By Rajosik Banerjee & Punit Ajani,
Commodity derivative trading volumes are rising in India and globally. However, trading activity is concentrated in a few commodities and exchanges often struggle to create liquidity in new contracts.
Globally, most of the commodity benchmarks continue to trade on the exchanges they were first launched on. For example, the Chicago Board of Trade soya bean contract was first launched in 1936 and it is still used as a global benchmark for price reference. Trading on the London Metal Exchange (LME) can be traced back to as early as 1877, and LME-traded industrial metals are still considered by global companies to set their product prices. These contracts were first launched due to a requirement to manage a new or increased price risk and succeeded due to the active participation of physical market players. But despite historical success, global commodity exchanges have seen mixed success in launching and sustaining new contracts.
There is no one-shoe-fits-all strategy when it comes to developing and sustaining the commodity derivatives market. Commodity trading is unique as both buyers and sellers are to be incentivised to come and trade on the derivative platform. The key reason for consumers and producers to trade is to manage their price risk and get better visibility about future prices. Physical market players may trade huge quantity; however, they may not trade regularly and may have limited risk appetite for higher price volatility. Hence, we need participation by financial market players to become counterparties to the consumers and producers. They provide the much-needed liquidity in the market and can help with easy entry and exit for physical market players, thereby reducing the impact cost.
Individually, if we talk about the Chicago Mercantile Exchange, the exchange has seen immense success due to its century-old presence, large product portfolio, open market access, and extensive incentive programmes. The Intercontinental Exchange is a recent entrant in commodity trading but has benefitted from the acquisition of key trading platforms. LME is another century-old exchange which has managed to maintain its lead in industrial metal trading due to a large base of physical market players and the extensive use of LME prices as a benchmark in the global market. China has seen a sharp burst in trading activity recently and has benefitted from the launch of products across the value chain and opening of some key commodities such as crude oil and iron ore to foreign participation.
India is a relatively new entrant in the global commodity derivative market and trade volumes have picked up significantly with the introduction new instruments such as options and index futures. However, the Indian commodity derivative market remains constricted by the concentration of volume in a few products, higher cost of trading, and limited
market awareness.
India is a major player in the commodity market and a well-developed derivative market is the need of the hour for efficient risk management. Commodity derivative trading in India is still at a nascent stage, and there is a need to take targeted action to boost participation. Based on the learnings from international markets, Indian exchanges can focus on developing derivatives in commodities in which the country plays a major role of a price maker. India plays a major role in determining prices of commodities like pulses, sugar, spices, etc., and the focus can be on developing derivative contracts on these commodities.
Also, similar to global exchanges, the Indian ones need to design a robust incentive scheme to attract participation in new and existing contracts. These schemes should be largely focused on new contracts and should continue until there is stable growth in trade volumes.
Given the early stage of Indian commodity markets, the cost of trading should be kept at a minimum. An important factor is widening the participation base, including with foreign and financial market players. Another important factor is regulation. Given the sensitive nature of commodity markets, regulatory oversight is a must. However, the focus should be only on controlling manipulation. Volatility in commodity prices cannot be controlled, given their dynamic nature and sensitivity to multiple factors. But constant intervention can dissuade new and existing market participants and arbitrary discontinuation of contracts can adversely impact the overall objective of commodity derivatives, which is price
risk management.
The importance of the Indian commodity derivative market is evident, but it needs fresh impetus to enter the growth trajectory seen by some major global exchanges. Such an impetus may come from the combined efforts of the exchanges, market participants, as well as the regulator.
This article is part of an independent research study conducted by KPMG Assurance and Consulting LLP, as part of an educational initiative of MCX-IPF.
Rajosik Banerjee & Punit Ajani, Respectively head of financial risk management (FRM) and deputy head of risk advisory, & associate partner (FRM), KPMG in India.
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