Commodities Market

What is a market?
A market is conventionally defined as a place where buyers and sellers meet to exchange goods or services for a consideration. This consideration is usually money. In an Information Technology-enabled environment, buyers and sellers from different locations can transact business in an electronic marketplace. Hence the physical marketplace is not necessary for the exchange of goods or services for a consideration. Electronic trading and settlement of transactions has created a revolution in global financial and commodity markets.

What is a commodity?
A commodity is a product that has commercial value, which can be produced, bought, sold, and consumed. Commodities are basically the products of the primary sector of an economy. The primary sector of an economy is concerned with agriculture and extraction of raw materials such as metals, energy (crude oil, natural gas), etc., which serve as basic inputs for the secondary sector of the economy.

To qualify as a commodity for futures trading, an article or a product has to meet some basic characteristics:

The product must not have gone through any complicated manufacturing activity, except for certain basic processing such as mining, cropping, etc. In other words, the product must be in a basic, raw, unprocessed state. There are of course some exceptions to this rule. For example, metals, which are refined from metal ores, and sugar, which is processed from sugarcane.
The product has to be fairly standardized, which means that there cannot be much differentiation in a product based on its quality. For example, there are different varieties of crude oil. Though these different varieties of crude oil can be treated as different commodities and traded as separate contracts, there can be a standardization of the commodities for futures contract based on the largest traded variety of crude oil. This would ensure a fair representation of the commodity for futures trading. This would also ensure adequate liquidity for the commodity futures being traded, thus ensuring price discovery mechanism.
A major consideration while buying the product is its price. Fundamental forces of market demand and supply for the commodity determine the commodity prices.
Usually, many competing sellers of the product will be there in the market. Their presence is required to ensure widespread trading activity in the physical commodity market.
The product should have adequate shelf life since the delivery of a commodity through a futures contract is usually deferred to a later date (also known as expiry of the futures contract).

Commodity Market: A Perspective
A market where commodities are traded is referred to as a commodity market. These commodities include bullion (gold, silver), non-ferrous (base) metals (copper, zinc, nickel, lead, aluminium, tin), energy (crude oil, natural gas), agricultural commodities such as soya oil, palm oil, coffee, pepper, cashew, etc.

Existence of a vibrant, active, liquid, and transparent commodity market is normally considered as a sign of development of an economy. It is therefore important to have active commodity markets functioning in a country.

Markets have existed for centuries worldwide for selling and buying of goods and services. The concept of market started with agricultural products and hence it is as old as the agricultural products or the business of farming itself. Traditionally, farmers used to bring their products to a central marketplace (called mandi / bazaar) in a town/village where grain merchants/ traders would also come and buy the products and transport, distribute, and sell them to other markets.

In a traditional market, agricultural products would be brought and kept in the market and the potential buyers would come and see the quality of the products and negotiate with the farmers directly on the price that they would be willing to pay and the quantity that they would like to buy. Deals were struck once mutual agreement was reached on the price and the quantity to be bought/ sold.

In traditional markets, shortage of a commodity in a given season would lead to increase in price for the commodity. On the other hand, oversupply of a commodity on even a single day could result in decline in price—sometimes below the cost of production. Neither farmers nor merchants were happy with this situation since they could not predict what the prices would be on a given day or in a given season. As a result, farmers often returned from the market with their products since they failed to fetch their expected price and since there were no storage facilities available close to the marketplace. It was in this context that farmers and food grain merchants in Chicago started negotiating for future supplies of grains in exchange of cash at a mutually agreeable price. This type of agreement was acceptable to both parties since the farmer would know how much he would be paid for his products, and the dealer would know his cost of procurement in advance. This effectively started the system of forward contracts, which subsequently led to futures market too.

Cash Market
Cash transaction results in immediate delivery of a commodity for a particular consideration between the buyer and the seller. A marketplace that facilitates cash transaction is referred to as the cash market and the transaction price is usually referred to as the cash price. Buyers and sellers meet face to face and deals are struck. These are traditional markets. Example of a cash market is a mandi where food grains are sold in bulk. Farmers would bring their products to this market and merchants/traders would immediately purchase the products, and they settle the deal in cash and take or give delivery immediately. Cash markets thus call for immediate delivery of commodities against actual payment.

Forwards and Futures Markets
In this case, the agreements are normally made to receive the commodities at a later date in future for a pre-determined consideration based on agreed upon terms and conditions. Forwards and Futures reduce the risks by allowing the trader to decide a price today for goods to be delivered on a particular future date. Forwards and Futures markets allow delivery at some time in the future, unlike cash markets that call for immediate delivery. These advance sales help both buyers and sellers with long-term planning. Forward contracts laid the groundwork for futures contracts. The main difference between these two contracts is the way in which they are negotiated.

For forward contracts, terms like quantity, quality, delivery date, and price are discussed in person between the buyer and the seller. Each contract is thus unique and not standardized since it takes into account the needs of a particular seller and a particular buyer only. On the other hand, in futures contracts, all terms (quantity, quality, and delivery date) are standardized. The transaction price is discovered through the interaction of supply and demand in a centralized marketplace or exchange.

Forward contracts help in arranging long-term transactions between buyers and sellers but could not deal with the financial (credit) risk that occurred with unforeseen price changes resulting from crop failures, inadequate storage or bottlenecks in transportation, factors beyond human control (floods, natural calamities, etc.), or other economic factors that may result in unexpected changes, and hence counterparty default risks for parties involved. This, in turn, led to the development of futures market. As mentioned above, since futures are standardized contracts that are traded through an exchange, they can be used to minimize price risk by means of hedging techniques. Since the exchange standardizes the quality and quantity parameters and offers complete transparency by using risk management techniques (such as margining system with mark-to-market settlement on a real-time basis with daily settlement), the counterparty default risk has been greatly minimized.

Brief History of the Development of Commodity Markets
Global Scenario
It is widely believed that the futures trade first started about approximately 6,000 years ago in China with rice as the commodity. Futures trade first started in Japan in the 17th century. In ancient Greece, Aristotle described the use of call options by Thales of Miletus on the capacity of olive oil presses. The first organized futures market was the Osaka Rice Exchange, in 1730.

Organized trading in futures began in the US in the mid-19th century with maize contracts at the Chicago Board of Trade (CBOT) and a bit later, cotton contracts in New York. In the first few years of CBOT, weeks could go by without any transaction taking place and even the provision of a daily free lunch did not entice exchange members to actually come to the exchange! Trade took off only in 1856, when new management decided that the mere provision of a trading floor was not sufficient and invested in the establishment of grades and standards as well as a nation-wide price information system. CBOT preceded futures exchanges in Europe.

In the 1840s, Chicago had become a commercial centre since it had good railroad and telegraph lines connecting it with the East. Around this same time, good agriculture technologies were developed in the area, which led to higher wheat production. Midwest farmers, therefore, used to come to Chicago to sell their wheat to dealers who, in turn, transported it all over the country.

Farmers usually brought their wheat to Chicago hoping to sell it at a good price. The city had very limited storage facilities and hence, the farmers were often left at the mercy of the dealers. The situation changed for the better in 1848 when a central marketplace was opened where farmers and dealers could meet to deal in "cash" grain—that is, to exchange cash for immediate delivery of wheat. Farmers (sellers) and dealers (buyers) slowly started entering into contract for forward exchanges of grain for cash at some particular future date so that farmers could avoid taking the trouble of transporting and storing wheat (at very high costs) if the price was not acceptable. This system was suitable to farmers as well as dealers. The farmer knew how much he would be paid for his wheat, and the dealer knew his costs of procurement well in advance.

Such forward contracts became common and were even used subsequently as collateral for bank loans. The contracts slowly got “standardized” on quantity and quality of commodities being traded. They also began to change hands before the delivery date. If the dealer decided he didn't want the wheat, he would sell the contract to someone who needed it. Also, if the farmer didn't want to deliver his wheat, he would pass on his contractual obligation to another farmer. The price of the contract would go up and down depending on what was happening in the wheat market. If the weather was bad, supply of wheat would be less and the people who had contracted to sell wheat would hold on to more valuable contracts expecting to fetch better price; if the harvest was bigger than expected, the seller's contract would become less valuable since the supply of wheat would be more.

Slowly, even those individuals who had no intention of ever buying or selling wheat began trading in these contracts expecting to make some profits based on their knowledge of the situation in the market for wheat. They were called speculators. They hoped to buy (long position) contracts at low price and sell them at high price or sell (short position) the contracts in advance for high price and buy later at a low price. This is how the futures market in commodities developed in the US. The hedgers began to efficiently transfer their market risk of holding physical commodity to these speculators by trading in futures exchanges.

The history of commodity markets in the US has the following landmarks:

Chicago Board of Trade (CBOT) was established in Chicago in 1848 to bring farmers and merchants together. It started active trading in futures-type of contracts in 1865.
The New York Cotton Exchange was started in 1870.
Chicago Mercantile Exchange was set up in 1919.
A legalized option trading was started in 1934.

Indian Scenario
History of trading in commodities in India goes back several centuries. But organized futures market in India emerged in 1875 when the Bombay Cotton Trade Association was established. The futures trading in oilseeds started in 1900 when Gujarati Vyapari Mandali (today’s National Multi Commodity Exchange, Ahmedabad) was established. The futures trading in gold began in Mumbai in 1920. During the first half of the 20th century, there were many commodity futures exchanges, including the Calcutta Hessian Exchange Ltd. that was established in 1927. Those exchanges traded in jute, pepper, potatoes, sugar, turmeric, etc. However, India’s history of commodity futures market has been turbulent. Options were banned in cotton in 1939 by the Government of Bombay to curb widespread speculation. In mid-1940s, trading in forwards and futures became difficult as a result of price controls by the government. The Forward Contract Regulation Act was passed in 1952. This put in place the regulatory guidelines on forward trading. In late 1960s, the Government of India suspended forward trading in several commodities like jute, edible oil seeds, cotton, etc. due to fears of increase in commodity prices. However, the government offered to buy agricultural products at Minimum Support Price (MSP) to ensure that the farmer benefited. The government also managed storage, transportation, and distribution of agriculture products. These measures weakened the agricultural commodity markets in India.

The government appointed four different committees (Shroff Committee in 1950, Dantwala Committee in 1966, Khusro Committee in 1979, and Kabra Committee in 1993) to go into the regulatory aspects of forward and futures trading in India. In 1996, the World Bank in association with United Nations Conference on Trade and Development (UNCTAD) conducted a study of Indian commodities markets. In the post-liberalization era of the Indian economy, it was the Kabra Committee and the World Bank–UNCTAD study that finally assessed the scope for forward and futures trading in commodities markets in India and recommended steps to revitalize futures trading.

There are four national-level commodity exchanges and 22 regional commodity exchanges in India. The national-level exchanges are Multi Commodity Exchange of India Limited (MCX), National Commodity and Derivatives Exchange Limited (NCDEX), National Multi Commodity Exchange of India Limited (NMCE), and Indian Commodity Exchange (ICEX).

Relevance and Potential of Commodity Markets in India
Majority of commodities traded on global commodity exchanges are agri-based. Commodity markets therefore are of great importance and hold a great potential in case of economies like India, where more than 65 percent of the people are dependent on agriculture.

There is a huge domestic market for commodities in India since India consumes a major portion of its agricultural produce locally. Indian commodities market has an excellent growth potential and has created good opportunities for market players. India is the world’s leading producer of more than 15 agricultural commodities and is also the world’s largest consumer of edible oils and gold. It has major markets in regions of urban conglomeration (cities and towns) and nearly 7,500+ Agricultural Produce Marketing Cooperative (APMC) mandis. To add to this, there is a network of over 27,000+ haats (rural bazaars) that are seasonal marketplaces of various commodities. These marketplaces play host to a variety of commodities everyday. The commodity trade segment employs more than five million traders. The potential of the sector has been well identified by the Central government and the state governments and they have invested substantial resources to boost production of agricultural commodities. Many of these commodities would be traded in the futures markets as the food-processing industry grows at a phenomenal pace. Trends indicate that the volume in futures trading tends to be 5-7 times the size of spot trading in the country (internationally, it is much higher at 15 to 20 times).

Many nationalized and private sector banks have announced plans to disburse substantial amounts to finance businesses related to commodity trading. The Government of India has initiated several measures to stimulate active trading interest in commodities. Steps like lifting the ban on futures trading in commodities, approving new exchanges, developing exchanges with modern infrastructure and systems such as online trading, and removing legal hurdles to attract more participants have increased the scope of commodities derivatives trading in India. This has boosted both the spot market and the futures market in India. The trading volumes are increasing as the list of commodities traded on national commodity exchanges also continues to expand. The volumes are likely to surge further as a result of the increased interest from the international participants in Indian commodity markets. If these international participants are allowed to participate in commodity markets (like in the case of capital markets), the growth in commodity futures can be expected to be phenomenal. It is expected that foreign institutional investors (FIIs), mutual funds, and banks may be able to participate in commodity derivatives markets in the near future. The launch of options trading in commodity exchanges is also expected after the amendments to the Forward Contract Regulation Act (1952). Commodity trading and commodity financing are going to be rapidly growing businesses in the coming years in India.

With the liberalization of the Indian economy in 1991, the commodity prices (especially international commodities such as base metals and energy) have been subject to price volatility in international markets, since India is largely a net importer of such commodities. Commodity derivatives exchanges have been established with a view to minimize risks associated with such price volatility.

Commodity Markets Ecosystem
After studying the importance of commodity markets and trading in commodity futures, it is essential to understand the different components of the commodity markets ecosystem. The commodity markets ecosystem includes the following components:

Buyers/Sellers or Consumers/Producers: Farmers, manufacturers, wholesalers, distributors, farmers’ co-operatives, APMC mandis, traders, state civil supplies corporations, importers, exporters, merchandisers, oil refining companies, oil producing companies, etc.
Logistics Companies: Storage and transport companies/operators, quality testing and certifying companies, valuers, etc.
Markets and Exchanges: Spot markets (mandis, bazaars, etc.) and commodity exchanges (national level and regional level)
Support agencies: Depositories/de-materializing agencies, central and state warehousing corporations, and private sector warehousing companies
Lending Agencies: Banks, financial institutions

The users are the producers and consumers of different commodities. They have exposure to the physical commodities markets, exposing themselves to price risk. In turn, they depend on logistics companies for transportation of commodities, warehouses for storage, and quality testing and certification agencies for assessment and evaluation of commodity quality standards. Commodity derivatives exchanges provide a platform for hedging against price risk for these users.

Benefits of Trading in Commodity Derivatives
Trading in futures provides two important functions of price discovery and price risk management. It is useful to all the segments of the economy, particularly to all the constituents of the commodity market ecosystem. It is important to know how resorting to commodity trading benefits the constituents.

Benefits to Investors, Producers, Consumers, Manufacturers:

Price risk management: All participants in the commodity markets ecosystem across the value chain of different commodities are exposed to price risk. These participants buy and sell commodities and the time lag between subsequent transactions result in exposure to price risk. Commodity derivatives markets enable these participants to avoid price risk by utilizing hedging techniques.
Price discovery: This is the mechanism by which a “fair value price” is determined by the large number of participants in the commodities derivatives markets. This is the result of automation and electronic trading systems established on the commodities derivatives exchanges.
High financial leverage: This is possible in commodity markets. For example, trading in gold calls for only 4% initial margin. Thus, if one gold futures contract (each gold futures contract lot size is 1 kg) is valued at Rs 900,000, the investor is expected to deposit an initial margin of only Rs 36,000 to be able to trade. If the price of gold goes up by even 2%, the investor would make a profit of Rs 18,000 on a deposit of Rs 36,000 before the expiry of the contract. This is the benefit of leveraged trading transactions. With futures contracts, the investor trades in the expectation of the price at a later date. This is possible with a margin deposit, which is usually between 5% and 10% of the value of the commodity. Correspondingly, the margins required for equity futures contracts are higher, due to higher volatility in equity markets as compared to commodities futures contracts. The reason for higher volatility in equity markets (especially in India) as compared to commodities derivatives transactions is due to the fact that delivery is possible in commodity derivatives transactions.
Commodities as an asset class for diversification of portfolio risk: Commodities have historically an inverse correlation of daily returns as compared to equities. The skewness of daily returns favours commodities, thereby indicating that in a given time period commodities have a greater probability of providing positive returns as compared to equities. Another aspect to be noted is that the Sharpe ratio of a portfolio consisting of different asset classes is higher in the case of a portfolio consisting of commodities as well as equities. Even with a marginal distribution of funds in a portfolio to include commodities, the Sharpe ratio is greatly enhanced, thereby indicating a decrease in risk.
Commodity derivatives markets are extremely transparent in the sense that the manipulation of prices of a commodity is extremely difficult due to globalization of economies, thereby providing for prices benchmarked across different countries and continents. For example, gold, silver, crude oil, etc. are international commodities, whose prices in India are indicative of the global situation.
An option for high networth investors: With the rapid spread of derivatives trading in commodities, the commodities route too has become an option for high networth investors.
Useful to the producer: Commodity trade is useful to the producer because he can get an idea of the price likely to prevail on a future date and therefore can decide between various competing commodities, the best that suits him. Farmers, for instance, can get assured prices, thereby enabling them to decide on the crop that they want to grow. Since there is transparency in prices, the farmer can decide when and where to sell, so as to maximize his profits.
Useful for the consumer: Commodity trade is useful for the consumer because he gets an idea of the price at which the commodity would be available at a future point of time. He can do proper costing/financial planning and also cover his purchases by making forward contracts. Predictable pricing and transparency is an added advantage.
Corporate entities can benefit by hedging their risks if they are using some of the commodities as their raw materials. They can hedge the risk even if the commodity traded does not meet their requirements of exact quality/technical specifications.
Useful to exporters: Futures trading is very useful to the exporters as it provides an advance indication of the price likely to prevail and thereby help the exporter in quoting a realistic price and thereby secure export contract in a competitive market.
Improved product quality: Since the contracts for commodities are standardized, it becomes essential for the producers/sellers to ensure that the quality of the commodity is as specified in the contract. The advent of commodities futures markets has also enabled defining quality standards of different commodities.
Credit accessibility: Buyers and sellers can avail of the bank finances for trading in commodities. Nationalized banks and private sector banks have come forward to offer credit facilities for commodity trading.

Benefits to Indian Economy
As the constituents of the commodity market ecosystem get benefited, the Indian economy is also benefited. Growth in the organized commodity markets and their constituents implies that there would be tremendous advantages and benefits accrued to the Indian economy in terms of business generation and growth in employment opportunities. As India imports bulk of raw material (especially in base metals and energy), there is scope for minimizing price risk for international commodities. With the consumption of commodities increasing rapidly, especially in developing countries such as China and India, the prices of commodities are volatile, emphasizing the need for organized commodity derivatives exchanges.

Back to top