The Securities and Exchange Board of India (Sebi) on Wednesday approved a proposal to allow options trading in commodity derivatives, which could potentially pave the way for a much wider basket of products and improve farmers’ ability to hedge the risk of price fluctuations in their produce. The regulator also gave its nod for a single licence for both equity and commodity brokers, which will help brokerages cut costs.
Allowing options trading is a “very big step towards further deepening the commodities derivatives market”, Sebi chairman Ajay Tyagi said after a meeting of the regulator’s board in Mumbai.
“To enable the commodity derivatives exchanges to organise trading of options, the board, after undertaking due public consultation process, has approved a proposal to amend the Securities Contract Securities Contract (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2012,” Sebi said.
The regulator is yet to give details on the list of commodities that can be traded and the exact share of farm and non-farm commodities, as well as the date from which trading in options will begin. However, unlike in stocks, Sebi will most likely desist from allowing options to be cash settled; instead options will have to be converted into derivatives (futures) and delivery will take place. This is to ensure that more serious players like delivery participants enter the market.
Sebi said it will soon issue detailed guidelines for trading in ‘options’ on commodity derivatives exchanges, which are expected to contain all the relevant details.
Presenting the Budget for 2016-17, finance minister Arun Jaitley had announced allowing new products in the commodity derivatives market, including options.
A put option gives the right but not the obligation to sell a commodity at a certain price in future.
So if the price of the commodity falls below a certain level in the spot market, the farmer who buys the put option can sell the commodity at the rate agreed upon earlier and, thereby, protect himself against the downside risk of volatility.
Commodity exchanges hailed the move. Mrugank Paranjape, MD & CEO of MCX, said: “Options definitely would complement the existing futures contracts and further bolsters price discovery process in Indian commodity market.” He added that options would attract hedgers — small to large — to hedge on domestic exchanges.
“The combination of options & futures can give market participants the leverage of futures with the safety of options. With addition of liquidity through options, various associated benefits such as lowering of impact cost, improved market stability, improved price discovery etc will also be seen,” NCDEX said in a statement.
As exchanges can introduce more trading products, farmers and other investors including traders will have greater choices besides more avenues to hedge their risks. Significantly, the futures trade in farm commodities, stymied by periodic bans, could thrive as a result of the proposed changes.
Analysts said the put option is a great product for farmers as they will have no obligation to sell their produce if they are not satisfied with the price. They can hedge their risks better by paying a simple premium. Moreover, if banks enter the commodity market at some point of time in the future, aggregation of farmers in large numbers will be possible, although amendments to the Banking Regulation Act is necessary for banks to enter, they said.
Kuntal Sur, partner, financial services (risk and regulation leader) at PwC India, said options give the holder the right to buy or sell the underlying asset at expiration while a futures contract holder is obligated to buy or sell the underlying asset on a future date. The buyer of a commodity option pays a premium to the seller of the option for the right. Sur said as a holder of option, the liability is limited to the premium amount to the buyer of options, since the holder has the right but is in no circumstances obligated to exercise the option. An option holder can participate fully in any upward price movement for the price of underlying commodity. Thus, commodity option trading can be used to price risk management.
Although market participants and analysts generally welcomed the government’s move, they stressed that awareness level has to be raised among farmers to reap the benefits. Also, adequate infrastructure facilities need to be built. Analysts also said launches of greater products would expose the market to greater manipulative elements and tighter vigil by Sebi will be required to stem their presence.