Views - MCX by qingyunliuliu

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        About Commodity Insights
        The Multi Commodity Exchange of India (MCX) and PricewaterhouseCoopers (PwC) joint effort — Commodity
        Insights — is a first-of-its-kind yearbook on commodities aimed at giving its readers rare insights into the entire
        commodity ecosystem.
        Commodity Insights will have a plethora of useful databases on commodity markets arranged in a novel way so
        that it is extremely useful to virtually all the ecosystem stakeholders as a one-point source for quick and easy
        Additionally, this unique publication attempts to deliberate on issues and concerns (with suggested solutions)
        that ought to be resolved for a healthy development of the domestic commodity market. This will be in the form
        of articles authored by change agents and thought leaders to provide a rich repertoire of analytical articles.
        Thus, Commodity Insights promises to be truly useful to not only all the commodities market stakeholders, such
        as traders, processors, consumers, banks, policymakers, analysts, and industry observers, but also others who
        matter in this industry, giving them a year-long reference book that is both fascinating and engaging. The
        yearbook aspires to be a benchmark resource for spreading knowledge about the commodity market.

        About PricewaterhouseCoopers
        PricewaterhouseCoopers (PwC), which measures its success by its clients, provides industry-focused advisory
        and tax services to build public trust and enhance value for its clients and their stakeholders. PwC professionals
        work collaboratively using connected thinking to develop fresh perspectives and practical advice.
        Complementing its depth of industry expertise and breadth of skills is PwC’s sound knowledge of the local
        business environment in India, with offices in Mumbai, New Delhi, Kolkata, Chennai, Bangalore, Gurgaon,
        Hyderabad, Ahmedabad, Bhubaneshwar and Pune. PwC is committed to working with its clients to deliver the
        solutions that help them take on the challenges of the ever-changing business environment.

        About Multi Commodity Exchange of India
        Multi Commodity Exchange of India (MCX) is a demutualised commodity exchange with permanent recognition
        from the Government of India to facilitate online trading, clearing and settlement operations for commodity
        futures markets across the country. Since its inception in November 2003, millions of small and medium
        enterprises, corporate houses, exporters, importers and traders have benefitted from this nationwide electronic
        trading platform through its efficient and transparent price discovery and price risk management. MCX ranks
        No. 1 in silver, No. 2 in gold, and No. 3 in crude oil, natural gas, copper and zinc futures trading (by the number of
        contracts traded in 2008-09), according to FIA and data put up on exchanges’ websites.


FOREWORD                                                                            5

FROM THE EDITORIAL DESK                                                             7

MARKET COMMENTARY                                                                   9


1.    An Integrated Approach to Agriculture Marketing and Financing
      By Prof. Gopal Naik                                                          14

2.    Commodity Futures in India – A Product of Globalisation and Liberalisation
      By Mr. Lamon Rutten                                                          22

3.    Role of Mutual Funds in Commodity Markets
      By Mr. Venkateswaran R.                                                      30

4.    Banks on Commodities Futures Platform – A Win-Win Situation
      By Mr. P. V. Ananthakrishnan                                                 34

5.    Warehouse Receipt Finance for Farmers – A Glimpse
      By Mr. Nachiket Mor and Dr. Kshama Fernandes                                 42

6     Carbon and Clean Energy Markets – the Potential in India
      By Ms. B.G. Ramola and Mr. Prashant Vikram Singh                             49

7.    Commodities Derivative Hedging: Portfolio and Effectiveness
      By Mr. Kumar Dasgupta and Dr. Chiragra Chakrabarty                           53

8.    Role of Brokerage Industry in linking Ecosystem with the Futures Markets
      By Ms. Priti Gupta                                                           62

9.    Role of Banks in Indian Commodity Derivative Markets
      By Mr. Shailesh Sukhthankar                                                  65

10.   Agriculture Financing under OTC Products
      By Mr. Venkatesh Tagat and Mr. Narendra Rathore                              69

11.   Commodity Exchange Technology Concepts – Looking Forward
      By Mr. Dipankar Chakrabarti and Ms. Rachna Nath                              75

12.   India Needs to Usher in the Next Agricultural Revolution
      By Mr. Amitabh Jaipuria                                                      81


Non-Agricultural Commodities                                                       87

Agricultural Commodities                                                           171
                                                                       Dated 6th October, 2009


Commodity markets in India have had a chequered but long history with the futures markets
remaining in virtual hibernation — a large part of them in the unorganized form — for over
four decades before they were resurrected in 1999-2000 as part of various reform measures
initiated by the government. The market was opened up for futures trading in any
commodity without any restrictions. However, the commodity futures market came really
into its own with the advent of national electronic futures exchanges in 2003. In just about
six years since then the sector has embarked upon a remarkable journey of rapid growth and
national outreach, integrating the asymmetrically informed or ill-informed, fragmented
domestic physical markets through effective application of information, communication
and technology (ICT) as well as connecting them with it through the creation of forward and
backward linkages. The Indian commodity futures market, comprising 19 commodity-
specific regional exchanges and three national-level multi-commodity electronic
exchanges, has staged a spectacular comeback with the total turnover increasing by a
compounded annual rate of over 100 percent during this period.

What lay behind this whole turnaround — from the hitherto status of the Indian commodity
markets as a ‘price taker’ to be on the path of being a ‘price setter’ — has been the increased
streamlining and convergence of diversified information on the market fundamentals of
commodities through transparent interaction of various stakeholders of the ecosystem on
the organized platform. And this was largely achieved through the sustained awareness-
creation and outreach efforts taken by both the exchanges and the Forward Markets
Commission besides coming up with innovative products, dynamically aligned from time to
time in keeping with the changing market/stakeholders’ needs. The hallmark of these
exchanges lies in the level of efficiency of market mechanism, the maturity and the globally-
competitive edge that they have managed to build into them in this short span of time,
because of which the Indian commodity futures market has scaled the heights of global

Information on commodities that constantly flows into and out of the commodity markets
remains the key driver of the price discovery and risk management process for which they
were brought into being in the Indian economy. It also makes the exchange platforms useful
and effective for participation by various stakeholders from within the ecosystem, such as
producers, processors, hedgers and arbitrageurs. The domain knowledge and expertise of
the previous generations which was largely lost in the decades of trading ban has been built
back to a large extent in this short span of time. This market which was known for its
innovations including creation of a revolutionary trading and risk mitigation concept called
“options” is rising from the ashes like a Phoenix once again and will certainly occupy a place
of pride in the global comity of commodity markets within the next decade or so. It is the
promotion of market research and knowledge management through generation and
maintenance of market information, and building up of rational expectations in the market,
which are of paramount importance to put it on the right path towards becoming the ‘price
setters’ for the global markets in many commodities.

                                                                                                  FOREWORD   |5
                             In this context, the initiative of the Multi Commodity Exchange of India (MCX) and
                             PricewaterhouseCoopers (PwC) to bring out a yearbook on data and information related to
                             the commodity markets and their fundaments is both timely and a very welcome one. I
                             congratulate them for this initiative. I am confident that this inspiring effort of theirs will go
                             a long way in encouraging extensive and intensive research into the Indian commodity
                             markets as well as pave the way for transforming the country’s commodity database
                             management towards excellence, becoming a constant, ready source for all kinds of
                             references by various stakeholders including industry players, traders, market analysts,
                             academicians, businesses, researchers and students. This, I am sure, will not only nurture
                             and strengthen the commodity markets to bring greater economic benefits to the
                             stakeholders but also benefit the national development strategy for the economy as a whole.

                             I wish the publication all success. Happy reading.

From the Editorial Desk

It is our pleasure to come together on a joint platform                        objective of better decision making. Global commodity
to bring ‘Commodities Insights’ yearbook to enrich the                         exchanges such as CME and CBOT, among others,
whole ecosystem consisting of varied stakeholders                              periodically publish information on markets which is
ranging from policymakers to                                                   avidly followed by those to whom it matters most.
academicians/researchers to media. Since the Indian                            Domestically, various sectors including infrastructure
commodity markets came into being, not only media                              and financial services have their own examples that led
and policymakers but also traders themselves have                              us on our way to providing a shape to this product.
been scrambling for data that they could use to put
prices and the market into an appropriate perspective.
In the process, those whoever succeeded in garnering
the necessary data were enabled to achieve their
objective while others who did not had to leave their
objective behind due to this lack of information. As a
result, despite their impressive growth performance,
the commodity markets lacked appropriate scrutiny by
the stakeholders to prove the worth for their existence
even though they had started making inroads into the
lives of both consumers and producers besides
effectively linking them with the financial markets.

Having reached several milestones in its journey to                            Standing (L-R): Mr. Nazir Ahmed Moulvi, Mr. Sujan Bhattacharyya, Mr. Niteen Jain
become India’s largest exchange, driven by its strategic                       Seated (L-R): Ms. Carol Daver, Dr. V. Shunmugam, Ms. Vidya Shintre
partnerships with various other ecosystem players, it
was time for MCX to join hands with                                            While the raw market data was a key part of the
PricewaterhouseCoopers to bring in yet another global                          endeavour, we gave our best to think innovatively to
benchmark practice into the Indian commodity                                   compile and publish various useful and related
markets, fulfilling the role of empowering the market                          variables in such way that the collection shall remain a
participants and perfecting the process of price                               one-stop shop for information that would be needed
discovery on its platform. Participants and followers of                       by all the stakeholders. Besides the datasets related to
global commodity exchanges keenly await publication                            commodities and their ecosystem, in our endeavour to
of such material covering all the global fundamentals                          flag the market growth and related issues we
year-wise in order to empower them to achieve their                            approached experts, in respective domains connected
                                                                               with commodity futures, to analyse them and put them
                                                                               in an appropriate perspective for researchers and
                                                                               policymakers to fall back on them whenever the need
                                                                               arises which would otherwise be missing. We did our
                                                                               best to include all the related variables and flag the
                                                                               growth process and issues impeding the market
                                                                               growth, along with the potential that it holds for the
                                                                               future, through a number of technical and non-
                                                                               technical articles authored by the invited experts.
                                                                               However, we are fully aware that improvement of this
                                                                               once-in-a-year effort will be a continuous affair and we
                                                                               assure users that we will take a giant leap to make the
                                                                               yearbook a far more enriched product when it is
Standing (L-R): Mr. Sarvesh Ramachandran, Mr. Dhruv Madeka, Mr. Ankan Mondal   released from our desk next year.
Seated (L-R): Mr. Kumar Dasgupta, Dr. Chiragra Chakrabarty

                                                                                                                                               FROM THE EDITORIAL DESK   |7
        We would like to thank Mr. Jignesh Shah, Vice Chairman     MCX for the enormous efforts they put in, day in and
        – MCX; Mr. Lamon Rutten, MD and CEO – MCX; Mr.             day out, without which this book would have remained
        Joseph Massey, MD and CEO – MCX-SX; and Mr. Kumar          just a concept. And finally, this message from the desk
        Dasgupta, Partner – Price Waterhouse; for their            will not be complete without thanking Ms. Carol Daver
        continuous encouragement and support towards this          and Ms. Vidya Shintre, who efficiently marketed this
        initiative of ours without which it would have been only   initiative of ours and got the much needed financial as
        half done. We would also like to thank Ankan Mondal,       well as knowledge support towards its
        Sarvesh Ramachandran and Dhruv Madeka from PwC             accomplishment.
        and Sujan Bhattacharya, Niteen Jain, Nazir Ahmed
        Moulvi, Dr. Ritambhara Singh and Dhiraj Pandya from

                       Dr. V. Shunmugam                                                       Dr. Chiragra Chakrabarty
                           Chief Economist                                                          Associate Director
             Multi Commodity Exchange of India                                                  PricewaterhouseCoopers

Market Commentary

Indian Commodity Futures Markets – Still Evolving…
Futures trading plays a key role in the marketing of a number of important agricultural and non-
agricultural commodities as it provides the industrial and farming communities with a
transparent price discovery platform, which also enables them to hedge their price risk and price
volatility. The growth of Indian commodities futures trading towards an efficient, transparent and
well-organised market has thrown open a window of benefits and opportunities to Indian
producers and traders. Besides the primary benefits of its twin economic functions of price
discovery and price risk management, commodity futures trading has also played an instrumental
role in integrating various fragmented components of the commodity ecosystem, thus
developing the overall infrastructure of agricultural commodities marketing in the country.

The yesteryears…                                                the government in 1918 set up Cotton Contracts
                                                                Committee, which was soon (1919) replaced by Cotton
Forward/futures markets have come a long way since              Contract Board. Futures trading in oilseeds was
the days of the “rice tickets” in Japan and the first           organised with the setting up of Gujarati Vyapari
organised futures market in the form of the Chicago             Mandali in 1900 in Bombay. And, over the years, the
Board of Trade (CBOT) in the US. Forward contracts              derivatives market developed in several other
were the earliest form of commodity derivatives, and            commodities in the country: raw jute and jute goods in
futures contracts have existed for centuries in one form        Calcutta (1912), wheat in Hapur (1913) and then bullion
or the other.                                                   in Bombay (1920). However, soon there were wide-
                                                                spread fears that derivatives trading fuelled
In India, the earliest reference to “futures’ can be found in   unnecessary speculation in essential commodities and
Kautilya’s Arthashastra, and the trade shot into                was therefore detrimental to healthy functioning of the
prominence in the mid-nineteenth century when                   markets for the underlying commodities and,
trading in agricultural commodity futures in the US             therefore, to farmers. To curb speculative activity in the
became organised. After the first recorded instance of          cotton market, the Government of Bombay barred
futures trading in “rice” in 17th century Japan, it took off    options trading in cotton in 1939. This was followed, in
in the US with “grain” contracts on CBOT (the first             1943, by a ban on forward trading in oilseeds and some
exchange to start there in 1848). Metals followed suit          other commodities such as food-grains, spices,
with contracts traded on the London Metal Exchange              vegetable oils, sugar and cloth.
(LME) in 1878. Thereafter a number of commodity
exchanges facilitating futures trading in numerous agri-        As, post-World War II, the Great Depression had its
and non-agri commodities sprang up the world over.              devastating effects on economies around the world
                                                                during 1939-45 and the British rulers imposed controls
In India, organised commodity derivatives trading               over the financial markets, the Indian commodity futures
began with the Cotton Trade Association’s debut in              market slipped into virtual extinction. It disintegrated
futures in 1875. Cotton merchants of Bombay took cues           and went into a hibernation, only to continue negligibly
from the US and the UK, and to regulate futures trading         in the form of over-the-counter (OTC) contracts. Almost a

                                                                                                                 MARKET COMMENTARY   |9
        decade later, Parliament passed the Forward Contracts         ban on some commodities in January 2007 and then in
        (Regulation) Act, 1952 (FCRA) to regulate commodity           May 2008 as well as imposition of higher margins and
        futures trading in the country.                               stringent norms for trading, the growth in trade
                                                                      volumes slowed down to Rs.40,65,983 crore in 2007-08.
        With the process of liberalisation and globalisation of       Nevertheless, the Indian commodity futures market
        the Indian economy and consequent reforms in its              staged a comeback in 2008-09 with a sharp increase in
        financial markets in the early 1990s, the Prof. K.N.          the turnover to Rs.52,48,956 crore, notwithstanding
        Kabra-headed committee, set up by the Government in           the ban. As the percentage of Gross Domestic Product
        1993 to examine the role of futures trading, made             (GDP) at market prices, the total trade accounted for
        several recommendations including cer tain                    97.3% in 2006-07, which only marginally slipped to
        amendments to Forward Contracts (Regulation) Act              94.1% in 2007-08 but shot up to 106.4% in 2008-09. In
        1952 and strengthening of the Forward Markets                 the current fiscal, for the April 1-August 31, 2009
        Commission (FMC). As it agreed to and acted upon              period, the cumulative value of trade stands at
        most of these recommendations, the Government                 Rs.27,29,248.80 crore, a y-o-y jump of 31%. And a major
        allowed futures trading in all the commodities                part of it was due to a surge in the trade volumes of
        recommended. The trade came into being after                  agricultural commodities futures, which shot up by
        remaining in hibernation for nearly four decades, as          53.5% to Rs. 405,671.40 crore, followed by the trade in
        realization that derivatives do perform a role in risk        the energy and industrial metals complex, which
        management dawned. The timing of this revival effort,         jumped by 27.5% to Rs.22,89,316.20 crore. After
        from the four decades of restrictive government               significant declines in the trade volumes of agricultural
        policies, turned out to be spot on, as the 1990s              commodities in the previous two consecutive fiscals i.e.
        heralded an upswing in the commodity cycle, globally.         2007-08 and 2008-09, the rise in agricultural
        FMC and the Government, on a fast-track mode,                 commodities’ trade in the current year is noteworthy.
        encouraged the idea of setting up commodity
        exchanges with state-of-the-art infrastructure and
        global best practices, and three national-level online
        exchanges — the Multi Commodity Exchange of India              Given the growth in trading
        Ltd. (MCX), the National Commodity and Derivatives             volumes and increasing integration
        Exchange Ltd (NCDEX) and the National Multi-
        Commodity Exchange Ltd (NMCE) were born.                       of Indian economy with the rest of
                                                                       the world, the Indian commodity
        The current scenario                                           futures market has begun to be
                                                                       recognized among the top
        At present, 24 commodity futures exchanges are
        operational in India, which include 21 regional bourses        derivatives exchanges of the world.
        and the three national-level players, with another three
        proposed exchanges on the cards. With the state-of-
        the-art technology-powered modern, secure and
        efficient operational infrastructure these national           The Indian commodity futures market has emerged as
        exchanges are creating a near-perfect market situation        one of the fastest growing markets with a combined
        with a much wider participation from the ecosystem            trade turnover of around Rs.52.48 trillion ($1.14 trillion),
        stakeholders in a large number of domestic and global         and the phenomenal growth (110% compounded
        commodities during local and international timings.           annual average growth since the market’s resurrection
                                                                      in 2003) is largely attributed to continuous outreach
        Since the reintroduction of commodity futures trading         efforts and all-round innovation by its national-level
        in India in 2003, the bulk of trading has been taking place   electronic commodity futures exchanges, which
        on the three national exchanges. Despite being a late         includes launches of a slew of new products suitable to
        starter, MCX overtook other domestic exchanges and            the fast-changing market dynamics and needs such as
        continues to be the No. 1 commodity futures exchange          certified emission reduction (CER), aviation turbine fuel
        in the country (by numbers/lots of contracts traded) with     (ATF), gold guinea contracts, and so on. As per FMC
        a market share of 85% as on August 31, 2009.                  estimates, total turnover of commodity futures trading
                                                                      is expected to cross Rs.60 lakh crore in the current fiscal
        Speaking of the combined turnover of domestic                 (2009-10) and Rs.100 lakh crore by 2010-11, provided
        commodities exchanges, what began with a notional             the FCRA amendment Bill is passed.
        value of Rs.1,29,364 crore in 2003-04 increased to
        Rs.36,77,226 crore in 2006-07. However, following a

Given the growth in trading volumes and increasing            Prevailing prices of banned agricultural commodities
integration of Indian economy with the rest of the            and the volatility that existed in their cash markets
world, the Indian commodity futures market has begun          clearly indicate that their trading in organised and well-
to be recognized among the top derivatives exchanges          regulated markets would have kept the volatility in
of the world. According to Futures Industry Association       their prices under control than otherwise.
(FIA) and data put up by benchmark international
exchanges, for the year ended March 31, 2009, MCX             Regulatory and market developments
fares as the world No. 1 in Silver, No. 2 in Gold (followed
by NYMEX and TOCOM) and No. 3 in Natural Gas, Crude           Abolition of CTT – The Union Budget 2009-10 did
Oil, Copper, and Zinc futures (by the number of               away with the Commodity Transaction Tax (CTT) of
contracts traded). Until August 31 of the current fiscal,     0.017% proposed in the Budget 2008-09. This will help
MCX retained its leadership position with 85% of the          Indian commodity futures markets not only become
total turnover of all the 24 exchanges.                       globally competitive but also develop into benchmark
                                                              markets, at the international level, by becoming ‘price
Drop in agricultural commodities trading volume               setters’ in many commodities (India is currently a ‘price
                                                              taker’ despite being one of the world’s largest
There had been a significant decline in the volumes of        producers/impor ters/expor ters of about 17
futures trade in agriculture commodities. During 2007-        commodities) through much wider participation. The
08, it fell by 28.5% and the trend continued in 2008-09       move will also help mobilise the resources that would
as well. And a major part of this fall in the trade volumes   have otherwise been diverted to CTT towards
of agricultural commodities was accounted for by              enhancing expertise and skills of domestic commodity
Chana, Maize, Mentha Oil, and Guar seed, Potato, Guar         futures markets to international standards. The
Gum, Chilly and Cardamom. The trade in these eight            proposed tax, had it been implemented, would have
commodities, which accounted for 57.9% of total futures       stunted the growth and maturity of a still-nascent
trade in agri-commodities in 2006-07, plummeted by            market whose turnover is less than even half (only 40%
over 66.4% during 2007-08 compared with the previous          in 2008) the country’s equity market turnover, while
year level. Further, this fall (in the eight commodities)     globally the corresponding figure is 5 to 10 times.
exceeded the overall drop in futures trading volumes in
all agricultural commodities together.

While the trade in non-agricultural commodities,
especially bullion and crude, has increased in the past          The passage of the FCRA
two financial years, the same in agricultural
commodities has declined. The share of agricultural              amendment Bill, currently being
commodities almost halved during 2008-09, due to the             awaited, will clear the deck for
continued ban on several commodities. Futures
trading in Wheat, Rice, Tur and Urad was banned in               introduction of long-awaited
March 2007 by the government following pressure
from many quarters blaming the futures market for an
                                                                 instruments in commodity
unprecedented surge in retail prices of food                     derivatives such as options and
commodities, though later the Abhijit Sen committee
appointed to find out the truth, found no direct link
                                                                 index-based trading, which will
between the price rise and futures trading. The                  deepen the market through wider
agricultural commodities vertical suffered another
shock on 7 May, 2008 as four other agri-commodities              participation of entities like banks,
— Chana, Soy Oil, Potato and Rubber — were banned                mutual funds, FIIs.
for four months until December 3, 2008 citing the same
reason. Rice, Tur and Urad are still under ban, while the
ban on what futures was lifted on May 15, 2009. Lately,
Sugar was also banned on May 27, 2009 following a
shortage and the associated increase in its price.

                                                                                                              MARKET COMMENTARY   | 11
         Amendment to FCRA: The proposed amendment to                  Conclusion
         FCRA will make FMC an autonomous regulator with
         functional and financial autonomy to play its                 Indian commodity exchanges have come a long way,
         regulatory role more effectively alongside its                with an impressive growth during the last six years
         developments responsibilities. The passage of the             since 2002-03 when the government embarked upon
         FCRA amendment Bill, currently being awaited, will            policy liberalisation. The three national online
         clear the deck for introduction of long-awaited               exchanges came into being, taking the erstwhile
         instruments in commodity derivatives such as options          turnover of Rs.66,530 crore to Rs.52,48,956 crore in
         and index-based trading, which will deepen the market         2008-09. As these exchanges grew over the past six
         through wider participation of entities like banks,           years, they also took along with them the stakeholders,
         mutual funds, FIIs. A large number of risk-averse             besides nurturing the ecosystem delivering both the
         economic stakeholders will likely be attracted towards        felt and the unfelt benefits of their existence to one and
         the market with increased information about                   all in the commodities supply chain right from the
         commodities enabling hedging of price risk at much            producer to the consumer. During this small yet
         lower costs (driven by increased liquidity). This will help   remarkable journey, these state-of-the-art exchanges
         India emerge as a price taker with a transparent flow of      have also crossed several policy hurdles to grow in
         market information converging from a highly increased         stature equivalent to their international counterparts,
         number of domestic and international participants. This       seamlessly integrating with the entire financial
         will also guarantee fair returns to farmers.                  markets architecture. They also did help spread risks in
                                                                       major commodities ecosystems across several
         Regulatory measures: FMC has recommended a                    stakeholders thereby making the economy more
         reduction in central value added tax (cenvat) from 8%         competitive in the current rapidly globalising world.
         to 5%. It has also directed commodity exchanges to            Being online with extended hours of operation, these
         levy non-compliance charges on high-value cash                modern commodity exchanges have also enabled the
         dealings. However, it stated, cash transactions up to         Indian industry manage risks as they flow from their
         Rs.10 lakh will attract no charges, while traders will        origins crossing economic borders. It is a further policy
         have to pay 0.1% of commodities’ transaction value if         boost and socio-economic-institutional change as
         they wish to settle in cash. The move obviously aims to       discussed above that will take the Indian commodity
         discourage cash dealing in commodities.                       markets to a much higher level of growth to help the
                                                                       economy allocate its resources effectively as with the
                                                                       developed economies, spread the risks thinly among
                                                                       all the stakeholders, and wade through the fear of
                                                                       globalisation affecting our economic and political

                                                       An Integrated Approach
                                                       to Agriculture
                                                       Marketing and Financing
                                                       By Prof. Gopal Naik

         An integrated approach, in which efficient systems of e-spot trading, grading and
         quality certification, scientific warehousing and collateral management, crop/weather
         insurance, and futures-benchmarked OTC offered forward contracting can exploit
         complementarities between agricultural marketing and financing, will help solve
         current problems in these functions.

         Agriculture sector development in India is very critical            agricultural commodities. This Act helped in
         today than ever before as the sector still supports                 establishing nearly 7,500 regulated markets
         nearly two-thirds of the country’s population even                  throughout the country and stipulating how
         though its share in national gross domestic product is              agricultural trade should take place. The APMCs, set up
         less than one-fifth, which creates a situation where a              in major production and arrival centres across the
         large number of households have too small an income                 country, perform the crucial function of organising
         to sustain their life. In addition, there are also serious          agriculture trade and providing a meeting point for
         questions raised about food security in the country.                buyers and sellers. However, during the past 50 years,
         Any effort to improve rural conditions on a sustainable             no significant improvement has taken place in the
         basis hinges to a large extent on how agriculture                   functioning of agricultural markets. Though the APMCs
         income can be increased. These efforts will have to be              were set up to protect farmers from exploitation of
         in the form of policy instruments in the area of                    intermediaries and traders, as well as ensure better
         technology, markets, infrastructure and institutions.               prices and timely payment for their produce, these
         India has had a very successful technology                          markets have become inefficient over a period of time.
         development in the past in agricultural production in
         general and particularly in crops such as cotton, maize             Agriculture sector financing has so far mainly
         and vegetables recently. Even now, a number of                      concentrated on production financing, leaving behind
         technology options seem to be available at the                      equally important marketing finance. During the Green
         laboratory level waiting for appropriate market,                    Revolution, cooperative institutions played a major
         infrastructure and institutional conditions for effective           role in providing production financing in many parts of
         adoption. Institutional conditions perform an                       India. However, over the years, various policies of the
         important function of providing easier financing to the             government weakened the performance of these
         agricultural sector through creating appropriate                    institutions creating a major vacuum in financing
         processes. All these factors are interrelated and unless            agriculture. This has enormously affected agriculture
         changes in them are made in an integrated manner,                   sector growth in the country. While considerable
         they will not help in creating an enabling environment              efforts have been made in recent years to improve
         for faster growth. India has certainly lagged behind in             agriculture financing through measures such as loan
         terms of bringing appropriate changes in markets,                   wavers, reduction in interest rates, mandating banks to
         infrastructure and institutions in order to leapfrog                increase the share of loans to the sector, and Kisan
         development of the agriculture sector.                              Credit Cards, among others, a large gap still remains
                                                                             between provisioning and the requirement, forcing
         Agricultural Marketing and Financing in India                       farmers to fall back on the informal sector. The world
                                                                             over agricultural marketing and financing developed
         During the Green Revolution, a major reform was                     together as complementary to each other. However, in
         initiated when almost all the states brought in                     India, they are dealt separately ignoring this attribute
         legislation the Agriculture Produce Market Committee                of complementariness.
         (APMC) Act to ensure an efficient system of trading

        In recent years, liberalisation of agriculture trade in     the crop-acreage and forward contracting decisions
        India as part of the globalization process has created      simultaneously based on the prices offered in the
        enormous pressure to reform the agricultural                forward contracting arrangement. The forward
        marketing system to be in tune with the rest of the         contracting system will be tagged on to the futures
        world both in terms of quality and efficient handling of    market, with the contract price derived from futures
        agricultural produce. And this challenge has been           prices. Farmers should be able to sell the crop to the
        accentuated because there has hardly been any               extent of insured quantity. These forward contracts are
        worthwhile reform undertaken in the country’s               the over-the-counter (OTC) transactions available at
        agricultural marketing for a long time now, while           APMCs, organised by private players and are based on
        elsewhere technology development, especially that of        the prevailing futures prices. This will be essentially
        information and communication, has been effectively         retailing futures contracts to farmers. A farmer can use
        used for improving the agricultural marketing system.       the forward contracting facility at any time during the
        In addition to technology development, several              crop production period. Based on the forward contract
        process improvements need to be brought in to reduce        and yield insurance, the farmer should be able to take
        the cost of transaction, which will help increase the       additional loans if he intends to do so. The forward
        price realised by the grower and decrease the price         contract buyer may have reinsurance arrangement to
        paid by the consumer. Lower prices at the consumer          meet the financial obligations in the event of a crop loss
        level increases demand and higher prices at the farm        which should not be recovered from the claim of the
        level increases supply, and these two changes together      farmers from the agency that had provided them with
        result in large volumes of production and                   crop insurance. This insurance may be given by the
        consumption, benefiting both consumers and                  same agency as the crop yield insurance which may
        producers and, thus, contributing significantly to the      facilitate faster processing. The Food Corporation of
        economy.                                                    India should buy the contract in case farmers are
                                                                    prepared to sell at the announced minimum support
        New System for Agricultural Marketing and Finance           prices. This futures contract, along with the crop yield
                                                                    insurance, enables farmers to get bank credit in
        Complementarities between agricultural marketing            addition to the crop loan. Once the harvest is done, the
        and financing help evolve an integrated approach to         farmers can check the quantity and quality of the
        address the current problems in these functions. A          produce. And they will have the following options (see
        good marketing system facilitates easier financing and      flowchart):
        a good financing system improves efficiency in
        marketing. The ultimate objective is to develop             1. Deliver the contracted amount to the forward
        marketing and financing systems where price                    contract seller and sell the remaining amount in
        discovery takes place in an efficient manner, cost of          one of the following ways:
        marketing reduces, quality of produce improves,
        farmers are able to receive payments as well as                a. Wait for the better prices in the future: if the
        production and marketing credit in time, transaction              current prices are not attractive and the farmer
        cost is reduced, and also risks are reduced. For the              expects the prices to go up in the coming
        development of such marketing and financing                       weeks/months, he keeps the produce in a
        systems, the following requirements have to be met:               warehouse, gets a warehouse receipt, may or
                                                                          may not go for a pledge loan from the bank
              •    An efficient spot trading system                       counter, sells at a later date and realises the
              •    An efficient grading system                            remaining value.
              •    An efficient forward market                         b. Sell it in the forward market: The farmer feels
              •    An efficient insurance market                          that one or more forward prices are attractive.
              •    An efficient warehouse receipt system                  He keeps the produce in the warehouse, gets a
              •    An efficient Government support system                 warehouse receipt and forward sells it using the
                                                                          forward market and delivers on the contract
        With these systems in place, a farmer will be able to get         maturity.
        both production and marketing credit as well as sell his       c. If the current prices are attractive, sells in the
        produce efficiently. At the time of planting, once the            spot market.
        farmer takes his decision on the crop and acreage, he
        should be able to avail of crop loan and crop yield         2. The farmer buys back the contracts he has sold
        insurance. With the crop-acreage decision, he has an           during the planting time and uses any one of the
        estimate of crop yield that he should be able to sell          above three options — keeps in the storage for a
        forward through a forward contracting arrangement to           sale at a later date, sells using the forward market,
        be established at an APMC. In fact, the farmer can make        sells in the current spot market.


This integrated system will provide the following               Price stability: With the forward contracting
advantages to the farmer:                                       arrangements, there will be a better estimate of the
                                                                supply of commodities that would be used in the
Easy financing of crop production and marketing:                futures market as forward contract sellers hedge in the
Farmers can get crop production credit and marketing            futures market to cover their risks. The additional
credit through insurance, forward selling and                   information flow into the system will lead to stability in
warehousing. At present, crop production loan is                the prices.
available, but credit limits are low. Farmers will still have
the option of going for crop loan in the existing               This integrated system will work well if each one of its
arrangements, without going for forward contracting.            components is made to work efficiently. And this will
However, farmers should be able to get more credit              require participation of both the public and private
through forward contracting.                                    players as well as government support.

Risks are covered: Farmers can cover the yield risk             Efficient Spot Trading System
through crop yield insurance and the market risk
through forward contracting. Thus, this provides                In the current marketing system, APMCs play a pivotal
comprehensive revenue insurance to farmers.                     role in spot trading. However, these primary markets
                                                                have not kept pace with the developments taking place
Low transaction costs: As systems develop and reach             in the international markets. Some of the deficiencies in
a steady state, the transaction costs in this mechanism         the existing agricultural marketing system are:
are likely to be low. A large volume of handling in
grading, warehousing, forward transaction and
insurance will facilitate transactions at a lower rate.

                                                                                                                    EXPERTS’ VIEWS   | 17
        Absence of a good quality assessment system: This                •   Setting up ‘special markets’ for perishable
        often result in lower price realization for the seller               commodities such as onions, fruits, vegetables, and
        (farmer), while the buyer takes advantage of the state               flowers.
        of affairs to offer lower prices to the farmers.                 •   Encouraging alternative marketing systems such as
                                                                             contract farming, direct marketing, and farmers
        Absence of a good grading system: This makes                         markets
        farmers unaware of the quality requirement of                    •   Promoting grading, standardization, and quality
        agricultural produce at the user end, making farmers                 certification of agricultural produce, which would
        neglect the quality aspect of their produce.
                                                                         While many of these initiatives are yet to be
        No post-harvest guidance system: Absence of any                  implemented, a significant initiative that can be taken
        extended system to guide farmers on post-harvest care            up immediately is the setting up of and enabling of
        results in substantial losses of value of the agricultural       “electronic spot trading” (e-spot trading) for
        produce.                                                         agricultural produce.

        Poor handling of agriculture produce: This practice              E-Spot Trading
        in the market yard results in large losses of the farm
        produce. Poor handling also results in substantial loss          The developments in ICT that have already taken place
        in quality during marketing of the produce, putting it           can facilitate agricultural marketing functions and
        far below international standards.                               processes, including buying and selling, payment, and
                                                                         transportation and logistics. This will connect local
        Poor knowledge of packing and scientific storage:                markets nationally and will effectively do away with
        This leads to losses in the supply chain, which gets built       information arbitrage that exists in today’s APMC
        up at the consumer end.                                          markets. ICT can also play a pivotal role in
                                                                         disseminating and using trade information. Adoption
        Lack of price information: Price information about               of ICTs for agricultural trade, in the form of electronic
        other markets is not available on right time, which              spot trading, will benefit farmers enormously. Thus, the
        makes farmers rely mainly on the prices quoted by local          e-spot exchange is a marketplace where local farmers
        traders.                                                         and traders can sell farm produce, while upcountry
                                                                         buyers, processors, exporters, and end-users can buy
        No access to warehouse receipt financing: This                   electronically through competitive bidding.
        pushes farmers to distress sales and lower price
        realizations. • Limitation of selling options: The system        E-spot trading is an effective method which enables
        of marketing through APMCs with only a few registered            farmers to sell their produce to anybody, anywhere,
        traders who often buy in collusion among themselves,             anytime in a transparent way. This can not only reduce
        farmers have restricted selling options.                         transaction costs and make intermediation in
                                                                         commodity markets cost-effective but can also
        Lack of effective information transmission: This                 effectively mitigate problems of lengthy supply chain
        leaves very high information arbitrage possibilities             through the elimination of middlemen connecting
        among the markets.                                               farmers through the shortest possible value chain,
                                                                         which in turn helps farmers realize a better share of
        Therefore, APMCs need to redefine their role in the              consumers’ rupee. Price realization by sellers will also
        context of present era of Information and                        be faster. Further, the anonymous nature of the system
        Communication Technology (ICT) and globalization. In             will ensure pricing transparency and reduce
        recent years, certain policy changes have been                   possibilities of speculation.
        announced to improve the agricultural marketing
        system and they are:                                             This screen-based trading will help small and marginal
                                                                         farmers participate as it will be possible to do trading in
        •     Encouraging procurement of agricultural                    small quantities, without any dependence on
              commodities directly from farmers’ field                   middlemen to sell their small marketable surpluses. The
        •     Removing all restrictions on production, supply,           e-trading will also remove the problem of information
              storage, and movement of produce                           asymmetry, as price information will be available
        •     Permitting the establishment of ‘private market            instantaneously in any terminal and quality assessment
              yards’, ‘direct purchase centres’, ‘farmers markets’ for   will be done before the transaction. The trading will help
              direct sales                                               the producer get the best possible price for his
        •     Promoting PPP (public-private partnership) in the          commodity/produce. Potential participants/traders on
              management and development of agricultural                 the exchange platform can be farmers, farmers’
              markets in the country                                     associations/co-operatives, corporate, wholesalers,
                                                                         exporters, importers, processors, the government, etc.

Requirements for successful implementation of e-             buyers to local delivery points. Hence, the synergy
spot trading:                                                between APMCs and NESEs will complete the chain
                                                             and make it most efficient.
•   Amendment of the APMC Act that gives recognition
    to these electronic spot exchanges.                      NESE is a new distribution channel with trade
•   Good warehousing facilities, coupled with grading        guarantee that offers advantages to the overall
    facilities at market yards where farmers’ produce        marketing system. It allows desktop monitoring of
    can be graded and stored, as well as be able to          trade, offers efficient warehousing and logistics
    pledge produce for warehouse receipts. This will         support, guarantees quality, functions as a
    enable farmers to get easy financing.                    complementary market to derivative traders, facilitates
•   Setting up grading laboratories at market yards for      timely disbursement of commodities and funds while
    establishment of uniform grading/quality                 ensuring transparency in transaction and settlement.
    standards. APMCs stand guarantee to the quality          More importantly, being online and accessible to
    specified in the auctioned lots.                         traders located across the nation, it prevents
•   Arrangement with transporters who can ensure             information arbitrage from getting added to
    delivery of the goods sold.                              consumers’ rupee. This model of marketing of produce
•   Removal of restrictions on interstate movement of        has advantages for farmers, APMCs, traders and
    agricultural produce.                                    exporters. Farmers will have better price realization,
•   Setting up of trader work stations, leased lines,        lower transaction cost, easy access to credit, clarity on
    internet facilities, power backups, etc                  quality requirements and quicker transaction. APMCs
•   Establishment of contract specifications that            will have better realization of market fees, greater
    include particulars such as opening of contracts,        outreach and timely transaction. Traders will have a big
    unit of trade, base value, price quote, maximum          and liquid market, where they can sell a large quantity,
    order quantity, delivery specifications (delivery unit   with the elimination of counterparty risk, credit risk,
    and centre) and quality specifications (grades,          rejection at the buyer’s godown at the time of delivery
    standards, tolerance limits, etc).                       and easier access to bank finance against warehouse
                                                             receipts. With the grading system in place, they can
APMCs and spot trading – the PPP model of                    effectively use the futures market for managing their
transformation                                               risk. With operational ease, availability of finance and
                                                             absence of counterparty risk under the NESE system,
Though the e-spot trading is a good alternative to           they can expand their activities to multiple
traditional marketing, the investment needed to set up       commodities. Exporters can buy certified quality
national-level electronic spot exchanges (NESE) by           material through a secured platform. Hassles relating
every APMC is likely to be a deterrent. The                  to procurement of material in physical markets can
infrastructure and quality of manpower needed are            completely be avoided. Exporters can save brokerage
also deterrents to setting up of an e-trading platform in    or commission payable to procurement agents. Using
agriculture. Therefore, a viable model is to have a PPP      the price available at NESE, they can make export
with NESEs. This can be done at the state level by           commitment and cover themselves immediately by
organizations like State Marketing Boards, which will        buying at NESE.
link each APMC with the existing NESE.
                                                             Efficient Grading System
Synergy between APMCs and NESEs
                                                             Formal grading of agricultural commodities is very
Synergy in this PPP is feasible due to the                   rarely done for internal transaction in India. This has
complementary nature of the two entities — APMC              caused the ‘lemon problem’ in agricultural markets
and NESE. APMCs have physical infrastructure,                where bad quality produce drive away good quality
knowledge and catchment of commodities, while                produce in the market as there is no price incentive for
electronic spot exchanges have pan-India reach with a        farmers to supply better quality produce. This also has
robust delivery and payment mechanism, which can             led to a larger gap between the quality of domestically
create an effective combination to transform                 traded produce and internationally traded produce,
agriculture marketing. NESE is neither a buyer nor a         making exports of agricultural produce difficult. In
seller nor a commission agent. It is a facilitator that      addition, imports of good quality produce are taking
undertakes delivery and payment responsibility and,          place to meet the needs of the emerging quality-
thus, functions like a national-level APMC facilitating      conscious section of Indian population. Reversing this
trade between the buyer and the seller. While APMCs          trend necessitates development of a value chain that is
provide a backward integration, linking farmers to           conscious of quality. This can be effectively facilitated
market yards, NESEs provide a forward integration            by introducing grading at the primary wholesale
linking processors, exporters, end-users and upcountry       market level.

                                                                                                                EXPERTS’ VIEWS   | 19
        Although Agmark standards and labelling has been in                        Efficient Forward Market
        existence for nearly half a century, its reputation has
        not helped produce quality crop in India. Also, for                        With the futures market, grading and warehousing
        commodities, grading is hardly practised in the                            system in place, private companies can offer retailing of
        country. But then the pressing need for a good system                      commodity futures contracts at the APMC level. A
        of grading to bring in quality consciousness among                         formula can be established to retail futures contracts to
        various participants in the agricultural value chain can                   farmers in the form of forward contracts. Since there is a
        hardly be overstated.                                                      problem of uncertainty about the amount of yield,
                                                                                   forward price contract may require a yield insurance to
        A good grading system ought to have unquestionable                         be obtained as a prerequisite. Once the decision on
        integrity and standards in line with the requirement of                    planting certain acres of a particular crop is made, he
        trade, continuous upgrading of standards and                               can obtain insurance and then forward sell at an APMC.
        harmonising with international standards. This could                       In case there is a shortfall of yield, the insurance can be
        be achieved effectively with participation of both the                     used to make up the losses. As more and more agencies
        public and private sectors. While the government                           come up to retail forward contracts, a much needed
        should set standards and continuously undertake                            healthy competition to provide this service will be
        research to upgrade and harmonise, the private sector                      created at the APMC yard. With yield insurance and
        can develop a system to implement it effectively. While                    forward contracting, farmers can effectively address
        steps should be taken to update Agmark standards to                        both yield and price risk, which will enable the farmer
        reflect consumer preferences and technical needs of                        to obtain credit easily.
        processors, a few national-level companies can be
        accredited for grading and certification of agricultural                   Efficient Insurance Market
        produce. These companies can have franchises so as to
        create enough facilities for grading and certification at                  Yield insurance has been existence in India for more
        all APMCs. This will help in facilitating e-spot trading,                  than three decades for crops such as rice and wheat.
        warehousing, financing and forward contracting. The                        However, they are offered on an area basis, as there are
        commodities futures exchanges already have already a                       no effective ways of dealing with moral hazard and
        grading system in place, but a robust grading system                       adverse selection problems. Nevertheless, with
        can be set up only when the government too pays                            increasing sophistication in the data collection
        adequate attention to the development of standards                         methodology, individual assessment-based insurance
        and grading systems.                                                       will become a reality. Such an insurance system will
                                                                                   address the risk management needs of farmers
        Efficient Warehouse Receipt System                                         effectively. With a good insurance market, financing at
                                                                                   the farm level and, thus, credit access to farmers
        An efficient warehousing receipt system can go a long                      becomes easier.
        way in helping reduce transaction costs in the supply
        chain and facilitate financing of agricultural                             Conclusions
        commodities. A scientific method of storage, which
        prevents deterioration in quality and quantity during                      An integrated approach, in which efficient systems of
        storage, will give financial institutions the confidence                   e-spot trading, grading and quality certification,
        to extend easy financing. The extent of finance that the                   scientific warehousing and collateral management,
        market participants can obtain through pledging will                       crop/weather insurance, and futures-benchmarked
        also increase. This will also make transactions over long                  OTC offered forward contracting could exploit
        distances easier. There are private sector companies                       complementarities between agricultural marketing
        which are already providing scientific warehousing                         and financing, will help address current problems in
        facilities including collateral management. With                           these functions. The ultimate objective is to develop
        appropriate backup of legislation, the warehouse                           marketing and financing systems wherein price
        receipt system will become easier to implement.                            discovery takes place in an efficient manner, cost of
                                                                                   marketing reduces, quality of produce improves,
        With the warehouse system available at the APMC                            farmers are able to get their payment in time, farmers
        level, a farmer can either sell his qualit y                               get both production and marketing credit in time,
        certified/graded produce immediately through an e-                         transaction costs are reduced and risks are minimised.
        spot exchange or defer the sale. In case of deferment he
        may go for pledge financing to meet immediate
        financial requirements. This protects farmers from
        distress sales.

        Prof. Gopal Naik is Professor, Indian Institute of Management – Bangalore. Views expressed by the author are personal and not of the institution.

                                                       Commodity Futures
                                                       in India – A Product of
                                                       Globalisation and
                                                       By Mr. Lamon Rutten

         A beginning has been made towards transforming the Indian commodities sector, from its
         current status of being a ‘price taker’ to a ‘price setter’, with the national online commodity
         futures exchanges taking the lead. These exchanges are offering the benefits of
         liberalisation and globalisation directly to the industry and consumers by empowering
         them to influence the global prices of commodities they deal in. It is time the markets were
         made much more vibrant and efficient by allowing participation of a larger number of new
         categories of economic stakeholders and introduction of innovative derivative
         instruments. This is to plug risks at the roots rather than when they finally sneak into the
         prices of end products. And this will make the Indian markets a force to reckon with on the
         global commodity map, turning them into a‘price setter’indeed.

         Economic liberalisation took off in the early 1990s in          many, is commodity price volatility. Companies need to
         India. Like in many countries, policymakers,                    be able to manage these risks if they are to be globally
         practitioners and academics responded to the growth             competitive, and this is where an efficient commodity
         of financial markets worldwide, and a new-found                 futures market plays a primordial role not only in
         ebullience surrounding emerging markets, by                     facilitating price/volatility risk mitigation but also
         advocating wide-ranging reforms. International trade            catalysing near-perfect price discovery.
         and investment were opened up, a process of
         deregulation and privatisation initiated, the tax regime        After decades of decay, India's organised futures
         reviewed.                                                       industry was revived in 2003. As it matures over time, its
                                                                         backward and forward linkages will strengthen,
         India's economy greatly benefitted. In 2007, the                resulting in widening and deepening of the market
         country clocked its highest ever GDP growth rate of 9%          through increased participation by various ecosystem
         the second-fastest in the world after China and a far cry       players. This in turn is changing the ways producers
         from its annual GDP growth in the three decades post-           make their cropping decisions, traders trade their
         Independence. However, the reform process is still              products, and banks lend against commodities or
         incomplete, and the financial sector has been lagging           those with exposure to commodity price risk. The
         behind many parts of the real economy. Stakeholders             ultimate results will be 'Financial Inclusion' and 'Market
         have still not reaped the fruits of greater competition in      Inclusive' growth.
         financial markets, unlike what has been seen in sectors
         such as telecom, banking, insurance, and aviation. But          The Enabler of Efficient Price Risk Management and
         now, Indian financial markets are poised to scale to the        Price Discovery
         next growth orbit.
                                                                         The price discovery process should not be left to just a
         India increasingly integrates with markets around the           handful of traders in asymmetrically informed or ill-
         world. This opens a window of opportunity to Indian             informed, segmented markets. Rather, the best price
         companies but also, exposes them to a whole new                 discovery comes when a large number of various
         world of risks. Among these risks, of key importance to         categories of market players with a wide range of

objectives and interests converge on an organized                                  To make these markets more relevant and useful to
futures platform. Such a platform and the Multi                                    different categories of stakeholders and thus their
Commodity Exchange of India Ltd. (MCX) is one                                      participation more effective, it is necessary that various
ensures that all relevant information is absorbed in the                           risks to the participants be effectively managed. Risk
price formation process, and the “right price” is                                  management tools on a futures platform include
discovered. The more efficient the discovered prices on                            margining, limits on open positions, and effective
a futures platform is, the more effective are the                                  surveillance (see table 1). Price volatility of
business and policy decisions that are taken based on                              commodities traded on an exchange is an indicator of
these prices.                                                                      how effectively these tools are used by the exchange
                                                                                   managers to improve the efficiency of price discovery.
The efficiency and transparency of price discovery                                 That is to gauge the capability of its futures contracts to
depends on the robustness of the trading platform; its                             predict its maturity prices more accurately (indicated
regulations; the right mix of its participants with                                by the percentage deviation between the first traded
relevant price information; making participation cost-                             price and the last traded price of a given contract). The
effective vis-à-vis alternatives available for risk                                efficiency of price discovery is also indicated by the
m a n a g e m e nt a n d / o r i nve s t m e nt ; e f fe c t i ve                  nearness of the spot and futures price movements. In
management of the participants' varied risks and, last                             the case of MCX, the correlation between its gold
but not the least, a robust and transparent clearing                               futures contract and gold spot prices is around 99.8%
policy.                                                                            (from January 2007 to August 2009), which indicates a
                                                                                   strong inter-linkage between domestic spot and
In just about six years, the national commodity futures                            futures markets. For the same period, MCX gold
exchanges in India performed better than the                                       contract's correlation with the global benchmark,
policymakers expected in terms of catching up with                                 COMEX gold futures contract, is around 99.9% (the
their age-old global counterparts on most of the                                   rupee adjusted). This reflects how efficient the Indian
aforesaid parameters. A lot of efforts delivered from a                            futures market is in capturing global cues.
base of strong domain knowledge and technical skills
went behind this spectacular growth. Selection of
commodities relevant to the stakeholders; right
contract design; keeping ears and eyes to market
needs; taking them to appropriate participants;
creating awareness; expanding infrastructure; and
bringing in world-class technology and global best
practices are some worth mentioning.

  Table 1: MCX vis-à-vis global parameters

                                   Domestic Exchanges                         Global Exchanges
   Particulars                Commodity        Stock                                  COMEX                                    Remarks
                            exchange (MCX) exchange (NSE)                            and CBOT
                                                                                                            Position limit is significantly lower than that
Position limit to
                                                                                                            of global benchmark exchanges indicating
physical market             Gold - 0.9%                       -               COMEX Gold - 18.7%
                                                                                                            that the domestic futures market cannot be
size (%)                                                                                                    distorted by single/a few players.

Avg. daily volatility Gold - 1.3%,                                                                          The lower price volatility on MCX compared
                                                                              COMEX Gold - 1.5%             with global exchanges reflects that price
in January 2007       Ref. Soy Oil - 1.2%
                                                      NIFTY - 1.60%           CBOT Soybean Oil              discovery on the domestic platform is
                      MCX Comdex
to August 2009                                                                - 2.1%                        happening with more price stability.
                            - 1.4%.

                                                                                                            The lower impact cost on MCX at par with
 Impact cost                Gold - 0.027%             NIFTY - 0.16%           COMEX Gold - 0.019%           global exchanges reflects better liquidity in
                                                                                                            terms of market depth and width.

Note: In the case of price discovery, we considered August 2009 contracts – MCX Gold contract, COMEX Gold and Nifty Futures.
Impact cost of the S&P CNX Nifty for a portfolio size of Rs.2 crore sourced from NSE website on September 9, 2009.
Impact cost for Nifty was calculated based on trading happened on a regular trading day. Impact cost of MCX gold calculated for a portfolio size of Rs.2 crore.
Impact cost of COMEX Gold calculated for a portfolio of USD4 lakh (app. Rs.2 crore).

                                                                                                                                                          EXPERTS’ VIEWS   | 23
        Again, as the same table shows, MCX gold contract is        over the Indian economy. The prices efficiently and
        more efficient than COMEX gold contract in terms of         transparently discovered on these exchanges are
        price discovery. The lower volatility on the Indian         gradually being transmitted to the physical markets,
        commodity exchanges is due to the close monitoring          and this will lead to increased competitiveness both in
        and the robust margining system adopted by them.            the manufacturing and services sectors.
        MCX follows strict vigilance with an automated system
        in place. The system, for example, provides automated       Global commodities traded on these Indian exchanges,
        alerts when a member’s margin utilization crosses           such as bullion, ferrous and non-ferrous metals
        various levels. If the margin utilization crosses 100%,     (copper, aluminium, steel, etc) and energy (crude oil
        the member in question is put automatically on a            and natural gas), account for more than 80% of their
        “square off” mode. This innovative risk management          average daily turnover. These commodities are largely
        system has been adopted to prevent any spread of            linked to the global markets as their imports and
        financial contagion. Besides the functional efficiency of   exports are allowed subject to a marginal tariff
        trading, the technological robustness (both hardware        incidence. Obviously, most of these commodities are
        and software) also adds value to the MCX participants       largely governed by their fundamentals (the supply
        by enabling cost reduction. It has a constant               and demand conditions) at the global level and partly
        collaboration with FTIL, the parent company, aimed at       by developments on the domestic front. Therefore, it is
        improving the software through telecom technology,          necessary for the users of these commodities to take
        and this works towards cost-effectively connecting the      positions on a futures platform with global linkages in
        stakeholders to the market.                                 order to hedge their risk. Such users may participate in
                                                                    exchange-traded contracts with their underlying
        Commodity Derivatives - the Road So Far                     physicals being the same as their raw materials and
                                                                    whose prices are linked to the prices discovered on the
        The introduction of commodity derivatives has               international benchmark exchanges. But in the
        remained one of the most significant developments in        absence of such an arrangement, trading on
        the Indian commodity market sector. The three               exchanges having the right mix of arbitragers between
        national online exchanges brought in revolutionary          the domestic and global benchmark exchanges will
        changes in this sector by bringing in spatial integration   also serve the hedging purpose. However, the second
        and temporal price discovery of commodities at the          option may not be workable due to lack of clear
        national level. In the span of just six years, they have    participation norms for international exchanges, while
        performed well, being successful in bringing various        the option of indirect participation will be costly for
        ecosystem participants such as producers, hedgers,          most of today’s corporate hedgers.
        arbitragers, and speculators on to a single platform. The
        annual turnover of domestic commodity exchanges             For globally traded commodities, particularly metals
        increased from Rs.5.7 lakh crore ($127.6 billion) during    and crude oil, the prices discovered on MCX have very
        2004-05 to about Rs.52.48 lakh crore ($1,143.1 billion)     high correlation (96%, on an average) with the
        in 2008-09 at 74.10% CAGR.                                  international benchmarks (see table 2) despite the high
                                                                    volatility in USDINR in the recent past. This also shows
        The exchanges clocked this robust growth despite            that the prices of MCX’s futures on globally traded
        continuance of various restrictions. For example, on        commodity follow efficiently — and in tandem — the
        instruments such as options and indices; participation      combined forces of domestic and international
        of commercial banks, mutual funds and FIIs; and so on.      fundamentals. And this makes the domestic online
        What helped these exchanges to leap forward and             exchanges a cost-effective and superior alternative to
        attain higher levels of efficiency and trade volumes are    their international counterparts.
        their innovative products, functional transparency
        based on sound regulation, innovative applications of        Table 2: Price correlation – MCX vs. global benchmark
        technology, effective adoption of global best practices,     exchanges in globally-linked commodities from
        etc. These exchanges’ efforts and performance helped         Apr ‘05-Mar ’09 (in %)
                                                                        Gold                                          94.3
        make Indian companies and economy globally
                                                                        Silver                                        94.8
        competitive. The robust growth numbers reflect the              Copper                                        94.4
        stakeholders’ strong faith in these exchanges’                  Crude oil                                     97.6
        functional efficiency and transparency, as well as              Average                                       96.0
        indicate the commodity markets’ growing influence           Data Source: Exchanges' websites

The Way Forward                                              Gone are those days when policymakers successfully
                                                             used MSP as an instrument to influence the cropping
At this juncture when the Indian markets are on their        pattern and production of farmers. It is the functioning
way to the heights achieved by the global benchmark          of the domestic commodity exchanges which will
markets, it is essential that they are allowed to have the   strengthen the market-based trading system in India
right mix of participants —and products — to have the        making it useful for Government procurement. The
necessary liquidity depth and width. Corporates and          exchanges will create an environment where farmers
physical market players in India are gradually realising     have multiple selling options (for their produce) such
the importance and need to participate on commodity          as the spot market, the futures market, and the futures
exchanges. An increased participation of such players        market-referred over-the-counter forward market. The
will go a long way in streamlining commodity trading         futures market in electronic format being executable at
in India by bringing in relevant information about the       the national level, integration of banks and
fundamentals into the markets and, thus, making the          institutional traders into the market will create several
price discovery process more efficient. Besides, this will   institutional options for farmers. Further, once allowed
also help corporate best practices percolate into the        options will help farmers lock in their prices on the
markets to fine-tune their functioning and efficiency.       commodity exchanges in a more efficient way than
Given the current trend of globalisation of economies,       they can currently do with the existing instruments.
competitiveness remains one of the most defining
factors for developing economies. And this not only          Besides the price risk, which can be mitigated by
means having competitive manufacturing and services          trading in relevant commodity derivatives, the weather
sectors but also necessitates promotion of markets to        risk has a profound impact on a farmer’s income under
make them globally-competitive.                              the predominantly rainfed farming (about 70% of net
                                                             cultivated area) conditions prevalent in India. And if
To cite an example, in I ndia, neither the                   there could be a single most positive and defining step
automobile/ancillary industries manage their input           that can be taken towards solutions to such problems
costs effectively nor do the suppliers of their raw          as mentioned above it shall be the passage of the long-
materials. This is partly due to lack of policy guidelines   pending amendment to For ward Contracts
allowing and promoting them to effectively participate       (Regulation) Act. The Act, once effective, will work
in the market and partly because of lack of awareness        towards an efficient and vibrant commodity market in
on their part. However, of late, the coming up of the        India (both on the physical and futures fronts) and
national commodity exchanges, armed with their               bring a world of good to the entire commodity market
global alliances, has provided industrial users of           ecosystem. The multi-faceted benefits will include
primary commodities with easy access to an alternative       introduction of a number of innovative instruments,
platform to trade on. The domestic exchanges offering        such as farmer-friendly weather derivatives.
such an opportunity to the industry ought to be
effectively harnessed to efficiently manage their profit
margins and safeguard their investor and consumer
interests by infusing efficiency and economy into their         India is a land of billions that
procurement operations. Effectiveness of participation
in global exchanges can only be replicated if the               consume a large portion of most
domestic exchanges meet the efficiency of trading in            primary commodities produced in
the global benchmark exchanges, especially in the
globally traded commodities (with least trade
                                                                the country. For the domestic
distortions).                                                   exchanges to rise to the challenge
Although India has a long way to cover in harnessing            of turning the country into a ‘price
the potential in the major commodities, the story of its        setter’ it is necessary that India has
bullion market is bright. The Indian bullion market has
demonstrated its resilience to remain the “price setter”
                                                                strong and transparent markets
for gold and silver in the Euro-Asian time zone. Indian         with robust infrastructure for
(MCX) bullion prices have strong correlation with those
of the international benchmark markets.
                                                                efficient transactions.

                                                                                                                EXPERTS’ VIEWS   | 25
        India is a land of billions that consume a large portion of     As the WR draws its power under the act, the value to it is
        most primary commodities produced in the country.               added by the linkages that the warehousing institution
        For the domestic exchanges to rise to the challenge of          creates with the funding institutions and the strength of
        turning the country into a ‘price setter’ it is necessary       the collateral management services for the funding
        that India has strong and transparent markets with              agencies and their clients at a cost which would keep
        robust infrastructure for efficient transactions. This in       both the financial institutions and clients happy.
        turn necessitates that Indian commodity exchanges
        have an upright regulatory framework under a robust             The WDRA will also create efficient linkages between
        regulator. Therefore, strengthening FMC through the             producers and markets. Application of information,
        FCRA will be a momentous step towards strengthening             communication and technology (ICT); innovative
        the commodity futures market as a whole.                        solutions to practical constraints; and effective
                                                                        nurturing of the linkages will go a long way in creating
        First, once amended, the FCRA will clear the deck for           a healthy warehousing system in the country.
        introduction of long-awaited instruments such as                Development of the warehousing sector — through
        options, intangibles like weather derivatives,                  the linkages to be created between the players and the
        commodity indices and freight indices, which through            institutions in the agricultural supply chain ecosystem
        value additions will attract risk-averse participants.          — will help achieve the ultimate objective of creating
        And the deepening of the commodity market, thus                 win-win supply chains for producers, intermediaries,
        achieved, will enhance the market’s efficiency of price         and consumers.
        discovery and efficacy of risk management. And this
        will eventually result in fairer returns to farmers.            MCX – Unrelenting in Its Endeavour

        Second, the amended FCRA will pave the way for                  Since its inception in 2003 MCX has taken a number of
        participation of banks, MFs and FIIs in the commodities         initiatives to help the farming community to realize a
        market. This will not only democratise the price                better value for their produce. It launched two major
        discovery process on the exchange platform but will             infrastructure projects - ?National Spot Exchange Ltd
        also stabilise the market forces and, thus, the overall         (NSEL) and National Bulk Handling Corporation Ltd.
        economy. Participation of financial institutions on             (NBHC). The combined strengths of MCX, NSEL and NBHC,
        exchanges will also enable lending at market-linked             along with its strategic partners, is committed to
        prices, which in turn will lead to the benefits of price        transforming the Indian rural economy to international
        discovery flowing down even to small farmers, as their          standards by providing the last mile connectivity to rural
        holding power will be enhanced.                                 areas and developing the required infrastructure.

        Warehouses and the related institutions (quality testing,       Availability of liquid futures contracts on various key
        standardization, and marketing yards) form a vital cluster      commodities on the MCX platform has dramatically
        in the logistics sector linking the producers of agricultural   changed the spot market scenario. The fact that these
        commodities with their end-users ensuring effective             prices are arrived through collective participation of the
        carryover of the commodity from the farm gate to the            stakeholders from various parts of the ecosystem and the
        consumers’ table. Efficient warehousing creates efficient       country makes it suitable to be benchmarked for the
        linkages among the participants in a value chain resulting      commodities underlying the futures contracts for the spot
        in improved efficiency with which the produce is being          markets. This is despite the standardised nature of
        marketed, enhanced income of the farmer, availability of        contracts and terms and conditions of futures trading. This
        credit through warehouse receipts (WR) etc. Besides the         has ensured emergence of benchmark prices of various
        revenue earned from scientific stock management, the            commodities representing the most prevalent varieties in
        coming into force of the Warehousing (Development and           the most active physical markets in India. Thus, these
        Regulation) Act, 2007 (WDRA) and setting up of the              benchmark prices, discovered on the MCX platform,
        authority will create an efficient warehousing ecosystem        reflect the sentiments of the entire producing, trading and
        that will include quality testing and certification,            consuming community representing a one-India market.
        standardization, and marketing. Following this, issuance        The futures market is also increasingly acting as a guiding
        of WRs and collateral management services will enable           light for the physical markets to assess the upcoming
        earning of higher revenues than the plain-vanilla storage       underlying fundamentals and sentiments, and provide
        charges levied on their clients.                                price signals to the physical markets.

Creating a silent revolution…                              Why Can India Not Be a ‘Price Setter’?

A pre-WDRA entity, NBHC, which was floated by MCX Despite the fact that it is fast developing into a major
with the felt need for delivering the underlying at the ‘economic powerhouse’ in the global arena India
maturity of contracts, is an end-to-end solutions continues to look up at other markets to decide the
provider in the entire gamut of collateral management; local prices of commodities. With the country being the
procurement; warehousing; bulk handling, grading and largest producer and consumer of a large number of
quality certification; commodity care and pest commodities, is it not just logical that the Indian
management; audit; accreditation and commodity markets upgrade to the level of ‘price setter’ from their
valuation; trade consultancy and disposal of current tag of a ‘price taker’? And this assumes more
commodities. In just a few years, NBHC, with its robust relevance and priority with the Indian markets
standardisation and quality-testing facilities, developed increasingly opening up and integrating with markets
its own sustainable business model and came out of around the world. As for commodity markets, in which
MCX’s shadow. One such business opportunity that it is either one of the largest producers or consumers or
evolved was collateral management undertaken to both, India has immense potential to have a domestic
facilitate trading against collaterals (warehouse market that is strong enough to set global market
receipts). NBHC, with about 437 warehouses spread over prices. In fact, given its share in global supply and
18 states with a total capacity of 16.5 lakh million tonnes demand as a dominant player in the world market (see
by the end of 2008-09, facilitated in its first year of table 3), the country has the potential to become the
operation (2006-07) collateral funding of Rs.1,500 crore, price setter in 17-odd commodities.
which rose to a cumulative
figure of over Rs.8,800 Table 3: India's share in global production and consumption
crore in the current fiscal.                      Share (%) in
                                                                Share (%) in total Global rank in
NBHC also facilitates Commodities                 total global
                                                               global consumption  production/consumption
government procurement
(cumulative of 5,34,007 Rice milled                   19.4             20.5        2nd largest producer behind China

tonnes of rice and wheat by                                                        3rd largest producer behind EU-27
                                Wheat                 12.1             12.0
2008-09).                                                                          and China

                              Soybean Oil        3.8                 6.1            6th largest producer and 5th largest
Taking the market to the                                                            consumer
masses…                       Gold                -                 22.7            Largest consumer

                              Coal               7.6                 7
MCX has achieved
remarkable success in Aluminium                         3.1                   3.2         6th largest producer
reaching out to a large
                                 Source: USDA, GFMS, BP Statistical review
number of agri-
c o m m o d i t y
producers/farmers hitherto unreached through its To transform the country into a 'price setter' the first
unique Gramin Suvidha Kendra (GSK) model. The logical step would be to democratize its markets to
innovative outreach network in tie-up with India Post enable an efficient flow of information for effective
to leverage the latter’s vast rural infrastructure in cost- determination of commodity prices. And this has partly
effective, traditional modes of communications for been taken care of by the modern national-level
price dissemination and providing other services like commodity exchanges, thanks to policy liberalization
redressal of technical queries and supplies of farm of 2002-03. The rapid ICT developments helped
inputs such as seeds, pesticides/fungicides/weedicides penetration of the online electronic exchanges
and fertilizers, has now spread over 768 villages served through reduced participation costs and increasing
by about 160 branch post offices, across five states, awareness. With the development of liquid futures
benefiting over 3,800 registered farmers more directly. contracts in many of the aforesaid commodities, India
Farmer registration with GSK shot up by 34% to 3,897 as has started emitting price signals to the linked global
on March 31, 2009 vis-à-vis 2,869 in 2007-08 — markets of those commodities. To a large extent, such
testifying the growing popularity of the model.                         benchmark futures prices of the standardised
                                                           contracts, as discovered on the MCX platform, have
                                                           started influencing the global counterparts. They have

                                                                                                                   EXPERTS’ VIEWS   | 27
         started discounting the Indian fundamentals and                         the participants tended to discount the global price-
         sentiments in Indian time zone. For example, in                         moving factors rather than domestic information.
         commodities such as gold, of which it is the world's                    Indian markets have to enable cost-effective
         largest importer and consumer, and chana, of which it                   participation of all those with information to effectively
         is the largest producer and consumer, India, on the                     discover prices, and the national online commodity
         strength of its futures market, is slowly gaining the                   exchanges are already helping various categories of
         rightful place among the world markets, in terms of                     participants get all such available information to
         influencing or setting the prices.                                      converge.

         Although it is still a long way to go, a beginning has                  It is time these markets were made much more vibrant
         been made towards transforming the country's                            and efficient by allowing participation of a larger
         commodities sector from being a price taker to a price                  number of new categories of economic stakeholders
         setter, with the national commodity futures exchanges                   and introduction of more innovative derivative
         taking a lead. They are offering the benefits of                        instruments, besides carrying out other next-level
         liberalisation and globalisation directly to the Indian                 reforms. This is to plug risks at the roots rather than
         industry and consumers by empowering them to                            when they finally sneak into the prices of end products.
         influence the global prices of the commodities they                     And this will make the Indian markets a force to reckon
         deal in. With increased accuracy of the prices                          with on the global commodity map, turning them into
         discovered and more effective price risk management,                    a 'price setter' indeed.
         the efficiency of the Indian industries and commodity
         markets will increase significantly. And this will result in
         a “multiplier effect” on the national economy.

         While proliferation of products and participants is
         evident from the phenomenal 110% annual
         compounded growth rate at which the trade on the
         domestic commodity futures exchanges grew
         between 2003-04 and 2008-09 (source: FMC and
         Economic Survey data), in many global commodities

        Mr. Laman Rutten is MD & CEO of Multi Commodity Exchange of India Ltd. Views expressed in this article are personal.

                                                       Role of Mutual Funds in
                                                       Commodity Markets
                                                       By Mr. Venkateswaran R.

                   Things that count, often can't be counted. Things that can be counted, often don't count.
                                                                                                            - Albert Einstein

         At present, domestic mutual funds are not allowed to invest in commodity markets. In fact, mutual funds’
         role in commodity markets is of very recent origin, globally, and is very limited or absent in emerging
         markets. Nevertheless, the growth so far has been good, buoyed by surging prices of crude oil, precious
         metals, minerals, and food items. With increased demand of a growing world population, the prospects
         for commodity markets, in general, and agricultural commodities, in particular, look bright.

         The Indian mutual funds industry is older than the               Interval Funds: 48) to the investors. Of the open-ended
         Indian public sector banks (other than the SBI Group).           schemes, six were Gold ETFs and 12 were other ETFs.
         The industry has made remarkable progress in terms of            The assets under the management of the mutual funds
         some parameters like opening up of the sector in                 stood at Rs. 7,56,638.17 crore as on August 31, 2009.
         stages to all sorts of players, entry of new fund houses,        Equity oriented schemes, viz., Growth/Equity Schemes,
         growth of assets under management (AUM), expansion               Balanced Schemes and ELSS, accounted for only
         in the number of unitholders, introduction of new                26.12% of the AUM. While debt oriented schemes, viz.,
         products, adoption of robust risk management system              Income Schemes, Liquid/Money Market Schemes and
         covering all operational aspects, relaxation of                  Gilt Schemes, made up for 73.26% of the AUM, ETFs
         investment restrictions, posting of consistent better            had 0.23% share in AUM and fund of funds investing
         returns, reduction of fees and other expenses, abolition         overseas 0.39% share in AUM. More than 56% of the
         of entry load (initially for direct applications and now         AUM was contributed to by corporates and institutions.
         for all) and investor awareness and distribution
         initiatives. The Article describes the current state of the      As a percentage of GDP at market prices at current
         domestic mutual fund industry, discusses the                     prices, the AUM stood at 14.22% as at end-August, 2009.
         investment objectives and restrictions applicable to a           The AUM of mutual funds in developed markets range
         domestic mutual fund and concludes with a brief                  between 20% and 70% of GDP. As on August 31, 2009,
         overview of the commodity funds.                                 open-ended schemes accounted for 91.42% of the AUM,
                                                                          close-ended schemes 8.48% of the AUM and interval
         The Indian Mutual Fund Industry                                  funds 0.10% of the AUM. The worldwide total net assets
                                                                          under management of mutual funds as at end-2008
         An overview                                                      were $ 18.975 trillion. Hence, Indian mutual funds, with $
                                                                          85.32 billion AUM as at end-2008, accounted for 0.45%
         As at end-August, 2009, there were 43 mutual funds               (down from 0.53% as at end-2007). As on August 31,
         registered with SEBI, who offered a total of 852                 2009, the number of folios with the domestic mutual
         schemes (Open-ended: 608; Close-ended: 196 and                   funds totaled 4,83,51,487. Individual investor accounts

made up about 96% of the total investor accounts.              money market instruments or gold or gold related
During April – August, 2009, mutual funds have seen net        instruments or real estate assets. A domestic mutual
inflows of Rs. 2,56,754.96 crore.                              fund can invest moneys collected under any of its
                                                               schemes in accordance with the investment objectives
During 2008-09, in spite of the increase in gross              specified in Regulation 43 and the investment
financial saving of the household sector, the household        objective of the relevant mutual fund scheme.
sector allocated only Rs. 19,349 crore to investments in       Accordingly, the moneys may be invested only in
shares, debentures and units of mutual funds, i.e., 2.6%       securities, money market instruments, privately placed
of the total gross financial saving and 0.36% of the GDP       debentures, securities debt instruments (which are
at current market prices (Rs. 89,134 crore; 12.4% of the       either asset backed or mortgage backed securities),
total gross financial saving and 1.89% of the GDP at           gold or gold related instruments or real estate assets.
current market prices during 2007-08). In the United           Regulation 45 further permits a mutual fund to enter
Kingdom, investments in units of mutual funds                  into derivatives transactions and short selling
comprised 26% of the gross financial saving of the             transactions on a recognized stock exchange. The
household sector. The global financial and economic            investments permissible under Regulation 43 are
crisis had affected the Indian financial markets and the       subject to the restrictions on investments specified in
Indian household sector preferred safe havens in the           the Seventh Schedule to SEBI (Mutual Funds)
midst of uncertainty and high volatility.                      Regulations, 1996.

Prospects                                                      Role of Mutual Funds in Commodity Markets

There is a need to widen the reach of the domestic             On account of high unpredictability of long term
mutual fund industry to the retail individual investors,       inflation rates, investments in traditional avenues like
especially to those outside of the Tier 1 and Tier 2 cities.   equity shares and non-inflation indexed bonds alone
Also, there is scope for the industry to tap the               cannot protect the real value of the portfolios.
technological prowess that has transformed the Indian          Commodities are often seen as a hedge against
secondary market microstructure. Though, several new           inflation. This is on account of commodity prices
products have been made available over the years, there        responding directly to changes in the economy that
is scope for further product innovation. From a financial      tend to produce inflation. And, this trend is contrary to
point of view, the growth of the domestic mutual fund          the inverse relationship between inflation and equity
industry is dependent upon the networth and                    share prices (A high rate of inflation is usually
profitability of the asset management companies. The           associated with a high rate of interest and high interest
emergence of a self-regulatory organization (SRO) (a           expense means low earnings per share). Thus,
reincarnation of the Association of Mutual Funds in India      investment in commodities has proved to be a
(AMFI)) can further strengthen the regulatory                  rewarding option for those investors diversifying their
framework.                                                     portfolios beyond equity shares and bonds.

The Regulatory Framework                                       Internationally, there are different ways in which
                                                               mutual funds invest in commodity markets. There are
The domestic mutual funds are registered with, and             some funds that own the commodities that the fund
regulated by, Securities and Exchange Board of India           represents. Then, there are other funds that do not own
(SEBI). SEBI was established as a statutory autonomous         the underlying commodity at all, but that own futures
regulator to protect the interests of investors in             contracts and undertake trading strategies so that the
securities, to promote the development of the                  assets of the fund and the net asset value (NAV) mirror
securities market and to regulate the same. SEBI came          the trends in the price of the underlying commodity. In
out with the first Mutual Fund Regulations in 1993,            most of these cases, the funds track the movement of
under which all mutual funds, except Unit Trust of India,      an underlying index so designed to track the trend in
were to be registered and governed. The 1993 SEBI              the price of the underlying asset.
(Mutual Fund) Regulations were substituted by a more
comprehensive and revised SEBI (Mutual Funds)                  The first case is similar to the gold ETF scheme of a
Regulations, 1996.                                             domestic mutual fund in India. A gold ETF has been
                                                               defined as a mutual fund scheme that invests primarily
A mutual fund has been defined as a fund established           in gold or gold related instruments. A gold related
in the form of a trust to raise monies through the sale of     instrument refers to such instrument having gold as its
units to the public or a section of the public under one       underlying, as may be specified by SEBI from time to
or more schemes for investing in securities including          time. The funds of a gold ETF scheme of a domestic
                                                               mutual fund are currently invested only in gold, which
                                                               are held under the custody of a SEBI-registered

                                                                                                                  EXPERTS’ VIEWS   | 31
        custodian of securities. As on August 31, 2009, the AUM     ETFs and commodity-oriented schemes of domestic
        of gold ETF schemes stood at Rs. 904 crore. Given gold’s    mutual funds are also quite impressive. With reference
        status as a safe haven, the share of the Indian demand      to Macquarie and Rogers China Agricultural Index,
        in the global demand for gold, the socio-cultural           noted financial investor James Beeland Rogers, Jr. ( Jim
        factors affecting the demand for gold in India and the      Rogers) had said that one thing everyone could count
        additional benefits of a gold ETF like absence of storage   on, no matter what happened in other sectors, was
        cost and insurance premium and no fear of theft, the        people would continue to eat, making agriculture a key
        demand for gold ETF schemes will grow exponentially         part of any commodity investment portfolio.
        with increased investor awareness.
                                                                    Some of the commodity mutual funds/index funds that
        It is worth noting that commodity based ETFs in the         have become the favourites of investors on the basis of
        United States, accounting for about 7% of the ETF           their performance are Deutsche Bank Liquid
        assets, are not registered or regulated by the Securities   Commodities Index, Dow Jones AIG Commodities
        and Exchange Commission (SEC). The commodity-               Index, Goldman Sachs Commodities Index,
        based ETFs that invest in commodity futures are             Oppenheimer Real Asset Fund, PIMCO Commodity
        regulated by the Commodity Futures Trading                  Real Return Strategy and Rogers International
        Commission (CFTC), while those that invest solely in        Commodities Index. This has prompted the launch of
        physical commodities are not regulated by the CFTC.         many new ones in the stable.

        The growing demand for ETFs in the United States            Several estimates are available regarding the size of the
        prompted sponsors to offer more funds with a great          AUM of commodity funds. According to Barclays
        variety of investment objectives. As at end-2008, there     Capital, the commodity assets under management of
        were 231 sector and commodity ETFs with $ 94 billion        institutional and retail investors at the end of March
        in assets. The Investment Company Institute (ICI)           2009 amounted to $ 172 billion. Gardner Finance
        estimated that commodity ETFs accounted for 19% of          estimated that commodity hedge funds’ assets under
        the number and 38% of the total assets of sector and        management ranged between $ 190 billion and $ 210
        commodity ETFs. Since their introduction in 2004,           billion as at end-March, 2009. It is estimated that the
        commodity ETFs grew from just over $ 1 billion to $ 36      assets of SPDR Gold Trust, the biggest exchange-traded
        billion by the end of 2008. Also, about three-quarters of   fund backed by gold, are more than the amount of
        commodity ETF assets tracked the price of two               bullion held by Switzerland’s central bank.
        precious metals, viz., gold and silver, through the spot
        and futures markets in 2008.                                Conclusion

        Another category of funds own the shares of                 Thus, it is clear that the domestic mutual funds are
        companies that are into the commodities sector. This        currently not permitted to invest in commodity
        strategy is also in vogue in India. There are now more      markets. But the role of mutual funds in commodity
        than half-a-dozen domestic mutual funds in India too        markets is of very recent origin globally and is very
        which invest in shares of Indian and foreign companies      limited or absent in emerging markets. Nevertheless,
        in the commodities sector. Some of the investments are      the growth so far has been vibrant, buoyed by the
        through feeder funds, i.e., through overseas funds          surging prices of crude oil, precious metals, minerals
        which in turn invest in the shares. Back home, indexes      and food articles. With the larger demands of a growing
        having companies in the commodities sector as their         world population, the prospects for the commodity
        constituents, like metals and oil and gas, are among the    markets in general and agricultural commodities in
        popularly tracked ones. Lastly, there is the commodity      particular appear to be bright. According to EPFR
        pool, or the managed futures fund, operated by the          Global and Gardner Finance AG, of late (in the first
        commodity pool operator, where many high networth           quarter of 2009), investors favour mutual funds over
        individual investors combine their moneys and trade in      hedge funds for investments in commodity markets,
        futures contracts or commodity options as a single          seeking the protection of regulated asset managers.

        The brighter growth prospects of the emerging
        economies and search for yield (often buying into the
        risk premium story) in the developed economies
        resulted in the launch of many commodity index funds
        blending the emerging markets and the commodity
        asset class. Notwithstanding the losses in 2008, the
        strategy paid off well. The year-to-date returns of gold

In the aftermath of the global financial crisis, which                   References:
wiped out 15 years of capital gains in 15 months, the
global asset management industry has explored how                        ??     SEBI (Mutual Funds) Regulations, 1996
the market dynamics would change and how the
business models would reshape. Investment goals over                     ??     Annual Report 2008 ? 09; Reserve Bank of India
the next three years would be conspicuous by the flight                         (August, 2009)
to quality, simplicity and safety. Retails investors would
be drawn into products that offer capital protection                     ???    2009 Investment Company Factbook; Investment
and tax efficiency, with periodic opportunistic forays                          Company Institute
into absolute returns or cash products. High networth
individuals would venture back into active long only
                                                                         ???    Indian Mutual Fund Industry ? The Future in a
space as well as alternatives, with a strong
                                                                                Dynamic Environment, Outlook for 2015 (CII ?
opportunistic slant. In this milieu, it is all the more
                                                                                KPMG; June, 2009)
imperative that the asset managers underscore what
they stand for and what they can deliver.
                                                                         ???    Business Impact of Regulations in the Indian
                                                                                Asset Management Industry: Playing in the New
                                                                                Market Place; McKinsey & Company (August,

                                                                         ???    Future of Investment: The Next Move?; Prof. Amin
                                                                                Rajan (CREATE-Research; 2009)



                                                                         ??? ?


Mr. Venkateswaran R. is Assistant Director, Securities and Exchange Board of India (SEBI). Views are personal and do not necessarily reflect
those of the SEBI.

                                                                                                                                        EXPERTS’ VIEWS   | 33
                                                       Banks on Commodities
                                                       Futures Platform –
                                                       A Win-Win Situation
                                                       By Mr. P. V. Ananthakrishnan

        With gradual liberalisation, Indian banks are getting increasingly exposed to various risks
        such as interest rate risk, forex risk, commodity/equity price risk, and credit risk. They can
        manage these risks by sharing them with other economic stakeholders, primarily by
        participating in commodity derivatives markets. It is time one looks forward to further
        policy liberalisation to allow banks’ participation in commodity futures exchanges given
        that these are equally well regulated as their equity counterparts.

         As economies and markets around the world opened                  providing credit, banks absorb a part of the risks
         up amid rapid globalisation, the phenomenon has                   associated with individual/institutional borrowers.
         thrown open huge opportunities to various industries,
         especially the financial sector – being critical to               Associated Risks and How Banks Usually Deal with
         economic growth and stability of any economy. What                Them…
         followed as a corollary is that businesses and
         entrepreneurs in large numbers joined the bandwagon               Risks that banks carry while discharging their services
         and this brought in the necessary investments as well             are of various types, but they do not necessarily absorb
         as global best practices for all these industries to              all kinds of risks. What banks require is managing these
         flourish. The banking sector, a key component of the              risks with tighter rules and regulations, and better
         financial services industry, has remained one of the              compliance, so that they can continue to expand their
         major beneficiaries of the current era of ‘globalisation          business and flourish. In other words, to operate
         and liberalisation’.                                              efficiently, banks do need to absorb some risks that are
                                                                           inherent in their operations and smartly avoid others
         In India, both public sector and private sector banks             that can be effectively passed on to other participants
         have, through the use of advanced technology and                  in the financial marketplace. In fact, banks do not even
         global best practices, made a phenomenal progress in              need to assume all the risks associated with their core
         recent years, making rapid inroads beyond urban India             business of lending and borrowing. They can mitigate
         into the country’s heartland, on the one hand, and                such risks through a combination of business practice,
         setting up units overseas, on the other hand. By now              product design, and pricing, efficiently transferring a
         everybody knows what happened to several frontline                part of the risks to other financial market participants.
         international banks in the recent past. They not only
         reported enormous losses but went on to collapse in               How Should Banks Go about Managing the Risks?
         the wake of a number of their credit exposures having
         met up with default deadlock. It is, therefore, just              First, banks can stave off risks associated with their
         logical to believe that with growing penetration, Indian          business through sound banking practices that include
         commercial banks, like their global counterparts, are             efficient por tfolio management, systematic
         getting increasingly exposed to a whole lot financial             procedures eliminating chances of unscrupulous
         risks. As banks play a key role in both economic growth           lending, and incentive-based remuneration to
         and dissemination of the benefits of economic                     employees who are made accountable. Second, they
         development cutting across social strata and                      can transfer risks that are not complex and can be easily
         geographies, experts lay great emphasis on banks’                 shared with other participants in the financial domain,
         ability to provide market information and have funding            by participating in derivative markets. Interest rate risk
         capability and transaction efficiency. Also, by way of            is one such risk that banks can mitigate through

interest rate swaps and other derivatives such as the          mitigate foreign exchange risk banks participate in the
forthcoming exchange traded plain vanilla futures              forward market (to a much more extent than in the
derivatives while continuing to retain market                  futures market). Credit risk — for example, in the case of
competiveness in their lending products. Third, there          warehouse lending — is however mitigated largely
are certain risks with financial assets which are              through futures market participation, wherein well-
complex, cannot be shared by banks in their business           established commodity markets act as an effective
interests and are proprietary in nature (the risk inherent     cushion. Also, globally, activity in commodity
with any business activity as it is carried on the back of     derivatives is rapidly growing and is increasingly being
expectations of returns). Banks have to manage such            looked as an investment/business opportunity by
risks at their end itself. A failure in effectively managing   many of international financial services providers
such risks not only means a reduction in the                   including banks and their investment arms.
opportunities for banks’ expansion but also reflects
poorly in their ability to reach performance targets,          In India, however, banks are yet to be allowed to
which assumes greater importance in an increasingly            participate in the commodity futures market. Banks
competitive world of banking post-consolidation                and financial institutions, as lenders to various players
through mergers and acquisitions.                              in all the three sectors of the economy, assume certain
                                                               risks associated with the business or the firm and its
Opportunities in the Wake of Financial Reforms                 inherent business risks. In case of collateral financing,
                                                               banks tend to carry the price risk associated with the
In most developed economies, corporate, banks and              underlying asset (see table 1). A popular example of
individuals do help each other through the                     this type would be lending against warehouse receipts
participatory sharing of risks and benefits. In India too,     (WR) or WR financing, which as a collateral-based
with the arrival of national-level commodity futures           product for farmers is finding increasingly more favour
exchanges, which threw open a new efficient and                with banks for various reasons such as high risk
transparent platform for players in the commodity or           associated with other types of lending to the farming
primary sector ecosystem to mitigate their risks, the          sector, their inability to meet the priority sector lending
banking system received a windfall in terms of                 target, etc. Also, the underlying assets in the case of
enabling transactions on these exchanges along with            WRs are commodities which would carry known price
their clearing functions on the exchange. They not only        volatility risk (accordingly a haircut can be taken) in
got new business opportunities but also a shot in the          most cases unlike equity prices which at times can go
arm in terms of being able to mitigate various risks           down to even zero level.
associated with their business.
                                                               In most developed countries, WRs, being a negotiable
Globally, banks participate in the equity and                  instrument, are widely used and form the core of their
commodity futures markets to mitigate risks or exploit         funding to the agricultural commodities sector, with
business opportunities by establishing trading desks.          commonly followed trading mechanism involving
They do actively participate in various derivatives            banks, warehousing companies and commodity
markets such as OTC (over-the-counter), forwards,              exchanges. This could serve as a model to emulate for
futures, and swaps to mitigate various systemic risks to       the Indian financial and economic structure.
a certain extent. While to reduce interest rate they
usually participate in interest rate swaps, bond
markets, and other derivative instruments, in order to

   Table 1: Risk exposure arising out of outstanding funds of banks (approx. in Rs./Crore)

      Sectors                           Outstanding credit            Annualised volatility            Risk exposure
                                           by banks (2)                  (Percent) (3)                    (2) X (3)

  Gems & Jewellery                                 24,995             20.1 (MCX Gold futures)                 5,024

  Metal & metal products
                                                  104,719             15.1 (MCX Metal index)                 15,813
  (including iron & steel)
  Agri & allied activities                        197,399             09.1 (MCX Agri index)                  17,963
  Industry (small,
                                                  871,900             25.6 (NSE Nifty)                      223,206
  medium and large)
  Total annual price risk exposure of banks in commodities                                                 262,006

Note: Outstanding figures as on March 31, 2008.

                                                                                                                      EXPERTS’ VIEWS   | 35
        Some participants on the sidelines of the derivatives        fluctuations that their debtors would face in their
        market may tend to believe that participating in this        incomes. Further, with the amendments to the Forward
        market is risky because of the uncertainty of the            Contracts Regulation Act, the subsequent launch of
        information that flows into this market. However, being      rainfall and weather derivatives will enable banks to
        professional and organized banks can have research-          hedge against price risk or help farmers cover
        based information flowing into the market compared           themselves against nature as there will be participants
        with a research arm of a broking house. Besides, as          in these markets ready to take the risks. So, this
        central bank regulations and guidelines already              produces a win-win situation for both producers and
        streamline and monitor their participation in the            lenders/banks.
        equity market, banks can be similarly allowed to
        operate in the commodity derivatives market within a         As for producers, use of price risk management
        given set of regulations and could counter the force of      instruments provides them with some sort of certainty
        unilateral market direction at times of crisis. The          about the minimum prices that their produce will likely
        opportunity will lend more balance and support to            fetch at a future point in time. This enables them to take
        banks’ portfolio of investments and also help spreading      efficient farming decisions — and improve their
        risks across various asset classes.                          economic conditions. Besides, use of price risk
                                                                     management instruments nullifies the main reason
        Why Should Banks Rrade in Commodities Futures                behind producers’ loan default: the unanticipated price
        Market?                                                      movement or inability to reap a better price that may
                                                                     prevail at a future point of time. This reduces the
        Commodities, like other asset classes whose prices are       exposure risk perception of lenders which in turn
        determined by all the various information that flow          enhances small farmers’ access to credit and its terms.
        into the markets about their fundamentals, inherently        This win-win situation can be a reality only with further
        carry price volatility. As for agricultural commodities in   liberalisation of the markets ensuring appropriate
        India, direct government intervention in the form of         opportunities to both public and private players,
        floor price, guaranteed price, minimum support price,        including banks, in the price discovery and price risk
        etc aimed at protecting buyers was not so successful.        management mechanism that an organised platform
        Of late, gradual liberalisation of domestic markets left     of commodity futures exchanges provides.
        this direct intervention limited and allowed market
        forces to decide the prices as well as private players to    Price Risk and Foreign Exchange Risk
        engage in providing farmers with assured prices
        through routes such as contract farming. This reform         Corporate India is being increasingly exposed to global
        initiative resulted in market-based instruments for          markets as the Indian markets began integrating with
        commodity risk management including futures,                 their international counterparts rapidly amid the
        options, etc. In India, with more than a billion mouths      globalisation since the early 1990s. The robust growth
        to feed and agriculture providing the livelihood of          of India’s merchandise trade, of around 30% to US$396
        more than two-thirds of the total national workforce,        billion in FY08 (R) over the previous fiscal, is a clear
        commercial banks are traditionally mandated to               reflection of the opportunities that are being reaped by
        maintain an adequate credit flow to the agriculture          India Inc. In this scenario, banks providing credit
        sector. Even then, banks’ lending to the priority sector     facilities to companies indirectly assume price risk
        remained low leading to low value realisation in             related to commodities that are used in various
        adhering to the norms set by the central bank. Reasons       business processes of these companies operating in
        are many: banks’ poor penetration in rural areas; lack of    various sectors. For example, banks holding gold or in
        development of collateral-based credit products; lack        physical trade of gold are exposed to the same amount
        of effective collaterals among farmers; perception of        of risk as in table 1.
        risk due to uncertainty over agricultural yield; market-
        related factors; and so on. From farmers’ standpoint, on     Risk arising out of volatility in foreign exchange rate
        the one hand, low prices are limiting their incomes and,     movement is borne by exporters and importers of
        therefore, the necessary investment in the overall           goods and services themselves who build that into the
        farming process. On the other hand, price volatility is      prices of their end-products or take that into their
        making it difficult for them to plan their production        balance sheets making their business or product
        activities, allocate resources efficiently and obtain        uncompetitive in the market. Given its total earnings,
        credit from organised sector.                                the average annualised forex volatility of around 11%
                                                                     works out to forex risk exposure worth around US$44
        Now, risk perception of banks can partially be               billion for India Inc. Fluctuations in commodity prices
        mitigated if they are allowed to participate in the          simply adds to this risk exposure of Indian companies
        organised commodity futures market to hedge their            denting their bottom-lines. Of late, with the value of
        exposure to agricultural lending arising out of price        INR against benchmark foreign currencies becoming

highly volatile, the forex risk situation has become even        price fluctuations that also makes their debtors
worse. For example, the rupee on March 29, 2007 had              vulnerable to potential default. Under such conditions,
seen an intra-day high-low difference of Rs.1.01 — over          what will be viable for banks is to lend against
2.33% movement, which is not healthy for either                  commodity collaterals enabled by modern collateral
companies or banks that finance their operations or              management agencies backed up by the credible
imports/exports. Appropriate positions in the futures            warehouse receipt system that they had developed.
market can help them mitigate such risk. By hedging
their exposure on this platform banks can safely lend             Table 3: Annualised volatility (%)
and enhance their credit exposure to these players.
                                                                                                 MCX                        NSE
Further, comparative data in table 2 indicate that                                         Agri      Energy      Metal
                                                                   Year     Comdex                                           Nifty
commodities are a much more stable asset class than                                       Index       Index      Index
equities. In other words, it is less risky for banks to trade     2006          17.7       12.5        21.5%    30.2%       26.5%
in commodities than in equities, which is vindicated by
                                                                  2007          12.2       9.1         20.8%    15.1%       25.6%
the fact that volatility of MCX Agri Index, which covers
                                                                  2008          25.4       22.3        36.8%    25.9%       44.9%
several essential commodities, is much lower (0.9%)
than the overall volatility in the equities market. This          2009*         20.3       11.2        40.9%    19.4%       42.4%
lays a strong case for banks to be allowed to operate in         Source: MCX & NSE; *Jan-June 2009
commodity markets when they are already allowed to
participate in equity markets.                                   Table 3 shows that based on the total exposure
                                                                 outstanding to various sectors of the primary economy
Table 2: Comparison of price volatility of various               and the annualised volatility worked out for the sectors
commodities traded on MCX and NSE Nifty index                    mentioned above. The quantum of price risk in the
                                                                 credit exposure will go further up if the services sector
  Commodities & indices          Average daily volatility (%)
                                                                 and other industries are included in the analysis. It is
 Gold                                          1.3               obvious that sharing this price risk with the economic
 Silver                                        2.0               stakeholders ready to take it for a cost will create
 Copper                                        2.1               balance in the economic engagement. Therefore,
 Crude Oil                                     2.3               banks with such large price risk exposure need be
 MCX Comdex                                    1.2               allowed to participate in an efficient market to
 MCX Agri Index                                0.9
                                                                 effectively hedge their position by transferring the risk
                                                                 to those participants who are willing to assume,
 MCX Energy Index                              1.9
                                                                 thereby reflecting appropriately discovered prices to
 MCX Metal Index                               1.5               the spot markets and thus help in efficient allocation of
 NSE Nifty                                    2.2                resources among various sectors of the economy.
Note: Prices of commodities and indices are taken from January
2006 to June 2009.                                               Demystifying a Mystical Relationship

Banks’ Risk Exposure in Agriculture Lending and                   In order to identify the relationship between the Indian
Primary Sector Outstanding                                       equity market and domestic crude oil prices — one of
                                                                 the major influencing factors behind inflation and
Increasingly realising how crucial the contribution of           generally in an economy, we considered BSE Sensex
agriculture to the country’s economic growth is, the             and MCX crude oil prices as respective benchmarks. A
Indian government has been laying added emphasis                 regression analysis was done by taking the Sensex as a
on the sector. This is reflected in its various measures         function of MCX crude oil prices. The analysis showed
aimed at boosting the sector in successive budget                that for the last two years, a 1% rise in crude oil prices
proposals, of late, including an unprecedentedly large           has led to a 0.17% drop in the Sensex as it cuts bottom
loan waiver. The Reserve Bank of India, on its part, is          lines of India Inc. Significantly, for the one-year period
issuing various guidelines from time to time to make
sure that formal lenders give top priority to the
agriculture sector in terms of credit advances. Over the         Table 4: Correlation analysis
years, there was only one loan that was effectively                                       Associated
utilised by the farm sector — production credit, which            Company                                      Correlation (%)
is often marred by poor recovery that leads to building
                                                                  Sterile Industries         Copper                 74.00
up of scepticism in the minds of organised lenders. The
basic reason is lack of effective collateral that can take        Apollo Tyre                Rubber                 50.45
care of the risk of default and/or an effective                  Note: The period considered is from the date of launch of respective
mechanism to share their risks in markets arising out of         commodities contracts on MCX to June 2009. Complied from spot
                                                                 prices of MCX and BSE closing prices of companies.

                                                                                                                              EXPERTS’ VIEWS   | 37
        between February 2006 and February 2007, it shows a            operations. Standard Chartered Bank - China, for
        value of -1.11 indicating a 1% rise in crude oil prices        example, received an approval to offer commodity
        leading to a 1.1% drop in the Sensex. Incidentally, in the     derivative products to cater to even a group of
        first instance, the adjusted R-squared (strength of the        investors who are highly ambitious yet risk-averse. In
        indicated relationship) is 98%, while in the second            fact, wide use of derivatives by banks in the US is a
        instance it was 94% (and statistically significant as well).   recent phenomenon and the reason behind the bulk of
                                                                       derivatives holdings by large US banks is, interestingly,
        The high correlation between equity prices and the             to hedge their own risks rather than those of their
        prices of the underlying commodities (in which these           customers.
        companies primarily deal in) on MCX (see table 4)
        provides equity market players, including banks and            Empowered with varied and innovative products, such
        funds, with an opportunity to hedge their risk by taking       as OTC and structured hybrid products, capable of
        appropriate positions in both the equity and                   catering to a wide range of different market needs and
        commodity futures markets simultaneously. With their           reach to various markets the world over, such global
        connectivity banks can additionally act as commodity           banks additionally provide arbitrage opportunities
        derivatives market access providers for the common             across the globe and enable customers to hedge risks
        man and small producers. For example, ICICI                    ranging from forex risk to interest rate risk and, which offers online trading facility          commodity/equity price risk — all at one go. Further,
        to its customers as a plain vanilla offering, can              these banks have research desks not only to help infuse
        additionally offer customised products to create               appropriate domestic fundamentals into the markets
        models of aggregation for both consumers and                   but also carry international fundamentals across
        producers of commodities and enable their                      borders into different markets that are open to them,
        participation in the futures market. Table 4 clearly           thereby adding value to customers and economies
        indicates a strong relationship between the prices of          they are operating in on a continuous basis. They do
        commodities and those of stocks in the case of                 also bring in other value-added services such as aiding
        commodity-intensive industries.                                local companies and clients participate in both the
                                                                       domestic and global markets to hedge their exposures
        Commodity Derivatives and Banks – International                in various markets across platforms. These activities of
        Experience                                                     large international banks play an instrumental role in
                                                                       integrating domestic economy with the global
        Today, most international (multi-national) banks deal          markets.
        in commodity derivatives to add value to their
        customers that include public sector and private sector Indian Commodity Exchanges – Not Far Behind
        companies and individuals. Their offerings cover Global Peers
        products such as OTC swaps, basis swaps, options and
        several other structured transactions. Specialists Despite several restrictions, such as on the products
        working with such banks, which include Bank of and participatory limitation to individuals and
        America, BNP Paribas,                                                                      corporate, domestic
        D e u t s c h e B a n k , CRDB Bank of Tanzania – A case study                             exchanges in India have
        Standard Chartered etc                                                                     made remarkable headway
        among others, come Tanzania-based CRDB Bank with one of the country’s largest in the space of just six years
        up with high level of share in cotton and coffee financing and agricultural — their turnover growing
        s e r v i c e f o r t h e i r commodities, carried heavy risk — and more so due to price from a negligible amount to
        customers even for volatility in the commodities market. The bank’s lending to about half of the total equity
                                      cotton, coffee, tobacco, and cashew verticals was more than
        small exposures to give 50%, and the bank was facing considerable problems of turnover (see table 5).
        them value for money.         default in the cotton and coffee sector. CRDB Bank’s adopted Position limits as prescribed
                                      collateral management system to exercise tighter control in commodities in India are
        Delivery of various over the lending to these high-risk sectors rather than pulling much tighter than those in
        services offered by out altogether. This lending against warehousing receipt global commodity markets.
        such global banks enhanced its capability to lend to farmers in rural areas. It The overall growth of the
        a c r o s s n a t i o n s implemented price risk management in two ways – hedging Indian commodities market
        d e p e n d s o n t h e the overall portfolio related to coffee and cotton by using risk has remained constrained by
        necessary regulatory management instruments and hedging the exposure by way many such strict regulatory
                                      of acting as a market intermediary in carrying hedging
        approvals acquired by transactions on behalf of borrowers.                                 controls that prevent large
        them for such                                                                              companies from

participating due to their huge exposure size, and the        in some way or the other by sharing them with various
sellers or buyers on the opposite side. Also, keeping         economic stakeholders — largely by participating in
sensitivity of the prices of the underlying commodities       the derivative market i.e. trading in derivatives on a
in view, contracts in the domestic commodity markets          variety of underlying assets. An analysis of outstanding
have been made deliverable compared with                      credit to various industries shows that banks tend to
financially-settled nature of stock market contracts.         lose an average of 23% of their aggregate lending to
Thus, Indian commodity derivative markets are much            these sectors, based on the annualised volatility in the
more relevant to the physical markets at this nascent         commodities which are used by these sectors in their
stage of their growth. Further, the volatility in the         production processes. Moreover, in select stocks of
commodity market — for example, on MCX (as                    companies with extensive exposure to primary
expressed by Comdex) — has been much lower than               commodities that are traded on the commodity
volatility in both the domestic stock market and global       exchange platform, there is an inverse relationship in
commodity markets with equally comparable                     their price movements indicating an opportunity for
regulatory practices (table 5).                               banks which had invested in those stocks to hedge
                                                              their exposure in appropriate commodity derivatives
Conclusion                                                    traded on exchanges. Furthermore, an analysis of the
                                                              global scenario indicates that major global banks
It is evident that by the very nature of their operations     participate in various products in several countries not
Indian banks are exposed to several risks ranging from        only to hedge their risks but also to add value to their
interest rate risk to forex risk to commodity/equity          customers, which include companies as well as high
price risk to credit risk. Banks can manage all these risks   net-worth individuals.

  Table 5: Commodity market vs. stock market
  Commodities                                                                              International Commodity
                                  Stock Markets               Commodity Markets
  & indices                                                                                       Exchanges

 Potential                 Affluent few with income       Almost the entire             Those in developed
 Investors/Operators       level to invest in the         population (family            markets reaches out to
                           secondary/tertiary growth      heads/individuals) of the     almost those who are
                           sector i.e. not more than 4-   country who in one way or     affected by the volatility in
                           5 lakh investors with          the other would be related    the commodity exchanges
                           sufficient flow of money       to the consumption of the
                                                          commodity. Numbering
                                                          around 200-250mn.
 Average Daily Market Rs. 45,359.1 Crore                  Rs. 17,042.1 Crore            -NA-
 Turnover (April 1-
 March 31, 2009)
 Products Available      Spot, Futures, Options,          Futures                       Futures, Options, Indices,
                         Indices                                                        Spot
 Participants            Individuals, Corporate, Banks,   Individuals, Corporate        Individuals, Corporate, Banks,
                         Institutions, Funds, FIIs                                      Institutions, Funds, FIIs
 Regulators              Stock Exchange Board of          Forward Markets               Single or Separate
                         India                            Commission                    Regulators for
 Regulatory tools        Margins – VAR adjusted           Margins - VAR adjusted        Similar regulation with
                         Index Circuits                   Price Circuits                variable position limits
                         Position Limits – Company        Position Limits - Member
                         level and Market Valuation       and Client Level
                         Level                            Penalties
 Institutional Structure Exchange                         Exchange                      Exchange,
                         Participating Banks              Participating Banks           Banks, Clearing House,
                         FIIs, Mutual Funds               Members                       Members, Brokers, Clients
                         Members                          Brokers/Sub-brokers
                         Brokers/Sub-brokers              Clients

                                                                                                                 EXPERTS’ VIEWS   | 39
           Trade Timings                        Only one session              Both morning and evening     Limited, extended and 24
                                                (morning session)             session                      hours
           Cross margining                      In the planning stages        Not existing                 Existing not only between
                                                (between cash market and                                   spot and futures but even
                                                futures market)                                            between two exchanges
           Index trading                        Existing                      Not existing                 Existing
           Delivery logic                       Financial settled contracts   Delivery based contracts     Both financial and delivery
           (derivatives market)                                                                            based contracts
           Electronic trading                   Yes                           Yes                          Yes
           Demutualization                      Demutualized exchanges        Demutualized exchanges       Demutualized exchanges
           Denomination of                      Single currency               Single currency              Single currency and
           contracts                            denomination contracts        denomination contracts       multiple currency
                                                                                                           denomination contracts
           Stage of                             Somewhere between          Just passed nascent stages      Maturity stage
           Development                          growth and maturity stages
           (derivatives market)

         In the process, these international banks have not just                 Foreign banks that have entered India are also most
         taken these as a mere risk management practice but                      likely to seek an entry into Indian commodity markets
         put in their best efforts in response to the intense and                in line with their global operational principles to help
         rising competition and came up with some marvellous                     them remain profitable in the market. Also, a
         results in terms of quality market research by their                    comparison of the regulatory principles and business
         analysts. This not only helped these banks’ own                         practices of Indian stock markets and commodity
         treasury and customers but also the markets to                          exchanges makes it amply clear that the domestic
         discover efficient prices with increased flow of accurate               commodity exchanges are as efficiently regulated as
         i n fo r m at i o n a b o u t co m m o d i t i e s a n d t h e i r      their equity counterparts, which is also confirmed by
         fundamentals into the ecosystem. Therefore, in India,                   commodity price volatility on the exchanges as a
         commercial banks with strong connectivity with rural                    measure. Therefore, there are no reasons why the
         areas and domestic commodity exchanges can                              regulators should stop banks from participating in the
         facilitate participation of all stakeholders in the value               commodity markets. This would rather help our
         chain from the producer to the end-consumer, making                     policymakers achieve the two primary objectives that
         this not only a business opportunity for banks but a                    they had aimed for while paving the way for national
         tool in linking these various participants with the                     online electronic commodity exchanges: efficient price
         markets and help them discover efficient prices.                        discovery and taking the hedging process closer to
                                                                                 producers, thus preventing risk from being priced to be
                                                                                 shared among others besides ensuring shrinkage of
                                                                                 the product value chain through the transparency
                                                                                 exuded by these markets.

        Mr. P. V. Ananthakrishnan is Country Head & CEO, Mashreq Bank – India. Formerly as Executive Vice-President of
        HDFC Bank, he started the commodity business for the bank. Views expressed in this article are personal.

                                                       Warehouse Receipt
                                                       Finance for Farmers –
                                                       A Glimpse
                                                       By Mr. Nachiket Mor and Dr. Kshama Fernandes

         While warehouse receipt (WR) finance has been in existence in India for a long time, and
         traders and large farmers do benefit by availing of the mechanism, small and marginal
         farmers have been virtually left out of it. This paper discusses the advantages and
         disadvantages of WR financing in India from small farmers’ point of view, while citing
         examples of how this mechanism has been used globally. It also lays stress on some key
         requirements for implementing a successful WR finance programme, concluding with a
         brief on IFMR Trust’s agricultural commodity pilot in Gujarat.

         Agricultural production, processing and trade are often         According to a report by the Reserve Bank of India
         considered low-margin, high-uncertainty operations,             Working Group on Warehouse Receipts & Commodity
         and are perceived as risky investments by financiers.           Futures (2005), the overall efficiency of markets,
         Physical collateral, such as land and real estate or            particularly in the agribusiness sector, immensely
         machinery and agriculture implements, is often of little        improves when producers and commercial outfits are
         use in mitigating financiers’ risks as such collateral          able to convert inventories of agricultural raw materials
         tends to either be very difficult to enforce or of very         or finished products into a readily tradable instrument.
         little resale value. No wonder, to obtain finance for           Producers receive a receipt against goods of a given
         agriculture can be really difficult and often expensive,        quality, quantity and grade deposited in accredited
         given the risk premium charged by financiers. In light of       warehouses. It also says that being negotiable
         this, warehouse receipt finance has emerged as an               instruments, these receipts can be traded, sold,
         attractive alternative for farmers and processors in the        swapped, used as collateral to enable borrowing, or
         developed world.                                                accepted for delivery against a derivative instrument
                                                                         such as a futures contract.
         Under a warehouse receipts financing scheme, goods
         stored in a warehouse are used as collateral against a          Warehouse Receipt Finance for Farmers
         loan. These goods could be agricultural or non-
         agricultural in nature. This has become a fairly                Despite growth projections, what remains the reality of
         mainstream method of financing in most industrialised           the agriculture-related business is its high dependence
         countries, and there is evidence that the overall               upon seasonality. Broadly speaking, farmers face two
         efficiency of markets, particularly in the agribusiness         major problems — lumpy cash flows and non-
         sector, is greatly enhanced when producers and                  availability of intermediate finance. Warehouse
         commercial entities can convert inventories of                  receipts finance can play an important role in
         agricultural raw materials or finished products into a          smoothening income for farmers by providing liquidity
         readily tradable device. Producers deposit goods of a           at times when cash flows dry out.
         certain quality, quantity, and grade in accredited
         warehouses and receive a receipt for it. Being                  WR financing as a means of extending the sales
         negotiable instruments, these receipts can be traded,           period beyond the harvest season: As the harvest
         sold, swapped, used as collateral to support borrowing,         season approaches, small and marginal farmers find
         or accepted for delivery against a derivative instrument        themselves in dire need of liquidity. The simple
         such as a futures contract.                                     demand and supply equation results in prices falling to
                                                                         their lowest during harvest and gradually rising during

the lean season1 . Although farmers are aware of this                                 Is There a Downside for the Farmer?
seasonal trend, they cannot take advantage of this and
benefit from it as they are hard put to organise                                      While availing of finance against warehouse receipts
immediate cash. A typical small farmer sells his crop                                 appears to be an attractive option for the farmer, there
when its prices are at their lowest. This crop is often                               are concerns about its inherent speculative nature. One
bought by traders or village-level aggregators who                                    must seriously look into a likely adverse outcome: this
hold the stock through the harvest season till prices                                 financing avenue may encourage farmers to take
pick up and then sell it at a profit. To cite some numbers,                           speculative positions having the potential of resulting
the seasonal variation in castor seed prices during 2008                              in losses beyond their risk-taking ability. Warehouse
was almost Rs.200 per 20kg which translates into a                                    receipt financing is profitable only when the expected
profit of Rs.750 a bag of castor seed (which translates                               rise in the value of the stored product is actually more
into an annualised return of 88.9 %). If farmers are                                  than the cost of storage plus that of the borrowed
enabled to hold on to their crop beyond harvest, a part                               funds (i.e., loan principal plus interest payments, bank
of the price benefit could accrue to them. So, by                                     fees, etc).
providing farmers with a mechanism to store and hold
on to their produce, warehouse receipts finance                                       Many would argue that farmers ought to confine their
enables the extension of the sales period beyond the                                  activity to the area of their core competence — farming
harvest season.                                                                       — and not indulge in speculation. However, in the
                                                                                      absence of a readily accessible hedging mechanism,
WRs as secure collateral for obtaining finance: Most                                  the Indian farmer is a speculator in any case. From the
banks are uncomfortable in extending pre-harvest                                      point of time he sows the seed till the point of time he
loans to farmers. Warehouse receipts form sound                                       sells the crop in the market the farmer is long on the
collateral whose market value can be easily estimated                                 commodity, unless he hedges his long spot exposure
and whose liquidity is much higher than conventional                                  by selling his produce in a forwards, futures or options
collateral such as land and machinery. In the event of                                market, which he has no access to in India. Most
default, the holder of the warehouse receipt has the                                  farmers who sell their standing crop to traders and
first call on the underlying goods or its value. This                                 other local financiers before harvest do so at sub-
provides banks and financiers with the comfort to lend                                optimal rates under tremendous liquidity pressure and
to the farmer without lengthy documentation and long                                  not from the point of view of hedging their exposure.
processing delays. Farmers, on their part, can avail of                               So, the contention that farmers should not engage in
loans either to overcome immediate liquidity                                          speculative activity because it is not their core
requirements or to finance future crop/investments on                                 competence is something that must be looked into in
farm equipment or alternative businesses. According                                   the light of alternatives available. Warehouse receipt
to the RBI Working Group report, on notion of reduced                                 financing is in essence a speculative activity. Availing of
risk premia, collateralisation of agricultural inventories                            the facility simply extends farmers’ already existing
using warehouse receipts will lead to increased credit                                price exposure beyond the harvest, providing him with
availability and reduced cost of credit. Besides, it will                             a readily available cash flow and a potential upside.
lead to mobilisation of mainstream financial resources                                And, in general, even if the farmer wishes to sell in the
into the agricultural sector.                                                         spot market, it allows him to do price averaging (thus
                                                                                      reducing his exposure to “impact” cost) by selling his
In their study on the use and impact of warehouse                                     harvest gradually instead of being forced to sell the
receipts in developing and transition economics,                                      entire quantity on a single day.
Lacroix and Varangis (1996) concluded that warehouse
receipts are an important addition to the store of
negotiable instruments in a country’s financial sector.
According to them, they not only provide important
long-term economic benefits but also have immediate
positive impact on the farmer’s life.

1 The persistence of this arbitrage is a conundrum. If indeed this pattern was risk-less and the large traders or buyers were not credit constrained then, at least for
  non-perishables, the return from this arbitrage should have been lower than the cost of financing and storage costs. In perishables, wherever possible, it should
  have led to more aggressive “calendaring” (more distributed production throughout the year). However, in almost all commodities this arbitrage persists. It is
  possible that the existence of the “peso problem” (the risk of a sudden, completely unexpected precipitous fall in value that is rationally anticipated by the market
  – first pointed out by Rogoff (1980)) makes this arbitrage both persistent and highly risky. If indeed that is the case, then one wonders if availability of warehouse
  receipt finance for the small farmer is a boon or a curse (discussed later in the note). Two alternate directions however look promising: commodity forward
  contracts to be offered to farmers at the time of sowing (so that they may “square off” the “long” position that they create as soon as they commit themselves to
  planting a particular crop and thereby lock in their profit margins) and an options contract or least a delta hedge (since options contracts on commodities are not
  legal in India) which allows the farmer to buy protection against a further drop in commodity prices but retain the right to benefit from a rise in prices.

                                                                                                                                                                EXPERTS’ VIEWS   | 43
        Warehouse Receipt Financing – International                   In a similar effort, the RBI Working Group report says,
        Experience                                                    PTA Bank in Kenya finances coffee exporting farmers by
                                                                      accepting warehouse receipts as collateral. It also offers
        Experiences around the world suggest that warehouse           them a put option, purchased at the London
        receipt financing can be a profitable avenue for both         Commodity Exchange, which guarantees sellers a
        the farmer and the financier. TechnoServe in Ghana has        minimum price for the coffee in storage. By assuring a
        achieved considerable success in its inventory credit         floor price for the stored coffee, PTA Bank can provide
        programme over the past two decades. According to             finance for a higher percentage of the value of coffee
        TechnoServe’s Inventory Credit Programme in Ghana             than it could justify in the absence of the floor price.
        by Frank Hicks, the firm believes that only the
        confidence of being able to sell the produce at a             According to Lamon Rutten (then Coordinator –
        reasonable profit to buyers can be the incentive for          commodity marketing, risk management and finance
        small and marginal producers, constituting 60% of             at United Nations Conference on Trade and
        Ghana’s farming population, to augment both                   Development), in Venezuela, under a system
        production and productivity, and supply to local              developed by private firm Induservices, provided
        industries and exporters. As in most agricultural             capital enhancement to warehouse receipts on
        markets including India, small farmers remain the             seasonal maize stocks. And this enabled the firm to
        classic “price takers”, cut off from information flowing      attract huge investment to finance maize stocks.
        into and out of the market and profitable market
        opportunities. To improve their conditions, Hicks says,       Again in Colombia, Rutten said, a more complex
        TechnoServe ushered in the concept of inventory               structure, introduced in mid-2000, made it possible for
        credit in Ghana in 1989. The idea was to create an            cattlemen to receive strong financing support to feed
        opportunity for these farmers to take advantage of            their cattle – at rates determined through the
        seasonal price swings (used smartly by local traders) to      competition among institutional investors on the
        mitigate risks for banks that were hesitant about             country’s stock and commodity markets.
        lending in the rural belt and to increase food security
        for farmers who can buy back (or “redeem”) their              Keys to Successful Implementation of a Warehouse
        produce rather than sell it.                                  Receipts Programme

        Participating farmers usually form groups of 20-50            According to the RBI Working Group report, to work
        members to store their produce and carry it into the          effectively, warehouse receipts require a recognised
        lean season when prices are at their peak — much              foundation in law ensuring that the ownership
        higher than harvest time price levels. At the same time,      established by the receipts is not challenged.
        they have the flexibility to exercise one of the following    Warehouse receipts must be functionally equivalent to
        options:                                                      stored commodities with well-defined rights, liabilities,
                                                                      and duties of each party to a warehouse receipt (for
        •     can decide to sell the produce through the group,       example a farmer, a bank, or a warehouseman). They
              using the proceeds to repay the bank for its credit     must be freely transferable by delivery and
              and the group for the use of storage facilities,        endorsement and the holder of a warehouse receipt
              earning a net profit of 40 to 100%;                     must be first in line to receive the stored goods or their
                                                                      fungible equivalent on liquidation or default of the
        •     They can take back the produce from the group to        warehouse. A robust legal framework is a prerequisite
              consume as food, repaying the bank loan and the         to warehouse receipts being treated as secure
              group’s storage costs, and still saving a substantial   collateral.
              amount by avoiding high lean season food prices.
                                                                      Also essential is a warehouse infrastructure, grading
        TechnoServe has refined the model of inventory credit         and collateral management system that provides
        and expanded its application to other areas in Ghana.         guarantees on quality, quantity and storage of
        At preset, it is offering facilitating over 100 farmers’      commodities, thus assuring that the quantities of
        groups access inventory credit. For nearly two decades        goods stored match those specified by the warehouse
        now the participating farmers have maintained a cent          receipt and also their quality is the same as stated on
        per cent on-time loan repayment record, significantly         the receipt. This will give farmers the confidence to
        improved their incomes and agricultural production,           store their produce and banks the comfort to accept
        cut down post-harvest losses and accumulated capital          warehouse receipts as secure collateral for financing
        to invest in other agricultural activities.                   agricultural inventories.

And finally what is required is a combination of fair and   This is in line with IFMR Trust's mission of ensuring
transparent spot and futures markets that provide           complete access of financial services to every
liquidity and price discovery, enabling both farmers        individual and every enterprise. Towards this, after
and banks to value and sell warehouse receipts at short     extensive survey, Dharampur, a village 20 km from Kadi
notice if need be.                                          town, with 1,000 acres under castor production and a
                                                            population of 3,000, has been identified as an ideal
In the Indian context, the proposed Warehousing             village to operate the pilot from.
(Development and Regulation) Act, 2007 incorporates
almost all the aforesaid legal and warehouse                Trading operations: The trading facility is located at
infrastructure related requirements. Once approved          Kadi in the exchange-managed warehouse premises.
and implemented, it should provide a sound basis for        As part of the servicer agreement, the exchange
developing and promoting warehouse receipt-backed           provides guarantee on quality, quantity, and storage of
trade and finance activity in the country.                  commodities in the warehouses managed by it. The
                                                            electronic exchange market provides nationwide
IFMR Trust’s Pilot in Kadi Taluka (Gujarat)                 access to buyers and sellers. The first crop to be traded
                                                            was castor seed. While the market is still at its nascent
In pursuit of its mission for financial inclusion, IFMR     stage, its volumes have been encouragingly large. The
Holdings has ventured into the agricultural space.          market caters to farmers from around 125 villages
Dealing exclusively with small and marginal farmers in      around Kadi. Farmers come to the warehouse with their
the Kadi Taluka of Mehasana in Gujarat, three of its        commodities which are then put through a standard
entities, Agricultural Terminal Markets Network             weighing and quality testing process. Depending upon
Enterprise (ATMNE), IFMR Holdings, and IFMR Capital         the quality, weight adjustments are made and the
are working together on a pilot with the following          commodity is packed in 75 kg bags and stacked away.
objectives:                                                 The collateral manager issues a receipt of weight and
                                                            quality, following which the farmer places a sell trade
•   To provide price discovery to farmers for their crops   through the ATMNE agri-broker sitting at the trading
    in a fair and transparent manner (ATMNE);               terminal at the warehouse. Once the trade goes
                                                            through, the farmer is handed over the cash and receipt
•   To explore other services required but not available    for the same.
    to small farmers currently such as transportation
    from the village to the market/buyer, village level     So far castor seed worth Rs. 2.5 crore has been traded
    warehousing capability, and agricultural extension      by over 500 farmers based in 25 different villages
    services (ATMNE and IFMR Holdings);                     surrounding Kadi, the smallest trade being one bag
                                                            and the largest 70 bags. Over the last four months, price
•   To provide commodity-backed finance to farmers          differentials between the mandi and the electronic
    who would like to avail of finance against the          exchange have dropped from Rs. 75 to Rs. 18 a bag
    commodity as collateral (IFMR Holdings);                possibly in response to a credible price discovery
                                                            mechanism being provided to small farmers through
•   To explore other financial products and services        the exchange.
    required but not available to small farmers currently
    such as commodity forward contracts and delta-          Financing operations: Warehouse receipt finance in
    hedging (IFMR Holdings and ATMNE);                      India is typically used by traders and affluent farmers. It is
                                                            largely perceived to be non-applicable to or non-viable
•   To develop tradable Asset-Backed Warehouse              for the small and marginal farmer. Barriers to
    Finance Receipts (ABWFRs) so that they may be sold      participation from the financiers’ side include reluctance
    to mutual funds and other financial institutions        on their part to deal with small-size transactions due to
    (IFMR Capital).                                         operational reasons. From the farmer’s end, there are
                                                            issues concerning non-availability of reliable price
As part of this pilot, the three IFMR Trust entities are    information, lack of storage space, inefficient quality
working with the National Spot Exchange Ltd. (NSEL) to      testing procedures, existence of multiple layers of
help farmers realise the best possible price for their      intermediaries, hidden charges, documentation
agricultural commodities. ATMNE is an institutional         challenges, and high transportation costs.
trading and clearing member and provides trading
access to small and marginal farmers. IFMR Holdings
provides warehouse receipt finance, helping farmers
wait out the low price realisation period during harvest.

                                                                                                                   EXPERTS’ VIEWS   | 45
        In our experience, the biggest challenge in terms of          Lack of awareness - For farmers used to centuries of
        giving farmers access to warehouse receipt finance has        trading through adhathiyas on the mandi and availing
        been awareness creation. IFMR Trust has been putting          of loans from them, trading on an electronic exchange
        in a lot of efforts at farmer education. By interacting       and availing of finance against the stored commodities
        with farmers in their local settings, it is explaining to     has been a new experience.
        them the concept of an electronic exchange that
        provides a transparent price discovery process, as well       Rigour of the quality testing process - The exchange
        as the documentation, process, risks and returns from         follows a rigorous quality-testing procedure unlike
        availing commodity-backed finance through IFMR                regular mandis where quality is gauged simply by
        Holdings.                                                     picking up a handful of commodity. A value reduction
                                                                      is applied if the commodity does not meet the set
        IFMR Holdings provides loan against commodities as            parameters. Farmers who initially took a while to
        collateral. The purpose of the loan product is to provide     understand the quality testing process now feel the
        short-term finance to farmers collateralised by               process is more fair and transparent than the one they
        commodities for which warehouse receipts are issued           were used to.
        by a collateral management company. The exchanges
        arrange for collateral management services and act as a       Reluctance to store commodity in warehouse -
        service provider.                                             Perishability of castor seed is almost negligible. Instead
                                                                      of storing it in a warehouse and incurring storage costs,
        The branch through which the IFMR Holdings finances           farmers prefer to store it in their backyards.
        farmers against commodities is located at Dharampur
        village such that it would serve a cluster of villages that   Prior advances taken from traders - Almost 30-40%
        cultivate in large quantities crop such as castor seed,       of farmers around Kadi have already taken loans from
        mustard seed, and wheat, among others. Currently,             traders against commitments to sell their existing
        loans are being given to farmers coming from five             commodities to these traders.
        villages. Farmers can avail of finance against a single
        bag of castor seed placed in a warehouse. The                 Conclusions
        maximum loan amount they can avail of against a
        particular commodity is Rs. 10 lakh (Rs.1 million). It        The contribution of warehouse receipt systems in
        goes like this: a farmer visits the branch and registers      developing agricultural markets has been well
        himself, which involves fulfilling the KYC (Know Your         recognised across the world. The Ghana experience
        Client) process that includes biometric identification        shows that these schemes can dramatically reduce
        and physical verification of address proof. On                inter-seasonal price fluctuations, benefiting small and
        completion of the process, the farmer is given a smart        marginal farmers who otherwise have no choice but to
        card which henceforth is used as a single source of           resort to distress sales (sell immediately after harvest).
        identification and data capture for all transactions          Warehouse receipt finance can offer farmers a
        done by the farmer. After charging appropriate                marketing and credit option that spurs productivity
        margins to cover price fluctuations, loan is given            and thus increases their incomes. Farmers can also sell
        against the warehouse receipt for the commodity               some of their stored products to finance future crop,
        stored by the farmer in the NSEL-managed warehouse.           thereby obviating or reducing the need for borrowing
                                                                      from moneylenders and traders. Financial institutions
        While farmers’ response to the warehouse receipt              benefit from reduced risks and from liquidity due to
        finance mechanism has so far been a cautious one, they        ready collateral to guarantee or reimburse defaulted
        are definitely gradually becoming aware of this facility      loans. Farmers, on their part, benefit from higher
        and coming forward to avail of loans through this             profitability being able to delay sales; from improved
        route. Reasons for their initial inhibitions could be:        price transparency, and from increased bargaining
                                                                      capacity through working in farmers’ groups.

However, warehouse receipt finance is essentially a                    References:
speculative activity and requires serious monitoring of
grain quality as well as market price trends and                       1. Bamako (Technical Note No. 5). 2000. “Warehouse
fluctuations. When properly designed and managed, a                       receipts: financing agricultural producers”
warehouse receipt finance programme can allow small
farmers to graduate from the status of “price takers” to               2. Evans, Martin D.D., and Karen K. Lewis. 1992. NBER
that of “price negotiators” in the local market economy.                  Working Paper Series, No.4003
The mechanism can also provide rural entrepreneurs
with a route to capital accumulation that can be                       3. Hicks, Frank. 1998. “TechnoServe inventory credit
invested in more diversified and sustainable ventures                     programme in Ghana”. United Nations Conference
capable of stimulating long-term rural economic                           on Trade and Development
growth and development, which in turn can contribute
significantly to the overall economic growth in line                   4. Lacroix, Richard, and Varangis, Panos. 1996. “Using
with national aspirations.                                                warehouse receipts in developing and transition
                                                                          economies”, Finance & Development

                                                                       5. “Report of the Working Group on Warehouse
                                                                          Receipts & Commodity Futures”. 2005. The Reserve
                                                                          Bank of India

                                                                       6. Rutten, Lamon. 2001. “Local market opportunities
                                                                          with respect to warehouse receipt finance -
                                                                          tapping into the local capital market”, ESCAP-ADB
                                                                          Joint Workshop

                                                                       7. Rutten, Lamon. 2001. “Financial engineering
                                                                          techniques for directly linking domestic capital
                                                                          markets and the agricultural sector – a short note”,
                                                                          ESCAP-ADB Joint Workshop

                                                                       8. The World Bank (Agricultural Investment
                                                                          sourcebook series). 2004. “Ghana: Inventory Credit
                                                                          for Small-Scale Farmers”

 Mr. Nachiket Mor is President, ICICI Foundation, and Dr. Kshama Fernandes is Vice-President, IFMR Trust. Views are personal.

                                                                                                                                EXPERTS’ VIEWS   | 47
                                           Carbon and Clean Energy
                                           Markets – the Potential
                                           in India
                                           By Ms. Bharti Gupta Ramola and Mr. Prashant Vikram Singh

Traditional energy and clean energy hold significant potential in the Indian commodity
market. Addressing jurisdictional and market participation issues will remain crucial
even as we consider market mechanisms for achieving strategic clean energy objectives
in the country so that our commodity markets can perform their role of risk mitigation in
this important sector of the economy effectively.

Even as the debate intensifies on whether or not there        volume for carbon in excess of 6 billion or more than 3
will be a global climate agreement on reducing                times the underlying physical market. Trade in primary
greenhouse gas (GHG) emissions post-2012, in                  CERs (Certified Emission Reductions), the developing
Copenhagen summit in December 2009, and on the                world’s instrument of access to the global carbon
contours of such an agreement, several developed and          markets, was below the 2007 level at 389 million in
developing countries have embarked on a number of             2008, while that in secondary CERs (CERs traded among
initiatives conveyed in pending and approved                  developed economy banks, traders, and utilities)
legislations, policies, and measures aimed to deal with,      witnessed a significant jump in volumes at 1,072
at the minimum, clean energy and, at the other end,           million in 2008. This is 5.3 times the underlying physical
binding GHG emission reduction targets. There is a            market of 275 million issued CERs up to 2008. We
momentum building as several of these legislations,           should see greater volumes of EUA and CER trades as
policies, and measures have been set on course in the         the carbon commodity markets deepen and reach the
last 12-18 months. This article looks at the potential of     level of other energy markets such as electricity and
clean energy and GHG emission reduction for                   natural gas markets where the total financial market is
commodity markets as many of these initiatives have           10 to 20 times the underlying physical market or crude
relied on domestic and, sometimes, global market              oil where it is more than 30 times.
mechanisms, which would inevitably translate into a
trading scheme and the trading of underlying targets          The linkage between the energy and the carbon
or commitments as commodities on exchanges.                   emissions markets is obvious, but it is interesting that
                                                              some analysts predict that the emissions market may
Rise of Global Carbon Commodity                               one day overtake the energy market (electricity and
                                                              gas). Estimates of the size of the global carbon market
Global carbon markets have been growing at 100% a             in 2020 are in the range of US$1 trillion to US$3 trillion.
year, touching US$126 billion in 2008. The EU ETS             Last year, Bart Chilton, US Commissioner of the
(European Union Emission Trading Scheme) saw 3.09             Commodities Futures Trading Commission, opined
billion EUAs (European Union Allowances) traded in            that “the potential size and scope of a structured carbon
2008, exceeding the annual allocation for 2008 of 1.8         emissions market in the US is unequivocally vast. It is
billion. Spot trading in EUAs jumped significantly to         certainly possible that the emissions markets could
250 million out of total 2.7 billion exchange-traded          overtake all other commodity markets," while estimating
EUAs in 2008 and further increased to 850 million out of      emissions futures to reach US$2 trillion in five years.
total 3.2 billion exchange-traded EUAs in the first half of
2009. The explosive growth in the EUA market and the          Data on transactions in the UK, one of the largest
significant increase in spot trading imply a deepening        electricity, gas and emissions markets in the Euro Zone,
of the EUA market, and if this growth continues, the          can read as a first sign of rapid growth of emissions
year 2009 could end up with the financial market              trading with high volatility in other energy markets in
                                                              the last three years.

                                                                                                                   EXPERTS’ VIEWS   | 49
          Contracts transacted by UK brokers –                            Projections by EPA show that this would require an
          notional value of markets in £ billion.                         emissions reduction (against the business as usual) of
                                                                          366 mtCO2e (million tons of carbon dioxide
                                 2005            2006    2007      2008   equivalent) per annum during the period 2012-2020.
          UK power                 25              30     30         63   The total US emissions in 2005 were at 7.2 billion. The
          UK gas                   54             108    134        176   ACES does not automatically allow all CDM/JI credits
          Euro power               77             147    193        178   but calls on the US EPA (Environment Protection
          Euro gas                  7              11     11         27   Agency) to develop its own process for approving
          Coal                     45             107     46        111   offset projects. It provides for allowable limits of two
                                                                          billion tons annually from domestic and international
          Emissions               1.5              5.5   8.8         36
                                                                          offsets, and international allowance trading. A carbon
        Source: Financial Services Authority (FSA) survey of the energy   market of US GHG emissions of this magnitude will
        derivatives market
                                                                          increase the global emissions market multiple times.

         The European Union has agreed to take a 30%                      Energy Markets in India
         reduction below 1990 by 2020, in the event of an
         international agreement on emission reductions. In its           In India, electricity exchanges have been a recent
         absence, it will take a 20% reduction below 1990 by              entrant in the commodity market, with Indian Energy
         2020, which translates into a 21% reduction between              Exchange Ltd (IEX) and the Power Exchange India Ltd
         2005 and 2020 in the EU ETS sectors. This implies                (PXIL) becoming operational last year. Recently, a third
         allocation/auction of 2 billion EUAs for 2013 decreasing         power exchange, National Power Exchange Ltd, has
         to 1.7 billion EUAs for 2020 valuing the physical market         received approval from CERC (Central Electricity
         at US$ 50 billion a year. The demand for CDM/JI (Clean           Regulatory Commission). Currently a day ahead
         Development Mechanism/ Joint Implementation)                     market, there are indications that term capacity
         credits is restricted, in the event no international             contracts and intraday contracts would be allowed to
         agreement takes place, to the allowances unused                  be traded on the exchange.
         during the period 2008-2012. In the event of an
         international agreement on emissions, the limit on use           The power exchanges deepen the existing bilateral
         of CDM/JI credits will automatically be increased up to          electricity trading by embedding the transmission
         half the additional reduction effort. Estimates put the          availability within the day-ahead contract in addition
         total limit of CDM/JI credits during the period 2008-            to the standard benefits of a trading platform — access,
         2020 at 1.4 billion (without international agreement)            risk mitigation, clearing and settlement processes. On
         and an additional 300 million in the event of an                 an annualised basis, the electricity traded by the
         international agreement being secured. However, the              trading licensees stood at 21.9 TWh (terawatt hour or
         CDM scheme is expected to change significantly from              billion kWh) in 2008-09, approximately 3% of the total
         the one that exists today — both internally, in terms of         electricity generation in India, valued at approximately
         improving the existing mechanism, and externally, in             US$3 billion (given the high traded prices in the range
         scope and coverage. There are calls for the existing             of US$150/MWh). Around 2 TWh was traded on the
         (improved) CDM scheme to be applicable only to ‘least            power exchanges in FY09 (part year operation of both
         developed countries’ in future and making sectoral               the exchanges). If one were to use the 10-20 multiple
         CDM applicable for major economies. Calls for                    benchmark of financial markets to the underlying
         exclusion of industrial gases have also been raised. On          physical markets, this shows a huge growth potential in
         the other hand, the developing countries have been               terms of electricity trade volumes and the share of
         raising the issue of financing and technology transfer,          exchange-traded electricity. There are some issues
         the key parameters set out in the Bali Action Plan.              relating to the appropriate regulatory agency that has
                                                                          primary jurisdiction over the electricity commodity
         The US is not yet a significant player in the global             market. While these issues are being deliberated, they
         carbon market. However, the recent passage of the                have not come in the way of developing the exchange-
         American Clean Energy & Security Act (ACES) through              traded electricity market.
         the US House of Representatives is expected to change
         that dramatically and, at the very least, has kept the           Multi Commodity Exchange of India Ltd (MCX) inter alia
         momentum to Copenhagen summit (the 15th                          trades in natural gas, which is one of the actively traded
         Conference of Parties in December 2009). The ACES                contracts, while National Commodity & Derivatives
         proposes 17% emissions reduction between 2005 and                Exchange Ltd (NCDEX) has recently introduced trading
         2020 (3% below 1990 levels) and 80% by 2050.                     in thermal coal. Crude oil and fuel oil are traded on both

MCX and NCDEX. Emissions trading (see section below)           understood that the premium was on the account of
got underway at both the exchanges last year. That is,         speculation over the exchange price (Euro Vs INR),
an entire suite of energy and emission products is             which was expected to rise. However, as the global
being traded on the two exchanges and is expected to           recession and economic slowdown hit Europe in the
grow significantly in volumes. We anticipate that, as          latter half of 2008, the demand for the EUAs — and
energy markets are further liberalised, new products in        hence for CERs — began to decrease. The price fall was
the form of spark and dark spreads with and without            further fuelled by companies in Europe selling surplus
embedded emissions will also emerge as hedging                 EUAs to raise much needed finances. When CER prices
tools.                                                         began to decline, Indian sellers preferred to wait and
                                                               watch rather than transact at lower prices. In the
Carbon Markets in India                                        absence of buyers and sellers in the Indian market,
                                                               speculators and arbitrators vanished. And this resulted
Carbon instruments were launched in India in 2008 in           in the drying up of trades on the Indian exchanges. The
anticipation of significant growth in the global carbon        2008 preliminary verified emissions data released in
markets and India’s position as the second-largest             2009 showed that EU ETS was overall short in spite of
supplier of emission reductions. MCX initially launched        the economic slowdown but this did not cause any
futures linked to EUA and later launched CER futures           significant market movements as this was generally
contracts (expiry December 2008-2012). NCDEX                   expected.
launched CER futures contract with expiry December
2008.                                                          Indian commodity exchanges do not allow direct
                                                               participation by foreign institutions. This may not
Exchange-traded carbon instruments were aimed to               impact price discovery for domestic commodities but
infuse greater liquidity and depth to a market that was        CERs are different as their primary use is by Annex 1
being serviced by the over-the-counter (OTC) market,           countries. As there are no compliance buyers in India
which largely comprised compliance buyers,                     and foreign traders and institutions are not allowed to
international brokers, traders, banks etc. The                 participate on NCDEX and MCX, liquidity and trading
exchange-traded market’s role in price discovery and           volumes are likely to continue to be low (affecting the
transparency was of particular relevance to Indian             price discovery process) until some elements of this
sellers as there was a general perception of lack of           equation are modified.
transparency in the OTC market. OTC transactions
generally involve longer lead times and more complex           Apart from market participation regulations, the
and largely bespoke emissions reduction purchase               development of carbon markets in India will also
agreements with extensive provisions to deal with              depend on the contours of global carbon markets post-
credit risk issues. Exchange-traded carbon instruments         2012, agreed in Copenhagen summit. Significant
were seen capable of addressing all these issues.              opportunities could emerge for compliance and
Importantly, exchange-traded carbon instruments                voluntary carbon for commodity exchanges if there is
were intended to give the treasuries of large carbon           continued use of market mechanisms for reducing
sellers in India the ability and the flexibility to actively   GHG emissions in the global context post-2012.
manage the company’s carbon portfolio and price risks
as commodity hedging on overseas carbon markets                Clean Energy Commodities on the Horizon
requires regulatory approvals not many companies are
willing to pursue. As with any trading scheme, primary         Negotiations at Copenhagen notwithstanding, there
CER sellers were seen as an important segment of the           will be opportunities for commodity trading products
market but the anticipation was that very significant          in the Indian clean energy space. A renewable energy
interest from speculators, traders and arbitrageurs            certificate (REC) trading programme is on the anvil. The
would provide the needed liquidity.                            Indian government and power regulators are in the
                                                               process of defining the tradable REC scheme, which is
The initial trades and growth in the volumes of                intended to promote renewable energy development
exchange-traded carbon instruments on MCX and                  and provide flexibility to electricity distribution utilities
NCDEX were encouraging, and there was a lot of                 that have renewable purchase obligations (RPO) fixed
interest. At times, the prices of CER futures contracts on     for more than 10 states in the country and to the states
these exchanges were at a premium over those of the            that have abundant resources for renewable energy
European Climate Exchange (ECX), the world’s largest           generation. In the absence of the tradable REC scheme,
carbon exchange. However, it was generally                     the states with renewable energy resources will have

                                                                                                                      EXPERTS’ VIEWS   | 51
        little incentive to promote renewable energy                          Looking ahead
        generation beyond their RPO, while those that do not
        have access to renewable energy resources will be hard                The conclusion we can draw is that there is significant
        pressed to meet their RPO. The REC trading is expected                trading potential for traditional energy and clean
        to be on the same platform as the electricity trading.                energy in the Indian commodity market. If a global
        Given the expectation of 25 GW (gigawatt) of                          carbon agreement that relies on market mechanisms
        renewable energy capacity targeted by 2012, this                      comes into being at Copenhagen summit, the energy
        creates an underlying physical renewable energy                       commodities markets in India can grow considerably
        market equivalent of 50 TWh/yr or US$4 billion/yr.                    with the inclusion of carbon. However, it will be
                                                                              important to sort out jurisdictional and market
        The Bureau of Energy Efficiency (BEE) has established the             participation issues even as we consider market
        Perform, Achieve and Trade (PAT) Scheme under the                     mechanisms for achieving strategic clean energy
        National Mission on Enhanced Energy Efficiency. Nine                  objectives in India so that the commodity markets can
        energy intensive industries have been notified as                     perform the role of risk mitigation in this important
        ‘designated consumers’ under the Energy Conservation                  sector of the economy.
        Act, 2001. These are thermal power stations, fertilizers,
        cement, iron & steel, chlor-alkali, aluminium, railways,
        textile and pulp & paper firms having energy
        consumption over certain thresholds. The goal setting,
        involving the setting up of specific energy consumption
        benchmarks, is in progress. Over the next three-four
        years, the designated consumers will have to reduce
        their specific energy consumptions to the target level or
        purchase Energy Saving Certificates (ESC) from others
        who have improved on their targets. Let us assume that
        the potential gains for industry energy efficiency are 50
        TWh/yr and assuming that two-thirds of this expected
        energy efficiency gains are covered under the PAT
        scheme, the underlying physical ESC market is expected
        to be 33 TWh/yr or US$ 3 billion/yr.

        The ESCs may be made fungible with the RECs, thus
        expanding the depth of the market. The potential for
        trade in RECs and ESCs, including trading of derivatives
        of these commodities, is significant. This will be an
        interesting and relevant extension to the electricity
        trading schemes already operational at the commodity
        exchanges including the possibility of trading
        electricity with embedded emission reductions.

         Ms. Bharti Gupta Ramola and Mr. Prashant Vikram Singh are both Executive Directors – PricewaterhouseCoopers Pvt. Ltd. Views expressed
         by the authors are personal and not of PricewaterhouseCoopers Pvt. Ltd.

                                        Commodities Derivative
                                        hedging: Portfolio and
                                        By Mr. Kumar Dasgupta and Dr. Chiragra Chakrabarty

“Commodities have been the bedrock of civilization. Ever since we arrived, our existence
has been defined by a quest for control over geological resources – call it oil, gold,
copper or even exotics like uranium. Man has undertaken treacherous expeditions and
fought battles to discover and conquer commodities. Civilisations rise and fall, and
economies prosper based on their ability to harness energy, mine metals, and cultivate
agricultural produce. Interesting to note: the progress of mankind has been marked
through the ages with different commodities – Stone Age, Bronze Age, Iron Age, and
now Nuclear Age. The enigma, called commodities, has determined the fate and wealth
of nations for eons and would continue to do so in future…”

1.   Introduction to Commodity Derivatives                      vehicles for accumulation of significant wealth for
     Markets                                                    individuals. Some of the most enduring fortunes
                                                                have been built with commodities. Among the
1.1. Commodities derivatives markets are deep and               stars in the galaxy, Mayer Rothschild single-
     broad, presenting both challenges and                      handedly built the banking empire by providing
     opportunities in their wakes. It has been the              vault facilities for storing bullion during World
     experience of participants that they have been             War II. John D. Rockefeller created the first true
     besieged by the vastness of the market and the             corporate, Standard Oil Co., by exploring crude
     types of underlying assets available. Despite              oil. Andrew Carnegie conglomerated the steel
     millennia of commerce in commodities, we are               industry in the United States to form US Steel.
     still perplexed by questions such as: “what should         Abdel-Aziz-Al-Saud, the founding father of Saudi
     we trade in?”, “how much do we buy or sell?”, “how         Arabia, created one of the most influential
     do we give or take delivery of commodities?”,              nations on energy products. Jim Rogers, the
     “when is the ideal time to enter and exit the              Ambanis, the Tatas and Laxmi Mittal have all
     market”, and so on. These asymptomatic                     become legends because they had the foresight
     behaviours of intermediaries and investors have            to invest in commodities.
     given naissance to the major commodity
     markets, as we know them today. From the             1.3. With a growing population of over one billion
     mandis in Asia and Africa to the sophisticated            (2001 census), India would remain one of the
     electronic platforms in the Western world,                largest markets for traders in global commodities,
     commodities trading has come a long way. The              with metals and energy playing a crucial role in
     mode of exchange of the value of commodities              the growth and development of the industrial
     has also seen a transformation over the ages —            sector of the Indian economy and agricultural
     from the rudimentary barter system, trade was             products. At this juncture, institutional
     revolutionised by the introduction of money, and          development of commodity markets will: (a)
     yet again with the advancement in electronic              create a “near-perfect” market situation, (b)
     transfer of credits called dematerialisation.             enable wider participation by different segments
                                                               of the economy, (c) create a global hub for trading
1.2. While it is true that commodities have dictated           in commodities due to its strategic geographical
     the economic passions of sovereign and non-               location, and (d) make India a potential “price
     sovereign nations, they have also acted as the            setter” for many commodities.

                                                                                                              EXPERTS’ VIEWS   | 53
            1.4. The paper has been divided into five sections.                             Rs.33,162.07 billion in 2008-09. The growth
                 While section 2 draws a comparison of Indian                               charted by the Indian commodity exchanges can
                 markets with international markets, the use of                             be summarised in Table 1.1.
                 commodity derivatives in portfolio management
                 is explained in section 3. Section 4 depicts the
                                                                                       Table 1.1: Turnover of the Indian Commodity
                 methodology and issues related to the
                 measurement of hedge effectiveness. Section 5 is                      Derivative Exchanges
                 devoted to conclusion.                                                 Year                           Turnover (in Rs. Billion)
                                                                                        2002-03                                  665.30
            2.        Indian Markets vs. International Markets –
                                                                                        2003-04                                1,293.64
                      Where We Stand
                                                                                        2004-05                                5,717.59
            2.1. If we look at our history, Indian market                               2005-06                               21,551.22
                 participants have had the experience of trading                        2006-07                               36,769.27
                 in commodity derivatives for ages. Even during                         2007 -08                              40,659.89
                 the long period of ban, there were reports of                          2008-09 (Nov. 2008)                   33,162.07
                 parallel markets in commodity derivatives. It is
                                                                                     Source: MCX, NCDEX, NMCE & NBOT
                 interesting to note that, in 2002, just after the ban
                 was lifted and the Government approved the
                 launch of national-level trading platforms, the                     2.3. The Group on Forward and Futures Markets, 2001,
                 Indian commodity market took a quantum jump.                             has estimated that the contribution of
                 Industry observers were left wondering as to how                         commodity derivatives exchanges would be as
                 India could pull off a coup d’état in such a short                       high as 10% of Gross Domestic Product (GDP) by
                 time. The question which was, and perhaps still                          the year 2007 compared with a nominal of 1.2% of
                 lingers (even after five years of operation) is: Is                      GDP in 1999. Compared by volumes (the number
                 such a progress sustainable and what are the                             of contracts traded), nine of the world’s top 22
                 obstacles that need attention if the market has to                       major commodity derivatives exchanges are in
                 realise its full potential?                                              developing countries. And interestingly, three of
                                                                                          them are based in India (MCX1, NCDEX2 and
            2.2. Since 2002 there has been a revival of commodity                         NMCE3). Further, one of these exchanges (MCX)
                 derivatives markets in India, both in terms of                           features in the world’s top 10, overtaking long-
                 commodities allowed for futures trading and                              established and mature institutions such as the
                 volumes of the trade. Let us consider some                               Tokyo Commodity Exchange and New York Board
                 statistics. While in 2001-02 futures trading was                         of Trade. A figurative assessment is given in Table
                 allowed only in eight commodities, the count                             1.2. The figures include the volumes in terms of
                 jumped to 109 in 2008-09. The value of trading in                        contracts traded in the first half of 2009. The
                 Rupee-denominated terms saw a quantum jump                               volumes in terms of USD or INR are not
                 from about Rs.350 billion in 2001-02 to                                  considered within the scope of this study.

              Table 1.2: Turnover of Global Commodity Derivatives Exchanges
                 Rank                                       Exchange                           Country
                                                                                                              (number of contracts traded)
                  1           New York Mercantile Exchange (NYMEX)                                 USA                   206,010,205
                  2           Dalian Commodity Exchange (DCE)                                     China                  170,869,127
                  3           Shanghai & Hong Kong Futures Exchange (SHFE)                        China                  151,544,472
                  4           Zhengzhou Commodity Exchange (ZCE)                                  China                  93,213,149
                  5           Chicago Board of Trade (CBoT)                                        USA                   83,233,736
                  6           ICE Futures, Europe                                              Belgium.                  78,372,945
                  7           Multi Commodity Exchange of India (MCX)                             India                  77,742,706
                  8           London Metal Exchange (LME)                                          UK                    55,185,086
                  9           ICE Futures U. S. (erstwhile New York Board of Trade)                USA                   25,271,245
                  10          Tokyo Commodity Exchange (TOCOM)                                  Japan                    14,643,397
            Source: Industry Analysis

            Multi Commodity Exchange of India Limited, Mumbai (
            National Commodity and Derivatives Exchange Limited, Mumbai (
            National Multi Commodity Ex change of India Limited, Ahmedabad (

2.4. In retrospect, MCX Comdex fell by 24% during                 Table 1.4: Global Sector-wise Futures &
     2008 — somewhat lower compared with the                      Options Volume
     decline in international commodity futures
     indices of Dow Jones AIG Commodity Index Cash                 Sector                       Contracts Traded in Millions
     Index (DJAIG) at 36.6% and Reuters/Jefferies                  Sector Equity Index                       6,488.62
     Commodity Research Bureau (RJCRB) at 36%. For                 Individual Equity                         5,511.19
     a comparative analysis of MCX Comdex with the
                                                                   Interest Rates                            3,204.84
     other global indices, we have recalibrated the
                                                                   Agriculture                                 888.83
     base period of all the indices to 100 from June
     2005. Levels are calculated as in January 2009,               Energy                                      580.40
     tabulated in Table 1.3.                                       Foreign Currency                            577.16
                                                                   Precious Metals                             180.37
Table 1.3: Comparison of MCX Comdex with                           Non – Precious Metals                       175.79
major global commodities indices                                   Other                                        45.50
                         Levels in          Levels in              TOTAL                                  17,652.70
                        June 2005         January 2009
  RJCRB                    100              128.7134            Note: Prices of commodities and indices are taken from January
                                                                2006 to June 2009.
  DJAIG                     100             102.7972
  Comdex                    100             128.5218
Source: Industry Analysis                                       2.7. Clocking an impressive growth within five years,
                                                                     this transformation has expanded the breadth
2.5. Even if we undertake a comparison of the share of               and intensity of potential impacts that a
     equity market investors’ wealth in GDP with that                commodity derivatives exchange can make on
     of the commodity futures markets, we find that                  underlying commodity sectors as well as the
     India ranks quite high among all countries. The                 economy. In a comparison of the Indian
     ratio of India’s market capitalisation to GDP                   commodity derivatives market with the
     touched a historical high of 165% in early 2008.                international markets, we find that there is a need
     While this is a substantially sharp rise, India is still        for elevating the products base of the exchanges
     in the fifth position, behind Hong Kong,                        in India. Limited commodities are limiting
     Singapore, Switzerland and Taiwan, some of                      industry participation. In the new economy
     which have ratios in excess of 200%. The value of               paradigm, banks are engaging in warehouse
     investors’ wealth in Rupee-denominated spot                     receipt financing and collateral management.
     market turnover terms is approximately                          Now, with the participation of banks, this industry
     Rs.30,860.75 billion in 2008-09 (excluding assets               is bound to flourish.
     under management of fund management
     houses). The derivatives segment of the                    2.8. There is a need for strengthening the regulatory
     historically more mature Indian equity markets                  framework of the market. The government's
     ranks seventh (S&P CNX Nifty Futures) and tenth                 approval to the amendment of Forward
     (S&P CNX Nifty Options), respectively, in terms of              Contracts (Regulation) Act, through an
     turnover ratio when compared to the top 20                      ordinance, paves the way for introduction of
     derivatives exchanges globally. The Indian                      long-awaited ‘options’ trading in commodity
     commodity derivatives exchanges, on the other                   derivatives. The move will certainly deepen
     hand, are among the top 10 in terms of volumes                  commodity markets, make them more mature
     generated.                                                      and spur wider participation in derivatives
                                                                     trading on the domestic commodity exchanges.
2.6. A snapshot of the global volumes of futures and                 If the move is symptomatic of the government's
     options contracts traded across the asset classes               softening stance towards commodity exchanges
     will ingrain an impression of what we are looking               and commodity futures, it must be hailed as one
     at. Table 1.4 shows the sectoral break-up of                    of the most pragmatic pieces of economic
     volumes in terms of million contracts traded                    legislation. Moreover, the existing national-level
     and/or cleared on 69 exchanges worldwide for                    exchanges support a strong and advanced
     the year ended March 2008.                                      technology-driven platform.

                                                                                                                           EXPERTS’ VIEWS   | 55
        3.       W h y Yo u r Po r t f o l i o S h o u l d I n c l u d e   3.4. Furthermore, on examining the correlations of
                 Commodities Derivatives                                        oil-based futures contracts with energy-related
                                                                                and non-energy-related stock, bond, real estate
        3.1. In our country, direct commodity investment has                    and commodity markets, and CPI, results confirm
             not been a major part of the investors’ pool. In                   that, except in periods of extreme energy price
             recent times, however, commodity-linked assets                     movement, many traditional forms of indirect
             have increased the number of available                             energy investments such as natural resource
             commodity-based products. Empirical studies                        mutual funds and energy-based common stocks
             have shown that investment in commodities                          are not correlated with energy price movements.
             results in significant diversification benefits.                   This is as expected. Given the risk management
             These benefits are traced to the unique exposure                   and firm diversification abilities of most
             of commodity investment to macroeconomic                           corporations, unless the price change in the
             variables, as well as the potential to capture a                   underlying commodity is structural and long
             positive ‘roll return’. But the principal thought                  lasting, short-term changes in commodity prices
             lingers: why should the investor think about                       may have little impact on a firm's equity
             diversifying the portfolio through investments in                  performance.
             commodity-linked instruments? The answer lies
             in the fact that direct or indirect investments in            3.5. It was also confirmed that in addition to energy-
             the commodities market actually increase the                       based “passive” long-only commodity indices
             Sharpe ratio of the portfolio and significantly                    offering returns not available in traditional equity
             reduce the annualized volatility. A few studies                    investments, “active” long/short energy traders
             have been cited.                                                   offer returns (positive returns in markets with
                                                                                declining energy prices) not available in long-
        3.2. The diversification benefits of commodities have                   only commodity indices or traditional
             been studied in length and breadth, and across                     commodity-based equity investments.
             the continents. Studies have found that the
             inclusion of portfolios of long commodity futures             3.6. The principal argument for investing in
             contracts (CRB and GSCI) improves the risk and                     commodities is that investing in assets that rise in
             return performance of stock and bond portfolios                    price with inflation provides a natural hedge
             for the period 1970 through 1990. It was                           against losses in equity and debt holdings that
             observed that the improvement is more                              typically lose value during periods of unexpected
             pronounced for the 1970s than the 1980s due to                     inflation. The studies have spanned across years
             the high inflation of the 1970s with commodities                   of high inflation such as 1978, 1983, 1998 and
             acting as a natural inflation hedge. Futures prices                2000. In continuation with the evidences
             were also found to have little value in predicting                 presented, we present our case by demonstrating
             inflation. Tests were performed on the theory of                   that during a same period analysis, equities show
             storage and present empirical evidence that in                     a n e g at i ve co r re l at i o n w i t h i n f l at i o n .
             periods of increasing volatility and risk,                         Commodities indices have shown a greater
             convenience yields increase for a wide variety of                  independence from inflation. This contradicts the
             metals prices.                                                     popular belief that commodity derivatives put
                                                                                inflationary pressures on the economy. We have
        3.3. Academicians have identified business cycle                        compared MCX Comdex with the BSE Sensitive
             component in the variation of spot and futures                     Index and inflation respectively for a period
             prices of industrial metals. The theory of storage                 spanning June 2005 to January 2009, the findings
             splits the difference between the futures price                    of which are tabulated in Table 1.5
             and the spot price into the forgone interest from
             purchasing and storing the commodity, storage                   Table 1.5: Comparative Analysis of BSE Sensex,
             costs and the convenience yield on the inventory.               MCX Comdex and Inflation
             The question of whether commodities represent                                              BSE        MCX
             a separate asset class has been extensively                                                                         Inflation
                                                                                                       Sensex     Comdex
             debated.                                                        BSE Sensex                 1.000        -               -
                                                                             MCX Comdex                 0.210       1.000            -
                                                                             Inflation                 (-)0.01     (-)0.08         1.000
                                                                           Source: Industry Analysis

3.7. Adding commodities to an equity portfolio can           4.   How Effective is “Highly Effective” –
     minimise the damage during economic crises or                An Accounting Perspective
     downturns. As commodities have the ability to
     react favourably to economic downturns or               4.1. Normally there are three common methodologies
     macroeconomic conditions unfavourable to                     for testing and analysing hedge effectiveness —
     equities, they are a perfect contender for                   the dollar-offset method, the variability-reduction
     reducing downside risks. The ability to protect the          method, and the regression method.
     value of investment in chaotic markets is the key
     to any diversification.                                 4.2. The above methods to an extent have also been
                                                                  enshrined in the new accounting norms dealing
3.8. Perhaps the major advantage of diversifying an               with such types of instruments. The new
     equity portfolio using commodities is the                    accounting norms for derivative instruments and
     mitigation of management risk. In any portfolio              hedging activities were issued because the
     management, risk seeps in from the style                     effects of the increasing quantity and variety of
     incorporated by the fund manager. Even though,               derivatives used by companies were not always
     in a given period, a fund manager investing in               transparent in their financial statements. These
     equities may give higher returns, the impression             standardise the accounting treatment for
     of the company management may have its                       derivative instruments by requiring all entities to
     effects on the financial statements during the               report derivatives as assets and liabilities on the
     same period. The return from the equity is subject           balance sheet at their fair value.
     to company policies, valuations, industry-wide
     conditions and management styles. These are             4.3. However, the new accounting norms also
     systemic risks associated with the equity market.            recognise hedges that are put in place by entities
     In the commodity market, however, the prices are             and try to reflect the economics of such hedges in
     dependent purely on demand and supply                        the financial statements. It basically allows for
     conditions. The macroeconomic variables                      three accounting models for hedges — a fair
     determine the prices and the behaviour of                    value hedge model, a cash flow hedge model and
     commodities. In a nutshell, investing in                     a net investment hedge model — with the first
     commodities automatically mitigates the                      two being most commonly used. A fair value
     abovementioned risks.                                        hedge offsets the price risk of a recognised asset
                                                                  or liability or an unrecognised firm commitment.
3.9. However, it is also emphasised that price risk               A cash flow hedge offsets the variability of the
     management may not always be the most                        cash flows of a balance sheet item or a forecasted
     important benefit. Commodity derivative                      transaction. If a derivative qualifies for hedge
     exchanges can yield other critical impacts:                  accounting and the hedge is deemed to be
     b ro a d e n a cce s s to m a r k e t s ; e m p owe r        “highly effective”, the standard permits entities to
     participants to take better decisions; reduce                match the timing of the gains and losses on the
     information asymmetries that have previously                 hedged item and with the gains and losses on the
     advantaged more powerful market actors;                      derivative positions in their profit or loss account.
     upgrade procurement, storage, grading and                    Or, in other words, the accounting captures the
     technology infrastructure; and expand access to              economics of the hedge whereby an entity has
     cheaper sources of finance. Last but not the least,          mitigated its exposure to commodity price risks
     these exchanges enable entities to create a                  through commodity derivative instruments.
     hedge against their exposures to the vagaries of
     commodity price movements.                              4.4. In principle, a hedge is highly effective if the
                                                                  changes in the fair value or the cash flow of the
3.10. But the moot question is: how effective is the              hedged item and the hedging derivative offset
      hedge created by commodity derivatives? The                 each other. To qualify a derivative position for
      next section tries to answer this question.                 hedge accounting, the hedging entity must
                                                                  specify the hedged item, identify the hedging
                                                                  strategy and the derivative, and document by
                                                                  statistical or other means the basis for expecting
                                                                  the hedge to be highly effective in offsetting the
                                                                  designated risk exposure. This documentation
                                                                  step is called prospective testing, and it must be
                                                                  done to justify continuing hedge accounting. The
                                                                  hedger must also regularly perform retrospective
                                                                  testing to determine how effective the hedging
                                                                  relationship has actually been.

                                                                                                                 EXPERTS’ VIEWS   | 57
        4.5. Defining and testing a measure of hedge                4.9. The other two methods of assessing hedge
             effectiveness represents an important and                   effectiveness i.e. the variability-reduction
             potentially challenging aspect of hedge                     method and regression analysis are closely
             accounting. Failure to meet the challenges hedge            related. The difference is that the variability-
             accounting presents may introduce substantial               reduction method assumes that the risk-
             volatility into reported earnings.                          minimising derivative position is equal and
                                                                         opposite to the hedged item in a one-to-one
        4.6. Highly effective hedge substantially offsets the            hedge.
             change in the fair value (or the cash flow) of the
             hedged item. That is, if the hedged item in a fair     4.10. If a one-to-one hedge performs perfectly, the
             value hedge appreciates by $100,000, then there              change in the value of the derivative exactly
             is some range of decline in values of the hedge              offsets the change in the value of the hedged
             that can be defined as substantially offsetting this         item. The variability-reduction method compares
             change. Defining this range is a matter of                   the variability of the fair value or the cash flows of
             subjective judgment. A highly effective hedge                the hedged (combined) position to the variability
             has been defined in literature as one that offsets           of the fair value or the cash flows of the hedged
             at least 80% of this change and no more than                 item alone. This method places greater weight on
             125%. Then the acceptable range of the change in             larger deviations than on smaller ones by using
             value for the derivative will be between                     the squared changes in value to measure
             (–)USD.80,000.00 and (–)USD.125,000.00.                      ineffectiveness. The preferred test statistic for this
             However, even when a hedge is determined to be               method is the proportion of the hedged item’s
             highly effective, there could be an impact on                mean-squared deviation from zero that the
             current earnings when there is not an exact offset           hedge eliminates. To calculate the test statistic,
             of the hedged risk. If, for example, the change in           subtract from one the ratio of the sum of the
             value of the derivative were (–)USD.110,000.00,              squared periodic changes in the hedge and the
             then the hedge would be highly effective,                    hedged item to the sum of the squared changes
             because this change in value falls within the                in the hedged item.
             specified range and hedge accounting would
             report an effect on income of                          4.11. The measure of hedging effectiveness using
             USD.(+100,000–110,000) = (–)USD.10,000.00. This              regression analysis is based on the regression line
             idea of offsetting has found its way into the hedge          in which the change in the value of the hedged
             effectiveness testing literature in the form of the          item is the dependent variable and the change in
             dollar-offset method of testing.                             the value of the derivative is the independent
                                                                          variable or vice versa. Given the definitions of X
        4.7. The dollar-offset method compares the changes                and Y, the slope of this regression equation
             in the fair value or the cash flow of the hedged             should be negative and close to (–)1.0. However,
             item and the derivative. The dollar-offset method            for the hedge to be considered effective it should
             can be applied either period by period or                    lie between -0.8 and -1.25. The interpretation of
             cumulatively. For a perfect hedge, the change in             the intercept term is also important. It is the
             the value of the derivative exactly offsets the              amount per (data measurement) period, on an
             change in the value of the hedged item.                      average, by which the change in value of the
             Therefore, the ratio of the cumulative sum of the            hedged item differs from the change in value of
             periodic changes in the value of the derivative              the derivative.
             and the cumulative sum of the periodic changes
             in the value of the hedged item will equal one in a    4.12. Ederington (1979) showed that the estimated
             perfect hedge (after multiplying the ratio by                slope coefficient is the variance-minimising
             negative one to adjust for the two sums having               hedge ratio. Consequently, the accounting
             opposite signs in a hedging relationship).                   literature explicitly allows for a hedge ratio that
                                                                          differs from 1.0.
        4.8. Anyone choosing this test should be aware that
             researchers question its reliability because of its
             excessive sensitivity to small changes in the value
             of the hedged item or the derivative. Canabarro
             (1999) showed that under reasonable
             assumptions about the distribution of changes in
             prices, the 80/125 standard rejects as ineffective
             36% of all hedges when the coefficient of
             determination (correlation squared) R2 is 0.98.

5.     Concluding Remarks

5.1. The need for commodity derivatives is                               5.2. As the recent global experience has exhibited,
     multifarious in a growing economy like India. Be it                      growth in derivative products without
     for ‘risk management’, ‘investment’, ‘portfolio                          corresponding development in regulation —
     diversification’ or to provide access to our                             both from a macroeconomic perspective and a
     producers to the most efficient markets in                               risk management perspective — is neither
     commodities, it is difficult to argue for other than                     desirable nor advantageous from the viewpoint
     an expansion of the availability of such products                        of long-term stability. In this arena, the new
     in the arena of exchange-traded instruments.                             literature on the accounting for such instruments
     However, as the above article demonstrates,                              is a welcome addition. What is also required is
     there has been unprecedented growth in this                              more detailed guidance from a risk management
     area over the last few years.                                            perspective by the Reserve Bank of India on the
                                                                              use of such products. It is only a combined
                                                                              approach that will lead to the establishment of
                                                                              stable and deep markets for commodities in
                                                                              India, which is essential for the long-term growth
                                                                              of our economy.

Mr. Kumar Dasgupta is Partner and Dr. Chiragra Chakrabarty is Associate Director, Price Waterhouse. Views expressed are personal.

                                                                                                                                    EXPERTS’ VIEWS   | 59

        Anand Rathi is a full service, relationship-led, financial         Financial Planning, as this is known in India was hitherto restricted
        intermediation company with sole focus on providing long-          to large HNI and select corporate houses. We bring customized
        term value to its clients. A client-centric focus, an open         financial planning to you. What makes us compelling is that we are
        architecture, third-party-product based platform and quality       unbiased, selling only third-party products.
        fundamental research across asset classes, form the
        cornerstone of the Company’s philosophy, helping us to             w w w. t r a d e. a n a n d r a t h i . c o m w a s c r e a t e d a s a
        achieve excellence in each of our business verticals.              comprehensive, interactive platform for all your financial
                                                                           information, news, views and trade.
        Founded by Mr. Anand Rathi and Mr. Pradeep Gupta in 1994,
        Anand Rathi today has a strong domestic presence as well as        Private Clients
        international reach. We employ close to 4,000 professionals
        and 20% of the group’s equity is currently held by Citigroup       Each one of our Relation Managers is dedicated to providing
        Venture Capital. We operate at over 739 locations through          superior financial solutions to affluent individuals including
        260 branches and 479 business associates. Our presence in          NRIs.
        Dubai, Bangkok and New York largely caters to Non Resident         We believe private clients need to be treated like corporates.
        Indians (NRIs) and Corporates and Institutions looking to          Just as in the case of a corporate, we analyze the client’s
        invest in India.                                                   financial profile and goals, understand his risks and offer
                                                                           unbiased investment management strategies. Our holistic
        The Anand Rathi team, a group of highly motivated and              wealth management solutions are focused entirely on the
        professional people, is our principal asset. The people are the    client. Be it differentiating different kinds of wealth,
        prime reason we consistently deliver strong results year after     distribution of assets or creation of safety nets for clients as
        year. We have grown from a base group of 15 people in 1994         well as their successors; Anand Rathi helps them capitalize on
        to the current strength of over 4000 people globally and           every opportunity.
        continue to be the firm of choice for the best people from the
        widest available pools of talent.                                  Corporates and Institutions

        We recently ranked as the “Best Domestic Private Bank” in Asia     Anand Rathi works closely with Corporates and Institutions to
        Money 2009 polls.                                                  understand their needs and create investment banking and
                                                                           hedging solutions according to their requirement.
        We provide a range of financial solutions divided across
        distinct client groups instead of product groups, enabling us      Our Investment Banking services include solutions in raising
        to understand the client better and giving us an added             debt and equity in the private markets, identifying strategic
        advantage. These include:                                          alliances and M&A opportunities, and acting as strategic
                                                                           advisors. We fulfill the client’s capital raising needs through
        •     Brokerage in equities, derivatives and commodities           equity markets (IPO/FPO/QIB), underwriting, private
                                                                           placements and other activities associated with debt and
        •     Third-party-product distribution of mutual funds, life and   equity products. We provide the insight and the expertise
              general insurance                                            clients require and deliver all the resources of our retail
                                                                           brokerage network, amongst the most highly regarded in the
        •     Investment banking                                           nation.

        •     Wealth management                                            Hedging solutions are largely provided to Corporates that
                                                                           would be exposed to commodity risk. We understand the
        Individual Clients                                                 client’s physical business, identify the commodity price risk
                                                                           and suggest optimal solutions in consultation with our
        At Anand Rathi, we believe in your individuality and your          dedicated product research team. Our membership with
        individual financial, investment need and approach. We have,       MCX, NCDEX, NMCE, DGCX and LME provide the client a
        over the years, gathered expertise across various investment       strong trading platform. Our exclusive tie-up with Natixis
        platforms – equity, mutual fund, fixed income and life and         Commodities Markets, one of the 11 members of the LME is
        non-life insurance. That’s just one part. The other is to marry    another added advantage.
        this expertise to the individual risk profile understanding
        your financial status and investment needs, given your             Anand Rathi’s competitive advantage comes from its
        lifestyle and family size.                                         network and the strength and breadth of its relationships in
                                                                           the business. These underpin the value the Company delivers
                                                                           to all its clients.

                                                       Brokerage Industry: Key
                                                       Link between Ecosystem
                                                       Players and Exchanges
                                                       By Ms. Priti Gupta

         A brokerage firm is the key link in the chain of commodity markets. It connects all the
         players of the ecosystem — producers, consumers, traders, etc — to these markets.

         The majority of India’s population — as high as 60% —              to be developed and made competent by means of
         depends on agriculture for its living. However, unlike in          exhaustive training. The next challenge was to take it to
         the developed world where a small number of people                 the target clients or users such as hedgers, traders,
         produce large quantities of agricultural commodities,              arbitrageurs, etc. Since over more than four decades
         in India a much larger number of people produce little.            people in the country had no idea about what
         This makes Indian commodity markets radically                      commodity futures were all about, a massive education
         different from their counterparts across the world and             drive had to be taken up. The last but not the least,
         extremely price-sensitive. This in turn makes the role of          setting up an in-house research desk was a daunting
         the government in power very critical in regulating the            task indeed. And the most critical part, there was no
         prices as well as the entire commodity ecosystem truly             reliable historical database — even of basic data or
         complex.                                                           data on fundamentals like production and
         On the other hand, commodity futures markets, which                consumption — to carry research on commodities. So
         are currently at a nascent stage since their revival by the        it was like starting from ground zero!
         government in 2002-03, have, in this short span of six
         years, played a commendable role in integrating the                The commodity brokerage industry has come a long
         country’s fragmented commodity markets and                         way over the last five years, but a long road yet needs to
         improving the overall conditions of the agricultural               be traversed.
         marketing infrastructure. A brokerage house acts as a
         key link connecting these markets to all categories of             Creation and Spread of Awareness
         physical market participants.
                                                                            The commodity market itself is a complex area with a
         Broking Firm – A Broader Perspective                               plethora of fundamentals influencing or determining
                                                                            its direction and is, as such, a very difficult subject for a
         General perception about a brokerage firm is that it is a          common man to understand. On top of that, the
         facilitator of ‘buy’ and ‘sell’ of commodities. But given          concept of a derivatives market makes the commodity
         the kind of role a commodity broker actually plays, this           market no less than a maze even to the seasoned
         would be mere understatement of the true importance                trader, leave alone a novice.
         of a commodity broking firm. In the Indian markets,
         when commodities brokerage firms were set up with                  The commodity ecosystem consists of corporations,
         the advent of national-level commodity exchanges,                  firms, and traders who do not directly deal in
         they had a challenging task ahead of them mainly                   commodities but have information on the
         because the segment was absolutely new and                         fundamentals specific to those commodities and want
         practically diverse.                                               to get the same converged on an efficient trading
                                                                            platform to get a nominal return, from the advantage of
         The first challenge was to acquire the necessary                   price movement. However, it is necessary that both
         resources or manpower. An entirely new breed of                    hedgers and investors in commodities should be aware
         people capable of handling this commodity space had                of the advantages and disadvantages, and make the

trading process on the exchange platform a healthy             Converging the Entire Spectrum on the Exchange
one. Even though awareness development has been
considered to be the prime responsibility of                   The commodity ecosystem consists of two different
commodity futures exchanges and the regulators,                sects: the one who always intends to ‘sell’ (the
broking firms cannot escape their share of this                producer) and the other who always intends to ‘buy’
responsibility of knowledge development and sharing            (the consumer). For healthy market ecology, balanced
among the participants of the commodity ecosystem.             participation of both the parties is essential. The
This put the onus on brokerages as well — alongside            broking house plays a crucial role in reaching out and
the exchanges — to perform this crucial task of                facilitating both the ends of the spectrum. Trade and
creating awareness about this market among both the            industry had survived in India without commodity
hedger and the investor who look to this market with           futures markets for a long time and that forced them to
completely opposite objectives.                                evolve several mechanisms in order to take care of their
                                                               hedging requirements, such as forward booking of the
Most commodity broking houses in the years 2004 and            commodity, the supplier itself accepting a periodical
2005 spent a very large chunk of their time, efforts and       average price (for metals) or farmers getting into
resources on creating awareness among the                      agreements with buyers at the time of sowing itself.
participants as well as undertaking training for their         These well-entrenched practices and habits were the
own staff. In addition to the reach the exchanges and          primary hurdles for any player to move on to the
regulators have had, brokerages have remained the              futures markets, as they strongly believed that their
connecting link reaching out to both the ends of the           risks were already well taken care of.
commodity chain and thus carrying the benefits from
end to end.                                                    It took a great deal of effort on the part of commodity
                                                               brokers, aided by the exchanges, to define the risks in
As most commodity deals/transactions are settled               these preset mechanisms. As brokers, we were taken
through delivery of the underlying commodity on                aback to see how counterparty risk was discounted by
expiration of a given contract it warrants making              these risk-mitigating practices! Here brokerages play a
traders/investors understand the procedure as well as          very important role of identifying the risks involved in
the risks involved in making or taking a physical              the indigenous systems and off market transactions,
delivery. And this adds another dimension making               and make them see the benefit of trading on the
training and spreading of awareness all the more               exchange platform where there is a clean and
important.                                                     transparent process of risk mitigation.

Transparency – the Essence of Markets                          From the perspective of the exchange broking houses
                                                               have brought in the much-needed liquidity and depth
Transparency is the essence of electronic commodity            to the markets by leveraging their customer reach.
markets and kudos to the initiatives and innovations
made by our home-born national-level commodity                 Taking Innovation to a New Height!
futures exchanges, which started a completely
automated trading system paving the way for the                Today, broking firms are equipped with state-of-the-
Indian commodity markets to be globally competitive.           art infrastructure and cutting-edge technologies for
In a short time, we have seen major global commodity           risk management and trade execution and, hence,
markets realise the importance of the electronic               capable of minimising human intervention and
platform — and technology — for enhancing                      manual error components. Less human intervention
transparency, and thus slowly move on to this format.          means lower transaction cost, which in turn helps in
                                                               bring an increased number of various categories of
Apart from mere trading side of it, commodity futures          commodity market players on to the exchange
are generally high-valued contracts and as such put            platform and, thus, integrate them with a much larger
huge amounts of money at stake. This makes                     market system than where they would have otherwise
transparency in the operations of brokerage houses             be trading i.e. at a mandi with higher cost of
extremely important for users. A broking firm must             transaction.
ensure that all the trades it executes for its client should
be communicated in a transparent manner and its
interests be kept open to the client. Transparency in the
operations of a broking house takes it a long way in
establishing a strong bond with its clients.

                                                                                                                 EXPERTS’ VIEWS   | 63
        Technology-enabled Smooth Compliance                                     A few broking houses like ours took upon the task of
                                                                                 conducting research and take the benefits of
        The broking fraternity takes on itself the responsibility                information to all the parties in the system and
        of compliance on its own behalf as well as on the behalf                 continue to do so now. Unlike in the developed
        of its customer. This may sound a fairly simple task but it              economies, statistics on agricultural commodities was
        is not. To take the responsibility of ensuring that each of              really scarce in India, and we converted a lot of
        its clients is eligible and authorised to use the exchange               manuscripts into software-powered systems by
        platform is a daunting task, given the time-consuming                    manually punching them in. There was no proper
        verification and documentation needed to be carried                      dissemination of the data that lay with the
        out. This was extremely challenging in the commodity                     government, and government websites were not
        space where most of the participants from upcountry                      updated month after month. We on our own initiated
        or mandis were not merely sceptic but were practically                   crop surveys, making a fair estimate of the crop and
        averse to sharing information.                                           keeping records of daily spot prices prevalent in
                                                                                 various mandis. In fact, a lot of hard work goes into
        On various occasions when foreign brokerage houses                       research, which is an integral part of a full-fledged
        visited us, they were utterly amazed to see how                          broking house and a key to bringing the various
        flawlessly we were able to manage tedious compliance                     ecosystem players together on a single platform, which
        as well as real-time risk management for such a large                    helps in bringing transparency and efficiency in both
        numbers of our private and individual clients. We believe                price discovery and risk management.
        it is the entrepreneurial instinct in Indians that help them
        carry out sensitive tasks in such innovative ways.                       Today, the picture is slightly changed. A few data
                                                                                 providers have popped up, government sites are
        Research and Market Intelligence                                         getting updated regularly, and weather updates have
                                                                                 turned more frequent and more accurate. This change
        Last but not the least, research in commodities and their                is welcome, but this does not in any way lessen the
        fundamentals was an alien subject in India before the                    responsibility of brokerage houses of keeping their
        advent of commodity futures exchanges. A few                             clients updated on a regular and consistent basis. At
        corporations had their own internal research setups that                 present, there are some broking firms which advise
        used to advise their top brass on their exposure to                      even the government on decisions with regard to
        commodities, and mandi traders used to get only limited                  imports, for example.
        information in the geographical area of their activity.
                                                                                 To sum it up all, a broking house is a key link between
                                                                                 the exchanges, the participants and the regulator.
                                                                                 Having access to all the stakeholders, a brokerage plays
                                                                                 a vital role in the integration of obligations and
                                                                                 requirements of all the parties.

         Ms. Priti Gupta is Executive Director of Anand Rathi Group. Views expressed are personal.

                                          Commodity Derivatives –
                                          An Opportunity for
                                          Banks to Diversify Risks
                                          By Mr. Shailesh Sukhthankar

As and when allowed to enter it, the commodity derivatives business holds enormous
potential for banks. It will be especially attractive for banks when they offer a
combination of multiple derivatives products to satisfy the requirements of their

Commodity derivatives in India have had a chequered          •   Hedging credit exposure
history. Until 2002 the market was virtually non-            •   Information Dissemination
existent, except trading in a few regional commodity         •   Advisory Services
exchanges. The advent of national-level multi-
commodity exchanges viz. Multi Commodity Exchange            Clearing and Settlement Services
of India, National Commodity & Derivatives Exchange
and National Multi Commodity Exchange provided a             Clearing is the process of determination of obligations,
much needed impetus to the growth of this market.            after which the obligations are discharged by
                                                             settlement. Settlement is a two-way process that
With the gradual withdrawal of the government from           involves legal transfer of the title to funds and
various sectors in the post-liberalisation era, the need     securities/other assets on the settlement date.
has been felt for various players in the commodities
market ecosystem to be permitted to participate in           The clearing bank services are a highly time critical activity
commodity derivative markets.                                as delays directly impact the members/exchange. Banks
                                                             can play an important role in settlement of obligations in
Bank, the strategically important institution in the         the overall ecosystem including exchanges, members,
overall growth and development of the economy, can           clients, custodians, etc. This is highly transactional nature
play various important roles in this market as well. This    of the business. Dedicated infrastructure, trained
article dwells on some of these roles, which can help in     manpower, and use of technology are the key parameters
nurturing and developing the commodity derivative            to doing this business.
market in India.
                                                             The banking settlement system plays a crucial role in
Some banks are already carrying out some vital               the overall risk management of the exchange
functions such as clearing and funding, as outlined          mechanism, wherein daily settlement of
below, while regulatory approvals are required for           trades/obligations, ability to manage fund flows in
considering other roles such as hedging and serving as       volatile days, coordination with exchanges and
an aggregator:                                               members, etc contribute towards effective functioning
                                                             of the exchange mechanism.
•   Clearing Bank Services
•   Depository Services                                      Apart from clearing services, banks also provide fund
•   Broking Services                                         and non-fund based facilities to the members of the
•   Professional Clearing Member                             exchange for managing their working capital
•   Structured Finance                                       requirements and, thus, earn revenues through float
•   Aggregator                                               funds, interest earned on overdrafts/loans, commission
•   Trading & Investments                                    income, etc.

                                                                                                                     EXPERTS’ VIEWS   | 65

                         CLEARING BANK                                                       CLEARING BANK

                                 MEMBER                                                           MEMBER

                                INVESTOR                                                         INVESTOR

        Depository Services                                          similar to the existing 3-in-1 account in equity markets
                                                                     interlinking the bank account, broking account and
        Commodity exchanges have revolutionised Indian               depository account of investors, which will be of great
        markets by enabling holding of warehouse receipts in         convenience to customers.
        electronic form. This mechanism is accomplished
        through the National Securities Depository Ltd (NSDL)        Professional Clearing Member
        and Central Depository Services Ltd (CDSL).
                                                                     A professional clearing member (PCM) is one who can
        Banks can empanel as Depository Participants of NSDL         only clear trades but cannot trade on one’s own account.
        and CDSL and provide this service to the members,            Institutions and corporates prefer clearing the trade
        clients, and general investors.                              through PCMs to avoid being exposed to brokers who
                                                                     may lack adequate capital, professionalism, etc.
        The Warehousing (Development & Regulatory) Act               Banks are ideal to serve as PCM too, as they have
        2007 also has provisions for issuance of electronic          necessary attributes such as adequate capital, strict
        warehouse receipts. The existing depository                  regulatory structure and strong internal controls, among
        system/processes (subject to appropriate regulatory          others. They can add value to market participants by
        approvals/modifications) may be utilised providing an        designing appropriate lending products.
        impetus to holding and transacting in electronic
        warehouse receipts. This will also throw open another        Large corporates and institutions may trade through
        opportunity for banks to lend against electronic             various brokers for their execution/advisory
        warehouse receipts in a seamless and efficient manner,       capabilities. However, for the settlement of trades, they
        with faster turnaround time.                                 may prefer PCMs due to less counterparty risk,
                                                                     customised MIS, dedicated service, etc.
        Broking Services
                                                                     Banks can benefit from economies of scale, additional
        The sheer growth in the commodity futures volumes            float funds, integration with their lending/credit
        and interest among the investor community will boost         assessment and generation of fee-based income.
        the growth of broking services. As they already play a
        key role in financial intermediation, banks can also offer   Structured Finance Products
        broking services by leveraging their existing customer
        base, branch network, and so on.                             Structured finance is a very exciting development. It
                                                                     involves tailoring of a product according to the
        Depending upon the regulatory structure/requirement,         requirements of the borrower and the lender, and helps
        banks can integrate this product into their overall          banks go beyond the normal balance-sheet lending by
        offering of retail products and also technological           structuring the cash flows/collateral. Banks can
        initiatives such as online banking-broking account —         leverage the exchange infrastructure in integrating the

traditional lending products with the exchange             The conventional warehouse receipt lending can be
mechanism and develop products such as financing           integrated with the exchange mechanism, wherein the
against warehouse receipts and settle                      borrower can hedge his price risk and deliver the
(receipt/payment of funds) through exchanges, enable       commodity on the exchange. The borrower can store
trades in spot and futures markets, funding through        his produce in an exchange-accredited warehouse and
collateral management structure, trade structure, and      get a warehouse receipt issued to him from the
so on.                                                     warehouse. Thereafter he can take loan from a bank at a
                                                           competitive interest rate against this warehouse
Here are two examples of structured finance product        receipt. Subsequently, the borrower can sell the
that can help the farmer and the end user industry.        commodity on an exchange using the PCM services of
                                                           the bank and mark the commodity for delivery. On
(a) Payout funding:                                        settlement, the bank shall deliver the commodity and
                                                           receive the funds. With these funds, the bank will close
Normally agricultural commodity prices tend to be          the loan and release the balance funds to the borrower.
lower during the season and increase during the
offseason. Warehouse receipt lending provides the          This mode of funding is very helpful to a
borrower/owner of the commodity with an                    producer/farmer as it provides them with a one-stop
opportunity to avail of financing to meet his liquidity    solution to storage, liquidity, and hedging of the price
requirements and thereby avoid distress sale.              risk. Once options are allowed, it will provide the upside
                                                           benefits as well.

Payout Funding:

                                                                               HEDGE THE
                                DEPOSIT OF                                     UNDERLYING

                                                                 BANK LENDING
                                 PLEDGE THE
                                                             AGAINST WAREHOUSE                     COMMODITY
  WAREHOUSE                      WAREHOUSE
                                                                 RECEIPT & ALSO                     EXCHANGE
                                                                 PCM SERVICES

(b) Payin funding:                                         Aggregator

The buyer can also opt for payin funding from the bank.    Since the Indian farming sector is characterised by
The buyer deposits the margin money with the bank.         small and marginal holdings, individually farmers do
He then enters into buy contract with the bank acting      not have the volume and expertise to hedge on the
as a PCM. On the due date, the bank takes the delivery     exchange platform. Banks can play a very important
by making the payin of funds. The same is then             part in this context by acting as an aggregator i.e.
converted to pledge finance by releasing the loan to       pooling the individual farmer’s requirements to create
the borrower.                                              the necessary volume and then hedge on the
                                                           exchange. A bank can perform the function of an entire
                                                           value chain for its customer by providing the crop
                                                           finance, hedge the price risk on the exchange and then

                                                                                                               EXPERTS’ VIEWS   | 67
                                                 Pool individual quantity
                                                 to get exchange
                   FARMER                        traded lot
                                                                            BANK                                   EXCHANGE
                                                                                         Hedge on
                   FARMER                                                                Exchange


        This provides a huge opportunity to various sections of                Information Dissemination
        the society including farmers, traders, processors, etc
        to participate in commodity exchanges and hedge                        Information is knowledge, and knowledge is power!
        their exposure at an optimal cost.
                                                                               A bank’s vast network of branches across the country
        Trading and Investments                                                can act as additional information dissemination
                                                                               centres for spot and futures prices of commodities and
        Commodities have become an important asset class in                    other related information. This can greatly facilitate the
        recent times, especially as a hedge against inflation.                 financial inclusion and general awareness process and
        Currently, in India, banks are not allowed to trade in                 empowerment of farmers.
        commodity futures. Once allowed to invest/trade in                     Commodity price information in this mode will also
        various commodity derivatives they can contribute                      likely attract target customers to avail of other banking
        significantly towards creating depth in the market.                    products, especially agriculture-related products such
                                                                               as crop loan, land development loan, tractor loan and
        Hedging credit Exposure                                                so on. Banks can also mobilise the savings accounts of
                                                                               these customers with their relevant products and
        While lending to customers, banks, as per their credit                 services under their financial inclusion agenda.
        policy, appraise the credit worthiness of the borrower.
        In case the borrower is from the commodity sector, he                  Advisory Services
        has an exposure/associated risk on the underlying
        commodities. The concerned bank can ask the                            Banks are already providing advisory services to their
        borrower to either hedge his position on a commodity                   high net-worth customers. With commodities gaining
        exchange or have a process of directly hedging the                     the prominence as a separate asset class and a natural
        underlying credit exposure himself.                                    hedge against inflation, banks can provide/assist in
                                                                               overall wealth management of individual customers.
        This initiative provides additional comfort to the                     As and when regulations allow, there is enormous
        banker, helping in:                                                    potential for banks in the commodity derivatives
                                                                               business, especially when a multiple of above products
        •     Higher amount of facility                                        will be combined to satisfy the requirements of their
        •     Longer tenor of the facility                                     customers.
        •     Competitive margin
        •     Competitive rate of interest, etc.

        Mr. Shailesh Sukhthankar is Senior Vice President & Head – Capital & Commodity Markets, HDFC Bank Ltd. Views expressed are personal and
        not of HDFC Bank Ltd.

                                          Agriculture Financing
                                          under OTC Products
                                          By Mr. Venkatesh Tagat and Mr. Narendra Rathore

Over-the-counter (OTC) products for agriculture financing may be seen in the light of
strong recommendations made in 2008 by the Reserve Bank of India working group on
introduction of credit derivatives. Purpose of this paper is to pursue with the
policymakers to reinitiate the debate on the use of credit derivatives as OTC products to
address problems of rural and agricultural banking through credit derivatives at least at
the interbank level and while dealing with corporates on a pilot basis.

Taking cues from various recommendations made by             corporations (NBFCs), and local money lenders, which
the International Securities and Derivatives                 in turn is dependent on the performance of financial
Association (ISDA) and Reserve Bank of India (RBI) draft     products of the agencies involved. While the informal
guidelines on credit derivatives, apex development           sector has the flexibility of structuring its products to
financing institutions (DFIs) can be identified to           meet financing requirements of both the borrower and
introduce various risk management systems and                the lender, the formal sector has restrictions despite
infrastructure for using credit derivatives to help rural    the fact that the informal sector has to deal with fewer
banks. Initially, this kind of system may be structured      and smaller risks and has a better control on its
on a pilot basis for interbank transfer of risks without     portfolio of loans and advances compared to the
compromising on the capital adequacy standards.              formal sector.
Later, other agencies such as insurance firms, mutual
funds, hedge funds, and corporates may be included           Health of formal financial institutions, especially
after due diligence. Once the systems are grounded           cooperative banks, has been a major concern.
exchange-traded products may also be introduced to           Cooperative banks accounted for 19% of the total
induce liquidity and wide-ranging participation. This        disbursement of Rs. 2,25,384 crore in 2007. The share of
paper discusses the benefits of development of credit        cooperative banks and RRBs in overall financing has
derivatives markets for rural banks and corporates such      also been decreasing over the years. Some of the major
as diversification of the risk-reward profile, optimal       areas of concern in the cooperative sector are low
utilization of resources, and so on. It also discusses the   resource base, portfolio imbalances, high dependence
conditions necessary for the development of such             on financial agencies, poor business diversification and
markets.                                                     recoveries, concentration of credit risks on a few
                                                             agricultural activities, illiquidity and inability of rural
Rural Banking and Credit Derivatives                         banks to transfer credit risk, absence of structure that
                                                             can attract new investment risk capital into assumption
The investment in agriculture to total national Gross        of credit risks1 , etc. As on March 31, 2008 the total
Domestic Product (GDP) was in the 1.9-2.2 percent            erosion in the value of assets of 127 district central
range between 2003 and 2007. Gross capital formation         cooperative banks (DCCBs) aggregated to Rs.14,998.1
in agriculture is a function of investment and financing     crore.
in agriculture through institutions such as commercial
banks, cooperative banks, regional rural banks (RRBs),
microfinance institutions, non-banking financial
              Accumulated losses and recovery (Rs./crore)
                  Year                                    SCBs                            DCCBs                          SCARDBs                           PCARDBs

              Accumulated losses
              (31March) and %                     Loss           %Rec              Loss            %Rec             Loss            %Rec              Loss           %Rec
              recovery (30.06.07)
              2005                                305              86             4776               72             1039              44             2466               54
              2006                                276              87             5298               69              876              46             2725               48
              2007                                389              86             5712               71              946              44             2870               52
              NPA (31.03.07)
              Sub-standard                               2957.05                          6375.13                          4315.42                           2511.29
              Doubtful                                   2624.51                          7648.34                          1310.25                           1783.23
              Loss assets                                1122.44                          2471.41                             17.46                             21.51
              Total                                     6704.00                        16494.88                           5643.13                           4316.03

          Source: NABARD Annual Report (2007-08)

          Credit derivatives, which are OTC financial contracts,                                 credit derivatives allow one party to shift credit risk of a
          are usually defined as ‘off-balance sheet financial                                    reference asset, which it owns, to another party
          instruments’ that are designed to transfer credit risk                                 without actually selling the asset. Thus, it “unbundles”
          from the person exposed to that risk (the protection                                   credit risk from the credit instruments and trades it
          buyer) to a person willing to take that risk (the                                      separately. Credit derivatives, generally, are bilateral
          protection seller) by means of payment of fees from the                                contracts designed to meet the specific requirement of
          protection buyer to the protection seller. It is a                                     the counterparties to the contract. The value of a credit
          protection against risk of financial loss due to                                       derivative is derived from the credit quality of an
          counterparty failure to perform its obligation. The                                    obligation. Most commonly used credit derivatives are
          credit risk is transferred between market participants                                 Credit Default Swap2, Credit Linked Notes, Total Default
          without the underlying assets changing hands. That is,                                 Swaps, etc.

                                                OWNERSHIP                        UNDERLYING ASSET(S)                OWNERSHIP
                                                                                  (LAND, PLANT, MACH)                                    BANKRUPTCY, INSOLVENCY, MERGER,
                                                                                                                                        CROSS ACCELERATION, CROSS DEFAULT,
                                                                LOAN                                                                       FAILURE TO PAY, REPUDIATION,
                      REF. OBLIGATION                                              1. COUNTER PARTY                                       RESTRUCTURING, DELINQUENCY,
                      (LOAN, ADVANCES)                                             (LOAN BENEFICIARY)                                    PRICE DECLINE, RATING DECLINE OF
                                                                                                                                                 ASSEST OR ISSUER

                                                                                  CREDIT DERIVATIVES

                                                                                        CREDIT RISK                                     3. PROTECTION SELLER/CREDIT RISK/
                                                                                                                  NO                           BUYER/GUARANTOR
                                                                               PREMINIUM/FEES/INTEREST                                      (PERSON WILLING TO TAKE RISK)
                 2. PROTECTION BUYER/                                                         OR
                   CREDIT RISK SELLER
                                                                                        CREDIT RISK
                                                                                 CREDIT EVENT PAYMENTS
                                                                                (PHYSICAL DELIVERY, CASH
                                                                                  SETTLEMENT: PAR LESS
                                                                                  RECOVERY VALUE FIXED

                Annual Report of NABARD (2007-08); Area of Concern - Page 82.
                These are contracts where the protection seller receives premium in quarterly installments throughout the life of the contract or till the credit event occurs,
                from the protection buyer as compensation for assuming the credit risk of a specialized reference obligation. In return of these premia, the protection buyer will
                receive a payment from the protection seller upon the occurrence of a credit event in respect of the reference obligation. According to RBI draft guidelines on
                credit derivatives in India, ‘credit event’ is defined as the scenario or the condition agreed between the contracting parties that will trigger the credit event
                payment from the protection seller to the protection buyer. The credit event usually includes bankruptcy, insolvency, merger, obligation acceleration, cross
                default, failure to pay (principal or interest), repudiation, moratorium or restructuring, price decline or rating downgrade of the underlying asset or the issuer.

Use f credit derivatives as OTC products has gained                            provide short-term credit and protection to farmers
support especially after the release of second                                 against their contingent financial requirements in
consultative document on New Basel3 Capital Accord in                          exchange of collateral or higher premium (interest) in
January 2001. RBI guidelines on Credit Risk                                    cash or kind. These kachha adatiyas take long-term
Management 4 , Foreign Exchange (Derivative                                    loan pacca adatiyas (bigger adatiyas) at a lower rate of
Contracts) Regulations Act 20005, and constitution of                          interest for lending to farmers. In the process kachha
Committee for Regulatory Framework for Derivative                              adatiyas seek protection from pacca adatiyas against
Trading in India (chaired by Dr LC Gupta) and RBI Draft                        risk of default from farmers/peasants in exchange of
Guidelines for Introduction of Credit Derivatives in                           part of the premium received from the farmers. The
India6 in March 2003. A working group on credit                                credit default of the farmers is settled either through
derivatives7 was also constituted by the RBI in 2008                           physical delivery of reference assets or in cash (see the
which recommended introduction of credit derivatives                           adjoining figure). Although there is no
in the country.                                                                comprehensive risk management tool deployed for
                                                                               effective management of credit risks, the system
Given that more than 70% of banks’ assets are loans                            works fairly well in rural areas, besides providing
and advances and credit risk has a major impact on                             flexibility to hierarchy of borrowers and lenders.
banks’ financial performance, it is important to take a                        Formal systems when introduced will definitely
look at certain financial OTC products that have                               require comprehensive risk management systems
performed well in the informal sector, albeit under                            through identification, measurement, monitoring,
different forms and names and even without much                                and control of credit risk exposures with proper
documentation and other formalities. In rural areas,                           documentation and registration of such transaction.
landowners and local adatiyaas (kachha adatiyas)


                                                                                                                          REFERENCE ASSET
                                                                                                                         (LAND, ANIMALS ETC)

                                          LOAN FOR                          HIGH PREMINUM/
                                     AGRI-RURAL ACTIVITY                      COLLATERAL

                                                                           PROTECTION BUYER-                              PROTECTION SELLER-
                                                                           KACHCHA ADDATIYA                                PUCCA ADDATIYA

                                                                          PRE AGREED AMOUNT
                                                                         OR PAR VALUE OF ASSET
                                                                             AT START DATE

                                                                                       INFORMAL CREDIT DERIVATIVES SYSTEM

    Basel Committee on Banking Supervision sets global standards and benchmarks on regulatory and supervisory practices. Its new accord has provide more risk-
    sensitive standardized approach on capital adequacy of banks so as to ensure soundness of banks in globally networked financial system.
    RBI circular No. BP.BC.26/21.04.103/2001 dated 20 September 2001.
    Notification No. FEMA 25/RB-2000 dated 3 May 2000
    RBI circular No. DBOD.BP.1057/21.04.103/2002-03 dated 26 March 2003.

                                                                                                                                                     EXPERTS’ VIEWS   | 71
         Indian banks are increasingly becoming vulnerable to           without selling the asset and without the
         credit risk. It is felt that risk premium in the form of       knowledge/consent of the borrower. Under this system
         interest charged by banks, especially on priority sector       there is no need for rural banks to assume credit risk and
         loans, is inadequate to cover the credit risk. Margins of      sell/hold assets to be able to hedge their credit risks.
         banks are also at risk with loss of value of traditional
         collaterals (e.g. land, animals, etc.). Credit derivatives
         provide hierarchy of rural banks with an opportunity
                                                                          Using credit derivatives, banks that are falling
         not just to manage their own credit risk but also to
                                                                          short of their lending targets for the priority sector
         expand their business as discussed below. Initially, this
                                                                          can be allowed to assume sector-specific credit
         kind of system may be structured for interbank transfer
                                                                          risks of other banks that have exceeded their
         of risks on a pilot basis and later other agencies such as
                                                                          targets, thereby diversifying portfolio risk and
         insurance firms, mutual funds, and hedge funds may be
                                                                          optimising capital of both types of banks.

         Benefits to Banks                                              Returns from customisation: Institutions can use
                                                                        credit-derivative structures for developing a system for
         Diversification of business opportunities: Rural               transferring credit risks with customised risk-reward
         banks tend to have geographic or sectoral                      profiles. Besides, credit derivatives have the potential
         concentration of their credit portfolio because of lack        to succeed where the traditional methods of adjusting
         of expertise and knowledge of new credit markets;              exposure (e.g. participation in the secondary loan
         industrial/sectoral biasness of the management; return         market) cannot provide an equivalent protection as
         requirement; political pressures; sticky client                they suffer from problems of high transaction costs,
         relationships; high switchover costs, etc. This                lack of liquidity, regulatory restriction, non-availability
         concentration increases their credit risk and reduces          of required currency, and inability to originate assets
         return on capital with in a restricted risk-return             from non-traditional markets. A bank can match its
         framework. These banks can manage their                        willingness to acquire a credit exposure to a particular
         concentration-risk by optimally diversifying within their      issuer, having securities with maturity different from
         credit portfolio by reducing overexposed risks while           that of the bank’s credit lines, by investing in a
         increasing exposure to the industrial/agricultural             structured credit derivative where default risks of the
         segments where it is sub-optimal. With the help of credit      two are linked. Current exposure norms restrict banks
         derivatives their risk profile can be changed without the      from concentrating certain credit risks in their books
         need to either purchase new assets or dispose of existing      and, therefore, they have to forgo otherwise lucrative
         assets. This can be done by selling protection on an           oppor tunities. O ff-balance -sheet nature of
         underexposed geographical/industrial segment and               transactions can help banks avail of such opportunities
         purchasing protection on the segment to which the              and maintain client relationships. Thus, the ability of
         bank is overexposed. Synthetic means of credit                 banks to customise credit risks on a spatial and
         exposure can enhance portfolio returns, which,                 temporal framework through credit derivative
         otherwise, are not directly available, prohibitive,            instruments provide them access to investments that
         expensive or difficult in view of regulatory/legal             would otherwise be difficult to secure.
         constraints or higher transaction cost. Commercial
         banks can provide protection to sponsored RRBs                 Capital optimisation: Banks can minimise their
         through these derivative instruments while isolating           forward gaps in utilisation of credit lines by selling or
         credit risk from other risks (interest rate/currency risks /   buying credit protection. In doing so it can fully utilise
         regulatory / political / business / sovereign) and from        the available credit capital and even increase the return
         the asset itself. In the process commercial banks will         on capital over the full term of credit lines by suitably
         themselves be able to diversify their credit portfolio         pricing forward default swap. Banks can also seize
         and ensure a regular flow of revenue in the form of            trading opportunity by structuring their risk-reward
         premium paid by RRBs that are currently seen as a              profile, adopting different credit exposures and
         burden rather than a source of revenue and liquidity.          defining credit events that trigger default payouts. In
                                                                        the process they will release their capital that is
         Hedge credit risk: Banks are often concerned with the          otherwise blocked in assets which they have to
         credit quality of an individual loan or a group of loans       maintain till maturity. The ability to churn assets can
         and want to hedge the credit risk, especially if that          possibly bring higher return on capital.
         involves long-term financing such as forestry, and
         horticulture. Credit derivatives enable a rural bank to
         transfer the credit risk associated with a loan to another
         party through a bilateral and confidential contract

Accessing credit exposure without funding or                  Funding arbitrage/warehousing risk: A corporate
relationship costs: RRBs have to invest a lot of time         with low funding cost and available capital, but with
and resources in maintaining relationship with regard         low risk appetite, can purchase an asset and then
to advance agricultural loans. Credit derivative              transfer the credit risk of that asset using a credit
protection can possibly be used for determining new           derivative to another institution that has high funding
credit lines or freeing up the existing lines for exploring   cost but higher risk-taking capacity. In the process the
new business opportunities without having the need            institution selling the protection need not make an
for maintaining rigorous client relationships.                outright investment in the asset to be able to gain from
                                                              credit arbitrage opportunities and there is also no need
Benefits to Corporates                                        to incur cost of building and maintaining relationship
                                                              with reference to that asset. On the other hand, the
Besides banks, corporates that have business exposure         protection buyer will pay a lower premium for the
in the rural economy can benefit from the use of credit       protection than the return that he earns on the
derivatives for managing financial and project risks, for     purchased asset.
increasing their range of business counterparties and
for covering default by major suppliers and purchasers        The RBI working group for introduction of credit
in the following manner.                                      derivatives has observed that credit derivatives are not
                                                              fundamentally different from convention credit risk
Protection against political and sovereign risks:             management tools such as guarantees, letter of credit,
Companies willing to make investments in politically          and unfunded sub-participation as credit default
volatile states can isolate the political risk from other     events are protected by the ‘protection seller’ under
risks of planned investments and consider appropriate         credit derivatives instead of the ‘guarantors’ who stand
protection. Similarly, sovereign credit risks incurred in     guarantee under conventional systems. However,
cross-border investments can be hedged by payment             conventional systems such as insurance, guarantees,
of premium for protection against default and rating          and securitisation are less liquid and involve increased
downgrade on the sovereign’s outstanding debt.                intermediation and transaction costs. Under these
                                                              systems banks are not permitted to assume risks of
Cost-efficient protection for business operations:            other banks and write guarantees in favour of other
Credit exposures related to day-to-day operations of          banks even to manage their own risk portfolio.
any company in terms of receivables, debtors, advance
contract payments, default of major suppliers or              The RBI working group has however come up with a
customers, business losses, etc. necessitate use of           caveat that an unbridled approach may expose banks
credit derivatives as a cost-effective protection against     to other associated risks related to liquidity, price, legal
risks. These instruments can help them diversify their        (compliance), foreign exchange, and reputation.
portfolio and seek protection from banks at a lower           Therefore, the group has laid down policies and
cost than the current economic cost of maintaining the        procedures for credit risk valuation and control such as
exposure through provisioning. Also, purchase of              development of adequate systems; approval of policy
credit-risk protection will free up capital that can be       by the board of directors; capturing of credit risk
used in core business activities. Companies can even          acquired through credit derivatives within banks’
choose a short-term protection for continuously               normal credit monitoring regime; development of an
adjusting their exposures vis-à-vis changes in the risks      appropriate mathematical model to incorporate fair
involved. The high level of certainty provided under the      economic value of assets and liabilities, and ensuring
system can help companies plan their future business          best practices.
expansion besides deciding pricing with pre-defined
contribution margins.                                         Although it is important to aim at increasing
                                                              participation of various sectors of the economy such as
Opportunities for new business: Corporate investors           banks, insurers, mutual funds, hedge funds, and
can not only arbitrage the pricing of credit risks in and     corporate in the credit derivatives market they may be
between separate market sectors but also participate          permitted in a cautious, step-by-step manner. Initially,
in the loan market which till date eluded them because        commercial banks, under the supervision of apex DFIs,
of the absence of required loan administrative                may be allowed to assume one-way credit risks of
infrastructure. Synthetic lending swap provides them          cooperative banks and RRBs. This may be done for
with an opportunity to participate in the bank markets        domestic reference assets with minimal exposure to
without having created an infrastructure of a bank.           foreign exchange risks. If required banks may hedge
Corporates with surplus funds can use credit                  their associated interest rate and currency risk on the
derivatives to invest in Credit Default Swaps and             exchange trading platforms. Later, good RRBs and state
provide credit protection and earn premium on                 cooperative banks may enter the scenario. Once the
diversified portfolio on credit exposures.                    market matures other agencies may also be permitted
                                                              in two-way transfer and management of risks.

                                                                                                                    EXPERTS’ VIEWS   | 73
        Identified DFIs will be required to standardise                          information, advice, representation in case of default,
        documents and registration system for use of credit                      distress, dispute, amendments and restructuring of
        derivatives by rural financial institutions. It must ensure              obligations etc. should to be adequately addressed by
        that due care with the consent of the top management                     the regulator.
        of the bank is taken and it is ensured that transactions
        are direct, explicit, irrevocable and unconditional8 .                   Development of credit risk models: Most credit risk
        Issues related to exposure norms, capital adequacy,                      management models, created in the developed
        accounting standards, etc. have also been discussed in                   financial markets, presume availability of default data
        detail by the RBI working group on credit derivatives9.                  and adequate expertise. However, the Indian financial
                                                                                 markets are marred by difficulty in estimation of
        Other conditions necessary for the development of a                      default probabilities, lack of term yield curve and
        robust credit derivatives market are:                                    proper identification of mismatches on account of poor
                                                                                 asset liability management systems, lack of
        Synergy of laws: Development of the credit                               standardised pricing practices etc. Complex models to
        derivatives market requires synergistic assimilation of                  suite Indian conditions need to be developed for
        governing laws and regulations such as RBI guidelines                    enabling an integrated risk management system and
        relating to FEMA, regulation relating to forex                           encompassing associated uncertainties in the credit
        derivatives contracts, insolvency laws, Securities                       derivatives market.
        Contracts (Regulation) Act, Securities Exchange Board
        of India regulations and provisions for derivative                       Development of internal systems and procedures
        trading, tax laws, Transfer of Property Act, state specific              with trained human resources: Derivatives business
        registration and stamp duties requirements, ISDA                         requires strong internal systems and procedures in
        Master Agreement, BIS interventions etc. Any                             conformation with international standards. It must
        confusion on the provisions of various regulations and                   address the issues of training and skill upgrades,
        their applications on the credit derivatives market must                 standardisation of back office operations and
        be addressed in the beginning itself.                                    movement of funds, development of relationships,
                                                                                 infrastructure, credit administration and monitoring
        Efficient regulatory environment: Organisations                          system, online trading, rating and surveillance system,
        transferring/covering the risk must gain confidence in                   credit-risk models and techniques, etc. Trained human
        the market with respect to its ability to enable them to                 resources are required to give regulatory treatment of
        hedge trade risks with an efficient regulatory                           credit derivatives vis-à-vis materiality of the expected
        environment. Issues related to confidentiality, access to                outcome and expectations of clients. An apex financial
                                                                                 institution will be better placed to train the required
                                                                                 human resources with requisite skills sets.

              Recommendation of the RBI Working Group on Credit Derivatives

        Mr. Venkatesh Tagat is Chief General Manger, National Bank for Agriculture & Rural Development, Bangalore, and Mr. Narendra Rathore is a
        freelance consultant, Bangalore. Views expressed by the authors are personal and not of the institutions.

            11                            Commodity Exchange
                                          Technology Concepts –
                                          Looking Forward
                                          By Mr. Dipankar Chakrabarti and Ms. Rachna Nath

Technology is and will remain pivotal for any commodity exchange in the near future.
Commodity exchanges should utilise the new wave of technology innovations to create
a differentiator for themselves. This will enable them to foster ever closer relations with
their users, provide transparency and build trust.

The day the portal “eBay” went down it realized that it     speculators, collateral managers, exchanges,
was not in the business of selling but in the business of   clearinghouses, brokers, regulators, the government,
information technology. This is because when the            infrastructure providers and technology vendors — is
portal was down there was no business. Likewise             creating the challenges, and proper usage of
information technology plays a key role in the success      technology can help resolve these issues to a large
of the business of an exchange helping it run efficiently   extent and create a differentiator that is getting
and effectively. In fact, technology can become a huge      increasingly important as the number of players
differentiator. Emerging technologies can add to the        increases in this market and globalization changes the
“customer delight” through:                                 way of business.

•   Faster enablement of trading of newer & innovative      A forward looking technology strategy could include
    products – adding flexibility to the system to meet     the use of innovative concepts for cost-optimised
    new requirements                                        communication, mobile enablement, a central
                                                            integrated exchange platform, easy information
•   Faster go-to-market from the conceptualization          dissemination, more self service enablement, better
    state – reducing time between conceptualization         market information management, faster learning kit
    and actual trading                                      for users, and increased service levels towards
                                                            customers with algorithms-embedded customer
•   Improved user experience – availability of              relationship management (CRM).
    information of major requirement for commodity
    trading                                                 The Current Need

•   Integrated system – seamless integration of all         To make technology act as an enabler for all actors of a
    stakeholders including clearing house, banks,           commodity exchange and thus leverage the maximum
    warehouse, assayers, spot markets, etc                  benefit from it, it is essential that we look into the
                                                            holistic picture of the information flow among all the
•   Proactive decision support system – easy                actors of the exchange. The adjoining figure shows a
    modification of contracts, management of risks, etc     conceptual information flow among the different
                                                            actors with the “central integrated commodity
•   Value added services - futuristic customer service      exchange platform”. In this discussion note our
    on an integrated voice, mail and internet platform.     emphasis would be on elaborating on the concept of
                                                            futuristic technologically utilization to have an
A stream of innovations in products, platforms and          integrated platform for a commodity exchange which
functionalities, as well as a fundamental restructuring     will be more customer-centric, agile, collaborative and
of the relations between market actors — hedgers,           self-service-oriented.

                                                                                                               EXPERTS’ VIEWS   | 75
             Possible technology-enabling pieces

                        Contracts                                            Market Analysis                                      Info Dissemination

                                                                                    Cont. &                       &
                                                                    DS               Batch                  Si
                                                                      S                                k et i s
                                                                                      Info           ar s
                                                                                                    M n al y
                       Producers/                                                   Analysis         A                                      Market Makers/
                                                       KYC, Raw Data Entry
                       Suppliers                                                                                               D at
                                                                                                                                   a       Spot Price Finders
                                                                                Central Integrated
                                                            EWR -               Exchange Platform
                                                            WMS                                                              in   g Stn
                                                                                                                                       .   Buyers – Brokers -

                                                                                                      Intrgtd. E-Com
                      Warehouse                                                                                                            Agents
                                                                             Automated -                                    On
                                                                e                                                              li   ne
                                                          lin                   fast
                                                       On                                                                                    Risk
                        Assayers                                                                                                             Management
                                                                     Clearing House                                    Banks

        Need of the day is to have an agile system to support                              What Does the Future Look Like?
        the customer need immediately and reduce the time
        from conceptualization to production. The wish list                                If we look back, commodity exchanges have been in
        today looks something like:                                                        existence since 17th century. Modern commodity
                                                                                           exchanges date back to the trading of rice futures in the
        •     I need innovative products to take to the market                             17th century Osaka, Japan. In ancient literature we find
        •     I need to take these faster to the market                                    the mention about commodity futures trading. The
        •     My system should be flexible, robust and fault                               first recorded account of derivative contracts can be
              tolerant to adopt these new products and                                     traced to the ancient Greek philosopher Thales of
              opportunities                                                                Miletus, who, during the winter, negotiated what were
        •     I should be able to integrate seamlessly all my                              essentially call options on oil presses for the spring
              stakeholders including clearing house, banks                                 olive harvest. Since then we have matured a lot and
        •     I need a ‘value adding’ decision support system to                           commodity exchanges are enjoying around 12% CAGR
              modify contracts fast according to the market need                           growth where technology is the main enabler.
        •     I should be able to manage risk online – automate                            Electronic trading has led to the emergence of many
              futuristic price movement management                                         globalised exchanges, accounting for three-quarters of
        •     My system should give me an integrated view of all                           the volume of futures traded. Not surprisingly,
              actors of the marketplace including warehouses                               agricultural products have the highest growth rate
              and assayers                                                                 followed by metals and energy. The globalized
        •     I need better spot market simulation                                         exchange market has intensified the competition as
        •     I need a framework that will help me with better                             well. Every exchange is looking forward to innovative
              customer retention.                                                          products, better reach to supplier/producer and buyers
                                                                                           and faster go-to-the market strategy.
        Given this scenario, technology enablement with
        innovation is becoming fast the theme of the day. It is                            The Reach
        imperative to say that only running the platform for
        bid-ask-rollover will not suffice as the horizon of                                New communication technology breakthrough has
        opportunity is waiting to open. Developed market                                   changed the landscape of reaching out to the
        knowledge is getting fed back to the emerging market                               exchange players in the recent past. Satellite
        to create an efficient risk-resilient market.                                      communication has improved the reach by manifold.
                                                                                           More communication improvements are on the cards.
                                                                                           If we judiciously use the communication technology, it
                                                                                           will help us tap into the rural market easily and thus
                                                                                           make till-date-unearthed huge resources available to
                                                                                           us. Concepts like a pan-African commodity market are
                                                                                           possible only with assurance of better connectivity.

The cost of broadband is going southward fast making                   Faster Go-to-Market
internet more accessible and changing the way
exchanges perform. Multi Protocol Label Switching                      It is very important for the commodity exchanges of
(MPLS) networking is increasing the quality of services                today to look for innovative complex products to stay
at a lesser cost. By prioritising internet traffic and the             ahead of competition within the framework of the
core network more efficiently, quality of service (QoS)                existing regulations of the country. This demands that
and traffic engineering functions can address the                      the technical platform of the exchange is such that it
performance issues related to emerging internet                        can launch any combination of products fast. There is
applications. Network equipment manufacturers are                      no time and cost for creating another platform to
constantly developing new solutions that solve many                    support a new product. The system should be robust
of the problems associated with today’s internet                       and scalable enough to go for a new product without
applications. MPLS is one such solution that has been                  evoking any customer dissatisfaction. In the online
standardised by the Internet Engineering Task Force                    scenario, a second of “service-out” makes people move
( I E T F ) . Th i s w i l l c h a n g e t h e l a n d s c a p e o f   out from the marketplace. Scaling up of hardware is
communications as this is creating a network that                      one way of supporting the need, but the cost of such
increases the reach manifold. Internet enablement of                   support will only go up as the exchange scales. Time
the trading platform has made it possible to trade                     has come to look for innovative solutions for a faster
anytime, anywhere. Newer concepts are emerging to                      and better delivery mechanism at a lower cost.
reach end-users directly, to benefit the community.
                                                                       Cloud computing is one of today’s most hotly
Despite the increase in penetration of information                     discussed/debated topics. Despite the relative decline
technology, there has been a lack of communication                     of grid computing and unfulfilled promises of utility
instrument availability in semi-urban and rural areas of               computing, cloud computing appears to be catching
developing nations. Hence, innovative methods of                       on, in both industry and academia. Compared to its
expanding reach, such as Kiosks, are becoming                          predecessors, cloud computing seems to be better
increasingly popular. A cooperative model, where the                   positioned in terms of economic viability, cost-
reach can be extended to a pool of people through                      effective approaches to scale and reliability, early
creation of Kiosks through a private-public                            adoption of inter faces, and open source
handshaking, can extend the reach of the exchange.                     implementations. In the 1990s, the world was
Initially, the model will work on VSAT but slowly, as the              introduced to the internet, and we began to see the
demand-supply scenario changes, a much lower cost                      power of distributed computing realised on a large
communication protocol can be adopted to minimise                      scale. Today, we have the ability to utilise scalable,
the cost and make information available to the                         distributed computing environments within the
remotest rural areas.                                                  confines of the internet, through cloud computing. This
                                                                       environment strives to be dynamic, reliable, and
In the recent past, IIT-Kanpur has propagated the                      customisable with guaranteed quality of service.
concept of Info-Thela which can empower village                        Within this system, users have a myriad of virtual
farmers to connect to national/international                           resources for their computing needs, and they do not
commodity exchanges. It is basically a pedal-driven                    need a complete understanding of the infrastructure. It
vehicle just like a common cycle rickshaw with a                       reminds us of Sun Microsystems founder Scott Mc-
personal computer onboard which will be connected                      Nealy, who declared long back “the network is the
to internet using wireless technology. It is designed                  computer”.
keeping in mind the village conditions in the country
where electricity is not available all the time. So a pedal            Using clouds, high hardware and network demanding
generator is designed in such a way that while                         organisations have more options to fully understand
pedalling the battery will keep on charging for running                the costs associated with owning versus renting CPUs,
the onboard computers and equipment. This simple                       storage, and networking. The costs usually revolve
but innovative mechanism may change the way reach                      around managing equipment (operational) and not
to the villages can be increased. The Info-Thela can                   just buying it (capital). Amazon and other providers are
provide an internet Wi-Fi network in a radius of about                 relying on consolidating resources with automated
20 km around the nearest internet access point,                        management to make it cheaper for customers to rent
without access charges.                                                resources than buy them. There are a few concerns
                                                                       about the security of the environment. Researchers are
                                                                       working to eliminate the lacuna, and this should be an
                                                                       adaptable platform for cost-effective online service

                                                                                                                         EXPERTS’ VIEWS   | 77
        Many models will emerge — from provisioning the             In addition, there has been a large increase in the
        core system on cloud to information dissemination           number of contracts being traded. Therefore, a much
        over cloud, and there will be an optimised model to         focused data mining tool will be required to manage
        have availability, security and cost in balance. Data       the huge volume of data pursing the information out of
        dissemination over cloud will depend to a great extent      these and creating a repository which is easily
        on the security of data and how that is being tackled. As   accessible and understandable and can be easily
        with most technological advances, regulators are            d i s s e m i n a t e d. Th i s c h a n g e a l s o b r i n g s i n
        typically in a “catch-up” mode to identify policy,          modernisation of regulatory legal system and efforts
        governance, and law. To facilitate the emergence of         should be put in to seamlessly integrate technology
        such policy and governance, the US created a cloud          and work processes to support investigation, trial, and
        computing security group. This group envisions its role     appellate work.
        as promoting “the effective and secure use of the
        technology within the government and industry by            We can very well see that the threat posed by the
        providing technical guidance and promoting                  changing pattern of technology due to online,
        standards. Given the situation, cloud computing will be     internet-based trading can only be mitigated by a
        excellently poised for information dissemination to         highly sophisticated online, auto-learning risk
        users. It may take some more time to move the base          management system.
        platform to cloud computing mode.
                                                                    Integrated Platform
        The programming technique is also getting changed to
        suit faster demand where programming is becoming            The central tendency of future exchanges is taking
        elastic with the highest level of scalability from a few    shape on an integrated platform where all actors’
        users/nodes to a large number of them, delivered on-        demands and needs are taken care of by robust usage
        demand without significant dependencies on                  of an internet-enabled technology platform. Demands
        hardware and with run-time composable screens. This         of key liquidity providers and institutional investors will
        is highly suitable for a commodity exchange to dish out     include fast execution speeds; straight-through
        new products from test bed to actual contracts. All         processing as standard, integrated value-added
        these will make the exchange more efficient.                clearing services into the trading platform; enhanced
                                                                    network resilience; and deployment of cutting-edge
        Risk Management                                             security software and high available systems. Users will
                                                                    be more tech-savvy and will use more and more
        Technology has opened up new opportunities in               algorithmic trading tools. The internet is rapidly
        commodity exchanges, but it has also increased the          evolving into an always-on, always-connected, device
        system risk. Robust online risk management is the call      independent environment for commodity exchange.
        of the day. Exchanges should possess an online, up-to-      This is changing the way traditional exchanges were
        the-moment risk mitigation mechanism which will             looking at the business strategy. Technological road
        make the system robust and yet user-friendly.               map to align with the exchange business strategy has
        Technologies like in-process data mining and auto           to be developed to utilize the wave of technological
        learning inference system are making the changes and        innovations and thus creating an integrated platform
        are providing a different level playing field for risk      for trading encompassing all the stakeholders. New
        management. Focus is more on proper data                    technologies with mobile workforces operating in
        management, inference drawing from data, and                dispersed mode, more technologically complex
        likelihood assessment of risk to auto-enable safety         environments including service-oriented architecture
        mechanisms to have a sound system.                          (SOA), software as a service (SaaS), rich internet
        The focus of risk management is also changing for           applications (RIAs) and Web 2.0 make enterprises think
        regulatory bodies — not the exchanges only. Change          differently. Faster adoption of innovative technology
        in trading pattern affected the working of market           will build the differentiation. Major opportunities for
        regulatory commissions to maintain a robust-yet-            integration lie in the following areas.
        flexible regulatory framework as market participants
        have an increasing number of choices available to           Mobile workforces may be deployed at different remote
        them as to where, when, and how to trade. The               mandis to provide online information feed for spot
        continuing shift of market volume to the electronic         market data which is essential for creation of a better
        trading environment poses new data processing               futures and option market. Technology will enable
        challenges to regulatory bodies. This medium allows         creation of a virtual spot market scenario for the
        exchanges to gather and transmit much more                  exchanges. Proper algorithm can be used to deduce the
        information about trading activity and hence warrants       spot value from a set of large data points which will be
        increase in overall capacity for processing and storage.    provided to the system online multiple times in a day.

Clearing house integration is another new concept            way. An integrated voice, mail, fax and walk-in system
which can provide straight-through faster processing of      will give users a very special experience. Technology can
transactions. As speed is the essence of the delivery        help in converging these and in faster retrieval of users’
mechanism, this will be a real help to the exchanges.        nature and queries for the past few cases.
Moreover, it will be also possible using technology to
create a common clearing house across the country from       Customer relationship - Finally, technology can
which services will be used by individual exchanges. This    provide the means for exchanges to foster ever closer
will make the system faster, efficient, and more robust      relations with their users. CRM systems can be used by
with increased liquidity. A concept of clearing house as a   exchanges as a mechanism to increase the service
distribution portal can also be thought of through the       levels. Algorithms embedded in CRM systems can
usage of modern Web-based technology.                        maximise the impact of an exchange’s marketing
                                                             efforts. These will be the basis for ‘data mining’ of
Warehouses and assayers can also be integrated with the      trading information, identifying the client’s product
exchange platform. Warehouse management system               focus and analysing his trading strategies. Suggestions
can be implemented at warehouses and data can be             will then be generated to help greater client
integrated with the exchanges to have real-time data         participation. Information dissemination to users in a
availability. This will make the supply chain more           targeted and measured manner is very important and
efficient and transparent to users. Electronic warehouse     should be looked into so that the system is cost-
receipts (EWR) can be utilised for financing seamlessly      effective and content self-sufficient.
through the exchanges. Even banks through their
payment gateways will be integrated with the exchange        Technology Investment
platform to do seamless and fast transactions.
                                                             Investments must be highly selective, targeted to those
Integration of information flow of all the actors will be    areas where it will generate maximum returns.
the future of commodity exchanges, and technology            Alignment of broader strategic approach to the
will be the major enabler for the integrated system.         technology deployment need will be the key. The major
                                                             need will be less upfront investment and ongoing
Customer Service                                             management through a lean IT organisation structure.

Innovative customer service will be the major                While choosing a technology platform it is to be noted
differentiator for these exchanges. A few differentiation    that the solution must ensure that operations can
factors to be enabled by technology will be:                 seamlessly scale up and scale out to handle growing
                                                             business, connectivity, and transaction needs. The
Better training tools – An online simulation-based           solution must provide a fault-tolerant trading
training kit with voice over in vernacular will be a dream   environment delivering the highest levels of
come true for users — more so, if the exchanges target       availability and continuity in trading operations. The
the rural market. It is also to be noted that convergence    technology framework must have ‘rapid customisation
of media and better packaging of video and audio             and deployment’ capability to enable the exchange to
enable delivery of good quality media over less              respond to market demands and requirements in the
bandwidth, which will be essential to delivery of            shortest possible time.
training to the remotest places.
                                                             It is necessary to calculate the ROI for each investment
Personalisation and self service – This will be another      and treat each of such improvement as projects which
major differentiation factor for the exchanges. This will,   will be managed professionally.
on one hand, save cost and will, on the other hand,
make users feel at home and special. Auto-learning           Epilogue
Web pages will make users feel that the exchange
understands their particular need and will thus give a       Technology is and will remain pivotal for any
large stickiness factor. Self-service modules will           commodity exchange in the near future. Commodity
empower users and will eliminate a majority of human         exchanges should utilise the new wave of technology
intervention and, hence, miscommunication.                   innovations to create a differentiator for themselves. This
                                                             will enable them to foster ever closer relations with their
Complaint and suggestion handling – A smooth,                users, provide transparency and build trust. For smaller
technology-enabled customer-focused complaint and            exchanges facing far tighter resource constraints, the
suggestion handling system takes an exchange to a long       development of close, collaborative partnerships with
                                                             technology developers will be the key to surviving —
                                                             and thriving — in the technology era.

                                                                                                                  EXPERTS’ VIEWS   | 79
         We want to reiterate that technology deployment is                    References
         only a means to an end, and success in the future will
         depend on meeting the foundational value                              1. United Nations Conference on Trade and
         propositions on which investor participation is                          Development (UNCTAD)
         premised: well-defined contracts in line with the
         requirements of market users; a smooth functioning                    2. PricewaterhouseCoopers’ internal analysis
         delivery system; liquid, efficient and transparent
         markets built on a robust, scalable, highly available and             3. Food and Agriculture Organization (FAO)
         risk resilient approach.

         In this note, we have provided some concepts of usage
         of new technology for efficient, fast and smooth
         operation of any commodity exchange. These will take
         a firm shape depending upon the nature of the
         exchange and will need customisation as per the
         business strategy and needs.

        Mr. Dipankar Chakrabarti is Managing Consultant and Ms. Rachana Nath is Executive Director, Performance Improvement,
        PricewaterhouseCoopers Pvt. Ltd. Views expressed by the authors in this article are personal and not of PricewaterhouseCoopers Pvt. Ltd.

                                            India Needs to Usher in
                                            the Next Agricultural
                                            By Mr. Amitabh Jaipuria

We need to produce more using less, earn more per unit of it and improve farmers' lives

The 1965 slogan of 'Jai Jawan, Jai Kisan' coined by Late       production while conserving land, water and energy,
Shri. Lal Bahadur Shastri, rightfully hailed the soldier       and inclusively improve farmer lives.
and the farmer as icons of patriotism and hard work.
The Green Revolution of the 1970s with Indian famers           Two-thirds of Indian agriculture is monsoon
at the forefront led to a sharp rise in food grain             dependent, and we are witness to the fact that this
production enabling the country to achieve self-               kharif season had deficient or scanty rainfall. It is
sufficiency and overcome the threat of famine. The             unfortunate that large areas of our country are facing a
Green Revolution, increasing food production through           drought-like situation. Agriculture contributes 18 per
agricultural intensification, played a significant role in     cent to the GDP and the overall growth for 2008-09 was
reducing poverty, is undoubtedly a great Indian                a modest 1.6 per cent.
success story.
                                                               In India, important food crops with wide consumption
Today, however, the world and our nation face                  including wheat, rice, maize, soybean and others,
tremendous challenges poverty, hunger, climate                 continue to grow in the low single-digit range. The Plan
change, amongst others. Experts estimate that                  document also speaks of yield fatigue and technology
between now and 2050, agriculture will need to                 gaps as the two main constraints in the development of
produce as much food as was produced in the last               Indian agriculture. Seeds with superior genetics and
10,000 years. Land resources are shrinking, area under         state-of-the-art technology coupled with quality
agriculture has witnessed a decline and water                  inputs are most important for productivity-led growth
resources are depleting. We're talking about having to         in agriculture improving the economic fate of the
double world food production in just forty years and           farmers as well.
doing it without much more land. This means that
almost all of it has to come from increased output on          Today's demand-supply challenge presents an
every acre, without using more water - that means              incredible opportunity for all those engaged in
getting a lot more out of the rain that is still free. Forty   agriculture business to unite to help agriculture
per cent of world production of food comes from 18 per         unleash its potential and solve one of the biggest
cent of land that needs irrigation. Leading this               challenges facing developed and developing nations.
agricultural revolution are the farmers - majority of who
live on less than Rs. 48 ($ 1) per day.                                            We need to take the Green
                                                                                   Revolution further- It's time for
According to a recent report
                                                                                   ushering in the next revolution
drafted for ministers of the G-8
nations, the world faces “a
                                                                                   Agriculture has a history of
permanent food crisis and global
                                                                                   making dramatic productivity
instability unless countries act
                                                                                   improvements due to the
now to feed a surging population
                                                                                   deployment of numerous
by doubling agricultural output”.
                                                                                   innovations, better genetics and
The world needs to increase food
                                                                                   better farming practices keeping
                                                                                   up with growth in population

                                                                                                                  EXPERTS’ VIEWS   | 81
         defying the famous Malthusian theory. Innovation in                                                                           Rapid adoption of insect-protected bt cotton
         agriculture provides the greatest hope for solutions.                                                                         technology has helped farmers increase yields and
         Agricultural research and extension systems need to be                                                                        earn an additional income Rs. 20,400 crores a direct
         strengthened to improve access to productivity-                                                                               contribution to India's GDP from 2002 to 2008.
         enhancing technologies. Indian agriculture has the                                                                            Additionally, India's Bt cotton farmers reduced pesticide
         potential to augment the process of the country's                                                                             usage by 80%, which resulted in savings of Rs. 1,127
         economic development and has immense potential to                                                                             crores in 2007 alone (IMRB). Research among bt cotton
         alleviate millions of households out of poverty. With a                                                                       farmers has indicated that 87% are enjoying better
         stable Government and strong visionary leadership                                                                             lifestyles, 84% felt more peace of mind, 72% invested in
         determined to make a difference to the lives of the                                                                           children's education, and 67% repaid long-pending
         farmer, Indian agriculture is at an inflection point.                                                                         debts (IMRB).

         Agricultural innovations can make farm families                                                                               Farmer Dyneshwar Buibhand from Antargaon village,
         and rural India prosperous                                                                                                    Yavatmal in Vidarbha, Maharashtra, recently purchased a
                                                                                                                                       new motorcycle. Income from his 14-acre cotton farm
         Today, Indian farmers have better access to technology                                                                        has increased to Rs. 21,000 per acre, in addition to per
         in agriculture in the form of enhanced seeds, inputs                                                                          acre savings of Rs. 7,500 from reduced pesticide usage
         and infrastructure. Amidst the challenges in                                                                                  from using Bollgard II BT cotton seeds. Mr. Buibhand is
         agriculture, India's success story with insect-protected                                                                      proud to be able to educate his son in an English-
         cotton seed stands out as a beacon of hope and pride.                                                                         medium convent school and to build a brick home worth
         Farmers cultivating Bt cotton seeds have made India                                                                           Rs. 550,000 for his family. Bollgard II BT cotton seed's
         the world's second largest producer and second largest                                                                        higher yield of 12 quintals per acre (compared with only
         exporter of cotton by doubling India's cotton                                                                                 7 quintals per acre with conventional seeds) has proven
         production within six years of its launch in 2002 to                                                                          successful for him and for cotton farmers across India
         2007; thus contributing Rs. 20,400 crores in foreign                                                                          who have adopted the technology. In fact, in 2008 alone,
         exchange to the Indian exchequer, taking India from                                                                           yields from BT Cotton in India increased by 31%,
         the position of a net cotton importer at the time of its                                                                      pesticide usage decreased by 39%, and profitability
         launch to a strong exporter in the world markets. In                                                                          increased by 88% equivalent to US $250 per hectare.
         2008, farmers adopted this technology on 82 per cent
         of India's total cotton acres - probably the fastest
         technology adoption across all product categories.
         This is testament to the benefits and superior value
         farmers derive from agriculture technology.

           Figure 7.7                                                All India area, production and yield of cotton
                              35                                                                                                                                                                                  430
            Area Production

                              30                                                                                                                                                                                  380             Yield

                              20                                                                                                                                                                                                   Area
                              10                                                                                                                                                                                                Production
                              5                                                                                                                                                                                   180
















                                                                                                                                                                                                   2006-07 (AE)

          Area: Million Hectares; Production: Million Bales of 170 kgs. each; Yield: Kg./Hectare
        Source: Economy Survey 2007-08

         India’s robust regulatory system has made this possible.
         Superior technology in a single crop has benefited over
         four million farmers across the country. This success can
         be, and needs to be replicated across other crops. The
         potential of innovative agriculture technologies for India
         and Indian agriculture representing 57 per cent of our
         population is tremendous.

The farmer-led white gold revolution should be              Monsanto is committed to addressing these increasing
replicated – We could witness a ‘yellow revolution’         needs. Through our diversified seed production, world
in corn                                                     class breeding and manufacturing processes, and
                                                            extensive market outreach, we are ensuring that the
Corn is India’s third largest cereal crop after rice and    Indian farmer has access to best-in-class products,
wheat, and is the fastest growing cereal amongst all        enabling him to produce more per acre on his farm.
food grains, directly contributing Rs. 15,500 crores to     Monsanto’s Dekalb™ high-yielding corn hybrid seeds,
the agricultural GDP. India is sixth largest producer and   cultivated across 18 Indian states are available in 13
fifth largest consumer of corn in the world.                high-yielding hybrids to suit India’s diverse agronomic
                                                                                 and climatic conditions. In 2008,
Corn production in India has                                                     Monsanto also started research
grown by over 60 per cent to 19.31                                               and regulatory work in India to
MMT in 2008 compared with 12.04                                                  introduce our biotech-improved
MMT in 2000, even though the area                                                corn technology offering farmers
under corn cultivation grew only                                                 solutions to the two key yield
by approx. 7 per cent (2008: 7.09                                                impacting factors: insects and
Mha vs. 2000: 6.61 Mha). This rapid                                              pests, and weeds. Biotech-
increase can be attributed to                                                    enhanced corn technology has
increased hybridization and                                                      tremendous relevance and
launch and adoption of superior                                                  potential to enhance corn
corn hybrids by the Indian farmers.                                              productivity in our country.
Farmers across India, with better
access to high-quality seeds through public and             One of our noteworthy projects includes ‘Project
private sectors are adopting improved hybrids at a fast     Sunshine’ - A Public Private Partnership of Monsanto
pace, thus experiencing higher productivity and             with the Government of Gujarat’s Tribal Development
adopting good agronomic practices.                          Department (TDD), aimed at improving economic self-
                                                            sufficiency and quality of life of tribal farmers of
Demand for corn has increased significantly too. Over       Gujarat. Under the aegis of their 10-point program
30 user industries produce more than 1000 products          ‘Van Bandhu Kalyaan Yojana’, TDD set up a goal of
from corn for textile, paper, medicinal and other allied    ‘Increasing income of tribal farmers by 100 per cent
industries. Higher incomes, better standards of living      within five years’ and amongst its various programs
and changing consumption patterns have led to               partnered with Monsanto on Project Sunshine.
increased demand for poultry and cattle products.           Monsanto partnered via its Dekalb™ high-yielding corn
India needs to increase growth rate of corn to 5.91 per     hybrid seeds (supplied to 30,000 tribal farmers across
cent from 4.2 per cent in 1995-2005 to meet the             535 villages through TDD). Additionally, we also
increasing domestic demand of 22.73 million tons by         committed resources to conduct farmer education
2011-12. Corn constitutes 50 per cent of the poultry        programs on agronomy, pest management, post
feed industry. India’s poultry sector consumes 7.5          harvest care and more, to increase productivity; and
million metric tons of corn today and is estimated to       also partnered with TDD to provide critical project
increase to 16.5 million metric tons by 2015. According     management. Due to better quality and timely supply
to IMDA Vision 2025 Report, for sustained growth of the     of inputs (seeds, fertilizers, etc.) farmers experienced a
poultry sector, corn production needs to be doubled in      healthy crop.
the next five years.
                                                            Project Sunshine generated outstanding results: A
Production growth is highly dependent on yield              three-fold increase in yield (15 quintals per acre vs. only
growth as land under corn cultivation is largely            five quintals per acre with conventional seeds) and a
stagnant at 7.2 million hectares. With only 46 per cent     cumulative incremental income of over Rs. 20 crores for
of acreage under hybrid corn, and the average corn          the 30,000 beneficiary tribal farmers.
productivity at less than one metric ton per acre as
compared to global average of two metric tons per           Farmer Ramabhai Khoyabhai Maaliwaad is one of the
acre, there is an opportunity to increase productivity      many corn farmers who are experiencing the benefits
through the most important input which can                  of higher productivity. A resident of Nava Muvada
dramatically alter yields, i.e. high-yielding corn hybrid   village, his family of nine members had seen tough
seeds. With its potential yet to be realized fully,
increasing corn productivity can be one of the
solutions to tackle the food security issue along with
rice and wheat.

                                                                                                                 EXPERTS’ VIEWS   | 83
        times growing corn although it partially met their food         Monsanto’s worldwide three-point commitment to
        needs. Low yields of not more than six quintals from            develop Indian Agriculture to put the Indian Economy
        conventional corn seeds and resultant low income                on a high growth path and to spread its benefits among
        thereof, was creating a challenge for his large family          the farming community includes:
        getting caught into a vicious cycle which was in
        operation. Under Project Sunshine, cultivation of MIL’s         Produce more – Monsanto will develop better seeds
        Dekalb™ high-yielding corn hybrid seeds produced                that will double yields in its three core crops of corn,
        three times more than he could earlier produce with             soybeans and cotton by 2030, compared to a base year
        conventional seeds – 20 quintals in his one acre farm.          of 2000 in countries where farmers have access to
        He saved 12 quintals for the consumption of his family          current and anticipated new seed choices offered by us.
        and sold the remaining produce in the market. With his          Recognizing the importance of wheat and rice as key
        income, he has setup a small dairy farm with eight              food crops, Monsanto established the ‘Beachell’ -
        buffaloes that generates an additional income of Rs.            Borlaug International Scholars Program to accelerate
        880 daily leading to a diversification in his farming           breakthrough public sector research in wheat and rice
        income as well. His family now has a mobile phone               yield.
        connecting them better with market opportunities
        outside their farm and an electricity connection in their       Conserve more – Develop seeds that will reduce by
        house to improve their personal productivity in various         one-third the amount of key resources like land,
        ways. To provide irrigation to his fields, he is investing in   energy, fertilizer and water required to grow crops by
        a 40-feet deep well, and will build a pipeline to link it to    the year 2030. Monsanto will also undertake a series of
        his farm. His son Mahesh is pursuing a vocational               partnerships to address key environmental issues.
        course to be an electrician.
                                                                        Improve farmers’ lives – Monsanto will help improve
        In a single season, Shri Ramabhai Khoyabhai                     the lives of farmers, including an additional five million
        Maaliwaad’s family has prospered. They have moved               people in resource-poor farm families by 2020 through
        from being below-poverty-line to being self-sufficient          innovative public-private partnerships including
        and empowered. An example of the positive impact                creation of effective market linkages.
        through a single input, i.e. high-yielding seeds and the
        power of public-private partnership.                            However, in the Indian context, we perceive that four
                                                                        factors can positively influence the future of agriculture
        At Monsanto, that remains the focus. Helping farmers            and need attention from Government and Policy
        produce more with less, building effective linkages and         Makers:
        partnerships, thereby improving farmers’ lives.
                                                                        •   A supportive environment and free market system
        Our opportunity to help make a difference lies at                   that encourages competition, research investment
        the intersection of demand, innovation, and                         and innovation;
                                                                        •   A strong science-based Regulatory framework;
        There is a unique role for technology in agriculture in
        the Indian scenario. Whether it is high-yielding seeds          •   Effective enforcement of intellectual property
        with better inherent genetic potential combined with                rights (IPR) that encourages private investment in
        biotech-enabled insect protection, stress tolerance,                agricultural research; and,
        a n d b e t te r we e d m a n a g e m e nt to p ro te c t
        productivity/yields; better agronomic practices; or             •   Rigorous promotion of Public-Private Partnership
        reduction in post-harvest losses – there is a clear and             and collaborative research.
        important role for agricultural technology in improving
        productivity.                                                   This will help in providing farmers with a choice of
                                                                        world’s best technologies and encourage investment
        In our quest to improve yields sustainably, Monsanto            in research to develop new higher-yielding products.
        has announced three commitments to help farmers                 With the objective of ensuring food security for the
        increase global food production in the face of growing          burgeoning population through sustainable
        demand, limited natural resources and a changing                agricultural practices, it is heartening to note that the
        climate; and have also pledged to work in new                   Public Sector R&D institutions in India are conducting
        partnerships with other businesses, citizen groups and          extensive research on the benefits of agricultural
        Governments.                                                    biotechnology, in addition to the private sector.

Monsanto has been a historically trusted partner of                   We envision a prosperous rural India that is both
Indian farmers for over four decades and are                          self-sufficient in food, feed and fibre, and also
committed to further improving their lives                            becomes a major player in global agricultural
                                                                      commodity trade
We are committed to strengthening communities and
doing what we can to help people lead safer, healthier,               Imagine the potential for Indian farmers to replicate
and more productive lifestyle. As the world’s largest                 the Indian cotton success story in other crops to
investor in farmer-focused agricultural research and                  contribute to meeting the world’s needs. For this to
India’s leading agriculture company – Monsanto, its                   happen, they need to have access to cutting-edge
people and partners are working to meet these needs                   agriculture technologies to help them remain globally
playing an important role in providing solutions to the               competitive and to take their rightful place in the
challenges that we face today. To cite an example, we                 global commodity trade. We believe, we have the
are researching innovative products that will enable                  capability to compete in the global market with agri-
corn farmers to reap higher crop productivity from the                commodity powerhouses like Brazil and Argentina. The
combined benefits of insect- and pest-protection and                  success of Indian IT can be repeated in agriculture. We
better weed management via eight unique                               need to revive, modernize, make agriculture accessible
technologies in a single corn seed. We are also                       to markets and sustainable to empower India to seek its
partnering with the Government and other                              rightful place on the global map.
stakeholders to make our products more accessible to
farmers; and to evaluate the need and potential of                    We are optimistic that the time has come for a new
future technologies.                                                  slogan for Indian agriculture. It can be Jai Ho all the way!

Our commitments represent the beginning of a
journey that we will expand on and deepen in the years
ahead. As a pure agriculture company, helping farmers
succeed is at the core of all we do. We are optimistic
about the role of agriculture in driving India’s economic
development in the next decade. We believe the
visionary political leadership in our country and our
robust regulatory system will accelerate this further.

Since two out of every three Indian’s livelihood is linked
to agriculture, the potential of each entrepreneurial
farmer, empowered with seeds that enhance yields,
infrastructure and market linkages, is tremendous.

Mr. Amitabh Jaipuria is Managing Director of Monsanto India Limited. Views expressed are personal.

                                                                                                                            EXPERTS’ VIEWS   | 85

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