange, the trades on the commodity futures exchanges are also standardized in terms of quality, lot sizes, delivery dates, expiry, etc so that entry and exit become simple.
The trading in commodity options was introduced in 2017, but it is yet to take off in a big way although the traction is visible in several commodities. In India, the volumes on options are predominantly the volumes on options on commodity futures and not on spot commodities. That is the difference between trading options in commodities in the Indian context.
Classifications of commodity futures trading in India
In India, there are broadly 4 categorizations of commodity futures.
- Commodity futures on Precious Metals include gold and silver futures contracts on the commodity exchanges. These contracts are extremely liquid and MCX has a leadership position in futures and options on precious metals.
- Commodity future on Base Metals or Industrial Metals includes factory commodities like futures contracts on copper, zinc, aluminum, etc on the commodity exchanges. These contracts are also extremely liquid and MCX has a leadership position in futures and options on these base or industrial metals.
- Commodity futures on precious metals include commodities like futures contracts on gold and silver on the commodity exchanges. Both the gold and silver contracts are among the most liquid contracts in the exchanges and MCX once again has a leadership position in futures and options on these precious metals.
- Commodity futures on agriculture commodities include essentially cash crops like cotton, guar, guar gum, palm oil, etc. These contracts are also extremely liquid and it is NCDEX that has a leadership position in futures and options on these agricultural commodities.
In India, many of the contracts are not permitted like many of the food crops are not allowed to be traded in commodity futures due to fears that they could lead to unnecessary speculation and price rise.
How do commodity futures help?
While speculating on price is surely one advantage of these commodity futures, another very important aspect of commodity futures is to hedge risk. For example, a company that needs to procure copper throughout the year and expects prices to rise can hedge risk by purchasing copper futures. Similarly, a copper miner and smelter can sell copper futures in the commodity market to lock in the selling prices. In both cases, they may lose out if the price moves in their favor but the commodity futures lock in prices and give greater certainty to the business. That is the key application of these commodity futures.
One of the best ways to invest in commodities is via the futures contract route, especially the exchange-traded commodity futures. It represents an agreement to buy or sell a specific quantity of a commodity at a set price at a future date. Such contracts can be for delivery or purely speculative for playing the expected price movement. Futures are available in most commodity categories. Traders use these contracts as protection from the risks associated with the price swing of an underlying finished product or raw material. Trading in commodities involves a high amount of risk for amateur investors since the levels of knowledge of the commodity and global trends are a must.
Major Commodities Exchange in India
There are 6 major commodity trading exchanges in India as listed below.
- Multi Commodity Exchange – MCX. This was founded by Financial Technologies almost 20 years ago and has a leadership position in commodity futures on base metals, precious metals, and energy.
- National Commodity and Derivatives Exchange – NCDEX is also around 20 years old and while it also offers most of the commodity futures for trading, it has a leadership position in trading agricultural commodities
- National Multi Commodity Exchange – NMCE
- Indian Commodity Exchange – ICEX
- Ace Derivatives Exchange – ACE
- The Universal Commodity Exchange – UCX
In addition to the above, the NSE and the BSE have also been authorized to offer trading in commodities by SEBI, although it will be in a phased manner. That is yet to pick up meaningfully.
Are Commodities a Good Investment?
First and foremost, commodities are not an investment. They can either be seen as a play on the future price movements of these commodities or they can be seen as a hedge. The hedge entails protection against price risk when you have an underlying risk involved like a warehouser, wholesaler, or manufacturer of any of these commodities.
Frequently Asked Questions Expand All
Commodities are basic products that are undifferentiated. For example, gold is a commodity, gold ornaments are not. Silver is a commodity but silver used in electronics is not a commodity. These commodities can be differentiated and are normally see their price being driven by the factors of demand and supply.
You have precious metals like gold and silver. Then there are industrial commodities like copper, zinc, aluminium etc. Then there are energy commodities which include crude oil and natural gas. Finally, there are agricultural commodities like cotton, guar, palm oil etc.
Commodity traders can be speculators, hedgers or even arbitrageurs. Normally, arbitrageurs work on the narrow spread between the spot market and the futures market. They also help make market by constant liquidity infusions.