The Hindu Business Line : Delivery mechanism in commodity exchanges

The pepper exchange... As commodities touch the common man's life, demand, supply and pricing are vital, and a tilt in any one of these can have a cascading effect on the economy. — K.K. Mustafah

DELIVERIES are an integral part of commodity exchanges (comex). Even though they form an insignificant portion of the total volume of trade transacted on the exchange, the basis of delivery and its effect on the ready delivery market are significant.

Unlike the stock market, not all the open positions result in compulsory delivery always. Apart from this, the options available for deliveries are (i) at the instance of the buyer (ii) at the instance of the seller, or (iii) a fixed quantity delivery.

The by-laws of the exchanges usually provide for the delivery mechanism, which inter alia includes the manner in which the deliveries are effected. Any by-law that does not provide for a delivery mechanism in the derivatives market (other than pertaining to trading on intangible goods such as freight futures, index futures, etc;) is illegal under the provisions of the Forward Contracts (Regulation) Act, 1952.

Apart from the market movement, the type of commodity traded in the comex also plays a vital role in determining the delivery pattern. If the total volume of operation in an exchange is not so large that it results in a small outstanding position, then to keep the market in order, it is desirable to implement the compulsory delivery system which means that all the short open position-holders will have to compulsorily deliver and be compulsorily taken up by the long open position-holders.

One of the important elements of deliverables in commodities trading is the shelf life of commodities. Barring commodities such as gold and silver, that are corrosion free and hence not subject to degradation of value and utility, most other commodities, more specifically agricultural commodities, have a life span within which consumption/utilisation has to take place.

Irrespective of the fact that the commodities can be dematerialised and converted to electronic mode for transfer of entities (ownership right) like securities, these products are to be physically exhausted within a period beyond which they would face erosion in value notwithstanding the rates at which they are physically traded/settled in the market.

There are striking differences between the stock market operations and commodity market operations in terms of delivery. Briefly, they can be spelt out as follows:

Fungibility: This has been explained above. In addition, mutilated shares, even in physical form, can be substituted for new certificates that are valid for "n"-number of years provided the company that issued the share is neither defunct nor wound up.

Uncertainty about supply: The company's accounts show the total issued capital of the company and the promoters' holding which would give a near-accurate figure about the floating stock. Commodities, especially agri-based commodities, on the other hand, suffer from infirmities due to various factors over which human beings have no control.

Change of climate, monsoon, international crop pattern, local/domestic consumption pattern, actual crop arrivals and acts of God play a vital role in the supply chain which invariably affects prices.

Poor storage and infrastructure facilities: While the securities market is neither concerned with nor affected by these phenomena, they have a significant effect on the commodities market. They affect the availability of goods and the quality of the products in question that get translated into the pricing mechanism and physical delivery.

Even after the goods are taken delivery of by the exchange (whether through a certified warehouse or in any other manner), if they are not immediately consumed, any deterioration during storage may have an adverse impact on their prices.

Government intervention: Politically sensitive commodities, such as rice, wheat and sugar, are vulnerable to constant political tinkering, their availability and prices being largely controlled by government agencies. The minimum support prices (MSP) on almost all agricultural commodities have an impact on the ultimate pricing. This phenomenon does not apply in the securities market. Another impediment is the restriction on movement of goods across States.

Impact on economy: Commodities touch upon every common man's life, unlike securities. Hence, demand, supply and pricing are vital, and any tilt/shift in any one of these aspects has a cascading effect on the economy. (Remember the onion fiasco that triggered the fall of the Government!)

Pricing and delivery go in tandem in the commodities market. Though they may not have any direct inverse proposition — increase in demand need not necessarily mean reduction in prices, and vice-versa — a scarcity in commodities nonetheless triggers escalation in prices. Scarcity may be due to lower production, hoarding in anticipation of spiralling prices, diversion of commodities to places where they are urgently needed, war-like situation, and so on.

There are certain finer aspects to deliveries in the commodities market. A healthy ready delivery (spot) market is essential for a vibrant futures market. Once this is established in respect of any commodity, both the markets are so interdependent that they drive each other at different points of time. This being the case, in reasonably well-developed and matured market conditions, delivery being effected either in the futures market or the ready market makes equal sense. This is basically driven by the price discovery mechanism. But the following points need to be addressed for a viable futures market to be a delivery-based operation:

Delivery not obligatory in futures market: As mentioned earlier, the delivery component in the futures market is insignificant given the fact that futures rates converge with the ready market on the due date. It is left to the individual exchanges to devise appropriate delivery mechanisms to suit a particular commodity. As mentioned earlier, it may make provisions in the by-laws/regulations for any one of the following methods for ascertaining deliveries.

Compulsory delivery: On the due date, all the outstanding positions would result in compulsory delivery: sellers will have to give delivery, and the buyers, likewise, will have to take delivery.

Delivery at option of buyer: The buyer will opt for the delivery he wishes to take and the seller will be obliged to tender delivery to the extent the deliverables are allotted to him.

Delivery at option of seller: The seller will opt for the delivery he wishes to tender and the buyer will be under obligation to take delivery to the extent the deliverables are allotted to him.

Fixed percentage/quantity of deliveries: In this method, the comex announces at the time of opening the contract the extent of delivery the seller will have to compulsorily tender and which correspondingly has to be lifted by the buyer. This is normally ascertained based on the exchange's open interest for a particular contract.

To exercise a delivery option, the parties must have outstanding position to the extent the deliveries are being offered/taken up. The parties are not allowed to square up the position thus offered for delivery-in/out as the case may be. This procedure, however, will not apply to the compulsory delivery mechanism.

In case of (b) and (c) above, if the option for calling or tendering deliveries, as the case may be, is not exercised by the respective parties, physical deliveries will not take place, which in effect means it is purely a speculative market. This can happen under the following circumstances:

In bullish market conditions, the seller would like to offload the goods in the ready market which will fetch him better prices than what is fixed as a settlement rate by the exchange for a particular contract. The buyers would, however, like to have deliveries as they can hold the same for some time and get better returns when market conditions are more favourable.

If there is a glut in the ready market, the seller would like to offer delivery through the exchange as it ensures lifting of delivery as well as recovery of dues (as the exchange guarantees performance of contract). The buyers, under the circumstances would like to avoid taking deliveries as they may not get adequate returns either immediately or in the near future.

It is, therefore, necessary that for the delivery mechanism to be effectively implemented, a certain degree of compulsory delivery has to be mandated.

This is necessary because if the futures market drives a ready market (which does happen in certain markets), the lack of a delivery being offered in the exchange will impact prices in the ready market, which is not desirable in the larger interest of trade.

Moreover, it is not the mandate of the exchange to act according to either buyers' or sellers' wishes as they will have their own positions and are, hence, likely to argue for the implementation of a mechanism to suit their individual requirements. The intention of the by-laws should also not be such that the exchange does not want, or discourages, deliveries under its umbrella.

Impact of hedgers vs speculators: Indian commodity exchanges usually do not distinguish between hedgers and speculators and, hence, have uniform margin calls and exposure limits for both these participants, despite their performing two distinct activities.

In the West, hedgers are under obligation to tender or take delivery, as the case may be, and, hence, have less margin calls than speculators. They are exempted from paying margin if the underlying asset is delivered in the form of a warehouse receipt (WR). Any provision on the above said lines is a welcome move to boost deliveries.

Negotiability of certified warehouse receipt (CWR): Theoretically speaking, the CWR is a hedged instrument and is, hence, insulated from price fluctuation.

Practically, when prices move frequently, the CWR's price protection factor is only temporary. CWRs issued by recognised comexes should be recognised as negotiable instruments by devising suitable guidelines and taking upfront premiums to secure the negotiability concept for a reasonable period. This will improve the chances of deliverables in the exchanges.

Towards achieving this purpose, the exchanges may also explore the possibility of accepting delivery orders issued by other exchanges (provided the quality specifications are the same in both cases) towards effecting delivery.

Bringing mandies into mainstream: For a proper and effective delivery mechanism, involving the farmers at one stage or other is a must. Though worldwide, farmers do not directly deal with commodities markets for delivery, the elevator mechanism (which acts as a conduit between farmer and exchange), if properly designed and implemented in India, will greatly help achieve effective physical delivery.

ITC's e-Choupal, marketing federations, etc., can be roped in for this purpose for an effective and efficient delivery mechanism.

Grades to be traded in the exchange should have a large presence in the physical market: In the absence of this provision, or if the grades in respect of the commodities are not in consonance with the prevailing marketable grades, physical deliveries cannot take place and the market will not reflect the price barometer properly.

In the short run, the market may feel elated, with surging volumes in the comexes, but in the long run and also in its true sense, a market that does not advocate a proper hedging mechanism with a strong delivery-link system will offer little economic benefit to market participants.

(The author is Executive Director, National Board of Trade Limited, Indore.)

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