By Chaahat Khattar
Trading in Cotton, Guar, Potato, etc. might sound as if someone is in middle of a wholesale vegetable market trying to buy and sell commodities of local consumption. As a matter of fact, in India the commodities industries constitute about 58% of the Gross Domestic Product (GDP) of the nation. Such a big constitution to the GDP naturally comes with certain risks as well. In this article we will highlight the basic aspects of the commodity trading in India and some must be kept taken care of risks associated with the commodity markets across the globe.
As the name suggests, commodity market refers to physical or virtual transactions of buying and selling commodities over a commodity exchange such as Multi Commodity Exchange of India Limited commonly known as MCX.
Commodities markets across the globe work on the concept of derivatives. Derivatives are securities whose prices are derived from one or more assets. For example, there can be a derivative for weather in which one can bet if it would rain or it would be a sunny day. There are primarily four different types of derivatives- Future Contracts, Forward Contracts, Options and Swaps. In future contract, a particular commodity or financial instrument is bought or sold at a pre-determined price whereas in forward contracts, the delivery of a contract is deferred till the actual trade. Forward contracts do not have a market per se and hence are often not traded. Options on the other hand, give the option to the investor to bet against the commodity or instrument without actually buying it. Swaps are nothing but hedging risk by buying a backup instrument or policy to trade in case of loss.
Commodity markets in India such as MCX offer future trading various commodities. It was in 2003 when the ban on commodity trading was lifted. We have 24 commodity exchanges in India out of which three operate at national level (MCX, National Commodity and Derivative Exchange and National Multi Commodity Exchange of India Limited). MCX constitutes about 87% of all commodities trading in India and it is one of the worlds largest commodity exchange. Just like the capital markets are regulated by Securities and Exchange Board of India, the commodities market in India is regulated by the Forward Markets Commission. Using a commodities futures contract, a farmer can sell his harvest much before he has planted it, even though he may get a better price for it in the future. If a boom in demand raises prices by the time the crop is available, the buyer of the futures contract wins. However, if prices fall, the speculator will make serious losses. Gold, Crude Oil and Silver are top traded commodities on Indias commodities trading exchanges.
Commodities trading market in India is no less than a boom. In times of inflation, the return from bonds and other financial instruments tend to go down but as the price of commodities goes up, one can easily make good money out of it.
Also, commodities market are much more secure than the equity markets because unlike stock of public companies (which can be manipulated if needed to), it is almost impossible to manipulate prices of commodities which are driven by demand, supply, inventory and trading patterns.
In India, all exchanges have both cash and delivery settlement systems. If one wants the contract be delivered in cash, he must indicate this at the time of placing the order. If one opts for delivery of the commodity, he must have the necessary warehouse receipts. It is the sole responsibility of the seller to manage his/her tax obligations.
Globally, commodities trading markets have been on rise in past as well as recent times. Investors have used it to make short term gains or to hedge their risks but at the same time the commodities trading has numerous risks that need to be catered to.
As commodity prices are extremely volatile in nature as a result of turbulence in global markets, monsoon, demand-supply mismatch and high liquidity, it is extremely difficult for an investor to be risk averse and he/she needs to take risks in calculative and predictive way.
- Derivatives have always been questionable because they have led not retail investors to risk their investments but business houses to risk their shareholders investments. Enron is the biggest example of it. As Enron became trading in derivatives, its balance sheet became too leveraged (leverage is a word to describe Debt to Equity ratio). Enron borrowed to invest further on something that possibly had no value. As the leveraged became too large to cater, it changed its accounting model to mark to market accounting to book profits based on future projections. It was never a sustainable way to bet against anything and this led to the collapse of a behemoth.
- Commodities trading market also need better regulation. It was lack of regulation in the US Economy that led to the financial turmoil in 2008 when investment banks dealt in derivatives such as options and futures and hedged there risks with swaps. If capital markets can be stringently monitored then why not regulate commodities trading. Dodd Frank Act (which is aimed at regulating derivatives, ensuring utmost corporate governance and protecting whistleblowers) should be made mandatory and every economy must regulate the commodities trading exchanges.
- Commodities trading is much more speculative than other financial markets because here the profit motive is way too high. Speculators tend to go to any limit to drive profits for themselves that can in turn harm the retail investors. Also, as the natural resources are located in different parts of the world, it is very much difficult to predict the movement of prices at times.
Commodity Trading is an ever growing sector. As the market demand for commodities is increasing at an ever increasing rate and as the stock markets are becoming more and more volatile, commodity trading is becoming more and more famous. With proper regulation and right fundamentals, commodity trading can be one of the safest modes of investment.
Chaahat Khattar is an ardent economist and is working with an international consultancy firm. He is an MBA and pursuing Masters in Business Laws. He is also a Harvard University alumnus and a certified financial modeller. He has keen interest and experience in authoring research papers and case studies and have contributed to various renowned journals. Chaahat can be reached at ckhattar@gmail.com