Commodity and Exchanges

What is a commodity?

  • Commodities are products that can be bought, sold or traded in different kinds of markets.
  • Commodities are the raw materials that are used to create products which are consumed in everyday life around the world, from food products in India to building new homes in Europe or to running cars in the US.

There are two main types of commodities:

  • Soft commodities  agricultural products such as corn, wheat, coffee, cocoa, sugar and soybean; and livestock.
  • Hard commodities  natural resources that need to be mined or processed such as crude oil, gold, silver and rubber.

What are the main differences between commodity spot and derivatives markets?

  • There are two types of commodity markets: spot (physical) and derivatives (such as futures, options and swaps).
  • In a spot market, a physical commodity is sold or bought at a price negotiated between the buyer and the seller.
  • The spot market involves buying and selling of commodities in cash with immediate delivery.
  • There are spot markets for individual consumers (retail market) and the business-to-business (wholesale market) category.
  • Spot markets also include traditional markets such as Delhi’s Azadpur Mandi that deal in fruits and vegetables.
  • On the other hand, a commodity can be sold or bought via derivatives contract as well.
  • A futures contract is a pre-determined and standardized contract to buy or sell commodities for a particular price and for a certain date in the future.
  • For instance, if one wants to buy 10 tonne of rice today, one can buy it in the spot market.
  • But if one wants to buy or sell 10 tonne of rice at a future date, (say, after two months), one can buy or sell rice futures contracts at a commodity futures exchange.
  • The futures contracts provide for the delivery or receipt of a physical commodity of a specified amount at some future date.
  • Under the physically settled contract, the full purchase price is paid by the buyer and the actual commodity is delivered by the seller.
  • But in a futures contract, actual delivery takes place later.
  • In practice, most futures contracts do not involve delivery of physical commodity as contracts are settled in cash through an exchange.
  • The financial investors prefer cash settlement because of no interest in buying or selling the underlying commodity, and lower transaction costs.
  • Nowadays, the entire process of futures trading in commodities is carried out electronically throughout the world.
  • For instance, a farmer enters into a futures contract to sell 10 tonne of rice at $100 per tonne to a miller on a future date. On that date, the miller will pay the full purchase price ($1,000) to the farmer and in exchange will receive the 10 tonne of rice.
  • However, under the cash-settled futures contract, the farmer and the miller would simply exchange the difference between the spot price of rice on the settlement date and the agreed upon price as mentioned in the futures contract and there would be no actual delivery of rice.
  • Following the above example, if on the settlement date the price of rice was $80 per tonne, while the agreed upon price of futures contract was $100 a tonne, the miller will pay $20 to the farmer in cash and there will be no delivery of rice to the miller.
  • If, on the settlement date, the price of rice was $120 a tonne, the farmer will pay $20 to the miller in cash and no delivery of rice will take place.

Commodity Market in India:

  • The first milestone in the 125 years rich history of organized trading in commodities in India was the constitution of the Bombay Cotton Trade Association in the year 1875.
  • India had a vibrant futures market in commodities till it was discontinued in the mid 1960’s, due to war, natural calamities and the consequent shortages.
  • In 2002, the Government of India allowed the re-introduction of commodity futures in India.
  • Together with this, three screen based, nation-wide multi-commodity exchanges were also permitted to be set up with the approval of the Forward Markets Commission. These are:
  • National Commodity & Derivative Exchange:
  • This exchange was originally promoted by ICICI Bank, National Stock Exchange (NSE), National Bank for Agriculture and Rural Development (NABARD) and Life Insurance Corporation of India (LIC). Subsequently other institutional shareholders have been added on.
  • NCDEX is popular for trading in agricultural commodities.
  • Multi Commodity Exchange:
  • This exchange was originally promoted by Financial Technologies Limited, a software company in the capital markets space.
  • Subsequently other institutional shareholders have been added on.
  • MCX is popular for trading in metals and energy contracts.
  • National Multi Commodity Exchange of India:
  • This exchange was originally promoted by Kailash Gupta, an Ahmedabad based trader, and Central Warehousing Corporation (CWC).
  • Subsequently other institutional shareholders have been added on.
  • NMCE is popular for trading in spices and plantation crops, especially from Kerala, a southern state of India.