INTRODUCTION

In nineteenth century, India came up with market derivatives, i.e. trading in cotton through the
establishment of the Cotton Trade Association in 1875. Exchange trade derivatives were
introduced in June 2000. The national stock exchange is the largest exchange in India in
derivatives. Nifty 50 index future contract is the first contract launched on NSE. After one and a
half year they introduced new derivative segment i.e. index futures, index options, stock options
and stock futures. NSE’s equity derivatives segment is called the Futures & Options Segment or
F&O Segment. NSE also trades in Currency and Interest Rate Futures contracts under a separate
segment.

Contemporary Issues:-
1) Policy Issues:-
With the adoption of liberalization and globalization in 1990, the governments setup a
committee in 1993 to examine the effectiveness of future trading. This committee was
headed by Prof. K.N.Kabra who recommended to allowing future trading in 17 commodity
groups. It also recommended strengthening the Forward Markets Commission, and certain
changes to Forward Contracts (Regulation) Act 1952, i.e. allowing options trading in goods
and registration of brokers with Forward Markets Commission. With the approval of
Government these recommendation and future trading were permitted in all recommended
commodities.

Because of doubts about benefits of derivatives on the commodity future trading in India
remain ineffective. With the realization that derivative is an effective tool to manage the risk
the government to change its position.

2) Institution effect use of Derivatives:-

Financial institutions like Bank have assets and liability of different maturity and different
currency and exposed to different risk. Thus they use derivatives on interest and derivatives on
currency and on risk management. Indian insurance regulators are yet to issue some guide lines
for the use of derivatives by insurance company. In India, financial institutions are fewer users of
derivatives, because total contribution to NSC trade is less than 8% in 2005. But domestic
financial institution and mutual fund have shown a great interest in OTC fixed income
instruments.

Banks and mutual funds are only allowed to use derivatives to hedge their existing positions in
the spot market, or to rebalance their existing portfolios. Since banks have little exposure to
equity markets because banking regulations, they have little incentive to trade equity derivatives.
Foreign investors must register as foreign institutional investors (FII) to trade exchange-traded
derivatives, and be subject to position limits as specified by SEBI. Alternatively, they can
incorporate locally as a broker-dealer. FIIs have a small but increasing occurrence in the equity
derivatives markets. They have no incentive to trade interest rate derivatives as they have little
investments in the domestic bond markets. It is possible that unregistered foreign investors and
hedge funds trade ultimately, using a local proprietary trader as a front.

Retail investors (including all small brokerages trading for themselves) are the most important
participants in equity derivatives, about 60% of turnover in 2005, according to NSE. The success
of single stock futures in India is distinctive, as this instrument has generally failed in most other
countries. One reason for this success is retail investors’ prior knowledge with “badla” trades
which is common in some features of derivatives trading. Another reason may be the small size
of the futures contracts, compared to similar contracts in other countries.

3) Systematic Risk:-
As OTC regulation in India is concerned, a centralized counters party, called CCIL, is entrust
with the job of engaging in the OTC derivatives market as a reporting platform and a clearing
agency for post-trading settlements. The banks and the primary dealers are requisite to report all
their trades on the reporting platform within 30 minutes of the deal. Since one of the
counterparty in an OTC transaction has to be regulated by the RBI regulated entity and has to
report to it on a regular basis. The Indian model, therefore, offers a unique model for automatic
close watch of the OTC exposure of all banks in India. Additionally, the use of the centralized
counter party as a reporting platform on a real-time basis helps RBI in keeping a real-time watch
on systemic risk.

For all OTC products that are guaranteed by CCIL, reduces the capital requirements for banks up
to 80% by eliminating the counter party risk. At present, CCIL collects initial margin, mark-to-
market margin and other margins like volatility margin. Such margins are collected in the form
of eligible government-of-India securities or cash or both.

4) Discloser:-
Accounting and valuation and reporting requirements for forward rate agreements and interest
rates swaps have been prescribed in the RBI guidelines in July 1999, to all scheduled commercial
banks, primary dealers and All India Financial Institutions. However, it is suggested that the
IOSCO principles would need to be suitably incorporated (through a statutory mandate) in the
public disclosure of trading and derivatives activities of banks and securities firms.

The disclosure should be on the major risks associated with their trading and derivatives
activities including credit risk, market risk, liquidity risk, operational risk, legal risk and
reputational risk. Further, institutions should also disclose about their performance in managing
these risks. The qualitative disclosures should also describe the accounting policies and methods
of income recognition that are used for trading activities and non-trading derivatives activity.
Since the accounting practices for derivatives
are not consistent across countries it is important that an institution sufficiently describes the
accounting treatment of its derivatives holdings. These qualitative disclosures may include the
methods used to account for derivatives, criteria for each accounting method used (for example
criteria for recognizing hedges), policies and procedures followed for netting, assets and
liabilities of derivatives transactions, methods used to determine the fair value of traded and non-
traded derivatives instrument, nature and justification for reserves for valuation adjustments
against instruments or portfolios.

Unsolved issues in India:-

Even though the commodity derivatives market has made good progress in the last few years, the
real issues facing the future of the market have not been resolved.

1) Commodity Option:-
Trading in commodity options contracts has been banned since 1952. The market for commodity
derivatives will not be completed without the existence of this important derivative. Both futures
and options are necessary for the sound growth of the market. While futures contracts help a
farmer to hedge against downside price movements, it does not allow him to collect the benefits
of an increase in prices. No doubt it is necessary to bring legal and regulatory changes to
introduce commodity options trading in the country. The matter is said to be under the active
consideration of the Government and the options trading may be introduced in the near future.

2) Warehousing:-
For commodity derivatives market to work efficiently, it is necessary to have a sophisticated,
cost-effective, reliable and convenient warehousing system in the country. Further, independent
labs or quality testing centers should be set up in each region to certify the quality, grade and
quantity of commodities so that they are appropriately standardized and there are no unexpected
waiting for the ultimate buyer who takes the physical delivery. Warehouses also need to be
conveniently located. Central Warehousing Corporation of India is operating 500 Warehouses
across the country with a storage capacity of 10.4 million tones. This is obviously impossible for
a vast country. To resolve the problem, a Gramin Bhandaran Yojana (Rural Warehousing Plan)
has been introduced to construct new and expand the existing rural godowns. Large scale
privatization of state warehouses is also being examined.

3) Cash versus physical settlement:-

This is of the inefficiencies in the present warehousing system that is only about 1% to 5% of the
total commodity derivatives trade in the country is settled in physical delivery. Therefore the
warehousing problem obviously has to be handled on a war footing, as a good delivery system is
the backbone of any commodity trade. All outstanding contracts at maturity should be settled in
physical delivery. To avoid this, participants square off their positions before maturity. So, in
practice, most contracts are settled in cash but before maturity. It is necessary to modify the law
to bring it closer to the widespread practice and save the participants from unnecessary hassles.

4) The regulator:-
As the market activity pick-up and the volumes rise, the market will definitely need a strong and
independent regular, similar to the Securities and Exchange Board of India (SEBI) that regulates
the securities markets. Unlike SEBI which is an independent body, the Forwards Markets
Commission (FMC) is under the Department of Consumer Affairs (Ministry of Consumer
Affairs, Food and Public Distribution) and depends on it for funds. It is imperative that the
Government should grant more powers to the FMC to ensure an orderly development of the
commodity markets. The SEBI and FMC also need to work closely with each other due to the
inter-relationship between the two markets.

5) Lack of economy of scale:-

There are too many (3 national level and 21 regional) commodity exchanges. Though over 80
commodities are allowed for derivatives trading, in practice derivatives are popular for only a
few commodities. Again, most of the trade takes place only on a few exchanges. All this splits
volumes and makes some exchanges unviable. This problem can possibly be addressed by
consolidating some exchanges. Also, the question of convergence of securities and commodities
derivatives markets has been debated for a long time now. The Government of India has
announced its intention to integrate the two markets. It is felt that convergence of these
derivative markets would bring in economies of scale and scope without having to duplicate the
efforts, thereby giving a boost to the growth of commodity derivatives market. It would also help
in resolving some of the issues concerning regulation of the derivative markets. However, this
would necessitate complete coordination among various regulating authorities such as Reserve
Bank of India, Forward Markets commission, the Securities and Exchange Board of India, and
the Department of Company affairs etc.

6) Tax issues:-
There are at present restrictions on the movement of certain goods from one state to another.
These need to be removed so that a truly national market could develop for commodities and
derivatives. Also, regulatory changes are required to bring about uniformity in octroi and sales
taxes etc. VAT has been introduced in the country in 2005, but has not yet been uniformly
implemented by all states.

CONCLUSION
India is one of the top producers of a large number of commodities, and also has a long history of
trading in commodities and related derivatives. The commodities derivatives market has seen ups
and downs, but seem to have finally corrected now. The market has made enormous progress in
terms of technology, transparency and the trading activity. Interestingly, this has happened only
after the Government protection was removed from a number of commodities, and market forces
were allowed to play their role. This should act as a major lesson for the policy makers in
developing countries, that pricing and price risk management should be left to the market forces
rather than trying to achieve these through administered price mechanisms. The management of
price risk is going to assume even greater importance in future with the promotion of free trade
and removal of trade barriers in the world. All this augurs well for the commodity derivatives
markets.