The Hindu Business Line : Taking commodity contracts forward

Commodities are essential to fuel economic growth. Steady integration of the domestic market with the global market raises the risk perception. As markets integrate, additional factors come into play. Participants have to keep track not only of domestic market developments but also global dynamics to be able to successfully manage price risk. Anyway, all risks — production, quality , processing — converge into price, and the management of price risk is the key.

Market participants need insurance against risk or an instrument of risk mitigation. Commodity futures trading, popularly known as hedging, is a time-tested instrument to manage the price risk.

Markets and transactions

Markets evolved over time. A market is where buyers and sellers meet to exchange goods and services; and usually goods are exchanged for money. Markets could be local, regional, national or even global, depending on the nature of commodity, location of buyers and sellers, utility of the commodity and other related factors. With technological advancement and communication revolution, there is no longer any need for buyers and sellers to physically meet. Today, market transactions take place without the buyers and sellers coming together because they can use information and communication technology to enter into a legally-binding transaction. Markets can thus be invisible or virtual.

Commodity contracts

Now, a look at `commodity contracts'. Commodity trading transactions are concluded on the basis of contracts. The seller agrees to sell and the buyer agrees to buy a specified commodity. Typically, a contract note (sauda chitti) contains the following: Name of the seller; the name of the buyer; the description of goods; the quantity sold/bought; the quality of goods; the packing; the period of delivery; the place of delivery; and the price. It may also contain such terms as mode of payment, credit period, arbitration clause and so on. This is a customised contract between buyers and sellers. A broker may or may not be involved.

Parties to the contract, by mutual consent, are free to amend the terms of the contract. Such a contract is usually not registered with any association or exchange or government authority. It remains only between the parties to the contract.

In other words, the market at large may not know about the contract at all. The performance of the contract is through delivery of contracted goods and payment of contracted price. The transaction is complete once the goods are delivered and the payment effected as per contract terms.

Is there any other way the contract can be performed? Yes, through payment of price difference. On the date of the delivery, if the seller is unable to supply the contracted goods or the buyer finds it difficult to take delivery or make payment, they may decide to settle the transaction through payment of price difference by the defaulting party. The difference between the contracted and the market price on the day of delivery will form the basis of settlement.

Forward Contracts (Regulation) Act

It is in this context that the Forward Contracts (Regulation) Act, 1952 assumes importance. FCRA recognises three broad categories of contracts — ready delivery; forward; and option in goods.

Ready delivery contracts are for purchase/sale and delivery of goods in which delivery of goods and payment thereof are completed within 11 days from the date of the contract. In other words, the performance of the contract is completed within 11 days from the date of signing. Such contracts are outside the purview of the FCRA.

Forward contracts are for purchase/sale and delivery of goods that are `not ready-delivery' contracts — that is, the transaction is completed beyond 11 days from the date of the contract. When either delivery or payment or both take place beyond 11 days from the date of the contract, it is considered a `Forward Contract' under FCRA. Such contracts are governed by the Act.

Options in goods are prohibited under FCRA. It is an agreement which gives option-buyer the right, but not the obligation, to buy or sell a particular futures contract at a stated price at any time prior to a specified date.

With options being banned, ready delivery contracts outside the purview of FCRA, and options in goods prohibited under the FCRA, we need to closely examine forward contracts. They are of two types: Specific delivery contracts and other than specific delivery contracts.

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