1 E - TRADING Dr. Yogesh Singh Agri. Business Manager Haryana State Agricultural Marketing Board Electronic trading, sometimes called e-trading, is a method of trading securities (such as stocks, and bonds), foreign exchange, financial, & commodity derivatives electronically. Information technology is used to bring together buyers and sellers through electronic trading platform and networks to create a virtual market places such as MCX, NCDEX etc. which are also known as electronic communications networks or ECNs. Derivatives A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty. On the other hand, a merchant with an ongoing requirement of grains too would face a price risk - that of having to pay exorbitant prices during dearth, although favourable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into a contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be a futures-type contract, which would enable both parties to eliminate the price risk. In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the 'to-arrive' contract that permitted farmers to lock in to price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price changes. These were eventually standardised, and in 1925 the first futures clearing house came into existence. Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton, wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of financial underlyings like stocks, interest rate, exchange rate, etc.
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E - TRADING
Dr. Yogesh Singh
Agri. Business Manager
Haryana State Agricultural Marketing Board
Electronic trading, sometimes called e-trading, is a method of trading securities (such
as stocks, and bonds), foreign exchange, financial, & commodity derivatives electronically.
Information technology is used to bring together buyers and sellers through electronic trading
platform and networks to create a virtual market places such as MCX, NCDEX etc. which are
also known as electronic communications networks or ECNs.
Derivatives
A derivative is a product whose value is derived from the value of one or more
underlying variables or assets in a contractual manner. The underlying asset can be equity,
forex, commodity or any other asset.
The origin of derivatives can be traced back to the need of farmers to protect
themselves against fluctuations in the price of their crop. From the time it was sown to the
time it was ready for harvest, farmers would face price uncertainty. Through the use of simple
derivative products, it was possible for the farmer to partially or fully transfer price risks by
locking-in asset prices. These were simple contracts developed to meet the needs of farmers
and were basically a means of reducing risk.
A farmer who sowed his crop in June faced uncertainty over the price he would
receive for his harvest in September. In years of scarcity, he would probably obtain attractive
prices. However, during times of oversupply, he would have to dispose off his harvest at a
very low price. Clearly this meant that the farmer and his family were exposed to a high risk
of price uncertainty.
On the other hand, a merchant with an ongoing requirement of grains too would face a
price risk - that of having to pay exorbitant prices during dearth, although favourable prices
could be obtained during periods of oversupply. Under such circumstances, it clearly made
sense for the farmer and the merchant to come together and enter into a contract whereby the
price of the grain to be delivered in September could be decided earlier. What they would
then negotiate happened to be a futures-type contract, which would enable both parties to
eliminate the price risk.
In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and
merchants together. A group of traders got together and created the 'to-arrive' contract that
permitted farmers to lock in to price upfront and deliver the grain later. These to-arrive
contracts proved useful as a device for hedging and speculation on price changes. These were
eventually standardised, and in 1925 the first futures clearing house came into existence.
Today, derivative contracts exist on a variety of commodities such as corn, pepper,
cotton, wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of
financial underlyings like stocks, interest rate, exchange rate, etc.
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Evolution of Futures Trading and its Present Status
Organized futures market evolved in India by the setting up of "Bombay Cotton Trade
Association Ltd." in 1875. In 1893, following widespread discontent amongst leading cotton
mill owners and merchants over the functioning of the Bombay Cotton Trade Association, a
separate association by the name "Bombay Cotton Exchange Ltd." was constituted. Futures
trading in oilseeds was organized in India for the first time with the setting up of Gujarati
Vyapari Mandali in 1900, which carried on futures trading in groundnut , castor seed and
cotton. Before the Second World War broke out in 1939 several futures markets in oilseeds
were functioning in Gujarat and Punjab.
Futures trading in Raw Jute and Jute Goods began in Calcutta with the establishment
of the Calcutta Hessian Exchange Ltd., in 1919. Later East Indian Jute Association Ltd.,was
set up in 1927 for organizing futures trading in Raw Jute. These two associations
amalgamated in 1945 to form the present East India Jute & Hessian Ltd., to conduct
organized trading in both Raw Jute and Jute goods. In case of wheat, futures markets were in
existence at several centres at Punjab and U.P. The most notable amongst them was the
Chamber of Commerce at Hapur, which was established in 1913. Other markets were
located at Amritsar, Moga, Ludhiana, Jalandhar, Fazilka, Dhuri, Barnala and Bhatinda in
Punjab and Muzaffarnagar, Chandausi, Meerut, Saharanpur, Hathras, Gaziabad, Sikenderabad
and Barielly in U.P.
Futures market in Bullion began at Mumbai in 1920 and later similar markets came up
at Rajkot , Jaipur , Jamnagar , Kanpur, Delhi and Calcutta. In due course several other
exchanges were also created in the country to trade in such diverse commodities as pepper,
turmeric, potato, sugar and gur(jaggory).
After independence, the Constitution of India brought the subject of "Stock Exchanges
and futures markets" in the Union list. As a result, the responsibility for regulation of
commodity futures markets devolved on Govt. of India. A Bill on forward contracts was
referred to an expert committee headed by Prof. A.D.Shroff and Select Committees of two
successive Parliaments and finally in December 1952 Forward Contracts (Regulation) Act,
1952, was enacted. The Act provided for 3-tier regulatory system;
(a) An association recognized by the Government of India on the recommendation of Forward Markets Commission,
(b) The Forward Markets Commission (it was set up in September 1953) and
(c) The Central Government.
Forward Contracts (Regulation) Rules were notified by the Central Government in
July,1954 The Act divides the commodities into 3 categories with reference to extent of
regulation, viz:
(a) The commodities in which futures trading can be organized under the auspices of recognized association.
(b) The Commodities in which futures trading is prohibited. (c) Those commodities which have neither been regulated for being traded under the
recognized association nor prohibited are referred as Free Commodities and the
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association organized in such free commodities is required to obtain the Certificate of
Registration from the Forward Markets Commission.
In the seventies, most of the registered associations became inactive, as futures as well
as forward trading in the commodities for which they were registered came to be either
suspended or prohibited altogether.
The Khusro Committee (June 1980) had recommended reintroduction of futures
trading in most of the major commodities , including cotton, kapas, raw jute and jute goods
and suggested that steps may be taken for introducing futures trading in commodities, like
potatoes, onions, etc. at appropriate time. The government, accordingly initiated futures
trading in Potato during the latter half of 1980 in quite a few markets in Punjab and Uttar
Pradesh.
After the introduction of economic reforms since June 1991 and the consequent
gradual trade and industry liberalization in both the domestic and external sectors, the Govt.
of India appointed in June 1993 one more committee on Forward Markets under
Chairmanship of Prof. K.N. Kabra. The Committee submitted its report in September 1994.
The majority report of the Committee recommended that futures trading be introduced in
seed , copra and soybean , and oils and oilcakes of all of them.
5) Rice bran oil
6) Castor oil and its oilcake
7) Linseed
8) Silver and
9) Onions.
The committee also recommended that some of the existing commodity exchanges
particularly the ones in pepper and castor seed, may be upgraded to the level of international
futures markets.
The liberalised policy being followed by the Government of India and the gradual
withdrawal of the procurement and distribution channel necessitated setting in place a market
mechanism to perform the economic functions of price discovery and risk management.
The National Agriculture Policy announced in July 2000 and the announcements of
Hon'ble Finance Minister in the Budget Speech for 2002-2003 were indicative of the
Governments resolve to put in place a mechanism of futures trade/market. As a follow up the
Government issued notifications on 1.4.2003 permitting futures trading in the commodities,
with the issue of these notifications futures trading is not prohibited in any commodity.
Options trading in commodity is, however presently prohibited. Futures contracts in Wheat
and Rice have been discontinued from 01.03 2007. Futures trade in Urad and Tur have been
banned from 23.01.2007.
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Structure of Indian Commodity Exchanges
Forward Markets Commission (FMC) headquartered at Mumbai, is a regulatory
authority which is overseen by the Ministry of Consumer Affairs, Food and Public
Distribution, Govt. of India. It is a statutory body set up in 1953 under the Forward
Contracts (Regulation) Act, 1952.
The functions of the Forward Markets Commission are as follows:
(a) To advise the Central Government in respect of the recognition or the withdrawal of recognition from any association or in respect of any other matter arising out of the
administration of the Forward Contracts (Regulation) Act 1952.
(b) To keep forward markets under observation and to take such action in relation to them, as it may consider necessary, in exercise of the powers assigned to it by or under the Act.
(c) To collect and whenever the Commission thinks it necessary, to publish information regarding the trading conditions in respect of goods to which any of the provisions of the
act is made applicable, including information regarding supply, demand and prices, and to
submit to the Central Government, periodical reports on the working of forward markets
relating to such goods;
(d) To make recommendations generally with a view to improving the organization and working of forward markets;
(e) To undertake the inspection of the accounts and other documents of any recognized association or registered association or any member of such association whenever it
considerers it necessary.
Commodity Exchanges A commodity exchange is a market where multiple buyers and sellers trade
commodity-linked contracts on the basis of terms and conditions laid down by the exchange.
Commodity Exchanges are the formal platform for trading, clearing & settlement,
warehousing and information dissemination for efficient price discovery mechanism for the
futures market.
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National Commodity Exchanges Government identified the best international systems and practices in respect of
trading, clearing, settlement and governance structure and invited applications from
associations - existing and potential - to set up National Commodity Exchanges by
introducing such systems and practices. The term, "National" used for these Exchanges does
not mean that other Exchanges are restricted from having nationwide operations.
National Commodity Exchanges would be granted recognition in all permitted commodities;
the other exchanges have to approach the Government for grant of recognition for each
futures contract separately. Also, National Commodity Exchanges would be putting is place
the best international practices in trading, clearing, settlement, and governance.
Major Indian Commodity Exchanges
National Exchanges National Commodity & Derivative Exchange (NCDEX)
Multi Commodity Exchange (MCX)
National Multi Commodity Exchange of India Ltd. (NMCE)
Indian Commodity Exchange (ICEX)
Ace Commodity & Derivatives Exchange
Regional Exchanges Some of the regional exchanges are:
National Board of Trade (NBOT), Indore
The East India Jute & Hessian Exchange, Kolkata
The Chamber of Commerce, Hapur
First Commodity Exchange of India Ltd., Kochi
Bikaner Commodity Exchange Ltd., Bikaner
Bombay Commodity Exchange Ltd., Vashi
Central India Commercial Exchange Ltd., Gwalior
Cotton Association of India, Mumbai
India Pepper & Spice Trade Association., Kochi
Meerut Agro Commodities Exchange Co. Ltd., Meerut
Rajkot Commodity Exchange Ltd., Rajkot
Rajdhani Oils and Oilseeds Exchange Ltd., Delhi
Surendranagar Cotton oil & Oilseeds Association Ltd., Surendranagar
Spices and Oilseeds Exchange Ltd. Sangli
Role of commodity exchanges
a) Providing platform for trade b) Efficient price discovery c) Development of contract specifications d) Fixation of quality specification of commodities e) Price dissemination to ensure that farmers can view them f) Provision of delivery platform g) Warehousing logistics h) Quality assurance
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Market Participants
Participants who trade in the commodity and derivatives market can be classified under
the following three broad categories - hedgers, speculators, and arbitragers.
1. Hedgers: The farmer’s example that we discussed about was a case of hedging. Hedgers
face risk associated with the price of an asset. They use the futures or options markets to
reduce or eliminate this risk.
2. Speculators: Speculators are participants who wish to bet on future movements in the
price of an asset. Futures and options contracts can give them leverage; that is, by putting
in small amounts of money upfront, they can take large positions on the market. As a
result of this leveraged speculative position, they increase the potential for large gains as
well as large losses.
3. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy
between prices of the same product across different markets. If, for example, they see the
futures price of an asset getting out of line with the cash price, they would take offsetting
positions in the two markets to lock in the profit.
Commodity Transactions
Every transaction has three components - trading, clearing and settlement. A buyer
and seller come together, negotiate and arrive at a price. This is trading. Clearing involves
finding out the net outstanding, that is exactly how much of goods and money the two should
exchange. For instance A buys goods worth Rs.100 from B and sells goods worth Rs.50 to B.
On a net basis A has to pay Rs.50 to B. Settlement is the actual process of exchanging money
and goods.
Spot transaction: In a spot transaction, trading, clearing and settlement happens
instantaneously.
Forwards: A forward contract is an agreement between two entities to buy or sell the
underlying asset at a future date, at today's pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell the underlying
asset at a future date at today's future price. Futures contracts differ from forward contracts in
the sense that they are standardised and exchange traded.
Options: There are two types of options - calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price on or before a
given future date. Puts give the buyer the right, but not the obligation to sell a given quantity
of the underlying asset at a given price on or before a given date.
Warrants: Options generally have lives of upto one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated options are
called warrants and are generally traded over-the-counter.
Baskets: Basket options are options on portfolios of underlying assets. The underlying asset
is usually a weighted average of a basket of assets. Equity index options are a form of basket
options.
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Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are :
• Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
• Currency swaps: These entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite
direction.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap.
• World over commodity markets are larger than stock markets.
• In India too, commodity futures markets are growing despite the prohibitions that had
been imposed on them.
• In the commodity futures market, the period after the set up of national level
exchanges witnessed exponential growth in trading. The turnover increased from 5.71
lakh crores in 2004-05 to 119.48 lakh crores in 2010-11.
• Commodities of different segments traded on commodity exchanges- Agri, metals,
energy etc.
Futures Trade in Commodities
Rs. Crore 2009-10 2010-11 Growth (%)
Total Value of Trade 77,64,754.05 119,48,942.35 53.89
Trade in Agri Commodities 12,17,949.04 14,56,389.62 19.58
Trade in Bullion 31,64,152.24 54,93,892.12 73.63
Trade in Metals other than Bullion 18,01,636.31 26,87,672.99 49.18
Trade in Energy 15,77,882.06 23,10,958.58 46.46
Trade in other commodities 3,134.40 29.04 -99.07
Critical components of a Commodity Futures Contract
• Commodity Specification – Contract Month
• Trading Unit , Additional Quotation
• Margins – Initial, Special, and Additional
• Price Quote (Basis), Tick Size, Price Circuit
• Maximum allowable open position
• Delivery – Center, Quality, Logic (sellers/buyers/both)
• Penal Provisions
Role of Futures Market
• Risk mitigation
– Risk transfer platform from actual users to traders/ speculators – Helps hedger concentrate on core activity i.e. production
• Price discovery
– Long term price signals helps farmers to decide cropping pattern based on future prices
• Improves bargaining power of stakeholders
• Warehousing and pledge loan
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Economic Benefits of Futures Trading
1. Price stabilization in times of violent price fluctuations: this mechanism dampens the peaks and lifts up the valleys i.e., the amplitude of price variation is reduced.
2. Leads to integrated price structure throughout the country 3. Facilitates lengthy and complex, production and manufacturing activities 4. Helps balance in supply and demand position throughout the year 5. Encourages competition and acts as a barometer to farmers and other trade
functionaries
There are, broadly, two types of trading in the markets:
• Business-to-business (B2B) trading, often conducted on exchanges, where large
investment banks and brokers trade directly with one another
• Business-to-consumer (B2C) trading, where retail (e.g. individuals buying and selling)
and institutional clients buy and sell from brokers or "dealers", who act as middle-men
between the clients and the B2B markets.
Role of an Exchange
• Anonymous auction platform
– Confluence of demand and supply: Price Discovery • Transparent real time, Pan geographic price Dissemination
– Benchmark reference price – Liquidity to participants
• Risk Management in a volatile market
– Robust Clearing & Settlement systems - counter party credit risk absorbed – Fair, Safe, orderly market - rigorous financial standards and surveillance