Regulatory Watch. Do SEBI's suggestions on commodity derivatives make the cut?

Commodity market regulator SEBI is currently in the process of reviewing the rules and regulations on commodity derivative trading and bringing about changes wherever required. One area that needed attention was the evaluation of commodities before derivative contracts were launched on them.

If enough deliberation had been done on this subject, future contracts on wheat or rice would not have been introduced in the country. These future contracts were banned from trading in 2007, when it was felt that speculators in commodity exchanges were pushing up the prices of these commodities, impacting inflation. Similarly, the launch of derivatives on thinly traded commodities could also have been avoided.

The circular brought out by the regulator recently addresses three areas. One, it spells out the parameters based on which commodities should be evaluated before derivatives are launched on them for the first time. Two, review of the commodity contracts currently being traded is also suggested so that those commodities found unsuitable can be discontinued. Three, rules have been laid down for re-introduction of contracts that are discontinued.

The Commodity Derivative Advisory Committee (CDAC) constituted to advise SEBI on the selection of commodities for trading suggested certain parameters to help in the selection process.

The committee has said that the market for the underlying should be large enough to justify derivative trading. The size of the market can be judged based on the production numbers, imports and inventory levels. If there is a mature spot market for the commodity, volume traded in the spot market can also be an indication.

Since commodity contracts have be to be in standard sizes, homogeneity of the commodity is also required for floating derivative contracts. For instance, if the quality of a certain variety of pulse varies greatly based on region and time, it will be difficult to float a contract on it. Sugar and cotton are examples of commodities where standardisation is easy.

Storability of the underlying commodity is another factor that will determine the contract’s suitability. For instance, commodities with a short shelf life such as vegetables are unsuitable as they cannot be deposited in warehouses to enable physical settlement of contracts.

Commodities that are traded globally are preferred for launch of commodity derivative contracts as an easy peg is then available to price the commodity. The presence of a large global market is one of the reasons that makes traders take to bullion contracts.

The other criteria prescribed by the CDAC is presence of a well-established value chain and wide coverage. If the commodity goes through multiple processes between the farm-gate and commodity exchange, the number of users in the commodity will also be more, leading to more demand for the product. Similarly, if it is produced in various regions across the country or if it is consumed in various localities spread across the country, the demand will also be higher.

The CDAC has also pencilled in ‘ease of doing business’ as a criterion for selecting commodities for trading. This relates to the extent of government regulation on the price and supply. For instance, cereals are considered important for providing food security to the poor. Hence, the likelihood of government intervention, in case of sharp prices moves, is higher, making these commodities unsuitable for derivative exchanges.

Commodities where the need for risk management is higher are also considered apt for the commodity derivative market. For instance, commodities that move in-step with internationally traded prices, those which trade at a higher price in certain seasons or commodities which are very volatile are suitable for commodity derivative market. For, users of these commodities are likely to use these contracts to hedge their risk.

SEBI has given a template to exchanges to help them evaluate new and existing derivative contracts. Exchanges have to give a weighted score between 1 and 5 for each parameter, with 1 being poor and 5, excellent. Exchanges have been told to complete the exercise and submit their evaluation to SEBI by three months. A review of the currently traded contracts is likely to be done once this exercise is complete.

SEBI has also tried to weed out illiquid contracts from commodity exchanges by specifying that all contracts should have annual turnover of more than ₹500 crore across all commodity exchanges, in at least one of the last three financial years. A gestation period of three years is provided to newly launched or re-launched commodities.

Commodities where trading is suspended because they do not meet the criteria can be re-launched only after the lapse of one year.

With the implementation of these rules, instances of undue volatility and frequent trading suspension in commodity markets should hopefully go down.