The regulators, as a first step, empowered commodity market intermediaries to be securities brokers. As the intermediaries became securities market members, the second logical step was taken, permitting trading in commodity derivatives on the existing stock exchanges such as the NSE and the BSE. While the earlier process was completed in 2017, the latter was enabled in 2018. In the meantime, the regulators appointed the Commodity Derivatives Advisory Committee, which drew a roadmap for the growth and development of the Indian commodity derivative markets.
Options on commodity futures became the first such product to be launched. Apart from this, index futures and options on commodities were also allowed. New participants such as bank subsidiaries – that is, their securities arms — were allowed by the central bank. Foreign entities in India have been empowered to hedge. The regulator had also streamlined the risk-management mechanism enhancing the trust. Despite the various efforts, the growth remains limited to a few commodities/instruments with limited institutional participation. The actively traded commodities have declined significantly.
With the custodians providing commodity/derivative related services to domestic institutional participants, they have started exploring participation strategies. . However, their participation was limited to few global commodities. While it’s an excellent start, DII (domestic institutional investor) participation must spread across all non-sensitive commodities.
The markets have been in turmoil on the back of pandemic-induced supply constraints since 2020. Further, central bank actions have also augmented the volatility conditions. The volatility, however, made trading in options on commodity futures attractive, aided by the lower transaction tax (CTT).
An analysis of the volumes in the respective underlying commodity futures contracts reveals that the growth in options outweighed the futures volumes. For example, crude options volume increased at an estimated 24 per cent, while the underlying futures volumes rose at a paltry 3 per cent m-o-m during May 2020 to February 2022.
Similarly, while the growth in metal futures is yet to gain traction since the settlement mode turned physical, the options on metal futures have gained traction. Essentially, it means that the efficiency of price discovery in the underlying futures markets has been moving south. Options on the futures markets would need a solid foundation of liquid futures enabling efficient discovery of risk premiums. The policy instability in agricultural commodity futures had resulted in dwindling participant interests.
With aspirations to enable farmers’ participation and delivery of the underlying commodity directly, options on commodities were introduced with necessary legal amends. However, trading in options is yet to reach the desired level. Active participation of options writers in this segment would be critical. Who can be better writers than banks and institutions? Disclosures by key MIIs (Market Infrastructure Institutions) reveal that there has not been a significant increase in hedgers’ participation over the last three years despite various measures. Month-on-month data show open interest in the futures segment declined 8 per cent during June 2020 to March 2022. Reasons for the poor hedging culture may range from awareness to lack of peer pressure.
Set of constraints
The agricultural/non-agricultural commodity derivative markets have their own set of constraints. In the metal markets, it is essential to have strong physical market participation to be seriously discounted in the global markets. The agricultural segment is not only plagued by limited stakeholder participation but also has no support from any quarter. Additionally, in commodity derivative markets, it is necessary that the derivative contracts have strong participation leading to low indirect participation cost. The direct cost of participation shall be reduced significantly if policymakers revisit the ‘Commodity Turnover Tax’.
The crude market slide into negative territory in 2020, and the nickel squeeze during early March 2022 reveal that commodity markets are prone to run-ons. Global regulators must reform their regulatory regime to prevent recurrence. A repeat shall take away participants’ trust. The compounded decline of 15 per cent in the daily nickel derivatives volumes (early March 2022 to late April 2022) is proof enough.
Banks are critical in delivering unbiased and robust research, empowering participants and improving information convergence. India’s metal market especially, with its not-so-well-developed forward curves, could be redesigned by the entry of banks.
As far as commodities serve as good portfolio diversifiers, pension/insurance sector regulators should consider their participation and the markets also need to evolve to provide them space. The next phase of commodity market growth should see the launch of innovative products and newer commodities. Rationalisation of the fiscal regime and the entry of missing institutions are critical to push markets to the next orbit.
The writers are with the National Institute of Securities Markets. Views are personal
June 05, 2022