UNIT-3: COMMODOTY EXCHANGES: FUNCTIONS AND ROLE OF EXCHANGES TRADING AND CLEARING METHOD COMMODITY FUTURES COMMODITY SPECFIC

CFIC EXCHANGES Vs. MULTI COMMODITY EXCHANGES

WHAT IS A COMMODITY EXCHANGE? An exchange is an institution, organization or association which hosts a market where stocks, bonds, options and futures, as well as commodities are traded, and where buyers and sellers can come together to trade during specific hours on business days. A commodity exchange offers a central meeting place where buyers and sellers meet to do business, and where various commodities are traded. The contracts traded on commodity exchanges can include spot, futures and options on futures contracts. The exchange only serves to provide the facilities where buying and selling can take place. The exchange itself does not buy and sell commodities or contracts, nor does it set or establish prices. The government of India has granted only those institutions, organization or association registered with the forward markets commission, which is demutalised where an exchange is one where ownership, management and trading are separated into different functions. As a good corporate governance practice, and in order to avoid any cornering or conflict of interests, trading rights do not accrue naturally to the owners of an exchange. They must be acquired by complying with the admission criteria laid down by the exchange. The Government of India took the landmark decision to remove all commodities from the restrictive list, and allowed setting up of new, modern, demutalised, nation-wide multi-commodity exchanges with investment support by public and private institutions. ROLE OF A COMMODITY EXCHANGE The essential role of that a commodity exchange performs is to provide a regulated and supervised forum for buyers and sellers of futures contracts to meet and trade. An aggregation of demand and supply of individual types of commodities will bring about transparency in discovery of market price. Traders can carry various hedging strategies to safeguard themselves against price volatilities. Distribute the risk through various traders raising liquidity of contracts in the commodity exchanges.

FUNCTIONS OF COMMODITY EXCHANGE It sets rules and regulations to standardize the practices of buying and selling. Mechanism for resolution of business disputes. Generate and disseminate valuable signals relating to price and market information to exchange members, their customers and other interested market participants on real-time basis. Eliminates counter-party risk.

TRADING AND CLEARING METHODS Commodities are an essential part of our everyday lives. Till the first half of the nineteenth century all sellers and buyers of a commodity traded by meeting in a common market place. Buyers would judge the amount of produce coming to the market for sale, while the sellers would estimate the amount of demand for their commodity. These views caused wide fluctuations in cash market prices and introduced uncertainty for producers, distributors and consumers of commodities. It is the all pervasive nature of commodities, the need to trade them in an environment of trust, combined with a need to offset or hedge commodity risk that was the reason for the start of commodity derivatives exchanges. Buyers and sellers of commodities in physical markets can trade in derivatives contracts to hedge the risks they face from price changes in these markets. Without futures contracts to manage risk, producers, refiners, and others would be exposed to greater uncertainty. By establishing prices for future delivery, the commodity derivatives markets also help buyers and sellers determine or discover the prices of commodities in physical markets, thus linking the two markets. Markets participants observe and analyse a myriad of information on factors that affect prices, and the derivative markets distill the diverse views of market participants into single price. A derivative is a financial instrument whose value depends upon the value of the underlying variables (prices of currency, stocks, commodity, indices, interest rates, etc.). The most commonly traded derivatives instruments are Forwards, Futures, Swaps and Options. A Forward contract is between a buyer and a seller to buy or sell a mutually predecided quantity and quality of underlying (commodity, stock, foreign currency, etc) for delivery on specified future date at a predetermined price. Forward contracts are not traded on derivatives exchanges as they are over the counter products. A Futures contracts are standardized contracts written against the clearing house of an exchange to buy or sell, exchange decided lot of underlying on a specified future date at a predetermined price. The predetermined price is referred to as a Strike Price.

Forward Contracts versus Futures Contracts Forward Contracts 1) Are not traded on exchanges 2) Are private, and are negotiated between Parties, with no exchange guarantees. 3) Involves no margin payments as mutual goodwill is the basis for contracting. 4) Are used for hedging and physical delivery. 5) Terms of the contract are dependent on the negotiated contract. 6) Are not transparent as they are private deals. 7) Contracts are settled by physical delivery Futures Contracts Are traded on an exchange Use a Clearing House which provides protection for both parties. Require a margin to be paid as good-faith money. Are used for hedging and speculating. Terms of the contract are Standardized and published by the exchange. Are transparent and are reported by the exchange. Most contracts are cash settled.

There are three distinct areas of commodity futures trading viz. Trading, Clearing and Settlement. COMMODITY FUTURES Commodity futures contract is a contract / agreement entered into between two parties on recognized commodity exchanges today, to buy or sell a specified quantity and quality of a commodity at a pre-decided future date at an agreed price today. OBJECTIVES 1) The prices are subject to change due to number of factors. Thus prime objective of futures is to hedge against risk of fluctuation in price of the commodity. 2) Discover the probable future price of the commodity. 3) Maintain liquidity. The consumers who wish to consume the commodity in future need not buy it immediately and thus locking of funds is avoided. Thus, liquidity is maintained. 4) Reduction in inventory. There is no need of maintaining buffer stock and thus, better allocation of resources is possible. 5) To obtain bank finance.

EXCHANGE MEMBERSHIP When the owners and management of an exchange do not have any trading rights, then trading is a distinct part of the activity on exchange. In order to gain access to trading privileges on the exchange, trading rights of that exchange must be acquired. This means that all purchases and sales must be made only through a registered member with valid membership of the exchange. It is possible for individuals, registered firms, corporate bodies and companies to be admitted for trading on exchange by complying with the membership norms of that exchange. Following types of entities are eligible to become members of most exchanges: (a) Individual/Proprietorship Firm (b) Registered Partnership Firm (c) Hindu Undivided Family (d) Private Limited Company (e) Public Limited Company (f) Co-operative Societies Generally, exchanges allow membership on the basis of financial soundness, corporate structure, track record, education and experience of the applicants. Applicants, in general, will undergo the course before they can become members of an exchange: Submission of Application Form, Documents and Payment by the Applicant Processing of Application by the Exchange Interview by an Admission committee Approval by the Exchange Activation of Membership to the Exchange Normally, exchanges specify a minimum lock in period for all kinds f membership and insist on the following requirements: 1 Minimum prescribed net worth for each applicant. 2 Annual subscription charges 3 Following deposits to be maintained with the exchange * Non refundable admission fees * Contribution towards the trade guarantee fund of exchange (refundable after lock in period) * Initial base capital (refundable) * Additional base capital

PARTICIPANTS There are four types of participants in futures markets viz. a) b) c) d) Hedgers Speculators Day-Traders / scalpers Arbitrageurs

Hedgers Hedgers is a user of the market, who enters into futures contract to manage the risk of adverse price fluctuation in respect of his existing or future asset (commodity). Hedgers are those who have interest in the underlying commodity and are using futures market to insure themselves against adverse price fluctuations. Speculators A trader, who trades or takes position without having exposure in the physical market, with the sole intention of earning profit from price movements is a speculator. Speculators are those who may not have an interest in the ready contract, etc. but see an opportunity of price movements favorable to them. They are prepared to assume the risk, which the hedgers are trying to cover in the futures market. Day traders/ Scalpers Day traders take position in futures or options contracts and liquidate them prior to the close of the same trading day. They speculate on price fluctuation during the day. Arbitrageurs Arbitrage refers to the simultaneous purchase and sale in two markets so that the selling price is higher than the buying price and the transaction cost, resulting in risk less profit to the arbitrageur. Pricing of Commodity Futures Initially exchange decides the Base Price of a commodity futures contract at the time of initiating the contract. Base price is a notional price based on the spot market price of that commodity on the previous day and a notional carrying cost. If no trade takes place on the first day of the contract then the exchange can take the closing price of spot market of the same day for the next day. Other method taken by the exchange to calculate the closing price

closing price is equal to weighted average of all trades done during the last 30 minutes before session is closed if in the last 30 minutes is less than 10, then average of last 10 trades of the day are taken if the trades done in the whole day are less than 10, then weighted average of all trades are taken if no trades have been executed in a contract on a day, then the previous trading session is taken as the official closing price for that day.

Cost of Carry Model of Futures Pricing Cost of carry is an important element in determining pricing relationship between spot and futures prices as well as between prices of futures contracts of different expiry months. Where, F=Futures Price, S=Spot Price and C= Cost of Carry. F=S+C Cost of carry is made up of cost of storage and insurance and cost of interest. Types of Commodity Futures Contracts Compulsory Delivery Contracts Sellers Option Contracts Intention Matching Contracts

Compulsory delivery contracts All contracts which are not squared off before the maturity date, are required to be settled by delivery of the underlying commodity. Those short have to give delivery and those long have to accept. Sellers option contracts In this case the sellers has the option to give delivery or not. If he decides to give delivery the buyers have to take it. Intention matching contracts In this case actual delivery takes place if both parties agree for physical settlement. In other cases its normally cash settlement. Orders in Commodity Futures Trading Market Order: Market on Open Market on Close

Margins Before trading in futures market customers has to deposit with the broker an initial amount fixed by the exchange. This amount is called margin. Brokers has to collect deposit from both buyers and sellers of futures contracts to ensure performance of terms of the contract. The margins varies from one contract to another and the margin levels are set by the exchange based on volatility of the underlying asset. Initial Margin It is the amount to be deposited by the market participants in his margin account with the clearing house before they can place order to buy sell futures contracts. Maintenance Margin Is 75% of the initial margin which is required to be maintained to ensure that the balance in the margin account never becomes zero or negative. Margin is called in any case if the account is have less than 75% of the initial margin. Mark to Market Margin It is that amount where the daily gains or loss on the position is calculate and is required to be paid on T+1 basis. Additional Margin When the market are volatility the exchange can call for additional margin, which is a pre-cautionary step to prevent breakdown i.e inability to continue trading. This is done when the exchange fears in some payment crisis. Clearing Margin Is the initial margin which is the clearing member firm is required to make according to clearing house rules based upon positions carried, determined separately for customer and proprietary positions. Trading Architecture Trading methods Open Outcry Electronic Trading

Open outcry trading is a vigorous face to face form of trading on exchange floor referred as Pit or Ring.

Connectivity Options VSAT LEASED LINES INTERNET (VPN) SETTLEMENT Commodity futures contracts places obligation on the contracting parties to tender delivery or take delivery of the commodity on a future date as per the terms and conditions of the contract. Methods of Settlement Closing Out Cash Settlement Physical Delivery Closing Out It means contracts positions are settled by squaring the position taken by he party. If its a long position (buy) then he has to sell the contract of the same month of the same quantity. Physical Delivery All types of commodity futures contracts can exercise this option of settlement. A future contract enters delivery period five days before the expiration of the contract. A delivery margin is imposed by the exchanges on members who have open position during the tender period and remains imposed till the settlement of the contract. The request for taking delivery ,usually has to be made by the clearing member at least 3 days before the expiry of the contract. The sellers submits the delivery with the surveyors certificate and the buyers make the payment. The clearing member intimates exchange the client code, demat account, warehouse location, quantity. The exchange then matches the request of the buyer and the seller and due diligence is taken place. Unmatched positions are cash settled. Cash Settlement In this case the loss or gain is calculated at the time of expiration on the last trading day. The buyer and seller has to pay cash on the loss calculate as per the closing spot price on that day. Normally maximum contracts are cash settled.

Clearing
There are two types of clearing taking place. One which takes care of close outs, cash settlements and physical settlement is called a clearing house. Clearing banks takes care of the movement of funds (money).

Clearing House A clearing house is a system by which exchanges guarantee the faithful compliance of all trade commitments undertaken on the exchange platform. Clearing house keeps track of the transactions that take place on the exchange platform during the day and at the end of the day calculates the net positions. Monitors and performs all activities related to delivery, funds settlement, margining, managing the settlement guarantee fund, etc Collects margins from members, effects pay in and pay out and monitor delivery and settlement process. Allocates delivers which it has received from the selling member to the buying member and its binding on the buyer Creates a lien on members deposits and deliveries in case of default by the member. Appoints clearing assistants Allotment of clearing code to members Delivery and payment through Custodians, clearing banks and clearing members. Issue of notices and directions to all members.

Clearing Banks Every member of the exchange has to maintain bank accounts with the designated branches of the exchange appointed Clearing Bank, which has electronic funds transfer facility. Two types of accounts Settlement / Clearing Accounts Can be used only for the purpose of settlement deals entered through the exchange for the payment of margin money and other purpose as may be specified by the exchange. Members can only issue cheques from this account for transfer of money from this account to his Client Account. Exchange has the power to withdraw money from this account by the way of direct debit instructions. No cheque book is issued. Client Account Member can deposit all cheques, cash, etc. received from clients in this account and from this account members can issue cheques to their clients towards their receivables. Risk Management Price limit Circuit Filters The exchanges in India notifies a daily circuit filter limit for all commodities in terms of % of variation allowed in a day with reference to the base price for that day. Exposure Limits and Deposit Requirements The exchange sets such limits whereby a member can trade up to that amount of money deposited with the exchange in terms of cash or collaterals. Up to 80% of such amount

can be used, beyond that a members trades are halted unless more money is deposited or trades squared off. Transaction Fees A transaction fees is charged on the daily turnover in all futures contracts in all commodities traded on the exchange platform. Penalty for Default The exchanges levies penalty on its members for any defaults and violation of any terms of the contract and the rules and bye-laws of the exchange. Settlement Guarantee Funds Is usually made up of the initial and additional deposits of the members to the exchange. Commodity Specific Regional Exchange V/S Multi Commodity Exchange Commodity Specific Regional Exchange The commodity exchanges in India developed on a regional basis and the management remained in the hands of a small group, which controlled bulk of the business. Transparency was questionable due to control remaining with a small group. Due to small size of participants liquidity was thin. A particular trading community dominated activities in each of these exchanges. This trading community did not share any kind of market information with the person not belonging to that community. Thus any person who did not have affiliation to that community faced some sort of entry barrier. In several of these exchanges, trading rights, ownership rights and managements control remained with the small group of people from particular community. Some of selected regional commodities exchange Ahmedabad Commodity Exchange Bikaner Commodity Exchange Chamber of Commerce, Harpur National Board of Trade (NBOT)

Difference between Commodity Specific Exchanges V/S Multi Commodity Exchange CSE * Membership is limited * Trading hours are small * Out cry and Electronic System is used for Trading * Specific Commodities are Traded depending on its Availability * Margin up to 100% required When trading is done * Turnover is Low * Clearing is on daily basis * Settlement is spot or T+3 MCE Membership is not limited Trading hours are long Fully Electronic system Trading All Commodities are traded Margin is up till 20% depends on Contract value Huge Amount of turnover Is witnessed Clearing Systems is more Accountable Settlement can be exercised in Many forms as per Contract expiry

Limitations of Commodity Specific Exchanges No independence of Ownership and management Existence of unofficial Markets Non Availability of prices and Non- Standardization of Contracts Fragmented nature of Markets

In all the above CSE are not transparent in any form of their working as they are not demutalised hence performance of these exchange is always in question. All this results in few participation and limited trading activity. Trades are not recorded hence lots of money is transferred in black money. Size of the contract and quality of goods is also not standardized there cheating in goods is possible. Activity like hedging, jobbing, arbitrage is just not possible.