18.8 What is unique about commodities?

From an investor’s point of view, commodity investment has certain unique features as it is different from other 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 qualities 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. Let us have a brief look at these issues.

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. There are limits on storage facilities in different states. There are restrictions in some commodities on interstate movement. 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. Let’s take a general overview at the process flow of physical settlement of commodities.

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. 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.

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. Alternatively, the clearing houses may assign deliveries to buyers on some basis. 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. 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 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 authorized representative in the presence of seller or his representative takes the physical stocks against the delivery order. Proof of physical delivery having been affected is forwarded by the seller to the clearing house and the invoice amount is credited to the seller’s account. In India, in compulsory delivery contracts, if the seller does not give notice of delivery at the expiry, then penalty is levied.

Now another question arises. Is delivery mandatory in futures contract trading? No. The provision for delivery in the futures contracts is made so as to ensure that the futures prices in commodities are in conformity with the underlying. Delivery in futures contracts could be either compulsory or based on the seller’s option. In the last two to three years, deliveries in most of the agricultural commodities traded on the futures exchanges is compulsory. Some of the contracts traded at the futures exchanges also give right to both the buyer and seller to demand/ give delivery.

NTSD & TSD contract

Non-Transferable Specific Delivery (NTSD) contract is an enforceable bilateral agreement under which the terms of contract are customized and the performance of the contract is by giving specific delivery of goods. The rights or liabilities under this contract cannot be transferred by transferring delivery order, railway receipt, or any other documents of title to the goods.

A Transferable Specific Delivery (TSD) contract is an enforceable customized agreement where, unlike NTSD, the right or liabilities under the delivery order, railway receipt, warehouse receipts or any other documents of title to the goods are transferable. The contract is performed by delivery of goods by first seller to the last buyer. The parties, other than the first seller and the last buyer, perform the contract merely by exchanging money differences.

Warehousing

One of the main differences between financial and a 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 at 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 use certified warehouses (CWH) for the purpose of handling physical settlements. Such CWH are required to provide storage facilities for participants in the commodities markets 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 warehouses too. Warehouses also come under the regulation of FMC.

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.