Chapter 1: Commodity Spot and Futures Market

A. Commodity Spot Markets Versus Commodity Futures Market

Commodity spot transactions are marked for immediate delivery as against commodity futures that are marked for delivery at a future date (which could be anything between 1 month and 6 months) in the Indian context. The following are some of the key differences between the spot commodity markets and the commodity futures market.

• The first difference between commodity spot market and futures market is in the nature of pricing in the two markets. Futures prices are different from spot market prices because of carrying costs and carrying return. This includes the interest cost of locking in funds as well as the cost of storage, taxes and damage if any. Although futures prices are marked to market on a daily basis, the price of the futures contracts differ from the underlying spot or cash market. Traders incur these costs during the respective month they are trading and hence the futures price factors in these costs on a proportionate basis. The difference between spot and futures is called the cost of carry.
• The second difference is on the subject of managing counterparty risk. What exactly is counterparty risk? It is the risk that one of the parties (buyer or seller) may default on its commitments to the contract. In case of spot, counterparty risk could become a big deal as the MTM margining is not done. Also, the margin in the spot market is an upfront fee with the broker and is not related to counter party risk. Therefore, counterparty risk is largely dependent on the creditworthiness of the institution and its supporting casts of banks and broker dealers. In case of commodity futures traded through a recognized exchange, the counterparty risk is eliminated as the clearing corporation of the exchange becomes the counterparty and guarantees the performance of both legs of the transaction. Risk is also managed better in the futures market by the exchange through a combination of SPAN margins, ELM margins, MTM margins, delivery margins, special margins and through real-time surveillance.
• The next big difference between spot markets and commodity futures markets pertains to the trade settlement period. For some spot markets, the allowable settlement time period is two working days, which is basically meant for the transfer of cash from the buyer to the seller. However, in most cases, spot market prices settle near real-time. In the case of futures commodity market, the underlying asset has a specific settlement date in the future. If you are long or short on a futures contract, you agree to buy or sell that contract on a specific date in the future. In case you choose not to deliver the contracts on the specified date, you will need to roll over the contracts to the next month expiry. Futures contracts can also be reversed and closed out during the month.
• Fourthly, the relationship between spot markets and futures market is more symbiotic rather than competitive. For example, the commodity futures market can be used for hedging against risk of adverse price movements in the commodity spot markets. If you are long on spot commodities, the same can be hedged either by selling equivalent futures of the same underlying or by purchasing put options which are slightly out of the money. Most traders use the futures and the options market as a hedge against spot market price fluctuations. It is like an insurance against price risk.
• The debate of spot commodities versus futures commodities is best understood based on your view on the commodity. In case, you are looking to trade price movements in the commodities then the futures market offers a much better alternative to the spot market. Trading in the spot market can be too cumbersome and expensive and the trading profits may get largely eroded. That is where, commodity futures with its more structured approach and lower costs and higher leverage helps put in a trade in a smarter and more granular manner.
• Last, but not the least, commodity futures give you the ability to leverage your margins, but this facility is not available in the spot market. What do we understand by commodity futures leverage? In commodity futures, every contract represents a specified amount of units of the underlying commodity or asset. This applies to all commodities irrespective of whether they pertain to base metals, precious metals, energy products or agricultural products. Paying a margin of 5% on the notional value of the contract is tantamount to getting 20X leverage. Leverage on commodity futures is much higher than in stock futures due to the lower volatility risk.

B. Regulation Of Commodity Spot And Commodity Futures Market

The commodity futures and options market was originally regulated by the Forward Markets commission. However, after the NSEL crisis of 2013, the government felt the need to bring commodity market regulation under the umbrella of a regulator that had a strong track record and experience. Effective 2016, the FMC was disbanded and the commodity futures and options market were brought under the ambit of SEBI regulation. However, it needs to be remembered that the regulation of spot and futures markets in commodities are two different lines altogether. This is unlike the equity markets where the spot and futures market in equities are regulated by SEBI.

Broadly, the commodities market exists in two distinct forms:

• Over-the-counter (OTC) market or telephone market
• Exchange based market

As stated earlier, the spot and futures market on commodities are not exactly aligned to each other in terms of regulation. Spot markets are essentially OTC markets and participation is restricted to people who are involved with that commodity, such as the farmer, processor, wholesaler, etc. What it means is that you need to have an underlying exposure to participate in the commodity spot markets.

A majority of the derivatives trading takes place through the exchange-based markets with standardized contracts, settlements, etc. The exchange-based markets are essentially derivative markets and are similar to equity derivatives in their working, that is, everything is standardized and a person can purchase a contract by paying only a percentage of the contract value. For trading in the exchange traded futures market, you do not require an underlying position. Even traders, scalpers and speculators can participate in the exchange traded commodity futures market and delivery is no mandatory in this market.

Two key commodity market regulators

Commodity market regulation typically is broken up into the OTC spot market regulation and SEBI. While all exchange traded futures and options contracts come under the purview of SEBI regulation, all spot transactions are regulated either by the Department of Consumer Affairs (DCA) or in some cases by the respective state governments.

Department of Consumer Affairs (DCA) is responsible for the formulation of policies pertaining to spot markets with specific reference to the following:

• Monitoring of prices, especially of sensitive food items
• Consumer movement from one place to another within India
• Control of statutory bodies (Bureau of Indian Standards (BIS) / Weights and Measures)
• Internal Trade within India and specifically inter-state trade
• Oversight of futures trading and Forward Contracts on price sensitive items. Here the DCA has the powers to override the futures regulator in large public interest
• Formulation of policies for food security, procurement and distribution
• Building and maintenance of food stocks
• Storage, movement and delivery to the distributing agencies and monitoring of production, stock and price levels of food grains
• Incentives to farmers through fair value via Minimum Support Price (MSP) mechanism
• Distribution of food grains to Below Poverty Line (BPL) families and covering poor households under Antyodaya Anna Yojna (AAY)
• Establishing grain banks in food scarce areas
• Enhancing the involvement of Panchayati Raj Institutions in PDS
• Export and import of food grains, sugar and edible oils

In countries like India, regulation of commodity markets by the DCA acquires a new perspective. Inflation rates have always been a worry for the government as it is socially and politically sensitive. The department, therefore, takes decision from time to time to stop forward / futures trading in some products tradable in commodity markets like cotton, sugar or other products, to curb excessive speculation in futures markets. The idea is to prevent any artificial rise in the prices of products required for daily use. Such measures are withdrawn when the prices and inflation comes under control. Of course, the hope is that over time the Indian commodity markets may mature and such interventions may become redundant.

Securities & Exchange Board of India (SEBI) regulates the exchange traded derivatives

The regulation of the commodity futures and options comes under the control of the Department of Consumer Affairs of the Government of India. SEBI has taken over the oversight of commodity derivatives from FMC in 2016. Its focus areas are:

• To advise the Central Government in respect of the recognition or the withdrawal of recognition from any association or in respect of any other matter arising out of the administration of the Forward Contracts (Regulation) Act 1952.
• To keep forward markets under observation and to take such action in relation to them, as it may consider necessary, in exercise of the powers assigned to it by or under the Act.
• To collect and whenever the Commission thinks it necessary, to publish information regarding the trading conditions in respect of goods to which any of the provisions of the Act is made applicable, including information regarding supply, demand and prices, and to submit to the Central Government, periodical reports on the working of forward market relating to such goods
• To make recommendations with a view to improving the organization and working of forward markets
• To undertake inspection of the accounts and other documents of any recognized association or registered association or any member of such association whenever it considers it necessary.

Originally posted on school.5paisa.com