Reforms to put the Indian commodity market in orbit

By: P. S. Reddy, MD & CEO, Multi Commodity Exchange of India Ltd. (MCX) Jun 2019

India’s commodity derivatives market was one of the fastest growing commodity derivative markets in 2018, with India’s largest exchange - Multi Commodity Exchange of India (MCX) - displaying an annual growth of 16% over the previous year, against a marginal 0.6% increase in 2018 in overall commodity derivatives volumes globally.[1] This growth - particularly when seen against the overall lull in benchmark global markets - can be clearly attributed to the reform measures being undertaken in the Indian market, since regulatory overhauls started in 2015.

India’s commodity derivatives market was brought into the regulatory remit of the Securities and Exchanges Board of India (SEBI) in September 2015, following the merger of the Forward Markets Commission with SEBI. SEBI is an autonomous regulator and has developed the Indian securities markets for the past two decades. With a market capitalisation USD 2.1 Tn (as at 31 December 2018), India's securities market is the world’s 7th largest. SEBI's experience therefore augured well for the commodity derivatives market.[2]

Benchmarking market regulation

Initial regulatory efforts centered around benchmarking market regulation in the areas of risk management, corporate governance, technological safeguards, and investor protection practices against regulatory prescriptions for other asset classes, in an effort to improve the level of trust amongst the markets’ current and prospective participants. These steps resulted in the creation of roadmap aimed at putting the market on a scaled-up growth path.

Various guidelines for product specifications, warehousing, and delivery safeguards were also brought to the table, and were rewritten in an effort to provide procedural transparency and safeguards to investors. One of the key policy reforms which enhanced participation in commodity markets was the removal of restrictions on commodity market brokerages offering services in other asset classes, leading to the integration of market intermediaries across product segments. On similar lines, all the regulated exchanges in India are permitted by SEBI to offer trading in regulated asset classes, including commodity derivatives. This took competition to a new high, and is expected to enhance innovation and lead to overall market development in the future.

Enriching the participant base 

Until recently only individuals and corporates were permitted to participate in the Indian commodity market, unlike other major global commodity exchanges that provide access to varied institutional participants. Reform measures were rolled out to permit institutional participation in the Indian market, with Alternative Institutional Funds (Category III (AIF-Cat III), similar to hedge funds in other geographies) being the first to be permitted in June 2017. In January 2019, in a major regulatory development, SEBI allowed custodians of securities to extend their custodial services to commodity market institutional players. This was a critical measure to bring institutional investors into the markets as institutions are required to appoint custodians to manage funds and securities. Significantly SEBI also permitted the participation of mutual funds and portfolio managers in commodity derivatives in March 2019.

Participation by these institutional investors (along with other institutional investors such as pension funds, insurance treasury investments - when allowed) will bring in rich liquidity in contracts that will enable more cost-effective hedging, and will contribute to improving overall market efficiency. Furthermore, institutions such as fund houses can also help make the process of price discovery more efficient with their robust research/analytic capabilities.

Enabling new products

In line with allowing new categories of participants, SEBI has also permitted new product segments, such as commodity options on futures, and announced its intention to allow index derivatives. Amendments to the regulatory framework were completed to enable derivatives on intangibles like weather.

Gold options were the first commodity options to be launched, with trading commencing on 17 October 2017. In addition to options on gold futures, trading in options on a few other commodity futures were also permitted in the country. Amongst these, MCX offers option contracts on gold, silver, crude oil, copper and zinc futures, with trading in gold and crude oil options accounting for 6% and 3% of the trading in the respective underlying futures contracts during January to April 2019. This growth in options on commodity futures bodes well for the Indian market, and compares favourably with established markets like CME, where gold options were about 15% of annual futures volumes in 2018. In a few years from now, India’s commodity derivatives market is likely to benchmark alongside its equity derivative markets; indeed, India’s Bank NIFTY Index options is the largest traded stock index options contract in the world.

In the trading world, it is well known that options and futures have a symbiotic relation, and the existence of these products provides participants with scope for executing a wide variety of strategies from the perspective of hedging as well as investment.

Propelling the Indian commodity derivative market into orbit

Commodity derivatives are important for all major businesses and corporates to manage price risks. This contributes towards enhancing the market competitiveness of an economy, and is therefore an important pillar in the financial landscape of any major economy. Given the fact that India is one of the world’s leading producer or consumer of various commodities, the initiatives being undertaken by SEBI have the potential to catapult the Indian commodity derivatives market into the league of the most influential markets on the global map.