Commodity derivatives have achieved one of the fastest growth rates, probably the highest among any other developmental initiatives undertaken either in agricultural sector or in financial sector of a developing economy like India. But certainly this achievement is not just erecting a castle in air. Reasons are deep-rooted. Indian traders have century old experiences in trading commodity derivatives. Permitting commodity exchanges to set up an anonymous electronic trading platform accessible across the nation has given all the required mileage for commodity trading to scale new heights.

Compared to the 130 years old stock market, the commodity market is in its nascent stage. It is very much in consensus that by the advent of commodity derivatives trading, a silent revolution is building up in the economy. Though trading volumes in this new market is gradually catching up that in the stock market, yet commodity exchanges are facing challenges that need to be addressed now. There are certain set of challenges where commodity exchanges require regulatory amendments to make this market vibrant and some other set of challenges, where commodity exchanges have to take up the initiatives.

Amendment in FCRA Act
According to the FCRA Act (1952) definition of goods is confined to whatever is deliverable. Due to this stringent definition, commodity exchanges are unable to deliver two important products:

Weather derivatives, which will provide hedge on volumetric risk to the farmers who are exposed to the vagaries of monsoon and other climatic disturbances. Farm insurance, though seen in some pockets of the country is still not all-pervasive and weather derivatives could fill in this lacuna for the farmers.?

Trading on index, which will give small investors a diversified investment option that can be easily tracked with an overall knowledge of the commodity market. FCRA Act even does not allow trading of commodity options. Unlike options, futures are not able to give the upside price advantage to an investor, but act as a good tool for hedging and covering up downward risk. This constraint is a big challenge for a derivative exchange, as lot of investors, especially farmers, are reluctant to enter this market due to the unavailability of options.

Amendment in Banking Regulations Act
According to the Banking Regulations Act, banks are not allowed to trade in the commodity derivatives. But contradictorily, banks have a big role to play in the development of the commodity market. As they have exposure to agriculture, they would be better off in case they were able to hedge their positions. Since banks have a strong rural reach and financial expertise, they can become aggregators and take an aggregative position on behalf of farmers.

Issues on Warehouse Receipts
Currently, WR is not an instrument, against which banks lend comfortably. There are number of risks associated with it. Some of them are like fraud WR, credit risk with the warehouse owner, financial strength of the warehouse, quality of the warehouse and of course the credibility of the goods valuation. Closely analyzing the problem, NCDEX in particular has taken some initiatives to bring banks closer to the farmer in the field of structured finance. Farmers can get finance through a pledged dematerialized warehouse receipt of an accredited warehouse of the Exchange. This instrument is pledged by borrowers against the loan. Since they sell forward the underlying on the Exchange's platform, the value of the collateral is fixed in a futuristic perspective, which mitigates the default risk for the banks. This value addition can boost up agri-lending, thereby strengthening the agricultural development process. At the same time, it will mean a better business for the banks too which are lending around Rs 9000 cr as lending against commodities. The potential can be seen to be in the region of at least Rs 150,000 cr. But there are certain issues which need to be resolved. If dematerialized WRs issued by the commodity exchanges are recognized by the Depository Act, it will give credibility to the receipt and will provide an ease for banks to lend against WRs. At the same time, WR should be allowed to become negotiable under the Negotiable Instrument Act.

Mutual Funds and FIIs are to be allowed to trade on commodity exchanges
For commodity markets to pick up, retail participation is essential as this has been the experiences of most western countries which have witnessed a boom in such business. The commodity derivatives market is still distant for retail investors who have neither the knowledge nor the ability to take such decisions in the commodity space. Unlike the financial derivatives market, one can enter the commodity derivatives market with a much lower investment, since margins are lower in the range of 5-10% compared to around 30% in the securities markets. But this highly leveraged market still remains out of the purview of the retail investor due to certain institutional reasons. A break can be achieved here in case mutual funds are allowed to participate in these markets by structuring commodity funds for retail investors. At the same time this financial instrument can stir up the awareness among the masses and become an excellent asset class and hedging tool in a retail portfolio. Unlike the stock market, commodity market has not yet gotten the exposure it deserves. This has led general investors away from the market. Tracking commodity prices is not just a balance sheet analysis or a company specific study. Global factors and rather macro factors play a much important role into it. That demands domain expertise in commodities, market dynamics and price forecasting. In this case, commodity mutual funds, equipped with qualified analysts and fund managers will undertake value investing and boost up the reliability for the retail investors. There is a strong conviction among mutual funds that there is need to move into commodities to diversify their portfolio and deliver better returns to investors. The exchange is also pursuing with the authorities to allow mutual funds to diversify into commodities so as to provide them with larger options. This particular avenue is believed to bring in revolutionary changes in the commodity market.


The presence of foreign funds in the securities market has been found to have a high correlation with the interest as well as activity in equity segment. A similar picture is expected to be replicated in the commodity market in case regulation permits the entry of foreign portfolio investors into this market. Foreign Institutional Investors (FIIs) parking their corpus in Indian commodity markets will certainly increase their depth and increase the liquidity in the system. Currently, Indian economy is being tracked very closely by all foreign investors. Indian capital market is one of the highest recipient of emerging market funds. But unfortunately none of them are allowed to pump in funds in commodity market. This is rather the best time to open the market and make it a benchmark in the commodity market across the globe.

Yet the other set of challenges in front of the exchanges are creating awareness and information dissemination. While volumes are important for commodity exchanges, what is probably more critical is awareness. There is need for exchanges to keep relentlessly pursuing an awareness creation strategy. Awareness at the grassroots will be essential to materialize and sustain the success it is foreseeing. Information dissemination still stands to be a major challenge in front of a commodity exchange. Disseminating market discovered prices to the farmer level calls for a mammoth structural framework and massive investments. Over here, all options need to be explored from IT-enabled facilities such as display boards and ticker boards to manual information spread where such facilities are not available.