Global Outlook

The Indian commodity market may even beat the equity market in terms of trading volumes sooner than later

Contributed by Nirmal Bang

By Nirmal Bang

Ever since the first national level commodity exchange was introduced in 2003, commodity exchanges have seen an exponential growth. In the last fiscal, that is, 2010-11 the total turnover of the Indian commodity markets was approximately Rs.112.52 trillion, an increase of more than 50% as compared to the year 2009-10.

Currently, there are five national commodity exchanges and several regional exchanges in India. The growth in trading volumes has been primarily propelled by Multi Commodity Exchange (MCX) and National Commodity Exchange (NCDEX). These two exchanges account for a large share of the total number of contracts traded on all the exchanges in India.

Following the sharp surge in turnover and trade volumes in recent years, the stakes in commodity trading are higher than ever before. Investment and trading in commodities is now considered a good alternative investment in the country.

GROWTH IN THE COMMODITY MARKET AS COMPARED TO THE EQUITY MARKET

The Indian commodity futures volumes have grown 5.5 times from Rs.20.53 trillion in 2005-06 to Rs.112.52 trillion in 2010-11. Currently, the average monthly volume on the Indian commodity exchanges is Rs.6 trillion. MCX leads the industry, followed by NCDEX. MCX is not only number one in India but has achieved some global milestones too. It was the largest exchange in silver (in terms of number of futures contracts traded in 2010), number two in gold, copper and natural gas and number three in crude oil. When we say India is the largest exchange in silver, it is a great achievement for the Multi Commodity Exchange.

Talking about agricultural commodities, the Indian commodities market has futures contracts of commodities such as black pepper, cumin seed, mentha oil and many more which are internationally traded but only listed in India; internationally traders tend to consider these as benchmark rates.

For example, exporters from Vietnam, the largest producer of black pepper, are keeping a close watch on Indian pepper futures. Slowly but steadily the Indian commodity market is laying a strong foundation for a takeoff in the near future.

Though it is at a nascent stage, the volumes in the Indian commodities market have a different story to tell. From Rs.20 trillion, the volumes have reached Rs.112.52 trillion in FY10-11. When we see this kind of a spurt in volumes, we must remember that it has primarily been a futures market, without Options.

Foreign institutional investors, domestic institutions, banks and insurance companies are not allowed to trade on the Indian commodity bourses and a majority of volumes come from jobbers, arbitrageurs, retail traders and small scale enterprises and corporates (for hedging). Even portfolio management services are not permitted.

There is a long awaited amendment in the Forward Commission Regulation Act 1952 (FCRA), which will strengthen the regulator, Forward Markets Commission and enable it to introduce new products like Options, index trading and open up the market for new participants, which will help achieve the next phase of growth. Globally, commodity derivatives volumes are 35x-40x of the physical market but in India it is just 4x. As the number of participants is increasing by the day and the overall interest in commodity futures market among traders and investors is increasing rapidly, the growth potential of this market is immense.

We expect the Indian commodity futures market to reach at least 15x-20x by FY15. With the contribution of Indian physical commodities to GDP being pegged at 45%, even if the commodity futures market trades at 15x-20x, we can imagine the kind of volumes our exchanges will generate.

Also, the regulatory bodies are yet to decide on allowing domestic institutions to trade in commodity futures and plans are afoot to introduce Options trading on our bourses. If these measures are adopted in the near future, even a 30x volume by FY15 over the physical market will not be surprising.

While the turnover in the equity derivatives segment has grown at a CAGR of 21.70% since FY08, the turnover in the commodity futures market has grown at a CAGR of 30.32% in the same period.

Over the last few years, the equity market has seen turbulent times due to the meltdown in the global financial markets. In FY09, the equity derivatives turnover had fallen from Rs.133.32 trillion in 2007-08 to Rs.110.22 trillion in 2008-09, a fall of 21%.

On the other hand, the commodities market has seen a steady growth rate over the years. Being in a nascent stage, the commodities futures market is catching up rapidly with equities and in the coming years, it has the potential to equal or surpass the equity turnover.

REASONS FOR GROWTH OF COMMODITIES VOLUMES

Commodities is an asset class which is cyclical and tradable by nature. In the western world, the volumes of the commodities market are almost two to three times as compared to the equity market.

Commodities is a volume game, you rarely see prices shooting up by 20%-30% in a single day, which is common in the equity markets. So, to make huge profits, one should have a high leverage to make the most of the 3%-4% movements which take place throughout the day.

Apart from other reasons that were witnessed around the globe post the 2008 recession, we have seen easy monetary policies being adopted by western central bankers and beyond that any slowdown or fear of a slowdown was tackled by stimulus packages. A massive debasement of currencies is taking place since the past three years and that is one of the prime reasons investors have found refuge in hard assets and commodities.

It is not just shortages that are fuelling the bull run in commodities. The introduction of exchange traded funds internationally in commodities, pension funds, sovereign funds as well as central bankers (in case of gold), who are increasing the exposure in commodities, are responsible in a very significant way for the spike that we have seen in commodity volumes.

Slowing growth in developed nations and high inflationary expectations in emerging markets have also benefited commodities. Investors have found a ‘store of value’ in commodities. The intrinsic value of commodities in comparison with other asset classes is very high. There is a secular bull run in the complex since the past decade. However, the year 2008 was an exception.

The rise in inflation is not just because of the spike in the prices of industrial commodities. In fact, the rising inflation in China was mainly attributed to rising pork prices. Despite the drop in crude oil prices, the biggest worries for Asia continue to be rising food prices, weather concerns, depleting carry forward stocks and growing demand, making a perfect case of a bull run in agro commodities.

There is increasing awareness about commodities among people and more and more people can be seen parking their money in agricultural commodities like soybean and corn, thus adding to the volumes on the exchange.

FUTURE OF INDIAN COMMODITIES: SPOT EXCHANGES

Futures markets are speculative by nature and without a product, which caters to investors, the growth of this industry would be incomplete. The concept of a national level spot exchange was pioneered by Financial Technologies in 2005.

Financial Technologies, in a joint venture with NAFED (a government agency engaged in food procurement/storage), set up the country’s first spot exchange – National Spot Exchange Ltd (NSEL). In order to stay invested in commodities, investors had to rollover their positions during the expiry of the futures contract which involves cost.

More than that, the futures market is subject to speculation, which can upset investors as they are required to pay huge mark-to-mark losses. Therefore, to attract more and more investors there is an urgent need for reforms to be introduced which will enable these spot markets to function efficiently.

The physical agri market in the country has been in a sorry state due to inefficiencies and strict regulations. Electronic spot exchanges at the national level are playing a major role in attracting investors and farmers on to the electronic platform as it is the future of the Indian spot market. These exchanges are still in the nascent phase and the potential is enormous.

Since the second half of 2010, volume of instruments like  e-gold and e-silver, which are offered by NSEL have picked up and since then we have seen the launch of more such instruments like e-copper and e-zinc, among others.

This has attracted investors and the awareness programmes have resulted in a spike in volumes of this exchange, which is an encouraging sign for the future of the market.

India is a world leader as far as the production of agricultural commodities is concerned. There is a need to promote more and more agro commodities on the electronic platform so that participants on the futures platform get an effective benchmark.

Changes in the warehousing act and the implementation of the goods and services (GST) act will enable spot exchanges to list more and more commodities on the Indian platform.

Spot exchanges, like other exchange systems, provide counter-party assurance in respect of all trades executed on its platform. In case the buyer/seller defaults, the exchange makes the payment from its own Settlement Guarantee Fund and subsequently recovers money from the defaulter’s deposit. Thus, the payment is fully secured. With physical delivery taking place, counter party default risk covered participants will have a good and a transparent trading platform.

When we combine the volumes of all futures exchanges and spot exchanges, we find that the Indian commodities market is gearing itself for the next phase of growth. Further, the amendment in several Acts will augment growth and prepare it for the big leap.

We believe that in the coming two years, the cumulative volume on the Indian commodities exchanges would be somewhere between 1,10,000 and 1,30,000 crore per day. Retail traders and investors should take advantage by being a part of this story. They should diversify at least 15% to 20% of their total portfolio in commodities.