Indian Commodity Exchanges – Purposes And Benefits

Since inception of derivatives trading in the Indian commodity markets, exchanges have showcased how these regulated platforms offer immense benefits and advantages to physical and non-physical commodity market participants. From a transparent price discovery mechanism to lower margins and risk management, the absence of counterparty risk helps investors reduce the risks associated with price uncertainties and volatilities. In the days prior to the formal and regulated derivatives exchanges, such benefits were largely not present due to the inefficiencies in the old structure. But with time and due to proactive government measures, the commodity futures exchanges now offer an endless amount of opportunity to investors from varied background and risk appetite. Other than that, commodities also offer a different investment avenue, are less volatile when compared with equities and bonds, are a highly liquid asset class, offer investors to multiply their potential earnings and most importantly, investors can take benefit of leveraging their investments.

The transparent pricing mechanism has been widely accepted as the main advantage of the future exchanges as commodity prices are available on a national-level on an electronic trading platform. The actual price discovery on the exchange platform happens in the following method, the seller of the commodity enters the quantity and the price at which he is willing to sell the commodity through a sell order, while a buyer enters the quantity and the price at which he wishes to buy through a buy order. When the sell and buy order match i.e. there is a buyer for the exact quantity and price offered by the seller, a trade gets generated. All this takes place on the electronic exchange platform where the buyer and seller remain anonymous thereby enabling a very transparent price discovery. Driven totally on the basis of ongoing market fundamentals, the risk factor associated with manipulation is negated. 

Secondly, the low margin in case of derivatives trading has helped traders and investors to take the big leap forward. However, lower margins in commodity derivatives attracts investors, mainly small traders, to invest more in number of lots, thus raising their limit of exposure despite having lower funds. Hence, speculation in futures contracts is not advisable to investors as price volatility either on the upside or the downside could wipe out one’s capital. 

The modern commodity derivatives exchanges offer state-of-the-art facilities like online trading, clearing and settlement of futures transactions and the existence of a settlement guarantee fund assures prudent risk management practices by the exchanges, thereby providing an investor a completely monitored trading platform. 

Another major advantage to commodity traders and investors is the absence of counterparty risk. With the Clearing house standing as a legal counter party between the buyer and the seller, it ensures the evasion of the risk factor as the clearing house becomes buyer to every seller and seller to every buyer. On account of this, an investor need not worry about the credit-worthiness of each counter party. This thus makes the overall procedure of commodity futures trading simpler than expected. 

In case of agricultural commodities as well, the farmers have benefited from the commodity futures platform. Prices of agricultural commodities tend to fluctuate during the harvesting period and this has been the major concern for the Indian farming community. Due to futures trading, farmers have been provided with a greater degree assurance on the price front. For example, farmer growing wheat is exposed to risk of decline in prices when his harvest comes out. But by using the futures market platform, he can sell the soybean futures contract today and lock in the price, thus eliminating the risk arising from price fluctuations. Another factor that has provided a great support to the farmers is the availability of warehouse and storage facilities with the exchanges. During times of storage, farmers earlier would have to opt for distress selling due to lack of storage. But now, by using the futures exchanges the farmers can store their produce in the exchange designated warehouse until they don’t receive reasonable returns on their produce. 

But as far as the Indian farmers are concerned, while they may not be directly participating in the commodity futures market, they are taking the benefit of the price signals that are derived on the futures exchanges. The long duration futures contract can be helpful for farmers to take decision about cropping patterns based on price signals. 

As we have deeply looked into factors that act as benefits to market participants that trade in commodity futures, we must know the type of investors that trade here. Right from a trader who wants to take the advantage of price movement to the hedger who wants to cover the price risk arising from uncertainty and volatility to the genuine investor who looks at holding the futures contract to take delivery of the commodity in the futures. The profile of someone who trades in commodity futures can vary as even retail investors and traders take the benefit of leverage and enter the market. For any commodity market intermediary today, he/she can efficiently utilize these exchanges to manage price risk and quote price of the listed commodities.