Evolution of Derivative in India

1. Introduction
Derivative products initially emerged as hedging devices against fluctuations in stock and
commodity prices, and financial and commodity-linked derivatives remained the sole form of
such products for almost three hundred years. By defining the term precisely, 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.
Financial derivatives came into spotlight in the post-1970 period due to growing instability in the
financial markets1. 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--vis derivative
products based on individual securities is another reason for their growing use.

2. Financial Derivatives in India

A liquid market for forward foreign exchange contracts has existed in India for several decades
now. This product is still the main instrument for hedging foreign exchange risk in India,
although foreign currency options are also getting increasingly popular. Over the last 10 years or
so, several other types of derivatives have begun trading in India. As you are aware, efforts are
on for introduction of credit derivatives in India. Feasibility probes for foreign exchange futures
have begun. Efforts are also on for an appropriate design for interest rate futures. In the recent
years, the regulatory ecosystem for financial derivatives has been sought to be made more
effective and straight forward. Insertion of a new Chapter IIID to the RBI Act, 1934 by way of
an amendment in 2006 has been a milestone in this regard, since this has provided legal clarity as
regards OTC derivatives and has also defined regulatory domain and scope. Accounting
treatment of financial derivatives in banks is also being streamlined so as to be broadly in tune
with international standards.
L. C. Gupta committee (1998) came out with the major recommendations on the parlance of
financial derivative in India. In post-liberalization, the committee was in favour of that futures
trading through derivatives should be introduced in phased manner starting with stock index
1

To mitigate the three risks, precisely, exchange rate risk, interest rate risk, and equities/market risk (systematic
risk).

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futures, which will be followed by options on index and later options on stock. This, in turn, will
expedite the efficiency and liquidity of cash markets in equities through arbitrage process.
In continuation of the report, there should be two-level regulation, i.e. one at exchange level and other is at
SEBI level (for financial derivatives). Further there must be considerable emphasis on self regulatory
competence of derivative exchanges under the overall supervision and guidance of SEBI. The derivative
trading should be initiated on a separate segment of existing stock exchange having an independent
governing council. The number of the trading members should be limited to 40 percent of the total
members. The chairman of the governing council will not be permitted to trade on any of the stock
exchange. The settlement of derivatives will be through an independent clearing corporation (e.g. National
Securities Clearing Corporation of India Limited, (NSCCL) looks after the settlement issue in India) house,
which will become counter-party for all trades or alternatively guarantees the settlement of all trades. The
clearing corporation will have adequate risk containment measure (four-sigma level at Value at Risk, 99%
level of Confidence of Interval) and with collect margins through electronic fund transfer (EFT). The
derivatives exchange will have on line trading and adequate surveillance system. It will disseminate trade
and price information on real time basis through two information vending networks which should inspect
100 percent of members every year. There will be complete segregation of client money at the level of
trading/clearing member level and even at the level of clearing corporation. The clearing members should
deposit minimum Rs 50 lakhs with clearing corporation (both for trading cum clearing member (TCM) and
permanent clearing member (PCM) and should have a net worth of rs.3 crore. Committee raised the point
for the removal of the regulatory prohibition on the use of derivatives by mutual funds while making the
trustees responsible to restrict the use of derivatives by mutual funds only to hedging and portfolio
balancing and not for restriction. The operations of the cash market on which the derivatives market will be
based, needed improvement in many areas. The committee asked for the creation of a derivative cell, a
Derivative Advisory Committee, and Economic Research wing by SEBI and the declaration of Derivatives
as securities under Section 2 (h) of the SC(RA) and suitable amendments in the notification issued by the
central Government in June, 1969 under Section 16 of the SCRA (Gupta, 2005, pp.121-122).

2.1. Categories of Derivatives Traded in India

Commodities futures for coffee, oil seeds, and oil, gold, silver, pepper, cotton, jute and jute
goods are traded in the commodity futures. FMC regulates the trading of commodities futures
and controls the trading nuances for 21 regional level exchanges including 3 national level multi
commodity exchanges.
Index futures based on Sensex and NIFTY index are also traded under the supervision of SEBI.
The RBI has permitted banks, and primary dealers (PDs, although before 2007 regulation being
ratified on futures market, financial institutions were permitted) to enter into forward rate
agreement (FRAs)/interest rate swaps in order to facilitate hedging of interest rate risk and
ensuring orderly development of the derivatives markets.
The National Stock Exchange (NSE) became the first exchange to launch trading in options on
individual securities apart from index futures/options. Trading in options on individual securities
commenced from July, 2001. Options contracts are American style and cash settled and are
available in about 40 securities stipulated by SEBI.
The NSE commenced trading in futures on individual securities on November 9, 2001. The
futures contracts are available in about 31 securities stipulated by SEBI. The BSE also started
trading in stock options and futures (both index and stocks) around at the same time as the NSE.

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The NSE commenced trading in interest rate future on June 2003. Interest rate futures contracts
are available on 91-day T-bills, 10-year bonds, and 10-year zero coupon bonds as specified by
the SEBI.
There are other schemes and categories of derivatives like exchange traded bonds, options and
currency futures to be introduced subsequently on futures trading platform. A notable change
observed in the year of 2008 is about currency futures which were commenced on August 29,
2008.
CME (Chicago Mercantile Exchange) created the first financial futures in 1972 when it offered a futures
contract between the dollar and seven currencies. It is, therefore, interesting to notice that Indian
Commodity Exchanges have also lined up to offer currency derivatives trading. But the success of the
trading will depend on the market microstructure and how it evolves over timethe first issue is the link
between the existing OTC market and the exchange-traded futures market that is about to kick off soon.
While the OTC market will understandably continue to dominate in volume terms, the first-cut structure of
the futures market seems to indicate that fetters have already been put on its growth. The nuance behind it
is participants in the exchange cant keep an open position larger than $5 million, a small limit compared to
the typical hedging needs of those with currency exposures. While speculators provide the liquidity and
efficient price discovery to any market, their role will be constrained by the predominance of the OTC
market and the apprehension of illiquidity in the futures market. Second, the report of technical committee
on exchange traded currency futures ahs prescribed that trading hours be restricted between 9 am to 5 pm.
Apart from raising financial questions about why the committee should be bothering about this issue, and
not leaving it to the discretion of exchange, it also displays the regulators determination to keep its control
over even the futures market. The OTC market is largely a telephone-quote driven market, dominated by
banks. The RBI typically uses one of the large public sector banks to send its currency signals through this
market, despite all claims of allowing the rupee to float freely. With markets closing simultaneously and
the OTC markets signaling role dominating, the futures markets will have to necessarily follow, and not
leadthird, the market has forbidden entry to non-resident Indians and foreign institutional investors
(FIIs). Most overseas investors, especially portfolio investors, have turned to the Singapore-based nondeliverable forwards market to hedge their investments in India. The regulators have looked as this offshore
market has grown in size. That begs the question: is there a future for the currency futures market, without
full convertibility or without round-the-clock trading? (Singhal, 2008: adapted from ET, under the editorial
column, Future of Currency Futures: Serendipity)

TABLE 1: Calendar of Introduction of Derivatives Products in Indian Financial Markets

OTC
Exchange traded
June, 2000-Equity index futures
1980s-Currency forwards
1997-Long term foreign currency, rupee June, 2001-Equity index options
swaps
July, 2001-Stock option
July, 1999-Interest rate swaps and FRAs
June, 2003-Interest rate futures
July, 2003-FC-rupee options
August, 2008-Currency futures
Source: www.derivativesportal.com

TABLE 2: Financial Derivatives in India: A Chronology

Date
Progress
NSE asked SEBI for permission to trade
14 December, 1995
futures
SEBI setup L.C.Gupta committee to draft a
18 November, 1996
policy framework for index futures
L.C.Gupta committee submitted report
11 May, 1998
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7 July, 1999
24 May, 2000
25 May, 2000
9 June, 2000
12 June, 2000
31 August, 2000
July, 2001
June, 2003
July, 2003
August, 2008

RBI gave permission for OTC forward rate

agreement (FRAs) and interest rate swaps
SIMES chose NIFTY for trading futures and
options on an Indian index
SEBI gave permission to BSE and NSE to do
index futures trading
Trading of BSE sensex futures commenced at
BSE
Trading of NIFTY futures commenced at NSE
Trading of futures and options on NIFTY to
commence at SIMES
Trading on equity futures commenced at NSE
on 31 securities
Trading on interest rate futures commenced at
NSE
Trading on FC-rupee options started
Currency Futures derivatives- mooted on the
platform of SEBI, RBI, BSE, and NSE

3. Evolution of Financial Derivatives in India

The most praiseworthy development in the history of secondary segment of the Indian Stock
market is the commencement of derivatives trading in June, 2000. The SEBI approved
derivatives trading based on futures contract at National Stock Exchange (NSE) and Bombay
Stock Exchange (BSE) in accordance with bye-laws/rules and regulations of the stock
exchanges. To begin with, the SEBI permitted equity derivatives named stock index futures,
which was introduced on BSE on 9 June, 2000 based on the sensitive index (also referred to as
SENSEX comprising 30 scripts) named BSX, and NSE started on June 12, 2000 stock index
future based on its S&P 500, CNX, NIFTY (comprised 50 scripts) in the name of
NFUTIDXNIFTY. Further the details are furnished as under (Gupta, 2005; Sinha, and Nath,
2001).
TABLE 3: Salient features of Index Futures Contract at BSE and NSE
S. No. Particulars
BSE
Date of commencement
9 June 2000
1
Name of Security
BSX
2
Underlying asset
BSE Sensitive index
3
(SENSEX)
Contract size
Sensex value50
4
5

Tick size/price step

6
7

Minimum Price fluctuation

Price bands

NSE
12 June 2000
N FUTIDX NIFTY
S&P CNX NIFTY

200 or multiples of
200
0.1 point of Sensex Rs.0.05
(equivalent to Rs.5)
Rs.5
Not applicable
NA
Not applicable
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8
9

Expiration months
Trading cycle

10

Last trading/Expiry day

11

Settlement

Index closing price on

last trading day which
is computed on the
basis of the weighted
average of last 15
min. trading.
Daily Settlement price (DSP)
Closing of futures
13
contract which is
computed on the basis
of weighted average
of the last 5 min, or if
the no. of weighted
average of the last 5
trades.
Trading hours
9:30 am to 3:30 pm
14
Margin
Upfront margin on
15
daily basis
Source: NSE and BSE weblinks, www.nseindia.com and www.bse.com
12

Final Settlement price (FSP)

3-near months
A maximum of 3
months, the near
month (1), the next
month (2), the a
month (3)
Last Thursday of the
month
or
the
preceding day
In cash on T+1 basis

3-near months
As
in
previous
column

As
in
column

previous

As
in
previous
column
Index closing price on
1st trading day which
is weighted average
for the last half an
hours trade.
Closing
contract

of

As
in
column

futures

previous

4. Commodity Derivatives in India

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.

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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 favorable 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.
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 purview of Securities Exchange Board of India (SEBI).
We thus have separate regulatory authorities for securities and commodity derivative markets.

5. History of commodity derivatives: world sketch

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 centralized 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
reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange
(CME). The CBOT and the CME remain the two largest organized 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.

6. Evolution of commodity derivatives in India: a time line

Commodity Derivative markets were set up in India in cotton in 1875 and in oilseeds in 1900 at
Bombay. Forward trading in raw jute and jute goods started at Calcutta in 1912. Forward
Markets in Wheat had been functioning at Hapur since 1913, and in bullion at Bombay, since
1920. In 1919, the government of Bombay passed Bombay Contract Control (War Provision)
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Act and set up the Cotton Contracts Board. With a view to restricting speculative activity in
cotton market, the Government of Bombay issued an Ordinance in September 1939 prohibiting
option business. Bombay Options in Cotton Prohibition Act, 1939, later replaced the Ordinance.
In 1943, the Defence of India Act was utilized on a large scale for the purpose of prohibiting
forward trading in some commodities and regulating such trading in others on an all India basis.
In the same year oilseeds forward contracts prohibition order was issued and forward contracts in
oilseeds were banned. Similarly orders were issued banning forward trading in food-grains,
spices, vegetable oils, sugar and cloth. These orders were retained with necessary modifications
in the Essential Supplies Temporary Powers Act 1946, after the Defence of India Act had lapsed.
With a view to evolving the unified systems of Bombay enacted the Bombay Forward Contract
Control Act, 1947.

6.1. Committee on Forward and Futures Markets: Review (1952-2001)

The Government of India appointed various committees at different time to look into the
regulatory framework of futures trading in the country. Tracing to different committees, in 1950,
the Indian Government appointed the A.D. Shroff committee whose report formed the basis of
Forward Contracts (Regulations) Act, 1952. In 1966, the M.L. Dantwala Committee reviewed
the SCR Act and the functioning of the Forward Markets (FMC, 1953). Further, in 1993, GOI
constituted the committee, K.N.Kabra Committee which submitted its report in September, 1994
with the noted recommendations.
The commodity exchanges should enroll more members. Capital adequacy norms must be ensured for
smooth functioning. The commodity exchanges should be computerized to accommodate on-line trading
other than open outcry. Internal vigilance mechanism of the exchanges should be strengthened (circuit
breakers). Non-transferable specific delivery forward contracts should be freed from restrictions. Option
and range forward contracts may be introduced. However, this was not agreed by the Chairman of the
committee. The exchanges should be recognized on permanent basis. The exchanges should be developed
into self-regulatory organizations. The Forward Markets Commission should be strengthened with more
powers including formation of statutory body of board of Directors. More commodities should be included
in futures trading like basmati rice, cotton seed, ground nut, rapeseed, linseed, copra, sesame seed, mustard
seed, soybean, etc. (Gupta, 2005: pp.156).

At the same time, in 1994, another committee was constituted under the chairmanship of
O.P.Sodhani on foreign exchange markets functioning. The reason behind the formation owing
to the forward contracts and options on foreign exchange are conducted through over-the-counter
(OTC) markets and regulated by RBI.
The companies should be given permission to book, cancel, and rebook options on foreign currencies.
Banks should offer range forward contracts. There should be no withholding taxes on derivatives
transactions. More liberty should be given to banks to use derivatives. More derivatives instruments like
caps, dollars, floors, FRAs, swaps should be allowed to offer by the banks to the traders without approval
of RBI. Different specific dealers should be allowed to offer derivatives instruments. Proper documentation
and market practices should be evolved for better functioning of the markets (Gupta, 2005: pp.157).

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After almost three years, RBI set up a committee under the aegis of R.V.Gupta (1997) to review
Hedging through International Commodity Exchanges and other related issues. The
committees main recommendations are as under.
All the Indian companies with genuine commodity price risk exposures are to be allowed to hedge through
off shore commodity futures and option markets. The Central Government should grant permission for such
hedging transactions and the RBI should grant the necessary exchange control permission. Only hedging
contracts for genuine price exposure through international markets should be allowed, not the speculative
or profit seeking objectives. OTC instruments like vanilla swaps would only be permitted where they have
only efficient means of hedging. Use of options would not be allowed. The committee recommended a
phased manner approach. In Phase-I, the hedging should ordinarily be through exchange traded commodity
futures. Phase I would be a period of acclimatization. At this stage prior approval would be required to
ensure existence of genuine underlying risk, the appropriateness of the hedging instrument, and
adequateness of risk management procedures. In Phase-II, no prior approval, as recommended in Phase-I
should be needed. Only periodic scrutiny of actual transactions and auditors adequacy of control are
sufficient. The committee further recommends that hedging should be allowed through foreign derivatives
markets (Gupta, 2005: pp.157).

In India, stock index futures are available for one-month, two month and three month maturities.
All the open positions in these contracts are settled daily. Further, the buyers and sellers are
required to deposit margin (initial and maintenance margin if required) with the respective stock
exchanges as per the SEBI guidelines. To facilitate the effective risk management in the
derivatives segment, all the important measures like minimum net worth (50 lakh to 25 lakh
including PCM and TCM, NCDEX, 2003) requirement for the broker, determination of margin
based on value at risk model, position limit for various participants, mechanism for collection
and enforcement of margin, etc. have been put in place. Subsequently, the derivative products
range had been increased by including options and futures on the indices and on several highly
traded stocks. In an estimate, the product wise turnover of derivatives on the Indian stock
markets as on July 6, 2002 is stock futures (50%), index futures (21%), stock options (25%), and
index options (4%) showing that stock futures are most popular derivative traded at the stock
market of India.
During the last decade, to make stock market functioning effective for futures trading, the SEBI
has adopted several internationally tested and accepted mechanisms for implementation at the
Indian stock exchanges. For this, surveillance and risk containment like the circuit breaker, price
bands, value at risk (VaR) based margin collections, etc. have been introduced.
The SEBI set up a Technical Group headed by Prf. J.R. Verma, IIM-Ahmedabad (1996) to
prescribe risk containment measures for new derivative products. The group recommended the
introduction of exchange traded options on indices which is also conformity with the sequence of
introduction of derivatives products recommended by the standing committee. The following are
the salient features of the risk containment framework for the trading and settlement of both
index futures and index options contracts.
European style options will be permitted initially. These will be settled in cash. Index option contracts will
have a minimum contract size of Rs. 2 lakh, at the time of its introduction. The risk containment measures
described hereunder are only for premium style European option. Index option contract will have a

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maximum maturity of 12 months and a minimum of three strikes, i.e. in the money, near the money and out
of the money. A portfolio based margining approach, which would take an integrated view of the risk
involved in the portfolio of individual client, will be adopted. It is for the first time that such an approach is
introduced in the Indian Stock market. It is inconsistent with the practices followed in the countries. This
approach will not only cover the risk but also help in reducing the transaction costs in derivatives. The
initial margin requirements will be based on worst case loss of a portfolio of an individual client to cover a
99% value at risk (VaR) over a one day horizon. The initial margin requirement will be netted at level of
individual client and it will be on gross basis at the level of trading/clearing member. Further, the initial
margin requirement for the proprietary position of trading/clearing member will also be on net basis. The
short option minimum margin equal to 30% of the notional value of all short index options will be charged
if sum of the worst scenario loss and the calendar spread margin is lower than the short option minimums
margin. Net option value (strike price minus exchange rate minus premium or option price, St-K-P or K-StP) will be calculated the option times the number of options (positive for long position and negative for
short position) in the portfolio. The net option value will be added to the liquid net worth (LNW) of the
clearing member (TCM and PCM). For option positions, the premium will be paid in by the buyer in cash
and paid out to the seller in cash on T+1 day until the buyer pays in the premium due shall be deducted
from the available LNW on real time basis. In case of index futures contracts, the mark-to-market (MTM)
gains-losses for index futures positions will continue to be settledSEBIs technical group on new
derivatives products has recently examined this issue and recommended the following measures for the
development of derivatives market. The systems of sub-brokers are to be used for increasing the volume of
trading in this market. Financial institutions and mutual funds should be permitted to sell short in the cash
market for facilitating the free arbitrage between cash and derivatives market. However, such short sale
may be restricted to the extent of corresponding exposure in the derivative market. Arbitrage between cash
and derivatives markets will assist in better price discovery in both the markets (Gupta, 2005: pp.129).

However, the futures markets experts observed that due to lack of experience of the Indian
corporate sector regarding the functioning of international commodity exchanges (CME, CBOT,
LME, NYBoT2 etc.) derivatives and inadequate experience amongst auditors, a longer
acclimatization period of at least three years is desirable instead of one year as recommended
by the committee.
Policy initiatives in commodity markets. The expert committee (Shankarlal Guru committee,
2001) was set up by the Govt. of India, MoA to suggest measure for strengthening and
developing of agricultural marketing system in the country, had made several important
recommendations in the year of 2001 to initiate policy, legal and market infrastructure related
reform programs. MoA constituted an inter-ministerial task force to examine the
recommendations of the above expert committee and to suggest measures to be initiated for
implementation within a period of three months. The inter-ministerial force constituted nine
different sub groups on different aspects to examine the feasibility of implementing
recommendations made by the expert committee. One of the groups was dealt with forward and
futures market (Raipuria et al, 2001; Economic Advisory Group). The salient features of
presented report are as under.
Some insights drawn from the report is a reform packages suggested by Govt. of India and the
FMC on the commodity exchanges, furnished below. (Prior to establishment of electronic
auction-traded exchanges in India)
2

CME-Chicago Mercantile Exchange, CBoT, Chicago Board of Trade, LME, London Mercantile Exchange,
NYBoT, New York Board of Trade (Commex)

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The system of daily mark-to-market (MTM) margining (based on contract specified maintenance margin) is
to improve financial integrity of the markets. The system of simultaneous reporting under which
members/brokers are required to put the transaction slips in a sealed box within fifteen minutes of
execution of transaction. This measure facilitates audit trail and ensures that clients contracts are executed
at a correct price. Trading ring discipline to be ensured by appointing a ring inspector, issuing of badges,
prohibiting the entry of unauthorized persons in pit, surprise checks is to be ensured by exchanges. The
exchanges are to appoint a qualified secretary to look after its day-to-day operation. Representation of
diverse groups like growers, processors, exporters, and importers are included in commodity futures
market. The commodity exchanges are to introduce a system of guaranteeing performance of the contract.
However, the manner in which the contracts would be guaranteed by the exchange or a separate clearing
house/corporation is left to the individual exchanges. Exchanges like IPSTA, BCE have set up independent
clearing houses, which guarantee performance of the contract. Other exchanges have set up, or are in
process of setting up, of Trade Guarantee Fund (TGF) within exchange to guarantee performance of
contracts.
The commodity exchanges are to amend their rules/Articles of Association so as to provide alteast one third
of the total strength of Board of Directors to be independent and non-trading directors. The measure has
been taken to professionalize the Board of exchanges in public interest and in the general trade interest. The
exchanges should be run as public institutions. Adoption of an online trading platform has been a necessary
condition for the exchanges recognized for futures trading in edible oil seed complex (FMC Bulletin, 2002:
pp.211-212).

From trading statistics during the latter half of the nineties volumes (VOT) and value of trading
(NOP) in some of the exchanges had reached reasonable levels while others had been striving
and the summary position is as follows.
TABLE 4: Volume of Trading and Net Open Position of consolidated regional exchanges
(Commodities)
Year
1996-97
1997-98
1998-99
1999-00
2000-01

VoT (Rs. in bn)

313.56
314.79
326.50
228.593
273.80

Source: FMC Bulletin, Vol. XLIV (1), Jan 2002

6.2. Progress in Indian Commodity Markets (1999-2001): Summing Up

The four exchanges which were recognized for edible oil seed complex like BCE, Mumbai,
NBoT, Indore, Kanpur commodity exchange, Kanpur, First commodity exchange, Kochi have
assured to go online in stipulated time-frame. The commission has been adopting a persuasive
approach by impressing them the need of switching over to online trading platform. BCE has
already introduced online trading, East India Cotton Association (EICA), and India Pepper and
Spice trade association (IPSTA) have made substantial progress in this direction (shown in
Annexure 1 & 2).

The drastic decline in value of trading in 1999-2000 was mainly on account of the reduced trading at the Jute
Exchange at Kolkata (dropped from Rs. 5022 to Rs.1234 mn) and castor seed exchange at Ahmedabad (decreased
from Rs. 6854 to Rs. 5220mn); refer to FMC Bulletin, Vol. XLIV (1), Jan 2002.

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Many exchanges have developed software for their back office operations and provided e-mail
connectivity. All the commodities are not suited for futures trading, for a commodity to be
suitable for futures trading it must possess the following characteristics, the commodity should
have a suitable demand and supply conditions, i.e. volume (production) and marketable surplus
should be large; price should be volatile to necessitate hedging through future trading, in this
case persons with spot market commitment face a price risk. Resulting there would be demand
for hedging facilities. The commodity should be free from substantial control from Govt.
regulations (or other bodies) imposing restrictions on supply, distribution, and prices of the
commodity. The commodity should be homogeneous (assaying quality, quantity) or alternately it
must be possible to specify standard grade and to measure deviations from the grade. This
condition is necessary for the futures trading in standardized contract. The commodities should
be storable and in absence of this condition arbitrage would not be possible and there would be
no relationship between spot and futures market. Based on the above criteria and as a follow up
of the recommendations of the Kabra committee (1994) the Government has permitted futures
trading in various commodities. However, the current practice in USA and other Western
countries is to allow futures trading in a range of commodities including live cattle, feeder cattle,
hogs, pork bellies, fluid milk, rubber, tea, wool, and industrial metals like copper, gold, lead,
aluminium, silver, zinc and even in a number of non-commodities such as weather index and
pollution permits (FMC, 2002-03).
TABLE 5: Trends in volume trade on Futures Exchange
Turnover
(Rs. in Cr)
Growth (%)

2002-03
66,530

2003-04
1,29,363

2004-05
5,71,759

2005-06
21,34,471

2006-07
33,27,633

92.8

94.4

342.0

273.3

55.9

Source: Annual Report, Ministry of Consumer Affairs, Food and Public Distribution, 2007, Delhi

TABLE 6: Trends in Exchange-wise Turnover

Value (Rs Crore)
2005
2006
MCX(market
share)
Metals
Energy
Agriculture
Total
NCDEX(market
share)
Metals
Energy
Agriculture
Total
NMCE(market

(Jan- 2005

Share (%)
2006

41.7

59.9

2007
Mar)
74.1

2007 (JanMar)

3,91,693
1,41,327
1,00,303
6,33,324
57.5

16,87,759
1,68,319.8
1,69,589.7
20,25,668
36.8

5,30,345
97,653
43,027
6,71,027
24.7

61.8
22.3
15.8
100.0

83.3
8.3
8.4
100.0

79.0
14.6
6.4
100.0

1,04,654
3,560
7,66,712
8,74,927
0.8

2,26,741
4,042.3
10,12,555
12,43,339
3.3

26,884
1,323
1,95,018
2,23,226
1.2

12.0
0.4
87.6
100.0

18.2
0.3
81.4
100.0

12.0
0.6
87.4
100.0

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Evolution of Derivative in India

share)
Metals
Agriculture
Total
Grand Total

12,133
12,133
15,20,385

8,116
1,03,226
1,11,343
33,80,350

3,689
7,379
11,068
9,05,322.7

100.0
100.0

7.3
92.7
100.0

33.3
66.7
100.0

Source: Market Review, Forward Markets Commission (www.fmc.gov.in)

7. Growth of Commodity Futures Market: Review (2003-2007)

The year 2003 is a watershed in the history of commodity futures market. The last group of 54
prohibited commodities was opened up for forward trading, along with establishment and
recognition of three new national exchanges with on-line trading and professional management.
Not only was prohibition on forward trading completely withdrawn, including in sensitive
commodities such value of trading since 2004-05. Although agricultural commodities led the
initial spurt, and constituted the largest proportion of the total value of trade till 2005-06
(55.32%), this place was taken over by bullion and metals in 2006-07. The growth in 2006 as
wheat, rice, sugar and pulses which earlier committees had reservations about, the new
exchanges brought capital, technology and innovation to the market. These markets notched up
phenomenal growth in terms of number of products on offer, participants, spatial distribution and
volume of trade. Starting with trade in 7 commodities till 1999, futures trading is now available
in 95 commodities out of 103 allowable commodities for participation in trading (Nath and
Lingareddy, 2008). There are more than 3000 members registered with the exchanges. More than
20,000 terminals spread over more than 800 towns/cities of the country provide access to trading
platforms. The volume of trade has increased exponentially since 2003- 04 to reach Rs. 36.77
lakh crore in 2006-07. Almost all of this (97.2%) of this is now accounted for by the three
national exchanges. The other 21 Exchanges have a miniscule share in the total volume. (Sen et
al., 2007, FMC)
The growth in commodity futures trade has spawned an upsurge of interest in a number of
associated fields, viz. research, and education and training activities in commodity markets,
commodity reporting for print and visual media, collateral management, commodity finance,
ware-housing, assaying and certification, software development, electronic spot exchanges etc.
Markets and fields almost non-existent four years ago now attract significant mind-share
nationally and internationally.

7.1. Major breakthrough in commodities futures

Futures contracts are available for major agricultural commodities, metals and energy.
Commodity group-wise -07 was almost wholly (88.7%) accounted for by bullion and metals,
with agricultural commodities contributing a small fraction (10.7%). This was partly due to the
stringent regulations, like margins and open interest limits, imposed on agriculture commodities
and the dampening of sentiments due to suspension of trade in few commodities. Futures market
growth in 2006-07 appears to have bypassed agriculture commodities.

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TABLE 7: Commodity-wise Trends in Volume-traded

2005
Share
2006
Share
January- (%)
January- (%)
December
December
4,87,333
32.1
16,81,220 49.7
Precious
metals:
2,06,398
13.6
10,45,573 30.9
Gold
2,80,935
18.5
6,35,647
18.8
Silver
0.3
2,33,449
6.9
Basemetals: 3916
5,072
0.2
Aluminium 31
3,544
0.2
1,76,941
5.2
Copper
337
Lead
230
946
Nickel
111
193
Tin
49,960
1.5
Zinc
5,099
0.3
7,947
0.2
Ferrous
1,44,888
9.5
1,72,362
5.1
Energy:
1,44,288
9.5
1,37,372
4.1
Crude oil
32,625
1.0
Natural gas
489
1,229
Polymers
8,79,149
57.8
12,85,372 38.0
Agri:
10,664
0.7
34,543
1.0
Cereal
9,327
0.6
7,602
0.2
Fibre
1,04,548
6.9
1,28,854
3.8
Oil
Complex
3,00,699
19.8
5,16,137
15.3
Pulses
0.3
6,944
0.2
Plantations 4,828
27,606
1.8
1,46,482
4.3
Spices
4,21,477
27.7
4,44,808
13.2
Others
15,20,385 100
33,80,350 100
Total

2007
JanuaryMarch
3,86,523

Share
(%)

2,04,261
1,82,263
1,73,353
3,966
99,909
1,110
11,996
335
56,037
1,043
98,978
87,181
11,793

22.6
20.1
19.1
0.4
11.0
0.1
1.3
0.0
6.2
0.1
10.9
9.6
1.3

42.7

Growth
in 2006
(%)
245
407
126
5,861
16,181
4,893
311
74
56
19
-5

2,45,426
2,749
2,401
46,971

27.1
0.3
0.3
5.2

151
46
224
-18
23

45,713
4,005
87,972
60,615
9,05,323

5.0
0.4
9.2
6.7
100

72
44
431
6
122

Source: Forward Markets Commission, NCDEX, and MCX, Mumbai, 2007

TABLE 8: Commodity Group-wise value of trade (Rs. in lakh Crore)

Commodity
2004-05
2005-06
2006-07
Groups
((Rs. in lakhs
Cr)
7.79 (36.15)
21.29 (57.90)
Bullion
and 1.80 (31.47)
other metals
Agriculture

3.90 (68.18)

11.92 (55.31)

13.17 (35.82)

2007-08

26.24 (64.55)
9.41 (23.15)

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Evolution of Derivative in India

Energy

0.02 (0.35)

1.82 (8.45)

2.31 (6.28)

5.00 (12.30)

Others

0.00 (0.00)

0.02 (0.09)

0.001 (0.00)

0.00 (0.00)

Total

5.72 (100.00)

21.55 (100.00)

36.77 (100.00)

40.65 (100.00)

Source: Sen, 2008: FMC Expert Committee Report the impact of futures trading on agricultural commodity prices

TABLE 9: Trends in turn-over of Agricultural Commodities (Rs. Crore)

JanuaryShare (%) JanuaryShare (%) JanuaryDecember
December
March
2005
2006
2007
8,79,149,1
100
12,85,372.0
100
2,45,426
Agriculture:
3,37,844.9 38.4
3,26,344.4 25.4
35,766
Guarseed
1,66,587.5 18.9
3,41,035.7 26.5
40,145
Gram
1,06,012.3 12.1
1,45,333.9 11.3
3,004
Urad
2.2
63,041.6
4.9
11,241
Mentha Oil 19,354.3
24,055.8
2.7
25,696.7
2.0
2,529
Tur
67,204.2
7.6
85,861.6
6.7
28,331
Soy oil
35,301.8
4.0
15,980.5
1.2
1,458
Guragum
14,493.9
1.6
22,145.4
1.7
8,620
Soy seed
9,213.0
1.0
60,905.8
4.7
31,891
Peeper
10,879.8
1.2
33,124.5
2.6
38,241
Jeera
9,072.7
1.0
28,828.8
2.2
1,409
Wheat
3,431.3
0.4
35,432.6
2.8
6,805
R Chillies

Share (%)

100
14.6
16.4
1.2
4.6
1.0
11.5
0.6
3.5
13.0
15.6
0.6
2.8

Source: Market Review, FMC (www.fmc.gov.in) (adapted from the article Impact of Futures Trading on
Commodity Prices, (Nath and Ligareddy, 2008), published in Economic and Political Weekly.

Moreover, there has been a very significant decline in volume of futures trade in agriculture
commodities during the year 2007-08, by 28.5%. The overwhelming bulk of this decline is
accounted for by Chana, Maize, Mentha Oil, Guar seed, Potato, Guar Gum, Chillies and
Cardamom. Trade in these eight commodities, which accounted for 57.9% of total futures trade
in agricultural commodities in 2006-07, declined by over 66.4% during 2007-08 compared to
previous year. The decline in these eight commodities exceeded the decline of futures trading
volumes in all agricultural commodities taken together.
Four commodities (wheat, rice, urad and tur) were de-listed for futures trading towards the end
of financial year 2006-07. This de-listing has been held responsible in many circles for the recent
general downturn in futures trading in agricultural commodities. But these four de-listed
commodities together accounted for only 6.65% of the total value of futures trading in all
agricultural commodities in 2006-07. Thus, although this may have affected market sentiments

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adversely, the delisting did not have any major direct contribution to the decline in trading
observed during 2007-08.
In fact, except chana and urad, the share of sensitive commodities in total value of futures trade in
agricultural commodities has so far been quite insignificant. The combined share of other food grains (i.e.
wheat, rice, maize and tur) peaked at 5.0% in 2005-06 and of sugar at only 2.2%. This is in line with what
various Committees mentioned earlier had foreseen regarding prospects of futures trading in commodities
with significant government intervention. If, nonetheless, de-listing has adversely affected market
sentiment regarding futures trading more generally, this must be because of the go-stop nature of
government policy on the matter (Sen et al, FMC, 2007).

7.2. Price Volatility issue of commodities

We have come across to witness the recent phenomena that futures prices of the commodities
leads to increase the spot or ready cash prices of the commodities owing to unscrupulous trading,
speculation and also enormous pressure on inventory functions and consumption functions
coupled with underlying market conditions. It has shown that 35.56 percent increase in minimum
support price (MSP) of rice, wheat, chana, and urad resulting into imposition of ban on futures
trading of the four commodities (Sen, 2008: FMC Expert Committee report)
Kamara (1982) found that the introduction of commodity futures trading gene rally reduced or at least did
not increase cash price volatility. The study compared cash market volatility before and after the
introduction of futures trading; thus, implicitly focused on the paradigm of introducing futures trading.
Singh (2000) investigated the Hessian cash (spot) price variability before and after the introduction of
futures trading (1988-97). Results of a multiplicative dummy variable model indicated that the futures
market has reduced the price volatility in the Hessian cash market. On the other hand, Dasgupta (2004)
found that there is a co-movement among futures prices, production decisions and inventory decisions. The
results showed that the futures price elasticity of inventory is inversely related to the carrying cost.
Therefore, an unnecessary hoarding will increase the carrying cost, leading to a lower responsiveness of
inventory to futures prices. This paper also determines the effect of expected production shocks on the
futures price elasticity of supply. Yang et al (2005) examined the lead-lag relationship between futures
trading activity and cash price volatility for major agricultural commodities. Granger causality tests and
generalized forecast error variance decompositions showed that an unexpected and unidirectional increase
in futures trading volume causes an increase in cash price volatility. Further, they found a weak causal
association between open interest and cash price volatility. Sahi (2006) studied the impact of introducing
futures contracts on the volatility of the underlying commodity in India. Empirical results suggest that the
nature of volatility has not changed with the introduction of futures trading in wheat, turmeric, sugar,
cotton, raw jute and soy oil. However, a weak destabilizing effect was found from futures to spot in the
case of wheat and raw jute. Further, results of Granger causality tests indicated that the unexpected increase
in futures activity in terms of increases in volumes and open interest has led to an increase in cash price
volatility in all the commodities listed. The study has confirmed the conception of the destabilizing effect
of futures trading on agricultural commodity prices. Thus, recent studies have shown mixed results
indicating that futures trading has either driven up or brought down volatilities in spot prices depending on
the commodities and underlying market conditions (Nath and Lingareddy, 2008:pp. 18-19 (2).

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8.0 Concluding notes: Price Stability and Futures Trading

We need to understand the efficacy of the markets from the point of large stakeholders including
growers or producers who want to hedge the commodities either for buying or for selling,
processors, investors including wholesale and retail. Indian derivatives market has been
undergoing rapid changes in terms of policy implications and world economy. Even the price
volatility and price discovery are two important issues being addressed by todays economy.
Precisely, conclusion lies in the line of the followings.
A market mechanism that is more efficient and viable for risk management and price discovery is the use of
futures, if there is wide participation by stake- holders. From a macro-development angle, this should
happen with appropriate measurement of risk. The present emphasis and reporting on trading turnover, be
it the stock or commodity market, lacks a macro-development framework. For example, resource
mobilization by capital markets has not kept pace with the in- creased turnover handled by the two
monoliths, BSE and NSE at all. On the other hand, small towns with meagre resources and small investors
have suffered all along, mainly due to the lack of any risk measurements and especially with liberalization.
This has indeed narrowed down market developments and SEBI recently set up a Market Development
Committee to look into this matter. The macro-development approach demands that the market performs
financial inter- mediation such that saving and investment rates rise and faster growth rates of GDP and
employment are achieved. Similarly in commodity futures, risk measurement, risk management and price
discovery are expected to affect macro-developments insofar as agricultural market reforms take place so
that agricultural growth in terms of GDP is achieved through the realization of higher value added and
employment. The speculative nature of futures how- ever, is the Achiles heel of the market, as are illegal
trade and round tripping practices that are intended to avoid transparency and taxes. Such phenomena
persist and traders unabashedly claim that re- ported trade is only a fraction of the trading activity taking
place outside the regime. This subverts regulation, undermines macro-development and thus public interest.
An ideal framework of growth is that in which tensions between micro- and macro-level frameworks are
known and avoided in time and, where their compatibility is taken to maximize the value added to GDP
growth and employment. Know- ledge of tensions between micro- and macro-level frameworks requires
crafting of certain indicators, besides a symmetric perfect system for dissemination of information on
trading and prices, for both spot and futures which makes full use of the latest ICT. The ways in which
combining micro- macro development frameworks brings advantage to the economy are listed below:

TABLE 10: Micro-Macro development framework for Price Stability and Futures Market

Feasibility Test

Present Micro and

Short-term
development
framework
Being done

Best
practices/services
Focus

Being developed

Impact

Comparison with spot

prices

On trading turnover

Desired Macro and

Long-term
development
framework
To include GDP
contribution and
employment valuetrading services
Value-adding services
Illegal and roundtripping in trading to
be stopped
Real time information
dissemination

Advantage

Income and
employment growth
A virtuous circle of
expansion of futures
Increased revenues to
exchanges and state
Growers knowledge
and efficient produce
management
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Indicators
Final result

None
Narrow-based growth

Futures Prices Index

Broad-based growth

Trend awareness
Increased interest of
growers at large

Source: Raipuria, K (2003), Price Stability and Futures: Need for Macro-development framework, published in
Economic and Political Weekly.
Given the noisy nature of Indian wholesale and retail markets particularly in essential items like wheat,
rice, oilseeds and edible oils, symmetry in dissemination of real time spot and future prices will help
consumers at large. (Raipuria 2003: pp. 5330(1)

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References
FMC (2002), Market Review, Vol. XLIV (1). Forward Markets Commission, Mumbai.
www.fmc.gov.in
Gupta, S.L. (2005). Financial Derivatives: Theory, Concepts and Problems, Prentice-Hall of
India Pvt. Ltd. Publication, New Delhi
Kolamkar, D.S. (2003) Regulation and Policy issues for Commodity Derivatives in India.
Retrieved from URL www.nmce.com/publication/dsk.jsp
MCX (2007): Market data, Multi Commodity Exchange of India Limited, www.mcxindia.com
Naik, Gopal & Jain, Sudhir (2002), Indian Agricultural Commodity Futures Market, Vol. 37
(30), pp.3161-3173, Economic and Political Weekly
Nath, Golaka & Lingareddy, Tulsi (2008) Impact of Futures Trading on Commodity Prices: A
Performance Survey, Vol. 43 (3), pp.18-23, Economic and Political Weekly
National Stock Exchange of India Limited (2004). NCFM: Commodities Market Module Work
Book, pp. 11-27, Mumbai. www.nseindia.com, www.bse.com
NCDEX (2007): Market data, National Commodities & Derivatives Exchange of India Ltd.
www.ncdex.com
Raipuria, Kalyan (2003), Price Stability and Futures: Need for Macro-Development
Framework, Vol. 38 (51-52), pp. 5330, Economic and Political Weekly.
Sen, Abhijit (2008). Expert Committee report The study of Impact of Futures Trading on
Agricultural Commodity Prices, pp. 4-20, Ministry of Consumer Affairs, Food & Public
Distribution, New Delhi.
Thomas, Susan & Shah, Ajay (2003), Equity Derivatives in India: the State of the Art
Derivatives Markets in India, Published by Tata McGraw Hill. New Delhi. Retrieved from
www.igidr.ac.in

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ANNEXURE-1
Details of the association conducting forward/futures trading are shown as under.
S. No Name of the association
(recognized under Section(6) of FCRA, 1952
The Ahmedabad Commodity Exchange, Ahmedabad
1

Commodity

Castorseed
(permanent
recognition w.e.f. 16th May
1959
The Bombay Commodity Exchange ltd. Mumbai
Castorseed
(08.09.1959),
2
castor oil international, RBd
palmolin, sunflower oil, and
groundnut oil
Rajkot seeds Oil and Bullion Merchants Assn. Rajkot
Castorseed
3
The East India Cotton Association Ltd. Mumbai
Cotton
4
The Ahmedabad Cotton Merchants Assn. Ahmedabad
Cotton (NTSD)
5
The
Central
Gujarat
Cotton
Dealers
Assn.,
Vadodara
Cotton (NTSD)
6
The South India Cotton Association, Coimbatore
Cotton (NTSD)
7
Bhatinda Om & Oil Exchange Ltd., Bhatinda
Gur
8
The Chamber of Commerce, Hapur
Gur and potatoes
9
The Meerut Agro Commodities Exchange Ltd., Meerut Gur
10
Rajdhani Oils & Oilseeds Exchange Ltd., Delhi
Gur
11
Vijai Beopar Chambers Ltd., Muzzafarnagar
Gur
12
The East India Jute & Hessian Exchange Ltd., Calcutta Jute & Jute goods (Hessian
13
Sacking)
India Pepper & Spice Trade Assn., Kochi
Pepper (both domestic and
14
international),
recognized
from 02.04.1960
The Kanpur Commodity Exchange Ltd., Kanpur
Rapeseed/Mustardseed, its Oil
15
and oilcakes
The National Board of Trade Ltd., Indore
Rapeseed/Mustardseed,
16
oilcake, Soyabean, its Oil and
Oilcake
The Spices & Oilseeds Exchange Ltd., Sangli
Turmeric
17
First Commodity Exchange India Ltd., Kochi
Copra, Coconut Oil and Copra
18
cake
Keshav Commodities Exchange Ltd., Delhi
Potatoes
19
The Coffee Futures Exchange India Ltd., Bangalore Coffee:
raw,
Arabic
20
(the Associations Registered under Section 14 (B) of parchment, Robusta cherry,
Forward Contracts (Regulation) Act, 1952
Cured: Plantation A &
Robusta Cherry AB
Source: FMC Bulletin, Vol. (), 2003

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ANNEXURE 2
Reform initiatives have also reached other stake holders association with futures trading, besides
as the regulatory body (FMC), warehouse agencies, clearing corporations, trade guaranteeing
agencies, settlement bodies, all need to adapt to the emerging situation in order to make
commodity futures trading vibrant. The regulatory set up of various markets is presented below.
S. No.
1

2
3

4
5

Institution
Reserve Bank of India

Major Regulatory Functions

Public debt, foreign exchange
interest and financial structure
(FRBM)
Ministry of Finance (department of Economic Capital markets, Public debt
Affairs)
related policy measures
Department of company affairs
Company Act and related
issues
of
registration,
reporting etc.
Department of consumer affairs
Policy issues related to
commodity futures trading
Securities and Exchange board of India
Regulator
for
securities
market including securities
derivative market
Forward Markets Commission
Regulator for commodity
derivatives market

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