FAQs on the forward contracts (regulation) amendment ordinance 2008 and the policy for FDI/FII in commodity exchanges

Backgrounder

Q 1. What is the legal framework to regulate the commodity futures market?

 

Ans. The Forward Contracts (Regulation) Act, 1952 (FC(R) Act) provides for the regulation of commodity futures markets in India and the Forward Markets Commission (FMC), the commodity futures market Regulator, is a statutory body set up in 1953 under the provisions of the FC(R) Act. Before the promulgation of the Forward Contracts (Regulation) Amendment Ordinance, 2008, FMC did not have regulatory powers and authority like Securities and Exchange Board of India (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 all matters including recruitment of staff.

 

Q2. What are the benefits of Commodity futures market?

 

Ans. Futures markets perform two very important roles. One is the price discovery and second is hedging of price risk. The price discovery comes about through collective assessment of a large number of individual market participants about the direction and price trends of a commodity in future. Such assessment can be based on the participant’s internal knowledge about the likely production, crop size, weather projections etc. This helps the producer (agriculturist) to 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. This also leads to the second function namely hedging of price risk. With a general sense of the likely future price, the producer or the seller can lock in his produce so that his risk of price or for that matter availability is mitigated.

 

Q3. What were the significant factors that necessitated amendment to the FCR Act?

 

Ans. The Government had introduced in the Parliament an amendment Bill to amend FCR Act in December 1998. The Bill was examined by the Department related Parliamentary Standing Committee and was passed by the Rajya Sabha. The Bill could not be passed as it lapsed with the dissolution of the Lok Sabha in 2003. At any rate, till about 2000-01, the general approach of the Government was to ban or prohibit the commodity derivatives. From 2000-01 onwards, this market was opened up. Today, there are about 100 commodities which are traded on the three national and twenty regional commodity exchanges. The volumes of these markets have grown very rapidly from Rs.1.29 lakh crores in 2003-04 to Rs.36.7 lakh crores in 2006-07. During 2007-08 (till January, 2008), the volumes traded on the commodity exchanges have been Rs.31.60 lakh crores. As per the estimates projected by ASSOCHAM, the trade value would increase to Rs. 74 lakh crores by 2010.

The role of FMC has consequently changed from enforcing prohibition to properly managing and regulating such explosive growth. It has so far managed to discharge this role through the instruments of margin, limit on open interest, price limits etc. However, a need is felt to further strengthen and enhance the capabilities of FMC as well as to give it the necessary autonomy by making comprehensive amendments to the FCR Act.

 

The Parliament has also passed the Warehousing (Development & Regulation) Act, 2007. The Act provides for negotiability of warehouse receipts and this will help farmers to avail credit lines against their stocks stored in Exchange accredited warehouses. Some banks have already begun to provide credit lines to farmers. In order to benefit the farmers most and to ensure orderly regulation of warehouses and other intermediaries necessary complementary provisions needed to be inserted in the FCR Act also. It was also necessary to give FMC the much needed financial and administrative autonomy as well as arm it with requisite legal powers to discharge its regulatory functions effectively.

Q4. What was urgency to promulgate an Forward Contracts (Regulation) Amendment) Ordinance, 2008?

 

Ans. In view of the change in the approach of the Government towards forward trading in commodities from “prohibition” to “regulation”, and the rapid acceleration of growth in the commodity futures market, there was an imperative and urgent need to upgrade legal and regulatory system. The regulatory provisions of the Forward Contracts (Regulation) Act, 1952 have not changed significantly ever since it was enacted in 1952. It was apprehended that any major crisis in this market may not only be a setback to further development of commodity futures trading, but would dissuade participants in the real sector, particularly those in the agricultural and agro-based sectors, from availing this price-risk management instrument. As the Government is withdrawing from administrative price mechanism and direct market-intervention, the participants in the real sector would be exposed to the price-volatility caused by market forces – both domestic and global. The representations received from several stakeholders in the recent past underscored the urgency to upgrade the legal and regulatory framework. This had given rise to an impression that FMC was working in a legal vacuum and the extant legal framework under which FMC operated might prove inadequate to enable it to continue to discharge its role as an effective regulator in the expanding commodities marketplace and that underlying legal framework of FMC should be suitably strengthened.

Since issue relate to financial and market integrity, it was not desirable to wait any longer to strengthen the legal and regulatory framework in respect of commodities forward markets. It was, therefore, considered appropriate to follow an Ordinance route.

 

Q5. What are the salient features of the Forward Contracts (Regulation) Amendment Ordinance, 2008 ?

 

Ans. The Forward Contracts (Regulation) Amendment Ordinance, 2008 mainly provides for strengthening and restructuring of FMC on the lines of SEBI. The amendments effected in the FC(R) Act, inter alia, provides for: (a) up-dation of existing definitions and insertion of some new definitions; (b) changes in provisions relating to composition and functioning of FMC; (c) enhancement of the powers of FMC; (d) corporatisation and demutualisation of the existing Commodities Exchanges and setting up of a separate Clearing Corporation; (e) registration of Intermediaries; (f) enhancement of penal provisions in the FC(R) Act; (g) permitting trading in options in goods or options in commodity derivatives; and (h) making provision for designating the Securities Appellate Tribunal (SAT) as the Appellate Tribunal for purposes of FC(R ) Act also including that of levying fee.

 

Q6. What would be the benefits of allowing trading in options?

Ans. Options in goods is an agreement by whatever name called, under which buyer of the option (called as applier) pays a premium to the seller of option (called as writer of the option) for acquiring from him right to buy or sell the goods at a mutually agreed rate (called as 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 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.

 

Q7. Is it correct that the futures market leads to the rise in prices of essential commodities?

 

Ans. The share of agriculture commodities including essential commodities in the total commodity futures trade turn over is about 25%. The share of essential commodities in the over all futures trading is about 8%.The volume of trade in bullion (gold and silver) has about 38% share, energy products has a share of 12% and other metals and commodities like aluminium, zinc, tin, copper, lead, sponge iron, steel, polymer etc. have a share of about of 25 % in the total turnover.

 

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 has set up an Expert Committee on 2.3.07 under the Chairmanship of Professor Abhijit Sen, Member, Planning Commission to study, inter alia, the extent of impact, if any, of futures trading on wholesale and retail prices of agricultural commodities. The report of the Committee is awaited.

 

Q8. How does an average farmer benefit from the commodity futures trading?

 

Ans. World over, farmers do not directly participate in the futures market.  They 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.

 

Q9. What are the main differences between securities market and commodities derivatives market?

 

Ans. Commodity futures contracts are standardized. In other words, the parties to the contracts do not decide the terms of futures contracts; but they merely accept terms of contracts standardized by the Exchange. The provision for delivery is made in the contract so as to ensure that the futures prices in commodities are in conformity with their spot prices.  To provide efficient delivery mechanism network of accredited warehouses backed by services of professional assayers is required. Seasonality of a commodity traded on the exchange platform plays a crucial role in price movements. Further spot /cash market/APMCs/Mandis of the commodities are regulated by the respective Sate Governments/ administrative Ministry /Department and FMC only regulates futures market of the notifies commodities through network of national and regional exchanges.

 

Securities market, on the other hand consist of both spot and derivatives segment regulated by sole regulator i.e. SEBI. Physical delivery is not involved in securities derivatives contracts and these are mainly cash settled. Seasonality does not play any role in price movement of securities derivatives.

 

Q10. What are the main component of the Foreign Investment policy in commodity Exchanges?

 

Ans. The policy for FDI/FII in commodity exchanges was not crystallized so far. As far as the stock exchanges are concerned, such a policy has already been finalized by the RBI/Finance Ministry by the end of 2006 (18.12.2006). In order to provide the necessary impetus to the growth of commodity market, the Government has decided to put in

 

place a Policy on the foreign investment in infrastructure companies including commodity Exchanges. Department of Consumer Affairs in consultation with Department of Economic Affairs and RBI have finalized the Policy on foreign investment in infrastructure companies in commodity market including commodity Exchanges and the same has since been approved by the Cabinet. The elements of this policy are as follows:

 

(i) Foreign Investment upto 49% will be allowed in the commodity Exchanges with separate Foreign Direct Investment (FDI) cap of 26% and Foreign Institutional Investment (FII) cap of 23%;

 

(ii) FDI will be allowed with specific prior approval of FIPB;

 

(iii) FIIs shall not seek and will not get representation on the Board of

Directors of the commodity Exchanges;

 

No foreign investor, including group/associate companies and

persons acting in concert, will hold more than 5% of the equity

in these companies;

 

(v) FIIs will be allowed to purchase shares either through primary

market/secondary market or through private placement.

 

Q. 11. What would be the benefit of FDI in Commodity Exchanges?

 

Ans. The foreign investors would bring with them international best practices, new and novel product offerings as well as linkages with international markets and trading platforms. Certain well reputed foreign investors such as New York Mercantile Exchange, New York Stock Exchange, Merrill Lynch, Citi Bank, Passport Capital, GLG Partners and New Vernon Capital have shown keen interest to invest in the National level Commodity Exchanges. The knowledge, experience and global trading practices of these foreign investors would provide growth momentum both in exchange management and day to day trading. The fear that FDI/FIIs investment in commodity exchanges would lead to speculative trading and thus hurt farmers need to be taken care of by strict rules, process and approach. A varied ownership provides a boost to evaluation and provides for perfect demutualized set up. The presence of FDI/FII would enhance the stature of the commodity exchanges in India.

 

MP:CP: backgrounder(FAQs)12.2.2008

(Release ID :35321)

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