ReportNo.

15453-IN

India
ManagingPriceRisksin India'sLiberalized
Agriculture:Can FuturesMarketsHelp?
November27, 1996
Agriculture and Water Operations Division
Country Department II
South Asia Region
World Bank

ConimnoditvDivision
United Nations Conferenceon Trade and Development

Documentof the World Bank

 CURRENCY

Rs/ US$
Currency Official Unified Market a
Prior to June 1966 4.76
June 6, 1966 to mid-December 1971 7.50
Mid-December 1971 to end-June 1972 7.28

1971-72 7.44
1972-73 7.71
1973-74 7.79
1974-75 7.98
1975-76 8.65
1976-77 8.94
1977-78 8.56
1978-79 8.21
1979-80 8.08
1980-81 7.89
1981-82 8.93
1982-83 9.63
1983-84 10.31
1984-85 11.89
1985-86 12.24
1986-87 12.79
1987-88 12.97
1988-89 14.48
1989-90 16.66
1990-91 17.95
1991-92 24.52
1992-93 26.41 30.65
1993-94 31.36
1994-95 31.40
1995-96 33.46

April 1996 34.24

May 1996 34.99
June 1996 34.99
July 1996 35.52
Aug 1996 35.69

NVote: The Indian fiscal year runs from April 1 through March 31.
,Source: IMF, International Finance Statistics (IFS), line "rf";Reserve Bank of India.

aA dual exchangerate systemwas createdin March 1992,with a free marketfor about 60 percent of
foreignexchangetransactions. The exchangerate was reunifiedat the beginningof March 1993at
the free marketrate.

Vice President D. Joseph Wood

Director Robert S. Drysdale
Division Chief/manager: Shawki Barghouti
Staff Member : Benoit Blarel, Senior Economist
 Abbrevations & Acronyms

BOOE BombayOilseedsand Oils Exchange Ltd.

EC Act EssentialCommoditiesAct, 1955
EICA East India CommodityAssociation,Ltd.
ELS Extra-longStaple
FC(R) Act Forward Contracts(Regulation)Act, 1952
FMC Forward Markets Commission
GOI Govermmentof India
IPSTA India Pepper and SpiceTrade Association
NTSD Non-transferablespecificdelivery(contracts)
RBI ReserveBank of India
TSD Transferablespecificdelivery(contracts)
UNCTAD UnitedNations Conferenceon Trade And Development
 Table of Contents

CURRENCY
ABREVIATIONS & ACRONYMS
ACKNOWLEDGEMENTS
ECONOMIC DEVELOPMENT DATA
EXECUTIVE SUMMARY

Chapter 1: The Role & Contribution of Commodity Futures Exchanges .................. 1

Commodity Futures Markets: A Historical Perspective........................................ 2
Economic Benefits from Using Commodity Futures Markets............................... 4
Role of Speculation in Futures Markets......................................................... ,,,.6
Relationship Between Futures and Physical Markets .......................... .................6
Domestic vs. Foreign Commodity Markets.......................................................... 7
Summary ......................................................... 7

Chapter 2: Structure and Organization of Indian Commodity Exchanges................. 9

History of Commodity Futures Markets in India ................................................. 9
The Regulatory Framework........................................................ 10
The Structure of Commodity Exchanges ........................................................ 19
A Brief Overview of Selected Commodity Exchanges........................................ 19
The Cotton Commodity Exchanges........... ........................................... 20
The Gur Commodity Exchanges.......................... ,.20
The Oilseeds Commodity Exchanges ......................... 21
The Pepper Commodity Exchange ............................................ . 21
User Composition of Indian CommnodityExchanges.21
Summary.. 23

Chapter 3: The Performance of Commodity Futures Trade 25

Operational Performance of Commodity Exchanges.25
Market Liquidity.2............................................... 25
Suitability of Indian Futures Contracts.26
Trading Practices.27
Clearing Operations.28
India's Unique Delivery System... 29
Supporting Infrastructure.30
Brokerage Industry .32
Promotional and Development Capacity .33
Impact of Government Interventions.34
Direct Government Interventions.34
Indirect Government Interventions.35
Summary.39

Chapter 4: Opportunities & Options: Policy Implications.41

Commodity Exchanges in a Changing Policy Environment 41
Creating the Enabling Environment for Commodity Futures Trading.42
 General Rules for a Permissive Government Policy............................... 42
Improving the Policy Framework of Commodity Exchanges ................... ...........44
Legal & Regulatory Framework of Futures Trading .................. ...........44
Exchange Regulations & Operations ............................................. 47
Institutional Development Assistance Required ..................................... 49
Potential for Internationalization of Indian Commodity Exchanges ....................
50
The Pepper ConmmodityFutures Market ............................................. 51
Introducing New Contracts ............................................. 53
General Considerations ............................................. 53
The Potential for New Cotton Contracts ............................................. 55
Potential for Oilseed, Oil and Oilmeal Contracts .......................... ......... 61
Summary ............................................. 65

Annexes

Glossary of Terms Used in Risk Management............................................. 67

 List of Tables

Table 2.1 Commodities Regulated by the

Forward Contracts (Regulation Act), 1952 ................................... 13
Table 2.2 Recognized Associations for Castorseed, Cotton,
Gur & Potatoes by States, 1995.................... 14
Table 2.3 Special Margins for
Castorseed, September 1994 .15
Table 2.4 Recognized Cotton Associations in India .19
Table 2.5 Recognized Gur Associations in India .20
Table 2.6 Active Oilseed Commodity Associations.20
Table 3.1 Bombay Castorseed Hedge Contract 1990-1993:
Amounts Tendered and Settled .................... 30
Table 4.1 Correlation Coefficients Between Week-end Cotton Seed
& Raw Cotton Prices in Bathinda, 1990/91 to 1994/95.................... 56
Table 4.2 Intra-year Correlation Coefficient Between
Cotton Lint & Cotton Yarn (60s carded) Prices, 1990-1994. 57
Table 4.3 Major Types of Cotton Produced in India, 1992-93.58
Table 4.4 The Correlation of Monthly Average Spot Prices
Between Main Cotton Varieties, 1984-1995 ............................. 59
Table 4.5 Correlation Coefficient between Oil Prices,
January 1989 - April 1995................ 61
Table 4.6 Correlation of Weekly Edible Oil Prices, by Year
1989 - 1994 ...... 62
Table 4.7 Correlation Coefficient of Oilseeds & Oils Prices,
1990 - 1995 ...... 63
Table 4.8 Correlation Coefficients of Groundnut Prices in
Rajkot, Hyderabad, and Bombay, 1989-1994.............................. 63
Table 4.9 Correlation Coefficients Between Castorseed &
Groundnut Prices, 1990-1994 .................. 63

List of Figures

Figure 2.1 Indian & International Classification of

Forward & Futures Contracts .12
Figure 2.2 Organizational Structure of Commodity Associations .17
Figure 4.1 Instability in Indian Oilseeds Gross Crushing Margins.64

List of Boxes

Box 3.1 Is Open Outcry Outmoded?.27

Box 3.2 A Typical Broker on the Bathinda Gur Exchange.32
Box 3.3 Contribution of Futures Markets to a Comprehensive
Agricultural Strategy: Potential & Limits of Governnent
Market Interventions - The American & European Experiences. 38
Box 4.1 Lessons From China's Experience.45
Box 4.2 Should Companies Be Protected From Futures Trade?. 46
Box 4.3 Should Options Be Introduced?.54
 Acknowledgements

This report is based on the findingsof a joint missionby the UNCTADand World Bank
which visitedIndia betweenApril 17 and 28, 1995,and recent UNCTADstudies. The mission
wascomposedof Messrs.LamonRutten(UNCTAD)and Beno^itBlarel(WorldBank). The report
was producedby LamonRutten, Dina Umali-Deininger(WorldBank), and BenoitBlarel (Task
Manager). Contributionshave been made to this report by M.L. Debatisseand P. Varangis
(World Bank). Peer reviewersare R. Henry (IFC), A. Valdes and G. Feder (World Bank).
Arrangementsfor the mission to India were made by Marilyn Chatterji and Padma Gopalan.
Productionassistancewas providedby RokoMorith.

We gratefully acknowledgethe cooperationof governmentofficials, in particular the

Ministryof Civil Supplies,the ForwardMarkets Commission,and the Departmentof Economic
Affairs. The documentwas discussedwith the Indianauthoritieson April 27, 1996.

We wish to expressour gratitudeto the staff and membersof the CommodityExchange

Associations, in particular the Bombay Oilseeds and Oils Exchange, the East India Cotton
Association,the India Pepper and SpiceAssociation,the Northern India CottonAssociation,the
VijayBeoparChamberLtd (Muzzafarnagar),for their supportand assistancein the productionof
this report,and for sharingwith the missionmemberstheir knowledgeand expertiseabout Indian
futures markets. We also gratefullyacknowledgeDr. K.N. Kabra for sharing with the mission
membershis viewson Indianfuturesmarkets.
 ECONOMIC DEVELOPMENT DATA

GNP Per Capita (US$, 1994-95): 330

Gross Domestic Product (1994-95)

AnnualGrowthRate (% p.a., constantprices)

% of 70-71- 75-76- 80-81- 85-86- 92-93- 93-94-
US$ Bln GDP 75-76 80-81 85-86 90-91 93-94 94-95
GDP at Factor Cost 272.0 90.3 3.4 4.2 5.4 5.9 5.0 6.3
GDP at Market Prices 301.2 100.0 3.3 4.2 5.6 6.2 3.9 6.3
Gross Domestic Investment 69.7 23.2 5.3 3.7 5.7 9.5 -5.8 19.8
Gross National Saving 67.0 22.3 4.4 2.6 3.5 8.7 -1.1 17.2
Current Account Balance -2.7 -0.9 -- -- -- -- -- --

Output, Employment and Productivity (1990-91)

Value Added Labor Forceb V. A. per Worker

USS Bln. % of Tot Mill. % of Tot. USS % of Avg.
Agriculture 82.5 31.0 186.2 66.8 443 46.4
Industry 78.0 29.3 35.5 12.7 2195 230.0
Services 105.7 39.7 57.2 20.5 1849 193.7
Total/ Average 266.2 100.0 278.9 100.0 954 100.0

Government Finance
General Government c Central Government
Rs. Bln. % of GDP Rs. Bin. % of GDP
1994-95 1994-95 90-91-94-95 1994-95 1994-95 90-91-94-95
Revenue Receipts 1809.0 19.1 19.5 910.8 9.6 10.1
Revenue Expenditures 2219.0 23.5 23.5 1221.1 12.9 13.3
Revenue Surplus/ Deficit (-) -409.9 4.3 -4.0 -310.3 -3.3 -3.2
Capital Expenditures d 337.9 3.6 4.3 266.8 2.8 3.5
Extemal Assistance (net) ' 51.5 0.5 0.7 51.5 0.5 0.7

Money, Credit, and Prices

89-90 90-91 91-92 92-93 93-94 94-95 95-96p

(Rs. billion outstanding, end of period)

Money andQuasi Money 2309.5 2658.3 3170.5 3668.3 4344.1 5308.0 6005.0
BankCredittoGovernuent(net) 1171.5 1401.9 1582.6 1762.4 2039.2 2224.2 2626.7
Bank Credit to Commercial Sector 1517.0 1717.7 1879.9 2201.4 2377.7 2896.6 3386.4
(percentage or index numbers)
Money and Quasi Money as % of GDP 50.6 49.6 51.4 52.0 54.2 56.1 54.7
Wholesale Price Index (1981-82 = 100) 165.7 182.7 207.8 228.7 247.8 274.7 295.8

Annual Percentage Changes in:

WholesalePriceIndex 7.4 10.3 13.7 10.1 8.4 10.9 7.7
BankCredittoGovemment(net) 20.3 19.7 12.9 11.4 15.7 9.1 18.1
BankCredittoCommercialSector 14.4 13.2 9.4 17.1 8.0 21.8 16.9
a. Theper capitaGNP estimateis at marketprices,usingWorldBankAtlasmethodology.Otherconversionsto dollars in this
table are at the prevailingaverageexchangerate for the periodcovered.
b. TotalLabor Forcefrom 1991Census. Excludesdata for Assamand Jammu& Kashmir.
c. TransfersbetweenCentreandStates havebeennettedout.
d. All loansand advancesto thirdpartieshave beennettedout.
e. Asrecordedin the governmentbudget.
Balanceof Payments(USS Millions)

1992-93 1993-94 19 94 -9 5 p
Merchandise Exports (Average 1990-91-1994-95)
Exports of Goods & NFS 23,585 28,925 34,141
Merchandise, fob 18,869 22,700 26,857 US$ Mill % of Tot.
Inports of Goods & NFS 26,825 29,433 39,450
Merchandise, cif 23,237 23,985 31,672 Tea 415 2.0
of which Crude Petroleum 3,711 3,468 3,428 Iron Ore 480 2.3
of which Petroleun Products 2,208 2,285 2,500 Chemicals 1,679 8.1
Trade Balance -4,368 -1,285 4,815 Leather & Leather product 1,382 6.7
Non Factor Service (net) 1,128 777 -494 Textiles 2,483 12.0
Garments 2,542 12.3
Resource Balance -3,240 -508 -5,309 Gems and Jewelry 3,449 16.7
Engineering Goods 2,674 13.0
Net factor Incomea -3,422 -4,002 -3,905 Others 5,536 26.8
Net Transfersb 2,773 3,825 6,200 Total 20,641 100.0

Balance on Current Account -3,889 -685 -3,014 External Debt, March 31, 1995

Foreign Investment 587 4,110 4,895 US$ Mill.

Official Grants and Aid 363 370 390 Public & Publicly Guaranteed 87,880
Net Medium & Long Term Capital 1,636 1,716 278 Private Non-Guaranteed 1,709
Gross Disbursements 4,586 5,884 5,091 Total (Including IMF and Short Ter 98,990
Principal Repayments 2,949 4,169 4,814
Debt Service Ratio for 1994-95
OtherCapital Flowsc -961 2,086 3,462
Non-Resident Deposits 2,001 940 847 % curr receipts
Net Transactions with MF 1,290 190 -1,174 Public & Publicly Guaranteed 19.6
Private Non-Guaranteed 1.2
Overall Balance -263 8,537 6,858 Total (Including IMF and Short Ter 25.3

Change in Net Reserves 263 -8,537 -6,858 IBRD/ IDA Lending, March 31, 1995 (USS Mill
GrossReserves (end of year)d 6,749 15,476 21,160
IBRD IDA
Rate of Exchange Outstanding and Disbursed 11,120 17,666
Undisbursed 4,227 4,663
End-March 1996e USS 1.00 = Rs. 34.45 Outstanding incl. Undisb 15,347 22,329

- Not available.
a. Figuresgivencoverall investmentincome(net). Majorpaymentsare intereston foreignloansand chargespaid to IMF,
and majorreceiptsis interestearnedon foreignassets.
b. Figuresgivenincludeworkers'remittancesbut excludeofficialgrantassistancewhichis includedwithinofficialloansand
grants,andnon-residentdepositswhichare shownseparately.
c. Includesshort-termnetcapitalinflow,changesin reservevaluationandother items.
d. Excludinggold.
e. The exchangerate was reunifiedat themarketrate in March 1993.
f Total exports(commerce);net of crudepetroleumexports.
 India
mNe Sa_ reufwim grow Nd2s
LatesJts kwr
gla nwca.r hi,
Une of .ssLa,a Semth 'lw. incom
Indicator rnwmr 1970-75 191045 1919-94 Asia bima group
Resources and Expenditures
HUMAN RESOURCES
Population (mre-1994) thousands 613,459 765,147 913,600 1.220.285 3,182.221 1,096,881
Age dependency rato raio 0.77 0.72 0.66 0.71 0.66 0.63
Urban % of pop. 213 243 26. 26.0 283 55.9
Populauiongrowth rae ennual % 23 2.0 1.7 13 1.7 13
Urban 3.7 3.0 2.7 3.1 3.2 2.7
Labor force thousands 260.515 329.606 394330 528.101 1590.533 488.647
Agricultum % of labor farm 70 67 64 63 67 36
Industy ' 13 14 16 16 14 26
Female - 31 32 32 32 39 40
Labor parcpaton rams
Total % of pop. 42 43 43 43 50 45
Fmanle 13 14 14 29 41 36
NATURAL RESOURCES
Ama thou.sq. km 3.27.59 3.27.59 3.27.59 5.133.49 40391.42 40.59443
Daiqty pop. per sq.km 13660 232.74 273.21 233.41 77.44 26.66
Agnculturaland %ofilndarea 60.83 60.86 60.Q9 59.11 52.42 41.05
Change m agncuiWrallad annual* 0.47 -0.07 40.05 .002 0.16 -138
Agnculursl landunder iriganon * 18.65 23.09 25.96 29.63 17.84 11.40
Forestsandwoodland thouLsq. km .. 551.19 517.29 65832 7.632.00 5.969.25
Deforestaton (net) * change.1980-90 _ .. 0.63
INCOME
Household income
Share of top 20* of houseboks % of inmo 49 41 43 _
Share of bonom 40* of households 16 20 21 _
Shre of bottorn20* of housebolds 6 3 J _
EXPENDrrURE
Food * of GDP 43.6 35.3 ..
Sapbs - 20.6 12.4 .. _
Meat fish milk. ches eggs 6.5 7.4 _.
Ceral impor tbou. metoe ous 7.669 205 694 6.211 36,922 68.936
Food sadin ceeals 1.5I2 304 276 1.624 8.516 5.771
Food producion percapta 197 -100 94 104 115 113 115 102
Ferilizer consumption kgzba 193 47.0 67.5 69.7 58.5 463
Shareof agriculturein GDP of GDP 36.6 29.5 26.9 26.6 27.6 14.0
Boning * of GDP 4.4 7.1 ..
Average householdsize person per househol 5.2 5.6 _.
Urban 4.1 5.5
Faxedinvestment housing * of GDP 23 2.8
Fue and power * of GDP 2.4 23 _.
Energy consumptionper cia kg of oil equiv. 124 170 243 219 373 1.602
Householdswith electieity
Urban % of households _ -_
Rural
Transport andcmamumiadoo % of GDP 4.7 5.1 _ _
Fixed investment tanisport equipment 1.4 23
Toal road length thoL kmn 1.375 1.546 2.962 _
DiVESTMENTIN HUMAN CAPITAL
Helith
Populuaon per physician penons 4.900 2.522 .. .. .. 3.064
Population per nurse 3.710 1.701
Population per hospiualbed 1.700 1300 1.371 1.675 1.034 592
Oral rehydyraion therapy(under-5) V. of cases .. .. 37 37 38
Education
Gros enrollment rtios
Secondary * of schoolagepop. 26 37 49 45 48 63
Female 16 26 38 35 42 62
Pupil-teacher rtio: pnmay pupils per teacher 42 58 63 61 39
Pupil-teacher raio: secondary 21 21 26 26 20
Pupils reaching grade 4 * of cohort 51 58 _. -
Repeater rate: prinmry * of total eno 17 .. _
illiteracy * of pop. (age 15.) 66 56 48 51 35
Female * of fen. (age 5I+) _ 71 62 64 46
Newspacer circulation per thou. vo. 15 26 31 26 .. 236
World Bank InternationalEconomicsDepartnent. April 1996
 India
Most S . r ri,.gincem. grw Neut
Last gLw
yhr rhnt , highw
UVtRof udmazz Smag& 'Lw- e...
Ii cater mewurr 1970-75 1950-15 19S94 Auia incoeme aromp
Priority Poverty Indicators
POVERM
Upperpovery line local c.. .. ..
HNedtt iida % of pop.
Lowerpovaty in localcn. .. ,. ._
Headcoemindex % of pop. ..

GNP p-ap iu USS ISO 280 310 320 390 1,670

SHORT TERM INCOME INDICATORS
Unskilld ban wga loca cur. -

Unsked twa wa. .

Rul mm of trade . 84 94
Conaumr pnce inex 1987-100 45. 85 139 _
Lowerincome
Food' 27 _ _ _
Urban - 83 176

SOCMALINDICATORS
Publicexpenditure
an bac socu services %of GDP .. .. ..
GM" umllmntranos
Primay % school ge pop. 79 96 102 98 105 104
Male 94 110 113 110 112 105
Female 62 80 91 37 98 101
;.dty
Infantmorlity per tbou. Ive birdh 132 108 70 73 58 36
Under 5 mortality ' .. 97 106 101 47
lmmuizadcn
meail"s V.%gegroup _ .. 85.8 84.2 86.2 77.4
DPI .. 41.0 90.2 83.6 89.1 82.0
Child ralmtition (under-5) .. .. 63.0 61.5 38.2
Ufc expectancy
Tot years 50 55 62 61 63 67
Femaleadvange -1.9 40.4 1.3 1.2 2.4 6.4
Total feaity ratc births per woman 5.6 4.8 3.3 3.6 3.3 2.7
Matde morality me per 100,000live birds .. 460 437 _
Supplementary Poverty Indicators
Expenditwa on a0a secunty % of totalgvt cap. .. .. ..
SoCialsecuty covetw V. eo alVe pOp. .. .. .. _ .. ..
Accessto afe waew. o %of pop. 31.0 56.3 ..
Urban 80.0 76.0 ..
Rural 18.0 50.0
Acc:essto health came. 75.0 .

Population growth rate GNP per capita growth rate Developmentdiamondb

(average
anual, percent) 5 (average Annual,pcnt)Lif

4 5

2 0 ______________________ U~~~~~~~~~~~~~NP Gros

2* ' O- lG1\u+
perI nw
capita enrollment
0 -5

-2 -10
1970-75 1980-85 1989-94 1970-75 198045 1989-94 tosdhwm

- Low-incom - Lowincome

a. Sce the technicalnooes,p.387. b. 7he devclopmentdiamnd, based on four key indicators,shows the averae level of developmentin the country
compaed with its income group. See the introduction.
 EXECUTIVE SUMMARY

MANAGING PRICE RISKS

IN INDIA'S
LIBERALIZED AGRICULTURE:
CAN FUTURES MARKETS HELP?

1. Context of Study in India's Agricultural Liberalization Agenda. Indian agriculture is

now gradually opening-up to world markets. While trade liberalization creates new economic
opportunities, it also poses new challenges. Notably, price volatility and the capacity to cope with
it are again becoming major policy concems. Price volatility creates uncertainty and risks which
can threaten agricultural performance, and negatively impact the income and welfare of farmers
and the rural poor. Indian policy makers have traditionally coped with the uncertainty and risks
associated with price volatility by resorting to policy instruments to minimize or eliminate price
volatility: a virtually closed external trade regime, pervasive government controls on private sector
activities, extensive market interventions, and crop insurance. These instruments, because of their
fiscal and economic costs, are now progressively and selectively being relinquished by the
Government of India (GOI) in an effort to spur agricultural growth. An alternative strategy to
manage the uncertainty and risks inherent in agricultural markets remains to be devised, and the
stalling of agricultural reforms avoided. The Kabra Committee recently submitted its report
(September 1994) to GOI, recommendingthe introduction of futures contracts in basmati rice, seed
cotton, cotton lint, raw jute and jute products, most oilseeds and their oils, major oilcakes, linseed,
onions, gold and silver.

2. Rationale & Organization of the Study. Agricultural futures markets are a market-based
instrument for managing risks that, potentially, could form part and contribute to the orderly
establishment of a more open and liberalized agricultural sector. Unlike most other developing
economies, India has a long experience in operating and managing commodity futures markets.
Indian futures markets, however, have been operating under highly restrictive policies, providing
them little chance to contribute in any significant way. The present study is part of a larger set of
studies undertaken by the World Bank in collaboration with GOI to review the constraints,
opportunities and options to the improved performance of Indian agricultural markets; it
complements companion studies that analyze the marketing performance of individual agricultural
markets --rice and wheat, oilseeds and its derived products, cotton, and sugar. It is not the purpose
of this study to justify the use of futures markets for individual commodities; this larger question is
addressed in the context of the companion, individual commodity studies. Instead, the present
study concentrates solely on the steps and actions needed to ensure the orderly development of
agricultural futures markets as a generic risk management tool to improve the performance of
agricultural markets. The study (1) describes the generic roles which futures markets play in
agriculturalmarketing (Chapter One); (2) describesthe current structureand operationsof Indian futures
markets (Chapter Two); (3) assesses the performanceof Indian futures markets, and identifiesits key
policy determinants(Chapter Three); and (4) examinesthe policy, regulatoryand institutionalconditions
and options for expanding and improving the contribution of commodity futures to agricultural
marketing,includingthe potentialfor the internationalizationof Indian exchangesand the introductionof
new futures contracts(Chapter Four). This study has been preparedon the basis of a reviewof available
literature, includingrecent UNCTAD studies, fieldvisits to a representativecross-sectionof commodity
 - ii -

exchanges, and interviewswith governnent officials, industry participants, and representatives from
commodityexchanges.

3. Economic Roles of Commodity Futures Markets. Futures markets have emerged out of
the need to deal with the risks associated with agricultural production, storage, trade and
processing; they have emerged also in response to the counterparty default risk associated with
forward markets, another risk management instrument developed earlier (paras 1.7 to 1.10).
Commodity futures markets, initially concentrated in a small number of developed economies, are
now being established in newly liberalizing, developing economies and economies in transition --
such as China, Brazil, Poland, Hungary, South Africa and Turkey. Futures markets are used to
hedge --i.e., cover for-- commodity price risks, by providing a vehicle for market participants to
exchange risks. Futures markets also serve as a low cost, highly efficient and transparent
mechanism for discovering prices in the future, by providing a forum for exchanging information
about supply and demand conditions. The hedging and price discovery functions of futures
markets promote more efficient production, storage, marketing and agro-processing operations,
financing, and overall agricultural marketing performance. Participation in futures markets is not
restricted to those directly involved with the actual, physical (spot) commodity market. In fact,
speculators play a critical role by providing for much of the needed liquidity in futures markets,
and generally represent the largest group of users. In contrast, farmers are rarely active on futures
markets, even in the USA; instead, farners benefit indirectly from the existence of futures markets
through easier access to better information about future prices, and through higher prices resulting
from lower marketing and processing costs (paragraphs 1.13 to 1.24).

Main Findings

4. Long, Well-Established Tradition of Regulating and Operating Commodity Futures

Trading in India. Unlike many other developing economies, India has a long history of
commodity futures markets. Futures trading was first introduced on the Bombay Cotton Exchange
and the Bombay Oilseeds & Oils Exchange as early as 1921 and 1926, respectively, and expanded
rapidly to other commodities as well as to options trading (paras 2.1 to 2.6). The Forward
Contracts (Regulation) Act, 1952 provides GOI with a well-developed, three-tier framework for
regulating futures trading activities (paragraphs 2.7 to 2.12). The Forward Markets Commission
(FMC), a statutory body under the administrative control of the Ministry of Civil Supplies,
Consumer Affairs and Public Distribution, monitors futures markets and controls the operations of
the recognized commodity exchanges associations (paragraphs 2.13 to 2.14). The recognized
associations, in turn, organize futures trading in selected agricultural commodities, which they
regulate under their trading by-laws, generally modeled after the British and American commodity
exchanges. The structure of commodity exchanges and their user composition are also very much
similar to that of other, international exchanges, although they provide fewer public services and
their capacity to design and introduce new contracts is limited (paragraphs 2.15 to 2.26).

5. Most trading practices of Indian exchanges are sound: the open outcry system functions
well and is cost effective, and trade recistratiotn procedures are well lald-out; other procedures,
such as the weekly clearing operations t r thc absei ( e of time-stamping of transactions, differ from
international practice and reflect the small scale of operations of most Indian exchanges
(paragraphs 3.10 to 3.17). One major weakness of Indian trading procedures lies in its unique
delivery system. Delivery to exchange warehouses is possible but not mandatory, and financial
settlement is allowed. The arbitrariness of the financial settlement system undermines the
economic usefulness of Indian futures markets by breaking their link with the underlying physical
 - iii -

markets, and supports the artificial backwardation --i.e., futures prices fall below spot prices-- of
futures markets whenever ceilings on futures prices are imposed (paragraphs 3.18 to 3.21).

6. Usefulness of Indian Futures Markets is Severely Reduced by the Selective and

Restrictive Implementation of the Regulatory Framework. Direct government regulations are
a major factor determining the access to, and potential usefulness of futures markets. GOI,
through the FMC, directly intervenes extensively and selectively to restrict access to futures
markets. Futures trading is currently allowed for only six, mostly minor agricultural commodities,'
and forward contracts for three commodities. Futures and forward trading is prohibited or
suspended for over 100 commodities including all cereals, pulses, sugar, all edible and nonedible
oilseeds --except castorseed-- their oils and meals, cotton seed and yam, coffee, etc. Option
trading is altogether prohibited (Table 2.1).

7. When permitted, the limits imposed by the FC(R) Act on contract specifications, such as
its transferability, have often become so stringent to make futures trading an unattractive and risky
operation. For example, in the case of cotton lint--the most significant commodity for which
forward trade is permitted-- only Non-Transferable Specific Delivery (NTSD) contracts are
allowed (paras 2.27 to 2.32). Because of their non-transferability, NTSDs do not qualify as
futures contracts according to intemational definition, but come closer to forward contracts. In
response to the legitimate risk management needs of commercial users, significant illegal trade in
futures contracts --seed cotton (kapas) and cotton lint, groundnut and mustard oils-- is reportedly
taking place across several Indian locations using standardized trading rules and open outcry
(paras 3.6 to 3.9).

8. Regulations and controls imposed by the FMC on the operation of commodity exchanges --
e.g., recognition of commodity exchanges, contract approval process, price ceilings, margins, and
positions limits-- cause most Indian futures markets to suffer from poor liquidity (paras 3.2 to 3.5),
and seriously hamper the economic usefulness of futures trade (paras 3.36 to 3.39). The
discretionary implementation of controls contrasts sharply with the initial intent of the FC(R) Act
and intemational practice. Additional regulations that limit the access to, and usefulness of futures
exchanges include: income tax rules which do not recognize hedging, creating a taxation
asymmetry between physical and futures markets transactions for potential users (para 3.40); or
the ban imposed by the Reserve Bank of India (RBI) on the participation of large, institutional
investors --pension funds, insurance companies-- which, elsewhere, provide market liquidity as
natural counterparts to the large hedgers. The participation of intemational users and some
domestic users, such as agricultural cooperatives, is also made virtually impossible as a result of
regulatory barriers (paras 2.41 to 2.46). The Indian brokerage industry, in contrast with other
countries, is small, poorly capitalized, highly fragmented, and remains un-regulated. While
consistent with the stringent constraints on the size of operations of commodity exchanges, the
current structure of the brokerage industry is likely to become a serious impediment to the orderly
developmentof futures markets (paras 3.27 to 3.35).

9. Economic Usefulness of Indian Futures Markets Further Reduced by Government

Interventions on the Physical Commodity Markets. Government interventions include storage
and movement controls embodied in the Essential Commodities Act (EC Act), 1955, the selective

1 Futurestrading is currentlyallowedin: rawjute andjute goods,blackpepper,castorseed,gur (a non-

centrifugalsugar),potatoes,and turmeric. Forwardtradingis allowedin cotton lint, jute goods,raw jute
and hessian.
 - iv -

credit controls issued by the RBI, external trade policies, and government market interventions
which are particularly relevant in the case of rice, wheat, sugar, and to a lesser extent cotton,
oilseeds and their products. The selective and ad-hoc controls on storage, movement and access to
trade credit severely restrict the economic usefulness of futures trade by preventing the arbitrage of
agricultural commodities across space and seasons in an efficient and competitive fashion (paras
3.41 to 3.48).

10. In the case of rice, wheat and sugar, government interventions on the physical markets
eliminate most price risks for private operators by dominating procurement and distribution (the
Food Corporation of India is estimated to procure about 40% of rice and wheat marketed surplus),
implementing pan-seasonal and pan-territorial pricing through price interventions (rice and wheat
procurement and issue prices, sugarcane State Advised prices, and sugar issue prices) with
subsidized transport and storage by the Food Corporation of India (rice and wheat), and the
administrative setting of processing margins (sugar). The absence of any reported illegal futures
trading activities in rice, wheat and sugar suggests the lack of interest by private operators in risk
management tools under existing policies on the physical market; even if GOI were to allow futures
trade, little interest from the pnrvate sector is likely to emerge. For other agricultural commodities,
direct market interventions by government are much less significant, allowing prices to clear the
market --within the confines imposed by the storage, movement, selective credit controls, and
external trade restrictions. The presence of more active legal futures trading in the case of
castorseed, gur, pepper, and illegal futures trading in the case of groundnut and rapeseed oils,
suggest a strong, inverse relationship between the extent of government interventions on the
physical markets and the demand for futures trading (paras 3.49 to 3.53).

Main Recommendations

11. Futures Markets Need Not Hinder Achievement of Existing Policy Goals Provided
Government Policies on Physical Markets Follow a Few Rules. Government interventions
should not eliminate price risks; they should not strongly restrict the normal flow of commodities in
the economy, should leave a sufficiently large part of the physical trade in the hands of the private
sector, and let prices clear the market; they should also provide for a stable and predictable
external trade environment (paras 4.5 to 4.7). Indian agricultural policies for rice, wheat and sugar
do not satisfy any of the above minimum rules, making futures markets impossible. For other
agricultural commodities, notably cotton, oilseeds and their derived products, several minimum
conditions are satisfied. In their case, spot and futures markets can be allowed to develop in
synergy. Remaining imperfections in the physical markets imposed by current government
restrictions on storage, movement and access to credit should not prevent commodity futures
markets from operating for those commodities. Instead, the presence of a futures market will
encourage those active in physical trade to improve their market practices every time a government
restriction is relaxed (para 4.8). The contrasting experience of American and European agricultural
policies shows the potential and limits which government interventions impose on the performance
of futures markets, and the latter's contribution to a strategy for risk management in agriculture
(Box 3.3).

12. Regulatory and Institutional Environment Governing Operations of Futures Markets

Needs to be Improved to Ensure Orderly Development. China's disappointing experience with
the introduction of futures markets underscores the central importance of a good regulatory and
institutional framework for the orderly development of futures trading (Box 4.1). Unlike many
developing economies, India enjoys a strong regulatory system for commodity exchanges and
 -v -

experience that will facilitate the development of its futures markets. Several measures are,
however, needed to optimize the potential contribution of futures markets to the agricultural
economy. These measures should aim at providing the framework for futures markets to realize
their full potential, while controlling abuses in the functioning and use of futures trade.

13. On the legal and regulatory front, the FMC should curb its discretionary interventions --
associations should be recognized on a permanent basis, renewal of contracts should be automatic,
regulatory measures standardized and price ceilings withdrawn-- and revert to the original intent of
the three-tier regulation model provided by the FC(R) Act (paras 4.9 to 4.12). Under such a
model, the government would still approve exchanges, and set the general legal and regulatory
framework. GOI would need to introduce a two-tier national brokerage regulation for the specific
purpose of consumer protection (para 4.23), and prudential rules for the use of risk management
instruments by companies to ensure that companies install proper internal control systems before
starting the use of futures exchanges (Box 4.2). The FMC would play a monitoring role, approve
requests for the introduction of new futures contracts emanating from the commodity exchange
associations, and intervene when the situation warrants it. The participation of commercial
hedgers, including cooperatives, and large institutional investors should be promoted through
changes in incomes tax rules, tax registration requirements, and bans on participation (paras 4.13
to 4.14). On the institutional front, the FMC would need to be strengthened to fulfill its new
responsibilities (paras 4.25 to 4.26). Commodity exchanges would need to up-grade their rules and
regulations -- trading procedures, delivery system, trade supervision -- clearing operations, and
promotional and development activities and their implementation and monitoring capacity (paras
4.15 to 4.24).

14. Low Volume of Trade and Regulatory Concerns Will Likely Limit
Internationalization of Indian Commodity Exchanges to a Few Commodities, Like Pepper,
Some Oilseeds and Oils. Indian commodity exchanges would benefit from foreign participation.
It would enhance market liquidity, bring-in valuable foreign exchange, as well as promote the
development of a warehousing and financial service industry. From the point of view of foreign
entities, participation in Indian commodity exchanges can provide new portfolio investment and
risk management opportunities. Accommodating foreign accounts in Indian exchanges will not be
difficult: by-laws were formulated in accordance with international standards. The limited trade
volume of Indian exchanges, and the fragmented, under-capitalized domestic brokerage industry,
are likely, however, to deter foreign participation. Attracting foreign participation will, in addition,
raise new policy concerns. Besides the lifting of the ban on their participation, changes in tax and
profit repatriation regulations will be required. The potential detrimental effects of short-term
capital outflows, and problems of possible money laundering will arise if foreign participation is
allowed; practical solutions from other countries are however available (paras 4.27 to 4.34). The
practical implications of the internationalization of the Cochin pepper exchange, being
contemplated by GOI, are briefly reviewed (paras 4.35 to 4.41). The willingness of the concerned
agencies to reevaluate some of their regulations attests to the renewed government interest in
futures markets.

15. Cotton Industry: Short Run Prospects for National Futures Contracts Higher for
Cotton Lint than Seed Cotton (kapas) and Yarn. Immediate prospects for the introduction of
futures contracts in seed cotton (kapas) and cotton yam appear very limited (paras 4.49 to 4.56).
Prospects for the successful re-introduction of futures contracts in cotton lint are very good in the
short run, as testified by the reported active illegal futures trading. To succeed, cotton lint futures
contracts would need to carefully develop an appropriate delivery system which balances the trade-
 - vi.-

offs between liquidity and basis risks among and within the large number of cotton varieties
produced across India. Available evidence suggests that cotton sector policy reforms, by improving
the performance of cotton physical markets and their stable integration with world markets, would
go a long way towards alleviating the current, apparent trade-offs between liquidity and basis risks.
At the national level, the introduction of one futures (hedge) contract which allows the delivery of
the main superior medium and long staple cottons throughout the country could be considered. The
delivery of one or more extra-long staple cottons against this national contract could be allowed,
subject to the proper determination of quality premia and discounts payment system (paras 4.57 to
4.67).

16. Oilseeds Industry: ComplementaryIntroduction of Groundnut Oil and Rapeseed Oil

Futures With Corresponding Seeds Futures Contracts in a Few Regional Exchanges is a
Likely Successful Strategy. Access to oilseeds and oils futures contracts will raise the
competitivenessof the Indian oilseed industirynow facing foreign competition from imported edible
oils. This, together with the presence of large illegal futures trading in oilseeds, points to the large
demand from the industry for the introduction of futures contracts in the oilseed complex. In an
open trade environment, futures contracts facing little competition from abroad are likely to stand a
greater chance of success. This implies that groundnut and rapeseed-mustard futures contracts
should stand a greater chance of success than soybean contracts which will compete with the
Chicago Board of Trade contracts. The available evidence points at the absence of a common,
domestic physical market for the oilseed industry, but better integrated regional physical markets.
This strongly suggests that a few regional exchanges will be better suited to the needs of an initially
imperfect physical market situation (paras 4.68 to 4.81).
 1 The Role & Contribution of
Commodity Futures Exchanges

1.1 Futures markets have traditionallybeen concentratedin a few countries heavily engaged in
world commoditytrade. Over the last decade,futures marketshave expandedinto many other countries
as diverse as Russia, China, Poland, Hungary, Brazil, Singapore and the Philippines. The reduction of
govemnmentinterventionsin agriculturalpricing togetherwith the opening-upto world markets leads to
the need for price discoverymechanisms. These policy changes also expose many actors to risks they
did not face previously, raising the need for new mechanismsto manage risk. In recent years, many
countries have found it worthwhile to promote the creation of new, domestically-orientedfutures
markets. During that process, however, many of these countries encountered problems, the most
significantof which are the absenceof a proper regulatoryframeworkand a lack of understandingof and
experiencewith futures trade. India, however, is well-off on both accounts. India has a multitude of
commodityexchanges, decades of experiencewith market regulation,and a strong legal base. India's
commodityexchangesare becoming increasinglyvocal in their desire to expandtheir operations. This
appears to fit well with India's economicliberalizationand its wish to increase exports. Is such an
expansionindeeddesirable,and if so, what factors would make it possible?

1.2 Futures contracts are standardizedforwardcontractsthat are tradable, and futures markets --or
commodity exchanges- are where trading of these contracts occur'. All futures contracts are
standardizedin their obligationsto make or take deliveryof a fixed quality and quantityof a commodity,
at a specific location, on a specific future date and time. In contrast, forward contracts are not
standardized. Two institutional features, margins and the clearinghouse, distinguish futures from
forward contracts. Margins are securitydepositsmade by both the buyer and sellerto the clearinghouse
whentrading; the clearinghouse,whichis either a divisionof an exchange(as is the case in France, India,
Japan and the United States of America), or an independentservice provider (the case for Australia,
Malaysia, and the United Kingdom),records and acts as the third party to all transactions in order to
ensure contract performance. In principle, the margins eliminates the risk of default, while the
clearinghouseeliminatescounterpartyrisk, thereby increasingliquidityof futures markets.

1.3 The Forward Contracts (Regulation)Act, 1952 (FC(R) Act) regulatesfutures markets in India.
The FC(R) Act, and its correspondingRulesand Notifications,do so by definingseveraltypes of futures
contracts, the commoditiesfor which individualtypes of futures contractsare allowed,and by providing
for the rules of operation,control,and enforcementof futures markets. By introducinga classificationof
contractsthat is uniqueto India, it should be notedthat the Indianterminologyprovidedin the FC(R) Act
differs from the intemationalterminology. This report will use the intemationalterninology, which
means amongother thingsthat it will referto as futures contracts-- as intemationallyunderstood-- those
contracts defined as transferable specificdelivery contractsand hedge contracts in India by the FC(R)
Act and its subsequentinterpretations. The intemationalreader should know that the FC(R) Act splits
commoditycontractsinto two categories: those which providefor the deliveryof goods and full payment
either immediatelyor within a period of less than elevendays after the date of the contract, at a price
fixed at the date of entering the contract (these are called "ready delivery contracts"); and all other
contracts, which are called forwvardcontracts. Within the group of forward contracts, the Act defines

i For a definition and explanation of the technical terms see Annex 1, and Risk Management in Liberalizing
Economies:Access to Futures & OptionsMarkets, by M.L. Debatisseet al, EMENATechnicalDepartmnent Report
Number 12220ECA,World Bank, 1993.
 2

non-tradablespecific deliverycontracts, and tradable specificdelivery contracts. The first are close to
what in internationalterminologyare calledforward contracts;the second are similar to futures contracts
but with the restrictionto only one basis deliveryvanety, and possiblelimitationon transferability. In its
implementation,the Act also regulates trade in contracts that are virtually identical to the futures
contracts traded in other courtries (that is, with vanous tenderablegrades and without limitations on
transferability),knownin India as "hedgecontracts";althoughthe Act does not definethis category, they
can by implicationbe considered as transferable non-specificdelivery contracts. Chapter Two will
provide a more detailedexplanationof Indiandefinitionsand their internationalequivalents.

1.4 Futures contractsin hxdiaare currertly traded in only six, minor agriculturalcommodities. The
recent Kabra Report2 , recommendsthe introductionof futures contracts in basmati rice, kapas (seed
cotton),cotton, raw jute and jute products, a number of oilseeds and their oils 3 , major oilcakes,linseed,
onions, gold and silver. The Kabra Committeebases its recommendationslargely on an analysis of the
supply/demandconditionsin the various markets, and the perceivedrisks of allowing futures trade for
the public interest.

1.5 This study assesses the general benefits and risks of futures markets trade, examines the
performanceof existingfutures markets, evaluatesthe reformsand investmentsneededto improve their
performance,and reviews possibilitiesfor introducingnew futures contracts. This report is written on
the basis of a reviewof the availableliterature,field visits in April 1995 to Bathinda, Bombay,Delhi and
MuzaIfmagar, and interviewswith governmentofficials,industryparticipants and exchangestaff

1.6 The report is dividedinto four chapters. This chapter discussesthe generic roles which futures
markets play in agriculturalmarketing. Chapter Two describesthe current structure and operations of
Indian futures markets. Chapter Three assesses the performance of Indian futures markets, and
identifiesthe factors which influence it. Chapter Four concludes by examining the conditions and
options for expandingand improvingthe contributionof commodityfutures to agricultural marketing.
The potential for the internationalizationof India's exchangesand the introductionof new contracts is
also explored.

A. Commodity FuturesMarkets: A Historical Perspective

1.7 Commodityproduction, processingand trade are fraught with risks. Agriculturalproduction is

subject to the vagaries of weather and other natral conditions. At the time of planting, the prices at
which the final product can be sold are not known. Processorsbuy raw commodities,and sell ther in
processed form at a later date; in the mean time, the price of the processed product may have declined
resulting in unprofitableoperations. Traders make sales commitmentswithout having the commodities
at hand, in the hope of buying low and then sellinghigh, and in the process earn reasonablereturns.

1.8 Conmmodity producers, traders and processors are not in their respectve businessesto speculate
on pnce movements, but are simply forced to do so. Their real business is to add value, through
production,transformation,and logisticsservices. But within the marketing chain, price risk is one of
the many factors they have to cope with in order to securetheir margins. Volatileprices are a hindrance
to adding value; the time involvedin choosingthe right moment to buy or sell and the effort neededto

2 Report of the Comrnmitteeon Forward Markets, Ministry of Civil Supplies, Consumer Affairs & Public
Distribution, September 1994.

3 These include groundnuts, rapeseed/mustardseed, cottonseed, sesamumseed, sunflower, safflower, coconut,

soybean and rice bran.
 3

avoid overly large risks takes away from the effort to becomemore effectivein the value-addingprocess.
It is not uncommon for firms, successful at creating value, to go bankrupt due to adverse price
movements.

1.9 Instrumentsfor ManagingPrice RisksAppeared Early. Price risk managementinstruments

were developedby traders in responseto the burden that volatileprices create. Processors,end-usersand
producers became involvedat a later stage. Contracts whichenabledthe improvedmanagementof price
risks have been a fixture of commoditymarkets since the sixteenth century, when forward delivery
contracts for grains were first developed.In the seventeenthcentury,the first options appeared, fixing a
price for future delivery without the obligation of the buyer to actually take possession of the goods.
Selling "short" -selling an option on a commoditywhile one does not possess the underlyingproduct--
soon became popular in such commoditiesas grain, cocoa and coffee. Tradable forward contracts
became importantafter the late seventeenthcentury. Most of these transactions are what is now called
"over-the-counter",i.e., directly between two parties. Even with tradable forward contracts, contract
performanceremainedthe responsibilityof each party involved. While these instrumentsreduced price
risks, they createda new source of risk, namelycounterpartyrisk.

1.10 Futures Markets Eliminate Counterparty Risks. In the mid-nineteenth century, futures
markets developedas an effectivemeans of managingprice and overcomingcounterpartyrisks. Trade in
these "tradable"forward contractsbecame centralizedin organizedcommodityfutures exchanges,where
contract performance was guaranteed by a clearinghousecollectingmargins, rather than by individual
traders or a trading house's "good name". Everyonecould henceforthsecure future prices without any
real risk of counterpartydefault. The first futures exchangeestablishedin 1848 was the Chicago Board
of Trade. At the end of the nineteenthcentury, futures contractsin commoditiessuch as grains, arabica
coffee, cocoa, cotton, copper, silver, and tin were already being traded. By the early 1980s, active
commodityfutures exchangesexisted in Australia, Canada, France, Japan, Malaysia, New Zealand, the
UnitedKingdom,the UnitedStates of America, and of course, India.

1.11 RenewedInterest in CommodityFutures. In the secondhalf of the 1980s, severaldeveloping

countries estabhshedtheir own commodityfutures exchanges;exchangesin Brazil and China have now
taken their place among the world's largest. Some newly liberalized economies,such as Russia and
Hungary, have also opened commodityfutures exchanges.In the last two years, many more developing
countriesare studyingthe possibilityof creatinga futures market.

1.12 Two factors contribute to the sudden interest in commodity futures markets. First, futures
markets assume special relevance m an increasinglycompetitive world market, where commodity
production and trade responsibilitiesare shifted from the State to the private sector, and where the
private sector is increasinglyexposed to the vagaries of the world market. Second, commodityfutures
markets remain the most efficient price formation mechanism, providing reliable benchmarks for
physicaltrade. Because a wide group of participantscan use the market, each participantbrings into the
price formation processthe informationhe/she possessesabout future demandand supply conditions. In
contrast to a cash market, a futures market is highly transparent, yet anonymous, making price
manipulationmore difficult. Futures markets, as institutions,have an interest in makingtheir prices as
widelyavailableas possible,thus providingmany smallermarket players with the price informationthey
require.
 4

B. EconomicBenefitsfrom UsingCommodityFuturesMarkets

1.13 Price Discovery and Hedging: the Two Main Economic Roles of Futures Markets. While
the supply of primary agriculturalcommodities,for examplecotton, oilseeds,sugarcane, is concentrated
at the time of harvests,their consumptionis spread out throughoutthe year. If markets are to function
properly,some entitieshave to be willingto hold stocks. Storage, however,not only freezes up working
capital, but it also exposesthe stockholderto downsideprice risks. In the absence of risk management
tools, traders will not only reduce their seasonalstocks, contributingto price volatility,but they will also
build-in a risk premium in their seasonal storage margins. Futures trading allows stockists to hedge
against price risks associated with storage. This process reduces the risk premiums added to storage
margins. Futures marketsalso provide a mechanismfor the discoveryof prices in the future, facilitating
production, processing,storage and marketing decisions. Futures prices serve as referenceprices for
forward purchases and sales. Futures marketscan also be very helpful for processors and traders in case
they want to sell (buy) on the physical market,but do not havea buyer (seller)immediately.

1.14 Improve Export Competitiveness. By allowing exporters to hedge price risks when short-
selling to foreign buyers, futures markets enable exporters to reduce their margins, improving their
export competitiveness. In physical trade, especially international trade, buyers often wish to buy
forward. For instance, Indian textile mills export 3 months forward, because their buyers need this
security; in the oilseeds sector, large international buyers prefer to buy at least one year forward.
Exporterswho enter into such forward deals generallydo not have all the required commoditiesin stock.
They will have to buy them on the physical market. The risk is, of course, that physical market prices
will increase,forcingthe trader to accept a loss. To avoid such risks, exportersmay refuse demands for
long-term contracts -hurting their own competitive position-- or hold working stocks higher than
otherwise necessary. Futures markets will allow exporters to hedge their anticipated purchase by
temporarily substituting for an actual purchase until the time is appropriate to buy on the physical
market. Experiencefrom other countriessuggests that the absence of access to risk managementtools
forces traders to increase,often doubletheir workingstock requirements,over and above what would be
required from a logisticspoint of view, makingthem less cost-competitive.In India, the risks of selling
forward to foreign buyers in the absence of futures trade have caused many cotton exporters to either
disappear or to convertinto brokers.

1.15 ReduceProcessingMargin Risks, Futures marketsallow agro-processorsto lock in profitable

margins, promoting competition and reducing nsk premiums. Agro-processorsoften work on slim
margins: raw material costs can equal 90 per cent of the output price. Output and raw material price
movementsoften result in negativeprocessingmargins. This is a commonphenomenonfor sugar and
edibleoils. Futures markets allow sugar refineriesand oilseedscrushers, through anticipatoryhedging,
to secure a profitableprocessingmargin by givingthem the flexibilityto fix their input and output prices
at the most favorable time. In the absenceof futures markets, processors can only achieve this through
careful, time-consuning and costly timing of their physical transactions--indeeda main occupation of
many oilseedscrushers and cotton gins, and governmentagenciesin the case of sugar in India. Futures
markets will allow Indian oilseeds crushers to reduce their marketing and processingmargins, and to
compete more effectivelywith the now free imports of edibleoils; by the same token, reduced margins
will enablecrushers to offer higherprices to oilseedsgrowers.

1.16 Good consumer-oriented marketing is difficult if no futures market exists for domestic
processors. The demandfor India'sedibleoils is highlyprice-elastic;to protect their market shares with
the free entry of imports, manufacturers have to keep prices fairly stable. With the use of futures
contracts, domesticprices can be made predictable,and manufacturerscan smooth out the influenceof
 5

changes m their input prices quite easily. If there are no futures markets, and in particular if there are
also limits on stockholding(as of mid-1995, manufacturerswere only allowed to hold up to 45 days
worth of consumption in stock), the manufacturer can be caught in between severe short-term price
movementsof oils and the needto keepthe product price stable. This conflictcan only be resolvedif the
manufacturer keeps sufficient financial reserves, funds that otherwise could have been used for
investment.

1.17 Farmers Benefit Indirectly Through Better Information, Lower and More Stable
Marketing and Processing Margins. Farmers are likely to benefit from the existence of futures
trade, even without using futures markets directly. In the absence of a well-functioning forward or
futures market, farmers bear the brunt of price instability. With a futures market, traders or
processors (e.g., oilseed crushers) need not build as large a cushion to protect themselves against
unfavorable price movements. As a result, they will reduce the risk premiums in their marketing or
processing margins and be able to pay farmers more for their products, sell cheaper, store more
and be more active in the markets. The degree to which traders or processors increase prices to
farmers depends on the level of competition, and on the price information available to farmers. As
futures exchanges have an interest in making their prices as widely available as possible, there is a
good chance that farmers will indeed be able to benefit. In addition, because of the lags between
planning and production, farmers can benefit from the market-determined price information
available from futures markets, which serves as an important basis for their production decisions.
In India, there is active competition among traders and processors of agricultural commodities.

1.18 FacilitateAccess to Credit. In the absenceof risk managementtools, agriculturalmarketing

and processing becomes an unnecessarilyrisky business activity to lend money to. Relatively small
changes in prices can wipe out a large part of the capital owned by traders, and even make it impossible
for them to reimbursetheir loans. Banks are thus hesitant to lend to commoditytraders, in particular
those who do not manage their price risks. If they do lend, they are likelyto do so at a high price. This
in tum hinders the proper functioningand competition of agricultural markets. Hedging lowers the
discount rate in lendingfor commodities. For example,in countrieswherefutures markets are allowed, a
bank will advance 80-90%of the value of the transactionif hedged,but only 50-60%if hedged.

1.19 Improve Product Standards. The existenceof exchange warehouses with grading facilities
coupled to the extra flexibility that traders have to make deliveryto such warehouses creates strong
incentives for the upgrading of qualities to a level acceptable to the exchange. It also facilitates the
standardizationof commoditytrade, including in terms of standard qualities: the quality certificates
deliveredby exchange warehouses have the potential to become the norm for physical trade -- as has
indeedhappenedin a number of countries.

1.20 In summary, commodity futures not only play an important role in price discovery and
managingprice risks, but they also assume other economicroles: financial stabilityfor market operators;
standardizationof quality for deliverablecommodities;flexibilityfor traders and processors by replacing
the need for storage or providingnew market outlets; reduction of storage costs; and finally, improved
accessto finance.

C. Role of Speculationin FuturesMarkets

1.21 Several concerns remain about the functioningof commodityfutures markets and their effects
on the distributionof market power. One common concemhas to do with speculation. Futures mnarkets
cannot function without the extra market depth and fluidity which speculation provides. Since the
 6

physical availability of commoditiesand a commercialfirm's decision to buy or sell commoditiesmay

not always coincidewith each other, the futures market will be extremelyilliquidif firms have to wait
until a compatiblebid or offer arose. Thus, speculatorsin futures markets play a vital role in absorbing
the frequentlyunbalancedsuppliesand demandsof commercialbuyers and sellers.

1.22 Speculationis also often mistaken for gambling or with manipulation. Both speculators and
gamblers seek to profit from assuming risk. But while a gambler creates risk where none exists, a
speculatorassumes risks which already exist in the market, fulfillingan economicallyuseful role. While
success in gambling is purely a matter of chance, success in speculation is dependent on the proper
understandingof fundamentalmarket forces. The interestthat speculatorshave in gathering information
on the underlying commodityis what makes futures markets such a viable price discoverymechanism.
Speculationis also not the same as manipulation:a speculatortries to forecasthow prices will move, and
his actions will indeed make prices move closer to the market equilibrium. A manipulatortries to move
prices away from their market equilibrium. Thus, futures marketswhich do not serve the legitimaterisk
managementneeds of traders or processors have no chance of survival because such a market would
soon lose its relationshipwith the underlyingphysical market.

D. RelationshipbetweenFutures andPhysicalMarkets

1.23 Despite the above economicroles, concerns are widespread that commodity futures markets
magnify price increasesor falls, leadingto lower farmers' prices and higher consumer prices. Research
in many countries suggeststhat commodityfutures markets follow,at least in the long term, the demand
and supply conditionsof the underlying physical market, and improve the functioningof the physical
market by reducing seasonalprice volatility. This is true irrespectiveof whether a market is in excess-
supply or excess-demand situation. With adequate contract specifications and regulations, any
aberrationsby futures markets are likely to be short-lived. Futures markets are also more difficult to
manipulatethan physical markets. Because futures markets are more transparentthan physical markets,
when prices move away from their market equilibrium, market participants will react, effectively
draggingprices back towardstheir equilibriumlevel.

1.24 At the same time, futures market helpto improvethe efficiencyof the physical market. When a
commodityis in short supply, futures market prices will increase; whether or not the futures market is
closed-down,physical market prices will also increase anyway. If the governmentconsiders the price
rise to be socially unacceptable, the only viable option is to change the basic supply and demand
situation.

E. Domestic vs. Foreign Commodity Exchanges

1.25 There is no economicreason for a country to insist that all its risk managementactivitiestake
place through a domesticexchange. Internationalmarkets could provide similar services. In fact, if a
well-functioninginternationalmarket already exists which adequately reflects Indian market conditions,
Indian companies would gain little from the creation of a futures market in India. At least in theory,
valuable foreignexchangemay be saved if the local rather than the foreignmarket is used. On the other
hand, interest in this market may well be limited, reducing its usefulness. However, risks associated
with exchangerate fluctuationswill generallyinvolvetrade-offsbetween basis and liquidityrisks, unless
instrumentsare availableto hedgeagainst exchangerate risks.

1.26 A stronger case can be made for commodity futures markets that offer risk management
opportunitiesnot available elsewhere. This may indeed be the case for most of India's agricultural
 7

products. Domestically-orientedfutures exchanges provide a price discovery and risk management

mechanismwhere none would exist otherwise. Moreover,they can play importantlogisticsfunctions,as
an assembly point for physical products, or a guarantor of quality standards. While domestically
focused futures contracts may be of litfle interest to foreignusers, regionally-orientedcontracts are, in
such an instance, contracts would need to be defined to balance the interest of both domestic and
internationalplayers.

Summary

1.27 Commodityfutures markets provide farmers, traders, processors, and exporters a mechanism
for hedgingtheir risks and improvingprice discoveryin their forward planning decisions. At the same
time, the benefits of futures trading extend beyond the boundaries of individual firm activities.
Marketing, storage and processing margins will narrow as a result of the reduction of the costs
associatedwith uncertaintyand risks, to the benefit of growersand consumers. Futures marketspromote
inter seasonal and intra-seasonalprice stability. By providinga mechanismfor price discovery,futures
markets help growers, traders and agro-processorsmake better productiondecisions. India was one of
the first developingcountriesin which commodityexchangeswere established.
 STRUCTURE AND ORGANIZATION OF INDIAN
2 COMMODITY EXCHANGES

A. History of Commodity Futures Markets in India

2.1 The Early Years. Commodity futures markets have a long history in India. The first
organized futures market for vanous types of cotton, the Bombay Cotton Exchange,was establishedin
1921. A second exchange, the Seeds Traders AssociationLtd. in Bombay, which traded oilseeds and
their products, including castorseed, groundnuts and groundnut oil, followed in 1926. Several other
exchanges were subsequently created, trading futures contracts in raw jute, jute products, pepper,
turmeric, potatoes, sugar, foodgrainsand gold. Many of these exchangestraded the same commodities,
and some had formal trading links. Users were quite sophisticated;for example, traders in the cotton
market undertookarbitrage with other major internationalcotton markets, such as Liverpool,New York
and Alexandria. At the same time, a number of foreigncompaniesused the Indianmarkets. A complete
regulatoryframework for futures trade was drafted,includingrules and conditionsfor trading in futures,
a broker's licensingsystem, and a clearinghouse structure. Optionson a number of commoditieswere
also traded; for example,options on cottonwere traded up to one year out, until their ban in 1939.

2.2 Introductionof Regulatory Controls. In the 1940s, trading in forward and futures contracts
and options was discouraged by pnce controls and in some instances was outlawed, as part of the
Government's drive to contain inflation. These controls were maintained until 1952, when the
governmentpassed the Forward Contracts (Regulation)Act, which up to this day controls all futures
contracts. Although restrictions on futures trade in essential foods, such as sugar and foodgrains
remained,the Act allowed futures market trade in a very limited number of commodities. The Act
stipulated that futures markets should normally be self-regulating,through the governing bodies of
recognizedassociations,in which the governmenthad the right to place several representatives. For all
practical purposes, it outlawed futures contracts other than between, with or through the members of
these recognizedassociations. The Forward Markets Commission(FMC) was createdto superviseand
regulate futures markets in the public interest, but in effect, gradually absorbed the exchanges' self-
regulatorypowers.

2.3 Increasing Government Intervention. The government'srole in the commodityexchanges

grew more intrusive during the 1960s, when futures trading in several commodities,including cotton,
raw jute, edible oilseeds and their products, was either banned or suspended. In the 1970s, futures
trading in non-edibleoilseeds like castorseedand linseedwas forbidden. Even non-transferablespecific
deliverycontracts were prohibitedfor a number of commodities.Other commoditieswere also brought
under the purview of the Forward Contracts (Regulation)Act. The crackdown on futures markets was
attributedto the Government'sconcemthat these markets helpedto drive commodityprices up by giving
free reign to speculation. To further combat speculation,other restrictivemeasures were imposed on the
activitiesof the tiirty-one "recognizedassociations". For example, speculatorswere asked to pay extra
margins whenever regulators deemed it necessary, and trade in contracts was simply stopped for
prolongedperiods (skippingone or more normal deliverymonths)whenprices reached certainceilings.

2.4 Evolving Policy Environment. Governmentpolicies softened somewhat in the late 1970s,
when futures trade in gur -a non-centrifugalsugar as importantas centrifugalsugar on India'ssweetener
market- was temporarily allowed. Castorseed futures were reintroducedin 1982. Two government-
 10

appointed committees'in 1966 and 1979recommendedthe revival of futures trading in a wide range of
commodities,but little actionwas taken.

2.5 Despitethe burdens imposedby heavy governmentinterventions,there is a large interest for risk
managementtools by the businesscommunityin India. Turnoverin those commoditiesfor which futures
trade is allowed is large, and the exchanges attract a wide variety of participants --large farners,
domestictraders, exporters, brokers and speculators. Futures contracts are activelytraded for periods
up to 6 months out, and, as expected, most contracts are used for hedging purposes, not for physical
delivery. "Underground"futures and optionstrade for commodities,such as cotton and a number of oils,
are widespread.

2.6 This interest is likelyto increase as a result of trade liberalization. Exporters are increasingly
confronted with highly competitiveworld markets where they are forced to work on slimmer margins,
but also to sell further forward to remain competitive. Againstthis background,the role of commodity
futures market is being reconsideredby the government.

B. The RegulatoryFramework

2.7 The Forward Contracts (Regulation)Act, 1952. Commnodity forward and futures trade is
regulated by the federal governmentthrough the FC(R) Act, 1952. The FC(R) Act differentiatesand
classifiesthe followingtypes of contracts:

aSpot or "ready" Contracts which provide for the delivery of goods and the full
delivery contracts payment of the value of the goods at the price settled when the
contract was enteredinto either immediatelyor within a period of
elevendays after signatureof the contract.

- Forward contracts These are contracts for the deliveryof goods and which are not
"ready" deliverycontracts.

*Non transferable These are forward contracts between two parties in which a
specific delivery (NTSD) commodity,of a specificgrade, has to be deliveredto a specified
contracts location during a pre-determinedtime frame at a predetermined
price.2 Neither buyer nor seller can transfer the contract to
another party, and financial settlement is not allowed. Grade,
location and delivery dates can not be renegotiated after the
contract has been signed. Originally,NTSD contracts were not
regulated under the Act, since they were considered a normal
part of trade. However,in practice, it was found that buyers and
sellers did at times make amendments to contract clauses, and
that delivery did not always take place in order to cope with

lThe DantwalaCommittee,ForwardMarketsReviewCommittee,1966;and the KhusroCommittee,Committeeon

Forward Markets, 1979.

2 Regulations do not provide for contracts where the price is separated from quantity and quality. Such contracts,
also known as "executable orders" or price-to-be-fixed contracts, do not set the price at the time the contract is
signed. Instead, one of the contract parties can fix the price at the time desired in relation to a certain reference price.
This type of physical market contracts is common internationally, and facilitate forward planning of supply and
delivery, without the risk that price developments endanger contract performance.
 11

unforeseen but unavoidabledevelopments,such as shipping or

harvest difficultiesor a lack of a specific desiredgrade.3 This
meant that NTSD contractswere effectivelyused as transferable
specific delivery (TSD) contracts falling under control of the
Act. Also, trade in NTSD contracts in some commoditieswas
used to camouflagetrade in other commodities. To close the
resulting loopholes, an ever increasing number of NTSD
contracts were brought under the purview of the Act from the
1950s onwards,and most were in effect prohibited.

Transferablespecific
delivery (TSD) contracts
These are defined as forward contracts that are not NTSD
contracts. In actual regulation, a difference is made between
TSD and hedge contracts. Hedge contracts are not defined as
such in the FC(R) Act, but can be considered as both delivery
contractsthat are both transferableand non-specific.
0 Transferablespecific delivery contracts specify a specific
(basis) grade, quantityand deliverylocationof a commodity,
just like NTSD contracts do. However, the buyer can
tansfer the contract to others, often up to a predetermined
number of times -six times in the case of oilseeds, for
example. Contracts can in principle even be transferred
back to the originalseller implyingthe financial closing out
of the contract.
0 Hedge contracts specify the basis and tenderable delivery
grades, and a range of delivery centers. Both buyers and
sellers can close out their positions, and delivery is not
obligatory. Hedge contracts are not definedas such in the
FC(R) Act, but can be consideredas deliverycontracts that
are both transferableand non-specificuntil enteredinto.

Option contracts
Option contractsgivethe right, but not the obligation,to make or
take delivery of a commodity(or a futures contract) at a given
price; for this right, one pays a premium. Options can thus be
likenedto insurance,but they can also be used for speculation:
the premium paid can be quite low in relation to the possible
profits if prices move in the anticipated manner. These
contracts, widespreadearlier, were banned for all commodities
underthe FC(R) Act.

2.8 The FC(R) Act regulates the Non-Transferable Specific Delivery contracts (NTSD); the
Transferable Specific Delivery contracts (TSD) and the Hedge contracts (Figure 2.1). The "ready"
contractsare not subjectedto the FC(R) Act.

3 Forward trade between two parties is quite common in other countries, but in contrast to India, considerable
flexibility is normally built into these contracts. For example, a seller is normally allowed to deliver products of
comparable quality if his/her own production has fallen short. Contracts can be liquidated ("washed out"), with final
payment between buyer and seller (representing price movements over the life of the contract) taking the place of
contract delivery. Postponements are not a real problem, with premiums or discounts on the original price often
directly calculated from futures market prices.
 12

Figure 2.1
Indian & International Classification
of Forward & Futures Contracts

Contracts

Ready ......... ........ ...............

Readay deliv r y............ .........

& payment within - -~d i-.-E

11days) -- i%|@ ide0i : igiv1 il02ll W l- |t 0

Forward Contracts Futures Contracts

in internationalterminology

*J Contracts regulated under the India Forward Contracts (Regulation) Act, 1952

2.9 Correspondence Between Indian and International Terminology. By introducing a

classificationof contracts uniqueto India, it should be noted that the Indianterminologyprovided in the
FC(R) Act differs from the internationalterminology. Figure 2.1 indicatesthe correspondencebetween
the Indianclassificationas definedby the FC(R) Act and the internationalterminology. Accordingto the
F C(R) Act, futures contractshave not been defined;instead,three types of forward contractsin India are
defined: the Non-TransferableSpecific Delivery contracts(NTSD); the Transferable Specific Delivery
contracts (TSD) and the Hedge contracts. These three forvard contracts offer different degrees of
flexibility to the buyer and seller, wvithNTSDs providing the least, and hedge contracts the most.
BecauseNTSD are not transferable,they would not qualifyas futures contract accordingto international
definition. TSDs, because of their transferability, would qualif~yas futures contracts; they present,
however, other limitations (e.g., extent of transferability, specific delivery)which do not make TSDs
useful as risk managementtool. The introductionof differentdegreesof flexibilityreflectedthe attempt
by Indianlegislatorsto balance their regulatoryconcernsabout speculationon the one hand, and the need
to satisfyvgenuinedemandsfor risk managementtools by private operatorson the other.

2.10 Commodity futures and forward trading is allowed for only eight, mostly minor
commodities. The FC(R) Act specifies the commoditiesfor which futures and forward trading is
allowed, as well as the type of contract that can be traded (Table 2.1). It allows NTSD trading for
cotton, hessian, raw jute andjute goods; TSD trading for raw jute and jute goods; and hedge trading for
hessian, black pepper,castorseed,gur, potatoesand turmeric. Futures trading is prohibitedor suspended
for over 100 commodities,except for contracts entered into by a number of federal or state entities.
Suspended commoditiesdiffer from prohibited commoditiesin the sense that, for the former, futures
 13

Table2.1
CommoditiesRegulatedby the Forward
Contracts(Regulation)Act, 1952

Non-transferable 79 commodities,including Castorseed, coconut oil, copra, Colton,jute goods,hessian and

Specific Delivery wheat, maize, mung beans, cottonseed,gur, groundnut, raw jute.
Contracts rice, paddy, sugar; mustard groundnut oil, kardiseed,
seed, rapeseed, linseed, rice kardiseed oil, sesamurn,
bran, sunflowerseed and their sesamum oil, and kapas.
oils and oilcakes, as well as
castor oil, cotonseed oil and
vanaspati; gold and silver.

Transferable Specific Idem as under Non-
Delivery Contracts transferable SpecificDelivery
Contracts, with 24
commoditiesadded -
including khandsari, cotton
yarn and cloth, a number of
spices, and copper, zinc, lead
and tin.
Coconut oil, copra, cottonseed, Raw jute and jute goods.
groundnut,groundnut oil,
kardiseed, kardiseed oil,
sesamum, sesamumoiL kapas,
cotton and staple fiber yarn.

Hedge contracts Idem as under Transferable
Specific Delivery Contracts.
Coconut oil, copra, cottonseed, Black pepper, castorseed, gur,
groundnut, groundnut oil, hessian, potatoes and turmeric.
kardiseed, kardiseed oil, linseed,
sesamum,sesamum oil, kapas,
cotton and staple fiber yam.

trading is legally recognized, but either no associations have been recognized for trading4 , or the
recognizedassociationshave not been grantedthe pernission to trade5.

2.11 Several entities, however, are exempted from the provisions of the Act. They include the
Governmentof India and State Governmentsand their corporationsand agents; groundnut famners,for
the sale of groundnutsproducedby them; and exporters,for contractssignedwith foreignbuyers.

2.12 The FC(R) Act establishesa three-tiersystem of cortrol: 6

* the Governmentof India,
* The Forward MarketsCommission,and
* the recognizedand registeredassociations.

2.13 The Forward Markets Commission. The Forward Markets Conmission (FMC) was
establishedby the Governmentof India as a statutory body, in which GOI appoints its members. The

4Forward contracts in sesarnum, sesamum oil, copra, kardiseed, kardiseed oil, cotton seed and staple fiber yarn are
in principle allowed, but the Government has not yet granted recognition to any association for trading these
contracts.

5This is the case for groundnut, groundnut oil, coconut oil, cottonseed, and linseed; castorseed for NTSDs

6 This is simnilarto regulatory policy in Europe and the United States, where there are two major tiers of regulatory
organizations. In these countries, government regulatory bodies oversee the establishment of exchanges, the approval
of contracts, the setting standards for market participants, creation of market oversight, and sometimes the setting of
position limits. The trade-related or commodity-exchange bodies focus their control at the exchange operations level,
to prevent market manipulation, trading outside the ring, illicit trading practices, and exceeding position limits, etc.
 14

FMC is under the administrativecontrolof the Ministiyof Civil Supplies, ConsumerAffhirs and Public
Distribution.The main functionsof the FMC are to:
* Advisethe centralgovernmentregardingthe recognitionof associations;
* Monitorforward marketsand take necessaryactions;
* Collectand publish informationregardingtrading conditionsfor commoditiesto whichthe
Act is applicable,and submitperiodicalreports to the Governmenton the operationof this
Act and the functioningof the forwardmarkets;
* Make recommendationswith a view to improvethe organizationand functioningof forward
markets; and
* Inspectthe accounts of recognizedassociations.

2.14 The FMC has broad powers to inspect the associations and their functioning. The Act
empowersthe FMC to access all books, accounts and correspondenceheld not only by the management
and members of the exchanges,but also all Table 2.2
persons or groups who have had dealings RecognizedAssociations For Castorseed,
with the managementor members. It can Cotton, Gur & Potatoes by Stas, 1995
suspend a memnber from his/herCotnGr&PtaesLas,19
membershipof a recognizedassociation, or
prohibit such members from entering into Andhra Pradesh 1
newcontracts.
Gujarat 2 3

2.15 ExchangeAssociations.There are Haryana I

29 active associations recognizedunder the Madhya Pradesh 2 1 I
Act to organize and regulate forward Maharashtra I I
trading in various commodities(Table 2.2). Punjab 1 3
Only one associationis to be recognizedin Tamil Nadu I
a city or region for forward contractsin any UttarPradesh 4 3
single commoditygroup, with the view to Source: Forward Markets Commission, Bombay
minimizecompetitionbetween associations.
Several commoditiesare traded by only one exchange: pepper in Cochin, Kerala; turmeric in Sangli,
Maharashtra; and jute, jute goods and hessian in Calcutta, West Bengal. Other commodities,such as
castorseed, cotton, gur and potatoes, are traded by a large number of associations spread over the
countiy, with potatoes and gur generallybeing traded on the same exchanges.

2.16 An associationhas to apply for recognitionfrom the central government. Taking into account
public and the industry's interests,the governmentmay or may not approve the application. In general,
recognition is granted for only a short period at a time -six months to three years. The central
governmentalso retains the right to withdraw its recognitionat any time.

2.17 The recognizedassociationsand their membersmust submit periodicalreports upon request of

the FMC. The associationsalso send regular reports to the FMC on prices, open positions, and margin
payments, generallyon a daily basis (by telegraph),as well as its annual report, according to a fornat
prescribed by the FMC. The members of recognizedassociations submit trading returns on a weekly
basis, indicatingtheir volumeof transaction,open positions, and names of clients (if it wishes,the FMC
can requestthese returns on a dailybasis).

2.18 The Associations' Rules and Regulations. Recognizedassociations are responsible for the
day-to-day operationsof the futures markets:they set the standards and rules of trade; register prices;
 15

work as clearing houses,includingthe collectionof marginmoneysand settlementof closedtransactions;

distributedeliverynotices;etc. All associationshave their trading-by-laws,memorandumand articles of
operationsgenerallymodeledafter British and Americancommodityexchanges. They have the power to
vet new members,and redraft the bye-lawson conditionof approval by the government,which also has
the rightto direct an associationto amend its bylaws.

2.19 For most commodities,trading in futures contracts is only allowedin the exchange trading ring
during officialtrading hours. Those in the ring (the "ring traders") represent firms that are members of
the association. These ring traders can be appointedon an ad-hocbasis by a member,and each member
is allowed to have several ring traders (up to a maximum, of 7 on the BOOE). Members are fully
responsiblefor all transactionsentered intoby the nrngtraders nominatedby them.

2.20 Several instruments are used by the associationsto regulate the behavior of traders. These
regulatory instruments can only be applied with the concurrenceof the FMC, although they can be
recommendedby the board of the exchange. These include:

* Ordinary margins. These are deposits paid by members on their outstanding or

"open" positions. Margins are payable at a government-specifiedrate per unit,
which is revisedperiodically.These margins are collectedby the clearinghouse as
a financial safeguard against possible default by a member if prices move
adversely.

* Special or automatic clearing. This serves to protect the clearing house against
the risks involvedin abrupt and sharp price fluctuationsand is stipulated in bye-
laws of the exchanges.

* Special margins.These margins seek to restrain price movementsbeyond certain

levels of prices knownas the "margin lines". Table 2.3 illustrates an example for
the castorseed Table 2.3
September 1994 Special margins for castorseed,
contract. For most September 1994 (Rs/100 kg)
new contracts,
exchanges have to
propose a schedule |
of special margins, 850 170 1300 260
that is often 800 240 1350 405
tightened by the 750 375 1400 700
FMC. In the case of Source: The Bombay Oilseeds & Oils Exchange Ltd., 67th Annual
castorseed,if prices Report & Accounts,Year 1993-1994.

fall below 850 Rs/100 kg and the speculativeshorts are unable to pay the required
special margins,they are forcedto liquidatetheir positions,thus pushingup prices
through their purchasing operations. Conversely, when prices increase beyond
1,300 Rs/100 kg, speculative longs are forced out of the market. Exporters who
can submit an export contract hedgedby futures contracts and stockholderswho
show they are hedgingan inventorycan receivean exemptionfrom the payment of
special margins.

* Withholding outward payment of profits. This makes it more difficult for

speculatorsto use their profitson their open trades to expandtheir positions.
 16

* Limits on open positions. Operators in futures market are pefmfittedto hold or

control an open position in excess of the limit only when they are legitimate
hedgers, such as exporters who can show export contracts, stockists after
submitting inventory statements. Even then, they are confronted with higher
marginpaymentsfor their open positionsexceedingthe open position limit.

* Suspension of trading. When an emergencyarises in the market, it takes some

time to judge its character, ascertain its causes and devise measures. During that
time, the regulatoryauthoritiescan suspend trading.

* Prohibition offresh trading. If serious difficultiesare anticipated,members can

be prohibitedfrom entering into fresh commitmentswith each other; they can only
liquidateoutstandingpositions.

* Skipping of trading in some delivery months. Wheneverthere are serious doubts

about the smooth and orderly running of a futures contract, the posting of a new
deliverymonth can be prohibited.

* Limits on pricefluctuations. These can be imposedeither whenprices rise or fall

or both, on a daily or weeklybasis.

* Maximum and minimumprices. The governmentcan prescribe these to prevent

futures prices from rising above the levels not warranted by what the government
considers as genuine supply and demand factors, or from falling below levels
consideredas unremunerative.

* Changes in the tenderable varieties. The varieties tenderable against futures

contract are generallylaid down in the bye-laws. If it appears a certain group is
tying to comer the market, the list of tenderable varieties can be expanded.
Similarly,some of the varietieswhich are tenderablecan be deletedfrom the list to
counteract a possible "bear raid". This regulatory tool is rarely used, most
recentlyin the turmeric market in 1988.

* Closure of contracts. If the market cannot be controlled by any of the above

methods, the closure of the outstanding contracts in the market at the time of the
crisis can be ordered.

* Prohibition offutures trading. When prices are rising continuouslywithout any

immediatesign of a reversal,the govermnentmay decideto prohibitfutures trading
altogether. It is believedthat this willhelp controlthe increasingprice trend.

C. The Structure of CommodityExchanges

2.21 Commodityexchangesin India are organized as so-called"recognizedassociations"of traders.

The associations have a partly elected Board of Directors, who supervise a number of exchange
commnittees (Figure 2.2). The secretary, who is appointed by and reports to the Board, is responsiblefor
daily operationsand administration. Most of the recognizedassociationsare without share capital, with
members paying an admissionfee, a membershipdeposit, and an anmualsubscription. Some are set up
as profit orientedventures, owned by a number of shareholders,and earningtheir income by providing
 17

trade facilitiesto members. Most exchangeshave membershiplimitedto those who have their place of
business in the city or state wherethe associationis located.

2.22 The Board of Directors. The Boardof Directorsenforcesthe various rules and regulationsof
the exchange. The Board is empoweredto fix the margin rates, upon approval by the FMC; to prohibit
trading on any day if the prices of a futures contract changeby more than a predeterminedlevel; close
the market for up to 3 days; with the concurrenceof the FMC, to fix limits on the open positions of
members and non-members;to prohibit trade above specifiedmaximum or below minimumprices; and
to forciblyclose out all outstandingcontracts.

Figure 2.2
OrganizationalStructure of Commodity Associations

Association
Board of Directors

Secretary

Admninistration
* Accountsand Finance
* Personnel & Administration
* Publications Department
* Margin and Clearing
Departnent
* Intemal Audit

leag Non-
Ring House Daily Rates Arbitration Vigilance member Inquiry Appellate
_Committee _Committee Cmmitee Committee Conmitee Com itee Committee Committee

2.23 The Board of Directors is generally divided into two or more panels, each representing the
various stakeholders in the exchange. The Bombay Oilseeds Exchange (BOOE), for example, has
four panels: brokers, dealers, crushers and exporters. The India Pepper and Spice Trade
Association has panels of exporters and dealers. For each panel, Directors are elected to one year
terms in general. The elected Directors then co-opt one or more outside Directors, while the
Ministry of Civil Supplies may nominate a number of Directors to represent farmers' interests,
often officials of the Forward Markets Commission, and "eminent economists" to represent the
public at large. In many instances, the Government has failed to nominate Directors, and these
posts have remained vacant.

2.24 The Exchange Administration. The secretary is charged with managing the day-to-day
operations of the exchange. The administrationof a few exchanges includes a margin and clearing
 18

department and an internal auditing department,although the books of all exchanges are also audited
amually by external accountants.. The formeris responsiblefor collectingmargins from members after
each clearing and managingthe member accounts. It does so through the clearinghouse account of the
exchange,which is used only for clearingsettlements.

2.25 The Committees. The committeesare set up by the Board of Directors to perform specific
functions.They are composedof associationmembers,and one or more Directors. The responsibilities
of the various committeesare describedbelow:

* Ring Committee Oversees activities in the trading ring, with a ring

superintendentwho records the opening, highest, lowest
and closingrates of the contract.

* Daily Rates Committee Fixes the daily settlernentprices of the futures contract, as
wellas the daily spot prices.

* Clearing House Committee Oversees clearing house operations, can meet daily, but
most exchangesonly have weeklyclearing.

* Arbitration Committee Also called the "conciliation committee" in the BOOE,

decides on disputes among members or between members
and non-members (with the appellate tribunal, or in the
case of the BOOE, the arbitration committee,providingthe
possibilityof recourse).

* VigilanceCommittee Empowered to verify the books and accounts of

members and non-members, and to investigate any
reported violation of the provisions of the exchange's
bye-laws, rules, regulations, orders, etc.

- Inquiry Committee Verifies hedge exemptions claimed by members on the

paymentof specialmargins.

* Non-Member Committee Decides whether individualswhich wish to trade through

memberscan indeeddo so.

2.26 ExchangesProvide a Number of Public Services. All the exchangescollect daily statistics
on commodity prices in their markets, which are widely published in India's press. Normally, the
associationsalso monitorspot trade. They play a more general role as forum for traders and processors.
Most gather and distribute information and market intelligencefor their commodities, while a few
publish trade journals, statistical overviews, yearbooks, and other materials. They generally provide
facilities for quality surveys and contract arbitration. They also represent the interests of their
constituencyin discussionswith the government.
 19

D. A Brief Overviewof Selected CommodityExchanges

The Cotton CommodityExchanges

2.27 Cotton lint was the first commodityfor which futures contracts were introduced in India, with
the first organized market forned in 1921. In the 1920s and 1930s, futures and option contracts on
several types of cotton lint were activelytraded in two different associations,and futures trade in the
largest of these, the East India Cotton Association (which organized export-orientedtrade) was of
international irnportance. Futures trade in cotton again became important after a short interval in the
1940s in which all futures trade was banned. From 1952 to 1966, several exchangesin the country
showedan activetrade in futures in cotton and also, between 1964 and 1970, in kapas.

2.28 Currently, only NTSD contracts in cotton are allowed, and regulated by nine recognized
associationsspread over the country (Table 2.4).

2.29 Contract Specifications. Six contract Table2.4

periods are traded every year, each coveringtwo Recognized Cotton Associations in India
months. Contracts can only be traded up to six l_
months out. Aside from NTSD contracts in Ahmiedad Cotto Memats Association Ahnedabad
cotton, only the non-regulated "ready" (cash) AmndhPradeshCoton Association Guitur
trade is allowed. Being non-transferable,the CentralGujaratCottonuDeales Associaion Vadodara
NTSD contract specifications are not Central ianCdCton Association Ujain
standardized. Trade does not take place in a Coton Association Indore
trading ring, but directly between members; East IndiaCottonAssociationLtid(EICA) Boibay
however, standard forms supplied by the Nothernmidia CottonAssociationLtd Bathida
exchange are used, and all trade has to be Sod IndiaCottonAssociation Coinbatore
reported. No margins are deposited. SouthemGujaratCottonDealersAssociation Swat

2.30 The Bombayexchangehas a nationwidemandate with cotton varietiesfrom all over the country
being traded, whilethe others have a more regionalmandate with trade only allowedin a small number
of cotton varieties. The largest exchanges -Bathinda, Bombay and Coimbatore-- have over 400
members, while the smaller ones, such as in Indoreand Guntur, have over 200 members. Most Indian
cotton traders, be they brokers, merchants or commission agents, are mernbers of one or more
associations.

2.31 Contracts' Turnover is Small, Highly Seasonal, and Trade For a Few Months Forward.
The total volumeof NTSD contractsreportedlytraded at all recognizedexchangeshas remainedmore or
less stable since 1990, at an average of 1.8 million bales (each of 170 kg) a year, or about 15% of
India's cotton production. Significantunreported trade in NTSD contracts is said to take place. The
Bathinda, Bombay and Coimbatore exchanges account for about 90% of NTSD contracts turnover.
Both in Bathinda(in the Punjab, in the heart of one of India'scotton producingcenters) and Bombay (the
traditional transit point for both domestic and external trade), trade in NTSD contracts is highly
seasonal. In Bathinda, during the period 1990 to 1993, on average 52% of the year's trade is in only
two of the annual six contracts, namely the contracts for November-Decemberand January-February
delivery. In Bombay for the same period,the two deliveryperiods plus March-April,account for 64%
of total volume. Trade in Coimbatore'sexchange,servingthe sizable textile industryin and around this
southem Indiantown, is better distributed,with only the November-Decembercontract being minimally
traded.
 20

2.32 NTSD contractsallow deliveryup to six months out. However,most trade is in nearby delivery
months, with the vast majority being no more than three months forward. For example, in the most
liquid months,up to 50-60% of NTSD contractsare in the nearby months. In contrast, only 10-15% of
NTSD contractsare entered into more than two months beforethe start of the contracts'deliveryperiod.

The Gur CommodityExchanges

2.33 Elevenexchangesare recognizedfor trade in gur hedge contracts (Table 2.5). The most active
exchangesare in Bathinda (31% of total turnover in the May 1992-April 1994 period), Muzaffarnagar
(26%), Hapur (20 %) and Agra (11 %). The exchangesin Ludhiana and Meerut, each with around 4%
of the total trade volume,are also reasonablyactive. The other five exchangesshare less than 3% of the
hedgecontractsturnover.

2.34 High Market Turnover. Table 2.5

Turnover in all the exchanges totaled on RecognizedGur AssociationsIn India
average 9 millionMT of gur a year in the
period 1990-1994.This can be compared AapaAgro ProductMandiPvt Ld Deb
to a physical production of 7.7 million BathindaOm and Oil Exchangeld, Bathinda
MT on average. In value terms, trade in Bullon and AgnicultralProduceExchangeLtd Agra
gur hedge contracts is the second largest CentralIndiaComnmercial
ExchangeLid Gwalior
in India --after the hessian contract traded ChamberofCommerce Hapur
in Calcutta- with a 1994 turnover worth IndianExchangeLtd. Amritsar
Rs 5,000 million. The three main LudhianaGrain ExchangeLtd Ludhiana
exchangestrade over 2,000 contracts per Meent Agro CommoditiesExchangeCompanyLtId Meenut
day each on most days. Trading is fairly RajdhaniOils& OilseedsExchangeLtd Delhi
well distributedover the year. MAk Kishna TradingCompanyLd Rohtak

2.35 Contract Specifications. Four VijaiBeopar Chamber Ltd Muzaffamagar

contract months are traded each year, for delivery in March, May, July and December, In principle,
contractsfor up to 8 months out can be traded. Each contract is for 4 metric tons, with the basis variety
varying accordingto the exchange. Each exchangehas between 4 and 12 deliverycenters.

The Oilseed CommodityExchanges

2.36 Futures contracts in oilseeds, oils and meals were introducednot much later than cotton, and
were activelytraded until the early 1960s. They were banned gradually during the 1960s, and the last
two remaining contracts, in castorseedand linseed,were disallowedin 1977. In 1985, the ban on the
castorseedhedge contract was lifted.

2.37 Four Recognized, Active Associations. Nine exchangesare recognized for trading futures
contracts in oilseeds, including castorseed, coconut oil, cottonseed,groundnuts, groundnut oil and/or
linseed. However, hedge contract in Table 2.6
castorseed only is permitted, restricting Active Oilseed Commnodit Associations
trading to only four recognized exchanges ...... ............
(Table 2.6). The other five recognized 7A_uM__e
associationsare inactive. Amongthe active AaWd SePduMandsAoitiLha
exchanges,
Bombay
the and Abmedabad SeedsMerchants'
i~~~Abtedabad Association
Ltd Ahmnedabad
exchanges, the Bombay and Ahmedabad Bmbay Oilseedsand Oils Exchage L Bombay
exchanges are tme oldest, dat og aack
to
pre-Independencetimes. The Rajkot andu aktSesOladBiir ecat'Rio
 21

Delhi exchangeswere recognizedfor trade in castorseedcontractsonly in 1991 and 1992,respectively.

2.38 Contract Specifications. Four hedge contracts are traded per year, for March, June,
Septemberand Decemberdelivery. Contracts can only be traded up to six months forward. The unitof
trading is 5 MT, and each of the exchanges defines specific basis and deliverable qualities. The
exchanges have from 11 to 56 delivery locations. In the case of BOOE, they are spread around the
country.

2.39 High Market Turnover. Trading in castorseed hedge contracts is very active in the four
exchanges. Despite its recent establishment,trading on the Rajkot exchange expandedconsiderablyto
rival within a year with the Ahmedabadexchange. Between 1992 and 1993, the Ahmedabadexchange
accounted for about 46% of total turnover, against 40% for the Rajkot exchange, and 10% for the
Bombay exchange. The Delhi exchange accountedfor the remainder. In relativeterns, the volume of
castorseedtrading is very large --3.6 millionMT were traded on average per year during 1990 to 1994,
reachinga peak of 5.5 millionMT in 1992- far exceedingthe annual productionwhich ranges between
500,000 and 750,000 MT. In general, the Ahmedabad and Rajkot exchanges each transact over a
thousand contractsper day. The Bombay exchangehas a nationwidemandate,with 56 deliverycenters
throughout the country: in Gujarat (includingAhmedabadand Rajkot), Andhra Pradesh, Maharashtra,
Bihar, Kamataka, Rajasthan, Uttar Pradesh and Madhya Pradesh. The deliverycenters in Ahmedabad
and Rajkot allow effectivearbitragebetweenthe three exchanges.

The Pepper CommodityExchange

2.40 India's pepper futures market trade is the only surviving pepper market in the world. In the
1930s, an early attempt in New York failed. The India Pepper and Spice Trade Association(IPSTA),
which manages the Cochin pepper futures exchange, reports an annual futures tumover of between
100,000and 110,000MT, more than doubleIndia's black pepper production. The exchange is used for
pepper futures trading by some larger farmers, town dealers,the larger interstate dealers and exporters.
Most of India'smajor pepper exportersare membersof the exchangeand use it regularly.

H. The User Compositionof IndianCommodityExchanges

2.41 The Indian User CompositionUsers Mirror InternationalExchanges. Indian commodity

exchanges which were visited during our field survey present a user composition similar to that of
westernexchanges.7 Half of the trade is estimatedto be speculative,half of which is conductedby day-
traders or "scalpers"8 . Scalpers earn their incomethroughtheir daily tradingtransactions, and contribute
significantlyto the liquidityof the exchange. The remaininghalf of the trade is hedging, with traders
being the most active. The various categoriesof users are discussedin more detail below.

2.42 Farmers Rarely Use Futures Markets, But Stand to Benefit Indirectly.Farmers in India
rarely use futures markets directly. This is similar to the United States, where futures markets have
operated for a long time, and where only a small percentage of farmers use futures or option contacts
directly. Indian farmers would benefit indirectly from using cooperatives or other iteriaries, or

7It should be noted that no detailed records of categories of users are kept or made public by the exchanges, unlike
in the case of the Commitment of Traders Reports in the United States.

8 Day-traders buy and sell during the same day, trying not to keep any positions open overnight.
 22

simply from better deals with traders using futures markets. The conditions exist for the indirect
participation of Indian farmers on futures markets, since in most states, farmers sell their commodities
through the "regulatedmarkets." In the regulatedmarkets, key commoditiesare auctioned-off,and the
price informationis displayed. Commissionagents operating in regulatedmarkets could play a useful
role in providinginformationand intermediatingrisk managementtransactions. Farmers' cooperatives
could also intermediaterisk managementtransactionsfor their members. Apart from lack of familiarity
with futures trade, regulatory barriers prevent cooperatives from using commodity exchanges: i) the
sales tax registrationrequirementfor membersof exchange,and ii) the fact that most cooperativesare in
effect state organizations,and accordinglyare not supposedto "speculate." It is unlikely,however,and
not evendesirablethat farmers trade directly in futures markets.

2.43 TradersAre the Largest Users, But The Extent of Their InvolvementRemains Marginal.
Traders, both large and small, are the main users of futures contracts in India. For gur, oilseeds or
pepper, there is an active participationof town dealers. For castorseedand pepper, most exporters are
active in the exchanges. Nevertheless,for most traders, the percentage share of trade they hedge through
the futures market remains small. Large exportersare confrontedat times with low exchange liquidity,
while smallertraders, because of poor access to credit,cannot afford to tie their funds in futures markets
for long periods.

2.44 Regulations Limit Speculationto Small Speculators. Virtually all speculators in Indian
commodity exchanges are relatively small, either day-traders or individualstrading through brokers.
Large, institutional investors, such as pension funds, insurance funds, and mutual funds are
conspicuouslyabsent. Their participation in commodityexchanges is not allowed under the Reserve
Bank of India regulations which stipulate the prudential norms for banks and non-banking financial
institutions. This is similar to the policy of the Securities and Exchange Board of India (SEBI) which
regulates participation by mutual funds on the stock exchange. In addition, commodity exchanges
regulations,by requiringall membersto acquire a local sales tax registration,also serve as an obstacleto
participationof the large, institutionalinvestors. Funds are unlikelyto be interestedin trading through
the generallysmall and poorly capitalizedbrokerswho dominateIndiancommodityexchanges.

2.45 Agro-Processors Rarely Use Commodity Exchanges Because of Their Deficiencies of

CommodityExchanges. Processors and manufacturersuse the exchangesto a limited extent for two
main reasons. First, some of the manufacturers,especiallyin the oils sector, are so large that they would
not be able to lay off a significantpart of their risks on domesticexchanges, which suffer from chronic
illiquidity. Second,the range of commodityfutures contract offeredis too small resulting in incomplete
risk management markets. Under such incompletemarkets, companies do not find it worthwhile to
manage risks in a highlyimperfectmanner. For example,many firms do not findthe castorseedcontract
useful, since few manufacturersuse castor oil and it is an imperfectrisk managementinstrument for
other oils.

2.46 InternationalUsers of Indian Commodity Exchanges Are Banned. Foreign trading firms
participated in some of India's commodityexchanges,until their participationwas banned. Currently,
Indian exchangesare not allowedby the FMC to accept foreign members,and they would need to seek
permnissionfrom the Forward Markets Commissionand amendtheir bye-lawsif they wish to changethis
situation.
 23

Summary

2.47 Commodity futures exchangeshave a long history in India. From the rapid multiplicationof
exchangesin the 1920s,the changingeconomic,policy and regulatoryenvironmenthas since drastically
reducedthe number of active exchanges,agriculturalcommodities,and types of contractswhich can be
traded. Presently,futures trading is permittedfor nine, mostly minor agriculturalcommodities. Three
types of futures contractscan be traded: (i) NTSD contracts--cotton,raw jute and jute goods (sacking);
(ii) TSD contracts--rawjute, jute goods and hessian; and (iii) hedge contracts--castorseed,gur, hessian,
pepper, potatoes, and turmeric. The changing compositionof agriculturalproduction and the evolving
policy and regulatory framework have also significantlyinfluencedthe pattem of developmentof the
exchanges. The followingchapter examinesthe performance of commodityfutures trade in India and
the factors which influenceits performanceand development.
 3 THE PERFORMANCE OF COMMODITY
3 FUTURES TRADE

3.1 Commodity exchange performance in India vanes considerablyacross exchanges trading the
same commodity contracts, and across commodities.This chapter will first examine the operational
performance of commodityexchanges. Their operational performance will be assessed in terms of
market liquidity,suitabilityof contracts, fairnessand efficiencyof trading practices,security providedby
clearing procedures,effectivenessof deliveryproceduresin linkingphysical and futures markets prices,
supporting infrastructure, and adequacy of their current promotionaland developmentalcapacities. In
the second section, the report will examine successivelythe impact of direct and indirect government
policieson the observedoperationalperformanceof commodityexchanges.

A. OperationalPerformanceof CommodityExchanges.

Marketliquidity

3.2 Definition. Markets have to allow commercialhedgers to lay off their risks without undue
problems. A market is liquid if normally-sizedtransactions can be executed within a short period,
without significantimpact on price levels. If transactions can be filled reasonablyonly over a period of
severaldays, or immediatelyresult in price movementsor "slippage",the market is said to be illiquid.

3.3 The Main Gur and CastorseedFutures Marketsare Liquid. The gur and castorseedfutures
are both liquid, but differ in their degree of market liquidity. The gur market is highly liquid. While
most physical trade in gur is in relativelysmall quantities, the market trades over 8,000 MT per day.
Thus, an order of 100 MT is unlikelyto cause any problems. In contrast, the castorseedmarket is not as
liquid. The two larger exchanges only trade some 5,000 MT per day. This trading volume poses
problem for exporters since equivalentto the amount neededto hedgethe price risks of a typical single
export cargo of castor oil --4,000 to 5,000 MT. To overcomethis constraint,exporters execute orders
for large quantitiesby combiningvarious markets and proper planning. They also report that it is not
difficultto roll-overpositionsof some 5,000 MT into a next contract month'1.

3.4 Poor LiquidityHas CausedProblems on the Bombay Castorseed Market. Strong market
movements, combined with insufficientfinancial strength of market users, resulted in severe liquidity
problems in castorseed trading in the BOOE in March 1994. Prices for the March delivery contract
started increasingstrongly in January 1994, and on January 18 the BOOE Board of Directors wamed
brokers to exercise restraint in building up large open positions, in particular for the account of
potentiallyunreliablenon-members. Two days later, trade in the BOOE halted completelyas two of the
main non-membersholding open positions communicatedto their brokers their inabilityto meet their
obligations. The heightenedfears for defaults stopped trade and the brokers were unable to liquidate
their positions. The physical market prices continuedrising, and there were fears that when the short
positionscould finallybe closedout, brokerswould be unable to assume the losses. On January 22, the

I That is, a hedge is extendedby buyingor selling the nearbycontracts,and undertakingthe oppositetransactionin
the next contractmonth;if roll-overswork well, one can get price protection,say, 1 year out evenif futurescontracts
are onlyofferedup to 6 monthsout.
 26

Board decidedto declarea state of emergencyin the market, and closed out the outstandingcontracts in
the March deliverymonthat a negotiatedsettlementprice.

3.5 Inadequate Regulations Compound The Poor Liquidity of Indian Exchanges. The poor
liquidityof Indianexchangesis compoundedby inadequateregulations.In particular, no rules govem the
relationshipbetween brokers and their clients. It is entirelyup to the brokers to collect margin moneys
from their clients. Financial safeguards between brokers and the exchange are also inadequate. The
BOOE respondedto the above crisis by establishinga Rs. 50,000 securitydepositfor every broker, and
by increasing the security margin deposit for larger positions. Despite these increases, the security
deposits and security margin deposits for, say a 500 MT position, would equal only about 5% of the
market value of this position,somewhatlow by internationalstandardsgenerallyaround 10%.

Suitabilityof IndianFuturesContracts

3.6 NTSD Contracts Are Highly ImperfectRisk ManagementTools. The stringent limnitations
imposedon NTSD contracts by the FC(R) Act make themhighly imperfectrisk managementtools. This
explains the small share --15%- of physical trade covered by NTSD cotton contracts, their highly
seasonal nature, and the fact that most contracts are only for up to three months. NTSD contracts tum
out to be rather risky forms of forward contractsunder presentregulations. Once a companyhas entered
into a NTSD contract, say for delivery in six months time, it cannot get out of the contract or even
renegotiate its specifications. Cotton ginning mills, for instance, often sell their lint forward in the
expectationthat they will be able to buy the seed cotton at an attractive price. If the harvest turns out to
be lower than expected,the mills who entered into forward contracts have no choice but wait until the
contracts' due dates. The only exception to this is when a general production crisis would cause a
general default, a situation in which the commodityexchange board can decideto forciblyclose out and
settleall outstandingcontracts,at a negotiatedprice. Such a forcedclosureof contracts --experiencedby
the Northem India Cotton Associationin Bathindain late 1994--causes significantdistress and results in
large financiallosses. It also reducespublic and governmentconfidencein futures markets.

3.7 Such a default crisis would not occur under standard, internationalfutures contracts definition.
As soon as the news of a disappointingharvest is known, futures prices increase. Those who sold
contractswill have to close them or pay extra margins. The clearinghouse of the exchange guarantees
contract perfonnanceand secures itselfthroughthe margin paymentsit receives. Defaultwill be avoided
automatically:speculativemills would be forced out of the market relatively fast and will be unable to
stay with an open position until the situationbecomesunbearable.

3.8 The Poor Suitability& Limitedrange of PermittedFutures Contracts Prompts an Active

IUegalFutures Trading.In responseto the legitimatehedging needs of cotton gins, a significantillegal
trade in seed cotton and cotton futures is reported to have developed with its main center in
Surendranagarin,whereV-797 cotton futures are traded primarilyaround harvesttime, but also in other
centers. This illegal trade appears to be relativelywell-organized:participants pay margins in case their
positions move against them, and default rates are reportedlyquite low. This futures trade takes place
outside of the law, exposingparticipants to counterparty risks. Moreover,the general public loses the
benefitsassociatedwith pricediscovery.

3.9 The risk managementneedsof commercialusers also spawned illegaltrading in oilseedsfutures

contracts, notably for groundnut oil (in Rajkot, Jamnnagar,Dhoraji and other centers) and mustard oil
 27

(such as Delhi, Hapur and Agra). According to a 1986 study, 2 it was found that somne60 operators
actively traded in oil futures in Rajkot, prior to its recognitionby the Forward Markets Commission,
closely resemblingformal exchange operations,with standardizedtrading rules and open outcry. Most
of the business served the risk management needs of genuine groundnut oil traders, millers and
wholesalers; speculationwas relatively unimportant. This illegal trade worked quite efficiertly, with
rules for cash-settlement,weeklymargin payments, and significant investmentin tele-communications.
Most offices in the market were linkedthrough internal telephones,with each office having at least six
telephones.The market also had 30 telex machines. About 70,000 calls were reportedly made each
working day betweenthis exchangeand other mnaincities.

Trading practices

3.10 The Open Outcry Trading System Is Appropriate. All conmmodityexchanges in India
function through open outcry, a seeminglychaotic but highly efficient and low-cost form of futures
market trading. Traders in a trading ring make bids and offers through shouts and hand-signals,and the
first to react gets the deal. Trading orders come in from outside,through telephoneclerks who represent
brokers who, in tum, are in contact with hedgers and speculators, often nationwideand in continuous
contactwith the trading floor.
BOX 3.1
IS OPEN OUTCRY OUTMODED?
Ope outy stil prvails throughthe wods ages exa s, although in Japan, Chti, New Zealad, and South Afhica,trade is
predominantly
throughan electronictradingsystem.In electronicexchanges,marketuses are connced thrgh computerterminalswith
a trading system that automatically matches bids and offem. Large exchanges in the ULnitedStates ad Europe have also developed
electronic wading systems to twadeoutside of their normal trading hours. Elecironictrading systems have high set up costs, but make it
very cheap to introduce new contracts. Some stock exchanges, including the one in Bombay, use a mixed elecronic/open outcry system.
Under this nixed system bids are relayed by monitor, and its reactions by open outcry, ring officials ar reponsible for constantly
matching the two parts of trade. This trading system could also be used for linking two open-outcry exchangesin the same time zone.
Is the open outcry system of India's exchanges out-moded? There is no compelling reasm for te eXisting,open outcry
exchnges to shift to another system. Whether new contracts should be traded electronically is a moe complicabtd queation, For opet
outcry trading one needs trading infrastnrcture: a trading ring, oesby offices and good teeconcatiom systeis. Electronictrading
can be done fromthe officesof the members;if there is an efficienttelephonesystem,these officescan then be linkedusingone of the
electronictradingsystemsalreadydevelopedby other exchanges. Open outcrytading atracts smalt floor traders,who are key in
prviding for marketliquidity,on theotherhand,electronictradingattact largerusersbeceise of te anonymityit provides.
In India,it wouldstill appearthat the openoutcrysystemis the mostefficientevenfor new contracts.In mostinstances,the
physicalfacilitiesalreadyexist,alongwi the correspondingconcentration of tradersandbmroen,Moreover,the scopeof increasingthe
numberof floorbrokersremainslarge. It wouldbe erroneousto electan electronictradingsystemonlybecauseof its high-techimage.
A mixedsystemcouldbe introducedfor linkingcommodityexchanges.Eveninthis instance,however,it shouldbe notedthat
the existingsystemof informationgatheringand orderplacementbytelephoneappeas to finctionwell. The gurmarketswhichare all
openat the sametime,for instance,appearto be wellintegrated,withsomekeytradernandbrokenin each exchangeremainingin constant
touchwiththe othermarketsand undertakingarbitragewhenthe situationwarrantsit. In principle,thereis no reasonwhy,fir example,a
numberof cottonmarketscouldnot be effectivelyintegratedthrougha brokeragenetworl. A mixedsystemwouldmakemore sensefor an
internationallinkage;the chargesof a leasedline betweentwo exchangeswouldthenhaveto be comparedwiththe chargesof individual
telephonecallsby potentialmarketusers.

3.11 Open outcry in the exchangesvisitedfunctionedwell (Box 3.1). Market participantsshowed all
the required skills. The trading sessionswere fast and competitive,with participantsengagingin a rapid
play of hand-signalsand shouts; deals were registeredinstantaneouslyon standard forms. Participants
understoodthe principles of arbitrage, put on straddlesover two contract months if the price diffrential
between months became too large or too small, and engaged in other more sophisticated trading
strategies.

2 Reported in V.P. Gulati and S.J. Phansalkar, Oilseeds and Edible Oil Economy of India, Delhi 1994.
 28

3.12 Futures Trading Skills Are Being Lost. One major differencewith European and American
exchanges is the age of participants. Indian exchanges have a much older active membership. For
example, most of those with experience in cotton futures trade are close to retirement age. Indian
universitieshave not given priority to futures trade in their curricula. As a result, most of the newer
generationof professionalsinvolvedin commoditytrading and those employedin supportinginstitutions
such as banks, have littleknowledgeand familiarityabout futures markets. These indicatea serious loss
of interestin exchangesand a loss of valuable skills,a reflectionof the strict policy constraintsgoverning
futures markets, as well as a their poor iiage in India. They also underscorethe strong need for training
programs.

3.13. Trade RegistrationProceduresAre Well Laid-out.' Although they differ from international
exchanges, Indian commodity exchanges have clear and adequate rules for the registration of
transactions. Contracts and proceduresneedto conformto the trade practices customaryin the market,
and it would be unwise to copy the rules and proceduresof a major internationalmarket. For instance,
the Vijai Beopar Chamber Ltd., in Muzaffamagar, Uttar Pradesh, prescribes the following trade
registrationprocedures:

* A broker (anyone active on the exchange)has to record a trade immediatelyon a

duplicate form (called a "Kachhi Bahi") as prescribed by the exchange; these
Kachhi Bahis resemblein form and purpose the trade confirmationslips used by
westernexchanges. All such forms have to be kept for a period of three years.
* A transaction not duly recordedis consideredillegal.
* Each broker is supplied a number of serially numbered Kachhi Bahis,
countersignedby the secretaryof the exchange.
* Every broker has to provide the exchange with the original pages of the Kachhi
Bahi on which the transactions are recorded, immediatelyafter the closure of the
market; upon receipt,the secretary,or his designatedofficers,signs the duplicates.
* At the end of the trading day, each brokerhas to record all transactions enteredinto
during the day on a separateform providedby the exchange,in duplicate;he then
has to obtain the signatures of the buyers and sellers,as confirmation,and send a
copy to the exchangebefore noonof the next trading day.

ClearingOperations

3.14 Clearing RequirementsVary Across ExchangesReflectingDifferencesAcross Contracts.

Clearingrequirementsdiffer markedlyacross commnodity exchanges.The cotton exchanges,becausethey
trade exclusively NTSD contracts, only provide a forum for their members to meet and draw up
contracts, and do not provide any performanceguarantees. Exchanges trading TSD or hedge contracts

3 Note that on some exchanges, trade outside the ring is allowed, and this would largely fall outside of normal
controls. In the gur market, trading members are allowed to enter into direct hedge contracts (called "rubru"
contracts) outside of the official trading sessions. Forms provided by the exchange have to be used, transactions
registered within a day, and trade has to take place at a price falling within the price band prevailing on the day the
contract was signed. This is not an unprecedented system. It is standard practice on the London Metal Exchange. As
long as this practice remains limited to traders and does not include brokers, problems should remain small.
Vigilance is however needed to ensure that client orders do not end up in this secondary circuit.
 29

should have clearing houses to guaranteecontract performance,with both buyers and sellers required to
pay a margin to the clearing house account. The larger exchanges, such as the pepper exchange in
Kochi, the turmeric exchange in Sangli, the gur exchangesin Muzzafimagar and Hapur, and the three
main exchanges in Ahmedabad, Bombay and Rajkot, all have clearing houses or arrangements which
would require improvements. Many of the other exchanges,however,do not collectmargins other than
the initialsecuritydeposit.

3.15 Weeldy Clearing Differs from International Norms, Reflecting the Small Scale of
Operations of Most Indian Commodity Exchanges. The clearing houses are departments of the
exchange, not independentlycapitalized entities. They are owned and guaranteed by all exchange
members --not just the larger ones. The castorseedexchangesand most other Indian exchangeswhich
operate clearing arrangementshave weekly clearing.A few of the gur markets and the Cochin pepper
exchange have daily clearing, a common practice with most intemationalexchanges. Exchanges with
weekly clearing have the possibilityof intra-week clearing ("automatic clearing"),if the day's closing
price movedmore than a certain amount away from the last clearingprice. Automatic clearing ensures
that the margin paymentsare sufficientto cover possiblelosses.For example,the margin depositis 3 per
cent in the BOOE. If the day's closingprice is more than 1.5 per cent away from the last clearing price, a
special clearingtakes place.

3.16 The speed at which members have to pay clearing margins also varies across exchanges. The
BOOE determinesthe clearing paymentsafter the close of trade on Friday, and margins have to be paid
before the openingof the trade on Tuesday. Positivemargins are paid out a few days later, on Friday.
In the Muzaffnaagar gur exchange,the clearingmargins establishedat the end of the trading day have
to be paid before the next trading day starts.

3.17 As an additional measure, special deposits can be requested from large market participants.
Extra securityis also built-induringthe deliveryperiod of the contract,when those to whom deliveryhas
been assignedto have to pay a relativelyhigh margin -30% in the case of castorseed. In addition, at
times of volatile prices, special security deposits can be instituted during the delivery period. For
example, for the June, September and December 1993 contracts in the BOOE, those holding open
positions during the delivery period were required to deposit Rs. 75,000 as guarantee, if they held
between 5 and 500 MT, and Rs. 150,000if they held between505 and 1500 MT

India's UniqueDeliverySystem.

3.18 Delivery is Not Mandatory. Indian commodityexchangesfollowa mixed system at the time
of maturity -either deliveryor financialsettlement- which is left at the option of those holding contracts.
This is unlike internationalexchangeswhere no choiceis providedto those holdingcontracts at maturity:
internationalfutures contractsalways specifythe exact method of settlementat maturity -either physical
delivery, or financial. Delivery procedures of Indian exchanges, when they apply, are adequate.
Deliverycan be done eitheron the seller'soption(e.g., for castorseed),or on the option of both buyer and
seller (e.g., for gur). Two approaches are followedin matchingbuyers and sellers.In some exchanges,
contractsare assignedon the basis of the holdingtime (the longest-heldshort contract is matched to the
longest-held long contract, and so on.), which is similar to the one used in American or European
exchanges. In other exchanges,each contractis tracked from the net sellerto the final buyer.

3.19 FinancialSettlementIs Allowed. Contractswhich do not go to deliveryand remain open until

the maturity date, are closed out and settledfinancially.Outstandingpositions are settledat a rate fixed
 30

by the Board of the exchange. Table 3.1 gives an

indication of the relative importance of the two types of Table 3.1
conract close-outon the BOOE. Bombay Castorseed Hedge
Contract, 1990-1993: Amounts
3.20 The Rules on Contract Settlement lack in Tendered And Settled
Clarity and Transparency. According to the exchanges' =
regulations,the Board of Directorshas considerableleeway .

in fixing the settlementprice. For example, the Board of _ B ' S m

the BOOE can fix the settlementprice after taking account 1990
severalvariables,including: March 10 Nil
* Openingprice of the contract; June 50 Nil
* Highest and lowest price of the contract December
September 135
30 130
Nil
during its life; 1991:
* Highest and lowest spot prices during the March Nil 375
contractlife; June 70 Nil
Maturityday'sclosingprice; September 235 320
* Contract prices and spot prices duringthe last 1992:
15daysof thedeliverymonth; March 210 95
* Tendersissuedduringthedeliveryperiod; June 210 660
Outstandingpositionsonthematuritydate September 200 365
* Highest and lowest outstanding positions 1993:
duringthe contractperiod; March 1,085 855
* Spot prices at three major upcountry centers; June Nil 105
and, and, ~~~~~~~~September
December
75
1,220
Nil
70
* Due date rates of the last four matured
contracts.
3.21 The actual implementationprocess,however, appears more transparent. Settlementprices are
determinedkeeping in view the spot market prices prevailing in key delivery centers for 3 to 4 days
before the contract is to mature, and after deductingthe expensesincurredin makingand taking delivery.
The settlementprice so arrived remainssubject to the weeklylimit on price variationsprescribed by the
FMC.

3.22 The Imperfectionsin the Indiandelivery and contractsettlementsystems causes the

artificial backwardation of Indian futures markets. Backwardation --usually a short-lived
phenomenon- occurs when futures prices fall below spot prices. On the gur futures markets where
ceilingson futures prices are set below spot prices, artificial backwardationis allowedto be maintained
by the flexibility which the Indian delivery system helps provide, enabling sellers to avoid physical
delivery,and insteadto settleoutstandingcontractsat a price taking into account futures contractprices.

SupportingInfrastructure

3.23 CommodityExchangeInfrastructureis Adequateto Support Current Needs. The physical

infrastructure of the commodity exchanges, although old, appears adequate to support the existing
volume of futures trade. As membership declined over the years, many exchanges have seen their
incomes declined, making it difficult to invest in new facilities. Nevertheless, the basic
infrastructure of the exchanges visited ( Bathinda, Bombay and Muzaffarnagar) is proper for trade
in futures contracts. The exchanges in Bombay have large trading halls --a new facility in the case
 31

of the BOOE, with recent investment in computer and communications equipment.4 The EICA
also plans to undertake the necessary investments, once the govemment approves cotton futures
trade. The exchanges in Bathinda and Muzaffamagar are not as spaciously housed, but their
facilities are perfectly suitable for a well-functioning futures trade. Their facilities include a central
trading ring, surrounded by brokers' and traders' offices, and telecommunications that operate well,
allowing easy arbitrage with the other markets as well as contact between users, brokers and
traders.

3.24 SupportingWarehousing,Bankingand Legal Infrastructureis Good. India possesses a

good warehousing,bankingand legal systemwhich can facilitatefutures trading.The country has a good
public warehousingsystem, with warehousereceipts --legally recognized 5 -- issued by Central and State

Warehousing Corporations,rural godownsset up under government schemes,and godowns set up by

Regulated Market Yards, which would discourage manipulation.The banking system is reliable, and
apparently,sufficientlyfast and efficientfor the purposesof futures trade. The Indian legal system, such
as Bankruptcylaw, is also supportive of the developmentof futures trading in the sense that contracts
can be effectivelyup-held in court, although delays continue to undennine the effectivenessof India's
strong legal system.

3.25 SupportingMarketing Infrastructurein Transport,Telecommunications,and Grading is

Weak. Weaknesses in the current supporting infrastructure for commodityexchange operations lie
mainly in the telecommunicationand transport system. The domestictelecommunicationsystem is not
very efficient, although most exchanges seem to have found ways to overcome this. Transport,
especiallyby rail, is slow, which could potentiallyhinder the efficiencyof futures trade if a corner is
attempted:it becomesmore difficultfor market playersto bring commoditiesto the deliverylocationsof
the exchange. Ports are slow and their timingunreliable. This will discourage foreigncompanies from
using Indiancommodityexchangesif allowedto do so.

3.26 Another major weakness of India's marketing system lies in the under-developed grading
practices, in spite of the efforts by agricultural marketing cooperatives to introduce and develop
more systematic grading management techniques. The overwhelming majority of agricultural
commodities traded on the regulated markets only undergo visual inspections. Sample testing of
physical attributes, for example in the case of cotton and oilseeds, remains the exception on
regulated markets. In the case of rice and wheat, the public management of vast procurement
operations does not provide the market with the needed incentives to develop an appropriate and
reliable system of grading and quality management. A weak grading system undermines the
reliability and confidence of users in futures markets. In the absence of reliable, standardized
grades, agricultural commodities cannot be valued properly and accurately on the physical
markets, undermining the relations between spot and futures prices and making difficult the
determination of price premiums and discounts to account for quality differences. The absence of
grading practices --and corresponding infrastructure-- stems from inadequate agricultural price

4 This includesa computerlink withKnightRidder,one of the world'smajor informationservices,whichwill make it

possiblefor foreigncompaniesto have instantaneousaccess to Bombayfuturesmarketprices.

5Warehouse Acts exist at boththe federaland state levelsallowingfor the issuanceof negotiablewarehousereceipts
by recognizedwarehouses,which couldthen be pledgedto obtaincheapercredit. Appropriatelegalconditionsappear
to be in place: in case of default, the lender has the powerto take possessionof the commnodities;
responsibilitiesof
warehouseoperatorsare specified;and provisionsare made for a range of potentialproblems(e.g., loss of warehouse
receipt,death,dispute, etc.).
 32

policies which do not provide for the needed economic and financial incentives in the agricultural
marketing chain.

Brokerage Industry

3.27 A Small-Scale Industry. A large number of brokers are active in India's commodity
exchanges. Brokers are persons paid a fee or commission for executing buy or sell orders for a
customer. Brokers are also used for arbitrage transactions, in which a trader or speculator takes
simultaneouspositionsin two differentexchangesto benefit from price discrepancies. In many respects,
the brokers active on the exchangesare quite similar to their counterpartsin western countries. Box 3.2
providesa descriptionof the types of transactionsa typical brokerin a small-townmarket undertakes.
Box 3.2

A TypicalBroker On The Bathinda

Gur Exchange
This broker, active for over 10 years in the gur market, trades on behalf of clients. His relations with clients are thl same as
elsewhere in the world: clients pay deposits and margins when their positions move against them, and in this way, the broker is ifly
secured. The bye-laws of the exchange provide all the provisions necessary for this type of policy. His tumover is only some 2,000 to
2,400 MT;a month, and most of his clients are hedgers,mostly small traders in the region. Through him, his clients could:sell gur etsst.
when they have acquired a large stock of gur and cannot immediately sell it, thus protecting the value of their inventory. Altenatively,
they nught buy futuireswhen prices appear low but cannot obtain gur on the physical market, the broker would then liquiae e&
tpositionsonce they have obtained the gur they need. Clients even undertake cash-and-carry operations, simultaneous ftwes and hysicl0
marketitansactions that helpstabilize prices.
Although commodity exchanges in India operate in much the same way as exchanges in other patts of the warld, commodity
trading is generally not considered a highly respectful career, particularly when the exchanges are subject to frequent police raids.Indian
brokers find it hard to believethat, elsewhere,such an occupationis viewed as perfectly normal and even econonically useful actv1ty.0

3.28 One major differencebetween brokers in India and those in Western countries is the scale of
their operations. Brokers in India usually operate small-scale, personalized businesses. In other
countries, commodity brokerages are often large enterprises, and they undertake a whole range of
activities. Companies,such as MerrillLynch, Goldman Sachs or Refco, are active in many commodity
markets, in financialfutures marketsand often in various other financialmarkets. Even smaller brokers
are activeon many exchanges,and the persons in contactwith the clientswould not typically execute the
orders on the floor. Rather, the orders are passed to another broker (working for the same or another
brokeragecompany). In contrast, brokeragesin India are typicallya one-personenterpriseor at the most
family businesses.As in most of India's commoditytrade sector, women's participation is absent. The
broker is active only on one market, and is responsiblenot only for contacts with clients, but also for
order execution on the floor of the exchange. Contrary to the situation on most other exchanges, all
brokers -including smallones-- have the status of clearingmember;i.e., they are themselvesresponsible
for paymentsto the clearingdepartmentof the exchange,and the clearingdepartmentdependson them to
ensureits financialsecurity.

3.29 The BrokerageIndustryis Fragmented.The fragmentedcharacter of the brokerage industry

creates several problemsthat are likelyto grow with the growth of the commodityfutures industry. One
problem is the lack of financial strength of many individual brokers. The limited financial base can
reduce the confidenceof potential clients and complicatesthe creation of a fidelity fund,which would
protect clientsagainst brokers'defaults.

3.30 A second problem relates to the difficulty potential clients face in finding a good broker.
Personal contacts play a large role, but distance and lack of informationare, at least under current
 33

conditions, a major obstacles for many potential users. A third problem is that brokers are not in a
position to provide full services to their clients, in particular the provision of infornation and market
analysis, and the handlingof some aspects of futures trade (e.g., physical delivery).If commodityfutures
trade is allowed to expand, brokerage companies able to overcome these problems will have a
competitiveadvantage. Such potentialgains should be sufficientto provide the neededincentivesfor the
consolidationprocess of the brokerage industry into larger, nationwideentities. However, the current
system of regulation, tailored to the requirementsof small-scale and fragmentedbrokerage industry,
would needto be overhauled.

3.31 Lack of a National Brokerage Regulation. The absence of a national brokerage regulation
system representsa major regulatorydeficiency. Brokerageregulation is now entirely under the control
of the associations,whichgenerallyhave fairly strict rules and are strengthenedby some financial safety
nets. The recognized associations provide for vetting procedures for new brokers; contribution of
brokers to a collectivesafetynet; and rules for the contactsbetween brokersand their clients.

3.32 This regulation system has worked well so far, partly because of the strong social controls
which the relativelysmall size of exchangetumover and the limitednumber of brokers actually involved
help provide. If futures markets are allowedto grow, the financial stakes in client-brokerrelationships
will increase correspondingly. With more trade coming from out-of-town brokers, existing social
controls may break down. If futures markets are allowed to grow, a new framework for brokerage
regulation should be allowedto developgradually. This should be phased so that undue hardships are
not placed on establishedbrokers.

Promotionaland DevelopmentCapacity

3.33 Most IndianExchangesWouldNeed to Strengthentheir Capacityto Support the Orderly

Developmentof Futures Markets. Indian Exchangesare inward-looking,a characteristic common in
many exchangesin other countries. They focus on the needsof their existingmembers, rather than the
possibility of increasing their business. Their institutionalcapacity has clearly been stunted by the
restrictivepolicy environmentunder whichthey had to operate.

3.34 Currently, many exchanges get-by by keeping a low profile, and only make their prices
available to newspapers and to some extent, radio. A few larger exchanges, in Bombay, Calcutta,
Cochin and Coimbatore,are more vocal, provide a wider range of services to their members, including
policy dialoguewith the Govemment. Even the larger exchanges, however, have no active policies to
recruitnew floor traders, train market users, or to promote the exchangesand futures trade to the public.
They also lack research departmentswhich, in other countries, investigatepossibilitiesfor introducing
new contracts. This directly reflects GOI's long-standingpolicy stance against the introductionof new
contracts.

3.35 If futures markets are allowed to play a more dynamic role, these weaknesses are likely to
become critical. Those exchangeswith an establishedcapacity will need to take the lead in developing
training programs and undertaking public promotion efforts. Other exchanges could pursue these
programs once they have the means. Commodityexchangeswill also need to develop strong research
departmentsto identifythose contract specificationsofferingthe greatest possibilityof success.
 34

B. Impact of GovernmentInterventions

3.36 Governmentpoliciesinfluencethe performanceof, as well as the usefulnessof futures markets.

These policies can be classified into direct and indirect government interventions. While the former
correspond to those interventionswhich directly regulate the operations of the exchanges, the latter
correspondto those which influencethe overallperformanceof the physical agncultural markets. Direct
government interventions relate mostly to the provisions of the FC(R) Act. Indirect government
interventions,instead, relate to the legal and regulatory environmentof agricultural commodity trade
embodiedin the provisions of the Essential CommoditiesAct, 1955 (EC Act) and the RBI's selective
creditcontrols, and agriculturalprice and trade policies.

Direct Government Interventions.

3.37 The Regulatory Objectives Have Been Lost in Over-Regulation of Futures Contracts.
The limits on contract specifications imposed by the FC(R) Act, originally intended to prevent
speculation, have often become so stringent to make futures contracts an unattractive and risky
proposition. A clear relationship can be observed between the extent of restrictions imposed on
futures contract and their level of use. The more flexible hedge contracts --e.g., castorseed,
pepper, gur-- are widely used by and acceptable to operators, while the inflexible NTSD contracts
--cotton-- are barely used. All hedge contracts report high market turnover, are highly liquid on the
main exchanges, and cover more than 100% of the physical trade. This is not so in the case of
cotton NTSD contracts which suffer from small turnover, low liquidity, and cover only a marginal
share (15%) of physical trade. Furthermore, the reported presence of active illegal in cotton
futures trading would appear to confirm the interest by operators in more flexible risk management
instrument.

3.38 Futures Price Ceilings Regulations are Ineffectivein StemmingSpeculation;They Also

Represent a Major Impedimentto EfficientFutures Trade. In India, ceilingprices are often set too
low so that market backwardation-futures market prices trade below physical market prices- takes
place. Although intended to stem speculation,this regulatory instrument is made ineffectiveby the
flexibilitythe Indiandeliverysystem provides(seepara 3.23). More importantly,market backwardation
has a negativeand damagingeffect on hedge effectivenessby breaking the normal process of arbitrage
between the physical and futures markets. It also reduces market transparency by encouragingfutures
traders to operate outsidethe exchanges. In order for futures marketsto fulfilltheir price discoveryand
hedging roles efficiently,and to minimizethe risks of manipulation,ceiling prices regulationsshould be
substitutedby other, less market-distortingtools.

3.39 The ContractApprovals Process Hindersthe Usefulnessof Futures Trade. Every contract
for a new deliverymonth has to be approvedby the FMC. This approval in some instancesarrives late,
and always comes with a specific set of conditions,in terms of marginingrules, margin lines, position
limits, etc. At times, the market situationmay have changed between the time of the determinationof
these conditionsand the start of the contract trading, in such a way that the conditionslargely prevent
futures trade. For instance,in the June 1994 castorseedcontract on the BOOE, the FMC had established
a margin line (above which special margins have to be paid) at 1,100 Rs/100 kg. By the time the
contract was introduced,prices had increasedbeyondthat level,and the resultinghigh marginobligations
kept market operators from trading. The exchangeboard was able to revise the margin lines upward,
but this took time. Such a discretionary process creates unnecessary uncertainty among users of the
exchangesand only servesto discourageusers.
 35

3.40 Tax Rules Do Not Recognize Hedging. Existing tax rules do not allow hedgers to deduct
hedging losses from their ordinary income, unlike investorsin financial derivatives. According to the
Income Tax Act, tax rules treat hedginglosses as speculativecapital losses which can only be deducted
from speculativegains -and can be deferredup to 8 years. This regulationcreates taxation asymmetry.
Unrealized profits on a hedge contract should be allowed to be deferred until the underlying physical
transaction has been realized. While it appears that many companies manage to get such a "hedge
treatment" through direct negotiation, the legal situation is far from clear. Such asymmetrical tax
treatment of physical transactions and their hedges only serves to discourage legitimate hedging.
Participation by traders in exchanges, especiallythose from outside the area, is further deterred by
exchange rules which requirethat all membersbe registeredin the town where the exchange is located,
which is also often a lengthyprocess. Some exchanges,however, are already attemptingto changetheir
bye-lawsto pernit participationby entitiesregisteredanywherein the country.

IndirectGovernmentInterventions

3.41 Government interventions in agricultural commodity markets have been designed to protect
the welfare of producer, processors and consumers, with the view to promote adequate food
supplies and price stability. These interventions include storage and movement controls embodied
in the EC Act, the selective credit controls issued by the RBI, external trade policies, and
government market interventions particularly relevant in the case of rice, wheat, sugar, and to a
lesser cotton and oilseeds. These policies have a considerable impact on the use, performance, and
feasibility of futures trading.

3.42 Essential Commodities Act, 1955. The Essential Commodities Act, 1955 (EC Act)
confers GOI with the powers to control the production, supply, and distribution of essential
commodities. Virtually all agricultural commodities can fall under the provisions of the EC Act.
The EC Act provides GOI with considerable powers including:

* issuance of licenses and permits for the production and processing of specific
crops;
* setting of buying and selling prices;
* regulationof storagetransport, distributionand use of commodities;
* prohibitionof sale;
* forcedsale of inventoriesto the government,its agentsor representatives.

3.43 In practice, the EC Act is applied arbitrarily and selectively to individual agricultural
commoditiesby GOI. It currently applies to virtually all major agriculturalcommodities.The powers
conferred by the EC Act may, by notified Order, be delegatedto state governments,an authority or
officer subordinateto the state. As a result, state govemments,have also developedtheir own series of
Orders. Various componentsof the EC Act have a significantimpacton the operationsof exchangesas
well the feasibilityof establishingnew ones.

3.44 Storage Controls Restrict the EconomicUsefulness of Futures Trade. Commoditiessuch

as foodgrains,sugar, kapas, cotton, oilseedsand oils, are subjectto strict stock limits. Storage controls
prevents temporal arbitrage from taking place efficiently,thus restricting the potential contributionof
futures marketsto more efficientstorage decisions. Storage limits are regularlyrevised, even duringthe
crop season, creating additionaluncertainty. For example, in April 1994,the maximum cotton stock of
mills was restricted to the three month average consumption(an increase from 45 days restriction in
 36

1993). Traders and ginmerswere also preventedfrom storing in excessof 110% of the quantity held on
the last day of the correspondingmonth of the previous year. Small traders and ginners are normally
exemptedfrom stock limits; so are the state trading companiesand cooperativefederations. Revisions
regularly occur such as the kapas and cotton exemption from controls in the October 1993-February
1994 period. In the case of oils and oilseeds,trader stock limits were reducedby 50 percent in October
1993.

3.45 Commodityfutures markets functionbest when efficientstorage is possibleand supported by a

well-functioningcredit system. Storage charges wvillkeep in check the price differentialsbetween spot
and futures prices. If spot market prices are considered low in relation to futures market prices,
operators will arbitrage: buy commoditiesnow, pushing up spot prices, sell futures contracts, pushing
futures prices down.; after a period of storage, commoditieswill be sold, pushingdown spot prices, and
buy back futures contracts. Arbitrage contributes to greater seasonal price stability. Such arbitrage
strategies freeze up working capital, but because the value of the commoditiesis protectedthrough the
hedgingfutures marketsprovide, it shouldnot be difficultto obtainbank finance.6

3.46 Selective Credit Controls Further Reduce the Demand for Futures Trade. The Reserve
Bank of India (RBI), as part of its selectivecreditcontrols, sets "minimummargins"on commnercial bank
advances against a range of "sensitive" conmmodities; for example, with a "minimum margin" of 40
percent,a bank is allowedto advanceonly up to 60 percentof the value of commoditiesto a stockholder.
In addition,lendingto each singleparty is subject to credit ceilings,with the maximum credits in a given
year limited to a function of the peak level reached during the three previous years.' Sensitive
conmmodities include foodgrains,pulses, oilseeds, vegetableoils, sugar, gur and khandsari, and kapas
and cotton. Processingunits normallycome under less restrictionsthan traders. Minimummargins are
revisedregularly,at least twice a year. The rationalefor this policy is that, such credit controlswill help
stem price increases. Central and state government agencies, those acting on their behalf of the
Government,and cooperatives are generally exempted from this policy. Other exemptionsare only
possiblewith Reserve Bank of India approval. The RBI has liftedits selectivecredit controls for several
comnmoodities in Ocotber 1996: coarse cereals, pulses, oilseeds and oils, sugar, guar and khandsari,
cotton lint and kapas.

3.47 Storage controls together with selectivecredit policies severely restrict the capacity of private
operators to undertake storage, reducing their need to cover price risks through hedging on futures
markets. The link between storage and credit control policies, and their stated purpose of preventing
hoarding of commoditiesand inflationis not very strong, exceptpossiblyin the short run. In practice, it
is likelythat such policies increase the vulnerabilityof markets to sudden shocks, making agricultural
prices more volatile,and requiringgreater,costliergovernmentinterventionson agriculturalmarkets than
would be otherwisenecessary. Alternativepolicies may be more effectivein reaching the same anti-
inflationarygoals.

6 It should also be noted that throughthis function,the private sector can take over a large part of the storage
function,relieving governmentagenciesof much of their burden: in order to reach certain price stabilizationgoals,
buffer stockscan be much lowerwith a futuresmarketthan without. Also, as the experienceof some international
buffer stockoperationshas shown,the existenceof a futuresmarketwill ensurethat buffer stockoperationsare more
effective:because of the transparencyof the market, open marketoperationswill be reflectedin the prices, while if
no futuresmarketexists, privatesectoroperatorscan just purchase (sell) whatever quantitiesthe governmentwishes
to sell (buy), without the rest of the market becoming really aware of it.

7 The maximumlevel is equal to this peak level, or 15 per cent higher or lower, as a functionof the Government's
desire to limit credits.
 37

3.48 Movement ControlsAlso Restrict the Economic Usefulnessof Futures Trade. Conunodity
movement is critical for efficient spatial arbitrage as well as making delivery on a futures contract.
Under the EC Act, however, movement controls or bans can be imposed by the GOI or state
governmentsat any time. In Gujarat, for example,the transport of groundnut oil was banned seven
times between 1990 and 1995. Andhra Pradesh exercisedthe same powers in 1992. Such commodity
movementrestrictionsmake futures trading impossibleby simplyfacilitatingthe manipulationof futures
contracts.

3.49 GovernmentMarket InterventionsMay Make FuturesTrade Impossible. Futures markets

cannot work when market interventionsby governnent do not allow market forces to operate. This is
the case for sugar wherethe governmentadministrativelysets prices of the sugar sold through the Public
Distribution System, regulates open market prices by controllingstock releases on the open domestic
market, and strictly manages foreign trade. It is also the case for rice and wheat where the Food
Corporation of India (FCI) acts as the "dominant" supplier by accounting for the bulk of trade and
storage. Pan-seasonaland pan-territorialpricing policies for rice, wheat, and sugar further discourage
private storage, the risk managementbenefits and arbitrage possibilitiesfutures markets would offer to
private operators. In the case of rice and wheat, the absence of futures markets also impliesthat most
storage costs and risks are bome by the Governmentand its associated agency,the FCI. The absence of
any reported illegalfutures trading activitiesin rice, wheat and sugar would appear to confirmthe lack of
interest by private operators in futures tradingfor these three commodities.

3.50 For other agricultural commodities,direct market interventionsby government are much less
significant, leaving greater room for market forces to operate --within the confines imposed by the
storage, movement,selectivecredit controls, and other extemal trade restrictions. The extent of market
interventionsvaries, however, from one crop to another. Governmentmarket interventionsare greater in
cotton than in castorseedand other minor agriculturalcommoditiessuch as gur, pepper, and potatoes.
The presence of much more active futures trading in the case of castorseed,gur, pepper than for cotton
would suggesta strong --and inverse--relationshipbetweenthe extentof govemmentinterventionson the
physical marketsand the operationand performanceof futures trading.

3.51 Futures Markets Do Not NecessarilyHinder the Achievementof Existing Policy Goals.
One possible policy concem is that futures marketswould prevent GOI from pursuing its price stability
and production objectives. In practice, however, a conmmodityfutures market does not prevent a
Government from subsidizing producers or consumers, or from controlling the extemal trade of
products. Instead, a futures market will reflect the policies in place, as part of the general market
conditionsunder which it operates, eitherthe world market, or the local market screenedoff from world
market influences. In the USA, for example,two raw sugar futures contracts are traded. One reflects
world market conditionswhile the other reflects domestic conditions;the latter therefore trades at a
considerably higher level, reflecting the US govemnment'sobjective of stimulating sugar production.
Even the cotton and the wheat contracts traded in the US which attract signuficantinternational
participation reflectUS conditions-including governmentinterventions--rather than the world market's
supply/demandconditions.

3.52 The govemment could still avail of the many useful functions a commnodityfutures market
performns,without giving-upcontrol over the underlyingphysical market. Governent interferencein the
pricing and trading of commoditiesis not necessarilya hindranceto the functioningof futures markets.
Throughoutthe world, commodityfutures marketsoperate behindtariff and non-tariffbarriers, and play
their price discovery and risk managementroles for local market participants. But while govenmment
 38

interference in itself does not need to be a problem, heavy-handedintervention and discretionary,

unpredictableinterferenceis.

3.53 Provided a physical agricultural commodity market is not under direct government control,
prices are set by market forces, and that commoditymovementand storageare allowed, futures markets
can continueto operate as long as there are clear rules on trade, includinggovernment interventions.
Sudden,discretionarygovernmentinterventions--e.g., impositionof movementrestrictionson inter-state
trade, changes in storage limitsand credit controls, immediateban on exports, changes in import tariffs,
or unpredictableoperations of parastatals or state trading enterprises--fundamentallyalter the supply
and demandconditionson the physicalmarkets, creatinghigherand unhedgeablerisks. They also make
Box 3.3

ContibutionofFuturesMarketsto a Comprehensive
Agricltural Strategy:
Potential& Limnits
of CGovernment
MarketInterventions
The Americanand EuropeanExperiences

The otrasting eperince of the Americanand CommonAgcultural Polices of the EuropeanUniob

showsthat producerpoetn policyobjectivescan be maintainedwhile allowingsuccessfulfiures trading
activities. The simplification of the two policy models described below, highlights the presence of alternative
foms oftmaetr interventnto achieve similar policy goals. Policies that have an indid effect on: the
performance of futures market trade need to be evaluated in light of their respectivecosts and benefits, and the
pOssibilitieshy offerfor less disruptive alternativerisk management instrument.

* erican lt polices protect producers,but do not eliminate price risks. Consequently, American
commodityfuilies marketsare activeand atract largeinternationalinterest,bringingwith it a significant
financialand commoditywarehousingserviceindustry.Storageby the privatesectorremnains econormially
ataive,f andthe governmentis notburdenedbylargestocks.

Th 'LiUSexperice also shows the limnitsof governmentinterventionsin allowingfutures rmarketsto

performeffectively.
:In the case of the United States,over the last ten years, strong arguments have
been made that wheat futures no longer representa goodhedging tool for internationalprices due to
USCGovernmentinterferencethrough exportenhancementprogram and other instruments,very much
affecting thelinka between domestic and international prices.

Bycontras0,in the EuiopeanUnion,the samegoalof protectionof agnculturalpiroducersas beenpursued

by policies that elimninatedmost price risks. As a consequence, virtially no futures contracts for the
commodities produced in the European Union were traded, and very large, publicly financed stocks
:accumuated over the years. Recent Common Agicultural Polcy changes now allow agncultural markets
to be subjetd to price risks, prompting the introductionof new futurescontracts -e.g., oilseeds contracts in
on the Pans exihnge (MATIF) with the deliverypoints in France and Gemany. Futures contracts for
cereals are also underdpreparationat the MATIF.
it very difficult for speculators to operate; and with speculative participation drying up, hedgers will find
it difficult to continue using the markets for lack of liquidity. Finally, they increase the risk that
managers of state companies abuse their control over marketing and pricing decisions.8 Government
interventions can go quite far --including targeted subsidies, an active role for state trading enterprises,

8 For example,the managerof a state-tradingcompanycould decideto take a hidden positionon the futuresmarket
on his own account,and then takes a physicaltrade decisionwhich costshis companymoney,but bringshim a profit
in his personal account. This type of abuse can be prevented by taking away from individual managers the
discretionarypower to make trading decisions; state-tradingcompaniescould instead sell according to a pre-
determined,automaticschedule,at pricesthat reflect the marketprices (e.g.the exchange-publishedprices).
 39

external trade restrictionsand even controls on storage activitiesby market operators. What matters is
that interventionistpolicies remain stable and credible, that changes are publicly announced long in
advance, and that government agencies abide by the market rules in their operations. The US and
European experiencesillustratethe potentialand limits that governmentagriculturalpolicy interventions
impose on the performance of futures market, and their potential contribution to a comprehensive
agricultural strategy (Box 3.3). When government interventions are achieved only through private
sector operations and in a predictable manner, and if prices are still able to clear the market, then
futures trading might co-exist with Government policy.

Summary

3.54 Indian commodityexchangesdo not perform as poorly as could be expected from the adverse
and restrictivepolicy environmentunder whichthey are required to operate. Their trading practices and
clearing procedures are generally adequate to handle the limited scale of most commodityexchanges.
The arbitrarinessof the financialsettlementunderminesthe deliverysystem and thereforethe viabilityof
futures markets. Market liquidityon the majorityof Indian exchangesleaves much to be desired, a direct
reflectionof the very restrictedaccess to futures trade, and the unfavorablepolicy environmenton the
physical markets. The access to as well as the performanceof Indiancommodityexchanges are strongly
influencedby governmentpolicieswith respectto physical trade and financialflows, including in price,
trade, storage and credit policies.The absenceof proper governmentpoliciesto regulatethe conmmodity
brokerageindustrycould also hinder future growth of futures market trade. There is considerablescope
for enhancing the contribution futures markets can make to the agricultural sector, both through
initiativesat the exchange level,and initiativesby the government. These policy options are discussedin
greater detailsin the followingchapter.
I
 4 OPPORTUNITIES& OPTIONS:
4 POLICY IMPLICATIONS
A. CommodityExchangesin a ChangingPolicy Environment

4.1 Greater Exposure to Price Volatility As Indian Agricultural Markets Become More
Open. The policy environmentgoverningthe Indianagriculturalsector is rapidlyevolving,offeringnew
opportunities,but posing new challenges as well. Significant external trade liberalizationhas been
initiated over the last couple of years. Common rice can now be freely exported, exposing hidian
growers, traders and exportersto internationalprices and competition. Oilseedscrushers and growers
now have to compete with edible oils importedunder relativelymodesttariff levels, in addition to the
already existing competition on the oilseed meal market. This recent, gradual opening-up of Indian
agriculture to world markets brings new economicopportunities. It also poses new challenges. In
particular, price volatility and the capacity to cope with it become major policy concerns. Price
volatilitycreates uncertaintyand risks which can threaten agriculturalperformancethrough reductionin
investments and export earnings, and greater dependenceon imports. Indian policy makers have
traditionally coped with such uncertainty and risks by resorting to policy instruments aimed at
minimizingor eliminatingprice volatility. These include pervasive extemal trade restrictions, price
controls,price support operations,procurernentand distributionschemes,buffer stock operations, crop
insurance, and restrictions on storage, movement and trade credit. These instruments are proving
fiscallycostly and create seriousprice and market distortionswhich reducegrowth and competitiveness
of Indian agriculture. These instrumentsare now progressivelybeing either reformned or abandoned by
the GOI in an effort to spur agriculturalgrowth.

4.2 Need for Commodity Price Risk ManagementStrategy. In this increasinglyliberalized

environment, futures markets offer a market-based instrument for managing risks and uncertainty.
Futures markets can complementor substitutefor the traditional policy instrumentsused to cope with
price volatility. Commodityfutures markets provide a powerful tool for efficientprice discoveryand
risk managementto a wide range of market players, which would help improve Indian agriculture's
competitiveness. The existence of futures markets provides small players, such as farmers or local
traders, access to the same informationas large players on likelyfutures market developments. Thus,
they help create a more level playingfield for commoditytrade that would benefit both consumersand
farmers.

4.3 Demandfor Futures Marketsis Strong and Growing. There is a strong demand, not only
from commodity exchanges and their members, but also from agro-processors and farmers'
associations, for the expansion of the number of commoditieseligiblefor futures trade. The Kabra
Committee, appointed by the Govermmentof India, has proposed a long list of commoditiesin which
futures trade should no longer be banned. Even though the Kabra Committee found that futures
contracts in all of these commoditiesmightnot be viable, it was also arguedthat the introductionof new
contracts would benefit many groups. Some of the exchangesappear ready to invest in this expansion
or have already invested; others are interested, but have not generatedenough resources during the
recent lean years to implementtheir plans.

4.4 Buildingon the earlier chapters, we now derive a set of recommendationsfor the establishment
of an enabling environment to the orderly development of futures markets. Three sets of
recommendationsare successively developed.First, we will address the set of conditions on the
 42

physical markets that need to be in place for futures markets to perform. The second set of
conditions relates to the policy, regulatory and institutional environment governing the operation
of futures markets. Finally, we will explore the feasibility of developmental options, such as the
internationalizationof India'scommodityexchangesand the introductionof new contracts.

B. Creatingthe EnablingEnvironmentfor CommodityFutures Trading

4.5 For futures markets in any commodityto be viable, minimum conditions need to be met,
among others: the prcing of the commoditymust be by free market forces, without monopolisticor
directgovemmentcontrolof prices; price fluctuationsneedto be sufficientlylarge to warrant the use of
risk managementtechniques;there has to be a sufficientlylarge group of speculators to provide the
neededliquidity;the spot market has to function reasonably,with sufficient standardizationof trading
practices,few barriers to movement,and a proper storage system, to enable commodityexchanges to
formulate contract specificationsthat would make market manipulation difficult. If any of these
conditionsis not met, a futures market is impossible. In India, government policies prevent these
conditionsfrom being met for a number of agriculturalcommodities.

GeneralRules for a PermissiveGovernmentPolicy

4.6 Futures markets wiOlbe able to function effectivelyeven when government policies strive to
establish remunerative prices for producers or affordable prices for consumers, provided that
govenmment interventionsfoOlowa few rules:

* Government interventionsshould not, in a direct or indirect manner, eliminate

price risks. The govenmmentshould not set prices on the marketing chain, nor
processingmargins. Minimumor maximum prices could be set, providedprices
can clear the market. Minimum(or maximum)price interventionsshouldprovide
a protection against distress sales (or price spikes), allowing market price
movementsto take place. Price volatilityshould not be eliminatedthrough pan-
territorialor pan-seasonalpolicies.Governmentpolicies for rice, wheat and sugar
currentlymake futures markets in these productsnon viable.
* Govemment interventions should not strongly restrict the normal flow of
commodities in the economy. Traders should be allowed to undertake the
arbitrage transactions that are worthwhile,and not be hindered by restrictionson
storage, movementand access to trade credit. Such restrictionswould need to be
either permanentlylifted or significantlyrelaxed for conunoditiessuch as oilseeds
and cotton and their derivedproducts, as well as other agricultural commodities
for whichgovemrnment restrictionshinder the normal flow of commoditiesacross
seasons and withinIndia.
* Government interventions should leave a sufficiently large part of physical
trade in the hands of the private sector. Governmentmarket operationsshould
be kept to the minimumrequired to achieve policy goals. This is particularly
relevant in the case of rice and wheat where the government dominates the
market.
* Government should provide for a stable and predictable external trade policy
environment. Changes in foreigntrade policies alter fundamentallythe supply
 43

and demand conditions of the physical market. Policy changes that reduce or
eliminatetrade distortions,such as the recent freeing-upof edible oils trade, go a
long way towards providinga more stable and predictable extemal trade policy
environment.However,sudden,unannouncedpolicy changes introduceshocks in
the physical market, creating un-hedgeablerisks that will deter participation on
futures markets. Examples include the recent (1995) decisions to free-up
vegetableoils imnport,to lower edible oils import tariff levels from 65% to 30%
overnight,and to offer a preferentialtariff (20%) to state trading enterprisesand
the National Dairy DevelopmentBoard (NDDB) for an unspecifiedtime. The
arbitrary release of cotton export quotas is anotherexample of un-predictableand
un-stable external trade policy that would undermine the viability of futures
markets.

4.7 Exchange associations in India are generally rather optimistic about the possibility of
introducingnew futures contracts. Even though some of the conditionsmentionedabove appear to be
met in India, not all conditionsare in place. While a filll assessmentof the potential of new futures
contracts is beyond the scope of this report, the link between governmentpolicies affecting physical
trade and the opportunitiesfor a futures contract shouldbe stressed. For example,India is the world's
largest sugar producer and consumer -not countingthe production of non-centrifugalsugar, gur and
khandsari. If a gur contract functionswell, one would expectthat an Indian sugar contract serving an
even larger market will also function well. The existing sugar contracts in New York, London and
Paris are not particularly useful for trade in Indian since basis risks are too high. However, the
extensivegovernmentinterventions--PDS procurement,storage and distributionof sugar; free market
releasescontrols; setting of minimumsugar cane and sugar issue prices; internationaltrade controls-
make for the time being an Indian sugar futures contract non-viable. Similarly for wheat and non-
basmati rice, pan-territorial and pan-seasonal prices are also achieved through price intervention,
with transport and storage subsidized by the intervention agency. Even if governmentwere to allow
futures trade in these commodities,there would be no or little interest from the private sector. For
basmati rice destned for exports, a futures contractcould potentiallywork.

4.8 Spot & Futures Markets Can be Allowed to Develop in Synergy. In the rice, wheat and
sugar sectors, government policies do not satisfy any of the conditionslisted above. In the case of
cotton and oilseeds,governmentpolicies meet some of the above conditions: price risks prevail on the
domestic market; government interventionsallow prices to clear the market within the confines of
government restrictions on external trade, the storage and movement of goods, and access to trade
credit. For these commodities,a commodityfutures market and its underlyingphysical market can well
developin a symbioticfashion. Imperfectionsin the physical market shouldnot prevent a commodity
futures market from operating, and indeeddo not as indicatedby the widespreadillegal futures trading
activities in cotton and oilseeds. In many instances,the presence of a futures market will encourage
those active in physical trade to improve their market practices. For example, informationon future
prices should improve storage decisions;the need to deliver specific grades of a commodityto an
exchange warehousewill encourageimprovementin grading performanceon the physical market. As
the physical market becomes more efficient, the futures market will also become more efficient.
Efficiency improvementsare only possible within the bounds posed by government restrictions, but
every time a restriction--e.g., on storage and movementcontrols, access to trade credit,bank financing
of hedging operations, foreigntrade - is relaxed, the interplay of futures and physical markets will
ensure a speedy adaptation of the private sector to the new environment. To survive and operate,
comnmodity exchangesdo not need to perform at their full potential. Indeed,most Indian commodity
 44

exchangesoperating today do not. Participationis often limitedto some of the larger traders; futures
prices, at times, move in strange ways, reducingthe effectivenessof hedges; arbitrage, which ensures
that physical marketsare well integrated,hardly takes place. Such imperfectionscan be expectedwhen
spot marketsdo not functionproperlyas a result of governmentpolicies.

C. Improvingthe PolicyFrameworkof CommodityExchanges

4.9 The regulatory and institutional environment governing the operations of futures markets
needs improvements for them to develop in an orderly fashion. Commodity exchanges policies,
including exchange regulations, should be focused on optimizing the contribution of futures
markets to the agricultural economy. These policies should provide the framework for futures
markets to realize their full potential, while controlling abuses in the functioning and use of
futures trade. Commodity exchanges should aim at avoiding abuses by their members, widening
access to the risk management functions performed by futures markets, and collecting and
disseminating price information. This raises legal, regulatory and institutional issues that are
being addressed successively in this section.

Legal & Regulatory Framework of Futures Trading

4.10 The FC(R) Act and Legal System Provide a Sound, InitialBasis. Governmentregulations
of commodity exchanges are major determinants of their performance. Contrary to many other
countries, India enjoys a strong regulatory system for commodity exchanges and considerable
experiencethat will facilitatesignificantlythe developmentof its futures markets, as the China example
(Box 4.1.) amply illustrates.

4.11 Discretionary InterventionsWould Need to Be Curbed. The FMC applies extensive

discretionarycontrols,predicatedupon the concernthat the rules and regulationswill be by-passed by
some individuals. When resorted to on a regular basis, discretionarycontrols cause insecurity among
market users, and hinderthe functioningof futures markets. Discretionarycontrols should be restricted
to emergencysituations, with standard procedures guiding the day-to-day functioningof exchanges.
Standardproceduresshould be appliedto the followingregulatoryareas:

* The recognition of associations should either be permanent, or at least on a

long-term (at least 10 years) basis, rather than on the current 2 years or even 6
months basis. If an association breaks governmentregulations, its recognition
can always be withdrawn.
* The introduction of new contracts should be automatic,that is, at least three or
more contracts should always be traded simultaneously,and if one contract
expires, the next contract should be introduced automatically. Regulatory
measures --special margins, margin lines, position limits, etc.- should be
standardizedto the extentpossible,rather than set differentlyfrom one contract to
the next. Ceilingprices should be withdrawnaltogether.
* The role of the FMC should be largely a monitoring one, with occasional
interventionsif abuses take place on a market.
 45

Box 4.1
Lessons from China's Experience
Withthe ihealisation of Chinasinternalmarket,the needarosefor forwardand fitures trading.The Chinesegovernment
startedto studythispossibilityin 1988. Tle conceptthat wasadoptedforesawthe developmentprocesswiththe wholesalemakets as a
firstphase,forwardmreketaas the secondphase,andfixturesmarketsas thefinalphase. Thisconceptwas,however,rapidlybypassedby
rethty andalnost as rapidly,thingsstartedto gowrong.
TheZhgwhou GrainWholesalemarketinHenanwasthe firstto beginoperations,in October1990. Threeyearslater,over
SGtnw exchangeswere cated, of which30 traded fiuturescontracts. By late 1993, the largestexchange-the ShanghaiMetals
En*anga- had becometheworlIS thid largestluturesexchangeintermsof contracturnover.In 1993,tot futurestradingapproah
-US$90 billion. Atthe samne time,the Chinesegovernmt facedincreasingdifficultieswithsomneaspectsof futuresmarketstrading.
Withlocal4uthoitiescompetingvigorouslyovera sliceof the fitures pie,it took sometimefor the Chinesegovernent to getthe sector
uder control. ventually,drastic
measureswere taken in late 1994. Moatexchangeswere dlosed4ownor bamnedfrom forwardor
liAniestrdgi: whileonly 15 restructuredfixturesexchangesreceivedformalgovernmentapproval. Futurestade in a numberof
stnicw products-steel, coal, gasoline,sugar and cotton- was banne4, Additional,subsequentrestrictivemeasureswere also
imposed:othe fitures contractswere banned;pricecontrolswere introduced;cash settlementwas prohibited,and henceforth,all
Wettleneihad to be throughphysicaldelivery.For a time,all contractsoverthreemonthsforwardwereforbidden;in October1995,
traderswereforbiddenfromdosingpositionsandbuildingnewoneson the me day. Whatwentwrong?
- Sownepracticalerrorswere made in setting-upthe exchanges.Many were createdwithoutthe involvententof thoseactive in
physicaltra4e,resultingIn poortradingarrangements.OperatingCos weretoo high; severaltines higherthan the westernopen-
oitcry exchanges. Most exchangeschosethe expensiveelectronictrading systems,which also reducedmarket liqutdity by
piventing floortradersfromtrading. Exchangeshardlyco-operated,
evenwithinthesametown.
Moreimportantly,fitures marketsfacedthre f _undmentl
shortcomings;
* ArbitragebetweenFuturesand PhysicalMarketsDid Not Work. WithChineseexchanges,the necessaryarbitragelink between
futwusand physicalmarketsdid not workproperly.Firs, manyof the so-calledfuturesexchangestraded whatin India wouldbe
knownas TSD contractswhichare easilyproneto marketmanipulation.Second,failuresonthe physicalnmrketmadethe futwes
markets' delivery rmeaism non viable: transportof commoditieswas difficultto atange, exchangewarehouseswere often
corolld byfew meibers who couldmanipulatethemarket. Third,theweakmonitoringandaccountancy systemsof statetrading
companiesprovided¢teir traderswith strong incentivesto take highly speculativepositionsrather than to enter into nonnal,
profitablearbitragepositions.Fourth,priceinformationwasnot wel diffusedby the exchanges:most snmalspeculatorsin effect
acledas gmnbt, reducingliquidityandcreatingexcessiveprce volatilityonthe futuresmarket.
* China Had No Historyof ExchangeOperationor FuturesTrade Regulation.Duringthe early 1990s,the central government
virually lostcontroloverthe exchangeswhichwere beingregulatedby provincialor evenmunicipalauthorities.Brokerageshad
spnungup almostoutsidethepurviewof any regulation.Thereweremanyabusesat the exchangelevel-exchangeswere profit
ventures,ratherthannon-profitorganisations as is the casein mostwestemcountries,Exchangesoftendid not havethe incentive,
nor the staff;to policeoperationson their exchangeandalso abusedconsumerconfidence.In October1992,a centraloversight
structure,the SecurtiesRegulatoryCommission, was createdbut it took anothertwo yearsto get the sector under control. For
instance,althoughcapital adequacystandardsand an approvalprocedurefor brokerswere adoptedin 1993, many brokers
contned to be officiallyrecognisedbecauseof theirconnctions.
* Lack of GovernmentExperiencewith FuturesTrading. Governmentregulatorsdid not evaluatefuturespricesin tenmsof the
underlyingsly and demandconditionsof the underlyingphysicalmarkets; instead,fitures prices wereevaluatedin terms of
political objective. Althougbthe bulk of futurestrad was accountedfor by state-ownedcompaniesrather than by small
speculators,priceswereat timesdeened excessiveby government regulators,reflectingthe artficialscarity causedby remaining
controlsonproducXti,distributionand externaltrade. In response,the governmentimposedceilingprices or banned contracts.
Chis xture industrywasallowedto developin an envirent withinsufficientchecksand balances,froma regulatory
pointofview, andfioman operationalpointof view. Besidestheregulatorybacklashit triggered,the futures
markets crisisalso resulted
ins lingri dist of ftues narkts amongsomeofthe policy-maklersChinascondios wereunique,andonemay well arguethat
policy#makers overreacted. However,it highlightsthe centralinportanceof a goodregulatoryframeworkand a wmpetitivephysical
trdig structe s necessarycondtionsto theorderlydevelopmentof commodityfixturestrade.

4.12 Reverting to A Purer Model of Three-Tier Regulation. The government could consider
revertingto the three-tiermodel of regulationwhichthe FC(R) Act providesfor. Under such a model,
the centl government would still approve exchanges and set the general legal and regulatory
fiamework, including brokerageregulations(paragraph 4.23) and prudentialstandards for the use of
risk managementinstrumentsby companies(Box 4.2). The futures markets regulatory agency would
approve requestsfor the inroduction of futures contractsfor new commodities,monitorthe operation of
commodityexchanges, and intervenewhen the situation warrants it. The exchanges would manage
their day-to-daybusiness, includingcontrollingthe financialstatus of their members, operatingclearing
 46

operations,and ensuringa proper functioningof trade. The introductionof new contract-monthswould

be automatic,and the conditionsattached to each corract would be as standardizedas possible.

Box 4 1
BePriete~l FromFuturesTrade?
ShotduldCompanies
Wthth}eM cllapse of 200-eyar old Bring at the hands of one 2g-year old trader, "deivative," and "fitures markets" have
becomwidelyXpubliciz2d Such publicity 'May wdI have conveyed tebelief that derivatives and futures markets are inherently
danrous,andthatompaniesiould be protectdfromthem.Towhatextentis thus fear justified?: Are futures markets and over-the-
6counterriskmanagement miarketsreally dangerous?
Derivatives edangerous
ar only.because they are relatively new and unknown. Fraudulent activities or unauthorized
speSlation by staff always ext in onohermakets, and are by no m eans6 cofined to daivatives makets only. More companies have
probably goneba after faild speculation in realdestatethithrough derivaivestride; many banks experience fiaudulent loans.
hile most c anymaage,in paticua bks, areaware of these problems and have set upgsytems to avoid them, the use of risk
managemenXt markesisoftennotpropeiirolly controlled.
Te he4dgedisasters dftfeiearly1990s have a inumber of Oommontheme:s:

* Flawedmontorng0ys ems: the monitoring and accountancy systems used did not always properly represent the real results of
derivativesdtransacions. Ot premiums have been booked as straighforward pofits; and the historical valuation of contrcta
allowed anumbergof onpanies tocarry-overhuge teses fromoneyear# to he neat.f00:d0:
: iInatenamel magement: in some:companies, desite the eidstenceof propercontrol sys the control philosophy never became
part of the ps way,of operating, and limits were ignored and control systems not used.
* o ear mtandaitesfor traders. traders' limits at timeswereVpoorlydefined, and, perhaps moreimportantly, these limitswere not
communicatedto brokers. Traders were thusfreeto undertake iiciittransactions.
*0 No epratn of radng, accountingiand controlresponsibihaes: in some cases, one trader or a single trading group set policy,
executed asaions, inputthevalue datawfortheir positions monitoredtheir own perfmrmance,and even sent out margin money.
* Lackoft omp ehensfonof risk managementproducts, exposures and netpositions:company traders have been tempted at times
:tu inoverly
dabble
J tot mpicatedinstruments;consequently, thleydid notreactw prperly when the underlying prces moved in an
unexpVectedway. Senior 0maagm often didnot underst the instrments.
*i Blind tustr too often blind tust on a person's capat replaced prudential controls and limit-setting. In many companies,
managers were afaid of checking ot reigning mi a successfultrader, rather than making surethey understood how he was making

F:X
romapublic policy staidpoit acasecan:be made for someformofgovernment protection. The "let the buyer beware"
philosophy is probibly not.approprate, in particularly not for overcounter tansactions where access to infonmation is not well
disbutedl.' T types of policymeasures can be envisaed. Firtyan oblgation for iftures market brokers to obtain the proper
4approvalfromseniorcormpanymanagement before acceptig the tradng autiority of an individual tader and secondly, an obligation for
ihe banksi and other
companies prvding over-the-couiter risk management instruments to be more transparent - one particularly
powfstoolwouldbeto obligethei toquote at least once a week the "replacmetntvalue. 6ofeach of the contracts they entered into, so
that a company knows its poston iandcanwdecideto reverse it,

4.13 Attracting Greater Participation from Commercial Hedgers & Speculators. The
governmentcould consider revising several rules in order to attract greater participation on Indian
exchanges by commercialhedgers --traders, agro-processors, manufacturers--and therefore promote
futures markets liquidity and the indirectaccess by farmers to risk managementtransactions. This
would involveliftingthe regulatorybarriers on the participationof agriculturalcooperativesto futures
trading;revisingthe IncomeTax Act to formallyprovide for tax symmetrybetweenphysical and hedge
transactions,recognizehedginglosses; relaxingthe (sales)tax registrationrequirements.

4.14 Attracting the Participation of Large Institutional Investors Institutionalinvestors,through

their large scale trading volume, function as automatic counterparts for the largest hedgers. This
creates incentivesfor large scalehedgersto trade in the exchanges,and reduces brokeragecosts. In view
of the growth potential of the large institutionalinvestorsin India--pensionfunds, insurance funds and
mutual funds- and their potential contributionto the perfonnanceof futures trading,it would be useful
to reconsiderthe ban on their participation. Some complementaryconditions, however, will also be
neededto support fundparticipation. Thisincludesthe relaxationof the tax registrationrequirements-
 47

all traders must have a local sales tax registration--and the presenceof larger more highly capitalized
brokeragefirms.

Exchange Regulations & Operations

4.15 Commodityexchangeswould needto improve their operationsin the followingareas: trading

procedures,delivery system, trade supervision,clearing operations,and promotionaland development
activities. These improvementswill not only enhance the efficiency of current operations, but also
ensurethe orderlyexpansionof their servicesin the future.

4.16 Improve the Transparencyof TradingProcedures. Trading procedures could be improved

by introducinga time stamping obligationand the monitoringof prices by an exchange official on a
nunute-to-minutebasis. Preferably,these prices should be entered into a computer and made available
as widely as possible, on a real-time basis. These two measures would make it easier to determine
whether a transaction indeed took place at a competitiveprice and prevent fraudulent behavior of
traders against their customers.' The length of the trading day needs to be carefully consideredsince a
long day dilutes liquidity over too many hours, and also makes it more difficult to monitor the proper
functioningof exchangetrading.

4.17 Remedy the Arbitrary SettlementSystem. Weaknesses of India's unique delivery system
would need to be corrected. A simple solution would be to adopt internationalpractices by giving-up
the settlementoption: positionsremainingopen at maturity date would have to go to delivery. A less
drastic solution, however,would be to set-out clear and transparent formula for determiningthe close-
out price, on the basis of spot prices at and near the maturity date. The formulawould be worked-out
by the Pricing Committee of the exchange, where all the participants in the trade would be
representedto ensure its fair and transparent operation.

4.18 StrengthenTrade Supervision.Greater effort should be directed at enforcingand educating

members about the rules and regulations of the exchange. Internal auditing departments should be
strengthenedin order to consistentlymonitor the trading behavior of brokers, in order to ensure an
honestand fair relationshipwith their customers.

4.19 Moving GraduallyTowards A Safer, EnforceableMarginingSystem. Margin deposits and

margin calls should be set in relation to what is necessaryto securethe survival of the market. Unlike
current practices, margin deposits and margin calls should be set irrespective of their impact on
individual members and the capacity of the less well-capitalizedmembers to carry these charges.
Exchanges should move gradually towards a better marginingsystem, while providingsome assistance
to the smaller floor-traders. For example, as in the US system of futures trade, larger traders may be
encouraged to serve as guarantors for floor-traders unable to carry the concomitant margin
requirements. In addition, the exchange system would gain in security by creating an independent
clearing house, with members that include both exchange users and financial firms --the case in
Malaysia-- or only financialfirms --the case in the UnitedKingdom.2 This would largely eliminatethe

I For example, instead of selling a contract at the prevailing market price, the contract could be sold at a lower
price to a colleague who then immediately sells it at a profit in the market, this profit is then shared between the two
traders.

2 In the United Kingdom, clearing houses are in the hands of a clearing house owned and guaranteed by a number
of major banks.
 48

credit risks of doing business on the exchange,making its use more attractiveto all, includingforeign
users.

4.20 Strengthen Promotion and Development Activities. To counter the potential deficit in
trading skills in the future, as an increasingnumber of traders approach retirement,the exchangesneed
to develop training programs, for members as well as non-members. In the long term, to ensure the
supply of trained professionals,the exchangescan work with universitiesin developingthe appropriate
curricula in the relevant specialization. In the short term, the exchanges also need to devote more
resources to promotional activities, to expand the awareness and understandingabout futures trade
amongboth policy makers and the generalpublic.

4.21 Research capacity in the exchangeswould need to be developed.Indian exchanges appear to

underestimatethe difficulties involvedin introducingnew futures contracts. It is often assumed that
since futures contractswere traded in the past, the same contracts would automaticallybe successful
today. Market conditionshave changed. Moreover,a large segment of the industry probably has no
livingmemory of how to undertake futures trade. Proper contract design is critical to the success or
failureof a contract. This would requiresignificantresearch on the part of the research department of
Indianexchanges.

4.22 Commodity Exchanges Would Select The Best Suited Contract Specifications.
Conmmodity exchangeswould have strong incentivesto design and offer contracts specificationsthat
respond best to the need of their clients. While the FMC approval would still be required for the
introductionof new contracts, it is the market that will dictate which contract specifications are best
suited.With such a regulation system,alternative,more flexiblecontracts permissibleunder the FC(R)
Act --e.g., TSD or hedge contracts- will be introduced,substitutingfor those that do not offer sufficient
flexibility,such as the NTSD cotton contracts.

4.23 Introduction of a Two-Tier, National Brokerage Regulation. A national system of

brokerage regulation for the specific purpose of consumer protection should be introduced if futures
markets are to expand their roles, and attract a larger number of participants. A two-tier system of
brokerage regulations would have to be established, at the government and the broker organization
level.

* At the governmentlevel, regulationswould lay down the rules of the game for the whole
country. This would include establishing the minimum qualifications and financial
strength of brokers and definingthe relationshipbetween brokers and customers and the
rights of customers. It should also ensure that brokers who have been barred from one
exchange are unableto becomemembersof other exchanges;
* At the exchangelevel, self-regulationby organizationsof brokers can continuevery much
through the existing system, that is, through the recognizedassociations. However, it
would be preferable to create an all-India body of brokerage organizations to share
experiencesand coordinatepolicies.

4.24 Even though the system of self-regulationby exchangescould remain more or less the sane,
current policiesmay need to be reformed,with the changes phased in gradually:
 49

* Formalization ofthe vettingprocess. Candidatescould for instancebe required

to pass a training course which would include the ethics of broker-customer
relations, and the legalityof various forms of floor trading.
* Strengtheningfinancial safeguards. Some minimum net worth requirements
could be introduced, or alternatively, a system where small brokers find the
patronage of a large clearing member,who ultimatelyguarantees their financial
performance, as is the practice in the United Sates. Brokers could also be
required to contribute towards a customer protection fund (also called "Fidelity
Fund"), to compensateclients of brokers who have gone bankrupt. This would
still fall short of the strict controls and capital adequacy rules of the United States,
but would appear the most feasible given the state of commodityexchanges in
India.
* Client Protection. Existingrules governingthe relationshipbetweena broker and
his/her client basically concernthe protectionof a broker against a client default.
They establish the rights that a broker has to demand margin deposits and
variationmargins and set out the fines clientshave to pay in case they do not meet
their obligationsto make or take physical delivery. These rules hardly take into
account the protection of customers. Self-regulatorybrokers' associationscould
ensure that their members follow the rules on contacts with clients, use the
required forms and in general,follow fair marketingpractices. They should also
make an effort to educatethe public at large on the differencesbetween legitimate
and illegitimatebrokers.

InstitutionalDevelopmentAssistanceRequired

4.25 Strengtheningthe FMC. For the purer model of three-tierregulationsof futures trading to be
effective,institutionalstrengtheningof the FMC is necessaryin order for the Commissionto be able to
be able to undertake its role in evaluatingnew contract proposals, and monitoringthe functioningof
exchanges. An additional form of control is needed on whether brokerage companies follow the
guidelines set-out in the brokerage regulations and prudential standards: private sector voluntary
organizations,such as a national brokerage organization,are useful for screeningpotential members,
but remain insufficient. This regulatory role could be given to the FMC, or the SEBI, or to a
completelynew organization. Likethe CommodityFutures Trading Commissionin the United States,
the FMC is a statutory body composedof government-nominated individuals,served by a permanent
secretariat. The secretariat of the FMC is small, only 80 people, compared to 200 at its inception.
Relative to the breadth of responsibilitiesit assumes, it is ill-equippedto perform its role effectively.
Staff and equipmentneedto be expanded,and particular attention needsto be given to buildingup the
skillsneededto fulfillits new regulatoryand promotionalroles.

4.26 Given the poor state of many futures markets, after years of contrary conditions,and the large
benefitsthat a speedy revival of futures trade would bring to large segmentsof the population,it can be
argued that assistanceto this sector is worthy of support. This may take the form of support for the
development of physical infrastructure. At least equally important is technical support to the
governmentfor the formulationof its policies,to the FMC to developand maintain the skills neededto
police the futures markets in a proper manner, to the exchange management in adapting to the
requirementsof a more active and widespreadtrade, and to the private sector, focusingnot only on the
larger trading,processingand manufacturingcompaniesthat are the obviouspotentialusers of a futures
 50

market, but also on the developmentof an institutionalframeworkthat would allow farmers and small
traders to use the markets.

D. Potentialfor Internationalization
of IndianCommodityExchanges

4.27 Indian commodityexchangeswould benefitfrom attracting internationalparticipation. Foreign

participationwould enhancemarket liquidityand bring in valuable foreignexchange and extra income
to the exchanges. From the point of view of foreignentities,participation in commodityexchangesin
India can provide portfolioinvestmentand risk managementopportunities. In this sectionwe will first
reviewthe conditionsthat will facilitatethe internationalizationof Indianexchangesin general; and then
reviewthe particular case of the Pepper CommodityExchange (Cochin)for which internationalization
is now being contemplatedby GOI.

4.28 IndianExchangesFollow InternationalExchangeRules. Accommodatingforeign accounts

in Indian exchanges will not be difficult, since the by-laws of several exchangeswere formulated in
accordance with internationaltrading needs. The Bombay cotton market operate under the rules and
regulationsof the Liverpoolmarket, and the BombayoilseedsexchangefollowChicago Board of Trade
and London trade practices. Most of the other exchanges in the country, which were set up later,
followedthe models of these two exchanges. In principle,then, foreign participants would not find it
difficult to get used to local exchange rules, nor should it be difficult for exchangesto accommodate
them.

4.29 LimitedTrade Volume May Pose a Constraint.One constraintwhich may influenceforeign

participation is the current relatively low volume of trade. Large intemational investment funds are
always looking for new markets to invest in, markets which show profit opportunities and a price
behaviorthat is not stronglycorrelatedwith that of the main westem markets. These funds, because of
their size, trade in large blocks of contracts, and are only interestedin markets which have reasonable
brokerage charges and show a high liquidity --a turnover of more than 5,000 contracts a day would
appear to be the minimum. It is currentlyimpossiblefor these funds to invest in futures market in India.
But evenif their participationwere allowedand capital controlsamended,it is unlikelythat these funds
would be interestedat once in participatingin Indian markets:now, the most liquid markets only trade
around 2,000 contracts a day. Another constraint may be the limited capitalizationof the clearing
departmentsof Indianexchanges(see paragraph 4.19).

4.30 Regulatory Reforms Necessary. Attracting foreign participation will require some
regulatory reforns including the lifting of the foreign participation ban, changes in tax and profit
repatriation policies. For foreign entities, the problem of asymmetrical tax treatment (para 3.40)
becomes particularlyrelevantbecauseof exchangerate movements. For example,the dollar value of a
loss today is likelyto be differentfrom the dollar value of a gain in the future. Hedginglosses should be
allowedto be deductedfrom a firm's ordinary income.

4.31 Existing capital control policies may also cause problems if foreign participants are to be
attractedto Indianmarkets. These difficultiescan be illustratedin the case of a foreigntrader who buys
Indian cotton forward for a fixed price in rupees and hedges by selling futures contracts. The trader
pays the major part of the purchase price in advance using a pre-export credit. To manage his
downside price risk, the trader sells futures contracts on an Indian exchange. If spot prices indeed
decline, and assuming a stable exchange rate, the foreigntrader will be able to cover for the losses on
the physical transaction by the gains he will make by closing-outthe futures position. The trader's
 51

financial position is safe as long as he is allowedto repatriate his futures market profits. If he is not,
trading in Indianexchangeswill not be useful for foreignparticipants.

4.32 Stability in Government Policy. The degree of stability in government policies will also
greatly influence foreign participation. For example, internationalcompanies may be interested in
hedgingtheir commoditypurchases from India. A foreignfirm can lock in cotton prices for next season
or their transactionsin other countries. It can enter into an anticipatoryhedge (buying futures contracts
in India in the expectancy of being able to buy physical cotton some months later). But if cotton
exports are suddenly banned, the hedge has turned into speculation. Such events will deter
participation. Foreign firms could possibly use the Indian castorseedcontract to manage the risks of
international castorseed trade; the jute contract in Calcutta to cover the price risks for exporters in
Bangladesh;or the black pepper contract in Cochinto lock in prices of purchases from Malaysia. For
these to be possible,prices in India must move more or less in tandem with internationalprices. This is
likely if India plays a major role as exporter of these commodity,and if discretionarycontrols over
exports remain minimal.

4.33 Addressing Potential Capital Flow Problems. New regulatory concerns, such as the
potentially detrimental effects of short-term capital outflows on the economy and the problems of
possible moneylaundering, would arise if foreignuse of commoditymarkets is allowed. In the case of
India, short-termcapital outflows should be of much less concernthan for, for example, Mexico. India
has a low current account deficit, has undertakenvery limited short-term borrowing, and has large
foreign exchange reserves. Nevertheless,one could consider a model, such as the one used by Chile,
which allows foreign portfolio investment,but puts clear limits on the speed at which funds can be
repatriated.

4.34 A situation may arise where an entity, having a large amount of black money, undertaking
opposite transactions on the futures and the physical market, with the purpose of losing the black
money in the futures market, while gaining the equivalentof now legitimateearnings on the physical
market. This type of practices is possible through a domestic company and could be quite easily
spotted; but checks on foreign companieswould be much more difficult. An entity could legitimately
buy stocks of a commodity,and then, once its stocks are in place, push up pnces by buying futures
contracts through an apparently unrelated foreigncompany. It will ultimately have to sell its futures
contracts at a loss, but will in the meantimehave made an apparently legitimateprofit on its physical
position. To reduce the likelihoodof this type of occurrences,a strengthenedFMC could enter into
"Memoranda of Understanding" with foreign regulatory agencies, and allow reciprocal rights to
investigatesuspectedmanipulationattempts.

The Pepper CommodityFuturesMarket

4.35 The scope for attracting internationalinterest to the pepper futures market in Cochin was
analyzedin a recentUNCTAD report.3 The findingsof this study appear relevant for some of the other
commodities traded in India.

4.36 Price Volatilityin Pepper Trade. Pepper prices are highly unstable promptingmost hidian
exportersto hedgetheir transactionson the pepper futures market in Cochin.Among food conmmodities,
only sugar exhibits more price fluctuations than pepper. The exposure to such risk reduces

3 Feasibilitystudy on a worldwidepepper futurescontract,UJNCTAD/COM/64,

17 October1995.
 52

competitivenessof traders if left un-hedged. It was found that Malaysianand Indonesianexporters,the

two other major pepper exporting countries,were hardly able to sell more than three months forward,
while Indian exporters who have access to the futures market for hedging purposes, regularly sold
forward more than 6 months. Pepper exporters from other countries should thus be potentially
interestedin gaining access to a hedging vehicle. Indian farmers also benefit from futures markets by
receiving a significantlyhigher share of the export price of their pepper than their counterparts in
SoutheastAsia.

4.37 Importersprefer a steady supply at predictableprices. Forward contracts are not appropriate
because the risk of default is too large. Internationaltrade houses report that, when prices decrease,
about a quarter of fixed-pricecommodity forward contracts need to be re-negotiatedon account of
sellers' unwillingnessor inability to deliver; if prices increase, buyers tend to invoke severe quality
penalties or stick rigidly to contract conditions, effectivelyforcing down the purchasing price. By
contrast, futures contractsare defaultrisk-freesince a clearinghouse interposesitself betweenthe buyer
and the seller. Consequently,importersshouldalso be interestedin gainingaccess to the Cochin futures
market.

4.38 The large majority of commodityfutures contracts introduced in recent years have failed.
Although studies had shownthe existenceof a strong need for risk management,potential participants
were hesitant to enter the market as long as liquidityremainedtoo low. It was a vicious cycle that has
proven hard to break. Allowing foreign participation in the pepper exchange would circumventthis
problem: a large pool of liquidity already exists, and foreign players would have little problem in
placing even relatively large orders. GOI is now contemplatingallowing the Cochin exchange to
developas an internationalpepper exchange.

4.39 Measures to Ensure SuccessfulOperations. The success of the Cochin pepper exchange
will require more thanjust liftingthe ban on foreign participation. The pepper exchange, despite its
good quality service,is not as dynamica business entityas its counterpartsin other countriesare. It has
not been very active in the promotionof the available servicesamong potential users: it does not even
have a marketing division. The decisionsof the various commissionsof the exchange are slow. The
prices of the exchangeare not distributedthrough any informationvendors (such as Reuters or Knight-
Ridder). If this were done, the relevanceof the market to pepper producers,traders and buyers would
immediatelybecome much larger. Access to the market has been made more difficult by rules which
force members of the exchangeto obtain a local sales tax registrationin accordance with government
regulations;this takes a minimumof six monthsto one year, and is only feasiblefor those who have an
office in Kochi. Trading hours are unduly long for the small number of contractstraded. It would be
better to concentratetrade in one or two shorter sessions,whichwould free up the trading floor for trade
in other, new futures contracts.

4.40 Trading proceduresin the Cochin futures exchangewould needto becomemore sophisticated.
There is no system of time-stamping,an absence which would make it relativelyeasy for floor traders
to abuse their clients'confidence. The Cochinexchangecurrentlydoes not have an audit departmentto
control floor practices. Moreover, although much effort has been made to improve the clearing
procedures --margin deposits are relativelyhigh, varying between US$ 180,000 and US$ 350,000 at
the beginningof 1994 and clearing takes place daily- the clearing house arrangements, including its
financial reserves,may still not be suitablefor gaininginternationalconfidence.

4.41 The Cochin futures exchangehas benefitedthe Indian pepper community,but it is still some
distance from becomingan internationalexchange. The exchangewill haveto adopt an action program
 53

to bring it up to a higher operational level. Moreover, it would have to consider which practical
arrangernentsneed to be made to promote its internationalvisibilityand, in particular, how to adapt its
contracts specifications-delivery grades and location,contract currency- to make them attractive to
both local and international players. High liquidity should be an overridingconcern in adapting the
contract specifications. The first best policy would be to maintain a single contract availableto both
local and international users. Necessary ancillary measures would include: the freeing up of capital
flows linked to risk management -models on how to do this without losing full control over capital
flows are available from other countries; amendmentsto the tax treatment of profits and losses in
commodityfutures; and the creation of a brokeragenetwork which links the Indian market to foreign
brokers and potential clients. Concernedagenciesare showing interest in amendingsome of their rules
that deter foreignparticipation. The RBI is consideringto allow profit repatriationfor foreignusers of
the Cochin exchange; the Ministry of Finance appears inclined to treat the profits and losses in
commodityfutures at par with those on financial derivatives. Finally, a promotionalcampaign by the
Cochinexchange would be essential. The Cochinexchange is consideringteaming-upwith one of the
well-establishedand better known exchanges in SoutheastAsia, which would make it gain a better
internationalreputation,and immediateaccess to an internationalbrokeragenetwork.4

E. IntroducingNew Contracts

4.42 This section first reviewsthe general conditionsfor the introductionof new contracts. We will
then briefly analyze the potentialfor introducingnew contractsfor cottonand oilseeds,respectively.

General Considerations

4.43 The Introduction of New Contracts Should be a Private Initiative. Initiatives for
introducingnew contracts should come from the commodityexchanges. These exchangesshould be
free to experiment,and free to compete. Theirmembershipwill keep themfrom enteringinto non viable
propositions. This is not to say that the Governmenthas no role to play in the approval of new futures
contracts. There has to be a clear procedure for requests for new contracts, and for the approval of
such contracts. The requests should be specific and well argued: the exchange involvedhas to set out
clearly what need there is for the contract, whose interests would be served, which economic interest
groups support the introductionof the contract, and what are the proposedcontract specifications. The
proposal should then be open to public debate, with specific comments solicitedfrom all the interest
groups involved. If after public discussion,the FMC considersthe introductionof the proposed new
contract, evenafter revision,not to be in the public interest,it should havethe possibilityof rejectingthe
proposed contract with the possibilityof submission of a revisedproposal at a later date. The only
general category of exchange-tradedcontractswhich, at least for the comingfew years, would appear
risky are options (Box 4.3).

4.44 Cross-Hedging: One Single Futures ContractCan Serve the Hedging Needs of Several
Commodities. Cross-hedging is the use of one contract to hedge price risks in another related

4One possibleoutcomecouldbe a link-upbetweena trading floorin South-EastAsia withthe Cochinexchangein

India,trading the same contracton what wouldeffectivelybe one globalmarketwith two trading floors. Multi-floor
markets are already in existence,both for conimoditiesand for financialmarkets, and the necessaryexpertise,
informationand software to operate such a market are available;in effect, a similar possibility has been under
discussionfor sometime for rubber, with the Singaporecommodityexchangein a positionto provide all necessary
trading systems.
 54

commodity. For example, besides hedging the price risks related to the production, trade and
processing of rapeseed oil, a futures contract in rapeseed oil can also be useful for hedging the price
risks of other oils or oilseedsas well. The Chicago soybeanoil contract is used to manage price risks in
other vegetableoils; the arabica coffee contracts in New York is used to manage price risks of robusta
coffee;the nickel contract in Londonis used to managerisks in steeltrade.
Box 4.3
Should Options Be Introduced?

(ptions
functionlike insurance:by payinga prenium, buyerscan protectthemselvesagainst the risks of
deterioratingprices, while still remainingable to benefitfrom improvingprices. Options wouldappear particularly
:usefulfbrfanners, faners' associations,and state tradingcompanies. They are also attractiveto speculators,since
thoeyprovidethepossibiliptyof a theoreticallyunlimited gain for the paymentof onlya relativelysmall premium.
FromtheEpoint of viewof futuresexchanges,an option exchangewouldhelp to increaseliquidity,because arbitrage
betweenthe two markets will bring in new business.

Under current conditions in India, however, the introduction of options appears premature for the
followingpracticalreasons:
* many market0opertrs are not yet well-skilledin futurestrade, and these skills will need to be built up.
* tWilethe:purchase of options is a fairly simple and low-risk affair, the sale of options is not. A company
which sells an option and does not coverits risks has an unlimitedloss potentialcompensatedby only a small
possiblegain. Most option sales on westernmarketscome from a groupcalledoption marketmakers, who use
complicatedmathematicaltechniquesto hedge their risks of option sales on futuresmarkets. Indianoperators
do not appear to have the required technicalknowledgeyet, nor the required computersystems. In effect, as
long as priceinformationfrom the commodityexchangesis not fed into a computersystem on a minute to
rinute basis durinigthe tradingsession,it will be verydifficultfor marketmakersto operatein a safe manner.
The existence of option markets can be exploited by unscrupulous brokers to lure small investors
(shopkeepers,retirees etc.). The unlimited profits possiblethroughoptions would appear very attractive to
many small investors, without knowingnor being adequately informed that the vast majority of small
speculators normally loses all or most of their money. Therefore, in the absence of a national brokerage
regulations,it wouldappear in the publicinterest to postponeapprovalof option trade.

4.45 Basis Risk and LiquidityAre the Major Determinantsof Cross-Hedging Effectiveness.
The lower the basis risk, the more effectivea cross-hedgewill be. Basis risk is likelyto be lower if the
underlyingcommodityof the futures contract is the commodityin which the hedger is interested;for
example,the prices of a cottonseedoil futures contract are likelyto be better correlatedto cottonseedoil
prices on the spot market,than those of a soybeanoil contract. The lowerthe market liquidity,the less
effective a cross-hedgewill be. On futures markets with low liquidity,the "slippage" loss --i.e., the
differencebetweenthe price at whichthe hedgerwantedto close out his position,and the price at which
he manages to close it out-- can be considerable,easily amountingto 5 to 10 per cent.

4.46 Slippagelosses may well outstrip the reducedbasis risks of having a more "suitable"contract.
Thus, white sugar buyers and sellerscontinueusingthe raw sugar contract in New York, even though a
white sugar contract exists in Londonand Paris; sour crude traders continueto use the existing sweet
crude oil contract in New York evenwhen a sour crude contract was introduced;and the world cotton
contract introducedin New York in 1992 failed to take off, even if the prices of the existing cotton
contract reflectedAmericanrather than worldwideconditions.

4.47 Pre-conditionsfor a Viable FuturesContract. To increasethe probabilityof success, given

that most futures contracts introduced in western exchanges in recent years have failed, several
conditionsneedto be met by a futures contracts. Theseinclude:

* Supply and demandfor the commodityinvolvedmust be sufficientlylarge;

 55

* Prices of the commodityneed to be determinedby free market forces, without

monopolisticor too much governmentcontrol;
* Well-standardizedcommodity;
* Price fluctuations need to be sufficiently large to warrant the use of risk
managementtechniques;
* Well-functioningspot market;
* Futures market have the support of commercialinterests;
* Sufficientlylarge group of speculators;
* Sufficientlywell-developedexchange infrastructuralfacilitiesand other services;
and,
* Legal and regulatoryframeworkconduciveto futures markettrading.

4.48 The futures contract also needs to be well-defined, with contract as well as delivery
specificationsensuring a convergenceof physical and futures market prices at contract maturity. The
exchange which will be trading the contract needs to have a good reputation, with a sound clearing
house, and a governingboard seen as balanced and neutral. Potentialmarket participants need to have
a basic understandingof the role and value of futures contracts, and an easy access to the futures
exchange. We now turn to the reviewthe potential for new futures contracts in seed cotton (kapas),
cotton and cotton yam, as well as oils, oilseedsand oil meals.

The Potentialfor New Cotton Contracts

4.49 The growth of India'scotton production,its potential for export, and importanceof the textile
sector point to a large potential demand for an effectivemechanism of risk management. Trade in
hedge and TSD contracts in cotton and kapas is currentlybanned, and only NTSD cotton contracts are
allowed. As mentionedearlier, NTSD contracts, however, are inefficientand risky tools for price risk
management,becausethey do not allow sufficient flexibilityto users and bring with them significant
counterparty risks.

4.50 Reportedly, due to the need for more effective risk managementmechanisms, some groups
have not waited for officialsanction and have traded futures in both kapas and cotton for a number of
years. Several associations, with the support of traders, farmers' associations and textile mills
organizations,have requested for permissionto resume trading futures contracts in cotton. Farmers
ultimately bear the brunt of price instabilityif traders have no means to lay off their risks: to secure
their operations,traders have to build in a risk premiumin the price they pay to growers. Textile mills,
faced with volatileprices of their main input, find it difficultto quote fixed prices for forward sales to
their potentialclients, reducingtheir competitivepositionin the internationalmarket.

4.51 If cotton futures contractsare to be introduced,three basic questionsarise. Shouldthe contract

be for cotton, kapas, or cotton yam, or a combinationof the three? Cottonand kapas futures contracts
have been traded in India in the past; cotton yarn futures have never been traded in India but are
actively traded in Japan. Should one contract that encompasses all the main types of cotton be
introduced,or several contracts each representingone type of cotton? Shouldthe contracts be traded
exclusivelyin one exchangesor in severalexchanges?
 56

4.52 Prospects for Kapas Futures Contracts Are Good, But May Require Some Gestation
Period. The potential for a kapas futures contract is quite good, and stems primarily from its
attractivenessto both ginners and cotton growers. The long-termcorrelationbetweenkapas and cotton
prices is relatively high, indicating the
possible effectivenessof cross-hedgingof a Table4.1
kpossib ectivenesssf
ct ct theing m ostyear, CorrelationCoefficients betweenWeek-endSeedCotton
kapas fuiturescontract. Within most years, (kapas)andCottonPricesin Bathinda
weekly prices of seed cotton and cotton 1990-91to 1994-95
appear well correlated, with the exception ~
of one season when the correlation fell
below 80 per cent (Table 4.1). Gins, 1991-92 0 78 0 68
however, argue that in the very short run, 1992-93 0.88 0.93
prices of kapas and cotton move at times 1992-94 099 0.99
quite differently. Since they normally buy 1994-95 0.92 0.99
their kapas and sell it after processing Source: North India Cotton Association, Bathinda.
within no more than a few weeks, a low
short-term correlation would significantlyreduce the effectivenessof cross-hedging,making a kapas
futures contract less attractive to gins. Cotton growers would also be attracted to a kapas contract
since they would not be able to deliver against a cotton contract, even if they can use it for hedging.
This underscoresthe need for further and more detailedanalysis of the basis risks between kapas and
cotton by the commodityexchangesto assess the prospects of kapas futures contracts.

4.53 Potential Users. A futures contract in kapas would be of primary interest to farmers and
cotton ginners. In fact, such a contract would be of major interestfor gins if simultaneously,there is a
futures contract for cotton. By using both kapas and cotton futures, gins will lock-in their ginning
margins and ensuretheir profitability. They can do so even if the average ginning margin throughout
the year is not sufficientlyhigh. Such hedgingpracticesoffer a powerful, market-basedsubstituteto the
Ginningand Pressing Act which administrativelysets ginning margins. This will help stimulate much
needed investmentsin ginning. However, for futures contract in kapas to be successful there should
also be an interestof farmers or those actingon their behalf

4.54 An institutional framework already exists that would allow Indian farmers to access risk
managementmarkets, imcontrast to other countries. Throughoutmost of India, cotton is sold through
regulated markets, where commissionagents sell on behalf of farmers. Regulated markets provide
farmers with price information, and the commnissionagents could, in principle, offer farmers risk
managementservices. Many farmers also use banks, which are other possible intermediariesfor the
use of risk managementmarkets; by convincingfarmers to fix their forward sales prices, banks could
securethe reimbursementof their loans. In the UnitedStates, it is quite common for farmers' banks to
insist on hedgingby their clients.

4.55 Critical Determinants of a Successful Kapas Contract. The success of a kapas futures
contract will be largely dependenton the interestgeneratedamong ginners and farmers. Under present
circumstances,however, farmers show little interestin forward sales. NTSD contracts by farmers are
already allowed,for periods up to 120 days, but only a very small percentageof farmers actually avail
of this facility. This could be partly attributedto the lack of forward price information:in the absence
of a futures market, farmers cannot know what would fair price for their kapas for deliveryin 3 months
time would be. The lack of kapas grading practices --except in Maharashtra-- also militate against the
successof a kapas futures contract. Without farmers' interest,and implementationof grading practices,
any futures market in kapas would be strongly lopsided and would have little chance of survival.
Therefore, a significant educationaleffort focused on larger farmers, farmers' associations, farmers'
 57

banks and commissionagents in the regulatedmarkets, and on the implementationof grading practices
would be necessary before a contract in kapas would stand a chance of success. Cotton growers
cooperativescould play a positiveand constructiverole in introducingtheir members to the benefits of
futures markets. To play that role, however,the rules preventingfutures trade by cooperativeswould
need to be lifted. Furthernore, kapas contract would only stand a reasonable chance, if no futures
contract in cotton is traded in the same market

4.56 Lack of HistoricalExperiencewith Cotton Yarn Futures ContractsMay Limit Prospects

in the Short Run. Textile factoriesare exposedto fluctuationsin yam prices and textile production in
India is high enough to provide at least a potential market for cotton yarn futures contracts. A cotton
lint contract would be of no interest to textile factories looking for a way to manage their price risks,
although in the long run, cotton yam and lint prices are clearly correlated.From January 1990 to April
1995,the correlationcoefficientbetweenthe two prices was 72 per cent. However,within years, prices
often move in opposite directions(Table 4.2). With the openingup of new foreignmarkets for India's
textile products, the textile industry may indeed be interested in a risk managementtool, an option
whichthe exchangesmay keepin mind.

Table4.2
Intra-YearCorrelationbetweenCotton
andCottonYarn(60scarded)Prices
1990-94

Yarn Index & J34 | -0.52 | 0.67 | 0.02 0.81 0.91 0.93
Yarn Index & S6 -0.53 0.98 0.02 0.77 0.89 0.94
Source:IndiaCottonMillsFederation.
4.57 Prospects for Cotton Futures Contracts Are Good, But for Which Cotton Variety?
Although severalcotton futures contractshave been traded in Indiain the past, an importantquestionin
re-introducingthem is whether one or several contract(s) in cotton would best meet the needs of the
Indiancotton sector? 5

4.58 At the beginningof the century, sevendifferenttypes of cotton futures contractswere traded, a
number that was reducedto five in 1922 -of whichthree were activelytraded.6 During this period,the
large number of contracts posed problems. Turnover in each of the contractswas relatively small and
attemptsto comer the market were rife, so that cotton mills urged EICA to replace its five contracts by
one or at most two. Traders resistedthis move. Only in 1942the five contracts were replaced by only
one, against which all major types of cotton were deliverable.Cotton futures trade was banned from
1943 to 1952, with an interval in 1949. Futures trade started again in 1953,with one contract for all
types of cotton. Most major types of cotton could be tenderedagainst the contract, at a discount or
premium dependingon the discounts and premiums prevailingin the cash market. In 1956, a second
contract was introduced,since it was felt that a single contract could not cover the widely dissimilar
varieties of cotton producedin the country. But it was withdrawnin 1957by regulatorswho considered

S For the reader not familiar with the Indian cotton industry,it should be pointed-outthat India is unique in its
capacityto producethe entire range of cottonstaple lengths,from short and extra-longstaple. Price volatilityand
risk managementneedsmay varyacrosscottonstaples.

6 See, for the historyof cotton futurestrade in India, MadhooPavaskar, Saga of the cotton exchange,East India
CottonAssociationLtd., 1985.
 58

thatthere was not enough volume on the market for two differentcontracts. This situation continued
until futures trade in cotton was bannedin 1966.

4.59 To Succeed, Futures Contracts in Cotton Would Need to Carefully Develop an

Appropriate DeliverySystem Which Balancesthe Trade-OffsBetweenLiquidityand Basis Risks
Among andWithin Cotton Varieties. In the past, havingone futures contract did not appear to cause
major problemsto the trade. The problem had more to do with the inefficientsystem for determining
premiums and discounts. Although production has doubled since them, it does not appear likely that
continuingwith one futures contract with a wide deliverybase would cause more problemsnow than it
did then. The factor that would influencethe decisionto introduce one or more contracts is the risk of
low liquidityversus basis risks.

4.60 Fewer Cotton ContractsWouldImprove Market Liquidity. Having more contractsmeans

that each contract will have a lower liquidity,a smaller physical base, and a higher susceptibilityto
manipulation.At the same time, it means that normally, each contract will follow closelythe physical
market conditionsin the underlying type of cotton, rather than the possibly differentgeneral market
conditionsfor cotton. On the other hand, if the underlyingphysical market does not function well, a
widely definedcontract can make the deliveryprocess less effective. In particular, mills would avoid
taking delivery,because they do not know what they will receive. However, conditionsappear to be
present for a good secondary market which allows easy resale of unwanted cotton. Moreover, with
proper proceduresfor re-tenderingdeliverynotices,exchangesshouldbe in a positionto avoid this type
of deliveryproblems.

4.61 For a new futures market, liquidityis the main consideration,and efforts should be made to
avoid a dilution of liquidityby simultaneouslyintroducingseveral contracts. After all, there is only a
limitednumber of day-traders who are potentiallyinterestedin being active in cotton; and the interest
from outside speculators is also not likely to multiply if two or more, rather than just one cotton
contract,are introduced.
Table4.3
4.62 Basis Risks Are High, MajorTypesOf CottonProducedIn India,
ReflectingPolicy Impedimentsto 1992-93(MillionBales)
Better Integration of Physical ... .. ....
Markets. Basis risks in cotton Short (19 mm and below) 0.68 Bengal Deshi (0.56)
contracts are inherently high in (Rajasthlan)
India. This stems from the fact Medium(20mmnto21.5mm) 0.72 V-797(0.55)
that about 80 cotton varieties are (Gljarat)
grown, although no single type of Superior Medium (22 mmto 24 mm) 4.34 J-34 (2.45)
cotton dominates (Table 4.3). (Punjab, Haryana, Rajasthan)
Even though states do tend to Long (24.5 mmto 26 mm) 2.75 F-414 (0.97)
specialize, there is no strong (Punjab, Maharashtra) LRA-5166 (0.96)
delineation between the North, Extra Long (27 mm and above) 5.51 Shankar-6 (1.42)
(Gujarat, Andhra Pradesh, Madhya Pradesh, MECH-1 (1.09)
Center and South with respect to Karnataka) DCH-32 (0.88)
specialization in specific staple H-4 (0.87)
lengths. Any futures market has to Source: Indian Cotton Annual 1992-93, East India Cotton AssociationLtd., Bombay
cope with these two realities. 1993.
 59

Table 4.4
The Correlation Of Monthly Average Spot Prices
Between Main Cotton Varieties, 1984-1995

J-34 J F-414 S-6 H-4 DCH-32 J-34 F-414 S-6 H-4 DCH-32
J-34 1 0.98 0.88 0.98 093 J-34 I 0.97 0.91 0.93 -0.49
F-414 1 0.90 0.96 0.93 F-414 1 0.88 0.88 -0.38
S-6 1 0.85 0.91 S-6 1 0.89 -0.20
H-4 1 0.88 H-4 1 -0.46
DCH-32 I DCH-32 1

J-34 F-414 S-6 H-4 DCH-32 J34 F-414 S-6 H-4 DCH-32
J-34 1 0.99 0.97 0.94 J-34 I 0.95 0.83 0.80 0.85
F-414 1 0.99 0.98 0.92 F-414 1 0.87 0.86 0.80
S-6 I 0.99 0.97 S-6 1 0.87 0.67
H-4 1 0.95 H-4 1 0.58
DCH-32 I DCH-32 1
........................
11
J-34 I FJI41I S.6 H-4 DCH-32 J-34 F-414 S-6 H-4 DCH-32
J-34 1 0.78 0.86 0.20 0.49 J-34 I 10.95 J 0.39 0.89 0.60
F-414 1 0.61 0.32 0.50 F-414 1 I 0.59 0.82 0.42
S-6 1 0.11 0.57 S-6 [ 1 0.19 -0.46
H-4 1 0.30 H-4 1 0.72
DCH-32 I DCH-32 1

.J-34 F-414 S-6 H-4 DCH-32 3-34 F-414 S-6 H-4 DCH-32
J-34 ii 1 [ 0.99 0.98 0.981 0.97 J-34 I 0.88 0.99 .07. 0.11
F-414 I 0.98 0.98 0.98 F-414 1 0.33 |0.9 0.19
S-6 11 1 1 0.97 0.96 S-6 1 0.68 -0.17
H-4 111 1 | 099 |H-4 11 0.31
DCH-32
11 1 1 IDCH-32111 I
11J-3
I F-14IS-6IH-4 IDCH-32| 11J-34 F14IS6 I H4 ID -3
J-34 1 I I0.98 19 1 .1 0;2 II-4 r ;9 .9 .98 0 10.96
F-414 11 | I |0.95 |0.88 10.91 |F-414 || I 0.99 |0.98 |0.95
S-6 111 iT 0.852 091 lS-6 11| I1 0.97 0.96
H-4 11 1 1 1 0.82 IIH-4 11 1 11 0.98
DCH-32
11H I |DCH-32
111
Source: East India Cotton Association, Bombay.

4.63 The inherently high basis risks are compounded by the policy impedimentsto a better
integration of physical markets and blunted incentives for the implementationof grading practices -
Maharashtra monopoly procurementscheme,movementcontrols, storage controls, and export quotas.
If severalgrades and staples are made deliverable,a good system of discounts and premiums needs to
be elaborated,together with a reliablegrading system which is currentlylacking. Deliveryto and from
an exchangeis normallyby deliverynotice; on the basis of the grade specifiedon this deliverynotice, it
is determinedwhat discount or premiumover the futures contract price the seller will receiveand the
buyer has to pay. The grade indicatedenablesbuyers to determinewhether specificloads of cotton are
indeedwhat they require,and whetherthey shouldtake deliveryor re-tenderit. The perceivedreliability
of an exchangewill suffer stronglyif the specifiedgradesare not correct; evenwith an arbitrage systemn,
this always causes delays and extra costs. Fortunately,the main cotton exchangesin India appear to
have a good grading system in place; unfortunately,most cotton players are not used to using this
system, and largely trade by sample, rather than description,apparentlybecause of lack of familiarity
 60

or sufficientincentives. Even though only a smallshare of futures tumover normally resultsin delivery,
the soundness of the deliverysystem is essentialfor ensuringthe convergenceof futures and physical
prices and the usefulnessof the market for hedgers. Therefore,the exchangesinterestedin introducing
futures contracts will have to make an effort to educate their prospectiveparticipants in the use of
grading systems.

4.64 Even if the differentstaple-lengthshave differentphysical uses, their price behavior may be
similar because of substitution possibilities. In fact, in the long run, the main markets are highly
integrated:the correlationsof monthlyprices of differentmajor varietiessuch as J-34, F-414, Shankar-
6, H-4 and DCH-32 duringthe 1984-1994periodwere between 91 and 99 per cent, includingbetween
J-34 and DCH-32, the two types that show the greatest difference in staple length and end-uses.
However, within seasons, price correlation can be poor (Table 4.4). While J-34 and F-414 show a
good correlation each single year, the price correlation between these two and the extra-long staple
cottons was poor in four out of ten seasons, and the price correlationsbetween the various types of
extra-longstaple cotton were poor in five out of ten seasons.

4.65 If one cotton futures contract specifyingeitherJ-34 or F-414 as basis variety is introduced,the
basis risks for superior medium and long staple cottons would be low. There is no need to introduce
two different contracts simply because the various staple lengths within these two groups trade at
different price levels since a system of premiums and discounts would be sufficient to address the
differences. However, given past price developments,there would be significantbasis risks for those
wishing to hedge the price risks of extra-long staples (ELS). Because ELS is the type of cotton most
commonlyexported,and exporters often need to enter into long-termcontractsto secure their markets,
this is a situation which needs resolving. Introducingone contract for extra-long staples will not be
adequate, sincethe prices of the main cotton types withinthis group are not well-correlated. It would be
necessaryto introduceat least three differentcontracts,7 which reduces the likelihoodthat the required
liquidityis attained. Allowingdeliveryof extra-longstaple cotton against a contract which has J-34 as
its basis would also appear to cause difficulties,given sharp fluctuations in differentialduring some
periods.

4.66 Cotton Policy Reforms to Alleviate Trade-Offs Between Liquidity And Basis Risks.
Indian cotton markets are not well-integrated,and the inefficienciesin trade and storage are to a large
extent induced by government policies which prevent the national market from absorbing and
cushioningregionaldevelopmentsin production.If governmentrestrictionson storage are removed,the
existenceof a futures contract whichhas, for example,J-34 as its standard and which allowsdeliveryof
extra-long staple cotton against a regularly revisedpremium, is likelyto improve the integration of
India's cotton market. Because cotton traders are often active nation-wide,they will be in a position to
undertakelow-risk arbitragebetweenthe prices of the differentvarietiesof cotton. At the national level,
the introductionof one contractwhich allowsthe deliveryof the main superior mediumand long staple
cottonsthroughoutthe country should be considered. It would also appear worthwhileto study whether
delivery of one or more extra-long staple cottons against this contract can be allowed, subject to the
possibilityof devisinga proper system for determiningpremiums.

7 Significantly,the govermment
decidedin January1987to permnit
EICAto re-introducefuturestrading,for a period
of four years, in four differentvarietiesof extra-longstaple cotton:DCH-32,MCU-5,Shankar-6and H4. However,
since the infrastructurefor futurestrade had to be build up after a gap of 21 years, the irmmediateresumptionof
trade was not possible;and when a droughthit the cottonbelt in the followingseason,this permissionwas kept in
abeyance,and no futurescontractswere introducedat this time or since.
 61

4.67 Developmentof ComplementaryRegional Cotton Markets. If a national cotton futures

market is successful,more regionalmarkets can probably also co-existin its shadow, with ginners and
traders benefitingfrom the possibilityof fixingmargins and undertakingarbitrage. This may apply to a
kapas contract in the producing regions, a contract in the most consumed type of cotton by India's
textile industry,or extra-longstaple cotton contracts in the regionswhere they are produced. As noted
earlier, it should be left to the respective associationsto analyze such possibilitiesand determinethe
potentialof success for new ventures. Trade in NTSD contracts, organizedthrough regionalor national
exchanges,is still likelyto survive. Althougha futures exchangeprovidesliquidityand a clearing house
guaranteeon contract performance,NTSD are still a cheaperway to fix forward prices and deliveryfor
specificgrades of cotton between two parties who trust each other. Also, if the use of referenceprices
rather than fixed prices is allowedin NTSD contracts, these contracts, in conjunctionwith more flexible
futures contracts, would allow market participants optimal planning of operations, while at the same
time protectingthem from major price risks.

Potentialfor Oilseed, Oil and OilmealContracts.

4.68 The Indian vegetableoils industry appears to be the most eager to reintroducefutures trade.
The oilseeds industry, with support from groups of producers, traders, processors and end-users, is
asking for the permissionto reintroducefutures contractsin a wide range of oilseeds,oils and oil meals.
As in cotton,the oilseedsindustryis faced with the same questions:is there a need and room for a wide
variety of contracts? Should futures trade be concentrated in one center, or can it take place
simultaneouslyin several exchangesthroughoutthe country?

Table4.5
CorrelationCoefficientbetweenOilPrices 4.69 Oilseeds are normally
January 1989- April 1995 not for direct consumption;they
----- Al.areprocessed by small-scale
-- --------
.l._.......:::::::;:::::s:::~':::
mcrushers near production areas,
Mustardoil,UttarPradesh 1 0.86 093 from where the oil and meal
Soybean
oil,MadhyaPradesh 1 0.83
, '.
Groundnutoil,Maharashtra
, V.J
1 . ~~~~~~~~~~~~~~~~output
o enter national and
Source:Ministry
of Agriculture itemationa trade. There are
two groups of oils: edible oils
and non-edible oils. The major edible oils in India are groundnut, soybean, sunflower and
rapeseed/mustardseed oils and vanaspati. The maimnonedibleoils include ricebran, castorseedand
coconut oil. Between edible and non-edibleoils, substitutionis difficult. Within edible oils, many of
these oils are, in some form or other, substitutes. They also compete with vegetable oils from non-
oilseed. Within non-edibleoils, eventhough substitutionpossibilitiesare not perfect, manufacturersare
often able to change their production process to some degree, shifting from one oil to another in
response to relativepricemovements.

4.70 Government Policies & Regulations Explain The Absence of a Common, Domestic
Market for Oilseeds and its Derived Products. The Indian domestic market for oilseeds and its
derived products, oils and meals, does not appear to be well-integrated. Although the exact causes for
the absenceof a common,domesticmarket in the oilseedscomplexare beyondthe scope of this report,
 62

8 They include strict and

they relate to a large extentto governmentpoliciesand regulatoryrestrictions.
unpredictablerestrictionson movement,storage and access to credit; non-uniformtaxation of oilseeds
and its derivedproductsacross states; small-scaleindustryreservationfor the major oilseeds,groundnut
and rapeseed-mustard;absence of level-playingfield between cooperativesand formal, private sector
enterprises;meal export incentives;tax rebates for establishingnew processingunits.

4.71 Edible oils are more substitutable than oilseeds, and, barring movement restrictions, can be
transported quite easily;consequently,oil prices are usually relativelywell correlatedover the long-run
(Table 4.5). In the short term, however, edibleoils marketsdisplay poor level of integrationacross the
country; the price correlation fell below 70% between soybeanoil and mustard oil prices in 1992 and
1993,and betweengroundnutoil and the other two oils in 1994 (Table4.6).

4.72 Within a same region, oilseeds and their correspondingoil markets --with the exception of
soybean-- appear fairly well integrated,although not as well as edible oils across the country (Table
4.7).9

Table 4.6
Correlationof Weekly Edible Oil Prices by Year, 1989-1994

groundnut oil mustard oil soybean oil groundnut mustard soybean oil
oil Oil
|groundnutoil 1 0.93 0.83 groundnut oil I 0.96 0.85
mustard oil 1 0.86 mustard oil 1 0.86
soybean oil I soybean oil I

groundnut oil mustard oil soybean oil groundnut mustard soybean oil
oil oil
groundnut oil 1 0.89 0.85 groundnutoil 1 0.82 0.78
mustard oil 0.86 mustard oil l 0.62
soybean oil 1 soybean oil I

8For amor iledgaundnut oil mustard oil

dsoybean oilft o
groundput mustard soybean oil
Tgroundnut oil betwee c 0.76 0.76
oi groundnut94
oil per i0.c5 0.69
cmustardoil B b a mar n 0.54
emust d oil
a l t s p 0.9i
fsoybean oil I soybean oil
Source: Bombay Oilseeds & Oils Exchange, Bombay.

8 For a more detailed analysis of the policy determinants of the performance of the marketing and processing
perforrnanceof the hIndian oilseeds industry refer to the companion report on the oilseeds inidustry, World Bank,
forthcoming.

9 Thbe price correlation between castorseed and castor oil in Bombay is 94 per cent, but this is largely due to the way
castorseed prices in Bombay are measured: not directly, but through a formula in which the seed price is derived
from measured oil prices.
 63

4.73 Edibleoilseedsmarkets appear well integratedin the same region, but poorly integratedacross
India. For example,the correlationof weeklyrapeseedand groundnutprices in Bombayover the period
January 1989 to April 1995 was
89 per cent, and did not fall below Table4.7
Correlationof oilseedsand oils rices 1990-1994
75 per cent in any single year; by :::::::z:::::....::Bi
. .............
contrast, m one year out of tWU&, X *
groundnut pnicesin Hyderabad and 1989:::989:.: 0.8
0.86
0.961
0.96
0.4
0.84-
Bombay displayed little 1990 0.86 0.99 0.87 0.54
correlation.(Table4.8) 1991 0.91 0.97 0.99 0.66
1992 0.68 0.94 0.73 0.59
4.74 The edible and non-edible 1993 0.94 0.90 0.99 0.20
oilseeds markets show poor levels 1994 0.67 0.94 0.95 0.29
of market integration,even on a Source: BombayOilseeds&OilsExchange,Ministryof Agriculture.
single regional market, as should
be expected (Table 4.9). The long-termprice correlationbetween castorseedand groundnut prices in
Bombay is only 48 per cent duringthe 1989 and 1995 period, and in most years, there was hardly any
-elationat all betweenthe price movementsof these two seeds.

Table4.8 4.75 Oilmealsare a residual product from

CorrelationCoefficients of GroundnutPrices oil crushing, and the various types of meals
in Rajkot,HyderabadandBombay have different end-uses. Their prices are not
1989-1994 well-correlatedwith those of oils or oilseeds,
E4~Lr ..... , and eventhe differentoil meals do not sow the
i.8 :.:I2.. ,*R .:.:_Z
':::Z.:-. e7. .:::.::... . .... § same price pattern.
1989 0.24 0.82 0.80
1990 -0.09 0.77 -0.19 4.76 Crushing Margins are Highly
1991 0.09 0.71 0.18 Volatile, Pointing at the Need for Risk
1993 0.89 0.89 0.94 Tools by the Oilseeds
Management
1994 0.53 0.29 0.73Industry. Another distinguishing feature of
Source: MinistryofAgncuhtur the oilseeds industry is the extreme volatility
of its processing margins (Figure 4. 1). It is
a common, worldwvide phenomenon of this industry that is not unique to India. Until the recent
freeing of edible oils imports, the Indian oilseeds processing industry was highly protected and
faced little external competition except for meal exports. In the absence of futures markets to
estimate and lock in their future processing margins, oilseeds crushers had the ability to cover for
Table4.9 margin volatility through risk premiums built into
Correlation Coefficients Between higher processing margins. Strong competitive
Castorseed & Groundnut Prices pressures are now imposed upon the Indian
BombayMarket, 1990-1994 oilseeds industry through the tariffication of
-094.6 0.5 -. 19 1 .11 00 former barriers to import edible oils and the
openness of the meal market to intemational
Source: Bombay Oilseeds & Oils Exchange,
Ministry of Agriculture influences. This leaves Indian processors with
few means of defending their processing margins
when world prices move against them. In the absence of futures markets in the oilseed complex,
then farm prices will be forced down whenever processors feel a squeeze on their margins.
Futures markets could provide the oilseeds industry with the much needed risk management tool
to compete more effectively. Oilseed growers would stand to gain greatly from a more
competitive and efficient domestic processing industry. Substantial demand from the industry
should be expected which appears to be reflected in the current requests emanating from the
 64

exchange associations and the oilseeds industry itself. For the government, futures markets would
also provide a viable, market-based alternative to the possible re-introduction of distorting
government policies --e.g., canalization of edible oils imports, sudden increases in tariffs -- in an
attempt to protect the interests of the oilseeds industry and oilseeds growers.

4.77 In an Open Trade Environment,Contracts Facing Little Competition From Abroad

Stand A Greater Chance of Success. Edible oils imports have been liberalized recently; oilmeals
are freely exportable; soybean imports also have Figure4.1
been recently permitted. Under an open trade Instabilityin IndianOilseedsGrossCrushing
environment, arbitrage on the domestic futures Margins
market would only serve the needs of smaller
operators unable to trade on foreign markets, and Crushln Margn for Groundnutin Raikot,Jan 88 to Dec. 92
sufficient liquidity is unlikely to be achieved on 10
domestic exchanges. Besides, trade liberalization 9
is likely to result in a different type of price 8
formation in India. Seasonality in international oil 7
prices is much stronger than in India, and is now 6
more than likely to be imported. For those two
reasons, contracts are likely to be more successful -
for those commodities facing little to no 3
competition from abroad. In the edible oils group, 2
the most likely contracts to be successful are 1
groundnuts and, possibly, rapeseed-mustard A..0-1 .....
although quality issues would become more .,. C W =
known and open. Soybean contracts are likely to RRupees
be more difficult since, with trade liberalization, it I
is very likely to become a subsidiary of the Frequency Distribution of Real Monthly
Chicago futures. If, on the other hand, trade Raveseed Crushing Margins, Kanpur, Jan 1988 - Dec. 92.
liberalization is not going to be maintained
permanently, then, the industry is more likely to
use Indian futures 20

4.78 In the Short Run, Few Regional 15 . .....

Contracts Are Likely to Perform Better Than ......
National Contracts. The absence of a common, 10 .......
domestic market for the oilseeds strongly suggest
that there may well be space for more than one 5 ........
exchange trading oilseeds products contracts. ..........
Starting from an imperfectphysical market situation
where regionalmarketsappear to be betterintegrated -25 25 75 125 175 225
than the national market, basis risks across Rupees
exchanges are likely to be large and deter active Source: Ministry of Agriculture.
participation on a single, national exchange. This risk, however, should be balanced by the risk of
facing poor market liquidityon a regional exchange if too many contracts are introduced., a topic to
which we turn in the followingparagraphs. With the gradual lifting of govemmentrestrictionson the
domesticoilseedsmarkets, the perfonnance of the oilseedsmarket is expectedto improve and regional
physical markets will become better integrated. As the domestic physical market becomes better
integrated,the competition among commodityexchanges will intensify. The most active and better
performing ones will be automaticallyfavored by market forces. Exchanges, therefore, should make
 65

every effort to make their operationsas attractiveand transparentto all potentialusers, includingfrom
other regions as well. For example,the Bombay oilseedsexchange is often criticizedby large potential
users from other regionfor its lack of transparency in the operation of the price committee. Enlarging
the representationof all participants in the trade on the exchange's committeeswould help improve
confidenceand reliabilityin the operationsof the exchange.

4.79 In the Short Run, There is No Room for Many Oil Futures Contracts. The pattern of
price correlationssuggests that edible oils and non-edibleoils should be seen as two distinct groups.
Providedgovernmentinterference in price formation over space (non-uniform tax, movement and
storage prohibitions) are reduced significantly, a futures contract in one type of oil is likelyto provide
for the risk managementneeds of other oils from that group. Traders in mustard oil could then use a
groundnut oil contract, with only small basis risks; users of linseedoil could use a castor oil contract.
The fact that one could not make or take delivery is only a minor inconvenience. If a contract is
successful, exchangescan always considerthe introductionof other oil contracts, but at least in the
initial phases, it would appear wise not to dilute liquidityby introducingmore than one oil contract in
each group.

4.80 Edible Oilseed Contracts Are Likely to Complement Edible Oil Contracts. Edible
oilseeds contracts, alone, could have a difficult life because it is unlikelythat they will attract much
interest from the oilseeds processing industry. As indicatedearlier (paragraph 4.76), the demand by
oilseeds processors for the combinationof both an oilseeds and oils futures contracts is likely to be
large since it will givethem the ability to estimate and securetheir future processingmargins. An effort
will have to be made anywayto generateparticipationfrom the tradingand, indirectly,from the farming
community--through commissionagents, oilseedsgrowers' associationsand cooperatives- in order to
generategreater market liquidity. The situationin the case of nonedibleoilseedsdiffers, suggestingthat
a seed and oil contractswill unnecessarilycompetewith one another. To a significantextent, available
evidence suggests that the castorseedcontract is used to manage castor oil prices, a logical process
given the close price correlationbetweenthe two.

4.81 Prospects for OilmealContracts.Neither an oil nor an oilseedfutures contract is likely to be

a good vehiclefor a firm hedgingits oil meal price risks; so there could be room for futures contracts in
oil meals. However, because this group appears to be fairly disparate, and oilmeals are low-value
products, it is not clear whether sufficientliquidityfor a viable futures trade could be obtained. If there
is adequate interest,then its most likely place would be where most export trade takes place. As the
oilseeds industry continues to be liberalized, oilmeals quality and export performance adjusts to
international standards, oilmeal prices may well start reflecting international conditions. In this
instance,existinginternationalcontractssuch as the Chicago soymeal contract would competedirectly
with an Indian contract;that is an issuethat would requiremore study.

Summary

4.82 Public policy, includingexchangeregulations,shouldfocus on optimizingthe contributionthat

futures markets can make to the national economy.This would require allowing them to realize their
potential,while at the same time controllingabuses, both in the functioningof futures trade and in the
use that unscrupulousbrokers may make of exchanges. Commodityexchangesshould make an effort
to avoid abuses by their members,and to make as wide a group as possible benefit from the functions
that they perform for risk management,and in the collectionand disseminationof price information.
 ANNEX
GLOSSARY OF TERMS USED IN RISK MANAGEMENT

anticipatoryhedging Thepurchaseor saleof futurescontractsin anticipationof actualneedor availability;the

futuresmarketprovidesa pricetodayforanticipatedpurchasesor saleof physical
commodities.

arbitrage Thesimultaneoussalesand purchaseof equivalentcontractsin differentmarketswith the

purposeof benefitingfromofa discrepancy
of prices.

arbitragehedging Theuse of fiuturescontractsforlockingin a returnto storage,throughthe predictablechange

in the relationbetweencashand futuresprices.

backwardation The extentto whichforwardpricesare lowerthannearbyprices. Alsousedto referto a

situationin whichforwardpricesare lowerthan nearbyprices.

basis The differencein pricebetweena physicalcommodityand its corresponding fiAures

quotation.The basisreflectsdifferenttime periods,productgrades,and/orlocations.

basisvariety/grade Termsusedin Indiato indicatethe referencecommodityvarietyor gradestipulatedin the

futurescontract.

basis risk The unexpectedrisk(andconversely,profitopportunities)associatedwith the fluctuationsof

the basisaroundits "normal"levelfora certaingradeofa commodityat a certainlocation,
betweenthe timethat a hedgingpositionis establishedandthe timeit is closed.

bid An offerto buya commodity(includingfuturescontracts)at a pre-statedprice.

bid-askspread The difference,at a givenmoment,betweenthepriceofferedforthe purchaseof a contract

andthe priceaskedforthe saleof a contract.

broker A person,or company,paida commissionforacceptingor executingthe buyand sellorders

of a customer.

bucket shop An enterprisethat presentsitselfas a broker,butat the sametimetakingthe oppositeposition

of anyclientorders,that is, not executingtheseorderson the exchange.Oneof the main
formsof customerabuse.

call option A contractgivingthe right,but notthe obligation,to buya futurescontractat a specifiedprice

at or beforesomelaterdate. If this specifiedpriceis closeto the actualphysicalprice,the
contractis calleda teji in India. If the specifiedpriceis muchhigherthan the currentprice
(theoptionis out-of-the-money), in India,the contractis calleda teji-gali.

cashsettlement A methodof settlingcertainfiuturesor optioncontractswherebyinsteadof physicaldelivery,

contractsare closedout at a certainsettlementprice.

closeout To reversea fiuturestrade(byan oppositetransaction),andthus enda long or a shortposition.

Also called liquidate.

clearinghouse A divisionof the commodityexchange,or an independententity,throughwhichtransactions

executedon the floorof the exchangeare settled.Oncea bidor offeris accepted,the futures
 68

andthe clearinghouse
contractis recordedwith the clearinghouse becomesthe opposingparty
to eachcontract.It assumesthe sellingpositionfor eachbuyerandthe buyingpositionfor
eachseller. Theclearinghouserequiresthe postingof marginsas securityagainstpossible
defaultbytraders.

commercialdifference A paymentsystemwhereinprenuaand discountson the futurespriceare fixedon the basisof

systemof quality actualdifferencesbetweenthe readypriceof the contractgradeand the tenderablegrade,and
premium& discount basedon the dailypriceduringthe deliverypenod.

commission Feepaidto a brokerforthe executionof an order.

commodityexchange Anyorganizedmarketplacewhichservesas a fonumfor the tradein spotcommodities,

forwardcontracts,or futuresand/oroptionscontracts.It generallyrefersto a futuresmarket.

contango Theextentto whichforwardpricesare higherthan nearbyprices.

counterparty
risk Therisk that a counterpartywilldefaulton an obligation(suchas fulfillingobligationsunder
a physicaltradecontractor an over-the-counterrisk managementcontract).

cross-hedge Hedginga cash marketpositionin a futurescontractfora differentbutprice-related

commodity.

default Failureto meetan obligation,suchas payingmargincallsor deliveringagainsta contract.

delivery Theprocessof supplyingphysicalcommodities

in settlementof an expiringfuturesposition.

deliverymonth The specifiedmonthwithinwhicha futurescontractmaturesand canbe settledby delivery.

deliverynotice A noticethat can be presentedby the sellerof a futurescontractto the clearinghouse, oncethe
contractentersits deliverymonthbutbeforeexpirationof the contract,whichis subsequently
sentby the clearinghouse to the holderof a futurescontractnearingmaturity,to the trader
that a specificlot ofa physicalcommodity,witha certaingradeand to be foundin oneof the
exchange'srecognizedwarehouses,has beenassignedto him andthat he has to take
possessionof the commodities withina certaintimeframe.

deposit Amountrequiredbyclearinghouseas securitywhena positionis opened. Alsocalledinitial

margin.

derivatives Contractswhereinthe pricedependsdirectlyuponthe valueof oneor moreunderlying

contracts,securities,commodities,
or anyother agreedpriceindex. Derivativesincludeboth
exchange-traded instruments(futuresand options)and over-the-counterinstruments
(swaps,commoditybondsandother"hybrid"instruments).

differential Thediscountor premiumallowedon deliveryagainsta futurescontractfor gradesor

locationsbetteror worsethanthe standardgradeor locationspecifiedin the futurescontract.

electronicmarket A marketforumin whichtradersbuyand sellcontractsthrougha computernetwork,with the

matchingbidsand offers.
computersystemautomatically

fixeddifferencesystem A paymentsystemwhereinthe premiaor discounton the futurespriceare fixedin advance,

of qualitypremium& oftenforall futurescontractsof the season,beforethe commencement
of the seasonor before
 69

discount the startoftradingin a particularfuturescontract.

floorbroker A personwhoexecutescustomerorderson the tradingfloorof an exchange;the floorbroker

can alsotradeon his/herownaccount.

forwardcontract A contractsforthe purchaseor saleof a commodityfordeferreddelivery.It is differentfroma

spotcontractin that deliveryis in sometime in the future.

futurescontract Standardizedforwardcontract,whichrepresentsan obligationto makeor take deliveryof a

fixedquantityandqualityofa commodity,at a specificlocation.Futurescontractsare
tradedin commodityexchanges;in the commodity"tradingpit" or "ring"with
traditionally
bids madebyopenoutcryor throughelectronictrading.Theyare generallyclosedout
beforedelivery.

futuresmarket An organizedmarketplace,providingthe facilitiesforfuturesmarkettrade. A futures

marketcanbe an open-outcryexchange,or an electronicmarket.

grading Theinspectionofphysicalgoods,necessaryto ensuretheyare of the tenderablequality

definedin the futurescontract.Seealsothe commercialdifferenceand fixeddifference
systemofqualitypremium& discount.

hedge A purchaseor saleon a futuresmarketor optionsmarketintendedto offseta pricerisk on the

physicalmarket.Seealsoarbitragehedging,operationalhedgingandanticipatory
hedging.

hedge contract In India,a sub-typeofthe transferableforwardcontractwhichspecifiesthe basisand

tenderabledeliverygrades,anda rangeof deliverycenters.Bothbuyersand sellerscanclose
out theirpositions,anddeliveryis notobligatory.

jobbers Floorbrokerswhospecializein takingshort-termposition:outsideofIndia,the term is only

usedto indicatethoseactiveon stockexchanges;in India,the termalsoappliesto commodity
exchanges.Alsocalledlocals,scalpersor day-traders.

leg One partof a transaction,for example,a hedgehas a futuresleg and a physicalleg.

life of contract Periodbetweenthe daythat a futurescontractstartstradingand the dayit expires.

liquidity Indicatesthe easeat whichorderscan be executedwithoutundueeffectson pricelevels.

liquidation The closingoutof a longor shortposition.

local A smallcommodityexchangetradertakingpositionson his/herownaccount.

long A positionwithmorepurchasecontractsthan salecontracts.

lot The unitof tradingonthe market.

manipulation The deliberateattemptto movemarketpricesawayfromtheir trueequilibrium.

margin The securitydepositrequiredfroma brokerfor a positionbya clearinghouse.Theinitial

marginis a depositmadeto the clearinghouseas securitywhena positionis opened.It is
reneweddailyas openpositionsare markedto the marketor gains(or losses)are calculated
andaddedto (subtractedfrom)the initialmargin.Shouldadversepricemovementsresultin
 70

the initialmarginfallingbelowthe minimumlevel,a margincall is issuedbythe

clearinghouse for thedepositof the variationmarginor additionalfundsare requiredto be
depositedto raisethe marginto initiallevels.The minimummarginin the smallest
allowablemarginforthe establishmentofa futurespositionand is tailoredto offsetthe
maximumallowablepricefluctuationduringa tradingday. .

marketmaker In stockexchangesand someelectroniccommodityexchanges,a professionaldealerwhohas

an obligationto buywhenthereis an excessof sellordersandto sellwhenthereis an excess
ofbuy orders. On commoditymarkets,morecommonlyrefersto specialistcompanieswhich,
usir6 ckinplexcomputerprograms,undertakeactivearbitragebetweenoptionsandfutures
marketsandin thisway,are ableto be constantlypresenton the optionsmarket. At times,
alsousedas synonymforfloortrder.

maturity Periodwithinwhicha futurescontractcanbe settledby deliveryof the underlying

commodity.

net long If purchasesof futurescontractsexceedsales.

net short If salesof futurescontractsexceedpurchases.

Non-Transferable As definedbythe ForwardContracts(Regulation)Act, 1952,theseare forwardcontracts

SpecificDelivery betweentwopartiesin whicha previouslydeterminedcommodityof a specificgradehas to be
Contract(NTSD- deliveredto a specificlocationwithina pre-determined time frame. Similarto whatgenerally
contract) are called"forwardcontracts",with the differencethat the two partiesinvolvedare not
allowedto renegotiatepartof the contractclauses.

offer An indicationofthe willingnessto sellat a givenprice.

offset Closingof maturingcontracts.

offsettrade Tradewhichclosesout a tradersposition,suchthat the traderhas a zeronet positionwiththe

clearinghouse.

open-outcry A methodof publicauctionwhereparticipantsin one locationand makebidsand offers

throughopenoutcryandthroughhand signals.

operationalhedging The use offuturesas a substituteforan actualpurchaseor saleof a commodity,normallyfora

very shortperiodof timeto providethe firmsufficienttimeto assemblethe desired
commodityon termssuitableforthe contract.

option but not the obligation,to buy or sella futurescontract

A contractgivingthe rightor "option"f,
at a specifiedpriceat or beforesomelaterdate. To obtainsucha contract,the buyerneedsto
paya premiumor the pricepaidforthe right. If the commoditypriceincreases(decreases)
above(below)the strikeor exerciseprice,the commodityis bought(sold)at the exercise
price.If the commoditypriceremainsbelow(above)the exerciseprice,the buyer(seller)of
the optionsimplyabandonsit and the maximumlossis limitedto this premium..Seealso
calloptionandputoption.

over-the-counter Refersto a risk managementmarketthat is notpart of an organizedexchange,or to the risk

managementinstrumentsthat are tradedon thismarket.

positionlimit Themaximumposition,eitherlong or short,in onecommodityfuturescontract,or in all

contractmonthscombined,that anyonecompanyis allowedto holdeitherdirectlyor
 71

indirectlv.

positiontraders A type speculativetrader in the commodity exchange.who absorbs the imbalancebetween

aggregate commercialbuyers and sellers futurescontracts with the expectationof making a
profit from price changes over time. These traders hold their positions for a day to as long as
several weeks, in contrast to spreadtraders and scalpers.

physicals The underlying commoditieson which a futurescontract is based.

price discovery The processof determining the price of a commoditybased on supply and demand factors.

put option A contract giving the right. but not the obligation, to sell a futurescontract at a specifiedprice
at or before some later date. If this specifiedprice is close to the actual phvsical price, the
contract is called a mandiin India. If the specifiedprice is much lower than the current price
(the option is out-of-the-money),in India. the contract is called a mantli-galli.

ready-deliverycontract In Indianlterms, contracts which provide for the deliveryof goods and the full paynienl of tlhe
value of the goods at the price settledwhen the contract was entered into either i cniediatelv
or within a period of eleven days after signature of the contract.

recognizedassociation In India, an association recognizedby the Fonvard Markets Conmuissionfor the organization
of trade in forvard and futurescontracts. In other countries called 'contract market'.

recognizedwarehouse A warehouserecognizedbv a commodityexchangeas acceptablefor deliveryof commodities

against futures contracts. Such a warehouseneeds to fulfillcertain requirements in terms of
supportinginfrastructure(including transport and loading infrastructure). storage facilities.
capacity and location. Also called exchangewarehouseor licensed warehouse.

roll-over Replacementof maturing contractswith more distant contracts.

retender The processwhich allows a holder of a futurescontract who has receiveda deliverynotice
throughthe clearing house to sell a futuresContaMct
to closc out his position. rathcr than
having to take physical deliven.

ring A circular area on the trading floor of an exchange where traders and brokers stanldwhlile
executingfuturestrade. Also called pit.

roll-over A trading procedureinvolving the shift of a position in one contract monithto a position in a
contract month further fonrard, by closing out the nearby position and simultaneously
opening a position in the new contract montlh. Also callcd switch.

scalper A type of speculativetrader in the commodityexchange. nwhotries to profit froi smallbtit

rapid price changes. holding positions for only a veryshort time and rarely carnring open
positionsover niglht,in contrast to positiontraders and spread traders.

settlementprice The daily price at whlichthe clearing house clears all trades. It is used to determine margin
calls. Also referslo a price establishedb! an cxchange for contracts to be closed out throuigh
a cash payment. rather than through physical delivenr.

short A position with more sales contracts than purchase contracts.

short selling Selling a commodity one does not v own, in the expectancyof acquiring it later. Normal
 72

part of commoditytrade.

slippage The differencebetween the price at which the trader/hedger hopes to buy or sell and the pricc
at w-hichthe order is actually executed.

speculator A trader in commodityexchanges, who assume the risk which comumercial users Nxishto
hedge in the hope of making a profit. They also absorb the frequentlyimbalanced demands
of commercial buyers and sellers. See also three types of speculatorsin commodity
cxchanges: positiontraders, spread traders, and scalpers.

spotmarket In international tenns, a marketwhere transactionsinvolve the buyingor selling of

commoditics for immediate delivery. Also calledcash. physical or prompt markets

slprcadtraders A type of speculativetrader in commodityexchanges who absorbs the imbalances in the

degree of futuritvrequired by commercialbuyers and sellers. For example. if a buyer
purchases a nearby future and a seller requires a more distant future, the spread trader or
spreader may take on both positionswith the exceptionof making a profit from the relative
price changes rather than actual price changes per se. Spread trading may be performed
wvithiin
the same market for contractsof different maturities (intra-market spread) or
betvecentwo or more markets for the same period (inter-market spread).

tender days Days when deliven of futurescontractscan be madc.

tenderable grade Alternate grade of a commoditywhich can bc deliveredagainst a futurescontract, while

making appropriate price adjustmentsupwards or downwvardsreflecting the differencc from
the basis grade.

tender To make delivery:or to give notice to the clearing house of tlheintention to initiate deliveryof
the physicalcommodity.against an open short position in the futurcs market.

terminalmarket Synonymfor futures market.

Transferable Specific As defiled bv the Fonrard Contracts (Regulationl)Act, 1952. these are fonrard contracts
DelivervContract which are not NTSD contracts: that is. the initial parties to the deal can transfer their contract
(TSD-contract) to others, up to a pre-detemined number of times. Final deliveryis still expected.

volatility A statistical measureof the tendencyof a market price to vary over time.

volume The nmmber

of contracts traded on a market.
IMAGING

Report No: 15453 IN

Type: SR

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