Introduction to Commodity Markets – History | Evolution | Market Participants

Commodity Markets are platforms where raw or primary products are exchanged. These raw commodities are traded on regulated exchanges, where they are bought and sold through standardized contracts.

Table of Contents

1. History of Commodity Trading
2. Spot and Derivatives Trading in Commodities
3. Major Commodities Traded in Derivatives Exchanges in India
4. Participants in Commodity Derivatives Markets

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1. History of Commodity Trading

Commodity trading is as old as human civilization and one of the earliest economic pursuits of mankind. Over the centuries, commodity trading has evolved from the barter system to spot markets to derivatives markets. In barter system, goods were exchanged between two parties with matching and opposite needs (for example, bags of wheat were exchanged for cattle). Over a period of time, commodities brought from distant places were exchanged for gold and silver. With the introduction of Money as a medium of exchange, there was a paradigm shift in commodity trading with the value of commodity being expressed in monetary terms and trading in commodities was conducted mainly through the medium of currency. Commodity spot markets evolved in many places and the counterparties met at these common places where goods were brought for immediate sale and delivery at the market price decided by the demand and supply forces. In commodity spot markets, traders sell goods such as rice for immediate delivery against cash. At some stage, counterparties started entering into agreements to deliver commodities (e.g.: wheat) at a specified time in future at a price agreed today. These agreements came to be known as forward contracts. For example, on May 25, a trader agreed to sell rice for delivery on a future specified date (say one month from May 25 i.e., on June 25) irrespective of the actual price prevailing on June 25.

These forward contracts, more often than not, were not honoured by either of the contracting parties due to price changes and market conditions. A seller pulled out of the contract if the spot price was more profitable for him than the contracted price. A buyer also backed out from executing the contract on maturity if he was able to get the commodity at a cheaper price from the spot market. Futures emerged as an alternative financial product to address these concerns of counterparty default, as the Exchange guaranteed the performance of the contract in case of the Futures.

The contracts of commodities being traded gradually got ‘standardized’ in terms of quantity and quality over a period of time. The contracts also began to change hands before the delivery date. For instance, if the buyer of a wheat contract decides that he does not 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 could pass on his contractual obligation to another farmer. The price of the contract would increase or decrease depending on what was happening in the wheat market.

Gradually, even those individuals who had no intention of ever buying or selling wheat began trading in the futures contracts expecting to make some profits by betting on their expectations. They were called speculators. They bought contracts with an expectation of selling them later at a price higher than their purchase price. Or, they sold the contracts in advance with an expectation of buying them later at a price lower than their sale price. This is how the futures market in commodities developed. The hedgers (in this case, the producers of the commodity or farmers) began to efficiently transfer their market risk of holding physical commodity to these speculators by trading at the futures exchanges.

1.1 Evolution of Commodity Exchanges

Organized commodities exchanges have a long history. Commodity futures trading first started in Japan and the first known organized futures market was the Osaka Rice Exchange set up in 1730. In the 17th century, Osaka emerged as the major trading center for rice in Japan. At that time, rice played an important role in the economy as rice was the main agricultural commodity. Rice from all over the country was sent to Osaka and stored there. It was sold by way of auctions and once deals were done, the sellers issued a certificate of title in exchange for money. The certificates were called rice bills. In the early stage, the rice bills were issued upon making a good-faith deposit which was directly and fully paid after the auction and with delivery of rice within a short period. Merchants could hold the bills or could sell them expecting to make a quick profit within the defined period. However, as the market developed the deposits shrank and the delivery dates extended. The rice bills represented the right to take up delivery of an agreed quantity of rice at a future date but at the current price. This was the precursor to futures.

The Chicago Board of Trade (CBOT) in USA and the London Metal Exchange (LME) in UK successfully launched their operations in 1848 and 1877, respectively. Many more exchanges were created in the next few decades, in different countries of the world such as Argentina, China, Egypt, Russia, Hungary, Turkey and India. After the 1990s, with market liberalization and explosive growth in information technology, commodity exchanges started mushrooming around the world. Major commodity exchanges around the world are listed in Annexure 1.

1.2 History of Commodities Trading in India

History of commodities trading in India dates back to several centuries. Forward trading in animal, agricultural produce and metals are believed to have existed in ancient India and references to such markets appear in Kautilya’s ‘Arthasastra’. Terms relating to commerce such as ‘Teji’, ‘Mandi’, ‘Gali’ and ‘Phatak’ have been coined and freely used as early as 320 B.C. However, organized trading in commodity derivatives started in India in 1875 by the Bombay Cotton Trade Association Limited with cotton as the underlying commodity. A few years later, Guajrati Vyapari Mandali was set up, which started trading in castor seed, groundnuts and cotton. In the year 1919, the Calcutta Hessian Exchange was setup which started trading in raw jute and jute goods. Subsequently, many other commodity derivatives trading centers emerged across the country in places such as Hapur, Amritsar, Bhatinda, Rajkot, Jaipur, Delhi, etc.

Due to reasons such as speculation, hoarding, wars and natural disasters, several controls were placed on trading of certain commodities from time to time. In 1919, the Government of Bombay passed the Bombay Contract Control (War Provision) Act and set up the Cotton Contracts Board. With an aim to restrict speculative activity in cotton market, the Government of Bombay issued an Ordinance in September 1939 prohibiting options trading in cotton which was later replaced by the Bombay Options in Cotton Prohibition Act, 1939. In 1943, the Defence of India Act was passed for the purpose of prohibiting forward trading in some commodities (spices, vegetable oils, sugar, cloth, etc.) and regulating such trading in others on all India basis. These orders were retained with necessary modifications in the Essential Supplies Temporary Powers Act, 1946, after the Defence of India Act had lapsed. After Independence, the Constitution of India placed the subject of “Stock Exchanges and Futures Market” in the Union list and therefore the responsibility for regulation of forward contracts devolved on the Government of India. The Parliament passed the Forward Contracts (Regulation) Act in 1952 to regulate the forward contracts in commodities across the country. The Forward Contracts (Regulation) Act (FCRA) 1952 was repealed and regulation of commodity derivatives market was shifted to the Securities and Exchange Board of India (SEBI) under Securities Contracts (Regulation) Act (SCRA) 1956 with effect from 28th September, 2015.

Commodity trading in Indian exchanges has reached a sophisticated level. The exchanges offer electronic trading platforms for buyers and sellers to manage their price risks better and to improve the marketing of their physical products. This has made the commodity sector more efficient and competitive. Globally, exchange- traded commodity derivatives have emerged as an investment product often used by institutional investors, hedge funds, sovereign wealth funds besides retail investors. There has been a growing sophistication of commodities investments with the introduction of exotic products such as weather derivatives, power derivatives and environmental emissions trading (carbon credits trading).

2. Spot and Derivatives Trading in Commodities

Commodities can be traded in both the spot market as well as the derivatives (forward and futures) market¹. Although the two markets are different in terms of time of delivery and other terms of trade, they are inter-related. The commodities are physically bought or sold on a negotiated basis in the spot market, where immediate delivery takes place. The physical markets for commodities deal in cash (spot) transactions for ready delivery and payment.

There are two main types of commodities that trade in the spot and derivatives markets:

• Soft commodities: These are the perishable agricultural products such as corn, wheat, coffee, cocoa, sugar, soybean, etc.
• Hard commodities: These are natural resources that are mined or processed such as the crude oil, gold, silver, etc.

2.1 Spot Market

Spot market is a place where commodity is traded and the transfer of ownership takes place immediately. This concept is also termed as “ready delivery contract” under which payment and delivery of good happens immediately. There are two variants of spot market: physical spot market and electronic spot market.

Physical Spot Market

In a physical spot market, the commodities are physically bought and sold by the buyers and sellers respectively for immediate delivery. In addition to the buyers and the sellers, the spot market has traders who are licensed by the mandi to trade in the market. These traders have to pay mandi fees. In a spot market, a physical commodity is sold or bought at a price negotiated between the buyer and the seller. The spot markets can be either a retail market i.e., targeted towards the actual consumers or a wholesale market i.e., market for intermediate traders.

In a Mandi, the farmers bring their produce, and the traders or middlemen known as commission agents or ‘aadhatiyas’ inspect the quality and bid for the same. The buyer with the highest bid acquires the produce. Thus, the traditional ‘Mandi’ system leaves the farmer with no bargaining power as the price setting power completely rests in the hands of the traders and middlemen (though the recent reforms are changing this situation). This results in a very inefficient price discovery mechanism.

Electronic Spot Exchange/Spot Commodity Exchange

A spot commodity exchange is an organized marketplace where buyers and sellers come together to trade commodity-related contracts following the rules set by the respective commodities exchange. An electronic spot commodity exchange provides a market place where the farmers or their Farmer Producer Organisation (FPO) can sell their produce and the processors, exporters, traders and other users can buy such produce through an electronic trading system. Electronic Spot Exchanges for agricultural produce were setup to bring large number of buyers and sellers on the same platform for better price realization for the farmers. Unlike in a traditional mandi market, here the farmer plays a role in the price discovery and is not a mere witness to the sale of the agricultural commodity.

National Agriculture Market (eNAM) plays a key role in the electronic spot market of agricultural produce. eNAM is a pan-India electronic trading portal which networks the existing APMCs (mandis) to create a unified national market for agricultural commodities. Small Farmers Agribusiness Consortium (SFAC) is the lead agency for implementing eNAM under the aegis of Ministry of Agriculture and Farmers’ Welfare, Government of India.

eNAM is set up to promote uniformity in agriculture marketing by streamlining the procedures across the integrated markets, removing information asymmetry between buyers and sellers and promoting real time price discovery based on actual demand and supply. The idea behind eNAM is the integration of APMCs across the country through a common online market platform to facilitate pan-India trade in agriculture commodities, providing better price discovery through transparent auction process based on quality of produce along with timely online payment.

2.2 Derivatives Market

“Derivatives” are financial instruments, the price of which is directly dependent on or derived from the value of one or more underlying securities such as equity indices, debt instruments, commodities, weather, etc. It is contract between a buyer and a seller, entered into at a point of time, regarding a transaction to be settled/closed at a future point in time. Derivatives provide risk protection with minimal upfront investment. They allow investors to trade on future price expectations and have very low total transaction costs compared to investing directly in the underlying asset.

Derivatives are either traded on an exchange platform, or bilaterally between counterparties, with the latter known as the over the counter (OTC) market. OTC derivatives are created by an agreement between two specific counterparties. Most of these contracts are held to maturity by the original counterparties. Exchange- traded derivatives, on the other hand, are fully standardized and their contract terms are specified by the derivatives exchanges. Over a period of time, based on the need of the market participants, various derivatives products have evolved in OTC and exchanged traded commodity derivatives markets such as commodity forwards, commodity futures, commodity options, commodity swaps, commodity loans & bonds, etc.

Derivatives have become an integral part of today’s commodity trading and are used for various types of risk protection and in innovative investment strategies. Derivatives’ trading has facilitated the integration of national commodity markets with the international markets. Commodity derivatives markets play an increasingly important role in the commodity market value chain by performing key economic functions such as risk management through risk reduction and risk transfer, price discovery and transactional efficiency.

Risk Reduction: Commodity derivatives market allows market participants such as farmers, traders, processors, etc. to hedge their risk against price volatility through commodity futures and options. Derivatives provide a mechanism through which investors, both individual and institutional (including corporations), can efficiently hedge themselves against the price risks through the mechanism of risk reduction and risk transfer. Hedging can bring greater certainty over the planting cycle, confidence to invest, adjust cropping patterns, diversify risk profile, and opt for higher revenue crops.

Risk Transfer: Derivatives help in transfer of risks from hedgers to speculators. On one side, hedgers try to hedge their spot positions via derivatives, on the other side, there are speculators who take up trading bets and try to gain on trading risks. Thus, volatility risks are transferred from hedgers to speculators.

Price Discovery: Price discovery in spot markets refers to the process of determining commodity price through forces of market demand and supply. The price discovery in futures markets refers to the process of determining the futures price through expected demand and supply after discounting expected news, data releases and information on the product. The ability of derivatives markets to provide information about potential future prices is an integral component of an efficient economic system. Knowledge of these prices is crucial for investors, consumers, and producers to make informed decisions. Efficiency of price discovery depends on the continuous flow of information and transparency. Price discovery in commodity futures market guides producers to make decisions on the timing of production and guides farmers in making cropping decisions. Price discovery reduces the effect of inter-seasonal price fluctuations.

Transactional Efficiency: Derivatives lower the costs of transacting in commodity markets. As a result, investments become more productive and lead to a higher rate of economic growth. Therefore, derivatives bring important social and economic benefits to consumers and producers alike and contribute positively to economic development.

2.3 Derivatives Instruments

A brief introduction to various derivative instruments such as forwards, futures, options and swaps is given below. The subsequent units of this workbook will cover these instruments in more detail.

Forwards

A forward contract is a legally enforceable agreement for delivery of goods or the underlying asset on a specific date in future at a price agreed on the date of contract. Forward contracts can be customized to accommodate any commodity, in any quantity, for delivery at any point in the future, at any place. These contracts are traded on the OTC markets. In a forward contract:

• The terms of the contract are tailored to suit the needs of the buyer and the seller.
• Generally, no money changes hands when the contract is first negotiated and it is settled at maturity.
• Both parties are obliged to fulfil their contractual terms.
• Most of the contracts are held till the expiry date and the contracts can be cancelled only on mutual consent of both the parties as it is a bi-partite agreement.

Two note-worthy features of forward contracts are: (1) Generally, no cash transfer occurs when the contract is signed. The seller of the commodity is obliged to deliver the commodity at maturity to the buyer and the buyer needs to pay money at the same time i.e., the buyer pays no money upfront (except for transaction fees). (2) There is an inherent credit or default risk since the counterparties of the forward transaction may fail either to deliver the commodity or to pay the agreed price at maturity.

Futures

A futures contract is a legally binding agreement between the buyer and the seller, entered on an exchange, to buy or sell a specified amount of an asset, at a certain time in the future, for a price that is agreed today. The buyer enters into an obligation to buy, and the seller is obliged to sell, on a specific date. Futures are standardized in terms of size, quantity, grade and time, so that each contract traded on the exchange has the same specifications.

Commodity Futures contracts are highly uniform and are well-defined. These contracts explicitly state the commodities (quantity and quality of the goods) that have to be delivered at a certain time and place (acceptable delivery date) in a certain manner (method for closing the contract) and define their permissible price fluctuations (minimum and maximum daily price changes).

Therefore, a commodity futures contract is a standardized contract to buy or sell commodities for a particular price and for delivery on a certain date in the future. For instance, if a hotel owner wants to buy 10 tonnes of wheat today, he can buy the wheat in the spot market for immediate use. If the hotel owner wants to buy 10 tonnes of wheat for future use, he can buy wheat futures contracts at a commodity futures exchange. The futures contracts provide for the delivery of a physical commodity at the originally contracted price at a specified future date, irrespective of the actual price prevailing on the actual date of delivery.

Options

Option is one more derivative product which provides additional flexibility in managing price risk. Options contracts can be either standardized or customized. There are two types of option contracts —call options and put options. Call option contracts give the purchaser the right to buy a specified quantity of a commodity or financial asset at a particular price (the exercise price) on or before a certain future date (the expiration date). Put option contracts give the buyer the right to sell a specified quantity of an asset at a particular price on or before a certain future date.

In an options transaction, the purchaser pays the seller (the writer of the option), an amount for the right to buy (in case of “call” options) or for the right to sell (in case of “put” options). This amount is known as the “Option Premium”.

Premium is the cost of the option paid by the buyer to the seller and is non-refundable. Since the buyer is paying the premium to the seller, he has the right to exercise the option when it is favourable to him but no obligation to do so. In case of both call and put options, the buyer has the right but no obligation whereas the seller, being the receiver of the premium, has no right but an obligation to the buyer. We will discuss these in more detail in subsequent units.

Swaps

Swaps are agreements between two counterparties to exchange a series of cash payments for a stated period of time. The periodic payments can be charged on fixed or floating price, depending on the terms of the contract. One of the commonly used commodity swaps is “fixed-for-floating swaps”.

In a “fixed-for-floating commodity swap”, one party known as the “fixed price payer” makes periodic payments based on a fixed price for a specified commodity that is agreed upon at the execution of the swap, while the other party known as the “floating price payer” makes payments based on a floating price for such commodity that is reset periodically. The floating price may be

(a) a spot price for the specified commodity,

(b) the price for a specified nearest futures contract for such commodity, or,

(c) an average price of such spot prices or futures contracts prices calculated over a period.

For example, the floating price for a “fixed-for-floating swap” on oil with monthly payments may be based on the average of the settlement prices for the first nearby month CME WTI Crude Oil Futures for each day of the relevant month. From the perspective of the fixed price payer, an increase in the overall price of the relevant commodity in the market will cause the swap to increase in value, because the fixed price payer’s contractually specified fixed price obligations will be lower than the then-prevailing commodity price in the market. Thus, fixed price payer indirectly has long exposure on actual commodity/underlying prices, while fixed price receiver indirectly has short exposure on actual commodity/underlying prices. Conversely, floating price payer is indirectly having short position on commodity/underlying prices while floating price receiver of the same is indirectly long on the same. Understanding of such exposures help traders and hedgers to hedge, wherever required, considering their natural exposures arising out of their businesses or portfolios.

Swap is a pure financial transaction that is used to lock in the long-term price and there is no physical delivery of the commodity and there is net cash settlement on maturity. Currently, commodity swaps are not allowed in India.

3. Major Commodities Traded in Derivatives Exchanges in India

Commodity means every kind of movable property other than actionable claims, money and securities. Commodities are things of value, of uniform quality and produced in large quantities by many producers. Derivatives trading can be conducted in any commodity subject to the condition that the said commodity is allowed for trading by the Government of India and the futures trading on the same is approved by SEBI on a specific exchange.

Futures trading in commodities can be conducted between members of an approved exchange. Futures trading in commodities is organized by these exchanges after obtaining a certificate of registration from the SEBI. The national exchanges in which commodity derivatives are currently traded in India are: Multi Commodity Exchange of India Limited (MCX), National Commodity & Derivatives Exchange Limited (NCDEX), Indian Commodity Exchange Limited (ICEX), National Stock Exchange of India Limited (NSE) and BSE Limited (Bombay Stock Exchange).

Commodities that are traded on Indian exchanges can be grouped into four major categories: Bullion, Metals, Energy and Agriculture. An indicative list of commodities traded in the Indian derivatives exchanges are:

Bullion: Gold, Silver, Diamond
Metals: Aluminum, Brass, Copper, Lead, Nickel, Steel, Zinc
Energy: Crude Oil, Natural Gas
Agriculture: Barley, Chana, Maize, Wheat, Guar Seed, Guar Gum, Isabgul Seed, Pepper, Cardamom, Coriander, Jeera, Turmeric, Sugar, Copra, Rubber, Jute, Cotton, Cotton Seed Oilcake, Castor Seed Oil, Mentha Oil, Soy Bean, Soy Bean Oil, Refined Soy Oil, Degummed Soy Oil, Rape/Mustard Seed, Crude Palm Oil, RBD Palmolein

Agriculture list may have either monsoon based contracts or winter based contracts majorly depending upon their season of production. For example, Wheat and Guar are winter based. Maize, however, is produced throughout the year and hence, there are both the contracts.

Please note that the above is an indicative list and changes from time to time due to introduction of trading on additional commodities by various exchanges from time to time. Please refer to the websites of exchanges for the latest list of commodities traded on those exchanges and the contract specifications of those commodity derivatives.

4. Participants in Commodity Derivatives Markets

Broadly, the participants in the commodity derivatives markets can be classified as hedgers, speculators and arbitrageurs, and are represented by manufacturers, traders, farmers/Farmer Producer Organisations (FPO), processors, exporters, and investors. An efficient market for commodity futures requires a large number of market participants with diverse risk profiles.

Hedgers

Hedgers are generally commercial producers, processors, exporters and importers of traded commodities who participate in the commodity derivatives markets to manage their spot market price risk. As commodity prices are volatile, participation in the futures and options markets allow hedgers to protect themselves against the risk of losses from fluctuating prices. Hedging implies taking position in Futures markets in such a way that overall net market risk is reduced, minimized or mitigated.

For any business or value chain participant, they are naturally short on raw materials and long on finished goods. It means, they gain if raw material prices reduce and they lose when raw material prices increase. Similarly, on finished goods, they gain when its prices gain and they lose when its prices fall. Hence, hedgers generally hedge by buying raw materials in derivatives markets or by selling finished goods in derivatives markets or both.

1. Please note that the terms cash market, spot market, physical market, mandis, APMC have been used synonymously in this article.