NCFM
NSE's CERTIFICATION IN FINANCIAL MARKETSCommodities Market Module
Work Book
Contents
1
Introduction to derivatives ...
11
1.1
Derivatives defined ...
11
1.2
Products, participants and functions ...
12
1.3
Derivatives markets ...
13
1.3.1
Spot versus forward transaction ...
14
1.3.2
Exchange traded versus OTC derivatives ...
14
1.3.3
Some commonly used derivatives ...
16
2
Commodity derivatives ...
19
2.1 Difference between commodity and financial derivatives ...
19
2.1.1
Physical settlement ...
19
2.1.2
Warehousing ...
21
2.1.3
Quality of underlying assets ...
22
2.2 Global commodities derivatives exchanges ...
22
2.2.1
Africa...
24
2.2.2
Asia ...
24
2.2.3
Latin America ...
24
2.3 Evolution of the commodity market in India ...
24
2.3.1
The Kabra committee report ...
25
2.3.2
Latest developments ...
27
3
The NCDEX platform ...
31
3.1 Structure of NCDEX ...
31
3.1:1 Promoters ...
32
3.1.2 Governance ...
32
3.2 Exchange membership ...
32
3.2.1
Trading cum clearing members (TCMs) ...
32
3.2.2
Professional clearing members (PCMs) ...
33
3.3
Capital requirements ...
33
3.4
The NCDEX system ...
34
3.4.1
Trading ...
34
3.4.2
Clearing ...
35
4
Commodities traded on the NCDEX platform ...
37
4.1 Agricultural commodities ...
37
4.1.1
Cotton ...
38
4.1.2
Crude palm oil ...
40
4.1.3
RBD Palmolein ...
42
4.1.4
Soy oil ...
43
4.1.5
Rapeseedoil ...
45
4.1.6
Soybean ...
46
4.1.7
Rapeseed...
47
4.2 Precious metals ...
49
4.2.1
Gold ...
50
4.2.2
Silver ...
54
5
Instruments available for trading ...
59
5.1 Forward contracts ...
59
5.1.1 Limitations of forward markets ...
60
5.2 Introduction to futures ...
60
5.2.1
Distinction between future and forwards contracts ...
61
5.2.2
Futures terminology ...
62
5.3 Introduction to options ...
62
5.3.1 Option terminology ...
63
5.4 Basic payoffs ...
64
5.4.1
Payoff for buyer of asset: Long asset ...
65
5.4.2
Payoff for seller of asset: Short asset ...
65
5.5 Payoff for futures ...
65
5.5.1
Payoff for buyer of futures: Long futures ...
65
5.5.2
Payoff for seller of futures: Short futures ...
67
5.6 Payoff for options ...
68
5.6.1
Payoff for buyer of call options: Long call ...
68
5.6.2
Payoff for writer of call options: Shortcall ...
69
5.6.3
Payoff for buyer of put options: Longput ...
69
5.6.4
Payoff for writer of put options: Shortput ...
70
5.7 Using futures versus us mg options ...
71
6
Pricing commodity futures ...
77
6.1
Investment assets versus consumption assets ...
77
6.2
The cost of carry model ...
78
6.2.1
Pricing futures contracts on investment commodities ...
80
6.2.2
Pricing .futures contracts on consumption commodities ...
82
7
Using commodity futures ...
87
7.1 Hedging ...
87
7.1.1
Basic principles of hedging ...
87
7.1.2
Short hedge ...
88
7.1.3
Long hedge ...
89
7.1.4
Hedge ratio ...
91
7.1.5
Advantages of hedging ...
92
7.1.6
Limitation of hedging: basis Risk ...
93
7.2 Speculation ...
94
7.2.1
Speculation: Bullish commodity, buy futures ...
94
7.2.2
Speculation: Bearish commodity, sell futures ...
95
7.3 Arbitrage ...
95
7.3.1
Overpriced commodity futures: buy spot, sell futures ...
96
7.3.2
Underpriced commodity futures: buy futures, sell spot ...
97
8
Trading ...
101
8.1
Futures trading system ...
101
8.2
Entities in the trading system ...
101
8.2.1 Guidelines for allotment of client code...
102
8.3
Contract specifications for commodity futures ...
103
8.4
Commodity futures trading cycle ...
103
8.5
Order types and trading parameters ...
104
8.5.1
Permitted lot size ...
108
8.5.2
Tick size for contracts ...
108
8.5.3
Quantity freeze ...
109
8.5.4
Base price ...
109
8.5.5
Price ranges of contracts ...
109
8.5.6
Order entry on the trading system ...
110
8.6
Margins for trading in futures ...
112
8.7
Charges ...
113
9
Clearing and settlement...
117
9.1 Clearing ...
117
9.1.1. Clearing mechanism ...
118
9.1.2
Clearing banks ...
118
9.1.3
Depository participants ...
119
9.2 Settlement ...
119
9.2.1
Settlement mechanism...
119
9.2.2
Settlement methods ...
122
9.2.3
Entities involved in physical settlement ...
124
9.3
Risk management ...
125
9.4
Margining at NCDEX ...
126
9.4.2
Initial margin ...
126
9.4.3
Computation of initial margin ...
126
9.4.4
Implementation aspects of margining and risk management ...
128
9.4.5
Effect of violation ...
130
10 Regulatory framework ...
135
10.1
Rules governing commodity derivatives exchanges ...
135
10.2
Rules governing intermediaries ...
136
10.2.1
Trading ...
136
10.2.2
Clearing ...
140
10.3 Rules governing investor grievances, arbitration ...
144
10.3.1
Procedure for arbitration ...
145
10.3.2
Hearings and arbitral award ...
146
List of Tables
2.1
The global derivatives industry ...
23
2.2
Volume on existing exchanges ...
27
2.3
Registered commodity exchanges in India ...
28
3.1
Fee / deposit structure and networth requirement: TCM ...
33
3.2
Fee / deposit structure and networth requirement: PCM ...
33
4.1
Country-wise share in gold production; 1968 and 1999 ...
51
5.1
Distinction between futures and forwards ...
61
5.2
Distinction between futures and options ...
72
6.1
NCDEX - indicative ware house charges...
82
7.1
Refined soy oil futures contract specification ...
89
7.3
Gold futures contract specification ...
93
8.1
Commodity futures contract and their symbols ...
103
8.2
Gold futures contract specification ...
104
8.3
Long staple cotton futures contract specification ...
105
8.4
Commodity futures: Quantity freeze unit ...
109
8.5
Commodity futures: Lot size another parameters ...
111
9.1
MTM on along position in cotton futures ...
120
9.2
MTM on a short position in cotton futures ...
121
9.3
Calculating outstanding position at TCM level ...
127
9.4
Minimum margin percentage on commodity futures contracts ...
127
9.5
Exposure limit as a multiple of liquid net worth ...
130
List of Figures
5.1
Payoff for a buyer of gold ...
66
5.2
Payoff for a seller of gold ...
66
5.3
Payoff for a buyer of gold futures ...
67
5.4
Payoff for a seller of cotton futures ...
68
5.5
Payoff for buyer of call option on gold ...
69
5.6
Payoff for writer of call option on gold ...
70
5.7
Payoff for buyer of put option on long staple cotton ...
71
5.8
Payoff for writer of put option on long staple cotton ...
72
6.1
Variation of basis overtime ...
84
7.1
Payoff for buyer of a short hedge ...
88
7.2
Payoff for buyer of a long hedge ...
90
Copyright © 2009 by National Stock Exchange of India Ltd. (NSE) Exchange Plaza, Bandra Kurla Complex, Bandra (East), Mumbai 400 051. INDIA.
All content included in this book, such as text, graphics, logos, images, data compilation etc. are the property of NSE. This book or any part thereof should not be copied, reproduced, duplicated, sold, resold or exploited for any commercial purposes. Furthermore, the book in its entirety or any part cannot be stored in a retrieval system transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise.
NOTE: Candidates are advised to refer to NSE’s website:
www.nseindia.com.click on ‘NCFM’ link and then go to ‘Announcements’ link, regarding revisions/updations in NCFM modules or launch of new modules, if any Chapter No. Title Weights (%) 1 Introduction to derivatives 6 2 Commodity Derivatives 7
3 The NCDEX Platform 5
4 Commodities traded on the NCDEX platform 3
5 Instruments available for trading 15
6 Pricing commodity futures 16
7 Using commodity futures 14
8 Trading 16
9 Clearing and settlement 17
10 Regulatory framework 8
Introduction to derivatives
The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk.
A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty.
On the other hand, a merchant with an ongoing requirement of grains too would face a price risk - that of having to pay exorbitant prices during dearth, although favourable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into a contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be a futures-type contract, which would enable both parties to eliminate the price risk.
In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the 'to-arrive' contract that permitted farmers to lock in to price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price changes. These were eventually standardised, and in 1925 the first futures clearing house came into existence.
Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton, wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of financial underlyings like stocks, interest rate, exchange rate, etc.
1.1 Derivatives defined
A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity
or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying" in this case.
The Forwards Contracts (Regulation) Act, 1952, regulates the forward/ futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity forward/ futures contracts. However when derivatives trading in securities was introduced in 2001, the term "security" in the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the perview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets.
Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines "derivative" to include -
1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.
2. A contract which derives its value from the prices, or index of prices, of underlying securities.
1.2 Products, participants and functions
Derivative contracts are of different types. The most common ones are forwards, futures, options and swaps. Participants who trade in the derivatives market can be classified under the following three broad categories - hedgers, speculators, and arbitragers.
1. Hedgers: The farmer's example that we discussed about was a case of hedging. Hedgers face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk.
2. Speculators: Speculators are participants who wish to bet on future movements in the price of an asset. Futures and options contracts can give them leverage; that is, by putting in small amounts of money upfront, they can take large positions on the market. As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses.
3.Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit.
Whether the underlying asset is a commodity or a financial asset, derivative markets performs a number of economic functions.
Prices in an organised derivatives market reflect the perception of market participants
about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices.
Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with index derivatives vis-a-vis derivative products based on individual securities is another reason for their growing use.
Box 1.1: Emergence of financial derivative products
• The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.
• Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
• Speculative traders shift to a more controlled environment of the derivatives market. In the absence of an organised derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.
• An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.
• Derivatives markets help increase savings and investment in the long run. The transfer of risk enables market participants to expand their volume of activity.
1.3 Derivatives markets
Derivative markets can broadly be classified as commodity derivative market and financial derivatives markets. As the name suggest, commodity derivatives markets trade contracts for which the underlying asset is a commodity. It can be an agricultural commodity like wheat, soybeans, rapeseed, cotton, etc or precious metals like gold, silver, etc. Financial derivatives markets trade contracts that have a financial asset or variable as the underlying. The more popular financial derivatives are those which have equity, interest rates and exchange rates as
the underlying. The most commonly used derivatives contracts are forwards, futures and options which we shall discuss in detail later.
1.3.1 Spot versus forward transaction
Using the example of a forward contract, let us try to understand the difference between a spot and derivatives contract. Every transaction has three components - trading, clearing and settlement. A buyer and seller come together, negotiate and arrive at a price. This is trading. Clearing involves finding out the net outstanding, that is exactly how much of goods and money the two should exchange. For instance A buys goods worth Rs.100 from B and sells goods worth Rs.50 to B. On a net basis A has to pay Rs.50 to B. Settlement is the actual process of exchanging money and goods.
In a spot transaction, the trading, clearing and settlement happens instantaneously, i.e. "on the spot". Consider this example. On 1st January 2004, Aditya wants to buy some gold. The goldsmith quotes Rs.6,000 per 10 grams. They agree upon this price and Aditya buys 20 grams of gold. He pays Rs. 12,000, takes the gold and leaves. This is a spot transaction.
Now suppose Aditya does not want to buy the gold on the 1st January, but wants to buy it a month later. The goldsmith quotes Rs.6,015 per 10 grams. They agree upon the "forward" price for 20 grams of gold that Aditya wants to buy and Aditya leaves. A month later, he pays the goldsmith Rs. 12,030 and collects his gold. This is a forward contract, a contract by which two parties irrevocably agree to settie a trade at a future date, for a stated price and quantity. No money changes hands when the contract is signed. The exchange of money and the underlying goods only happens at the future date as specified in the contract. In a forward contract the process of trading, clearing and settlement does not happen instantaneously. The trading happens today, but the clearing and settlement happens at the end of the specified period.
A forward is the most basic derivative contract. We call it a derivative because it derives value from the price of the asset underlying the contract, in this case gold. If on the 1st of February, gold trades for Rs.6,050 in the spot market, the contract becomes more valuable to Aditya because it now enables him to buy gold at Rs.6,015. If however, the price of gold drops down to Rs.5,990, he is worse off because as per the terms of the contract, he is bound to pay Rs.6,015 for the same gold. The contract has now lost value from Aditya's point of view. Note that the value of the forward contract to the goldsmith varies exactly in an opposite manner to its value for Aditya.
1.3.2 Exchange traded versus OTC derivatives
Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. These contracts were typically OTC kind of contracts. Over the counter(OTC) derivatives are privately negotiated contracts. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for prearranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. Later
Early forward contracts in the US addressed merchants' concerns about ensuring that there were buyers and sellers for commodities. However "credit risk" remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralised location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first "exchange traded" derivatives contract in the US, these contracts were called "futures contracts". In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganised to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organised futures exchanges, indeed the two largest "financial" exchanges of any kind in the world today.
The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.
Box 1.2: History of commodity derivatives markets
many of these contracts were standardised in terms of quantity and delivery dates and began to trade on an exchange.
The OTC derivatives markets have the following features compared to exchange-traded derivatives:
1. The management of counter-party (credit) risk is decentralised and located within individual institutions. 2. There are no formal centralised limits on individual positions, leverage, or margining.
3. There are no formal rules for risk and burden-sharing.
4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants.
5. The OTC contracts are generally not regulated by a regulatory authority and the exchange's self-regulatory organisation, although they are affected indirectly by national legal systems, banking supervision and market surveillance.
The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernisation of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter.
The largest OTC derivative market is the interbank foreign exchange market. Commodity derivatives the world over are typically exchange-traded and not OTC in nature.
1.3.3 Some commonly used derivatives
Here we define some of the more popularly used derivative contracts. Some of these, namely futures and options will be discussed in more details at a later stage.
Forwards: As we discussed, a forward contract is an agreement between two entities to buy or sell the
underlying asset at a future date, at today's pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell the underlying asset at a future
date at today's future price. Futures contracts differ from forward contracts in the sense that they are standardised and exchange traded.
Options: There are two types of options - calls and puts. Calls give the buyer the right but not the obligation to
buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges
having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.
Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a
weighted average of a basket of assets. Equity index options are a form of basket options.
Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a
prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are :
• Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
• Currency swaps: These entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options.
Thus a swaption is an option on a forward swap.
Solved Problems
Q: Futures trading commenced first on
1. Chicago Board of Trade 3. Chicago Board Options Exchange
4. London International Financial Futures and
2. Chicago Mercantile Exchange Options Exchange
Q: Derivatives first emerged as --- products
1. Speculative 3. Volatility
2. Hedging 4. Risky
A: The correct answer is number 2. • •
Q: Which of the following exchanges offer commodity derivatives trading
1. National Commodity Derivatives Exchange 3. Over The Counter Exchange of India 2. Interconnected Stock Exchange 4. ICICI Securities Limited
A: The correct answer is number 1. • •
Q: OTC derivatives are considered risky because
1. There is no formal margining system. 3. They are not settled on a clearing house. 2. They do not follow any formal rules or mechanisms. 4. All of the
above
A: The correct answer is number 4. • •
Q: The first exchange traded financial derivative in India commenced with the trading of
1. Index futures 3. Stock options
2. Index options 4. Interest rate futures
A: The correct answer is number 1. • •
Q: A ____ is the simplest derivative contract
1. Option 3. Forward
2. Future 4. Swap
A: The correct answer is number 3. • •
Q: In a transaction, trading involves ___
1. The buyer and seller agreeing upon a price. 3. The buyer and seller calculating the net out-standing.
2. The buyer and seller exchanging goods and
money. 4. None of the above.
Q: In a transaction, clearing involves
1. The buyer and seller agreeing upon a price. 3. The buyer and seller calculating the net out- standing.
2. The buyer and seller exchanging goods and
money. 4. None of the above.
A: The correct answer is number 3. • •
Q: In a transaction, settlement involves __
1. The buyer and seller agreeing upon a price. 3. The buyer and seller calculating the net out- standing.
2. The buyer and seller exchanging goods and
money. 4. None of the above.
Commodity derivatives
Derivatives as a tool for managing risk first originated in the commodities markets. They were then found useful as a hedging tool in financial markets as well. In India, trading in commodity futures has been in existence from the nineteenth century with organised trading in cotton through the establishment of Cotton Trade Association in 1875. Over a period of time, other commodities were permitted to be traded in futures exchanges. Regulatory constraints in 1960s resulted in virtual dismantling of the commodities future markets. It is only in the last decade that commodity future exchanges have been actively encouraged. However, the markets have been thin with poor liquidity and have not grown to any significant level. In this chapter we look at how commodity derivatives differ from financial derivatives. We also have a brief look at the global commodity markets and the commodity markets that exist in India.
2.1 Difference between commodity and financial derivatives
The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality
of asset does not really exist as far as financial underlyings are concerned. However in the case of
commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. We have a brief look at these issues.
2.1.1 Physical settlement
Physical settlement involves the physical delivery of the underlying commodity, typically at an accredited warehouse. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. This may sound simple, but the physical
settlement of commodities is a complex process. The issues faced in physical settlement are enormous. There are limits on storage facilities in different states. There are restrictions on interstate movement of commodities. Besides state level octroi and duties have an impact on the cost of movement of goods across locations. The process of taking physical delivery in commodities is quite different from the process of taking physical delivery in financial assets. We take a general overview at the process flow of physical settlement of commodities. Later on we will look into details of how physical settlement happens on the NCDEX.
Delivery notice period
Unlike in the case of equity futures, typically a seller of commodity futures has the option to give notice of delivery. This option is given during a period identified as 'delivery notice period'. Such contracts are then assigned to a buyer, in a manner similar to the assignments to a seller in an options market. However what is interesting and different from a typical options exercise is that in the commodities market, both positions can still be closed out before expiry of the contract. The intention of this notice is to allow verification of delivery and to give adequate notice to the buyer of a possible requirement to take delivery. These are required by virtue of the fact that the actual physical settlement of commodities requires preparation from both delivering and receiving members.
Typically, in all commodity exchanges, delivery notice is required to be supported by a warehouse receipt. The warehouse receipt is the proof for the quantity and quality of commodities being delivered. Some exchanges have certified laboratories for verifying the quality of goods. In these exchanges the seller has to produce a verification report from these laboratories along with delivery notice. Some exchanges like LIFFE, accept warehouse receipts as quality verification documents while others like BMF-Brazil have independent grading and classification agency to verify the quality.
In the case of BMF-Brazil a seller typically has to submit the following documents:
• A declaration verifying that the asset is free of any and all charges, including fiscal debts related to the stored goods.
• A provisional delivery order of the good to BM&F (Brazil), issued by the warehouse. • A warehouse certificate showing that storage and regular insurance have been paid.
Assignment
Whenever delivery notices are given by the seller, the clearing house of the exchange identifies the buyer to whom this notice may be assigned. Exchanges follow different practices for the assignment process. One approach is to display the delivery notice and allow buyers wishing to take delivery to bid for taking delivery. Among the international exchanges, BMF, CBOT and CME display delivery notices. Alternatively, the clearing houses may assign deliveries to buyers on some basis. Exchanges such as COMMEX and the Indian commodities exchanges have adopted this method.
Any seller/ buyer who has given intention to deliver/ been assigned a delivery has an option to square off positions till the market close of the day of delivery notice. After the close of trading, exchanges assign the delivery intentions to open long positions. Assignment is done typically either on random basis or first-in-first out basis. In some exchanges (CME), the buyer has the option to give his preference for delivery location.
The clearing house decides on the daily delivery order rate at which delivery will be settled. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. The discount/ premium for quality and freight costs are published by the clearing house before introduction of the contract. The most active spot market is normally taken as the benchmark for deciding spot prices. Alternatively, the delivery rate is determined based on the previous day closing rate for the contract or the closing rate for the day.
Delivery
After the assignment process, clearing house/ exchange issues a delivery order to the buyer. The exchange also informs the respective warehouse about the identity of the buyer. The buyer is required to deposit a certain percentage of the contract amount with the clearing house as margin against the warehouse receipt.
The period available for the buyer to take physical delivery is stipulated by the exchange. Buyer or his authorised representative in the presence of seller or his representative takes the physical stocks against the delivery order. Proof of physical delivery having been effected is forwarded by the seller to the clearing house and the invoice amount is credited to the seller's account.
In India if a seller does not give notice of delivery then at the expiry of the contract the positions are cash settled by price difference exactly as in cash settled equity futures contracts.
2.1.2 Warehousing
One of the main differences between financial and commodity derivative is the need for warehousing. In case of most exchange-traded financial derivatives, all the positions are cash settled. Cash settlement involves paying up the difference in prices between the time the contract was entered into and the time the contract was closed. For instance, if a trader buys futures on a stock at Rs.100 and on the day of expiration, the futures on that stock close Rs.120, he does not really have to buy the underlying stock. All he does is take the difference of Rs.20 in cash. Similarly the person who sold this futures contract at Rs.100, does not have to deliver the underlying stock. All he has to do is pay up the loss of Rs.20 in cash.
In case of commodity derivatives however, there is a possibility of physical settlement. Which means that if the seller chooses to hand over the commodity instead of the difference in cash, the buyer must take physical delivery of the underlying asset. This requires the exchange to make an arrangement with warehouses to handle the settlements. The efficacy of the commodities settlements depends on the warehousing system available. Most international commodity exchanges used certified warehouses (CWH) for the purpose of handling physical settlements. Such CWH are required to provide storage facilities for participants in the commodities markets
The New York Cotton Exchange has specified the asset in its orange juice futures contract as "U.S Grade A, with Brix value of not less than 57 degrees, having a Brix value to acid ratio of not less than 13 to 1 nor more than 19 to 1, with factors of color and flavour each scoring 37 points or higher and 19 for defects, with a minimum score 94".
The Chicago Mercantile Exchange in its random-length lumber futures contract has specified that "Each delivery unit shall consist of nominal 'i y- is of random lengths from 8 feet to 20 feet, grade-stamped Construction Standard, Standard and Better, or #1 and #2; however, in no case may the quantity of Standard grade or #2 exceed 50%. Each deliver unit shall be manufactured in California, Idaho, Montana, Nevada, Oregon, Washington, Wyoming, or Alberta or British Columbia, Canada, and contain lumber produced from grade-stamped Alpine fir, Englemann spruce, hem-fir, lodgepole pine, and/ or spruce pine fir".
Box 2.3: Specifications of some commodities underlying derivatives contracts
and to certify the quantity and quality of the underlying commodity. The advantage of this system is that a warehouse receipt becomes a good collateral, not just for settlement of exchange trades but also for other purposes too. In India, the warehousing system is not as efficient as it is in some of the other developed markets. Central and state government controlled warehouses are the major providers of agri-produce storage facilities. Apart from these, there are a few private warehousing being maintained. However there is no clear regulatory oversight of warehousing services.
2.1.3 Quality of underlying assets
A derivatives contract is written on a given underlying. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing. When the underlying asset is a commodity, the quality of the underlying asset is of prime importance. There may be quite some variation in the quality of what is available in the marketplace. When the asset is specified, it is therefore important that the exchange stipulate the grade or grades of the commodity that are acceptable. Commodity derivatives demand good standards and quality assurance/ certification procedures. A good grading system allows commodities to be traded by specification.
Currently there are various agencies that are responsible for specifying grades for commodities. For example, the Bureau of Indian Standards (BIS) under Ministry of Consumer Affairs specifies standards for processed agricultural commodities whereas AGMARK under the department of rural development under Ministry of Agriculture is responsible for promulgating standards for basic agricultural commodities. Apart from these, there are other agencies like EIA, which specify standards for export oriented commodities.
2.2 Global commodities derivatives exchanges
Globally commodities derivatives exchanges have existed for a long time. Table 2.1 gives a list of commodities exchanges across the world. The CBOT and CME are two of the oldest derivatives
exchanges in the world. The CBOT was established in 1848 to bring farmers and merchants together. Initially its main task was to standardise the quantities and qualities of the grains that were traded. Within a few years the first futures-type contract was developed. It was know as the
to-arrive contract. Speculators soon became interested in the contract and found trading in the
contract to be an attractive alternative to trading the underlying grain itself. In 1919, another exchange, the CME was established. Now futures exchanges exist all over the world. On these exchanges, a wide range of commodities and financial assets form the underlying assets in
Table 2.1 The global derivatives industry
Country Exchange
United States of America Chicago Board of Trade (CBOT) Chicago Mercantile Exchange Minneapolis Grain Exchange New York Cotton Exchange New York Mercantile Exchange Kansas Board of Trade
New York Board of Trade
Canada The Winnipeg Commodity Exchange
Brazil Brazilian Futures Exchange Commodities
and Futures Exchange
Australia Sydney Futures Exchange Ltd.
People's Republic Of China Beijing Commodity Exchange Shanghai Metal Exchange
Hong Kong Hong Kong Futures Exchange
Japan Tokyo International Financial Futures Exchange
Kansai Agricultural Commodities Exchange Tokyo Grain Exchange
Malaysia Kuala Lumpur commodity Exchange
New Zealand New Zealand Futures& Options Exchange Ltd.
Singapore Singapore Commodity Exchange Ltd.
France Le Nouveau Marche MATIF
Italy Italian Derivatives Market
Netherlands Amsterdam Exchanges Option Traders
Russia The Russian Exchange
MICEX/ Relis Online St. Petersburg Futures Exchange
Spain The Spanish Options Exchange
Citrus Fruit and Commodity Futures Market of Valencia
United Kingdom The London International Financial Futures Options exchange
various contracts. The commodities include pork bellies, live cattle, sugar, wool, lumber, copper, aluminium, gold and tin. We look at commodity exchanges in some developing countries.
2.2.1 Africa
Africa's most active and important commodity exchange is the South African Futures Exchange (SAFEX). It was informally launched in 1987. SAFEX only traded financial futures and gold futures for a long time, but the creation of the Agricultural Markets Division (as of 2002, the Agricultural Derivatives Division) led to the introduction of a range of agricultural futures contracts for commodities, in which trade was liberalised, namely, white and yellow maize, bread milling wheat and sunflower seeds.
2.2.2 Asia
China's first commodity exchange was established in 1990 and at least forty had appeared by 1993. The main commodities traded were agricultural staples such as wheat, corn and in particularly soybeans. In late 1994, more than half of China's exchanges were closed down or reverted to being wholesale markets, while only 15 restructured exchanges received formal government approval. At the beginning of 1999, the China Securities Regulatory Committee began a nationwide consolidation process which resulted in three commodity exchanges emerging; the Dalian Commodity Exchange (DCE), the Zhengzhou Commodity Exchange and the Shanghai futures Exchange, formed in 1999 after the merger of three exchanges: Shanghai Metal, Commodity, Cereals & Oils Exchanges. The Taiwan Futures Exchange was launched in 1998. Malaysia and Singapore have active commodity futures exchanges. Malaysia hosts one futures and options exchange. Singapore is home to the Singapore Exchange (SGX), which was formed in 1999 by the merger of two well-established exchanges, the Stock Exchange of Singapore (SES) and Singapore International Monetary Exchange (SIMEX).
2.2.3 Latin America
Latin America's largest commodity exchange is the Bolsa de Mercadorias & Futures, (BM&F) in Brazil. Although this exchange was only created in 1985, it was the 8th largest exchange by 2001, with 98 million contracts traded. There are also many other commodity exchanges operating in Brazil, spread throughout the country. Argentina's futures market Mercado a Termino de Buenos Aires, founded in 1909, ranks as the world's 51st largest exchange. Mexico has only recently introduced a futures exchange to its markets. The Mercado Mexicano de Derivados (Mexder) was launched in 1998.
2.3 Evolution of the commodity market in India
Bombay Cotton Trade Association Ltd., set up in 1875, was the first organised futures market. Bombay Cotton Exchange Ltd. was established in 1893 following the widespread discontent
amongst leading cotton mill owners and merchants over functioning of Bombay Cotton Trade Association. The Futures trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali, which carried on futures trading in groundnut, castor seed and cotton. Futures trading in wheat was existent at several places in Punjab and Uttar Pradesh. But the most notable futures exchange for wheat was chamber of commerce at Hapur set up in 1913. Futures trading in bullion began in Mumbai in 1920. Calcutta Hessian Exchange Ltd. was established in 1919 for futures trading in rawjute and jute goods. But organised futures trading in raw jute began only in 1927 with the establishment of East Indian Jute Association Ltd. These two associations amalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct organised trading in both Raw Jute and Jute goods. Forward Contracts (Regulation) Act was enacted in 1952 and the Forwards Markets Commission (FMC) was established in 1953 under the Ministry of Consumer Affairs and Public Distribution. In due course, several other exchanges were created in the country to trade in diverse commodities.
2.3.1 The Kabra committee report
After the introduction of economic reforms since June 1991 and the consequent gradual trade and industry liberalisation in both the domestic and external sectors, the Government of India appointed in June 1993 a committee on Forward Markets under chairmanship of Prof. K.N. Kabra. The committee was setup with the following objectives:
1. To assess
(a) The working of the commodity exchanges and their trading practices in India and to make suitable recommendations with a view to making them compatible with those of other countries (b) The role of the Forward Markets Commission and to make suitable recommendations with a
view to making it compatible with similar regulatory agencies in other countries so as to see how effectively these agencies can cope up with the reality of the fast changing economic scenario.
2. To review the role that forward trading has played in the Indian commodity markets during the last 10 years.
3. To examine the extent to which forward trading has special role to play in promoting exports. 4. To suggest amendments to the Forward Contracts (Regulation) Act, in the light of the
recommendations, particularly with a view to effective enforcement of the Act to check illegal forward trading when such trading is prohibited under the Act.
5. To suggest measures to ensure that forward trading in the commodities in which it is allowed to be operative remains constructive and helps in maintaining prices within reasonable limits.
6. To assess the role that forward trading can play in marketing/ distribution system in the commodities in which forward trading is possible, particularly in commodities in which resumption of forward trading is generally demanded.
The committee submitted its report in September 1994. The recommendations of the committee were as follows:
• The Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act, 1952, would need to be strengthened.
• Due to the inadequate infrastructural facilities such as space and telecommunication facilities the commodities exchanges were not able to function effectively. Enlisting more members, ensuring capital adequacy norms and encouraging computerisation would enable these exchanges to place themselves on a better footing.
• In-built devices in commodity exchanges such as the vigilance committee and the panels of surveyors and arbitrators be strengthened further.
• The FMC which regulates forward/ futures trading in the country, should continue to act a watch-dog and continue to monitor the activities and operations of the commodity exchanges. Amendments to the rules, regulations and bye-laws of the commodity exchanges should require the approval of the FMC only.
• In the context of globalisation, commodity markets in India could not function effectively in an isolated manner. Therefore, some of the commodity exchanges, particularly the ones dealing in pepper and castor seed, be upgraded to the level of international futures markets.
• The majority of me committee recommended that futures trading be introduced in the following commodities:
1. Basmatirice 2. Cotton and kapas 3. Raw jute and jute goods
4. Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed, copra and soybean, and oils and oilcakes of all of them.
5. Rice bran oil
6. Castor oil and its oilcake 7. Linseed
8. Silver 9. Onions
The liberalised policy being followed by the government of India and the gradual withdrawal of the procurement and distribution channel necessitated setting in place a market mechanism to perform the economic functions of price discovery and risk management.
The national agriculture policy announced in July 2000 and the announcements in the budget speech for 2002-2003 were indicative of the governments resolve to put in place a mechanism of futures trade/market. As a follow up, the government issued notifications on 1.4.2003 permitting futures trading in the commodities, with the issue of these notifications futures trading is not prohibited in any commodity. Options trading in commodity is, however presently prohibited.
2.3.2 Latest developments
Commodity markets have existed in India for a long time. Table 2.3 gives the list of registered commodities exchanges in India. Table 2.2 gives the total annualised volumes on various exchanges. While the implementation of the Kabra committee recommendations were rather slow, today, the commodity derivative market in India seems poised for a transformation. National level commodity derivatives exchanges seem to be the new phenomenon. The Forward Markets Commission accorded in principle approval for the following national level multi commodity exchanges. The increasing volumes on these exchanges suggest that commodity markets in India seem to be a promising game.
• National Board of Trade
• Multi Commodity Exchange of India
• National Commodity & Derivatives Exchange of India Ltd Table 2.2 Volume on existing exchanges
Commodity exchange Products Approx. annual vol
(Rs.Crore)
National board of trade, Indore Soya, mustard 80000
National multicommodity exchange, Ahmedabad Multiple 40000
Ahmedabad commodity exchange Castor, cotton 3500
Rajdhani Oil & oilseeds Mustard 3500
Vijai Beopar Chamber Ltd. Muzzaffarnagar Gur 2500
Rajkot seeds, oil & bullion exchange Castor, groundnut 2500
IPSTA, Cochin Pepper 2500
Chamber of commerce, Hapur Gur, mustard 2500
Bhatinda Om and oil exchange Gur 1500
Other (mostly inactive) 1500
Table 2.3 Registered commodity exchanges in India
Exchange Product traded
Bhatinda Om & Oil Exchange Ltd. Gur
The Bombay Commodity Exchange Ltd. Sunflower oil
Cotton (Seed and oil)
Safflower (Seed, oil and oil cake) Groundnut (Nut and oil)
Castor oil, Castorseed Sesamum (Oil and oilcake) Rice bran, rice bran oil and oilcake Crude palm oil
The Rajkot Seeds oil & Bullion Merchants Association, Ltd.
Groundnut oil Castorseed
The Kanpur Commodity Exchange Ltd. Rapeseed/ Mustardseed oil and cake The Meerut Agro Commodities Exchange Co. Ltd. Gur
The Spices and Oilseeds Exchange Ltd.Sangli Turmeric
Ahmedabad Commodities Exchange Ltd. Cottonseed, Castorseed Vijay Beopar Chamber Ltd., Muzaffarnagar Gur
India Pepper & Spice Trade Association, Kochi Pepper
Rajdhani Oils and Oilseeds Exchange Ltd., Delhi Gur, Rapeseed/ Mustardseed Sugar Grade-M
National Board of Trade, Indore Rapeseed/ Mustard seed/ Oil/ Cake Soybean/ Meal/ Oil, Crude Palm Oil
The Chamber of Commerce, Hapur Gur, Rapeseed/ Mustardseed
The East India Cotton Association, Mumbai Cotton The Central India Commercial Exchange Ltd., Gur The East India Jute & Hessian Exchange Ltd.,
Kolkata
Hessian, Sacking
First Commodity Exchange of India Ltd., Kochi Copra, Coconut oil & Copra cake The Coffee Futures Exchange India Ltd., Bangalore Coffee
National Multi Commodity Exchange of India Limited, Ahmedabad
Gur, RBD Pamohen Crude Palm Oil, Copra
Rapeseed/ Mustardseed, Soy bean Cotton (Seed, oil, oilcake) Safflower (seed, oil, oilcake) Groundnut (seed, oil, oilcake) Sugar, Sacking, gram Coconut (oil and oilcake) Castor (oil and oilcake)
Sesamum (Seed,oil and oilcake) Linseed (seed, oil and oilcake) Rice Bran Oil, Pepper, Guarseed Aluminium ingots, Nickel, tin Vanaspati, Rubber, Copper, Zinc, lead National Commodity & Derivatives Exchange
Limited
Soy Bean, Refined Soy Oil Mustard Seed
Expeller Mustard Oil
RBD Palmolein Crude Palm Oil Medium Staple Cotton
Long Staple Cotton Gold, Silver
Solved Problems
Q: Which of the following feature differentiates a commodity futures contract from a financial
futures contract?
1. Exchange traded product 3. MTM settlement
2. Standardised contract size 4. Varying quality of underlying asset
A: The correct answer is number 4. •
•
Q: Physical settlement involves the physical delivery of the underlying commodity at
1. an accredited warehouse 3. the buyers requested destination
2. the exchange 4. None of the above
A: The correct answer is number 1 •
•
Q: Typically, in all commodity exchanges, delivery notice is required to be supported by a
1. Letter of credit 3. Undertaking
2. Warehouse receipt 4. Advance payment
A: The correct answer is number 2. •
•
Q: Who identifies the buyer to whom the delivery notice is assigned?
1. The exchange 3. The warehouse
2. The clearing corporation 4. The seller
A: The correct answer is number 2. •
•
Q: Which of the following exchanges do not offer commodity derivatives trading?
1. National Commodity Derivative Exchange 3. National Board of Trade 2. Multi Commodity Exchange of India 4. National Stock Exchange
Q: On the NCDEX ___
1. The clearing house assigns delivery to the 3. The buyer chooses which delivery to take buyer
4. The warehouse assigns the delivery to the 2. The seller assigns delivery to the buyer buyer
A: The correct answer is number 1. ••
Q: The ____ committee recommended that the Forward Markets Commission(FMC) and the
Forward
Contracts (Regulation) Act, 1952, need to be strengthened.
1. L C Gupta Committee 3. Khusro Committee
2. Kabra Committee 4. J R Varma Committee
The NCDEX platform
National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. It is a public limited company registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. It has been launched to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.
NCDEX is regulated by Forward Markets Commission in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working. It is located in Mumbai and offers facilities to its members in about 91 cities throughout India at the moment.
NCDEX currently facilitates trading of ten commodities - gold, silver, soy bean, refined soy bean oil, rapeseed-mustard seed, expeller rapeseed-mustard seed oil, RBD palmolein, crude palm oil and cotton - medium and long staple varieties. At subsequent phases trading in more commodities would be facilitated.
3.1 Structure of NCDEX
NCDEX has been formed with the following objectives:
• To create a world class commodity exchange platform for the market participants. • To bring professionalism and transparency into commodity trading.
• To inculcate best international practices like de-modularization, technology platforms, low cost solutions and information dissemination without noise etc. into the trade.
• To provide nation wide reach and consistent offering. • To bring together the entities that the market can trust.
3.1.1 Promoters
NCDEX is promoted by a consortium of institutions. These include the ICICI Bank Limited (ICICI Bank), Life Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE). NCDEX is the only commodity exchange in the country promoted by national level institutions. This unique parentage enables it to offer a variety of benefits which are currently in short supply in the commodity markets. The four institutional promoters of NCDEX are prominent players in their respective fields and bring with them institution building experience, trust, nationwide reach, technology and risk management skills.
3.1.2 Governance
NCDEX is run by an independent Board of Directors. Promoters do not participate in the day to day activities of the exchange. The directors are appointed in accordance with the provisions of the Articles of Association of the company. The board is responsible for managing and regulating all the operations of the exchange and commodities transactions. It formulates the rules and regulations related to the operations of the exchange. Board appoints an executive committee and other committees for the purpose of managing activities of the exchange.
The executive committee consists of Managing Director of the exchange who would be acting as the Chief Executive of the exchange, and also other members appointed by the board.
Apart from the executive committee the board has constitute committee like Membership committee, Audit Committee, Risk Committee, Nomination Committee, Compensation Committee and Business Strategy Committee, which, help the Board in policy formulation.
3.2 Exchange membership
Membership of NCDEX is open to any person, association of persons, partnerships, co-operative societies, companies etc. that fulfills the eligibility criteria set by the exchange. All the members of the exchange have to register themselves with the competent authority before commencing their operations. The members of NCDEX fall into two categories, Trading cum Clearing Members (TCM) and Professional Clearing Members (PCM).
3.2.1 Trading cum clearing members (TCMs)
NCDEX invites applications for Trading cum Clearing Members (TCMs) from persons who fulfill the specified eligibility criteria for trading in commodities. The TCM membership entitles the members to trade and clear, both for themselves and/ or on behalf of their clients. Applicants accepted for admission as TCM are required to pay the required fees/ deposits and also maintain net worth as given in Table 3.1.
Table 3.1 Fee/ deposit structure and networth requirement: TCM
Particulars (Rupees in Lakh) Interest free cash security deposit
Collateral security deposit Annual subscription charges Advance minimum transaction charges Net worth requirement 15.00 15.00 0.50 0.50 50.00
Table 3.2 Fee/ deposit structure and networth requirement: PCM
Particulars (Rupees in Lakh) Interest free cash security deposit
Collateral security deposit Annual subscription charges Advance minimum transaction charges Net worth requirement 25.00 25.00 1.00 1.00 5000.00
3.2.2 Professional clearing members (PCMs)
NCDEX also invites applications for Professional Clearing Membership (PCMs) from persons who fulfill the specified eligibility criteria for trading in commodities. The PCM membership entitles the members to clear trades executed through Trading cum Clearing Members (TCMs), both for themselves and/ or on behalf of their clients. Applicants accepted for admission as PCMs are required to pay the following fee/ deposits and also maintain net worth as given in Table 3.2.
3.3 Capital requirements
NCDEX has specified capital requirements for its members. On approval as a member of NCDEX, the member has to deposit Base Minimum Capital (BMC) with the exchange. Base Minimum Capital comprises of the following:
1. Interest free cash security deposit 2. Collateral security deposit
All Members have to comply with the security deposit requirement before the activation of their trading terminal. Members can opt to meet the security deposit requirement by way of the following:
• Cash: This can be deposited by issuing a cheque/ demand draft payable at Mumbai in favour of National Commodity & Derivatives Exchange Limited.
• Bank guarantee: Bank guarantee in favour of NCDEX as per the specified format from approved banks. The minimum term of the bank guarantee should be 12 months.
• Fixed deposit receipt: Fixed deposit receipts (FDRs) issued by approved banks are accepted. The FDR should be issued for a minimum period of 36 months from any of the approved banks.
• Government of India securities: National Securities Clearing Corporation Limited (NSCCL) is the approved custodian for acceptance of Government of India securities. The securities are valued on a daily basis and a haircut of 25% is levied.
Members are required to maintain minimum level of security deposit i.e. Rs.15 Lakh in case of TCM and Rs. 25 Lakh in case of PCM at any point of time. If the security deposit falls below the minimum required level, NCDEX may initiate suitable action including withdrawal of trading facilities as given below:
• If the security deposit shortage is equal to or greater than Rs. 5 Lakh, the trading facility would be withdrawn with immediate effect.
• If the security deposit shortage is less than Rs.5 Lakh the member would be given one calendar weeks' time to replenish the shortages and if the same is not done within the specified time the trading facility would be withdrawn.
Members who wish to increase their limit can do so by bringing in additional capital in the form of cash, bank guarantee, fixed deposit receipts or Government of India securities.
3.4 The NCDEX system
As we saw in the first chapter, every market transaction consists of three components - trading, clearing and settlement. This section provides a brief overview of how transactions happen on the NCDEX's market.
3.4.1 Trading
The trading system on the NCDEX, provides a fully automated screen-based trading for futures on commodities on a nationwide basis as well as an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. The trade timings of the NCDEX are 10.00 a.m. to 4.00 p.m. After hours trading has also been proposed for implementation at a later stage.
The NCDEX system supports an order driven market, where orders match automatically. Order matching is essentially on the basis of commodity, its price, time and quantity. All quantity fields are in units and price in rupees. The exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities . The exchange notifies the regular lot size and tick size for each of the contracts traded from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and gets
