Long wait before trading in commodity index derivatives takes off

Photo: Kamlesh Pednekar
Market experts don't expect trading in commodity index derivatives to kick off soon, regardless of recent a statement made two days ago by Ajay Tyagi.  The Sebi chairman had indicated two days ago in an annual report, that the market regulator plans to launch more commodity options contracts and is working on guidelines for index products. 

Experts say that preparing indices for commodities is much more complex than equities, where most of the volumes come from index derivatives and index options. 

Sebi will have to first finalise common standards in its guidelines for the preparation of commodity indices, after which there will be regulations on trading. So it’s a long wait before actual trading in index-based derivatives starts.

Sources said the guidelines will also include assigning weights to components of the index along with some technical parameters on its preparation. One such would be to regard actual commodity contracts traded as the commodity components  in the index and second will be to set it as a future price index and not a spot price index. The benchmark index is of spot prices and futures are traded on that.

The contracts will form part of the index because in commodities such as crude oil, other energy products and even base and precious metals, price movements are based on international prices and India doesn’t have efficient one for domestic spot price discovery.

When a commodity contract is an index component, on its expiry, the roll-over contract or near month contract replaces the expiring contract and hence index values will change based on near month contract price difference. 

MCX and NCDEX, the two leading commodity exchanges, have different indices for various segments like metals, agri indices and composite etc. However, they should meet the sebi index norms and standards whenever finalised. Usually International Organisation of Securities Commission (IOSCO) index standards have to be complied with.

In equities, the market cap of companies and their floating stock are important criteria for deciding weight of they enjoy in the index. However, there are no such data for commodities. For example market cap or size of the wheat market can be only notional. There are several varieties and different prices based on the quality of all varieties and these keep changing with change in crop size. Final crop estimates come late. 

Even if the market cap is estimated, crop size multiplied by the MSP, wherever possible, need not be a true indicator, as all commodities trade either below or above the MSP. Somehow, if that data can be standardised, or based on some formula, its trade on the exchange may be thinner than other commodities. Sebi is looking at the possibility of using prices traded in futures market.

MCX had launched new indices including a composite index prepared by Thomson Reuters. These indices are for base metals and bullion, and include single-commodity indices for gold, copper and crude oil, along with a composite index. The composite index is for all actively traded commodities and the methodology has two criteria -- physical market size and liquidity in the respective contract on the exchange. In a composite index, caps have to be fixed for physical market size and liquidity. 

For example if a highly liquid commodity is small in size, then its liquidity component will be capped. The Thomson Reuters index for MCX follows IOSCO (or International Organization of Securities Commissions or global market regulators body) norms.

However, the MCX composite index has only two agri commodities with a total weight less than five per cent, while crude oil is the heaviest with a 35 per cent weight. Hence the index may be more representative of the global markets than of the Indian commodity sector. 

NCDEX had, over a decade ago, launched a commodity index in which those interested in trading had to buy contracts of index-component commodities according to their weights in the index. The initiative, though well-conceived, failed. The exchange has the ‘dhanya’ index since 2011 but it is not a truly representative of India’s agri commodity market. other components of the index include sugar, soybean, chana and cotton seed which have very high weight.

Agriculture commodities in general are not trading in a big way in the futures market. Some large commodities such as wheat and rice are listed but aren't liquid in futures. Any commodity index without wheat and rice will not reflect a true picture. In other agri commodities there are frequent government policy interventions by way of stock limits, MSP, quota and duty changes.

Vijay Sardana, a noted agriculture market expert says, “An efficient commodity delivery market should have a delivery threat to keep speculation in check, and hence there has to be an option of physical settlement. Along with that, what is more important than indices for derivatives, is efficient spot markets. In India, especially in agriculture, there are several government protections and interventions. Agriculture being a state subject, several state policies will impact efficient market-based price discovery and hence making markets efficient is more important.”

A commodity derivative consultant says, “Globally commodity derivatives indices are traded by institutional investors. They take positions in representative commodities or exchange-traded funds based on indices. In India, institutional investors are yet away from dealing in commodities and even after they are allowed, efficient and representative indices must be in place for them to trade or hedge.”

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