India. Long on potential but often seen as short on delivery. But that traditional view of the country’s commodity derivatives markets is changing fast. Colin Packham reports on the rapid, if bumpy, ride to success that market participants are enjoying.
What’s all the fuss about India? To understand why many derivative market participants are so excited, you must, like Aurobina Prasad Gayan, chief executive of Mumbai’s KCTL Research, examine the numbers
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“India’s Multi Commodity Exchange ranked first in silver, second in gold and third in crude oil, copper, zinc and natural gas in terms of number of contracts being traded worldwide in 2008,” he says. “MCX also ranks fifth in the top five commodity exchanges in the world.”
And MCX is not even India’s biggest futures and options exchange.
That is the National Stock Exchange of India, seventh biggest among all the world’s markets in 2009 for number of contracts traded, according to Futures and Options Intelligence. Its volume of 692m contracts was more than the Chicago Board of Trade.
Figures based on contract numbers can be misleading, of course. In notional value traded, NSE reached Rp156tr in 2009, or $3.21tr – less than a sixth as much as the Chicago Board Options Exchange.
But $3tr is still a lot of money, and India’s markets are growing fast – by 30% to 40% in 2009.
Bumpy ride so far
One might think this was the sign of a market that enjoyed a serene and uncomplicated regulatory environment.
But that is far from the case. In commodities especially, government intervention has caused problems for the three main exchanges, MCX, the National Commodity Derivatives Exchange of India (NCDEX) and the National Multi Commodity Exchange of India (NMCEX).
It was only in May 2009 after the Congress Party’s general election victory that the Forward Markets Commission lifted a two year ban on trading wheat futures.
The contracts, along with those in rice and two kinds of pulses, tur and urad, had been suspended in March 2007 by the Congress-led coalition, including Communist allies, which suspected that food price inflation was being exacerbated by excessive speculation in derivatives.
From May to November 2008, rubber, soybean oil, chickpea and potato futures were also banned by the Ministry of Consumer Affairs, which supervises the FMC.
These interventions have affected the market. Volume at NCDEX, for example, fell 29% from 2007 to 2008, though it recovered by 26% last year.
| Currencies and interest rates: progress, one inch at a time
Of all the principal risk classes, interest rates have been the slowest to develop in India since 2000. In 2003 a future based on 91 Day Treasury Bills was introduced, but the product has not caught on.
A new impulse to develop currency and rates derivatives was started by the Reserve Bank of India and Securities and Exchange Board of India in February 2008. They formed a standing committee that decided in June 2009 to introduce rules for a new set of futures, based on the 10 Year Government of India Coupon-Bearing Security.
First to market was the National Stock Exchange; rival exchanges have committed to entering the market as soon as they receive regulatory permission.
Ravi Narain, managing director at NSE, says: “The launch of interest rate derivatives means a lot to the NSE, its constituency of brokers and all economic entities who face interest rate risk.”
So far, the NSE’s volume has been disappointing – 14,559 contracts in August 2009, and none since. This may partly be because commercial banks are allowed to take trading positions for themselves but cannot trade on behalf of their clients.
The RBI-SEBI committee decided not to allow futures based on overnight interest rates, and to leave a decision on the 91 day contracts until later.
The RBI and SEBI are also letting currency derivatives grow. In August 2008 they permitted the introduction of rupee/dollar futures. This year, on January 19, they opened the way for euro, yen, and sterling contracts, with immediate effect.
On February 1, both NSE and MCX Stock Exchange – MCX’s financial derivatives arm – launched futures on those three currencies.
MCX said its instruments would be financially settled with a tick size of Rp0.0025. It has initially offered 12 expiry months. NSE’s new products have identical specifications, because of a request from the regulators, which laid down strict conditions on the trading of the new instruments.
Sajith Kumar, CEO of JRG Securities in Mumbai, believes currency futures have a bright future, helped by “significant” demand. |
But impressively, India’s commodity derivative markets have grown to their present size without any input from foreign investors. International participants are not permitted to trade commodity contracts, or India’s currency derivatives – though they can use equity futures and options.
And these markets have grown up only since 2002, the last time the FMC liberalised derivatives. That newness belies the fact that India has one of the oldest derivatives markets in the world – the Cotton Trade Association started futures trading in 1875, barely a decade after commodity derivatives started in Chicago.
Since then there has been a long history of market expansions and contractions, often caused by regulatory clampdowns.
Mounting competition
Despite the recent bans on specific commodities, the present phase seems unequivocally to be one of expansion. Not only are India’s three commodity exchanges cementing their relative strengths – new participants are lining up to compete with them.
The Universal Commodity Exchange has applied for permission to set up a commodity exchange. The project is being headed by Ketan Seth, an entrepreneur with a background in information technology, alongside others in the IT industry.
Praveen Pillai, director at the planned exchange, says that while UCX has yet to formalise its plans, it will list a suite of “bullion and commodity products”.
Also in the pipeline is the International Multi Commodity Exchange, promoted by Indiabulls Financial Services and Minerals and Metals Trading Corp. Other stakeholders include the United Stock Exchange of India and Indian Potash Ltd, an agency for importing fertilisers.
Ajit Mittal, chief executive of IMCX, said in June that the exchange would launch contracts covering the farm, bullion, energy, and base metals sectors. However, despite assurances that it would go live in August, the exchange has yet to start operations.
Competition might emerge also from the Gujarat-based Ahmedabad Commodity Exchange, which is planning to upgrade and convert itself into a nationwide multi-commodity exchange within a year, according to Reuters. The exchange obtained in-principle approval from the FMC in May.
ACE offers futures on castor seeds and cotton seeds, via open outcry trading.
Veeresh Hiremath, an analyst at commodity broker Karvy Comtrade in Hyderabad, says the spate of new exchanges coming to market owes much to the growth of commodity trading in India.
“In the last two years, the commodity market in India grew more tremendously than the equity market,” Hiremath says. “India is one of the major traders in the commodity market. This creates more potential for the new exchange to take up the opportunity.”
Hiremath believes the new exchanges will add to the overall market’s liquidity and increase participation, if they allow a wider range of products to be traded. But in his opinion, both MCX and NCDEX have very strong positions in the commodity market.
Growth despite the crisis
That India’s derivatives markets grew in 2009 is surprising, considering that nearly everywhere else volumes were depressed by the financial crisis.
Gayan at KCTL Research says this pattern has much to do with who is most active in the market. “The success story in rising volumes on Indian commodity bourses lies in huge retail participation, where contracts are designed in such a way that small investors can also indulge in trading,” Gayan says.
He highlights the success of India’s gold market, which he says has four kinds of contract, “able to meet the requirements of every section of investors”.
Gayan says retail investors can buy gold and silver futures in lots of only 100g, making them cheap to get into. “Increased awareness at grassroots level and the pan-India presence of broking houses or exchanges” also contribute to what Gayan calls “a stunning rise in trading volumes”.
His comments are echoed by Sunny Arora, CEO of Jaypee Commodities, but he also says the market has benefited from the introduction of direct market access (DMA) and automated trading.
MF Global became the first broker to offer DMA services to its Indian clients in June 2008. BNP Paribas and Morgan Stanley followed the month after, and they were joined by UBS and Credit Suisse in September 2008.
Merrill Lynch, Goldman Sachs, JP Morgan, Citigroup and Credit Suisse all offer automated trading services in India.
“Electronic trading and DMA are important businesses for MF Global, and having been the first to market demonstrates our commitment to this important segment,” says Vineet Bhatnagar, MF Global India’s chief executive. Bhatnagar says DMA has proved extremely popular with MF Global’s clients, and that he expects demand to keep growing.
A balancing act
Outside the locked gates of India’s commodity markets, a small crowd is gathering. These are the foreign institutional investors (FII) who are keen to get in.
Jerome Burban, managing director of Newedge India Broker, says his firm gets many requests for access, mainly because clients abroad see the high volume on India’s commodity exchanges.
“Back in December 2005,” he says, “there were suggestions that an FII might be able to trade gold, silver, and WTI oil. It did not happen for various reasons, though we would like to see that happen.”
Burban is philosophical about when change might come. “India follows its own schedule,” he says. “We need to be patient.”
Market participants point out that the modern Indian commodity market is just five or six years old. The entry of FIIs, mutual funds and banks at this nascent stage could allow unwarranted speculation to creep in.
One observer also warns that a regulatory shake-up is needed before FIIs are admitted. The present structure – involving the FMC, SEBI and RBI as well as periodic ministerial interventions – lacks clarity and could lead to confusion, he argues.
Burban is more understanding of the balancing act Indian regulators face. “Retail represents a large proportion of the overall market volume, so regulators seek to protect efficiently the small investor without impeding the market growth,” he says. “Regarding commodity markets, when they believe the time is right to add FIIs, they will do it.”
Although several commodity trading bans have been overturned, rice, tur and urad futures are still outlawed, and market participants remain divided as to the prospects of that changing.
Unupom Kausik, chief business officer at NCDEX, believes “a more liberalised environment in economic circles will facilitate the lifting of the ban and listing of more commodities”.
Arora at Jaypee also concludes that it is “just a matter of time” before the contracts are allowed again, although the FMC will do it only when “they believe the time is right”, he says.
Hurdles to be overcome
Although FIIs are not allowed to trade in India’s commodity markets, Burban says Newedge India believes it is essential to have a presence on the ground. “It is important to be in India because it is one of the biggest markets. We see a lot of potential in the Indian market, we need to be there,” Burban says.
As an FII Newedge is permitted to trade in India’s equity cash and derivative markets. Newedge India has memberships for both at NSE and for cash equities at the Bombay Stock Exchange.
It can trade equities on behalf of customers that are not registered with the SEBI, and are therefore not categorised as FIIs. However, Burban says Newedge India only trades for registered FII members, thus avoiding the need for it to issue Participatory Notes.
PNs are instruments issued by registered FIIs to overseas investors who wish to invest in the Indian equity markets without registering with SEBI.
Despite the excitement surrounding the Indian markets, many hurdles must be cleared before India can take its place in the top rank of world derivative markets.
Just as some believe the FMC needs overhaul, there are structural problems associated with the commodity markets.
One is the availability of a sophisticated, cost-effective, reliable and convenient warehousing system in the country.
| Options are a long bet
Commodity futures may be booming in India, but commodity options are still labouring under a ban imposed in 1952. Can a market devoid of options be called complete?
Shri K Jayanth, director at the FMC, says commodity options are one area that the regulator is considering, but he would not be drawn on the prospects.
Aurobina Prasad Gayan at KCTL Research is pessimistic, however. He does not believe it will happen “in the foreseeable future”, as it would require “a huge makeover in the regulatory framework”.
Yet the head of derivatives at an international bank says it is just a matter of time before options are introduced, adding that the regulator has just been cautious. |
Gayan says that as a result Indian exchanges are “lagging behind in terms of delivery”. His research suggests that 7%-8% of India’s bullion market requires physical delivery.
But metals and energy are cash-settled on MCX, unlike the London Metal Exchange and the New York Mercantile Exchange, which offer a physical delivery option.
Gayan concludes: “Central and state warehouses are not integrated with commodity futures exchanges.”
Despite its particular restrictions, India remains the focus of much attention.
While some argue that the authorities need to move faster and do more to open up markets to international investors, in openness India is years ahead of China, its chief rival for the title of the next big thing.
Compared to China, says Burban: “at least you can trade products now”, though he says it is necessary to educate the market away from preconceived ideas about how difficult it is to do business in India. “More and more, business is transferring towards Asia,” he says. “These preconceived ideas are something that will now change.”