As a first step, regulators authorized intermediaries in the commodities market to be securities brokers. When the intermediaries became securities market participants, the second logical step was taken by allowing commodity derivatives to be traded on the existing stock exchanges such as the NSE and the BSE. While the former process was completed in 2017, the latter was activated in 2018. Meanwhile, regulators appointed the Commodity Derivatives Advisory Committee, which set out a roadmap for the growth and development of India’s commodity derivatives markets.
Commodity futures options were the first products of this type to hit the market. Index futures and options on commodities were also permitted. New participants such as bank subsidiaries – i.e. their securities departments – were admitted by the central bank. Foreign companies in India have been authorized to hedge. The regulator had also streamlined the risk management mechanism to boost confidence. Despite multiple efforts, growth remains confined to a few commodities/instruments with limited institutional involvement. Actively traded commodities have declined significantly.
As the custodians provide commodity/derivatives related services to domestic institutional participants, they have started to explore participation strategies. . However, their participation was limited to a few global commodities. While this is an excellent start, DII (domestic institutional investors) involvement must extend to all non-sensitive commodities.
Markets have been in turmoil since 2020 due to pandemic-related supply shortages. Additionally, central bank actions have also exacerbated volatility conditions. However, volatility made trading options on commodity futures attractive, helped by the lower Transaction Tax (CTT).
An analysis of the volumes in the underlying commodity futures contracts shows that the growth in options outweighed futures volumes. For example, crude oil options volume was up an estimated 24 percent, while underlying futures volumes from May 2020 to February 2022 were up a meager 3 percent month-on-month.
While growth in metals futures has yet to gain momentum since settlement mode went physical, options on metals futures have gained traction. In essence, this means that the efficiency of price discovery in the underlying futures markets has moved downwards. Options on the futures markets require a solid foundation of liquid futures that allows risk premiums to be calculated efficiently. The political instability in soft commodity futures had led to dwindling participant interest.
In an effort to allow farmers to participate and have the underlying raw material delivered directly, options on raw materials have been introduced with the necessary legal changes. However, options trading has not yet reached the desired level. Active participation by option writers in this segment would be crucial. Who can write better than banks and institutions? Disclosures from major MIIs (Market Infrastructure Institutions) show that despite various measures, hedger involvement has not increased significantly over the past three years. Month-on-month data shows that futures segment open interest fell 8 percent from June 2020 to March 2022. The reasons for the poor hedging culture can range from awareness to a lack of peer pressure.
set of restrictions
The agricultural/non-agricultural commodity derivatives markets have their own limitations. In the metals markets, strong physical market participation is essential to be seriously discounted in the global markets. The agricultural segment not only suffers from limited stakeholder participation, but also receives no support from either side. In addition, commodity derivatives markets require derivative contracts to have high participation, resulting in low indirect participation costs. The direct costs of participation should be significantly reduced if politicians reconsider the “sales tax”.
The crude oil market is slipping into negative territory in 2020 and the nickel squeeze in early March 2022 shows that commodity markets are vulnerable to run-ons. Global regulators need to reform their regulatory regime to prevent a repeat. A repetition should take away the confidence of the participants. The 15 percent cumulative drop in daily nickel derivatives (early March 2022 to late April 2022) is evidence enough.
Banks play a critical role in delivering unbiased and robust research, empowering participants and enhancing information convergence. The Indian metal market in particular, with its not quite as pronounced futures curves, could be redesigned if banks got involved.
To the extent that commodities serve as good portfolio diversifiers, pension/insurance regulators should consider their involvement, and markets must also evolve to accommodate them. The next phase of commodity market growth should involve the introduction of innovative products and newer commodities. The streamlining of the tax system and the entry of missing institutions are crucial to propel the markets into the next orbit.
The authors are with the National Institute of Securities Markets. Views are personal
Published on
June 05, 2022
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