Report No. 15453-IN

IndiaManaging Price Risks in India's LiberalizedAgriculture: Can Futures Markets Help?November 27, 1996

Agriculture and Water Operations DivisionCountry Department IISouth Asia RegionWorld Bank

Conimnoditv DivisionUnited Nations Conference on Trade and Development

Document of the World Bank

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CURRENCY

Rs/ US$Currency Official Unified Market a

Prior to June 1966 4.76June 6, 1966 to mid-December 1971 7.50Mid-December 1971 to end-June 1972 7.28

1971-72 7.441972-73 7.711973-74 7.791974-75 7.981975-76 8.651976-77 8.941977-78 8.561978-79 8.211979-80 8.081980-81 7.891981-82 8.931982-83 9.631983-84 10.311984-85 11.891985-86 12.241986-87 12.791987-88 12.971988-89 14.481989-90 16.661990-91 17.951991-92 24.521992-93 26.41 30.651993-94 31.361994-95 31.401995-96 33.46

April 1996 34.24May 1996 34.99June 1996 34.99July 1996 35.52Aug 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 exchange rate system was created in March 1992, with a free market for about 60 percent offoreign exchange transactions. The exchange rate was reunified at the beginning of March 1993 atthe free market rate.

Vice President D. Joseph WoodDirector Robert S. DrysdaleDivision Chief/manager: Shawki BarghoutiStaff Member : Benoit Blarel, Senior Economist

Abbrevations & Acronyms

BOOE Bombay Oilseeds and Oils Exchange Ltd.EC Act Essential Commodities Act, 1955EICA East India Commodity Association, Ltd.ELS Extra-long StapleFC(R) Act Forward Contracts (Regulation) Act, 1952FMC Forward Markets CommissionGOI Govermment of IndiaIPSTA India Pepper and Spice Trade AssociationNTSD Non-transferable specific delivery (contracts)RBI Reserve Bank of IndiaTSD Transferable specific delivery (contracts)UNCTAD United Nations Conference on Trade And Development

Table of Contents

CURRENCYABREVIATIONS & ACRONYMSACKNOWLEDGEMENTSECONOMIC DEVELOPMENT DATAEXECUTIVE SUMMARY

Chapter 1: The Role & Contribution of Commodity Futures Exchanges .................. 1Commodity Futures Markets: A Historical Perspective ........................................ 2Economic Benefits from Using Commodity Futures Markets ............................... 4Role of Speculation in Futures Markets ......................................................... ,,,.6Relationship Between Futures and Physical Markets .......................... .................6Domestic vs. Foreign Commodity Markets .......................................................... 7Summary ......................................................... 7

Chapter 2: Structure and Organization of Indian Commodity Exchanges ................. 9History of Commodity Futures Markets in India ................................................. 9The Regulatory Framework ........................................................ 10The Structure of Commodity Exchanges ........................................................ 19A Brief Overview of Selected Commodity Exchanges ........................................ 19

The Cotton Commodity Exchanges ........... ........................................... 20The Gur Commodity Exchanges .......................... ,. 20The Oilseeds Commodity Exchanges ......................... 21The Pepper Commodity Exchange ............................................ . 21

User Composition of Indian Commnodity Exchanges .21Summary .. 23

Chapter 3: The Performance of Commodity Futures Trade 25Operational Performance of Commodity Exchanges .25

Market Liquidity .2............................................... 25Suitability of Indian Futures Contracts .26Trading Practices .27Clearing Operations .28India's Unique Delivery System... 29Supporting Infrastructure .30Brokerage Industry .32Promotional and Development Capacity .33

Impact of Government Interventions .34Direct Government Interventions .34Indirect Government Interventions .35

Summary .39

Chapter 4: Opportunities & Options: Policy Implications .41Commodity Exchanges in a Changing Policy Environment 41Creating the Enabling Environment for Commodity Futures Trading .42

General Rules for a Permissive Government Policy ............................... 42Improving the Policy Framework of Commodity Exchanges ................... ........... 44

Legal & Regulatory Framework of Futures Trading .................. ........... 44Exchange Regulations & Operations ............................................. 47Institutional Development Assistance Required ..................................... 49

Potential for Internationalization of Indian Commodity Exchanges .................... 50The Pepper Conmmodity Futures Market ............................................. 51

Introducing New Contracts ............................................. 53General Considerations ............................................. 53The Potential for New Cotton Contracts ............................................. 55Potential 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 theForward Contracts (Regulation Act), 1952 ................................... 13

Table 2.2 Recognized Associations for Castorseed, Cotton,Gur & Potatoes by States, 1995 .................... 14

Table 2.3 Special Margins forCastorseed, September 1994 .15

Table 2.4 Recognized Cotton Associations in India .19Table 2.5 Recognized Gur Associations in India .20Table 2.6 Active Oilseed Commodity Associations .20Table 3.1 Bombay Castorseed Hedge Contract 1990-1993:

Amounts Tendered and Settled .................... 30Table 4.1 Correlation Coefficients Between Week-end Cotton Seed

& Raw Cotton Prices in Bathinda, 1990/91 to 1994/95 .................... 56Table 4.2 Intra-year Correlation Coefficient Between

Cotton Lint & Cotton Yarn (60s carded) Prices, 1990-1994 . 57Table 4.3 Major Types of Cotton Produced in India, 1992-93 .58Table 4.4 The Correlation of Monthly Average Spot Prices

Between Main Cotton Varieties, 1984-1995 ............................. 59Table 4.5 Correlation Coefficient between Oil Prices,

January 1989 - April 1995 ................ 61Table 4.6 Correlation of Weekly Edible Oil Prices, by Year

1989 - 1994 ...... 62Table 4.7 Correlation Coefficient of Oilseeds & Oils Prices,

1990 -1995 ...... 63Table 4.8 Correlation Coefficients of Groundnut Prices in

Rajkot, Hyderabad, and Bombay, 1989-1994 .............................. 63Table 4.9 Correlation Coefficients Between Castorseed &

Groundnut Prices, 1990-1994 .................. 63

List of Figures

Figure 2.1 Indian & International Classification ofForward & Futures Contracts .12

Figure 2.2 Organizational Structure of Commodity Associations .17Figure 4.1 Instability in Indian Oilseeds Gross Crushing Margins .64

List of Boxes

Box 3.1 Is Open Outcry Outmoded? .27Box 3.2 A Typical Broker on the Bathinda Gur Exchange .32Box 3.3 Contribution of Futures Markets to a Comprehensive

Agricultural Strategy: Potential & Limits of GovernnentMarket Interventions - The American & European Experiences. 38

Box 4.1 Lessons From China's Experience .45Box 4.2 Should Companies Be Protected From Futures Trade? . 46Box 4.3 Should Options Be Introduced? .54

Acknowledgements

This report is based on the findings of a joint mission by the UNCTAD and World Bankwhich visited India between April 17 and 28, 1995, and recent UNCTAD studies. The missionwas composed of Messrs. Lamon Rutten (UNCTAD) and Beno^it Blarel (World Bank). The reportwas produced by Lamon Rutten, Dina Umali-Deininger (World Bank), and Benoit Blarel (TaskManager). Contributions have been made to this report by M.L. Debatisse and P. Varangis(World Bank). Peer reviewers are R. Henry (IFC), A. Valdes and G. Feder (World Bank).Arrangements for the mission to India were made by Marilyn Chatterji and Padma Gopalan.Production assistance was provided by Roko Morith.

We gratefully acknowledge the cooperation of government officials, in particular theMinistry of Civil Supplies, the Forward Markets Commission, and the Department of EconomicAffairs. The document was discussed with the Indian authorities on April 27, 1996.

We wish to express our gratitude to the staff and members of the Commodity ExchangeAssociations, in particular the Bombay Oilseeds and Oils Exchange, the East India CottonAssociation, the India Pepper and Spice Association, the Northern India Cotton Association, theVijay Beopar Chamber Ltd (Muzzafarnagar), for their support and assistance in the production ofthis report, and for sharing with the mission members their knowledge and expertise about Indianfutures markets. We also gratefully acknowledge Dr. K.N. Kabra for sharing with the missionmembers his views on Indian futures markets.

ECONOMIC DEVELOPMENT DATA

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

Gross Domestic Product (1994-95)

Annual Growth Rate (% p.a., constant prices)% 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 94-95GDP at Factor Cost 272.0 90.3 3.4 4.2 5.4 5.9 5.0 6.3GDP at Market Prices 301.2 100.0 3.3 4.2 5.6 6.2 3.9 6.3Gross Domestic Investment 69.7 23.2 5.3 3.7 5.7 9.5 -5.8 19.8Gross National Saving 67.0 22.3 4.4 2.6 3.5 8.7 -1.1 17.2Current Account Balance -2.7 -0.9 -- -- -- -- -- --

Output, Employment and Productivity (1990-91)

Value Added Labor Force b V. A. per WorkerUSS Bln. % of Tot Mill. % of Tot. USS % of Avg.

Agriculture 82.5 31.0 186.2 66.8 443 46.4Industry 78.0 29.3 35.5 12.7 2195 230.0Services 105.7 39.7 57.2 20.5 1849 193.7Total/ Average 266.2 100.0 278.9 100.0 954 100.0

Government Finance

General Government c Central GovernmentRs. Bln. % of GDP Rs. Bin. % of GDP1994-95 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 10.1Revenue 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 -3.2Capital Expenditures d 337.9 3.6 4.3 266.8 2.8 3.5Extemal 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 6005.0BankCredittoGovernuent(net) 1171.5 1401.9 1582.6 1762.4 2039.2 2224.2 2626.7Bank 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 54.7Wholesale 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 7.7BankCredittoGovemment(net) 20.3 19.7 12.9 11.4 15.7 9.1 18.1BankCredittoCommercialSector 14.4 13.2 9.4 17.1 8.0 21.8 16.9

a. The per capita GNP estimate is at market prices, using World Bank Atlas methodology. Other conversions to dollars in thistable are at the prevailing average exchange rate for the period covered.

b. Total Labor Force from 1991 Census. Excludes data for Assam and Jammu & Kashmir.c. Transfers between Centre and States have been netted out.d. All loans and advances to third parties have been netted out.e. As recorded in the government budget.

Balance of Payments (USS Millions)

1992-93 1993-94 19 94-9 5pMerchandise Exports (Average 1990-91-1994-95)

Exports of Goods & NFS 23,585 28,925 34,141Merchandise, fob 18,869 22,700 26,857 US$ Mill % of Tot.

Inports of Goods & NFS 26,825 29,433 39,450Merchandise, cif 23,237 23,985 31,672 Tea 415 2.0

of which Crude Petroleum 3,711 3,468 3,428 Iron Ore 480 2.3of 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 6.7Non Factor Service (net) 1,128 777 -494 Textiles 2,483 12.0

Garments 2,542 12.3Resource Balance -3,240 -508 -5,309 Gems and Jewelry 3,449 16.7

Engineering Goods 2,674 13.0Net factor Incomea -3,422 -4,002 -3,905 Others 5,536 26.8Net 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 87,880Net 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 98,990Principal Repayments 2,949 4,169 4,814

Debt Service Ratio for 1994-95Other Capital Flowsc -961 2,086 3,462Non-Resident Deposits 2,001 940 847 % curr receiptsNet Transactions with MF 1,290 190 -1,174 Public & Publicly Guaranteed 19.6

Private Non-Guaranteed 1.2Overall 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 MillGross Reserves (end of year)d 6,749 15,476 21,160

IBRD IDARate of Exchange Outstanding and Disbursed 11,120 17,666

Undisbursed 4,227 4,663End-March 1996e USS 1.00 = Rs. 34.45 Outstanding incl. Undisb 15,347 22,329

- Not available.

a. Figures given cover all investment income (net). Major payments are interest on foreign loans and charges paid to IMF,and major receipts is interest earned on foreign assets.

b. Figures given include workers' remittances but exclude official grant assistance which is included within official loans andgrants, and non-resident deposits which are shown separately.

c. Includes short-term net capital inflow, changes in reserve valuation and other items.d. Excluding gold.e. The exchange rate was reunified at the market rate in March 1993.f Total exports (commerce); net of crude petroleum exports.

IndiamNe Sa_ reufwim grow Nd2s

LatesJt s gla kwr nwca.r hi, Une of .ssLa,a Semth 'lw. incom

Indicator rnwmr 1970-75 191045 1919-94 Asia bima group

Resources and Expenditures

HUMAN RESOURCESPopulation (mre-1994) thousands 613,459 765,147 913,600 1.220.285 3,182.221 1,096,881Age dependency rato raio 0.77 0.72 0.66 0.71 0.66 0.63Urban % of pop. 213 243 26. 26.0 283 55.9Populauion growth rae ennual % 23 2.0 1.7 13 1.7 13Urban 3.7 3.0 2.7 3.1 3.2 2.7

Labor force thousands 260.515 329.606 394330 528.101 1590.533 488.647Agricultum % of labor farm 70 67 64 63 67 36Industy ' 13 14 16 16 14 26Female - 31 32 32 32 39 40Labor parcpaton rams

Total % of pop. 42 43 43 43 50 45Fmanle 13 14 14 29 41 36

NATURAL RESOURCESAma thou. sq. km 3.27.59 3.27.59 3.27.59 5.133.49 40391.42 40.59443Daiqty pop. per sq. km 13660 232.74 273.21 233.41 77.44 26.66Agnculturaland %ofilndarea 60.83 60.86 60.Q9 59.11 52.42 41.05Change m agncuiWral lad annual * 0.47 -0.07 40.05 .002 0.16 -138Agnculursl land under iriganon * 18.65 23.09 25.96 29.63 17.84 11.40Forests and woodland thouL sq. km .. 551.19 517.29 65832 7.632.00 5.969.25Deforestaton (net) * change. 1980-90 _ .. 0.63

INCOMEHousehold incomeShare of top 20* of houseboks % of inmo 49 41 43 _Share of bonom 40* of households 16 20 21 _Shre of bottorn 20* of housebolds 6 3 J _

EXPENDrrUREFood * 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 68.936Food sad in ceeals 1.5I2 304 276 1.624 8.516 5.771Food producion percapta 197 -100 94 104 115 113 115 102Ferilizer consumption kgzba 193 47.0 67.5 69.7 58.5 463Share of agriculture in GDP of GDP 36.6 29.5 26.9 26.6 27.6 14.0Boning * of GDP 4.4 7.1 ..

Average household size person per househol 5.2 5.6 _.Urban 4.1 5.5

Faxed investment housing * of GDP 23 2.8Fue and power * of GDP 2.4 23 _.Energy consumption per cia kg of oil equiv. 124 170 243 219 373 1.602Households with electieityUrban % of households _ -_

RuralTransport and cmamumiadoo % of GDP 4.7 5.1 _ _Fixed investment tanisport equipment 1.4 23Toal road length thoL kmn 1.375 1.546 2.962 _

DiVESTMENT IN HUMAN CAPITALHelithPopuluaon per physician penons 4.900 2.522 .. .. .. 3.064Population per nurse 3.710 1.701Population per hospiual bed 1.700 1300 1.371 1.675 1.034 592Oral rehydyraion therapy (under-5) V. of cases .. .. 37 37 38EducationGros enrollment rtiosSecondary * of school age pop. 26 37 49 45 48 63Female 16 26 38 35 42 62

Pupil-teacher rtio: pnmay pupils per teacher 42 58 63 61 39Pupil-teacher raio: secondary 21 21 26 26 20Pupils reaching grade 4 * of cohort 51 58 _. -

Repeater rate: prinmry * of total eno 17 .. _illiteracy * of pop. (age 15.) 66 56 48 51 35Female * of fen. (age 5I+) _ 71 62 64 46

Newspacer circulation per thou. vo. 15 26 31 26 .. 236

World Bank International Economics Departnent. April 1996

IndiaMost S . r ri,.gincem. grw Neut

Last gLw yhr rhnt , highwUVtR of udmazz Smag& 'Lw- e...

Ii cater mewurr 1970-75 1950-15 19S94 Auia incoeme aromp

Priority Poverty Indicators

POVERMUpper povery line local .. ..c..HNedtt iida % of pop.

Lower povaty in localcn. .. ,. ._Headcoem index % of pop. ..

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

SHORT TERM INCOME INDICATORSUnskilld ban wga loca cur. -

Unsked twa wa. .Rul mm of trade . 84 94

Conaumr pnce inex 1987-100 45. 85 139 _Lower incomeFood' 27 _ _ _

Urban - 83 176

SOCMAL INDICATORSPublic expenditure an bac socu services % of GDP .. .. ..

GM" umllmntranosPrimay % school ge pop. 79 96 102 98 105 104Male 94 110 113 110 112 105Female 62 80 91 37 98 101

;.dtyInfant morlity per tbou. Ive birdh 132 108 70 73 58 36Under 5 mortality ' .. 97 106 101 47

lmmuizadcnmeail"s V. %ge group _ .. 85.8 84.2 86.2 77.4DPI .. 41.0 90.2 83.6 89.1 82.0

Child ralmtition (under-5) .. .. 63.0 61.5 38.2Ufc expectancyTot years 50 55 62 61 63 67Female advange -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 2.7Matde morality me per 100,000 live birds .. 460 437 _

Supplementary Poverty IndicatorsExpenditwa on a0a secunty % of total gvt cap. .. .. ..

SoCial secuty covetw V. eo alVe pOp. .. .. .. _ .. ..Access to afe waew. o %of pop. 31.0 56.3 ..

Urban 80.0 76.0 ..

Rural 18.0 50.0Acc:ess to health came. 75.0 .

Population growth rate GNP per capita growth rate Development diamondb(average anual, percent) 5 (average Annual, pcnt)Lif

4 5

2 0 ______________________ U~~~~~~~~~~~~~NP Gros2 * ' O- lG1\u+ perI nw

capita enrollment

0 -5

-2 -101970-75 1980-85 1989-94 1970-75 198045 1989-94 tosdhwm

- Low-incom - Lowincome

a. Sce the technical nooes, p.387. b. 7he devclopment diamnd, based on four key indicators, shows the averae level of development in the countrycompaed with its income group. See the introduction.

EXECUTIVE SUMMARY

MANAGING PRICE RISKSIN INDIA'S

LIBERALIZED AGRICULTURE:CAN FUTURES MARKETS HELP?

1. Context of Study in India's Agricultural Liberalization Agenda. Indian agriculture isnow gradually opening-up to world markets. While trade liberalization creates new economicopportunities, it also poses new challenges. Notably, price volatility and the capacity to cope withit are again becoming major policy concems. Price volatility creates uncertainty and risks whichcan threaten agricultural performance, and negatively impact the income and welfare of farmersand the rural poor. Indian policy makers have traditionally coped with the uncertainty and risksassociated with price volatility by resorting to policy instruments to minimize or eliminate pricevolatility: a virtually closed external trade regime, pervasive government controls on private sectoractivities, extensive market interventions, and crop insurance. These instruments, because of theirfiscal and economic costs, are now progressively and selectively being relinquished by theGovernment of India (GOI) in an effort to spur agricultural growth. An alternative strategy tomanage the uncertainty and risks inherent in agricultural markets remains to be devised, and thestalling of agricultural reforms avoided. The Kabra Committee recently submitted its report(September 1994) to GOI, recommending the introduction of futures contracts in basmati rice, seedcotton, 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-basedinstrument for managing risks that, potentially, could form part and contribute to the orderlyestablishment of a more open and liberalized agricultural sector. Unlike most other developingeconomies, India has a long experience in operating and managing commodity futures markets.Indian futures markets, however, have been operating under highly restrictive policies, providingthem little chance to contribute in any significant way. The present study is part of a larger set ofstudies undertaken by the World Bank in collaboration with GOI to review the constraints,opportunities and options to the improved performance of Indian agricultural markets; itcomplements companion studies that analyze the marketing performance of individual agriculturalmarkets --rice and wheat, oilseeds and its derived products, cotton, and sugar. It is not the purposeof this study to justify the use of futures markets for individual commodities; this larger question isaddressed in the context of the companion, individual commodity studies. Instead, the presentstudy concentrates solely on the steps and actions needed to ensure the orderly development ofagricultural futures markets as a generic risk management tool to improve the performance ofagricultural markets. The study (1) describes the generic roles which futures markets play inagricultural marketing (Chapter One); (2) describes the current structure and operations of Indian futuresmarkets (Chapter Two); (3) assesses the performance of Indian futures markets, and identifies its keypolicy determinants (Chapter Three); and (4) examines the policy, regulatory and institutional conditionsand options for expanding and improving the contribution of commodity futures to agriculturalmarketing, including the potential for the internationalization of Indian exchanges and the introduction ofnew futures contracts (Chapter Four). This study has been prepared on the basis of a review of availableliterature, including recent UNCTAD studies, field visits to a representative cross-section of commodity

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exchanges, and interviews with governnent officials, industry participants, and representatives fromcommodity exchanges.

3. Economic Roles of Commodity Futures Markets. Futures markets have emerged out ofthe need to deal with the risks associated with agricultural production, storage, trade andprocessing; they have emerged also in response to the counterparty default risk associated withforward 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, arenow 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 tohedge --i.e., cover for-- commodity price risks, by providing a vehicle for market participants toexchange risks. Futures markets also serve as a low cost, highly efficient and transparentmechanism for discovering prices in the future, by providing a forum for exchanging informationabout supply and demand conditions. The hedging and price discovery functions of futuresmarkets promote more efficient production, storage, marketing and agro-processing operations,financing, and overall agricultural marketing performance. Participation in futures markets is notrestricted 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 futuresmarkets, even in the USA; instead, farners benefit indirectly from the existence of futures marketsthrough easier access to better information about future prices, and through higher prices resultingfrom lower marketing and processing costs (paragraphs 1.13 to 1.24).

Main Findings

4. Long, Well-Established Tradition of Regulating and Operating Commodity FuturesTrading in India. Unlike many other developing economies, India has a long history ofcommodity futures markets. Futures trading was first introduced on the Bombay Cotton Exchangeand the Bombay Oilseeds & Oils Exchange as early as 1921 and 1926, respectively, and expandedrapidly to other commodities as well as to options trading (paras 2.1 to 2.6). The ForwardContracts (Regulation) Act, 1952 provides GOI with a well-developed, three-tier framework forregulating 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 ofthe recognized commodity exchanges associations (paragraphs 2.13 to 2.14). The recognizedassociations, in turn, organize futures trading in selected agricultural commodities, which theyregulate under their trading by-laws, generally modeled after the British and American commodityexchanges. The structure of commodity exchanges and their user composition are also very muchsimilar to that of other, international exchanges, although they provide fewer public services andtheir 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 functionswell and is cost effective, and trade recistrati otn procedures are well lald-out; other procedures,such as the weekly clearing operations t r thc absei ( e of time-stamping of transactions, differ frominternational 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 uniquedelivery system. Delivery to exchange warehouses is possible but not mandatory, and financialsettlement is allowed. The arbitrariness of the financial settlement system undermines theeconomic usefulness of Indian futures markets by breaking their link with the underlying physical

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markets, and supports the artificial backwardation --i.e., futures prices fall below spot prices-- offutures 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 andRestrictive Implementation of the Regulatory Framework. Direct government regulations area 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 futuresmarkets. Futures trading is currently allowed for only six, mostly minor agricultural commodities,'and forward contracts for three commodities. Futures and forward trading is prohibited orsuspended for over 100 commodities including all cereals, pulses, sugar, all edible and nonedibleoilseeds --except castorseed-- their oils and meals, cotton seed and yam, coffee, etc. Optiontrading is altogether prohibited (Table 2.1).

7. When permitted, the limits imposed by the FC(R) Act on contract specifications, such asits transferability, have often become so stringent to make futures trading an unattractive and riskyoperation. For example, in the case of cotton lint--the most significant commodity for whichforward trade is permitted-- only Non-Transferable Specific Delivery (NTSD) contracts areallowed (paras 2.27 to 2.32). Because of their non-transferability, NTSDs do not qualify asfutures contracts according to intemational definition, but come closer to forward contracts. Inresponse to the legitimate risk management needs of commercial users, significant illegal trade infutures contracts --seed cotton (kapas) and cotton lint, groundnut and mustard oils-- is reportedlytaking 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, andpositions 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). Thediscretionary implementation of controls contrasts sharply with the initial intent of the FC(R) Actand intemational practice. Additional regulations that limit the access to, and usefulness of futuresexchanges include: income tax rules which do not recognize hedging, creating a taxationasymmetry between physical and futures markets transactions for potential users (para 3.40); orthe ban imposed by the Reserve Bank of India (RBI) on the participation of large, institutionalinvestors --pension funds, insurance companies-- which, elsewhere, provide market liquidity asnatural counterparts to the large hedgers. The participation of intemational users and somedomestic users, such as agricultural cooperatives, is also made virtually impossible as a result ofregulatory barriers (paras 2.41 to 2.46). The Indian brokerage industry, in contrast with othercountries, is small, poorly capitalized, highly fragmented, and remains un-regulated. Whileconsistent with the stringent constraints on the size of operations of commodity exchanges, thecurrent structure of the brokerage industry is likely to become a serious impediment to the orderlydevelopment of futures markets (paras 3.27 to 3.35).

9. Economic Usefulness of Indian Futures Markets Further Reduced by GovernmentInterventions on the Physical Commodity Markets. Government interventions include storageand movement controls embodied in the Essential Commodities Act (EC Act), 1955, the selective

1 Futures trading is currently allowed in: raw jute and jute goods, black pepper, castorseed, gur (a non-centrifugal sugar), potatoes, and turmeric. Forward trading is allowed in cotton lint, jute goods, raw juteand hessian.

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credit controls issued by the RBI, external trade policies, and government market interventionswhich 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 totrade credit severely restrict the economic usefulness of futures trade by preventing the arbitrage ofagricultural commodities across space and seasons in an efficient and competitive fashion (paras3.41 to 3.48).

10. In the case of rice, wheat and sugar, government interventions on the physical marketseliminate most price risks for private operators by dominating procurement and distribution (theFood 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 wheatprocurement and issue prices, sugarcane State Advised prices, and sugar issue prices) withsubsidized transport and storage by the Food Corporation of India (rice and wheat), and theadministrative setting of processing margins (sugar). The absence of any reported illegal futurestrading activities in rice, wheat and sugar suggests the lack of interest by private operators in riskmanagement tools under existing policies on the physical market; even if GOI were to allow futurestrade, 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 themarket --within the confines imposed by the storage, movement, selective credit controls, andexternal trade restrictions. The presence of more active legal futures trading in the case ofcastorseed, 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 thephysical 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 ProvidedGovernment Policies on Physical Markets Follow a Few Rules. Government interventionsshould not eliminate price risks; they should not strongly restrict the normal flow of commodities inthe economy, should leave a sufficiently large part of the physical trade in the hands of the privatesector, and let prices clear the market; they should also provide for a stable and predictableexternal trade environment (paras 4.5 to 4.7). Indian agricultural policies for rice, wheat and sugardo not satisfy any of the above minimum rules, making futures markets impossible. For otheragricultural commodities, notably cotton, oilseeds and their derived products, several minimumconditions are satisfied. In their case, spot and futures markets can be allowed to develop insynergy. Remaining imperfections in the physical markets imposed by current governmentrestrictions on storage, movement and access to credit should not prevent commodity futuresmarkets from operating for those commodities. Instead, the presence of a futures market willencourage those active in physical trade to improve their market practices every time a governmentrestriction is relaxed (para 4.8). The contrasting experience of American and European agriculturalpolicies shows the potential and limits which government interventions impose on the performanceof 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 MarketsNeeds to be Improved to Ensure Orderly Development. China's disappointing experience withthe introduction of futures markets underscores the central importance of a good regulatory andinstitutional framework for the orderly development of futures trading (Box 4.1). Unlike manydeveloping economies, India enjoys a strong regulatory system for commodity exchanges and

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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 agriculturaleconomy. These measures should aim at providing the framework for futures markets to realizetheir 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 ofthe three-tier regulation model provided by the FC(R) Act (paras 4.9 to 4.12). Under such amodel, the government would still approve exchanges, and set the general legal and regulatoryframework. GOI would need to introduce a two-tier national brokerage regulation for the specificpurpose of consumer protection (para 4.23), and prudential rules for the use of risk managementinstruments by companies to ensure that companies install proper internal control systems beforestarting the use of futures exchanges (Box 4.2). The FMC would play a monitoring role, approverequests for the introduction of new futures contracts emanating from the commodity exchangeassociations, and intervene when the situation warrants it. The participation of commercialhedgers, including cooperatives, and large institutional investors should be promoted throughchanges in incomes tax rules, tax registration requirements, and bans on participation (paras 4.13to 4.14). On the institutional front, the FMC would need to be strengthened to fulfill its newresponsibilities (paras 4.25 to 4.26). Commodity exchanges would need to up-grade their rules andregulations -- trading procedures, delivery system, trade supervision -- clearing operations, andpromotional and development activities and their implementation and monitoring capacity (paras4.15 to 4.24).

14. Low Volume of Trade and Regulatory Concerns Will Likely LimitInternationalization 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 thedevelopment of a warehousing and financial service industry. From the point of view of foreignentities, participation in Indian commodity exchanges can provide new portfolio investment andrisk management opportunities. Accommodating foreign accounts in Indian exchanges will not bedifficult: by-laws were formulated in accordance with international standards. The limited tradevolume 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 andprofit repatriation regulations will be required. The potential detrimental effects of short-termcapital outflows, and problems of possible money laundering will arise if foreign participation isallowed; practical solutions from other countries are however available (paras 4.27 to 4.34). Thepractical implications of the internationalization of the Cochin pepper exchange, beingcontemplated by GOI, are briefly reviewed (paras 4.35 to 4.41). The willingness of the concernedagencies to reevaluate some of their regulations attests to the renewed government interest infutures markets.

15. Cotton Industry: Short Run Prospects for National Futures Contracts Higher forCotton Lint than Seed Cotton (kapas) and Yarn. Immediate prospects for the introduction offutures 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 theshort run, as testified by the reported active illegal futures trading. To succeed, cotton lint futurescontracts would need to carefully develop an appropriate delivery system which balances the trade-

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offs between liquidity and basis risks among and within the large number of cotton varietiesproduced across India. Available evidence suggests that cotton sector policy reforms, by improvingthe performance of cotton physical markets and their stable integration with world markets, wouldgo 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 ofthe main superior medium and long staple cottons throughout the country could be considered. Thedelivery 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 to4.67).

16. Oilseeds Industry: Complementary Introduction of Groundnut Oil and Rapeseed OilFutures With Corresponding Seeds Futures Contracts in a Few Regional Exchanges is aLikely Successful Strategy. Access to oilseeds and oils futures contracts will raise thecompetitiveness of the Indian oilseed industiry now facing foreign competition from imported edibleoils. This, together with the presence of large illegal futures trading in oilseeds, points to the largedemand from the industry for the introduction of futures contracts in the oilseed complex. In anopen trade environment, futures contracts facing little competition from abroad are likely to stand agreater chance of success. This implies that groundnut and rapeseed-mustard futures contractsshould stand a greater chance of success than soybean contracts which will compete with theChicago 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 initiallyimperfect physical market situation (paras 4.68 to 4.81).

1 The Role & Contribution ofCommodity Futures Exchanges

1.1 Futures markets have traditionally been concentrated in a few countries heavily engaged inworld commodity trade. Over the last decade, futures markets have expanded into many other countriesas diverse as Russia, China, Poland, Hungary, Brazil, Singapore and the Philippines. The reduction ofgovemnment interventions in agricultural pricing together with the opening-up to world markets leads tothe need for price discovery mechanisms. These policy changes also expose many actors to risks theydid not face previously, raising the need for new mechanisms to manage risk. In recent years, manycountries have found it worthwhile to promote the creation of new, domestically-oriented futuresmarkets. During that process, however, many of these countries encountered problems, the mostsignificant of which are the absence of a proper regulatory framework and a lack of understanding of andexperience with futures trade. India, however, is well-off on both accounts. India has a multitude ofcommodity exchanges, decades of experience with market regulation, and a strong legal base. India'scommodity exchanges are becoming increasingly vocal in their desire to expand their operations. Thisappears to fit well with India's economic liberalization and its wish to increase exports. Is such anexpansion indeed desirable, and if so, what factors would make it possible?

1.2 Futures contracts are standardized forward contracts that are tradable, and futures markets --orcommodity exchanges- are where trading of these contracts occur'. All futures contracts arestandardized in their obligations to make or take delivery of a fixed quality and quantity of a commodity,at a specific location, on a specific future date and time. In contrast, forward contracts are notstandardized. Two institutional features, margins and the clearinghouse, distinguish futures fromforward contracts. Margins are security deposits made by both the buyer and seller to the clearinghousewhen trading; the clearinghouse, which is either a division of an exchange (as is the case in France, India,Japan and the United States of America), or an independent service provider (the case for Australia,Malaysia, and the United Kingdom), records and acts as the third party to all transactions in order toensure contract performance. In principle, the margins eliminates the risk of default, while theclearinghouse eliminates counterparty risk, thereby increasing liquidity of futures markets.

1.3 The Forward Contracts (Regulation) Act, 1952 (FC(R) Act) regulates futures markets in India.The FC(R) Act, and its corresponding Rules and Notifications, do so by defining several types of futurescontracts, the commodities for which individual types of futures contracts are allowed, and by providingfor the rules of operation, control, and enforcement of futures markets. By introducing a classification ofcontracts that is unique to India, it should be noted that the Indian terminology provided in the FC(R) Actdiffers from the intemational terminology. This report will use the intemational terninology, whichmeans among other things that it will refer to as futures contracts -- as intemationally understood -- thosecontracts defined as transferable specific delivery contracts and hedge contracts in India by the FC(R)Act and its subsequent interpretations. The intemational reader should know that the FC(R) Act splitscommodity contracts into two categories: those which provide for the delivery of goods and full paymenteither immediately or within a period of less than eleven days after the date of the contract, at a pricefixed at the date of entering the contract (these are called "ready delivery contracts"); and all othercontracts, which are called forwvard contracts. 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 LiberalizingEconomies: Access to Futures & Options Markets, by M.L. Debatisse et al, EMENA Technical Departmnent ReportNumber 12220 ECA, World Bank, 1993.

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non-tradable specific delivery contracts, and tradable specific delivery contracts. The first are close towhat in international terminology are called forward contracts; the second are similar to futures contractsbut with the restriction to only one basis delivery vanety, and possible limitation on transferability. In itsimplementation, the Act also regulates trade in contracts that are virtually identical to the futurescontracts traded in other courtries (that is, with vanous tenderable grades and without limitations ontransferability), known in India as "hedge contracts"; although the Act does not define this category, theycan by implication be considered as transferable non-specific delivery contracts. Chapter Two willprovide a more detailed explanation of Indian definitions and their international equivalents.

1.4 Futures contracts in hxdia are currertly traded in only six, minor agricultural commodities. Therecent Kabra Report2, recommends the introduction of futures contracts in basmati rice, kapas (seedcotton), cotton, raw jute and jute products, a number of oilseeds and their oils

3, major oilcakes, linseed,

onions, gold and silver. The Kabra Committee bases its recommendations largely on an analysis of thesupply/demand conditions in the various markets, and the perceived risks of allowing futures trade forthe public interest.

1.5 This study assesses the general benefits and risks of futures markets trade, examines theperformance of existing futures markets, evaluates the reforms and investments needed to improve theirperformance, and reviews possibilities for introducing new futures contracts. This report is written onthe basis of a review of the available literature, field visits in April 1995 to Bathinda, Bombay, Delhi andMuzaIfmagar, and interviews with government officials, industry participants and exchange staff

1.6 The report is divided into four chapters. This chapter discusses the generic roles which futuresmarkets play in agricultural marketing. Chapter Two describes the current structure and operations ofIndian futures markets. Chapter Three assesses the performance of Indian futures markets, andidentifies the factors which influence it. Chapter Four concludes by examining the conditions andoptions for expanding and improving the contribution of commodity futures to agricultural marketing.The potential for the internationalization of India's exchanges and the introduction of new contracts isalso explored.

A. Commodity Futures Markets: A Historical Perspective

1.7 Commodity production, processing and trade are fraught with risks. Agricultural production issubject to the vagaries of weather and other natral conditions. At the time of planting, the prices atwhich the final product can be sold are not known. Processors buy raw commodities, and sell ther inprocessed form at a later date; in the mean time, the price of the processed product may have declinedresulting in unprofitable operations. Traders make sales commitments without having the commoditiesat hand, in the hope of buying low and then selling high, and in the process earn reasonable returns.

1.8 Conmmodity producers, traders and processors are not in their respectve businesses to speculateon pnce movements, but are simply forced to do so. Their real business is to add value, throughproduction, transformation, and logistics services. But within the marketing chain, price risk is one ofthe many factors they have to cope with in order to secure their margins. Volatile prices are a hindranceto adding value; the time involved in choosing the right moment to buy or sell and the effort needed to

2 Report of the Comrnmittee on Forward Markets, Ministry of Civil Supplies, Consumer Affairs & PublicDistribution, September 1994.

3 These include groundnuts, rapeseed/mustardseed, cottonseed, sesamumseed, sunflower, safflower, coconut,soybean and rice bran.

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avoid overly large risks takes away from the effort to become more effective in the value-adding process.It is not uncommon for firms, successful at creating value, to go bankrupt due to adverse pricemovements.

1.9 Instruments for Managing Price Risks Appeared Early. Price risk management instrumentswere developed by traders in response to the burden that volatile prices create. Processors, end-users andproducers became involved at a later stage. Contracts which enabled the improved management of pricerisks have been a fixture of commodity markets since the sixteenth century, when forward deliverycontracts for grains were first developed. In the seventeenth century, the first options appeared, fixing aprice for future delivery without the obligation of the buyer to actually take possession of the goods.Selling "short" -selling an option on a commodity while one does not possess the underlying product--soon became popular in such commodities as grain, cocoa and coffee. Tradable forward contractsbecame important after the late seventeenth century. Most of these transactions are what is now called"over-the-counter", i.e., directly between two parties. Even with tradable forward contracts, contractperformance remained the responsibility of each party involved. While these instruments reduced pricerisks, they created a new source of risk, namely counterparty risk.

1.10 Futures Markets Eliminate Counterparty Risks. In the mid-nineteenth century, futuresmarkets developed as an effective means of managing price and overcoming counterparty risks. Trade inthese "tradable" forward contracts became centralized in organized commodity futures exchanges, wherecontract performance was guaranteed by a clearinghouse collecting margins, rather than by individualtraders or a trading house's "good name". Everyone could henceforth secure future prices without anyreal risk of counterparty default. The first futures exchange established in 1848 was the Chicago Boardof Trade. At the end of the nineteenth century, futures contracts in commodities such as grains, arabicacoffee, cocoa, cotton, copper, silver, and tin were already being traded. By the early 1980s, activecommodity futures exchanges existed in Australia, Canada, France, Japan, Malaysia, New Zealand, theUnited Kingdom, the United States of America, and of course, India.

1.11 Renewed Interest in Commodity Futures. In the second half of the 1980s, several developingcountries estabhshed their own commodity futures exchanges; exchanges in Brazil and China have nowtaken their place among the world's largest. Some newly liberalized economies, such as Russia andHungary, have also opened commodity futures exchanges. In the last two years, many more developingcountries are studying the possibility of creating a futures market.

1.12 Two factors contribute to the sudden interest in commodity futures markets. First, futuresmarkets assume special relevance m an increasingly competitive world market, where commodityproduction and trade responsibilities are shifted from the State to the private sector, and where theprivate sector is increasingly exposed to the vagaries of the world market. Second, commodity futuresmarkets remain the most efficient price formation mechanism, providing reliable benchmarks forphysical trade. Because a wide group of participants can use the market, each participant brings into theprice formation process the information he/she possesses about future demand and supply conditions. Incontrast to a cash market, a futures market is highly transparent, yet anonymous, making pricemanipulation more difficult. Futures markets, as institutions, have an interest in making their prices aswidely available as possible, thus providing many smaller market players with the price information theyrequire.

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B. Economic Benefits from Using Commodity Futures Markets

1.13 Price Discovery and Hedging: the Two Main Economic Roles of Futures Markets. Whilethe supply of primary agricultural commodities, for example cotton, oilseeds, sugarcane, is concentratedat the time of harvests, their consumption is spread out throughout the year. If markets are to functionproperly, some entities have to be willing to hold stocks. Storage, however, not only freezes up workingcapital, but it also exposes the stockholder to downside price risks. In the absence of risk managementtools, traders will not only reduce their seasonal stocks, contributing to price volatility, but they will alsobuild-in a risk premium in their seasonal storage margins. Futures trading allows stockists to hedgeagainst price risks associated with storage. This process reduces the risk premiums added to storagemargins. Futures markets also provide a mechanism for the discovery of prices in the future, facilitatingproduction, processing, storage and marketing decisions. Futures prices serve as reference prices forforward purchases and sales. Futures markets can also be very helpful for processors and traders in casethey want to sell (buy) on the physical market, but do not have a 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 theirexport competitiveness. In physical trade, especially international trade, buyers often wish to buyforward. For instance, Indian textile mills export 3 months forward, because their buyers need thissecurity; in the oilseeds sector, large international buyers prefer to buy at least one year forward.Exporters who enter into such forward deals generally do not have all the required commodities in stock.They will have to buy them on the physical market. The risk is, of course, that physical market priceswill increase, forcing the trader to accept a loss. To avoid such risks, exporters may refuse demands forlong-term contracts -hurting their own competitive position-- or hold working stocks higher thanotherwise necessary. Futures markets will allow exporters to hedge their anticipated purchase bytemporarily substituting for an actual purchase until the time is appropriate to buy on the physicalmarket. Experience from other countries suggests that the absence of access to risk management toolsforces traders to increase, often double their working stock requirements, over and above what would berequired from a logistics point of view, making them less cost-competitive. In India, the risks of sellingforward to foreign buyers in the absence of futures trade have caused many cotton exporters to eitherdisappear or to convert into brokers.

1.15 Reduce Processing Margin Risks, Futures markets allow agro-processors to lock in profitablemargins, promoting competition and reducing nsk premiums. Agro-processors often work on slimmargins: raw material costs can equal 90 per cent of the output price. Output and raw material pricemovements often result in negative processing margins. This is a common phenomenon for sugar andedible oils. Futures markets allow sugar refineries and oilseeds crushers, through anticipatory hedging,to secure a profitable processing margin by giving them the flexibility to fix their input and output pricesat the most favorable time. In the absence of futures markets, processors can only achieve this throughcareful, time-consuning and costly timing of their physical transactions--indeed a main occupation ofmany oilseeds crushers and cotton gins, and government agencies in the case of sugar in India. Futuresmarkets will allow Indian oilseeds crushers to reduce their marketing and processing margins, and tocompete more effectively with the now free imports of edible oils; by the same token, reduced marginswill enable crushers to offer higher prices to oilseeds growers.

1.16 Good consumer-oriented marketing is difficult if no futures market exists for domesticprocessors. The demand for India's edible oils is highly price-elastic; to protect their market shares withthe free entry of imports, manufacturers have to keep prices fairly stable. With the use of futurescontracts, domestic prices can be made predictable, and manufacturers can smooth out the influence of

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changes m their input prices quite easily. If there are no futures markets, and in particular if there arealso limits on stockholding (as of mid-1995, manufacturers were only allowed to hold up to 45 daysworth of consumption in stock), the manufacturer can be caught in between severe short-term pricemovements of oils and the need to keep the product price stable. This conflict can only be resolved if themanufacturer keeps sufficient financial reserves, funds that otherwise could have been used forinvestment.

1.17 Farmers Benefit Indirectly Through Better Information, Lower and More StableMarketing and Processing Margins. Farmers are likely to benefit from the existence of futurestrade, even without using futures markets directly. In the absence of a well-functioning forward orfutures market, farmers bear the brunt of price instability. With a futures market, traders orprocessors (e.g., oilseed crushers) need not build as large a cushion to protect themselves againstunfavorable price movements. As a result, they will reduce the risk premiums in their marketing orprocessing margins and be able to pay farmers more for their products, sell cheaper, store moreand be more active in the markets. The degree to which traders or processors increase prices tofarmers depends on the level of competition, and on the price information available to farmers. Asfutures exchanges have an interest in making their prices as widely available as possible, there is agood chance that farmers will indeed be able to benefit. In addition, because of the lags betweenplanning and production, farmers can benefit from the market-determined price informationavailable 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 Facilitate Access to Credit. In the absence of risk management tools, agricultural marketingand processing becomes an unnecessarily risky business activity to lend money to. Relatively smallchanges in prices can wipe out a large part of the capital owned by traders, and even make it impossiblefor them to reimburse their loans. Banks are thus hesitant to lend to commodity traders, in particularthose who do not manage their price risks. If they do lend, they are likely to do so at a high price. Thisin tum hinders the proper functioning and competition of agricultural markets. Hedging lowers thediscount rate in lending for commodities. For example, in countries where futures markets are allowed, abank will advance 80-90% of the value of the transaction if hedged, but only 50-60% if hedged.

1.19 Improve Product Standards. The existence of exchange warehouses with grading facilitiescoupled to the extra flexibility that traders have to make delivery to such warehouses creates strongincentives for the upgrading of qualities to a level acceptable to the exchange. It also facilitates thestandardization of commodity trade, including in terms of standard qualities: the quality certificatesdelivered by exchange warehouses have the potential to become the norm for physical trade -- as hasindeed happened in a number of countries.

1.20 In summary, commodity futures not only play an important role in price discovery andmanaging price risks, but they also assume other economic roles: financial stability for market operators;standardization of quality for deliverable commodities; flexibility for traders and processors by replacingthe need for storage or providing new market outlets; reduction of storage costs; and finally, improvedaccess to finance.

C. Role of Speculation in Futures Markets

1.21 Several concerns remain about the functioning of commodity futures markets and their effectson the distribution of market power. One common concem has to do with speculation. Futures mnarketscannot function without the extra market depth and fluidity which speculation provides. Since the

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physical availability of commodities and a commercial firm's decision to buy or sell commodities maynot always coincide with each other, the futures market will be extremely illiquid if firms have to waituntil a compatible bid or offer arose. Thus, speculators in futures markets play a vital role in absorbingthe frequently unbalanced supplies and demands of commercial buyers and sellers.

1.22 Speculation is also often mistaken for gambling or with manipulation. Both speculators andgamblers seek to profit from assuming risk. But while a gambler creates risk where none exists, aspeculator assumes risks which already exist in the market, fulfilling an economically useful role. Whilesuccess in gambling is purely a matter of chance, success in speculation is dependent on the properunderstanding of fundamental market forces. The interest that speculators have in gathering informationon the underlying commodity is what makes futures markets such a viable price discovery mechanism.Speculation is also not the same as manipulation: a speculator tries to forecast how prices will move, andhis actions will indeed make prices move closer to the market equilibrium. A manipulator tries to moveprices away from their market equilibrium. Thus, futures markets which do not serve the legitimate riskmanagement needs of traders or processors have no chance of survival because such a market wouldsoon lose its relationship with the underlying physical market.

D. Relationship between Futures and Physical Markets

1.23 Despite the above economic roles, concerns are widespread that commodity futures marketsmagnify price increases or falls, leading to lower farmers' prices and higher consumer prices. Researchin many countries suggests that commodity futures markets follow, at least in the long term, the demandand supply conditions of the underlying physical market, and improve the functioning of the physicalmarket by reducing seasonal price volatility. This is true irrespective of whether a market is in excess-supply or excess-demand situation. With adequate contract specifications and regulations, anyaberrations by futures markets are likely to be short-lived. Futures markets are also more difficult tomanipulate than physical markets. Because futures markets are more transparent than physical markets,when prices move away from their market equilibrium, market participants will react, effectivelydragging prices back towards their equilibrium level.

1.24 At the same time, futures market help to improve the efficiency of the physical market. When acommodity is in short supply, futures market prices will increase; whether or not the futures market isclosed-down, physical market prices will also increase anyway. If the government considers the pricerise to be socially unacceptable, the only viable option is to change the basic supply and demandsituation.

E. Domestic vs. Foreign Commodity Exchanges

1.25 There is no economic reason for a country to insist that all its risk management activities takeplace through a domestic exchange. International markets could provide similar services. In fact, if awell-functioning international market 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 foreign exchange may be saved if the local rather than the foreign market is used. On the otherhand, interest in this market may well be limited, reducing its usefulness. However, risks associatedwith exchange rate fluctuations will generally involve trade-offs between basis and liquidity risks, unlessinstruments are available to hedge against exchange rate risks.

1.26 A stronger case can be made for commodity futures markets that offer risk managementopportunities not available elsewhere. This may indeed be the case for most of India's agricultural

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products. Domestically-oriented futures exchanges provide a price discovery and risk managementmechanism where none would exist otherwise. Moreover, they can play important logistics functions, asan assembly point for physical products, or a guarantor of quality standards. While domesticallyfocused futures contracts may be of litfle interest to foreign users, regionally-oriented contracts are, insuch an instance, contracts would need to be defined to balance the interest of both domestic andinternational players.

Summary

1.27 Commodity futures markets provide farmers, traders, processors, and exporters a mechanismfor hedging their risks and improving price discovery in their forward planning decisions. At the sametime, 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 costsassociated with uncertainty and risks, to the benefit of growers and consumers. Futures markets promoteinter seasonal and intra-seasonal price stability. By providing a mechanism for price discovery, futuresmarkets help growers, traders and agro-processors make better production decisions. India was one ofthe first developing countries in which commodity exchanges were established.

STRUCTURE AND ORGANIZATION OF INDIAN2 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 firstorganized futures market for vanous types of cotton, the Bombay Cotton Exchange, was established in1921. A second exchange, the Seeds Traders Association Ltd. in Bombay, which traded oilseeds andtheir products, including castorseed, groundnuts and groundnut oil, followed in 1926. Several otherexchanges were subsequently created, trading futures contracts in raw jute, jute products, pepper,turmeric, potatoes, sugar, foodgrains and gold. Many of these exchanges traded the same commodities,and some had formal trading links. Users were quite sophisticated; for example, traders in the cottonmarket undertook arbitrage with other major international cotton markets, such as Liverpool, New Yorkand Alexandria. At the same time, a number of foreign companies used the Indian markets. A completeregulatory framework for futures trade was drafted, including rules and conditions for trading in futures,a broker's licensing system, and a clearing house structure. Options on a number of commodities werealso traded; for example, options on cotton were traded up to one year out, until their ban in 1939.

2.2 Introduction of Regulatory Controls. In the 1940s, trading in forward and futures contractsand options was discouraged by pnce controls and in some instances was outlawed, as part of theGovernment's drive to contain inflation. These controls were maintained until 1952, when thegovernment passed the Forward Contracts (Regulation) Act, which up to this day controls all futurescontracts. Although restrictions on futures trade in essential foods, such as sugar and foodgrainsremained, the Act allowed futures market trade in a very limited number of commodities. The Actstipulated that futures markets should normally be self-regulating, through the governing bodies ofrecognized associations, in which the government had the right to place several representatives. For allpractical purposes, it outlawed futures contracts other than between, with or through the members ofthese recognized associations. The Forward Markets Commission (FMC) was created to supervise andregulate futures markets in the public interest, but in effect, gradually absorbed the exchanges' self-regulatory powers.

2.3 Increasing Government Intervention. The government's role in the commodity exchangesgrew 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, futurestrading in non-edible oilseeds like castorseed and linseed was forbidden. Even non-transferable specificdelivery contracts were prohibited for a number of commodities. Other commodities were also broughtunder the purview of the Forward Contracts (Regulation) Act. The crackdown on futures markets wasattributed to the Government's concem that these markets helped to drive commodity prices up by givingfree reign to speculation. To further combat speculation, other restrictive measures were imposed on theactivities of the tiirty-one "recognized associations". For example, speculators were asked to pay extramargins whenever regulators deemed it necessary, and trade in contracts was simply stopped forprolonged periods (skipping one or more normal delivery months) when prices reached certain ceilings.

2.4 Evolving Policy Environment. Government policies softened somewhat in the late 1970s,when futures trade in gur -a non-centrifugal sugar as important as centrifugal sugar on India's sweetenermarket- was temporarily allowed. Castorseed futures were reintroduced in 1982. Two government-

10

appointed committees' in 1966 and 1979 recommended the revival of futures trading in a wide range ofcommodities, but little action was taken.

2.5 Despite the burdens imposed by heavy government interventions, there is a large interest for riskmanagement tools by the business community in India. Turnover in those commodities for which futurestrade is allowed is large, and the exchanges attract a wide variety of participants --large farners,domestic traders, exporters, brokers and speculators. Futures contracts are actively traded for periodsup to 6 months out, and, as expected, most contracts are used for hedging purposes, not for physicaldelivery. "Underground" futures and options trade for commodities, such as cotton and a number of oils,are widespread.

2.6 This interest is likely to increase as a result of trade liberalization. Exporters are increasinglyconfronted with highly competitive world markets where they are forced to work on slimmer margins,but also to sell further forward to remain competitive. Against this background, the role of commodityfutures market is being reconsidered by the government.

B. The Regulatory Framework

2.7 The Forward Contracts (Regulation) Act, 1952. Commnodity forward and futures trade isregulated by the federal government through the FC(R) Act, 1952. The FC(R) Act differentiates andclassifies the following types of contracts:

a Spot or "ready" Contracts which provide for the delivery of goods and the fulldelivery contracts payment of the value of the goods at the price settled when the

contract was entered into either immediately or within a period ofeleven days after signature of the contract.

- Forward contracts These are contracts for the delivery of goods and which are not"ready" delivery contracts.

*Non transferable These are forward contracts between two parties in which aspecific delivery (NTSD) commodity, of a specific grade, has to be delivered to a specifiedcontracts location during a pre-determined time frame at a predetermined

price.2 Neither buyer nor seller can transfer the contract toanother party, and financial settlement is not allowed. Grade,location and delivery dates can not be renegotiated after thecontract has been signed. Originally, NTSD contracts were notregulated under the Act, since they were considered a normalpart of trade. However, in practice, it was found that buyers andsellers did at times make amendments to contract clauses, andthat delivery did not always take place in order to cope with

lThe Dantwala Committee, Forward Markets Review Committee, 1966; and the Khusro Committee, Committee onForward 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 issigned. 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 anddelivery, without the risk that price developments endanger contract performance.

11

unforeseen but unavoidable developments, such as shipping orharvest difficulties or a lack of a specific desired grade.3 Thismeant that NTSD contracts were effectively used as transferablespecific delivery (TSD) contracts falling under control of theAct. Also, trade in NTSD contracts in some commodities wasused to camouflage trade in other commodities. To close theresulting loopholes, an ever increasing number of NTSDcontracts were brought under the purview of the Act from the1950s onwards, and most were in effect prohibited.

Transferable specific These are defined as forward contracts that are not NTSDdelivery (TSD) contracts contracts. In actual regulation, a difference is made between

TSD and hedge contracts. Hedge contracts are not defined assuch in the FC(R) Act, but can be considered as both deliverycontracts that are both transferable and non-specific.

0 Transferable specific delivery contracts specify a specific(basis) grade, quantity and delivery location of a commodity,just like NTSD contracts do. However, the buyer cantansfer the contract to others, often up to a predeterminednumber of times -six times in the case of oilseeds, forexample. Contracts can in principle even be transferredback to the original seller implying the financial closing outof the contract.

0 Hedge contracts specify the basis and tenderable deliverygrades, and a range of delivery centers. Both buyers andsellers can close out their positions, and delivery is notobligatory. Hedge contracts are not defined as such in theFC(R) Act, but can be considered as delivery contracts thatare both transferable and non-specific until entered into.

Option contracts Option contracts give the right, but not the obligation, to make ortake delivery of a commodity (or a futures contract) at a givenprice; for this right, one pays a premium. Options can thus belikened to insurance, but they can also be used for speculation:the premium paid can be quite low in relation to the possibleprofits if prices move in the anticipated manner. Thesecontracts, widespread earlier, were banned for all commoditiesunder the FC(R) Act.

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

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

12

Figure 2.1Indian & International Classification

of Forward & Futures Contracts

Contracts

R eady ......... ........ ...............

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

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

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

Forward Contracts Futures Contractsin international terminology

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

2.9 Correspondence Between Indian and International Terminology. By introducing aclassification of contracts unique to India, it should be noted that the Indian terminology provided in theFC(R) Act differs from the international terminology. Figure 2.1 indicates the correspondence betweenthe Indian classification as defined by the FC(R) Act and the international terminology. According to theF C(R) Act, futures contracts have not been defined; instead, three types of forward contracts in India aredefined: the Non-Transferable Specific Delivery contracts (NTSD); the Transferable Specific Deliverycontracts (TSD) and the Hedge contracts. These three forvard contracts offer different degrees offlexibility to the buyer and seller, wvith NTSDs providing the least, and hedge contracts the most.Because NTSD are not transferable, they would not qualify as futures contract according to internationaldefinition. TSDs, because of their transferability, would qualif~y as futures contracts; they present,however, other limitations (e.g., extent of transferability, specific delivery) which do not make TSDsuseful as risk management tool. The introduction of different degrees of flexibility reflected the attemptby Indian legislators to balance their regulatory concerns about speculation on the one hand, and the needto satisfyv genuine demands for risk management tools by private operators on the other.

2.10 Commodity futures and forward trading is allowed for only eight, mostly minorcommodities. The FC(R) Act specifies the commodities for which futures and forward trading isallowed, as well as the type of contract that can be traded (Table 2.1). It allows NTSD trading forcotton, hessian, raw jute and jute goods; TSD trading for raw jute and jute goods; and hedge trading forhessian, black pepper, castorseed, gur, potatoes and turmeric. Futures trading is prohibited or suspendedfor over 100 commodities, except for contracts entered into by a number of federal or state entities.Suspended commodities differ from prohibited commodities in the sense that, for the former, futures

13

Table 2.1Commodities Regulated by the Forward

Contracts (Regulation) Act, 1952

Non-transferable 79 commodities, including Castorseed, coconut oil, copra, Colton, jute goods, hessian andSpecific 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, sunflower seed and their sesamum oil, and kapas.oils and oilcakes, as well ascastor oil, cotonseed oil andvanaspati; gold and silver.

Transferable Specific Idem as under Non- Coconut oil, copra, cottonseed, Raw jute and jute goods.Delivery Contracts transferable Specific Delivery groundnut, groundnut oil,

Contracts, with 24 kardiseed, kardiseed oil,commodities added - sesamum, sesamum oiL kapas,including khandsari, cotton cotton and staple fiber yarn.yarn and cloth, a number ofspices, and copper, zinc, leadand tin.

Hedge contracts Idem as under Transferable Coconut oil, copra, cottonseed, Black pepper, castorseed, gur,Specific Delivery Contracts. 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 therecognized associations have not been granted the pernission to trade5.

2.11 Several entities, however, are exempted from the provisions of the Act. They include theGovernment of India and State Governments and their corporations and agents; groundnut famners, forthe sale of groundnuts produced by them; and exporters, for contracts signed with foreign buyers.

2.12 The FC(R) Act establishes a three-tier system of cortrol: 6

* the Government of India,* The Forward Markets Commission, and* the recognized and registered associations.

2.13 The Forward Markets Commission. The Forward Markets Conmission (FMC) wasestablished by the Government of 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 arein principle allowed, but the Government has not yet granted recognition to any association for trading thesecontracts.

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

6 This is simnilar to regulatory policy in Europe and the United States, where there are two major tiers of regulatoryorganizations. In these countries, government regulatory bodies oversee the establishment of exchanges, the approvalof contracts, the setting standards for market participants, creation of market oversight, and sometimes the setting ofposition 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 administrative control of the Ministiy of Civil Supplies, Consumer Affhirs and PublicDistribution. The main functions of the FMC are to:

* Advise the central government regarding the recognition of associations;* Monitor forward markets and take necessary actions;* Collect and publish information regarding trading conditions for commodities to which the

Act is applicable, and submit periodical reports to the Government on the operation of thisAct and the functioning of the forward markets;

* Make recommendations with a view to improve the organization and functioning of forwardmarkets; and

* Inspect the accounts of recognized associations.

2.14 The FMC has broad powers to inspect the associations and their functioning. The Actempowers the FMC to access all books, accounts and correspondence held not only by the managementand members of the exchanges, but also all Table 2.2persons or groups who have had dealings Recognized Associations For Castorseed,with the management or members. It can Cotton, Gur & Potatoes by Stas, 1995suspend a memnber from his/herCotnGr&PtaesLas,19membership of a recognized association, orprohibit such members from entering into Andhra Pradesh 1

new contracts.Gujarat 2 3

2.15 Exchange Associations. There are Haryana I

29 active associations recognized under 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 association is to be recognized in Tamil Nadu I

a city or region for forward contracts in any Uttar Pradesh 4 3

single commodity group, with the view to Source: Forward Markets Commission, Bombay

minimize competition between associations.Several commodities are 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 ascastorseed, cotton, gur and potatoes, are traded by a large number of associations spread over thecountiy, with potatoes and gur generally being traded on the same exchanges.

2.16 An association has to apply for recognition from the central government. Taking into accountpublic and the industry's interests, the government may 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 centralgovernment also retains the right to withdraw its recognition at any time.

2.17 The recognized associations and their members must submit periodical reports upon request ofthe FMC. The associations also send regular reports to the FMC on prices, open positions, and marginpayments, generally on a daily basis (by telegraph), as well as its annual report, according to a fornatprescribed by the FMC. The members of recognized associations submit trading returns on a weeklybasis, indicating their volume of transaction, open positions, and names of clients (if it wishes, the FMCcan request these returns on a daily basis).

2.18 The Associations' Rules and Regulations. Recognized associations are responsible for theday-to-day operations of the futures markets: they set the standards and rules of trade; register prices;

15

work as clearing houses, including the collection of margin moneys and settlement of closed transactions;distribute delivery notices; etc. All associations have their trading-by-laws, memorandum and articles ofoperations generally modeled after British and American commodity exchanges. They have the power tovet new members, and redraft the bye-laws on condition of approval by the government, which also hasthe right to direct an association to amend its bylaws.

2.19 For most commodities, trading in futures contracts is only allowed in the exchange trading ringduring official trading hours. Those in the ring (the "ring traders") represent firms that are members ofthe association. These ring traders can be appointed on an ad-hoc basis by a member, and each memberis allowed to have several ring traders (up to a maximum, of 7 on the BOOE). Members are fullyresponsible for all transactions entered into by the nrng traders nominated by them.

2.20 Several instruments are used by the associations to regulate the behavior of traders. Theseregulatory instruments can only be applied with the concurrence of the FMC, although they can berecommended by 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-specified rate per unit,which is revised periodically. These margins are collected by the clearing house asa financial safeguard against possible default by a member if prices moveadversely.

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

* Special margins. These margins seek to restrain price movements beyond certainlevels of prices known as the "margin lines". Table 2.3 illustrates an example forthe castorseed Table 2.3September 1994 Special margins for castorseed,contract. For most September 1994 (Rs/100 kg)new contracts,exchanges have topropose 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 Annualcastorseed, if prices Report & Accounts, Year 1993-1994.

fall below 850 Rs/100 kg and the speculative shorts are unable to pay the requiredspecial margins, they are forced to liquidate their positions, thus pushing up pricesthrough their purchasing operations. Conversely, when prices increase beyond1,300 Rs/100 kg, speculative longs are forced out of the market. Exporters whocan submit an export contract hedged by futures contracts and stockholders whoshow they are hedging an inventory can receive an exemption from the payment ofspecial margins.

* Withholding outward payment of profits. This makes it more difficult forspeculators to use their profits on their open trades to expand their positions.

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* Limits on open positions. Operators in futures market are pefmfitted to hold orcontrol an open position in excess of the limit only when they are legitimatehedgers, such as exporters who can show export contracts, stockists aftersubmitting inventory statements. Even then, they are confronted with highermargin payments for their open positions exceeding the open position limit.

* Suspension of trading. When an emergency arises in the market, it takes sometime to judge its character, ascertain its causes and devise measures. During thattime, the regulatory authorities can suspend trading.

* Prohibition offresh trading. If serious difficulties are anticipated, members canbe prohibited from entering into fresh commitments with each other; they can onlyliquidate outstanding positions.

* Skipping of trading in some delivery months. Whenever there are serious doubtsabout the smooth and orderly running of a futures contract, the posting of a newdelivery month can be prohibited.

* Limits on pricefluctuations. These can be imposed either when prices rise or fallor both, on a daily or weekly basis.

* Maximum and minimum prices. The government can prescribe these to preventfutures prices from rising above the levels not warranted by what the governmentconsiders as genuine supply and demand factors, or from falling below levelsconsidered as unremunerative.

* Changes in the tenderable varieties. The varieties tenderable against futurescontract are generally laid down in the bye-laws. If it appears a certain group istying to comer the market, the list of tenderable varieties can be expanded.Similarly, some of the varieties which are tenderable can be deleted from the list tocounteract a possible "bear raid". This regulatory tool is rarely used, mostrecently in the turmeric market in 1988.

* Closure of contracts. If the market cannot be controlled by any of the abovemethods, the closure of the outstanding contracts in the market at the time of thecrisis can be ordered.

* Prohibition offutures trading. When prices are rising continuously without anyimmediate sign of a reversal, the govermnent may decide to prohibit futures tradingaltogether. It is believed that this will help control the increasing price trend.

C. The Structure of Commodity Exchanges

2.21 Commodity exchanges in India are organized as so-called "recognized associations" of traders.The associations have a partly elected Board of Directors, who supervise a number of exchangecommnittees (Figure 2.2). The secretary, who is appointed by and reports to the Board, is responsible fordaily operations and administration. Most of the recognized associations are without share capital, withmembers paying an admission fee, a membership deposit, and an anmual subscription. Some are set upas profit oriented ventures, owned by a number of shareholders, and earning their income by providing

17

trade facilities to members. Most exchanges have membership limited to those who have their place ofbusiness in the city or state where the association is located.

2.22 The Board of Directors. The Board of Directors enforces the various rules and regulations ofthe exchange. The Board is empowered to fix the margin rates, upon approval by the FMC; to prohibittrading on any day if the prices of a futures contract change by more than a predetermined level; closethe market for up to 3 days; with the concurrence of the FMC, to fix limits on the open positions ofmembers and non-members; to prohibit trade above specified maximum or below minimum prices; andto forcibly close out all outstanding contracts.

Figure 2.2Organizational Structure of Commodity Associations

AssociationBoard of Directors

Secretary

Admninistration* Accounts and 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 Committe e

2.23 The Board of Directors is generally divided into two or more panels, each representing thevarious stakeholders in the exchange. The Bombay Oilseeds Exchange (BOOE), for example, hasfour panels: brokers, dealers, crushers and exporters. The India Pepper and Spice TradeAssociation has panels of exporters and dealers. For each panel, Directors are elected to one yearterms in general. The elected Directors then co-opt one or more outside Directors, while theMinistry 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 thepublic at large. In many instances, the Government has failed to nominate Directors, and theseposts have remained vacant.

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

18

department and an internal auditing department, although the books of all exchanges are also auditedamually by external accountants.. The former is responsible for collecting margins from members aftereach clearing and managing the member accounts. It does so through the clearing house account of theexchange, which is used only for clearing settlements.

2.25 The Committees. The committees are set up by the Board of Directors to perform specificfunctions. They are composed of association members, and one or more Directors. The responsibilitiesof the various committees are described below:

* Ring Committee Oversees activities in the trading ring, with a ringsuperintendent who records the opening, highest, lowestand closing rates of the contract.

* Daily Rates Committee Fixes the daily settlernent prices of the futures contract, aswell as the daily spot prices.

* Clearing House Committee Oversees clearing house operations, can meet daily, butmost exchanges only have weekly clearing.

* Arbitration Committee Also called the "conciliation committee" in the BOOE,decides on disputes among members or between membersand non-members (with the appellate tribunal, or in thecase of the BOOE, the arbitration committee, providing thepossibility of recourse).

* Vigilance Committee Empowered to verify the books and accounts ofmembers and non-members, and to investigate anyreported violation of the provisions of the exchange'sbye-laws, rules, regulations, orders, etc.

- Inquiry Committee Verifies hedge exemptions claimed by members on thepayment of special margins.

* Non-Member Committee Decides whether individuals which wish to trade throughmembers can indeed do so.

2.26 Exchanges Provide a Number of Public Services. All the exchanges collect daily statisticson commodity prices in their markets, which are widely published in India's press. Normally, theassociations also monitor spot trade. They play a more general role as forum for traders and processors.Most gather and distribute information and market intelligence for their commodities, while a fewpublish trade journals, statistical overviews, yearbooks, and other materials. They generally providefacilities for quality surveys and contract arbitration. They also represent the interests of theirconstituency in discussions with the government.

19

D. A Brief Overview of Selected Commodity Exchanges

The Cotton Commodity Exchanges

2.27 Cotton lint was the first commodity for which futures contracts were introduced in India, withthe first organized market forned in 1921. In the 1920s and 1930s, futures and option contracts onseveral types of cotton lint were actively traded in two different associations, and futures trade in thelargest of these, the East India Cotton Association (which organized export-oriented trade) was ofinternational irnportance. Futures trade in cotton again became important after a short interval in the1940s in which all futures trade was banned. From 1952 to 1966, several exchanges in the countryshowed an active trade 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 recognizedassociations spread over the country (Table 2.4).

2.29 Contract Specifications. Six contract Table 2.4periods are traded every year, each covering two Recognized Cotton Associations in Indiamonths. 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) AmndhPradesh Coton Association Guitur

trade is allowed. Being non-transferable, the Central Gujarat Cottonu Deales 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 India Cotton Association Ltid (EICA) Boibay

however, standard forms supplied by the Nothernm idia Cotton Association Ltd Bathida

exchange are used, and all trade has to be Sod India Cotton Association Coinbatore

reported. No margins are deposited. Southem Gujarat Cotton Dealers Association Swat

2.30 The Bombay exchange has a nationwide mandate with cotton varieties from all over the countrybeing traded, while the others have a more regional mandate with trade only allowed in a small numberof cotton varieties. The largest exchanges -Bathinda, Bombay and Coimbatore-- have over 400members, while the smaller ones, such as in Indore and Guntur, have over 200 members. Most Indiancotton traders, be they brokers, merchants or commission agents, are mernbers of one or moreassociations.

2.31 Contracts' Turnover is Small, Highly Seasonal, and Trade For a Few Months Forward.The total volume of NTSD contracts reportedly traded at all recognized exchanges has remained more orless stable since 1990, at an average of 1.8 million bales (each of 170 kg) a year, or about 15% ofIndia's cotton production. Significant unreported trade in NTSD contracts is said to take place. TheBathinda, 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's cotton producing centers) and Bombay (thetraditional transit point for both domestic and external trade), trade in NTSD contracts is highlyseasonal. In Bathinda, during the period 1990 to 1993, on average 52% of the year's trade is in onlytwo of the annual six contracts, namely the contracts for November-December and January-Februarydelivery. In Bombay for the same period, the two delivery periods plus March-April, account for 64%of total volume. Trade in Coimbatore's exchange, serving the sizable textile industry in and around thissouthem Indian town, is better distributed, with only the November-December contract being minimallytraded.

20

2.32 NTSD contracts allow delivery up to six months out. However, most trade is in nearby deliverymonths, with the vast majority being no more than three months forward. For example, in the mostliquid months, up to 50-60% of NTSD contracts are in the nearby months. In contrast, only 10-15% ofNTSD contracts are entered into more than two months before the start of the contracts' delivery period.

The Gur Commodity Exchanges

2.33 Eleven exchanges are recognized for trade in gur hedge contracts (Table 2.5). The most activeexchanges are in Bathinda (31 % of total turnover in the May 1992-April 1994 period), Muzaffarnagar(26%), Hapur (20 %) and Agra (11 %). The exchanges in Ludhiana and Meerut, each with around 4%of the total trade volume, are also reasonably active. The other five exchanges share less than 3% of thehedge contracts turnover.

2.34 High Market Turnover. Table 2.5Turnover in all the exchanges totaled on Recognized Gur Associations In Indiaaverage 9 million MT of gur a year in theperiod 1990-1994. This can be compared Aapa Agro Product Mandi Pvt Ld Deb

to a physical production of 7.7 million Bathinda Om and Oil Exchange ld, Bathinda

MT on average. In value terms, trade in Bullon and Agnicultral Produce Exchange Ltd Agra

gur hedge contracts is the second largest Central India Comnmercial Exchange Lid Gwalior

in India --after the hessian contract traded Chamber ofCommerce Hapur

in Calcutta- with a 1994 turnover worth Indian Exchange Ltd. Amritsar

Rs 5,000 million. The three main Ludhiana Grain Exchange Ltd Ludhiana

exchanges trade over 2,000 contracts per Meent Agro Commodities Exchange Company LtId Meenut

day each on most days. Trading is fairly Rajdhani Oils & Oilseeds Exchange Ltd Delhi

well distributed over the year. MAk Kishna Trading Company Ld Rohtak

2.35 Contract Specifications. Four Vijai Beopar Chamber Ltd Muzaffamagar

contract months are traded each year, for delivery in March, May, July and December, In principle,contracts for up to 8 months out can be traded. Each contract is for 4 metric tons, with the basis varietyvarying according to the exchange. Each exchange has between 4 and 12 delivery centers.

The Oilseed Commodity Exchanges

2.36 Futures contracts in oilseeds, oils and meals were introduced not much later than cotton, andwere actively traded until the early 1960s. They were banned gradually during the 1960s, and the lasttwo remaining contracts, in castorseed and linseed, were disallowed in 1977. In 1985, the ban on thecastorseed hedge contract was lifted.

2.37 Four Recognized, Active Associations. Nine exchanges are recognized for trading futurescontracts in oilseeds, including castorseed, coconut oil, cottonseed, groundnuts, groundnut oil and/orlinseed. However, hedge contract in Table 2.6castorseed only is permitted, restricting Active Oilseed Commnodit Associationstrading to only four recognized exchanges ...... ....... .... .(Table 2.6). The other five recognized 7A_uM__eassociations are inactive. Among the active AaWd SePdu MandsAoitiLha

exchanges, the Bombay and Abmedabad i~~~Abtedabad Seeds Merchants' Association Ltd Ahmnedabadexchanges, the Bombay and Ahmedabad Bmbay Oilseeds and Oils Exchage L Bombayexchanges are tme oldest, dat og aack topre-Independence times. The Rajkot andu aktSesOladBiir ecat'Rio

21

Delhi exchanges were recognized for trade in castorseed contracts only in 1991 and 1992, respectively.

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

2.39 High Market Turnover. Trading in castorseed hedge contracts is very active in the fourexchanges. Despite its recent establishment, trading on the Rajkot exchange expanded considerably torival within a year with the Ahmedabad exchange. Between 1992 and 1993, the Ahmedabad exchangeaccounted for about 46% of total turnover, against 40% for the Rajkot exchange, and 10% for theBombay exchange. The Delhi exchange accounted for the remainder. In relative terns, the volume ofcastorseed trading is very large --3.6 million MT were traded on average per year during 1990 to 1994,reaching a peak of 5.5 million MT in 1992- far exceeding the annual production which ranges between500,000 and 750,000 MT. In general, the Ahmedabad and Rajkot exchanges each transact over athousand contracts per day. The Bombay exchange has a nationwide mandate, with 56 delivery centersthroughout the country: in Gujarat (including Ahmedabad and Rajkot), Andhra Pradesh, Maharashtra,Bihar, Kamataka, Rajasthan, Uttar Pradesh and Madhya Pradesh. The delivery centers in Ahmedabadand Rajkot allow effective arbitrage between the three exchanges.

The Pepper Commodity Exchange

2.40 India's pepper futures market trade is the only surviving pepper market in the world. In the1930s, 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 between100,000 and 110,000 MT, more than double India's black pepper production. The exchange is used forpepper futures trading by some larger farmers, town dealers, the larger interstate dealers and exporters.Most of India's major pepper exporters are members of the exchange and use it regularly.

H. The User Composition of Indian Commodity Exchanges

2.41 The Indian User Composition Users Mirror International Exchanges. Indian commodityexchanges which were visited during our field survey present a user composition similar to that ofwestern exchanges.7 Half of the trade is estimated to be speculative, half of which is conducted by day-traders or "scalpers"8. Scalpers earn their income through their daily trading transactions, and contributesignificantly to the liquidity of the exchange. The remaining half of the trade is hedging, with tradersbeing the most active. The various categories of users are discussed in more detail below.

2.42 Farmers Rarely Use Futures Markets, But Stand to Benefit Indirectly. Farmers in Indiararely use futures markets directly. This is similar to the United States, where futures markets haveoperated for a long time, and where only a small percentage of farmers use futures or option contactsdirectly. 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, unlikein 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.

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simply from better deals with traders using futures markets. The conditions exist for the indirectparticipation of Indian farmers on futures markets, since in most states, farmers sell their commoditiesthrough the "regulated markets." In the regulated markets, key commodities are auctioned-off, and theprice information is displayed. Commission agents operating in regulated markets could play a usefulrole in providing information and intermediating risk management transactions. Farmers' cooperativescould also intermediate risk management transactions for their members. Apart from lack of familiaritywith futures trade, regulatory barriers prevent cooperatives from using commodity exchanges: i) thesales tax registration requirement for members of exchange, and ii) the fact that most cooperatives are ineffect state organizations, and accordingly are not supposed to "speculate." It is unlikely, however, andnot even desirable that farmers trade directly in futures markets.

2.43 Traders Are the Largest Users, But The Extent of Their Involvement Remains Marginal.Traders, both large and small, are the main users of futures contracts in India. For gur, oilseeds orpepper, there is an active participation of town dealers. For castorseed and pepper, most exporters areactive in the exchanges. Nevertheless, for most traders, the percentage share of trade they hedge throughthe futures market remains small. Large exporters are confronted at times with low exchange liquidity,while smaller traders, because of poor access to credit, cannot afford to tie their funds in futures marketsfor long periods.

2.44 Regulations Limit Speculation to Small Speculators. Virtually all speculators in Indiancommodity exchanges are relatively small, either day-traders or individuals trading through brokers.Large, institutional investors, such as pension funds, insurance funds, and mutual funds areconspicuously absent. Their participation in commodity exchanges is not allowed under the ReserveBank of India regulations which stipulate the prudential norms for banks and non-banking financialinstitutions. This is similar to the policy of the Securities and Exchange Board of India (SEBI) whichregulates participation by mutual funds on the stock exchange. In addition, commodity exchangesregulations, by requiring all members to acquire a local sales tax registration, also serve as an obstacle toparticipation of the large, institutional investors. Funds are unlikely to be interested in trading throughthe generally small and poorly capitalized brokers who dominate Indian commodity exchanges.

2.45 Agro-Processors Rarely Use Commodity Exchanges Because of Their Deficiencies ofCommodity Exchanges. Processors and manufacturers use the exchanges to a limited extent for twomain reasons. First, some of the manufacturers, especially in the oils sector, are so large that they wouldnot be able to lay off a significant part of their risks on domestic exchanges, which suffer from chronicilliquidity. Second, the range of commodity futures contract offered is too small resulting in incompleterisk management markets. Under such incomplete markets, companies do not find it worthwhile tomanage risks in a highly imperfect manner. For example, many firms do not find the castorseed contractuseful, since few manufacturers use castor oil and it is an imperfect risk management instrument forother oils.

2.46 International Users of Indian Commodity Exchanges Are Banned. Foreign trading firmsparticipated in some of India's commodity exchanges, until their participation was banned. Currently,Indian exchanges are not allowed by the FMC to accept foreign members, and they would need to seekpermnission from the Forward Markets Commission and amend their bye-laws if they wish to change thissituation.

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Summary

2.47 Commodity futures exchanges have a long history in India. From the rapid multiplication ofexchanges in the 1920s, the changing economic, policy and regulatory environment has since drasticallyreduced the number of active exchanges, agricultural commodities, and types of contracts which can betraded. Presently, futures trading is permitted for nine, mostly minor agricultural commodities. Threetypes of futures contracts can be traded: (i) NTSD contracts--cotton, raw jute and jute goods (sacking);(ii) TSD contracts--raw jute, jute goods and hessian; and (iii) hedge contracts--castorseed, gur, hessian,pepper, potatoes, and turmeric. The changing composition of agricultural production and the evolvingpolicy and regulatory framework have also significantly influenced the pattem of development of theexchanges. The following chapter examines the performance of commodity futures trade in India andthe factors which influence its performance and development.

3 THE PERFORMANCE OF COMMODITY3 FUTURES TRADE

3.1 Commodity exchange performance in India vanes considerably across exchanges trading thesame commodity contracts, and across commodities. This chapter will first examine the operationalperformance of commodity exchanges. Their operational performance will be assessed in terms ofmarket liquidity, suitability of contracts, fairness and efficiency of trading practices, security provided byclearing procedures, effectiveness of delivery procedures in linking physical and futures markets prices,supporting infrastructure, and adequacy of their current promotional and developmental capacities. Inthe second section, the report will examine successively the impact of direct and indirect governmentpolicies on the observed operational performance of commodity exchanges.

A. Operational Performance of Commodity Exchanges.

Market liquidity

3.2 Definition. Markets have to allow commercial hedgers to lay off their risks without undueproblems. A market is liquid if normally-sized transactions can be executed within a short period,without significant impact on price levels. If transactions can be filled reasonably only over a period ofseveral days, or immediately result in price movements or "slippage", the market is said to be illiquid.

3.3 The Main Gur and Castorseed Futures Markets are Liquid. The gur and castorseed futuresare both liquid, but differ in their degree of market liquidity. The gur market is highly liquid. Whilemost physical trade in gur is in relatively small quantities, the market trades over 8,000 MT per day.Thus, an order of 100 MT is unlikely to cause any problems. In contrast, the castorseed market is not asliquid. The two larger exchanges only trade some 5,000 MT per day. This trading volume posesproblem for exporters since equivalent to the amount needed to hedge the price risks of a typical singleexport cargo of castor oil --4,000 to 5,000 MT. To overcome this constraint, exporters execute ordersfor large quantities by combining various markets and proper planning. They also report that it is notdifficult to roll-over positions of some 5,000 MT into a next contract month'1 .

3.4 Poor Liquidity Has Caused Problems on the Bombay Castorseed Market. Strong marketmovements, combined with insufficient financial strength of market users, resulted in severe liquidityproblems in castorseed trading in the BOOE in March 1994. Prices for the March delivery contractstarted increasing strongly in January 1994, and on January 18 the BOOE Board of Directors wamedbrokers to exercise restraint in building up large open positions, in particular for the account ofpotentially unreliable non-members. Two days later, trade in the BOOE halted completely as two of themain non-members holding open positions communicated to their brokers their inability to meet theirobligations. The heightened fears for defaults stopped trade and the brokers were unable to liquidatetheir positions. The physical market prices continued rising, and there were fears that when the shortpositions could finally be closed out, brokers would be unable to assume the losses. On January 22, the

I That is, a hedge is extended by buying or selling the nearby contracts, and undertaking the opposite transaction inthe next contract month; if roll-overs work well, one can get price protection, say, 1 year out even if futures contractsare only offered up to 6 months out.

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Board decided to declare a state of emergency in the market, and closed out the outstanding contracts inthe March delivery month at a negotiated settlement price.

3.5 Inadequate Regulations Compound The Poor Liquidity of Indian Exchanges. The poorliquidity of Indian exchanges is compounded by inadequate regulations. In particular, no rules govem therelationship between brokers and their clients. It is entirely up to the brokers to collect margin moneysfrom their clients. Financial safeguards between brokers and the exchange are also inadequate. TheBOOE responded to the above crisis by establishing a Rs. 50,000 security deposit for every broker, andby increasing the security margin deposit for larger positions. Despite these increases, the securitydeposits and security margin deposits for, say a 500 MT position, would equal only about 5% of themarket value of this position, somewhat low by international standards generally around 10%.

Suitability of Indian Futures Contracts

3.6 NTSD Contracts Are Highly Imperfect Risk Management Tools. The stringent limnitationsimposed on NTSD contracts by the FC(R) Act make them highly imperfect risk management tools. Thisexplains the small share --15%- of physical trade covered by NTSD cotton contracts, their highlyseasonal nature, and the fact that most contracts are only for up to three months. NTSD contracts tumout to be rather risky forms of forward contracts under present regulations. Once a company has enteredinto a NTSD contract, say for delivery in six months time, it cannot get out of the contract or evenrenegotiate its specifications. Cotton ginning mills, for instance, often sell their lint forward in theexpectation that they will be able to buy the seed cotton at an attractive price. If the harvest turns out tobe lower than expected, the mills who entered into forward contracts have no choice but wait until thecontracts' due dates. The only exception to this is when a general production crisis would cause ageneral default, a situation in which the commodity exchange board can decide to forcibly close out andsettle all outstanding contracts, at a negotiated price. Such a forced closure of contracts --experienced bythe Northem India Cotton Association in Bathinda in late 1994-- causes significant distress and results inlarge financial losses. It also reduces public and government confidence in futures markets.

3.7 Such a default crisis would not occur under standard, international futures contracts definition.As soon as the news of a disappointing harvest is known, futures prices increase. Those who soldcontracts will have to close them or pay extra margins. The clearing house of the exchange guaranteescontract perfonnance and secures itself through the margin payments it receives. Default will be avoidedautomatically: speculative mills would be forced out of the market relatively fast and will be unable tostay with an open position until the situation becomes unbearable.

3.8 The Poor Suitability & Limited range of Permitted Futures Contracts Prompts an ActiveIUegal Futures Trading. In response to the legitimate hedging needs of cotton gins, a significant illegaltrade in seed cotton and cotton futures is reported to have developed with its main center inSurendranagarin, where V-797 cotton futures are traded primarily around harvest time, but also in othercenters. This illegal trade appears to be relatively well-organized: participants pay margins in case theirpositions move against them, and default rates are reportedly quite low. This futures trade takes placeoutside of the law, exposing participants to counterparty risks. Moreover, the general public loses thebenefits associated with price discovery.

3.9 The risk management needs of commercial users also spawned illegal trading in oilseeds futurescontracts, 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 somne 60 operatorsactively traded in oil futures in Rajkot, prior to its recognition by the Forward Markets Commission,closely resembling formal exchange operations, with standardized trading rules and open outcry. Mostof the business served the risk management needs of genuine groundnut oil traders, millers andwholesalers; speculation was relatively unimportant. This illegal trade worked quite efficiertly, withrules for cash-settlement, weekly margin payments, and significant investment in tele-communications.Most offices in the market were linked through internal telephones, with each office having at least sixtelephones. The market also had 30 telex machines. About 70,000 calls were reportedly made eachworking day between this exchange and other mnain cities.

Trading practices

3.10 The Open Outcry Trading System Is Appropriate. All conmmodity exchanges in Indiafunction through open outcry, a seemingly chaotic but highly efficient and low-cost form of futuresmarket trading. Traders in a trading ring make bids and offers through shouts and hand-signals, and thefirst to react gets the deal. Trading orders come in from outside, through telephone clerks who representbrokers who, in tum, are in contact with hedgers and speculators, often nationwide and in continuouscontact with the trading floor.

BOX 3.1IS OPEN OUTCRY OUTMODED?

Ope outy stil prvails through the wods ages exa s, although in Japan, Chti, New Zealad, and South Afhica, trade ispredominantly through an electronic trading system. In electronic exchanges, market uses are connced thrgh computer terminals witha trading system that automatically matches bids and offem. Large exchanges in the ULnited States ad Europe have also developedelectronic wading systems to twade outside of their normal trading hours. Elecironic trading systems have high set up costs, but make itvery 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 constantlymatching the two parts of trade. This trading system could also be used for linking two open-outcry exchanges in the same time zone.

Is the open outcry system of India's exchanges out-moded? There is no compelling reasm for te eXisting, open outcryexchnges to shift to another system. Whether new contracts should be traded electronically is a moe complicabtd queation, For opetoutcry trading one needs trading infrastnrcture: a trading ring, oesby offices and good teeconcatiom systeis. Electronic tradingcan be done from the offices of the members; if there is an efficient telephone system, these offices can then be linked using one of theelectronic trading systems already developed by other exchanges. Open outcry tading atracts smalt floor traders, who are key inprviding for market liquidity, on the other hand, electronic trading attact larger users beceise of te anonymity it provides.

In India, it would still appear that the open outcry system is the most efficient even for new contracts. In most instances, thephysical facilities already exist, along wi the corresponding concentration of traders and bmroen, Moreover, the scope of increasing thenumber of floor brokers remains large. It would be erroneous to elect an electronic trading system only because of its high-tech image.

A mixed system could be introduced for linking commodity exchanges. Even in this instance, however, it should be noted thatthe existing system of information gathering and order placement by telephone appeas to finction well. The gur markets which are allopen at the same time, for instance, appear to be well integrated, with some key tradern and broken in each exchange remaining in constanttouch with the other markets and undertaking arbitrage when the situation warrants it. In principle, there is no reason why, fir example, anumber of cotton markets could not be effectively integrated through a brokerage networl. A mixed system would make more sense for aninternational linkage; the charges of a leased line between two exchanges would then have to be compared with the charges of individualtelephone calls by potential market users.

3.11 Open outcry in the exchanges visited functioned well (Box 3.1). Market participants showed allthe required skills. The trading sessions were fast and competitive, with participants engaging in a rapidplay of hand-signals and shouts; deals were registered instantaneously on standard forms. Participantsunderstood the principles of arbitrage, put on straddles over two contract months if the price diffrentialbetween months became too large or too small, and engaged in other more sophisticated tradingstrategies.

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

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3.12 Futures Trading Skills Are Being Lost. One major difference with European and Americanexchanges is the age of participants. Indian exchanges have a much older active membership. Forexample, most of those with experience in cotton futures trade are close to retirement age. Indianuniversities have not given priority to futures trade in their curricula. As a result, most of the newergeneration of professionals involved in commodity trading and those employed in supporting institutionssuch as banks, have little knowledge and familiarity about futures markets. These indicate a serious lossof interest in exchanges and a loss of valuable skills, a reflection of the strict policy constraints governingfutures markets, as well as a their poor iiage in India. They also underscore the strong need for trainingprograms.

3.13. Trade Registration Procedures Are Well Laid-out.' Although they differ from internationalexchanges, Indian commodity exchanges have clear and adequate rules for the registration oftransactions. Contracts and procedures need to conform to the trade practices customary in the market,and it would be unwise to copy the rules and procedures of a major international market. For instance,the Vijai Beopar Chamber Ltd., in Muzaffamagar, Uttar Pradesh, prescribes the following traderegistration procedures:

* A broker (anyone active on the exchange) has to record a trade immediately on aduplicate form (called a "Kachhi Bahi") as prescribed by the exchange; theseKachhi Bahis resemble in form and purpose the trade confirmation slips used bywestern exchanges. All such forms have to be kept for a period of three years.

* A transaction not duly recorded is considered illegal.

* Each broker is supplied a number of serially numbered Kachhi Bahis,countersigned by the secretary of the exchange.

* Every broker has to provide the exchange with the original pages of the KachhiBahi on which the transactions are recorded, immediately after the closure of themarket; upon receipt, the secretary, or his designated officers, signs the duplicates.

* At the end of the trading day, each broker has to record all transactions entered intoduring the day on a separate form provided by the exchange, in duplicate; he thenhas to obtain the signatures of the buyers and sellers, as confirmation, and send acopy to the exchange before noon of the next trading day.

Clearing Operations

3.14 Clearing Requirements Vary Across Exchanges Reflecting Differences Across Contracts.Clearing requirements differ markedly across commnodity exchanges. The cotton exchanges, because theytrade exclusively NTSD contracts, only provide a forum for their members to meet and draw upcontracts, and do not provide any performance guarantees. 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 normalcontrols. 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, transactionsregistered within a day, and trade has to take place at a price falling within the price band prevailing on the day thecontract was signed. This is not an unprecedented system. It is standard practice on the London Metal Exchange. Aslong 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.

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should have clearing houses to guarantee contract performance, with both buyers and sellers required topay a margin to the clearing house account. The larger exchanges, such as the pepper exchange inKochi, the turmeric exchange in Sangli, the gur exchanges in Muzzafimagar and Hapur, and the threemain exchanges in Ahmedabad, Bombay and Rajkot, all have clearing houses or arrangements whichwould require improvements. Many of the other exchanges, however, do not collect margins other thanthe initial security deposit.

3.15 Weeldy Clearing Differs from International Norms, Reflecting the Small Scale ofOperations of Most Indian Commodity Exchanges. The clearing houses are departments of theexchange, not independently capitalized entities. They are owned and guaranteed by all exchangemembers --not just the larger ones. The castorseed exchanges and most other Indian exchanges whichoperate clearing arrangements have weekly clearing. A few of the gur markets and the Cochin pepperexchange have daily clearing, a common practice with most intemational exchanges. Exchanges withweekly clearing have the possibility of intra-week clearing ("automatic clearing"), if the day's closingprice moved more than a certain amount away from the last clearing price. Automatic clearing ensuresthat the margin payments are sufficient to cover possible losses. For example, the margin deposit is 3 percent in the BOOE. If the day's closing price is more than 1.5 per cent away from the last clearing price, aspecial clearing takes place.

3.16 The speed at which members have to pay clearing margins also varies across exchanges. TheBOOE determines the clearing payments after the close of trade on Friday, and margins have to be paidbefore the opening of the trade on Tuesday. Positive margins are paid out a few days later, on Friday.In the Muzaffnaagar gur exchange, the clearing margins established at the end of the trading day haveto be paid before the next trading day starts.

3.17 As an additional measure, special deposits can be requested from large market participants.Extra security is also built-in during the delivery period of the contract, when those to whom delivery hasbeen assigned to have to pay a relatively high margin -30% in the case of castorseed. In addition, attimes of volatile prices, special security deposits can be instituted during the delivery period. Forexample, for the June, September and December 1993 contracts in the BOOE, those holding openpositions during the delivery period were required to deposit Rs. 75,000 as guarantee, if they heldbetween 5 and 500 MT, and Rs. 150,000 if they held between 505 and 1500 MT

India's Unique Delivery System.

3.18 Delivery is Not Mandatory. Indian commodity exchanges follow a mixed system at the timeof maturity -either delivery or financial settlement- which is left at the option of those holding contracts.This is unlike international exchanges where no choice is provided to those holding contracts at maturity:international futures contracts always specify the exact method of settlement at maturity -either physicaldelivery, or financial. Delivery procedures of Indian exchanges, when they apply, are adequate.Delivery can be done either on the seller's option (e.g., for castorseed), or on the option of both buyer andseller (e.g., for gur). Two approaches are followed in matching buyers and sellers. In some exchanges,contracts are assigned on the basis of the holding time (the longest-held short contract is matched to thelongest-held long contract, and so on.), which is similar to the one used in American or Europeanexchanges. In other exchanges, each contract is tracked from the net seller to the final buyer.

3.19 Financial Settlement Is Allowed. Contracts which do not go to delivery and remain open untilthe maturity date, are closed out and settled financially. Outstanding positions are settled at a rate fixed

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by the Board of the exchange. Table 3.1 gives anindication of the relative importance of the two types of Table 3.1conract close-out on the BOOE. Bombay Castorseed Hedge

Contract, 1990-1993: Amounts3.20 The Rules on Contract Settlement lack in Tendered And SettledClarity and Transparency. According to the exchanges' =regulations, the Board of Directors has considerable leeway .

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

the BOOE can fix the settlement price after taking account 1990several variables, including: March 10 Nil

* Opening price of the contract; June 50 Nil

* Highest and lowest price of the contract September 135 130December 30 Nilduring its life; 1991:

* Highest and lowest spot prices during the March Nil 375contract life; June 70 Nil

Maturity day's closing price; September 235 320

* Contract prices and spot prices during the last 1992:

15 days of the delivery month; March 210 95* Tenders issued during the delivery period; June 210 660

Outstanding positions on the maturity date September 200 365

* Highest and lowest outstanding positions 1993:

during the contract period; March 1,085 855* Spot prices at three major upcountry centers; June Nil 105

and, ~~~~~~~~September 75 Niland, December 1,220 70

* Due date rates of the last four maturedcontracts.

3.21 The actual implementation process, however, appears more transparent. Settlement prices aredetermined keeping in view the spot market prices prevailing in key delivery centers for 3 to 4 daysbefore the contract is to mature, and after deducting the expenses incurred in making and taking delivery.The settlement price so arrived remains subject to the weekly limit on price variations prescribed by theFMC.

3.22 The Imperfections in the Indian delivery and contract settlement systems causes theartificial backwardation of Indian futures markets. Backwardation --usually a short-livedphenomenon- occurs when futures prices fall below spot prices. On the gur futures markets whereceilings on futures prices are set below spot prices, artificial backwardation is allowed to be maintainedby the flexibility which the Indian delivery system helps provide, enabling sellers to avoid physicaldelivery, and instead to settle outstanding contracts at a price taking into account futures contract prices.

Supporting Infrastructure

3.23 Commodity Exchange Infrastructure is Adequate to Support Current Needs. The physicalinfrastructure of the commodity exchanges, although old, appears adequate to support the existingvolume of futures trade. As membership declined over the years, many exchanges have seen theirincomes declined, making it difficult to invest in new facilities. Nevertheless, the basicinfrastructure of the exchanges visited ( Bathinda, Bombay and Muzaffarnagar) is proper for tradein futures contracts. The exchanges in Bombay have large trading halls --a new facility in the case

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of the BOOE, with recent investment in computer and communications equipment.4 The EICAalso plans to undertake the necessary investments, once the govemment approves cotton futurestrade. The exchanges in Bathinda and Muzaffamagar are not as spaciously housed, but theirfacilities are perfectly suitable for a well-functioning futures trade. Their facilities include a centraltrading 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 andtraders.

3.24 Supporting Warehousing, Banking and Legal Infrastructure is Good. India possesses agood warehousing, banking and legal system which can facilitate futures trading. The country has a goodpublic warehousing system, with warehouse receipts --legally recognized5-- issued by Central and StateWarehousing Corporations, rural godowns set up under government schemes, and godowns set up byRegulated Market Yards, which would discourage manipulation. The banking system is reliable, andapparently, sufficiently fast and efficient for the purposes of futures trade. The Indian legal system, suchas Bankruptcy law, is also supportive of the development of futures trading in the sense that contractscan be effectively up-held in court, although delays continue to undennine the effectiveness of India'sstrong legal system.

3.25 Supporting Marketing Infrastructure in Transport, Telecommunications, and Grading isWeak. Weaknesses in the current supporting infrastructure for commodity exchange operations liemainly in the telecommunication and transport system. The domestic telecommunication system is notvery efficient, although most exchanges seem to have found ways to overcome this. Transport,especially by rail, is slow, which could potentially hinder the efficiency of futures trade if a corner isattempted: it becomes more difficult for market players to bring commodities to the delivery locations ofthe exchange. Ports are slow and their timing unreliable. This will discourage foreign companies fromusing Indian commodity exchanges if allowed to do so.

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

4 This includes a computer link with KnightRidder, one of the world's major information services, which will make itpossible for foreign companies to have instantaneous access to Bombay futures market prices.

5Warehouse Acts exist at both the federal and state levels allowing for the issuance of negotiable warehouse receiptsby recognized warehouses, which could then be pledged to obtain cheaper credit. Appropriate legal conditions appearto be in place: in case of default, the lender has the power to take possession of the commnodities; responsibilities ofwarehouse operators are specified; and provisions are made for a range of potential problems (e.g., loss of warehousereceipt, death, dispute, etc.).

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

Brokerage Industry

3.27 A Small-Scale Industry. A large number of brokers are active in India's commodityexchanges. Brokers are persons paid a fee or commission for executing buy or sell orders for acustomer. Brokers are also used for arbitrage transactions, in which a trader or speculator takessimultaneous positions in two different exchanges to benefit from price discrepancies. In many respects,the brokers active on the exchanges are quite similar to their counterparts in western countries. Box 3.2provides a description of the types of transactions a typical broker in a small-town market undertakes.

Box 3.2

A Typical Broker On The BathindaGur Exchange

This broker, active for over 10 years in the gur market, trades on behalf of clients. His relations with clients are thl same aselsewhere in the world: clients pay deposits and margins when their positions move against them, and in this way, the broker is iflysecured. The bye-laws of the exchange provide all the provisions necessary for this type of policy. His tumover is only some 2,000 to2,400 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 futuires when prices appear low but cannot obtain gur on the physical market, the broker would then liquiae e&tpositions once they have obtained the gur they need. Clients even undertake cash-and-carry operations, simultaneous ftwes and hysicl0marketitansactions that help stabilize prices.

Although commodity exchanges in India operate in much the same way as exchanges in other patts of the warld, commoditytrading is generally not considered a highly respectful career, particularly when the exchanges are subject to frequent police raids. Indianbrokers find it hard to believe that, elsewhere, such an occupation is viewed as perfectly normal and even econonically useful actv1ty. 0

3.28 One major difference between brokers in India and those in Western countries is the scale oftheir operations. Brokers in India usually operate small-scale, personalized businesses. In othercountries, commodity brokerages are often large enterprises, and they undertake a whole range ofactivities. Companies, such as Merrill Lynch, Goldman Sachs or Refco, are active in many commoditymarkets, in financial futures markets and often in various other financial markets. Even smaller brokersare active on many exchanges, and the persons in contact with the clients would not typically execute theorders on the floor. Rather, the orders are passed to another broker (working for the same or anotherbrokerage company). In contrast, brokerages in India are typically a one-person enterprise or at the mostfamily businesses. As in most of India's commodity trade sector, women's participation is absent. Thebroker is active only on one market, and is responsible not only for contacts with clients, but also fororder execution on the floor of the exchange. Contrary to the situation on most other exchanges, allbrokers -including small ones-- have the status of clearing member; i.e., they are themselves responsiblefor payments to the clearing department of the exchange, and the clearing department depends on them toensure its financial security.

3.29 The Brokerage Industry is Fragmented. The fragmented character of the brokerage industrycreates several problems that are likely to grow with the growth of the commodity futures industry. Oneproblem is the lack of financial strength of many individual brokers. The limited financial base canreduce the confidence of potential clients and complicates the creation of a fidelity fund, which wouldprotect clients against 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 information are, at least under current

33

conditions, a major obstacles for many potential users. A third problem is that brokers are not in aposition to provide full services to their clients, in particular the provision of infornation and marketanalysis, and the handling of some aspects of futures trade (e.g., physical delivery). If commodity futurestrade is allowed to expand, brokerage companies able to overcome these problems will have acompetitive advantage. Such potential gains should be sufficient to provide the needed incentives for theconsolidation process of the brokerage industry into larger, nationwide entities. However, the currentsystem of regulation, tailored to the requirements of small-scale and fragmented brokerage industry,would need to be overhauled.

3.31 Lack of a National Brokerage Regulation. The absence of a national brokerage regulationsystem represents a major regulatory deficiency. Brokerage regulation is now entirely under the controlof the associations, which generally have fairly strict rules and are strengthened by some financial safetynets. The recognized associations provide for vetting procedures for new brokers; contribution ofbrokers to a collective safety net; and rules for the contacts between brokers and their clients.

3.32 This regulation system has worked well so far, partly because of the strong social controlswhich the relatively small size of exchange tumover and the limited number of brokers actually involvedhelp provide. If futures markets are allowed to grow, the financial stakes in client-broker relationshipswill increase correspondingly. With more trade coming from out-of-town brokers, existing socialcontrols may break down. If futures markets are allowed to grow, a new framework for brokerageregulation should be allowed to develop gradually. This should be phased so that undue hardships arenot placed on established brokers.

Promotional and Development Capacity

3.33 Most Indian Exchanges Would Need to Strengthen their Capacity to Support the OrderlyDevelopment of Futures Markets. Indian Exchanges are inward-looking, a characteristic common inmany exchanges in other countries. They focus on the needs of their existing members, rather than thepossibility of increasing their business. Their institutional capacity has clearly been stunted by therestrictive policy environment under which they had to operate.

3.34 Currently, many exchanges get-by by keeping a low profile, and only make their pricesavailable 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, includingpolicy dialogue with the Govemment. Even the larger exchanges, however, have no active policies torecruit new floor traders, train market users, or to promote the exchanges and futures trade to the public.They also lack research departments which, in other countries, investigate possibilities for introducingnew contracts. This directly reflects GOI's long-standing policy stance against the introduction of newcontracts.

3.35 If futures markets are allowed to play a more dynamic role, these weaknesses are likely tobecome critical. Those exchanges with an established capacity will need to take the lead in developingtraining programs and undertaking public promotion efforts. Other exchanges could pursue theseprograms once they have the means. Commodity exchanges will also need to develop strong researchdepartments to identify those contract specifications offering the greatest possibility of success.

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B. Impact of Government Interventions

3.36 Government policies influence the performance of, as well as the usefulness of futures markets.These policies can be classified into direct and indirect government interventions. While the formercorrespond to those interventions which directly regulate the operations of the exchanges, the lattercorrespond to those which influence the overall performance of the physical agncultural markets. Directgovernment interventions relate mostly to the provisions of the FC(R) Act. Indirect governmentinterventions, instead, relate to the legal and regulatory environment of agricultural commodity tradeembodied in the provisions of the Essential Commodities Act, 1955 (EC Act) and the RBI's selectivecredit controls, and agricultural price 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 preventspeculation, have often become so stringent to make futures contracts an unattractive and riskyproposition. A clear relationship can be observed between the extent of restrictions imposed onfutures 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 themain exchanges, and cover more than 100% of the physical trade. This is not so in the case ofcotton NTSD contracts which suffer from small turnover, low liquidity, and cover only a marginalshare (15%) of physical trade. Furthermore, the reported presence of active illegal in cottonfutures trading would appear to confirm the interest by operators in more flexible risk managementinstrument.

3.38 Futures Price Ceilings Regulations are Ineffective in Stemming Speculation; They AlsoRepresent a Major Impediment to Efficient Futures Trade. In India, ceiling prices are often set toolow so that market backwardation -futures market prices trade below physical market prices- takesplace. Although intended to stem speculation, this regulatory instrument is made ineffective by theflexibility the Indian delivery system provides (see para 3.23). More importantly, market backwardationhas a negative and damaging effect on hedge effectiveness by breaking the normal process of arbitragebetween the physical and futures markets. It also reduces market transparency by encouraging futurestraders to operate outside the exchanges. In order for futures markets to fulfill their price discovery andhedging roles efficiently, and to minimize the risks of manipulation, ceiling prices regulations should besubstituted by other, less market-distorting tools.

3.39 The Contract Approvals Process Hinders the Usefulness of Futures Trade. Every contractfor a new delivery month has to be approved by the FMC. This approval in some instances arrives late,and always comes with a specific set of conditions, in terms of margining rules, margin lines, positionlimits, etc. At times, the market situation may have changed between the time of the determination ofthese conditions and the start of the contract trading, in such a way that the conditions largely preventfutures trade. For instance, in the June 1994 castorseed contract on the BOOE, the FMC had establisheda margin line (above which special margins have to be paid) at 1,100 Rs/100 kg. By the time thecontract was introduced, prices had increased beyond that level, and the resulting high margin obligationskept market operators from trading. The exchange board was able to revise the margin lines upward,but this took time. Such a discretionary process creates unnecessary uncertainty among users of theexchanges and only serves to discourage users.

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3.40 Tax Rules Do Not Recognize Hedging. Existing tax rules do not allow hedgers to deducthedging losses from their ordinary income, unlike investors in financial derivatives. According to theIncome Tax Act, tax rules treat hedging losses as speculative capital losses which can only be deductedfrom speculative gains -and can be deferred up to 8 years. This regulation creates taxation asymmetry.Unrealized profits on a hedge contract should be allowed to be deferred until the underlying physicaltransaction has been realized. While it appears that many companies manage to get such a "hedgetreatment" through direct negotiation, the legal situation is far from clear. Such asymmetrical taxtreatment of physical transactions and their hedges only serves to discourage legitimate hedging.Participation by traders in exchanges, especially those from outside the area, is further deterred byexchange rules which require that all members be registered in the town where the exchange is located,which is also often a lengthy process. Some exchanges, however, are already attempting to change theirbye-laws to pernit participation by entities registered anywhere in the country.

Indirect Government Interventions

3.41 Government interventions in agricultural commodity markets have been designed to protectthe welfare of producer, processors and consumers, with the view to promote adequate foodsupplies and price stability. These interventions include storage and movement controls embodiedin the EC Act, the selective credit controls issued by the RBI, external trade policies, andgovernment market interventions particularly relevant in the case of rice, wheat, sugar, and to alesser cotton and oilseeds. These policies have a considerable impact on the use, performance, andfeasibility 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 essentialcommodities. 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 specificcrops;

* setting of buying and selling prices;* regulation of storage transport, distribution and use of commodities;* prohibition of sale;* forced sale of inventories to the government, its agents or representatives.

3.43 In practice, the EC Act is applied arbitrarily and selectively to individual agriculturalcommodities by GOI. It currently applies to virtually all major agricultural commodities. The powersconferred by the EC Act may, by notified Order, be delegated to state governments, an authority orofficer subordinate to the state. As a result, state govemments, have also developed their own series ofOrders. Various components of the EC Act have a significant impact on the operations of exchanges aswell the feasibility of establishing new ones.

3.44 Storage Controls Restrict the Economic Usefulness of Futures Trade. Commodities suchas foodgrains, sugar, kapas, cotton, oilseeds and oils, are subject to strict stock limits. Storage controlsprevents temporal arbitrage from taking place efficiently, thus restricting the potential contribution offutures markets to more efficient storage decisions. Storage limits are regularly revised, even during thecrop season, creating additional uncertainty. For example, in April 1994, the maximum cotton stock ofmills was restricted to the three month average consumption (an increase from 45 days restriction in

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1993). Traders and ginmers were also prevented from storing in excess of 110% of the quantity held onthe last day of the corresponding month of the previous year. Small traders and ginners are normallyexempted from stock limits; so are the state trading companies and cooperative federations. Revisionsregularly occur such as the kapas and cotton exemption from controls in the October 1993-February1994 period. In the case of oils and oilseeds, trader stock limits were reduced by 50 percent in October1993.

3.45 Commodity futures markets function best when efficient storage is possible and supported by awell-functioning credit system. Storage charges wvill keep in check the price differentials between spotand futures prices. If spot market prices are considered low in relation to futures market prices,operators will arbitrage: buy commodities now, pushing up spot prices, sell futures contracts, pushingfutures prices down.; after a period of storage, commodities will be sold, pushing down spot prices, andbuy back futures contracts. Arbitrage contributes to greater seasonal price stability. Such arbitragestrategies freeze up working capital, but because the value of the commodities is protected through thehedging futures markets provide, it should not be difficult to obtain bank finance.6

3.46 Selective Credit Controls Further Reduce the Demand for Futures Trade. The ReserveBank of India (RBI), as part of its selective credit controls, sets "minimum margins" on commnercial bankadvances against a range of "sensitive" conmmodities; for example, with a "minimum margin" of 40percent, a bank is allowed to advance only up to 60 percent of the value of commodities to a stockholder.In addition, lending to each single party is subject to credit ceilings, with the maximum credits in a givenyear limited to a function of the peak level reached during the three previous years.' Sensitiveconmmodities include foodgrains, pulses, oilseeds, vegetable oils, sugar, gur and khandsari, and kapasand cotton. Processing units normally come under less restrictions than traders. Minimum margins arerevised regularly, at least twice a year. The rationale for this policy is that, such credit controls will helpstem price increases. Central and state government agencies, those acting on their behalf of theGovernment, and cooperatives are generally exempted from this policy. Other exemptions are onlypossible with Reserve Bank of India approval. The RBI has lifted its selective credit controls for severalcomnmoodities in Ocotber 1996: coarse cereals, pulses, oilseeds and oils, sugar, guar and khandsari,cotton lint and kapas.

3.47 Storage controls together with selective credit policies severely restrict the capacity of privateoperators to undertake storage, reducing their need to cover price risks through hedging on futuresmarkets. The link between storage and credit control policies, and their stated purpose of preventinghoarding of commodities and inflation is not very strong, except possibly in the short run. In practice, itis likely that such policies increase the vulnerability of markets to sudden shocks, making agriculturalprices more volatile, and requiring greater, costlier government interventions on agricultural markets thanwould be otherwise necessary. Alternative policies may be more effective in reaching the same anti-inflationary goals.

6 It should also be noted that through this function, the private sector can take over a large part of the storagefunction, relieving government agencies of much of their burden: in order to reach certain price stabilization goals,buffer stocks can be much lower with a futures market than without. Also, as the experience of some internationalbuffer stock operations has shown, the existence of a futures market will ensure that buffer stock operations are moreeffective: because of the transparency of the market, open market operations will be reflected in the prices, while ifno futures market exists, private sector operators can just purchase (sell) whatever quantities the government wishesto sell (buy), without the rest of the market becoming really aware of it.

7 The maximum level is equal to this peak level, or 15 per cent higher or lower, as a function of the Government'sdesire to limit credits.

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3.48 Movement Controls Also Restrict the Economic Usefulness of Futures Trade. Conunoditymovement 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 stategovernments at any time. In Gujarat, for example, the transport of groundnut oil was banned seventimes between 1990 and 1995. Andhra Pradesh exercised the same powers in 1992. Such commoditymovement restrictions make futures trading impossible by simply facilitating the manipulation of futurescontracts.

3.49 Government Market Interventions May Make Futures Trade Impossible. Futures marketscannot work when market interventions by governnent do not allow market forces to operate. This isthe case for sugar where the government administratively sets prices of the sugar sold through the PublicDistribution System, regulates open market prices by controlling stock releases on the open domesticmarket, and strictly manages foreign trade. It is also the case for rice and wheat where the FoodCorporation of India (FCI) acts as the "dominant" supplier by accounting for the bulk of trade andstorage. Pan-seasonal and pan-territorial pricing policies for rice, wheat, and sugar further discourageprivate storage, the risk management benefits and arbitrage possibilities futures markets would offer toprivate operators. In the case of rice and wheat, the absence of futures markets also implies that moststorage costs and risks are bome by the Government and its associated agency, the FCI. The absence ofany reported illegal futures trading activities in rice, wheat and sugar would appear to confirm the lack ofinterest by private operators in futures trading for these three commodities.

3.50 For other agricultural commodities, direct market interventions by government are much lesssignificant, leaving greater room for market forces to operate --within the confines imposed by thestorage, movement, selective credit controls, and other extemal trade restrictions. The extent of marketinterventions varies, however, from one crop to another. Government market interventions are greater incotton than in castorseed and other minor agricultural commodities such as gur, pepper, and potatoes.The presence of much more active futures trading in the case of castorseed, gur, pepper than for cottonwould suggest a strong --and inverse--relationship between the extent of govemment interventions on thephysical markets and the operation and performance of futures trading.

3.51 Futures Markets Do Not Necessarily Hinder the Achievement of Existing Policy Goals.One possible policy concem is that futures markets would prevent GOI from pursuing its price stabilityand production objectives. In practice, however, a conmmodity futures market does not prevent aGovernment from subsidizing producers or consumers, or from controlling the extemal trade ofproducts. Instead, a futures market will reflect the policies in place, as part of the general marketconditions under which it operates, either the world market, or the local market screened off from worldmarket influences. In the USA, for example, two raw sugar futures contracts are traded. One reflectsworld market conditions while the other reflects domestic conditions; the latter therefore trades at aconsiderably higher level, reflecting the US govemnment's objective of stimulating sugar production.Even the cotton and the wheat contracts traded in the US which attract signuficant internationalparticipation reflect US conditions -including government interventions-- rather than the world market'ssupply/demand conditions.

3.52 The govemment could still avail of the many useful functions a commnodity futures marketperformns, without giving-up control over the underlying physical market. Governent interference in thepricing and trading of commodities is not necessarily a hindrance to the functioning of futures markets.Throughout the world, commodity futures markets operate behind tariff and non-tariff barriers, and playtheir price discovery and risk management roles for local market participants. But while govenmment

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interference in itself does not need to be a problem, heavy-handed intervention and discretionary,unpredictable interference is.

3.53 Provided a physical agricultural commodity market is not under direct government control,prices are set by market forces, and that commodity movement and storage are allowed, futures marketscan continue to operate as long as there are clear rules on trade, including government interventions.Sudden, discretionary government interventions --e.g., imposition of movement restrictions on inter-statetrade, changes in storage limits and credit controls, immediate ban on exports, changes in import tariffs,or unpredictable operations of parastatals or state trading enterprises-- fundamentally alter the supplyand demand conditions on the physical markets, creating higher and unhedgeable risks. They also make

Box 3.3

Contibution of Futures Markets to a Comprehensive Agricltural Strategy:Potential & Limnits of CGovernment Market Interventions

The American and European Experiences

The otrasting eperince of the American and Common Agcultural Polices of the European Uniobshows that producer poetn policy objectives can be maintained while allowing successful fiures tradingactivities. The simplification of the two policy models described below, highlights the presence of alternativefoms oftmaetr interventnto achieve similar policy goals. Policies that have an indid effect on: theperformance of futures market trade need to be evaluated in light of their respective costs and benefits, and thepOssibilities hy offer for less disruptive alternative risk management instrument.

* erican lt polices protect producers, but do not eliminate price risks. Consequently, Americancommodity fuilies markets are active and atract large international interest, bringing with it a significantfinancial and commodity warehousing service industry. Storage by the private sector remnains econormiallyataive,f and the government is not burdened by large stocks.

Th 'LiUS experice also shows the limnits of government interventions in allowing futures rmarkets toperform effectively. :In the case of the United States, over the last ten years, strong arguments havebeen made that wheat futures no longer represent a good hedging tool for international prices due toUSC Government interference through export enhancement program and other instruments, very muchaffecting thelinka between domestic and international prices.

By contras0, in the Euiopean Union, the same goal of protection of agncultural piroducers as been pursuedby policies that elimninated most price risks. As a consequence, virtially no futures contracts for thecommodities 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 marketsto be subjetd to price risks, prompting the introduction of new futures contracts -e.g., oilseeds contracts inon the Pans exihnge (MATIF) with the delivery points in France and Gemany. Futures contracts forcereals are also underdpreparation at the MATIF.

it very difficult for speculators to operate; and with speculative participation drying up, hedgers will findit difficult to continue using the markets for lack of liquidity. Finally, they increase the risk thatmanagers of state companies abuse their control over marketing and pricing decisions.8 Governmentinterventions can go quite far --including targeted subsidies, an active role for state trading enterprises,

8 For example, the manager of a state-trading company could decide to take a hidden position on the futures marketon his own account, and then takes a physical trade decision which costs his company money, but brings him a profitin his personal account. This type of abuse can be prevented by taking away from individual managers thediscretionary power to make trading decisions; state-trading companies could instead sell according to a pre-determined, automatic schedule, at prices that reflect the market prices (e.g. the exchange-published prices).

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external trade restrictions and even controls on storage activities by market operators. What matters isthat interventionist policies remain stable and credible, that changes are publicly announced long inadvance, and that government agencies abide by the market rules in their operations. The US andEuropean experiences illustrate the potential and limits that government agricultural policy interventionsimpose on the performance of futures market, and their potential contribution to a comprehensiveagricultural strategy (Box 3.3). When government interventions are achieved only through privatesector operations and in a predictable manner, and if prices are still able to clear the market, thenfutures trading might co-exist with Government policy.

Summary

3.54 Indian commodity exchanges do not perform as poorly as could be expected from the adverseand restrictive policy environment under which they are required to operate. Their trading practices andclearing procedures are generally adequate to handle the limited scale of most commodity exchanges.The arbitrariness of the financial settlement undermines the delivery system and therefore the viability offutures markets. Market liquidity on the majority of Indian exchanges leaves much to be desired, a directreflection of the very restricted access to futures trade, and the unfavorable policy environment on thephysical markets. The access to as well as the performance of Indian commodity exchanges are stronglyinfluenced by government policies with respect to physical trade and financial flows, including in price,trade, storage and credit policies. The absence of proper government policies to regulate the conmmoditybrokerage industry could also hinder future growth of futures market trade. There is considerable scopefor enhancing the contribution futures markets can make to the agricultural sector, both throughinitiatives at the exchange level, and initiatives by the government. These policy options are discussed ingreater details in the following chapter.

I

4 OPPORTUNITIES & OPTIONS:4 POLICY IMPLICATIONS

A. Commodity Exchanges in a Changing Policy Environment

4.1 Greater Exposure to Price Volatility As Indian Agricultural Markets Become MoreOpen. The policy environment governing the Indian agricultural sector is rapidly evolving, offering newopportunities, but posing new challenges as well. Significant external trade liberalization has beeninitiated over the last couple of years. Common rice can now be freely exported, exposing hidiangrowers, traders and exporters to international prices and competition. Oilseeds crushers and growersnow have to compete with edible oils imported under relatively modest tariff levels, in addition to thealready existing competition on the oilseed meal market. This recent, gradual opening-up of Indianagriculture to world markets brings new economic opportunities. It also poses new challenges. Inparticular, price volatility and the capacity to cope with it become major policy concerns. Pricevolatility creates uncertainty and risks which can threaten agricultural performance through reduction ininvestments and export earnings, and greater dependence on imports. Indian policy makers havetraditionally coped with such uncertainty and risks by resorting to policy instruments aimed atminimizing or eliminating price volatility. These include pervasive extemal trade restrictions, pricecontrols, price support operations, procurernent and distribution schemes, buffer stock operations, cropinsurance, and restrictions on storage, movement and trade credit. These instruments are provingfiscally costly and create serious price and market distortions which reduce growth and competitivenessof Indian agriculture. These instruments are now progressively being either reformned or abandoned bythe GOI in an effort to spur agricultural growth.

4.2 Need for Commodity Price Risk Management Strategy. In this increasingly liberalizedenvironment, futures markets offer a market-based instrument for managing risks and uncertainty.Futures markets can complement or substitute for the traditional policy instruments used to cope withprice volatility. Commodity futures markets provide a powerful tool for efficient price discovery andrisk management to a wide range of market players, which would help improve Indian agriculture'scompetitiveness. The existence of futures markets provides small players, such as farmers or localtraders, access to the same information as large players on likely futures market developments. Thus,they help create a more level playing field for commodity trade that would benefit both consumers andfarmers.

4.3 Demand for Futures Markets is Strong and Growing. There is a strong demand, not onlyfrom commodity exchanges and their members, but also from agro-processors and farmers'associations, for the expansion of the number of commodities eligible for futures trade. The KabraCommittee, appointed by the Govermment of India, has proposed a long list of commodities in whichfutures trade should no longer be banned. Even though the Kabra Committee found that futurescontracts in all of these commodities might not be viable, it was also argued that the introduction of newcontracts would benefit many groups. Some of the exchanges appear ready to invest in this expansionor have already invested; others are interested, but have not generated enough resources during therecent lean years to implement their plans.

4.4 Building on the earlier chapters, we now derive a set of recommendations for the establishmentof an enabling environment to the orderly development of futures markets. Three sets ofrecommendations are successively developed. First, we will address the set of conditions on the

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physical markets that need to be in place for futures markets to perform. The second set ofconditions relates to the policy, regulatory and institutional environment governing the operationof futures markets. Finally, we will explore the feasibility of developmental options, such as theinternationalization of India's commodity exchanges and the introduction of new contracts.

B. Creating the Enabling Environment for Commodity Futures Trading

4.5 For futures markets in any commodity to be viable, minimum conditions need to be met,among others: the prcing of the commodity must be by free market forces, without monopolistic ordirect govemment control of prices; price fluctuations need to be sufficiently large to warrant the use ofrisk management techniques; there has to be a sufficiently large group of speculators to provide theneeded liquidity; the spot market has to function reasonably, with sufficient standardization of tradingpractices, few barriers to movement, and a proper storage system, to enable commodity exchanges toformulate contract specifications that would make market manipulation difficult. If any of theseconditions is not met, a futures market is impossible. In India, government policies prevent theseconditions from being met for a number of agricultural commodities.

General Rules for a Permissive Government Policy

4.6 Futures markets wiOl be able to function effectively even when government policies strive toestablish remunerative prices for producers or affordable prices for consumers, provided thatgovenmment interventions foOlow a few rules:

* Government interventions should not, in a direct or indirect manner, eliminateprice risks. The govenmment should not set prices on the marketing chain, norprocessing margins. Minimum or maximum prices could be set, provided pricescan clear the market. Minimum (or maximum) price interventions should providea protection against distress sales (or price spikes), allowing market pricemovements to take place. Price volatility should not be eliminated through pan-territorial or pan-seasonal policies. Government policies for rice, wheat and sugarcurrently make futures markets in these products non viable.

* Govemment interventions should not strongly restrict the normal flow ofcommodities in the economy. Traders should be allowed to undertake thearbitrage transactions that are worthwhile, and not be hindered by restrictions onstorage, movement and access to trade credit. Such restrictions would need to beeither permanently lifted or significantly relaxed for conunodities such as oilseedsand cotton and their derived products, as well as other agricultural commoditiesfor which govemrnment restrictions hinder the normal flow of commodities acrossseasons and within India.

* Government interventions should leave a sufficiently large part of physicaltrade in the hands of the private sector. Government market operations shouldbe kept to the minimum required to achieve policy goals. This is particularlyrelevant in the case of rice and wheat where the government dominates themarket.

* Government should provide for a stable and predictable external trade policyenvironment. Changes in foreign trade policies alter fundamentally the supply

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and demand conditions of the physical market. Policy changes that reduce oreliminate trade distortions, such as the recent freeing-up of edible oils trade, go along way towards providing a more stable and predictable extemal trade policyenvironment. However, sudden, unannounced policy changes introduce shocks inthe physical market, creating un-hedgeable risks that will deter participation onfutures markets. Examples include the recent (1995) decisions to free-upvegetable oils imnport, to lower edible oils import tariff levels from 65% to 30%overnight, and to offer a preferential tariff (20%) to state trading enterprises andthe National Dairy Development Board (NDDB) for an unspecified time. Thearbitrary release of cotton export quotas is another example of un-predictable andun-stable external trade policy that would undermine the viability of futuresmarkets.

4.7 Exchange associations in India are generally rather optimistic about the possibility ofintroducing new futures contracts. Even though some of the conditions mentioned above appear to bemet in India, not all conditions are in place. While a filll assessment of the potential of new futurescontracts is beyond the scope of this report, the link between government policies affecting physicaltrade and the opportunities for a futures contract should be stressed. For example, India is the world'slargest sugar producer and consumer -not counting the production of non-centrifugal sugar, gur andkhandsari. If a gur contract functions well, one would expect that an Indian sugar contract serving aneven larger market will also function well. The existing sugar contracts in New York, London andParis are not particularly useful for trade in Indian since basis risks are too high. However, theextensive government interventions --PDS procurement, storage and distribution of sugar; free marketreleases controls; setting of minimum sugar cane and sugar issue prices; international trade 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 government were to allowfutures trade in these commodities, there would be no or little interest from the private sector. Forbasmati rice destned for exports, a futures contract could potentially work.

4.8 Spot & Futures Markets Can be Allowed to Develop in Synergy. In the rice, wheat andsugar sectors, government policies do not satisfy any of the conditions listed above. In the case ofcotton and oilseeds, government policies meet some of the above conditions: price risks prevail on thedomestic market; government interventions allow prices to clear the market within the confines ofgovernment restrictions on external trade, the storage and movement of goods, and access to tradecredit. For these commodities, a commodity futures market and its underlying physical market can welldevelop in a symbiotic fashion. Imperfections in the physical market should not prevent a commodityfutures market from operating, and indeed do not as indicated by the widespread illegal futures tradingactivities in cotton and oilseeds. In many instances, the presence of a futures market will encouragethose active in physical trade to improve their market practices. For example, information on futureprices should improve storage decisions; the need to deliver specific grades of a commodity to anexchange warehouse will encourage improvement in grading performance on the physical market. Asthe physical market becomes more efficient, the futures market will also become more efficient.Efficiency improvements are only possible within the bounds posed by government restrictions, butevery time a restriction --e.g., on storage and movement controls, access to trade credit, bank financingof hedging operations, foreign trade - is relaxed, the interplay of futures and physical markets willensure a speedy adaptation of the private sector to the new environment. To survive and operate,comnmodity exchanges do not need to perform at their full potential. Indeed, most Indian commodity

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exchanges operating today do not. Participation is often limited to some of the larger traders; futuresprices, at times, move in strange ways, reducing the effectiveness of hedges; arbitrage, which ensuresthat physical markets are well integrated, hardly takes place. Such imperfections can be expected whenspot markets do not function properly as a result of government policies.

C. Improving the Policy Framework of Commodity Exchanges

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

Legal & Regulatory Framework of Futures Trading

4.10 The FC(R) Act and Legal System Provide a Sound, Initial Basis. Government regulationsof commodity exchanges are major determinants of their performance. Contrary to many othercountries, India enjoys a strong regulatory system for commodity exchanges and considerableexperience that will facilitate significantly the development of its futures markets, as the China example(Box 4.1.) amply illustrates.

4.11 Discretionary Interventions Would Need to Be Curbed. The FMC applies extensivediscretionary controls, predicated upon the concern that the rules and regulations will be by-passed bysome individuals. When resorted to on a regular basis, discretionary controls cause insecurity amongmarket users, and hinder the functioning of futures markets. Discretionary controls should be restrictedto emergency situations, with standard procedures guiding the day-to-day functioning of exchanges.Standard procedures should be applied to the following regulatory areas:

* The recognition of associations should either be permanent, or at least on along-term (at least 10 years) basis, rather than on the current 2 years or even 6months basis. If an association breaks government regulations, its recognitioncan always be withdrawn.

* The introduction of new contracts should be automatic, that is, at least three ormore contracts should always be traded simultaneously, and if one contractexpires, the next contract should be introduced automatically. Regulatorymeasures --special margins, margin lines, position limits, etc.- should bestandardized to the extent possible, rather than set differently from one contract tothe next. Ceiling prices should be withdrawn altogether.

* The role of the FMC should be largely a monitoring one, with occasionalinterventions if abuses take place on a market.

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Box 4.1Lessons from China's Experience

With the ihealisation of Chinas internal market, the need arose for forward and fitures trading. The Chinese governmentstarted to study this possibility in 1988. Tle concept that was adopted foresaw the development process with the wholesale makets as afirst phase, forward mreketa as the second phase, and fixtures markets as the final phase. This concept was, however, rapidly bypassed byrethty and alnost as rapidly, things started to go wrong.

The Zhgwhou Grain Wholesale market in Henan was the first to begin operations, in October 1990. Three years later, overSG tnw exchanges were cated, of which 30 traded fiutures contracts. By late 1993, the largest exchange -the Shanghai MetalsEn*anga- had become the worlIS thid largest lutures exchange in terms of contrac turnover. In 1993, tot futures trading approah-US$ 90 billion. At the samne time, the Chinese governmt faced increasing difficulties with somne aspects of futures markets trading.With local 4uthoities competing vigorously over a slice of the fitures pie, it took some time for the Chinese governent to get the sectoruder control. ventually, drastic measures were taken in late 1994. Moat exchanges were dlosed 4own or bamned from forward or

liAnies trdgi: while only 15 restructured fixtures exchanges received formal government approval. Futures tade in a number ofstnicw products -steel, coal, gasoline, sugar and cotton- was banne4, Additional, subsequent restrictive measures were also

imposed: othe fitures contracts were banned; price controls were introduced; cash settlement was prohibited, and henceforth, allWettlenei had to be through physical delivery. For a time, all contracts over three months forward were forbidden; in October 1995,

traders were forbidden from dosing positions and building new ones on the me day. What went wrong?

- Sowne practical errors were made in setting-up the exchanges. Many were created without the involventent of those active inphysical tra4e, resulting In poor trading arrangements. Operating Cos were too high; several tines higher than the western open-oitcry exchanges. Most exchanges chose the expensive electronic trading systems, which also reduced market liqutdity bypiventing floor traders from trading. Exchanges hardly co-operated, even within the same town.

More importantly, fitures markets faced thre f _undmentl shortcomings;

* Arbitrage between Futures and Physical Markets Did Not Work. With Chinese exchanges, the necessary arbitrage link betweenfutwus and physical markets did not work properly. Firs, many of the so-called futures exchanges traded what in India would beknown as TSD contracts which are easily prone to market manipulation. Second, failures on the physical nmrket made the futwesmarkets' delivery rmeaism non viable: transport of commodities was difficult to atange, exchange warehouses were oftencorolld by few meibers who could manipulate the market. Third, the weak monitoring and accountancy systems of state tradingcompanies provided ¢teir traders with strong incentives to take highly speculative positions rather than to enter into nonnal,profitable arbitrage positions. Fourth, price information was not wel diffused by the exchanges: most snmal speculators in effectacled as gmnbt, reducing liquidity and creating excessive prce volatility on the futures market.

* China Had No History of Exchange Operation or Futures Trade Regulation. During the early 1990s, the central governmentvirually lost control over the exchanges which were being regulated by provincial or even municipal authorities. Brokerages hadspnung up almost outside the purview of any regulation. There were many abuses at the exchange level -exchanges were profitventures, rather than non-profit organisations as is the case in most westem countries, Exchanges often did not have the incentive,nor the staff; to police operations on their exchange and also abused consumer confidence. In October 1992, a central oversightstructure, the Securties Regulatory Commission, was created but it took another two years to get the sector under control. Forinstance, although capital adequacy standards and an approval procedure for brokers were adopted in 1993, many brokerscontned to be officially recognised because of their connctions.

* Lack of Government Experience with Futures Trading. Government regulators did not evaluate futures prices in tenms of theunderlying sly and demand conditions of the underlying physical markets; instead, fitures prices were evaluated in terms ofpolitical objective. Althougb the bulk of futures trad was accounted for by state-owned companies rather than by smallspeculators, prices were at times deened excessive by government regulators, reflecting the artficial scarity caused by remainingcontrols on producXti, distribution and external trade. In response, the government imposed ceiling prices or banned contracts.

Chis xture industry was allowed to develop in an envirent with insufficient checks and balances, from a regulatorypoint ofview, and fiom an operational point of view. Besides the regulatory backlash it triggered, the futures markets crisis also resultedins lingri dist of ftues narkts among some ofthe policy-maklers Chinas condios were unique, and one may well argue thatpolicy#makers overreacted . However, it highlights the central inportance of a good regulatory framework and a wmpetitive physicaltrdig structe s necessary condtions to the orderly development of commodity fixtures trade.

4.12 Reverting to A Purer Model of Three-Tier Regulation. The government could considerreverting to the three-tier model of regulation which the FC(R) Act provides for. Under such a model,the centl government would still approve exchanges and set the general legal and regulatoryfiamework, including brokerage regulations (paragraph 4.23) and prudential standards for the use ofrisk management instruments by companies (Box 4.2). The futures markets regulatory agency wouldapprove requests for the inroduction of futures contracts for new commodities, monitor the operation ofcommodity exchanges, and intervene when the situation warrants it. The exchanges would managetheir day-to-day business, including controlling the financial status of their members, operating clearing

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operations, and ensuring a proper functioning of trade. The introduction of new contract-months wouldbe automatic, and the conditions attached to each corract would be as standardized as possible.

Box 4 1

ShotduldCompanies BePriete~l From FuturesTrade?Wthth}eM cllapse of 200-eyar old Bring at the hands of one 2g-year old trader, "deivative," and "fitures markets" have

becomwidelyX publiciz2d Such publicity 'May wdI have conveyed tebelief that derivatives and futures markets are inherentlydanrous,andthatompaniesiould be protectd fromthem.Towhatextentis thus fear justified?: Are futures markets and over-the-6counterrisk management miarkets really dangerous?

Derivatives ar edangerous only. because they are relatively new and unknown. Fraudulent activities or unauthorizedspeSlation by staff always ext in onoher makets, and are by no m eans6 cofined to daivatives makets only. More companies haveprobably 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 riskmanagemenXt markesisoftennotpropei irolly controlled.

Te he4dge disasters dftfeiearly 1990s have a inumber of Oommon theme:s:

* Flawed montorng 0ys ems: the monitoring and accountancy systems used did not always properly represent the real results ofderivativesdtransacions. Ot premiums have been booked as straighforward pofits; and the historical valuation of contrctaallowed anumbergof onpanies tocarry-overhuge teses fromone year# to he neat.f00:d0:

: iInatenamel magement: in some:companies, desite the eidstence of proper control sys the control philosophy never becamepart of the ps way,of operating, and limits were ignored and control systems not used.

* o ear mtandaites for traders. traders' limits at times wereVpoorly defined, and, perhaps more importantly, these limits were notcommunicatedto brokers. Traders were thusfreeto undertake iiciittransactions.

*0 No epratn of radng, accountingi and control responsibihaes: in some cases, one trader or a single trading group set policy,executed asaions, inputthevalue datawfor their positions monitored their own perfmrmance, and even sent out margin money.

* Lackoft omp ehensfonof risk managementproducts, exposures and netpositions: company traders have been tempted at timesJ tot :tu dabble inoverly mpicatedinstruments;consequently, thleydid notreactw prperly when the underlying prces moved in anunexpVectedway. 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 successful trader, rather than making sure they 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 welldisbutedl.' T types of policymeasures can be envisaed. Firtyan oblgation for iftures market brokers to obtain the proper4approval fromseniorcormpany management before acceptig the tradng autiority of an individual tader and secondly, an obligation forihe banksi and other companies prvding over-the-couiter risk management instruments to be more transparent - one particularlypowfstoolwouldbeto oblige thei to quote at least once a week the "replacmetnt value. 6of each of the contracts they entered into, sothat a company knows its poston iand canwdecide to reverse it,

4.13 Attracting Greater Participation from Commercial Hedgers & Speculators. Thegovernment could consider revising several rules in order to attract greater participation on Indianexchanges by commercial hedgers --traders, agro-processors, manufacturers-- and therefore promotefutures markets liquidity and the indirect access by farmers to risk management transactions. Thiswould involve lifting the regulatory barriers on the participation of agricultural cooperatives to futurestrading; revising the Income Tax Act to formally provide for tax symmetry between physical and hedgetransactions, recognize hedging losses; relaxing the (sales) tax registration requirements.

4.14 Attracting the Participation of Large Institutional Investors Institutional investors, throughtheir large scale trading volume, function as automatic counterparts for the largest hedgers. Thiscreates incentives for large scale hedgers to trade in the exchanges, and reduces brokerage costs. In viewof the growth potential of the large institutional investors in India --pension funds, insurance funds andmutual funds- and their potential contribution to the perfonnance of futures trading, it would be usefulto reconsider the ban on their participation. Some complementary conditions, however, will also beneeded to support fund participation. This includes the relaxation of the tax registration requirements -

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all traders must have a local sales tax registration-- and the presence of larger more highly capitalizedbrokerage firms.

Exchange Regulations & Operations

4.15 Commodity exchanges would need to improve their operations in the following areas: tradingprocedures, delivery system, trade supervision, clearing operations, and promotional and developmentactivities. These improvements will not only enhance the efficiency of current operations, but alsoensure the orderly expansion of their services in the future.

4.16 Improve the Transparency of Trading Procedures. Trading procedures could be improvedby introducing a time stamping obligation and the monitoring of prices by an exchange official on anunute-to-minute basis. Preferably, these prices should be entered into a computer and made availableas widely as possible, on a real-time basis. These two measures would make it easier to determinewhether a transaction indeed took place at a competitive price and prevent fraudulent behavior oftraders against their customers.' The length of the trading day needs to be carefully considered since along day dilutes liquidity over too many hours, and also makes it more difficult to monitor the properfunctioning of exchange trading.

4.17 Remedy the Arbitrary Settlement System. Weaknesses of India's unique delivery systemwould need to be corrected. A simple solution would be to adopt international practices by giving-upthe settlement option: positions remaining open at maturity date would have to go to delivery. A lessdrastic solution, however, would be to set-out clear and transparent formula for determining the close-out price, on the basis of spot prices at and near the maturity date. The formula would be worked-outby the Pricing Committee of the exchange, where all the participants in the trade would berepresented to ensure its fair and transparent operation.

4.18 Strengthen Trade Supervision. Greater effort should be directed at enforcing and educatingmembers about the rules and regulations of the exchange. Internal auditing departments should bestrengthened in order to consistently monitor the trading behavior of brokers, in order to ensure anhonest and fair relationship with their customers.

4.19 Moving Gradually Towards A Safer, Enforceable Margining System. Margin deposits andmargin calls should be set in relation to what is necessary to secure the survival of the market. Unlikecurrent practices, margin deposits and margin calls should be set irrespective of their impact onindividual members and the capacity of the less well-capitalized members to carry these charges.Exchanges should move gradually towards a better margining system, while providing some assistanceto the smaller floor-traders. For example, as in the US system of futures trade, larger traders may beencouraged to serve as guarantors for floor-traders unable to carry the concomitant marginrequirements. In addition, the exchange system would gain in security by creating an independentclearing house, with members that include both exchange users and financial firms --the case inMalaysia-- or only financial firms --the case in the United Kingdom.2 This would largely eliminate the

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

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

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credit risks of doing business on the exchange, making its use more attractive to all, including foreignusers.

4.20 Strengthen Promotion and Development Activities. To counter the potential deficit intrading skills in the future, as an increasing number of traders approach retirement, the exchanges needto develop training programs, for members as well as non-members. In the long term, to ensure thesupply of trained professionals, the exchanges can work with universities in developing the appropriatecurricula in the relevant specialization. In the short term, the exchanges also need to devote moreresources to promotional activities, to expand the awareness and understanding about futures tradeamong both policy makers and the general public.

4.21 Research capacity in the exchanges would need to be developed. Indian exchanges appear tounderestimate the difficulties involved in introducing new futures contracts. It is often assumed thatsince futures contracts were traded in the past, the same contracts would automatically be successfultoday. Market conditions have changed. Moreover, a large segment of the industry probably has noliving memory of how to undertake futures trade. Proper contract design is critical to the success orfailure of a contract. This would require significant research on the part of the research department ofIndian exchanges.

4.22 Commodity Exchanges Would Select The Best Suited Contract Specifications.Conmmodity exchanges would have strong incentives to design and offer contracts specifications thatrespond best to the need of their clients. While the FMC approval would still be required for theintroduction of new contracts, it is the market that will dictate which contract specifications are bestsuited. With such a regulation system, alternative, more flexible contracts permissible under the FC(R)Act --e.g., TSD or hedge contracts- will be introduced, substituting for those that do not offer sufficientflexibility, such as the NTSD cotton contracts.

4.23 Introduction of a Two-Tier, National Brokerage Regulation. A national system ofbrokerage regulation for the specific purpose of consumer protection should be introduced if futuresmarkets are to expand their roles, and attract a larger number of participants. A two-tier system ofbrokerage regulations would have to be established, at the government and the broker organizationlevel.

* At the government level, regulations would lay down the rules of the game for the wholecountry. This would include establishing the minimum qualifications and financialstrength of brokers and defining the relationship between brokers and customers and therights of customers. It should also ensure that brokers who have been barred from oneexchange are unable to become members of other exchanges;

* At the exchange level, self-regulation by organizations of brokers can continue very muchthrough the existing system, that is, through the recognized associations. However, itwould be preferable to create an all-India body of brokerage organizations to shareexperiences and coordinate policies.

4.24 Even though the system of self-regulation by exchanges could remain more or less the sane,current policies may need to be reformed, with the changes phased in gradually:

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* Formalization ofthe vetting process. Candidates could for instance be requiredto pass a training course which would include the ethics of broker-customerrelations, and the legality of various forms of floor trading.

* Strengthening financial safeguards. Some minimum net worth requirementscould be introduced, or alternatively, a system where small brokers find thepatronage of a large clearing member, who ultimately guarantees their financialperformance, as is the practice in the United Sates. Brokers could also berequired to contribute towards a customer protection fund (also called "FidelityFund"), to compensate clients of brokers who have gone bankrupt. This wouldstill fall short of the strict controls and capital adequacy rules of the United States,but would appear the most feasible given the state of commodity exchanges inIndia.

* Client Protection. Existing rules governing the relationship between a broker andhis/her client basically concern the protection of a broker against a client default.They establish the rights that a broker has to demand margin deposits andvariation margins and set out the fines clients have to pay in case they do not meettheir obligations to make or take physical delivery. These rules hardly take intoaccount the protection of customers. Self-regulatory brokers' associations couldensure that their members follow the rules on contacts with clients, use therequired forms and in general, follow fair marketing practices. They should alsomake an effort to educate the public at large on the differences between legitimateand illegitimate brokers.

Institutional Development Assistance Required

4.25 Strengthening the FMC. For the purer model of three-tier regulations of futures trading to beeffective, institutional strengthening of the FMC is necessary in order for the Commission to be able tobe able to undertake its role in evaluating new contract proposals, and monitoring the functioning ofexchanges. An additional form of control is needed on whether brokerage companies follow theguidelines set-out in the brokerage regulations and prudential standards: private sector voluntaryorganizations, such as a national brokerage organization, are useful for screening potential members,but remain insufficient. This regulatory role could be given to the FMC, or the SEBI, or to acompletely new organization. Like the Commodity Futures Trading Commission in the United States,the FMC is a statutory body composed of government-nominated individuals, served by a permanentsecretariat. The secretariat of the FMC is small, only 80 people, compared to 200 at its inception.Relative to the breadth of responsibilities it assumes, it is ill-equipped to perform its role effectively.Staff and equipment need to be expanded, and particular attention needs to be given to building up theskills needed to fulfill its new regulatory and promotional roles.

4.26 Given the poor state of many futures markets, after years of contrary conditions, and the largebenefits that a speedy revival of futures trade would bring to large segments of the population, it can beargued that assistance to this sector is worthy of support. This may take the form of support for thedevelopment of physical infrastructure. At least equally important is technical support to thegovernment for the formulation of its policies, to the FMC to develop and maintain the skills needed topolice the futures markets in a proper manner, to the exchange management in adapting to therequirements of a more active and widespread trade, and to the private sector, focusing not only on thelarger trading, processing and manufacturing companies that are the obvious potential users of a futures

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market, but also on the development of an institutional framework that would allow farmers and smalltraders to use the markets.

D. Potential for Internationalization of Indian Commodity Exchanges

4.27 Indian commodity exchanges would benefit from attracting international participation. Foreignparticipation would enhance market liquidity and bring in valuable foreign exchange and extra incometo the exchanges. From the point of view of foreign entities, participation in commodity exchanges inIndia can provide portfolio investment and risk management opportunities. In this section we will firstreview the conditions that will facilitate the internationalization of Indian exchanges in general; and thenreview the particular case of the Pepper Commodity Exchange (Cochin) for which internationalizationis now being contemplated by GOI.

4.28 Indian Exchanges Follow International Exchange Rules. Accommodating foreign accountsin Indian exchanges will not be difficult, since the by-laws of several exchanges were formulated inaccordance with international trading needs. The Bombay cotton market operate under the rules andregulations of the Liverpool market, and the Bombay oilseeds exchange follow Chicago Board of Tradeand London trade practices. Most of the other exchanges in the country, which were set up later,followed the models of these two exchanges. In principle, then, foreign participants would not find itdifficult to get used to local exchange rules, nor should it be difficult for exchanges to accommodatethem.

4.29 Limited Trade Volume May Pose a Constraint. One constraint which may influence foreignparticipation is the current relatively low volume of trade. Large intemational investment funds arealways looking for new markets to invest in, markets which show profit opportunities and a pricebehavior that is not strongly correlated with that of the main westem markets. These funds, because oftheir size, trade in large blocks of contracts, and are only interested in markets which have reasonablebrokerage charges and show a high liquidity --a turnover of more than 5,000 contracts a day wouldappear to be the minimum. It is currently impossible for these funds to invest in futures market in India.But even if their participation were allowed and capital controls amended, it is unlikely that these fundswould be interested at once in participating in Indian markets: now, the most liquid markets only tradearound 2,000 contracts a day. Another constraint may be the limited capitalization of the clearingdepartments of Indian exchanges (see paragraph 4.19).

4.30 Regulatory Reforms Necessary. Attracting foreign participation will require someregulatory reforns including the lifting of the foreign participation ban, changes in tax and profitrepatriation policies. For foreign entities, the problem of asymmetrical tax treatment (para 3.40)becomes particularly relevant because of exchange rate movements. For example, the dollar value of aloss today is likely to be different from the dollar value of a gain in the future. Hedging losses should beallowed to be deducted from a firm's ordinary income.

4.31 Existing capital control policies may also cause problems if foreign participants are to beattracted to Indian markets. These difficulties can be illustrated in the case of a foreign trader who buysIndian cotton forward for a fixed price in rupees and hedges by selling futures contracts. The traderpays the major part of the purchase price in advance using a pre-export credit. To manage hisdownside price risk, the trader sells futures contracts on an Indian exchange. If spot prices indeeddecline, and assuming a stable exchange rate, the foreign trader will be able to cover for the losses onthe physical transaction by the gains he will make by closing-out the futures position. The trader's

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financial position is safe as long as he is allowed to repatriate his futures market profits. If he is not,trading in Indian exchanges will not be useful for foreign participants.

4.32 Stability in Government Policy. The degree of stability in government policies will alsogreatly influence foreign participation. For example, international companies may be interested inhedging their commodity purchases from India. A foreign firm can lock in cotton prices for next seasonor their transactions in other countries. It can enter into an anticipatory hedge (buying futures contractsin India in the expectancy of being able to buy physical cotton some months later). But if cottonexports are suddenly banned, the hedge has turned into speculation. Such events will deterparticipation. Foreign firms could possibly use the Indian castorseed contract to manage the risks ofinternational castorseed trade; the jute contract in Calcutta to cover the price risks for exporters inBangladesh; or the black pepper contract in Cochin to lock in prices of purchases from Malaysia. Forthese to be possible, prices in India must move more or less in tandem with international prices. This islikely if India plays a major role as exporter of these commodity, and if discretionary controls overexports remain minimal.

4.33 Addressing Potential Capital Flow Problems. New regulatory concerns, such as thepotentially detrimental effects of short-term capital outflows on the economy and the problems ofpossible money laundering, would arise if foreign use of commodity markets is allowed. In the case ofIndia, short-term capital outflows should be of much less concern than for, for example, Mexico. Indiahas a low current account deficit, has undertaken very limited short-term borrowing, and has largeforeign 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 berepatriated.

4.34 A situation may arise where an entity, having a large amount of black money, undertakingopposite transactions on the futures and the physical market, with the purpose of losing the blackmoney in the futures market, while gaining the equivalent of now legitimate earnings on the physicalmarket. This type of practices is possible through a domestic company and could be quite easilyspotted; but checks on foreign companies would be much more difficult. An entity could legitimatelybuy stocks of a commodity, and then, once its stocks are in place, push up pnces by buying futurescontracts through an apparently unrelated foreign company. It will ultimately have to sell its futurescontracts at a loss, but will in the meantime have made an apparently legitimate profit on its physicalposition. To reduce the likelihood of this type of occurrences, a strengthened FMC could enter into"Memoranda of Understanding" with foreign regulatory agencies, and allow reciprocal rights toinvestigate suspected manipulation attempts.

The Pepper Commodity Futures Market

4.35 The scope for attracting international interest to the pepper futures market in Cochin wasanalyzed in a recent UNCTAD report.3 The findings of this study appear relevant for some of the othercommodities traded in India.

4.36 Price Volatility in Pepper Trade. Pepper prices are highly unstable prompting most hidianexporters to hedge their transactions on the pepper futures market in Cochin. Among food conmmodities,only sugar exhibits more price fluctuations than pepper. The exposure to such risk reduces

3 Feasibility study on a worldwide pepper futures contract, UJNCTAD/COM/64, 17 October 1995.

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competitiveness of traders if left un-hedged. It was found that Malaysian and Indonesian exporters, thetwo 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 soldforward more than 6 months. Pepper exporters from other countries should thus be potentiallyinterested in gaining access to a hedging vehicle. Indian farmers also benefit from futures markets byreceiving a significantly higher share of the export price of their pepper than their counterparts inSoutheast Asia.

4.37 Importers prefer a steady supply at predictable prices. Forward contracts are not appropriatebecause the risk of default is too large. International trade houses report that, when prices decrease,about a quarter of fixed-price commodity forward contracts need to be re-negotiated on account ofsellers' unwillingness or inability to deliver; if prices increase, buyers tend to invoke severe qualitypenalties or stick rigidly to contract conditions, effectively forcing down the purchasing price. Bycontrast, futures contracts are default risk-free since a clearing house interposes itself between the buyerand the seller. Consequently, importers should also be interested in gaining access to the Cochin futuresmarket.

4.38 The large majority of commodity futures contracts introduced in recent years have failed.Although studies had shown the existence of a strong need for risk management, potential participantswere hesitant to enter the market as long as liquidity remained too low. It was a vicious cycle that hasproven hard to break. Allowing foreign participation in the pepper exchange would circumvent thisproblem: a large pool of liquidity already exists, and foreign players would have little problem inplacing even relatively large orders. GOI is now contemplating allowing the Cochin exchange todevelop as an international pepper exchange.

4.39 Measures to Ensure Successful Operations. The success of the Cochin pepper exchangewill require more than just lifting the ban on foreign participation. The pepper exchange, despite itsgood quality service, is not as dynamic a business entity as its counterparts in other countries are. It hasnot been very active in the promotion of the available services among potential users: it does not evenhave a marketing division. The decisions of the various commissions of the exchange are slow. Theprices of the exchange are not distributed through any information vendors (such as Reuters or Knight-Ridder). If this were done, the relevance of the market to pepper producers, traders and buyers wouldimmediately become much larger. Access to the market has been made more difficult by rules whichforce members of the exchange to obtain a local sales tax registration in accordance with governmentregulations; this takes a minimum of six months to one year, and is only feasible for those who have anoffice in Kochi. Trading hours are unduly long for the small number of contracts traded. It would bebetter to concentrate trade in one or two shorter sessions, which would free up the trading floor for tradein other, new futures contracts.

4.40 Trading procedures in the Cochin futures exchange would need to become more sophisticated.There is no system of time-stamping, an absence which would make it relatively easy for floor tradersto abuse their clients' confidence. The Cochin exchange currently does not have an audit department tocontrol floor practices. Moreover, although much effort has been made to improve the clearingprocedures --margin deposits are relatively high, varying between US$ 180,000 and US$ 350,000 atthe beginning of 1994 and clearing takes place daily- the clearing house arrangements, including itsfinancial reserves, may still not be suitable for gaining international confidence.

4.41 The Cochin futures exchange has benefited the Indian pepper community, but it is still somedistance from becoming an international exchange. The exchange will have to adopt an action program

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to bring it up to a higher operational level. Moreover, it would have to consider which practicalarrangernents need to be made to promote its international visibility and, in particular, how to adapt itscontracts specifications -delivery grades and location, contract currency- to make them attractive toboth local and international players. High liquidity should be an overriding concern in adapting thecontract specifications. The first best policy would be to maintain a single contract available to bothlocal and international users. Necessary ancillary measures would include: the freeing up of capitalflows linked to risk management -models on how to do this without losing full control over capitalflows are available from other countries; amendments to the tax treatment of profits and losses incommodity futures; and the creation of a brokerage network which links the Indian market to foreignbrokers and potential clients. Concerned agencies are showing interest in amending some of their rulesthat deter foreign participation. The RBI is considering to allow profit repatriation for foreign users ofthe Cochin exchange; the Ministry of Finance appears inclined to treat the profits and losses incommodity futures at par with those on financial derivatives. Finally, a promotional campaign by theCochin exchange would be essential. The Cochin exchange is considering teaming-up with one of thewell-established and better known exchanges in Southeast Asia, which would make it gain a betterinternational reputation, and immediate access to an international brokerage network.4

E. Introducing New Contracts

4.42 This section first reviews the general conditions for the introduction of new contracts. We willthen briefly analyze the potential for introducing new contracts for cotton and oilseeds, respectively.

General Considerations

4.43 The Introduction of New Contracts Should be a Private Initiative. Initiatives forintroducing new contracts should come from the commodity exchanges. These exchanges should befree to experiment, and free to compete. Their membership will keep them from entering into non viablepropositions. This is not to say that the Government has no role to play in the approval of new futurescontracts. There has to be a clear procedure for requests for new contracts, and for the approval ofsuch contracts. The requests should be specific and well argued: the exchange involved has to set outclearly what need there is for the contract, whose interests would be served, which economic interestgroups support the introduction of the contract, and what are the proposed contract specifications. Theproposal should then be open to public debate, with specific comments solicited from all the interestgroups involved. If after public discussion, the FMC considers the introduction of the proposed newcontract, even after revision, not to be in the public interest, it should have the possibility of rejecting theproposed contract with the possibility of submission of a revised proposal at a later date. The onlygeneral category of exchange-traded contracts which, at least for the coming few years, would appearrisky are options (Box 4.3).

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

4One possible outcome could be a link-up between a trading floor in South-East Asia with the Cochin exchange inIndia, trading the same contract on what would effectively be one global market with two trading floors. Multi-floormarkets are already in existence, both for conimodities and for financial markets, and the necessary expertise,information and software to operate such a market are available; in effect, a similar possibility has been underdiscussion for some time for rubber, with the Singapore commodity exchange in a position to provide all necessarytrading systems.

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commodity. For example, besides hedging the price risks related to the production, trade andprocessing of rapeseed oil, a futures contract in rapeseed oil can also be useful for hedging the pricerisks of other oils or oilseeds as well. The Chicago soybean oil contract is used to manage price risks inother vegetable oils; the arabica coffee contracts in New York is used to manage price risks of robustacoffee; the nickel contract in London is used to manage risks in steel trade.

Box 4.3Should Options Be Introduced?

(ptions function like insurance: by paying a prenium, buyers can protect themselves against the risks ofdeteriorating prices, while still remaining able to benefit from improving prices. Options would appear particularly:useful fbrfanners, faners' associations, and state trading companies. They are also attractive to speculators, sincethoeyprovide thepossibilipty of a theoretically unlimited gain for the payment of only a relatively small premium.FromtheE point of view of futures exchanges, an option exchange would help to increase liquidity, because arbitragebetween the two markets will bring in new business.

Under current conditions in India, however, the introduction of options appears premature for thefollowing practicalreasons:* many market 0opertrs are not yet well-skilled in futures trade, and these skills will need to be built up.* tWile the: 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 cover its risks has an unlimited loss potential compensated by only a smallpossible gain. Most option sales on western markets come from a group called option market makers, who usecomplicated mathematical techniques to hedge their risks of option sales on futures markets. Indian operatorsdo not appear to have the required technical knowledge yet, nor the required computer systems. In effect, aslong as price information from the commodity exchanges is not fed into a computer system on a minute torinute basis durinig the trading session, it will be very difficult for market makers to operate in a safe manner.The existence of option markets can be exploited by unscrupulous brokers to lure small investors(shopkeepers, retirees etc.). The unlimited profits possible through options would appear very attractive tomany small investors, without knowing nor being adequately informed that the vast majority of smallspeculators normally loses all or most of their money. Therefore, in the absence of a national brokerageregulations, it would appear in the public interest to postpone approval of option trade.

4.45 Basis Risk and Liquidity Are the Major Determinants of Cross-Hedging Effectiveness.The lower the basis risk, the more effective a cross-hedge will be. Basis risk is likely to be lower if theunderlying commodity of the futures contract is the commodity in which the hedger is interested; forexample, the prices of a cottonseed oil futures contract are likely to be better correlated to cottonseed oilprices on the spot market, than those of a soybean oil contract. The lower the market liquidity, the lesseffective a cross-hedge will be. On futures markets with low liquidity, the "slippage" loss --i.e., thedifference between the price at which the hedger wanted to close out his position, and the price at whichhe manages to close it out-- can be considerable, easily amounting to 5 to 10 per cent.

4.46 Slippage losses may well outstrip the reduced basis risks of having a more "suitable" contract.Thus, white sugar buyers and sellers continue using the raw sugar contract in New York, even though awhite sugar contract exists in London and Paris; sour crude traders continue to use the existing sweetcrude oil contract in New York even when a sour crude contract was introduced; and the world cottoncontract introduced in New York in 1992 failed to take off, even if the prices of the existing cottoncontract reflected American rather than worldwide conditions.

4.47 Pre-conditions for a Viable Futures Contract. To increase the probability of success, giventhat most futures contracts introduced in western exchanges in recent years have failed, severalconditions need to be met by a futures contracts. These include:

* Supply and demand for the commodity involved must be sufficiently large;

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* Prices of the commodity need to be determined by free market forces, withoutmonopolistic or too much government control;

* Well-standardized commodity;* Price fluctuations need to be sufficiently large to warrant the use of risk

management techniques;* Well-functioning spot market;* Futures market have the support of commercial interests;* Sufficiently large group of speculators;* Sufficiently well-developed exchange infrastructural facilities and other services;

and,* Legal and regulatory framework conducive to futures market trading.

4.48 The futures contract also needs to be well-defined, with contract as well as deliveryspecifications ensuring a convergence of physical and futures market prices at contract maturity. Theexchange which will be trading the contract needs to have a good reputation, with a sound clearinghouse, and a governing board seen as balanced and neutral. Potential market participants need to havea basic understanding of the role and value of futures contracts, and an easy access to the futuresexchange. We now turn to the review the potential for new futures contracts in seed cotton (kapas),cotton and cotton yam, as well as oils, oilseeds and oil meals.

The Potential for New Cotton Contracts

4.49 The growth of India's cotton production, its potential for export, and importance of the textilesector point to a large potential demand for an effective mechanism of risk management. Trade inhedge and TSD contracts in cotton and kapas is currently banned, and only NTSD cotton contracts areallowed. As mentioned earlier, NTSD contracts, however, are inefficient and risky tools for price riskmanagement, because they do not allow sufficient flexibility to users and bring with them significantcounterparty risks.

4.50 Reportedly, due to the need for more effective risk management mechanisms, some groupshave not waited for official sanction and have traded futures in both kapas and cotton for a number ofyears. Several associations, with the support of traders, farmers' associations and textile millsorganizations, have requested for permission to resume trading futures contracts in cotton. Farmersultimately bear the brunt of price instability if traders have no means to lay off their risks: to securetheir operations, traders have to build in a risk premium in the price they pay to growers. Textile mills,faced with volatile prices of their main input, find it difficult to quote fixed prices for forward sales totheir potential clients, reducing their competitive position in the international market.

4.51 If cotton futures contracts are to be introduced, three basic questions arise. Should the contractbe for cotton, kapas, or cotton yam, or a combination of the three? Cotton and kapas futures contractshave been traded in India in the past; cotton yarn futures have never been traded in India but areactively traded in Japan. Should one contract that encompasses all the main types of cotton beintroduced, or several contracts each representing one type of cotton? Should the contracts be tradedexclusively in one exchanges or in several exchanges?

56

4.52 Prospects for Kapas Futures Contracts Are Good, But May Require Some GestationPeriod. The potential for a kapas futures contract is quite good, and stems primarily from itsattractiveness to both ginners and cotton growers. The long-term correlation between kapas and cottonprices is relatively high, indicating thepossible effectiveness of cross-hedging of a Table 4.1kpossib ectivenesssf ct ct theing m ost year, Correlation Coefficients between Week-end Seed Cottonkapas fuitures contract. Within most years, (kapas) and Cotton Prices in Bathindaweekly prices of seed cotton and cotton 1990-91 to 1994-95appear well correlated, with the exception ~of one season when the correlation fellbelow 80 per cent (Table 4.1). Gins, 1991-92 0 78 0 68however, argue that in the very short run, 1992-93 0.88 0.93prices of kapas and cotton move at times 1992-94 099 0.99quite differently. Since they normally buy 1994-95 0.92 0.99their kapas and sell it after processing Source: North India Cotton Association, Bathinda.

within no more than a few weeks, a lowshort-term correlation would significantly reduce the effectiveness of cross-hedging, making a kapasfutures contract less attractive to gins. Cotton growers would also be attracted to a kapas contractsince they would not be able to deliver against a cotton contract, even if they can use it for hedging.This underscores the need for further and more detailed analysis of the basis risks between kapas andcotton by the commodity exchanges to assess the prospects of kapas futures contracts.

4.53 Potential Users. A futures contract in kapas would be of primary interest to farmers andcotton ginners. In fact, such a contract would be of major interest for gins if simultaneously, there is afutures contract for cotton. By using both kapas and cotton futures, gins will lock-in their ginningmargins and ensure their profitability. They can do so even if the average ginning margin throughoutthe year is not sufficiently high. Such hedging practices offer a powerful, market-based substitute to theGinning and Pressing Act which administratively sets ginning margins. This will help stimulate muchneeded investments in ginning. However, for futures contract in kapas to be successful there shouldalso be an interest of farmers or those acting on their behalf

4.54 An institutional framework already exists that would allow Indian farmers to access riskmanagement markets, im contrast to other countries. Throughout most of India, cotton is sold throughregulated markets, where commission agents sell on behalf of farmers. Regulated markets providefarmers with price information, and the commnission agents could, in principle, offer farmers riskmanagement services. Many farmers also use banks, which are other possible intermediaries for theuse of risk management markets; by convincing farmers to fix their forward sales prices, banks couldsecure the reimbursement of their loans. In the United States, it is quite common for farmers' banks toinsist on hedging by their clients.

4.55 Critical Determinants of a Successful Kapas Contract. The success of a kapas futurescontract will be largely dependent on the interest generated among ginners and farmers. Under presentcircumstances, however, farmers show little interest in forward sales. NTSD contracts by farmers arealready allowed, for periods up to 120 days, but only a very small percentage of farmers actually availof this facility. This could be partly attributed to the lack of forward price information: in the absenceof a futures market, farmers cannot know what would fair price for their kapas for delivery in 3 monthstime would be. The lack of kapas grading practices --except in Maharashtra-- also militate against thesuccess of a kapas futures contract. Without farmers' interest, and implementation of grading practices,any futures market in kapas would be strongly lopsided and would have little chance of survival.Therefore, a significant educational effort focused on larger farmers, farmers' associations, farmers'

57

banks and commission agents in the regulated markets, and on the implementation of grading practiceswould be necessary before a contract in kapas would stand a chance of success. Cotton growerscooperatives could play a positive and constructive role in introducing their members to the benefits offutures markets. To play that role, however, the rules preventing futures trade by cooperatives wouldneed to be lifted. Furthernore, kapas contract would only stand a reasonable chance, if no futurescontract in cotton is traded in the same market

4.56 Lack of Historical Experience with Cotton Yarn Futures Contracts May Limit Prospectsin the Short Run. Textile factories are exposed to fluctuations in yam prices and textile production inIndia is high enough to provide at least a potential market for cotton yarn futures contracts. A cottonlint 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 April1995, the correlation coefficient between the two prices was 72 per cent. However, within years, pricesoften move in opposite directions (Table 4.2). With the opening up of new foreign markets for India'stextile products, the textile industry may indeed be interested in a risk management tool, an optionwhich the exchanges may keep in mind.

Table 4.2Intra-Year Correlation between Cotton

and Cotton Yarn (60s carded) Prices1990-94

Yarn Index & J34 | -0.52 | 0.67 | 0.02 0.81 0.91 0.93Yarn Index & S6 -0.53 0.98 0.02 0.77 0.89 0.94

Source: India Cotton Mills Federation.4.57 Prospects for Cotton Futures Contracts Are Good, But for Which Cotton Variety?Although several cotton futures contracts have been traded in India in the past, an important question inre-introducing them is whether one or several contract(s) in cotton would best meet the needs of theIndian cotton sector? 5

4.58 At the beginning of the century, seven different types of cotton futures contracts were traded, anumber that was reduced to five in 1922 -of which three were actively traded.6 During this period, thelarge number of contracts posed problems. Turnover in each of the contracts was relatively small andattempts to comer the market were rife, so that cotton mills urged EICA to replace its five contracts byone or at most two. Traders resisted this move. Only in 1942 the five contracts were replaced by onlyone, against which all major types of cotton were deliverable. Cotton futures trade was banned from1943 to 1952, with an interval in 1949. Futures trade started again in 1953, with one contract for alltypes of cotton. Most major types of cotton could be tendered against the contract, at a discount orpremium depending on the discounts and premiums prevailing in the cash market. In 1956, a secondcontract was introduced, since it was felt that a single contract could not cover the widely dissimilarvarieties of cotton produced in the country. But it was withdrawn in 1957 by regulators who considered

S For the reader not familiar with the Indian cotton industry, it should be pointed-out that India is unique in itscapacity to produce the entire range of cotton staple lengths, from short and extra-long staple. Price volatility andrisk management needs may vary across cotton staples.

6 See, for the history of cotton futures trade in India, Madhoo Pavaskar, Saga of the cotton exchange, East IndiaCotton Association Ltd., 1985.

58

that there was not enough volume on the market for two different contracts. This situation continueduntil futures trade in cotton was banned in 1966.

4.59 To Succeed, Futures Contracts in Cotton Would Need to Carefully Develop anAppropriate Delivery System Which Balances the Trade-Offs Between Liquidity and Basis RisksAmong and Within Cotton Varieties. In the past, having one futures contract did not appear to causemajor problems to the trade. The problem had more to do with the inefficient system for determiningpremiums and discounts. Although production has doubled since them, it does not appear likely thatcontinuing with one futures contract with a wide delivery base would cause more problems now than itdid then. The factor that would influence the decision to introduce one or more contracts is the risk oflow liquidity versus basis risks.

4.60 Fewer Cotton Contracts Would Improve Market Liquidity. Having more contracts meansthat each contract will have a lower liquidity, a smaller physical base, and a higher susceptibility tomanipulation. At the same time, it means that normally, each contract will follow closely the physicalmarket conditions in the underlying type of cotton, rather than the possibly different general marketconditions for cotton. On the other hand, if the underlying physical market does not function well, awidely defined contract can make the delivery process less effective. In particular, mills would avoidtaking delivery, because they do not know what they will receive. However, conditions appear to bepresent for a good secondary market which allows easy resale of unwanted cotton. Moreover, withproper procedures for re-tendering delivery notices, exchanges should be in a position to avoid this typeof delivery problems.

4.61 For a new futures market, liquidity is the main consideration, and efforts should be made toavoid a dilution of liquidity by simultaneously introducing several contracts. After all, there is only alimited number of day-traders who are potentially interested in being active in cotton; and the interestfrom outside speculators is also not likely to multiply if two or more, rather than just one cottoncontract, are introduced.

Table 4.3

4.62 Basis Risks Are High, Major Types Of Cotton Produced In India,Reflecting Policy Impediments to 1992-93 (Million Bales)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 Association Ltd., Bombay

cope with these two realities. 1993.

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Table 4.4The 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 -0.49F-414 1 0.90 0.96 0.93 F-414 1 0.88 0.88 -0.38S-6 1 0.85 0.91 S-6 1 0.89 -0.20H-4 1 0.88 H-4 1 -0.46DCH-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 0.85F-414 1 0.99 0.98 0.92 F-414 1 0.87 0.86 0.80S-6 I 0.99 0.97 S-6 1 0.87 0.67H-4 1 0.95 H-4 1 0.58DCH-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-32J-34 1 0.78 0.86 0.20 0.49 J-34 I 10.95 J 0.39 0.89 0.60F-414 1 0.61 0.32 0.50 F-414 1 I 0.59 0.82 0.42S-6 1 0.11 0.57 S-6 [ 1 0.19 -0.46H-4 1 0.30 H-4 1 0.72DCH-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. 0.11F-414 I 0.98 0.98 0.98 F-414 1 0.33 |0.9 0.19S-6 11 1 1 1 0.97 0.96 S-6 1 0.68 -0.17H-4 111 1 | 099 |H-4 11 0.31DCH-32 11 1 1 IDCH-32 111 I

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

4.63 The inherently high basis risks are compounded by the policy impediments to a betterintegration of physical markets and blunted incentives for the implementation of grading practices -Maharashtra monopoly procurement scheme, movement controls, storage controls, and export quotas.If several grades and staples are made deliverable, a good system of discounts and premiums needs tobe elaborated, together with a reliable grading system which is currently lacking. Delivery to and froman exchange is normally by delivery notice; on the basis of the grade specified on this delivery notice, itis determined what discount or premium over the futures contract price the seller will receive and thebuyer has to pay. The grade indicated enables buyers to determine whether specific loads of cotton areindeed what they require, and whether they should take delivery or re-tender it. The perceived reliabilityof an exchange will suffer strongly if the specified grades are not correct; even with an arbitrage systemn,this always causes delays and extra costs. Fortunately, the main cotton exchanges in India appear tohave a good grading system in place; unfortunately, most cotton players are not used to using thissystem, and largely trade by sample, rather than description, apparently because of lack of familiarity

60

or sufficient incentives. Even though only a small share of futures tumover normally results in delivery,the soundness of the delivery system is essential for ensuring the convergence of futures and physicalprices and the usefulness of the market for hedgers. Therefore, the exchanges interested in introducingfutures contracts will have to make an effort to educate their prospective participants in the use ofgrading systems.

4.64 Even if the different staple-lengths have different physical uses, their price behavior may besimilar because of substitution possibilities. In fact, in the long run, the main markets are highlyintegrated: the correlations of monthly prices of different major varieties such as J-34, F-4 14, Shankar-6, H-4 and DCH-32 during the 1984-1994 period were between 91 and 99 per cent, including betweenJ-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 agood correlation each single year, the price correlation between these two and the extra-long staplecottons was poor in four out of ten seasons, and the price correlations between the various types ofextra-long staple cotton were poor in five out of ten seasons.

4.65 If one cotton futures contract specifying either J-34 or F-414 as basis variety is introduced, thebasis risks for superior medium and long staple cottons would be low. There is no need to introducetwo different contracts simply because the various staple lengths within these two groups trade atdifferent price levels since a system of premiums and discounts would be sufficient to address thedifferences. However, given past price developments, there would be significant basis risks for thosewishing to hedge the price risks of extra-long staples (ELS). Because ELS is the type of cotton mostcommonly exported, and exporters often need to enter into long-term contracts to secure their markets,this is a situation which needs resolving. Introducing one contract for extra-long staples will not beadequate, since the prices of the main cotton types within this group are not well-correlated. It would benecessary to introduce at least three different contracts,7 which reduces the likelihood that the requiredliquidity is attained. Allowing delivery of extra-long staple cotton against a contract which has J-34 asits basis would also appear to cause difficulties, given sharp fluctuations in differential during someperiods.

4.66 Cotton Policy Reforms to Alleviate Trade-Offs Between Liquidity And Basis Risks.Indian cotton markets are not well-integrated, and the inefficiencies in trade and storage are to a largeextent induced by government policies which prevent the national market from absorbing andcushioning regional developments in production. If government restrictions on storage are removed, theexistence of a futures contract which has, for example, J-34 as its standard and which allows delivery ofextra-long staple cotton against a regularly revised premium, is likely to improve the integration ofIndia's cotton market. Because cotton traders are often active nation-wide, they will be in a position toundertake low-risk arbitrage between the prices of the different varieties of cotton. At the national level,the introduction of one contract which allows the delivery of the main superior medium and long staplecottons throughout the country should be considered. It would also appear worthwhile to study whetherdelivery of one or more extra-long staple cottons against this contract can be allowed, subject to thepossibility of devising a proper system for determining premiums.

7 Significantly, the govermment decided in January 1987 to permnit EICA to re-introduce futures trading, for a periodof four years, in four different varieties of extra-long staple cotton: DCH-32, MCU-5, Shankar-6 and H4. However,since the infrastructure for futures trade had to be build up after a gap of 21 years, the irmmediate resumption oftrade was not possible; and when a drought hit the cotton belt in the following season, this permission was kept inabeyance, and no futures contracts were introduced at this time or since.

61

4.67 Development of Complementary Regional Cotton Markets. If a national cotton futuresmarket is successful, more regional markets can probably also co-exist in its shadow, with ginners andtraders benefiting from the possibility of fixing margins and undertaking arbitrage. This may apply to akapas contract in the producing regions, a contract in the most consumed type of cotton by India'stextile industry, or extra-long staple cotton contracts in the regions where they are produced. As notedearlier, it should be left to the respective associations to analyze such possibilities and determine thepotential of success for new ventures. Trade in NTSD contracts, organized through regional or nationalexchanges, is still likely to survive. Although a futures exchange provides liquidity and a clearing houseguarantee on contract performance, NTSD are still a cheaper way to fix forward prices and delivery forspecific grades of cotton between two parties who trust each other. Also, if the use of reference pricesrather than fixed prices is allowed in NTSD contracts, these contracts, in conjunction with more flexiblefutures contracts, would allow market participants optimal planning of operations, while at the sametime protecting them from major price risks.

Potential for Oilseed, Oil and Oilmeal Contracts.

4.68 The Indian vegetable oils industry appears to be the most eager to reintroduce futures trade.The oilseeds industry, with support from groups of producers, traders, processors and end-users, isasking for the permission to reintroduce futures contracts in a wide range of oilseeds, oils and oil meals.As in cotton, the oilseeds industry is faced with the same questions: is there a need and room for a widevariety of contracts? Should futures trade be concentrated in one center, or can it take placesimultaneously in several exchanges throughout the country?

Table 4.5Correlation Coefficient between Oil Prices 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,Mustard oil, Uttar Pradesh 1 0.86 093 from where the oil and mealSoybean oil, Madhya Pradesh 1 0.83

, '. , V.J . ~~~~~~~~~~~~~~~~output enter national andGroundnut oil, Maharashtra 1 o

Source: Ministry of Agriculture itemationa trade. There aretwo groups of oils: edible oils

and non-edible oils. The major edible oils in India are groundnut, soybean, sunflower andrapeseed/mustard seed oils and vanaspati. The maim nonedible oils include ricebran, castorseed andcoconut oil. Between edible and non-edible oils, substitution is difficult. Within edible oils, many ofthese oils are, in some form or other, substitutes. They also compete with vegetable oils from non-oilseed. Within non-edible oils, even though substitution possibilities are not perfect, manufacturers areoften able to change their production process to some degree, shifting from one oil to another inresponse to relative price movements.

4.70 Government Policies & Regulations Explain The Absence of a Common, DomesticMarket for Oilseeds and its Derived Products. The Indian domestic market for oilseeds and itsderived products, oils and meals, does not appear to be well-integrated. Although the exact causes forthe absence of a common, domestic market in the oilseeds complex are beyond the scope of this report,

62

they relate to a large extent to government policies and regulatory restrictions.8 They include strict andunpredictable restrictions on movement, storage and access to credit; non-uniform taxation of oilseedsand its derived products across states; small-scale industry reservation for the major oilseeds, groundnutand rapeseed-mustard; absence of level-playing field between cooperatives and formal, private sectorenterprises; meal export incentives; tax rebates for establishing new processing units.

4.71 Edible oils are more substitutable than oilseeds, and, barring movement restrictions, can betransported quite easily; consequently, oil prices are usually relatively well correlated over the long-run(Table 4.5). In the short term, however, edible oils markets display poor level of integration across thecountry; the price correlation fell below 70% between soybean oil and mustard oil prices in 1992 and1993, and between groundnut oil and the other two oils in 1994 (Table 4.6).

4.72 Within a same region, oilseeds and their corresponding oil markets --with the exception ofsoybean-- appear fairly well integrated, although not as well as edible oils across the country (Table4.7).9

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

groundnut oil mustard oil soybean oil groundnut mustard soybean oiloil 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 oiloil oil

groundnut oil 1 0.89 0.85 groundnut oil 1 0.82 0.78

mustard oil 0.86 mustard oil l 0.62soybean oil 1 soybean oil I

8For amor iledgaundnut oil mustard oil dsoybean oilf t groundput o mustard soybean oilT groundnut oil betwee 0.76 c 0.76 oi groundnut oil 94 per 0.c5 i 0.69

c mustard oil B b a mar 0.54 n emust d oil a l t s p 0.9i

f soybean 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 processingperforrnance of 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 waycastorseed prices in Bombay are measured: not directly, but through a formula in which the seed price is derivedfrom measured oil prices.

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4.73 Edible oilseeds markets appear well integrated in the same region, but poorly integrated acrossIndia. For example, the correlation of weekly rapeseed and groundnut prices in Bombay over the periodJanuary 1989 to April 1995 was89 per cent, and did not fall below Table 4.7

Correlation of oilseeds and oils rices 1990-199475 per cent in any single year; by :::::::z:::::....:: . ..Bi ...........contrast, m one year out of tWU&, * X

groundnut pnices in Hyderabad and :::989:.: 0.8 0.961 0.41989 0.86 0.96 0.84-

Bombay displayed little 1990 0.86 0.99 0.87 0.54

correlation. (Table 4.8) 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: Bombay Oilseeds & Oils Exchange, Ministry of Agriculture.

single regional market, as shouldbe expected (Table 4.9). The long-term price correlation between castorseed and groundnut prices inBombay is only 48 per cent during the 1989 and 1995 period, and in most years, there was hardly any-elation at all between the price movements of these two seeds.

Table 4.8 4.75 Oilmeals are a residual product fromCorrelation Coefficients of Groundnut Prices oil crushing, and the various types of meals

in Rajkot, Hyderabad and Bombay have different end-uses. Their prices are not1989-1994 well-correlated with those of oils or oilseeds,

E4~Lr ..... , and even the different oil meals do not sow thei.8 :.:I2 .. ,*R .:.:_Z ':::Z.:- . e7. .:::.:: ... . .... § sam e price pattern.1989 0.24 0.82 0.801990 -0.09 0.77 -0.19 4.76 Crushing Margins are Highly1991 0.09 0.71 0.18 Volatile, Pointing at the Need for Risk

1993 0.89 0.89 0.94 Management Tools by the Oilseeds1994 0.53 0.29 0.73 Industry. Another distinguishing feature ofSource: MinistryofAgncuhtur the oilseeds industry is the extreme volatility

of its processing margins (Figure 4. 1). It isa common, worldwvide phenomenon of this industry that is not unique to India. Until the recentfreeing of edible oils imports, the Indian oilseeds processing industry was highly protected andfaced little external competition except for meal exports. In the absence of futures markets toestimate and lock in their future processing margins, oilseeds crushers had the ability to cover for

Table 4.9 margin volatility through risk premiums built intoCorrelation Coefficients Between higher processing margins. Strong competitive

Castorseed & Groundnut Prices pressures are now imposed upon the IndianBombay Market, 1990-1994 oilseeds industry through the tariffication of

-094.6 0.5 -. 19 1 .11 00 former barriers to import edible oils and theopenness 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 marginswhen 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 toolto compete more effectively. Oilseed growers would stand to gain greatly from a morecompetitive and efficient domestic processing industry. Substantial demand from the industryshould 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 wouldalso provide a viable, market-based alternative to the possible re-introduction of distortinggovernment policies --e.g., canalization of edible oils imports, sudden increases in tariffs -- in anattempt to protect the interests of the oilseeds industry and oilseeds growers.

4.77 In an Open Trade Environment, Contracts Facing Little Competition From AbroadStand A Greater Chance of Success. Edible oils imports have been liberalized recently; oilmealsare freely exportable; soybean imports also have Figure 4.1been recently permitted. Under an open trade Instability in Indian Oilseeds Gross Crushingenvironment, arbitrage on the domestic futures Marginsmarket would only serve the needs of smalleroperators unable to trade on foreign markets, and Crushln Margn for Groundnut in 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 tworeasons, contracts are likely to be more successful -for those commodities facing little to no 3competition 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 Iis 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 maintainedpermanently, then, the industry is more likely touse 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 suggestthat there may well be space for more than one 5 ........

exchange trading oilseeds products contracts. ..........Starting from an imperfect physical market situationwhere regional markets appear to be better integrated -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 offacing poor market liquidity on a regional exchange if too many contracts are introduced., a topic towhich we turn in the following paragraphs. With the gradual lifting of govemment restrictions on thedomestic oilseeds markets, the perfonnance of the oilseeds market is expected to improve and regionalphysical markets will become better integrated. As the domestic physical market becomes betterintegrated, the competition among commodity exchanges will intensify. The most active and betterperforming ones will be automatically favored by market forces. Exchanges, therefore, should make

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every effort to make their operations as attractive and transparent to all potential users, including fromother regions as well. For example, the Bombay oilseeds exchange is often criticized by large potentialusers from other region for its lack of transparency in the operation of the price committee. Enlargingthe representation of all participants in the trade on the exchange's committees would help improveconfidence and reliability in the operations of the exchange.

4.79 In the Short Run, There is No Room for Many Oil Futures Contracts. The pattern ofprice correlations suggests that edible oils and non-edible oils should be seen as two distinct groups.Provided government interference in price formation over space (non-uniform tax, movement andstorage prohibitions) are reduced significantly, a futures contract in one type of oil is likely to providefor the risk management needs of other oils from that group. Traders in mustard oil could then use agroundnut oil contract, with only small basis risks; users of linseed oil could use a castor oil contract.The fact that one could not make or take delivery is only a minor inconvenience. If a contract issuccessful, exchanges can always consider the introduction of other oil contracts, but at least in theinitial phases, it would appear wise not to dilute liquidity by introducing more than one oil contract ineach group.

4.80 Edible Oilseed Contracts Are Likely to Complement Edible Oil Contracts. Edibleoilseeds contracts, alone, could have a difficult life because it is unlikely that they will attract muchinterest from the oilseeds processing industry. As indicated earlier (paragraph 4.76), the demand byoilseeds processors for the combination of both an oilseeds and oils futures contracts is likely to belarge since it will give them the ability to estimate and secure their future processing margins. An effortwill have to be made anyway to generate participation from the trading and, indirectly, from the farmingcommunity --through commission agents, oilseeds growers' associations and cooperatives- in order togenerate greater market liquidity. The situation in the case of nonedible oilseeds differs, suggesting thata seed and oil contracts will unnecessarily compete with one another. To a significant extent, availableevidence suggests that the castorseed contract is used to manage castor oil prices, a logical processgiven the close price correlation between the two.

4.81 Prospects for Oilmeal Contracts. Neither an oil nor an oilseed futures contract is likely to bea good vehicle for a firm hedging its oil meal price risks; so there could be room for futures contracts inoil meals. However, because this group appears to be fairly disparate, and oilmeals are low-valueproducts, it is not clear whether sufficient liquidity for a viable futures trade could be obtained. If thereis adequate interest, then its most likely place would be where most export trade takes place. As theoilseeds industry continues to be liberalized, oilmeals quality and export performance adjusts tointernational standards, oilmeal prices may well start reflecting international conditions. In thisinstance, existing international contracts such as the Chicago soymeal contract would compete directlywith an Indian contract; that is an issue that would require more study.

Summary

4.82 Public policy, including exchange regulations, should focus on optimizing the contribution thatfutures markets can make to the national economy. This would require allowing them to realize theirpotential, while at the same time controlling abuses, both in the functioning of futures trade and in theuse that unscrupulous brokers may make of exchanges. Commodity exchanges should make an effortto avoid abuses by their members, and to make as wide a group as possible benefit from the functionsthat they perform for risk management, and in the collection and dissemination of price information.

ANNEX

GLOSSARY OF TERMS USED IN RISK MANAGEMENT

anticipatory hedging The purchase or sale of futures contracts in anticipation of actual need or availability; thefutures market provides a price today for anticipated purchases or sale of physicalcommodities.

arbitrage The simultaneous sales and purchase of equivalent contracts in different markets with thepurpose of benefiting from of a discrepancy of prices.

arbitrage hedging The use of fiutures contracts for locking in a return to storage, through the predictable changein the relation between cash and futures prices.

backwardation The extent to which forward prices are lower than nearby prices. Also used to refer to asituation in which forward prices are lower than nearby prices.

basis The difference in price between a physical commodity and its corresponding fiAuresquotation. The basis reflects different time periods, product grades, and/or locations.

basis variety/grade Terms used in India to indicate the reference commodity variety or grade stipulated in thefutures contract.

basis risk The unexpected risk (and conversely, profit opportunities) associated with the fluctuations ofthe basis around its "normal" level for a certain grade of a commodity at a certain location,between the time that a hedging position is established and the time it is closed.

bid An offer to buy a commodity (including futures contracts) at a pre-stated price.

bid-ask spread The difference, at a given moment, between the price offered for the purchase of a contractand the price asked for the sale of a contract.

broker A person, or company, paid a commission for accepting or executing the buy and sell ordersof a customer.

bucket shop An enterprise that presents itself as a broker, but at the same time taking the opposite positionof any client orders, that is, not executing these orders on the exchange. One of the mainforms of customer abuse.

call option A contract giving the right, but not the obligation, to buy a futures contract at a specified priceat or before some later date. If this specified price is close to the actual physical price, thecontract is called a teji in India. If the specified price is much higher than the current price(the option is out-of-the-money), in India, the contract is called a teji-ga li.

cash settlement A method of settling certain fiutures or option contracts whereby instead of physical delivery,contracts are closed out at a certain settlement price.

close out To reverse a fiutures trade (by an opposite transaction), and thus end a long or a short position.Also called liquidate.

clearinghouse A division of the commodity exchange, or an independent entity, through which transactionsexecuted on the floor of the exchange are settled. Once a bid or offer is accepted, the futures

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contract is recorded with the clearinghouse and the clearinghouse becomes the opposing partyto each contract. It assumes the selling position for each buyer and the buying position foreach seller. The clearinghouse requires the posting of margins as security against possibledefault by traders.

commercial difference A payment system wherein prenua and discounts on the futures price are fixed on the basis ofsystem of quality actual differences between the ready price of the contract grade and the tenderable grade, andpremium & discount based on the daily price during the delivery penod.

commission Fee paid to a broker for the execution of an order.

commodity exchange Any organized market place which serves as a fonum for the trade in spot commodities,forward contracts, or futures and/or options contracts. It generally refers to a futures market.

contango The extent to which forward prices are higher than nearby prices.

counterparty risk The risk that a counterparty will default on an obligation (such as fulfilling obligations undera physical trade contract or an over-the-counter risk management contract).

cross-hedge Hedging a cash market position in a futures contract for a different but price-relatedcommodity.

default Failure to meet an obligation, such as paying margin calls or delivering against a contract.

delivery The process of supplying physical commodities in settlement of an expiring futures position.

delivery month The specified month within which a futures contract matures and can be settled by delivery.

delivery notice A notice that can be presented by the seller of a futures contract to the clearinghouse, once thecontract enters its delivery month but before expiration of the contract, which is subsequentlysent by the clearinghouse to the holder of a futures contract nearing maturity, to the traderthat a specific lot of a physical commodity, with a certain grade and to be found in one of theexchange's recognized warehouses, has been assigned to him and that he has to takepossession of the commodities within a certain time frame.

deposit Amount required by clearing house as security when a position is opened. Also called initialmargin.

derivatives Contracts wherein the price depends directly upon the value of one or more underlyingcontracts, securities, commodities, or any other agreed price index. Derivatives include bothexchange-traded instruments (futures and options) and over-the-counter instruments(swaps, commodity bonds and other "hybrid" instruments).

differential The discount or premium allowed on delivery against a futures contract for grades orlocations better or worse than the standard grade or location specified in the futures contract.

electronic market A market forum in which traders buy and sell contracts through a computer network, with thecomputer system automatically matching bids and offers.

fixed difference system A payment system wherein the premia or discount on the futures price are fixed in advance,of quality premium & often for all futures contracts of the season, before the commencement of the season or before

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discount the start of trading in a particular futures contract.

floor broker A person who executes customer orders on the trading floor of an exchange; the floor brokercan also trade on his/her own account.

forward contract A contracts for the purchase or sale of a commodity for deferred delivery. It is different from aspot contract in that delivery is in some time in the future.

futures contract Standardized forward contract, which represents an obligation to make or take delivery of afixed quantity and quality of a commodity, at a specific location. Futures contracts aretraditionally traded in commodity exchanges; in the commodity "trading pit" or "ring" withbids made by open outcry or through electronic trading. They are generally closed outbefore delivery.

futures market An organized market place, providing the facilities for futures market trade. A futuresmarket can be an open-outcry exchange, or an electronic market.

grading The inspection of physical goods, necessary to ensure they are of the tenderable qualitydefined in the futures contract. See also the commercial difference and fixed differencesystem of quality premium & discount.

hedge A purchase or sale on a futures market or options market intended to offset a price risk on thephysical market. See also arbitrage hedging, operational hedging and anticipatoryhedging.

hedge contract In India, a sub-type of the transferable forward contract which specifies the basis andtenderable delivery grades, and a range of delivery centers. Both buyers and sellers can closeout their positions, and delivery is not obligatory.

jobbers Floor brokers who specialize in taking short-term position: outside of India, the term is onlyused to indicate those active on stock exchanges; in India, the term also applies to commodityexchanges. Also called locals, scalpers or day-traders.

leg One part of a transaction, for example, a hedge has a futures leg and a physical leg.

life of contract Period between the day that a futures contract starts trading and the day it expires.

liquidity Indicates the ease at which orders can be executed without undue effects on price levels.

liquidation The closing out of a long or short position.

local A small commodity exchange trader taking positions on his/her own account.

long A position with more purchase contracts than sale contracts.

lot The unit of trading on the market.

manipulation The deliberate attempt to move market prices away from their true equilibrium.

margin The security deposit required from a broker for a position by a clearing house. The initialmargin is a deposit made to the clearinghouse as security when a position is opened. It isrenewed daily as open positions are marked to the market or gains (or losses) are calculatedand added to (subtracted from) the initial margin. Should adverse price movements result in

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the initial margin falling below the minimum level, a margin call is issued by theclearinghouse for the deposit of the variation margin or additional funds are required to bedeposited to raise the margin to initial levels. The minimum margin in the smallestallowable margin for the establishment of a futures position and is tailored to offset themaximum allowable price fluctuation during a trading day. .

market maker In stock exchanges and some electronic commodity exchanges, a professional dealer who hasan obligation to buy when there is an excess of sell orders and to sell when there is an excessof buy orders. On commodity markets, more commonly refers to specialist companies which,usir6 ckinplex computer programs, undertake active arbitrage between options and futuresmarkets and in this way, are able to be constantly present on the options market. At times,also used as synonym for floor trder.

maturity Period within which a futures contract can be settled by delivery of the underlyingcommodity.

net long If purchases of futures contracts exceed sales.

net short If sales of futures contracts exceed purchases.

Non-Transferable As defined by the Forward Contracts (Regulation) Act, 1952, these are forward contractsSpecific Delivery between two parties in which a previously determined commodity of a specific grade has to beContract (NTSD- delivered to a specific location within a pre-determined time frame. Similar to what generallycontract) are called "forward contracts", with the difference that the two parties involved are not

allowed to renegotiate part of the contract clauses.

offer An indication of the willingness to sell at a given price.

offset Closing of maturing contracts.

offset trade Trade which closes out a traders position, such that the trader has a zero net position with theclearing house.

open-outcry A method of public auction where participants in one location and make bids and offersthrough open outcry and through hand signals.

operational hedging The use of futures as a substitute for an actual purchase or sale of a commodity, normally for avery short period of time to provide the firm sufficient time to assemble the desiredcommodity on terms suitable for the contract.

option A contract giving the right or "option"f, but not the obligation, to buy or sell a futures contractat a specified price at or before some later date. To obtain such a contract, the buyer needs topay a premium or the price paid for the right. If the commodity price increases (decreases)above (below) the strike or exercise price, the commodity is bought (sold) at the exerciseprice. If the commodity price remains below (above) the exercise price, the buyer (seller) ofthe option simply abandons it and the maximum loss is limited to this premium.. See alsocall option and put option.

over-the-counter Refers to a risk management market that is not part of an organized exchange, or to the riskmanagement instruments that are traded on this market.

position limit The maximum position, either long or short, in one commodity futures contract, or in allcontract months combined, that any one company is allowed to hold either directly or

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indirectlv.

position traders A type speculative trader in the commodity exchange. who absorbs the imbalance betweenaggregate commercial buyers and sellers futures contracts with the expectation of making aprofit from price changes over time. These traders hold their positions for a day to as long asseveral weeks, in contrast to spread traders and scalpers.

physicals The underlying commodities on which a futures contract is based.

price discovery The process of determining the price of a commodity based on supply and demand factors.

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

ready-delivery contract In Indianl terms, contracts which provide for the delivery of goods and the full paynienl of tlhevalue of the goods at the price settled when the contract was entered into either i cniediatelvor within a period of eleven days after signature of the contract.

recognized association In India, an association recognized by the Fonvard Markets Conmuission for the organizationof trade in forvard and futures contracts. In other countries called 'contract market'.

recognized warehouse A warehouse recognized bv a commodity exchange as acceptable for delivery of commoditiesagainst futures contracts. Such a warehouse needs to fulfill certain requirements in terms ofsupporting infrastructure (including transport and loading infrastructure). storage facilities.capacity and location. Also called exchange warehouse or licensed warehouse.

roll-over Replacement of maturing contracts with more distant contracts.

retender The process which allows a holder of a futures contract who has received a delivery noticethrough the clearing house to sell a futures ContaMct to closc out his position. rathcr thanhaving to take physical deliven.

ring A circular area on the trading floor of an exchange where traders and brokers stanld whlileexecuting futures trade. Also called pit.

roll-over A trading procedure involving the shift of a position in one contract monith to a position in acontract month further fonrard, by closing out the nearby position and simultaneouslyopening a position in the new contract montlh. Also callcd switch.

scalper A type of speculative trader in the commodity exchange. nwho tries to profit froi small btitrapid price changes. holding positions for only a very short time and rarely carnring openpositions over niglht, in contrast to position traders and spread traders.

settlement price The daily price at whlich the clearing house clears all trades. It is used to determine margincalls. Also refers lo a price established b! an cxchange for contracts to be closed out throuigha 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 expectancy of acquiring it later. Normal

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part of commodity trade.

slippage The difference between the price at which the trader/hedger hopes to buy or sell and the priccat w-hich the order is actually executed.

speculator A trader in commodity exchanges, who assume the risk which comumercial users Nxish tohedge in the hope of making a profit. They also absorb the frequently imbalanced demandsof commercial buyers and sellers. See also three types of speculators in commoditycxchanges: position traders, spread traders, and scalpers.

spot market In international tenns, a market where transactions involve the buying or selling ofcommoditics for immediate delivery. Also called cash. physical or prompt markets

slprcad traders A type of speculative trader in commodity exchanges who absorbs the imbalances in thedegree of futuritv required by commercial buyers and sellers. For example. if a buyerpurchases a nearby future and a seller requires a more distant future, the spread trader orspreader may take on both positions with the exception of making a profit from the relativeprice changes rather than actual price changes per se. Spread trading may be performedwvithiin the same market for contracts of different maturities (intra-market spread) orbetvecen two or more markets for the same period (inter-market spread).

tender days Days when deliv en of futures contracts can be madc.

tenderable grade Alternate grade of a commodity which can bc delivered against a futures contract, whilemaking appropriate price adjustments upwards or downwvards reflecting the differencc fromthe basis grade.

tender To make delivery: or to give notice to the clearing house of tlhe intention to initiate delivery ofthe physical commodity. against an open short position in the futurcs market.

terminal market Synonym for futures market.

Transferable Specific As defiled bv the Fonrard Contracts (Regulationl) Act, 1952. these are fonrard contractsDeliverv Contract 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 delivery is still expected.

volatility A statistical measure of the tendency of a market price to vary over time.

v olume The nmmber of contracts traded on a market.

IMAGING

Report No: 15453 INType: SR

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