Framework of Forward Contracts in India and FCRA Amendment Bill

The Forward Contract is a contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today.

How does it work?

We take an example.

We suppose that Suresh wants to buy a house in next year October. At the same time, Ramesh has a house worth Rs. 15 Lakh and he plans to sell it in October next year. Since the current price is Rs. 15 Lakh, Ramesh and Suresh enter into an agreement via which Suresh will buy that house in October 2013 in Rs. 17 Lakh. This would be called a Forward Contract. The price agreed upon would be called Delivery price. Since Suresh is buying it, for him, it would be called Long Forward Contract. On the other side, Ramesh is selling it; it would be called Short Forward Contract.

Now, we suppose that in next year October, instead of Rs. 17 Lakh, the market price of that house becomes Rs. 20 Lakh. Since Ramesh is already in contract with Suresh to sell him the house in Rs. 17 Lakh, Suresh would earn a profit of Rs. 3 lakh. Ramesh would lose Rs. 3 Lakh. Here we note that forward contract is in contrast with the Spot contract. Spot contract is an agreement to buy or sell an asset today.

There is one more term related to Forward Contracts called NDF or Non-Deliverable Forward. Non-deliverable forwards are over-the-counter transactions settled not by delivery but by exchange of the difference between the contracted rate and some reference rate such as the one fixed by the Reserve Bank of India. For example, if Ramesh pays Suresh Rs. 3 Lakh without delivering the actual house, it would be called NDF. The same is basic funda for commodity forward contracts and currency forward contracts.

In this article, we are discussing about the Forwards contracts related to Commodities in India.

Role of Future Markets in Economy

There are two important roles of the Futures markets.

• Price Discovery: Price discovery is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers. The forward markets provide the collective assessment of a large number of individual market participants about the direction and price trends of a commodity in future. The price discovery is affected by the internal knowledge about the likely production, crop size, weather projections etc of the buyers and sellers.

  The benefit of forwards is that the producers of commodities such as farmers can plan production and to shift acreage or production facilities from one commodity to another. The fight for acreage between wheat, soya bean and corn is an example of the demand forecast given by futures against the backdrop of complex interplay of forces like by forces bio-fuel demand, meat consumption (giving rise to larger utilization of feed to animals- in turn larger demand) etc.

• Hedging of price Risk: if a producer or buyer has a general sense of the likely future price, the he can lock the produce so that his risk of price or for that matter availability is mitigated.

However, Speculators are one of the biggest segment of future markets participants. The speculative investors pour their money into the futures markets and thus are held responsible for increased volatility in commodities.

In any case, the social utility of futures markets is considered to be mainly in the transfer of risk, and increased liquidity between traders with different risk and time preferences. However, it does not take much time to convert the hedger into a speculator.

History of Commodity Forward Contracts

• In our country, the Commodity Futures market dates back to more than a century. The first organized futures market was established in 1875, under the name of ‘Bombay Cotton Trade Association’ to trade in cotton derivative contracts. This was followed by institutions for futures trading in oilseeds, foodgrains, etc.
• The futures market in India underwent rapid growth between the period of First and Second World War. As a result, before the outbreak of the Second World War, a large number of commodity exchanges trading futures contracts in several commodities like cotton, groundnut, groundnut oil, raw jute, jute goods, castorseed, wheat, rice, sugar, precious metals like gold and silver were flourishing throughout the country. In view of the delicate supply situation of major commodities in the backdrop of war efforts mobilization, futures trading came to be prohibited during the Second World War under the Defence of India Act.
• After Independence, especially in the second half of the 1950s and first half of 1960s, the commodity futures trading again picked up and there were thriving commodity markets. However, in mid-1960s, commodity futures trading in most of the commodities was banned and futures trading continued in two minor commodities, viz, pepper and turmeric.

The FCRA 1952 & FMC

In 1952, an act to provide for the regulation of certain matters relating to forward contracts, the prohibition of options in goods and for matters connected therewith was enacted that we know as Forward Contracts (Regulation) Act, 1952.

This act makes provision that Central Government may, by notification in the official Gazette, establish a Commission to be called the Forward Markets Commission for the purpose of exercising such functions and discharging such duties as may be assigned to the Commission by or under this Act. However, the commission was basically an advisory body whose main work was to advise the Central Government in respect of the recognition of or the withdrawal of recognition from any association or in respect of any other matter arising out of the administration of this Act.

• FMC as an advisory, statutory body set up in 1953 under the provisions of the FCRA. Form 1953 till 2008, FMC had no regulatory powers like those of SEBI. It also did not have the financial autonomy as it depended on budgetary allocation and its administrative autonomy was also restricted as it was subject to rules and regulations of the Government in matters including recruitment of staff.

Reviving of the Futures Trading

For many years, the theme of regulation of Forward markets in India remained “prohibition” rather then “regulation”. Since a blanket ban was not in favour of the producers, some committees were established to recommend how to go about the regulation. In 1980, the Khusro Committee recommended for reintroduction of futures trading in most of the major commodities, including cotton, raw jute and jute goods. The committee also suggested that steps may be taken for introducing futures trading in commodities, like potatoes, onions, etc. at appropriate time. From 1980 to 1992, government allowed futures in many more commodities.

After the economic liberalization, government set up the K N Kabra committee in 1993, which recommended the futures trading almost all commodities that are traded today. The Kabra committee recommended that the existing Commodity Exchanges should be upgraded. However, by that time, India was not open for Options in Commodities.

What are Options?

Options in goods is an agreement under which buyer of the option (applier) pays a premium to the seller of option (writer) for acquiring from him right to buy or sell the goods at a mutually agreed rate (strike price), in respect of which the premium amount is paid. It is possible to acquire rights both to buy and to sell the goods; but in this case higher premium amount would have to be paid. The buyer acquires only right, i.e. he is under no obligation to buy or sell, as the case may be, at the mutually agreed price.

Options were prohibited under section 19 of the FCRA Act. Options have been permitted now as it allows hedgers such as farmers or their representative bodies (association, societies etc.) to take advantage of upward movement in the prices while protecting them against downward movement in the prices.

Prices & Futures: Abhijit sen committee

The futures markets have been connected to the rise in prices of essential commodities. However, experts have divided opinion upon this. The level of prices of commodities is determined largely by a variety of factors operating on the demand and supply side. These include domestic production, arrivals in the market, quantity of imports, international prices, consumption requirements, expectations regarding behaviour of prices etc. Therefore, it is difficult to segregate the impact of one factor on the level of prices. In the context of discussion regarding whether and to what extent futures trading has contributed to price rise in agricultural commodities in recent times, the Government had set up an Expert Committee in 2007under the Chairmanship of Professor Abhijit Sen.

The Abhiit Sen committee could not conclusively say that futures impacted prices. The committee noted that the foodgrains had at no point accounted for more than 6% of total volume of futures trading in agricultural commodities. Thus, the panel made a case for actually enlarging futures trading. The farmers take advantage of the price signals emanating from a futures market. Price-signals given by long-duration new-season futures contract can help farmers to take decision about cropping pattern and the investment intensity of cultivation. Direct participation of farmers in futures market to manage price risk –either as members of an Exchange or as non-member clients of some member – can be cumbersome as it involves meeting various membership criteria and payment of daily margins etc.

Current Position

The FMC is the futures market regulator in India. Currently 5 national exchanges, viz. Multi Commodity Exchange, Mumbai; National Commodity and Derivatives Exchange, Mumbai and National Multi Commodity Exchange, Ahmedabad, Indian Commodity Exchange Ltd., Mumbai (ICEX) and ACE Derivatives and Commodity Exchange, regulate forward trading in 113 commodities. Besides, there are 16 Commodity specific exchanges recognized for regulating trading in various commodities approved by the Commission under the Forward Contracts (Regulation) Act, 1952.

Allowed Commodities

The commodities traded at these exchanges comprise the following:

Edible oilseeds complexes like Groundnut, Mustardseed, Cottonseed, Sunflower, Rice bran oil, Soy oil etc.

• Food grains – Wheat, Gram, Dals, Bajra, Maize etc.
• Metals – Gold, Silver, Copper, Zinc etc.
• Spices – Turmeric, Pepper, Jeera etc.
• Fibres – Cotton, Jute etc.
• Others – Gur, Rubber, Natural Gas, Crude Oil etc.

Out of the 113 commodities, regulated by the FMC, in terms of value of trade, Gold, Silver, Copper, Zinc, Soy Oil, Jeera, Pepper and Chana are the prominently traded commodities. The cumulative turnover of the commodity exchanges is about ` 80.30 lakh crore till September 15 of the fiscal year 2012-13.

Banned Commodities

• As of October 2012, futures trading in urad, tur and rice remain suspended. The ban on rice, tur and urad was imposed in early 2007 following a steep rise in prices.
• In March 2012, FMC had banned futures trading in guarseed and guargum, which is increasingly used in oil and gas industry, to curb price volatility and speculation. Guar gum is extracted from guar seed, production of which is around 10 lakh tonnes in the country. India is the world’s biggest exporter of the commodity.

The proposed FCRA Amendment Bill

Giving a reform boost to commodity markets, the government has recently approved the FCRA Bill that seeks to provide more powers to sectoral regulator Forward Markets Commission (FMC) and allow a new category of products. Here are some notable points:

• The amendment will give more teeth to FMC; it also aims to provide financial autonomy to the regulator. FMC can become self-sufficient by collecting revenues in form of fees from exchanges after the bill is passed.
• The retirement age of FMC Chairman and its members will go up to 65 years from 60 years. The number of members in FMC has also been proposed to increase from four to nine.
• The Bill also seeks to facilitate entry of institutional investors and pave the way for introduction of new category of products, like Options.
• The Bill seeks to increase penalty on defaulters to Rs 50 lakh from the existing Rs 25 lakh.

If the Bill is passed in parliament, FMC will get powers to permit derivative trading in indices and options in commodities and indices like in the futures and options (F&O) segment in the stock exchanges. This will give it more depth and volumes. Options are the cheapest instruments to hedge commodities. The buyer of an option will risk only the premium amount. For example, an importer of edible oil enters into a contract to import oil with an overseas supplier, delivery comes after a month or so and market situation at that time is not known. In that case he can buy the put option and protect the down side. Now, he has to sell the quantity in the far month futures. In several commodities, far month futures do not have enough breadth.