I. DERIVATIVE CONTRACTS (“VAYADA KABALA”) AND THEIR BENEFITS
1. What is a Derivative Contract?
Derivative Contract is an enforceable agreement whose value is derived
from the value of an underlying asset, the underlying asset can be a
commodity, precious metal, currency, bond, stock, or indices of
commodities, stocks etc. Four most common examples of derivative
instruments are forwards, futures, options and swaps/spreads.
2. What is a Forward Contract ?
A Forward Contract is a legally enforceable agreement for delivery of goods or the underlying asset on a specific date in future at a price agreed on the date of contract. Under Forward Contracts (Regulation) Act, 1952, all the contracts for delivery of goods, which are settled by payment of money difference or where delivery and payment is made after a period of 11 days are forward contracts.
3. What are Standardized Contracts ?
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.
4. What are Customized Contracts ?
Forward contracts (other than a futures) are customized. In other words, the terms of Forward Contracts are individually agreed between two counter-parties
5. Is delivery mandatory in Futures Contract trading ?
The provision for delivery is made in the Byelaws of the Associations so as to ensure that the futures prices in commodities are in conformity with the underlying. Delivery is generally at the option of the sellers. However, provisions vary from Exchange to Exchange. Byelaws of some Associations give both the buyer and seller the right to demand/give delivery.
6. What are N.T.S.D Contracts ?
Non-Transferable Specific Delivery Contracts is an enforceable bilateral agreement under which the terms of contract are customized and the performance of the contract is by giving specific delivery of goods. The rights or liabilities under this contract cannot be transferred by transferring delivery order, railway receipt, bill of lading, warehouse receipts or any other documents of title to the goods.
7. Are N.T.S.D Contracts regulated by the Forward Markets Commission?
Though the Forward Contracts (Regulation) Act, 1952, contains enabling provisions to regulate or prohibit such contract in notified goods, the Government have freed N.T.S.D. contracts from regulation or prohibition by issue of Notification No.369(E) dated 1.4.2003.
8. What are T.S.D Contracts ?
Transferable Specific Delivery contracts is an enforceable customised agreement where unlike known transferable specific delivery contracts, the right or liabilities under the delivery order, railway receipt, bill of lading, warehouse receipts or any other documents of title to the goods are transferable. The contract is performed by delivery of goods by first seller to the last buyer. The parties, other than the first seller and the last buyer, perform the contract merely by exchanging money differences.
II. FUTURES CONTRACTS
9. What is a Futures Contract?
Futures Contract is specie of Forward Contract. Futures are Exchange – Traded Contracts to sell or buy standardized financial instruments or physical commodities for delivery on a specified future date at an agreed price. Futures contracts are used generally for protecting against rich of adverse price fluctuation (hedging). As the terms of the contracts are standardized, these are generally not used for merchandizing propose.
10. What are the commodities suitable for futures trading ?
All the commodities are not suitable for futures trading and for conducting futures trading. For being suitable for futures trading the market for commodity should be competitive, i.e., there should be large demand for and supply of the commodity – no individual or group of persons acting in concert should be in a position to influence the demand or supply, and consequently the price substantially. There should be fluctuations in price. The market for the commodity should be free from substantial government control. The commodity should have long shelf-life and be capable of standardisation and gradation.
11. How many commodities are permitted for futures trading ?
With the issue of the Notifications dated 1.4.2003 futures trading is not prohibited in any commodity. Futures trading can be conducted in any commodity subject to the approval /recognition of the Government of India. 91 commodities are in the regulated list i.e. these commodities have been notified under section 15 of the Forward Contracts (Regulation) Act. Forward trading in these commodities can be conducted only between, with, or through members of recognized associations. The commodities other than those listed under Section 15 are conventionally referred to as 'Free' commodities. Forward trading in these commodities can be organized by any association after obtaining a certificate of Registration from Forward Markets Commission.
12. How are futures prices determined?
Futures prices evolve from the interaction of bids and offers emanating from all over the country – which converge in the trading floor or the trading engine. The bid and offer prices are based on the expectations of prices on the maturity date.
13. How professionals predict prices in futures?
Two methods generally used for predicting futures prices are fundamental analysis and technical analysis. The fundamental analysis is concerned with basic supply and demand information, such as, weather patterns, carryover supplies, relevant policies of the Government and agricultural reports. Technical analysis includes analysis of movement of prices in the past. Many participants use fundamental analysis to determine the direction of the market, and technical analysis to time their entry and exist.
14. How is it possible to sell, when one doesn't own commodity?
One doesn't need to have the physical commodity or own a contract for the commodity to enter into a sale contract in futures market. It is simply agreeing to sell the physical commodity at a later date or selling short. It is possible to repurchase the contract before the maturity, thereby dispensing with delivery of goods.
15. What are long position?
In simple terms, long position is a net bought position.
16. What are short position?
Short position is net sold position.
17. What is bull spread (futures)?
In most commodities and financial derivatives market, the term refers to buying contracts maturing in nereby month, and selling the deferred month contracts, to profit from the wide spread which is larger than the cost of carry.
18. What is bear spread (futures)?
In most of commodities and financial derivatives market, the term refers to selling the nearby contract month, and buying the distant contract, to profit from saving in the cost of carry.
19. What is ‘Contango'?
Contango means a situation, where futures contract prices are higher than the spot price and the futures contracts maturing earlier.
20. When is futures contract in ‘Contango'?
It arises normally when the contract matures during the same crop-season. In an well-integrated market, Contango is equal to the cost of carry viz. Interest rate on investment, loss on account of loss of weight or deterioration in quantity etc.
21. What is ‘Backwardation'?
When the prices of spot, or contracts maturing earlier are higher than a particular futures contract, it is said to be trading at Backwardation.
22. When is futures contract at ‘Backwardation'?
It is usual for a contract maturing in the peak season to be in backwardation during the lean period.
23. What is ‘basis'?
It is normally calculated as cash price minus the futures price. A positive number indicates a futures discount (Backwardation) and a negative number, a futures premium (Contango). Unless otherwise specified, the price of the nearby futures contract month is generally used to calculate the basis.
24. What is cash settlement?
It is a process for performing a futures contract by payment of money difference rather than by delivering the physical commodity or instrument representing such physical commodity (like, warehouse receipt)
25. What is offset?
It refers to the liquidation of a futures contract by entering into opposite (purchase or sale, as the case may be) of an identical contract.
26. What is settlement price?
The settlement price is the price at which all the outstanding trades are settled, i.e, profits or losses, if any, are paid. The method of fixing Settlement price is prescribed in the Byelaws of the exchanges; normally it is a weighted average of prices of transactions both in spot and futures market during specified period.
27. What is convergence?
This refers to the tendency of difference between spot and futures contract to decline continuously, so as to become zero on the date on maturity.
28. Can one give delivery against futures contract?
Futures contract are contracts for delivery of goods. But most of the futures contracts, the world over, are performed otherwise than by physical delivery of goods.
29. Why the proportion of futures contracts resulting in delivery is so low?
The reason is, futures contracts may not be suitable for merchandising purpose, mainly because these are standardized contracts; hence various aspects of the contracts, viz., quality/grade of the goods, packing, place of delivery, etc. may not meet the specific needs of the buyers/sellers.
30. Why delivery of good is permitted when futures contract by their very nature not suitable for merchandising purposes?
The threat of delivery helps in dissuading the participants from artificially rigging up or depressing the futures prices. For example, if manipulators rig up the prices of a contract, seller may give his intention to make a delivery instead of settling his outstanding contract by entering into purchase contracts at such artificially high price.
31. How can one avoid delivery being imposed against outstanding purchase contracts?
All the Exchanges give option to the participants to liquidate their outstanding position by entering into offsetting contract, before the “delivery period” commences. There is no delivery if the contracts are so liquidated. The threat of delivery – whether in terms of physical goods or by warehouse receipts – becomes a reality once delivery period commences.
32. Can a buyer demand delivery against futures contract?
The Byelaws of different Exchanges have different provisions relating to delivery. Some Exchanges give the option to seller, i.e., if the seller gives his intention to give delivery, buyers have no choice, but to accept delivery or face selling on account and/or penalty. Some Exchanges, particularly the northern Exchanges trading contracts in “gur”/jaggery provide the option both to buyer and seller. In some Exchanges, if the sellers do not give intention to give delivery, all outstanding short and long position are settled at the “Due Date Rate”.
33. What is “Due Date Rate”?
Due Date Rate is the weighted average of both spot and futures prices of the specified number of days, as defined in the Byelaws of Associations.
34. What is delivery month?
It is the specified month within which a futures contract matures.
35. What is delivery notice?
It is a written notice given by sellers of their intention to make delivery against outstanding short open futures positions on a particular date.
36. What is Warehouse Receipt?
It is a document issued by a warehouse indicating ownership of a stored commodity and specifying details in respect of some particulars, like, quality, quantity and, some times, indicating the crop season.
37. Are futures markets “satta” markets?
Participants in futures market include market intermediaries in the physical market, like, producers, processors, manufacturers, exporters, importers, bulk consumers etc., besides speculators. There is difference between speculation and gambling. Therefore futures markets are not “satta markets”.
38. Why do we need speculators in futures market?
Participants in physical markets use futures market for price discovery and price risk management. In fact, in the absence of futures market, they would be compelled to speculate on prices. Futures market helps them to avoid speculation by entering into hedge contracts. It is however extremely unlikely for every hedger to find a hedger counterparty with matching requirements. The hedgers intend to shift price risk, which they can only if there are participants willing to accept the risk. Speculators are such participants who are willing to take risk of hedgers in the expectation of making profit. Speculators provide liquidity to the market, therefore, it is difficult to imagine a futures market functioning without speculators.
39. What is the difference between a speculator and gambler?
Speculators are not gamblers, since they do not create risk, but merely accept the risk, which already exists in the market. The speculators are the persons who try to assimilate all the possible price-sensitive information, on the basis of which they can expect to make profit. The speculators therefore contribute in improving the efficiency of price discovery function of the futures market.
40. Does it mean that speculation need not be curbed?
Informed and speculation is good for the market. However over-speculation needs to be kerbed. There is no unanimity about what constitutes over-speculation.
41. How is over-speculation kerbed?
In order to curb over-speculation, leading to distortion of price signals, limits are imposed on the open position held by speculators. The positions held by speculators are also subject to certain margins; many Exchanges exempt hedgers from this margins.
42. How should a futures contract be designed ?
The most important principle for designing a futures contract is to take into account the systems and practices being followed in the cash market. The unit of price quotation, unit of trading should be fixed on the basis of prevailing practices. The “basis” – the standard quality/grade – variety should generally be that quality or grade which has maximum production. The delivery centers should be important production or distribution centers. While designing a futures contract care should be taken that the contract designed is fair to both buyers and sellers and there would be adequate supply of the deliverable commodity thus preventing any squeezes of the market.
43. What are the benefits from Commodity Forward/Futures Trading?
Forward/Futures trading performs two important functions, namely, price discovery and price risk management with reference to the given commodity. It is useful to all segments of the economy. It enables the ‘Consumer' in getting an idea of the price at which the commodity would be available at a future point of time. He can do proper costing and also cover his purchases by making forward contracts. It is very useful to the ‘exporter' as it provides an advance indication of the price likely to prevail and thereby helps him in quoting a realistic price and secure export contract in a competitive market It ensures balance in supply and demand position throughout the year and leads to integrated price structure throughout the country. It also helps in removing risk of price uncertainty, encourages competition and acts as a price barometer to farmers and other functionaries in the economy.
44. What is hedging?
Hedging is a mechanism by which the participants in the physical/cash markets can cover their price risk. Theoretically, the relationship between the futures and cash prices is determined by cost of carry. The two prices therefore move in tandem. This enables the participants in the physical/cash markets to cover their price risk by taking opposite position in the futures market.
45. Illustrate hedging by a stockist by using futures market?
To illustrate the concept of hedging, let us assume that, on 1st December, 2002, a stockist purchases, say, 10 tonnes of Castorseed in the physical market @ Rs. 1600/- p.q.. To hedge price-risk, he would simultaneously sell 10 contracts of one tonne each in the futures market at the prevailing price. Assuming the ruling price in May, 2003 contract is Rs.1750/- p.q., the stockist is able to lock in a spread/“badla” of Rs. 150/- p.q., i.e., about 9% for about 6 months. The stockist would, in the first instance, take the decision to purchase stock only if such a spread covers his cost of carry and a reasonable profit of margin. Assuming that the stockist sells his stock in the month of April when the spot price is Rs. 1500/- p.q.. The stockist would incur a loss of Rs. 100/- p.q. on his physical stocks. He would also make a loss of expenses incurred for carrying the stocks. However, since the spot and futures prices move in parity, futures price is also likely to decline, say, from Rs. 1750/- p.q. to, say, Rs. 1625/- p.a. The stockist can liquidate his contract in the futures market by entering into purchase contract @ Rs. 1625/- p.q. He would end up earning a profit of Rs. 125/- in the futures segment. Looking at the gain/loss in the two segments, we find that the stockist is able to hedge his price risk by operating simultaneously in the two markets and taking opposite positions. He gains in the futures market if he loses in the spot market; but he would lose in futures market if he gains in the spot market. Similarly, processors, exporters, and importers can also hedge their price risks.
46. How does futures market benefit farmers?
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. Options in goods would be relatively more farmer-friendly, as and when they are legally permitted.
47. Can the loss incurred on the futures market be set off against normal business profit?
Loss incurred in futures market by entering into contracts for hedging purposes can be set off against normal profit. The loss incurred on account of speculative transactions in futures market cannot be set off against normal business profit. This loss is however allowed to be carried forward for eight years, during which it can be set off against speculative profit.
48. How can futures trading be successful when the cash markets of the underlying commodities are fragmented?
It is true that in order to attract wide participation, the cash market of commodities should be geographically integrated and free from Government restrictions on production, marketing and distribution, like limit on stock-holding, movement of goods across state borders etc. Differential inter-state tax structure as well as the APMC Acts introduced by various State Governments restraining direct purchase from farmers also comes in the way of developing nationwide market. It is however not a bad idea to introduce futures trading in commodity without waiting for the cash market in the commodity to become geographically integrated. The number of commodities attracting Essential Commodities Act, as well as the restrictions imposed on production, marketing and distribution of the commodities under the Essential Commodities Act have declined rapidly. Existence of futures/derivatives market as well as wide use of derivatives in commodities to manage price risk would create conditions for the Government to consider dilution/withdrawal of Administered price mechanism.
III. PARTICIPANTS IN DERIVATIVES MARKETS
49. Who can be a member of the Exchange ?
The Bye-laws and Articles of the Association prescribed the criteria for being a member of the Exchange. Any person desirous of being a member of the Exchange may approach the contact persons whose names, telephone numbers, fax numbers, email addresses etc. are available on the website of fmc: < www.fmc.gov.in >. They may also refer to the Bye-law and Articles of Association of the concerned Exchange which contain various criteria for the membership of the Exchange.
50. Who are the participants in forward/futures markets?
Participants in forward/futures markets are hedgers, speculators, day-traders/scalpers, market makers, and, arbitrageurs.
51. Who is hedger?
Hedger is a user of the market, who enters into futures contract to manage the risk of adverse price fluctuation in respect of his existing or future asset.
52. What is arbitrage?
Arbitrage refers to the simultaneous purchase and sale in two markets so that the selling price is higher than the buying price by more than the transaction cost, so that the arbitrageur makes risk-less profit.
53. Who are day-traders?
Day traders are speculators who take positions in futures or options contracts and liquidate them prior to the close of the same trading day.
54. Who is floor-trader?
A floor trader is an Exchange member or employee, who executes trade by being personally present in the trading ring or pit floor trader has no place in electronic trading systems.
55. Who is speculator?
A trader, who trades or takes position without having exposure in the physical market, with the sole intention of earning profit is a speculator.
56. Who is market maker?
A market maker is a trader, who simultaneously quotes both bid and offer price for a same commodity throughout the trading session.
57. What kinds of risks do participants face in derivatives markets?
Different kinds of risks faced by participants in derivatives markets are:
• credit risk
• market risk
• liquidity risk
• legal risk
• operational risk
58. What is credit risk?
Credit risk on account of default by counter party: This is very low or almost zeros because the Exchange takes on the responsibility for the performance of contracts
59. What is market risk?
Market risk is the risk of loss on account of adverse movement of price.
60. What is liquidity risk?
Liquidity risks is the risk that unwinding of transactions may be difficult, if the market is illiquid
61. What is Legal risk?
Legal risk is that legal objections might be raised, regulatory framework might disallow some activities.
62. What is operational risk?
Operational risk is the risk arising out of some operational difficulties, like, failure of electricity, due to which it becomes difficult to operate in the market.
IV. EXCHANGES AND THEIR ROLE
63. How many recognized/registered associations engaged in commodity futures trading?
At present 21 Exchanges are recognized/registered for forward/ futures trading in commodities.
64. Why are associations required to get recognized?
Under the Forward Contracts (Regulation) Act, 1952, forward trading in commodities notified under section 15 of the Act can be conducted only on the Exchanges, which are granted recognition by the Central Government (Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution).
65. Which associations are recognized?
The list of the Exchanges and the commodities in which they are recognized is given at Annex-I.
66. Are the associations organizing forward trading required to get themselves registered?
All the Exchanges, which deal with forward contracts, are required to obtain certificate of Registration from the Forward Markets Commission.
67. What is the difference between Registered Associations and Recognized Associations?
All the associations concerned with regulation and control of business relating to forward contracts in goods, including recognized associations, are required to obtain Certificate of Registration from the Forward Markets Commission. Such business can be conducted only in accordance with the conditions of Certificate of Registration. All the Associations concerned with the regulation and control of business relating to forward contracts in commodities, which are notified u/sec. 15 of the Act have to obtain recognition from the Central Government. The associations organizing trading in commodities other than those notified under section 15, need not seek recognition; they merely have to obtain certificate of registration.
68. What is the procedure for obtaining recognition for an Association?
The application for grant of recognition will have to be made in triplicate in a prescribed form to Secretary, Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution, Krishi Bhavan, New Delhi – 110 00. Form A prescribed for application for the recognition is placed on the web site of the FMC www.fmc.gov.in .The application for grant of recognition should be forwarded through Forward Markets Commission, Everest, 3rd Floor, 100, Marine Drive, Mumbai – 400 002.. The Government may grant recognition to the applicant association on the basis of recommendations made by the Forward Markets Commission. A fee of Rs. 2500/- will have to be paid by the applicant association for grant of recognition. The fee could also be deposited in the nearest Government Treasurery or the nearest branch of State Bank of India; provided that at Mumbai, Kolkatta, Delhi, Kanpur and Chennai, the amount has to be deposited in the Reserve Bank of India. The fee can also be remitted by crossed Indian Postal Order drawn in favour of Secretary, Forward Markets Commission. The application has to be accompanied by 3 copies of Memorandum and Articles of Association and Byelaws.
69. What is the procedure for obtaining certificate of registration from the Forward Markets Commission?
Application in triplicate for grant of certificate of Registration in Form B - placed on the web site of the FMC < www.fmc.gov.in > - should be sent to Forward Markets Commission, Everest, 3rd Floor, 100, Marine Drive, Mumbai – 400 002. A fee of Rs. 50/- will have to be paid by the applicant association for grant of registration certificate. The fee could also be deposited in the nearest Government Treasurery or the nearest branch of State Bank of India; provided that at Mumbai, Kolkatta, Delhi, Kanpur and Chennai, the amount has to be deposited in the Reserve Bank of India. The fee can also be remitted by crossed Indian Postal Order drawn in favour of Secretary, Forward Markets Commission. The application has to be accompanied by 3 copies of Memorandum and Articles of Association and Byelaws.
70. What is “National” Commodity Exchange?
Government identified the best international systems and practices in respect of trading, clearing, settlement and governance structure and invited applications from associations – existing and potential – to set up National Commodity Exchanges by introducing such systems and practices. The term, "National" used for these Exchanges does not mean that other Exchanges are restricted from having nationwide operations.
71. How do National Commodity Exchanges differ from other Commodity Exchanges?
National Commodity Exchanges would be granted recognition in all permitted commodities; the other exchanges have to approach the Government for grant of recognition for each futures contract separately. Also, National Commodity Exchanges would be putting is place the best international practices in trading, clearing, settlement, and governance.
72. Which are the approved National Commodity Exchanges?
The Government of India identified four commodity exchanges – two existing and two at proposal stage for setting up of Nation-Wide Commodity Exchanges. One of these existing Exchanges, Online Commodity Exchange of India Ltd. – now renamed as National Multicommodity Exchange of India Ltd. - completed the preconditions for grant of national status, and was granted permanent recognition in all commodities, permitted from time to time. National Board of Trade, Indore is also an existing Exchange, recognised in Soya Complex, Mustard Complex and Palm Derivatives. Three Exchanges, including National Board of Trade, Indore, were given ten months' time to complete the preconditions. They are expected to be operational by October, 2003.
73. What is the role of an Exchange in futures trading?
An Exchange designs a contract, which alone would be traded on the Exchange. The contract is not capable of being modified by participants, i.e., it is standardized. The Exchange also provides a trading platform, which converges the bids and offers emanating from geographically dispersed locations. This creates competitive conditions for trading. The Exchange also provides facilities for clearing, settlement, arbitration facilities. The Exchange may also provide financially secure environment by putting in place suitable risk management mechanism (margining system etc.), and guaranteeing performance of contract through the process of novation.
74. Why does Exchange collect margin money?
The aim of margin money is to minimize the risk of default by either counter party. The amount of initial margin is so fixed as to ensure that the probability of loss on account of worst possible price fluctuation, which cannot be met by the amount of ordinary/initial margin is very low. The Exchanges fix rates of ordinary/initial margin keeping in view need to balance high security of contract and low cost of entering into contract.
75. What are the different types of margins payable on futures?
Different margins payable on futures contracts are:
Ordinary/initial margin, mark-to-market margin, special margin, volatility margin, and delivery margin.
76. What is initial/ordinary margin?
It is the amount to be deposited by the market participants in his margin account with clearing house before they can place order to buy or sell a futures contracts. This must be maintained throughout the time their position is open and is returnable at delivery, exercise, expiry or closing out.
77. What is Mark-to-Market margin?
Mark-to-market margins (MTM or M2M or valan) are payable based on closing prices at the end of each trading day. These margins will be paid by the buyer if the price declines and by the seller if the price rises. This margin is worked out on difference between the closing/clearing rate and the rate of the contract (if it is enterned into on that day) or the previous day's clearing rate. The Exchange collects these margins from buyers if the prices decline and pays to the sellers and vice versa.
78. Why is Mark-to-Market margin collected daily in commodity market?
Collecting mark-to-market margin on a daily basis reduces the possibility of accumulation of loss, particularly when futures price moves only in one direction. Hence the risk of default is reduced. Also, the participants are required to pay less upfront margin – which is normally collected to cover the maximum, say, 99.9%, of the potential risk during the period of mark-to-market, for a given limit on open position. Alternatively, for the given upfront margin the limit on open position would have to be reduced, which has the effect of restraining the trade and liquidity.
79. What is Volatility?
It is a measurement of the variability rate (but not the direction) of the change in price over a given time period. It is often expressed as a percentage and computed as the annualized standard deviation of percentage change in daily price.
80. What is a Client Account?
Client Account is an account maintained for any individual or entity being serviced by an agent (broker, members), for a commission. A customer's business must be segregated from the broker's/member's/principal's own business and clients' money should be kept in segregated accounts.
81. What is a client agreement?
It is a legal document entered into between the broker and the client setting out the conditions of their relationship and meeting the requirements of the relevant self-regulatory organization and the Regulator.
82. What is the ‘Trade Guarantee Fund'?
The main objectives of Trade Guarantee fund are (a) to guarantee settlement of bonafide transactions of the members of the Exchange (b) thereby, to inculcate confidence in the minds of market participants' (c) to protect the interest of the investors. All the members of the Exchange are required to make initial contribution towards trade guarantee fund of the Exchange.
83. What is the role of Clearing House?
Clearing House performs post trading functions like confirming trades, working out gains or losses made by the participants during the course of the clearing period – usually a day-collecting the losses from the members and paying out to other who have made gains.
84. What is novation?
Some Clearing Houses interpose between buyers and sellers as a legal counter party, i.e., the clearing house becomes buyer to every seller and vice versa. This obviates the need for ascertaining credit-worthiness of each counter party and the only credit risk that the participants face is the risk of clearing house committing a default. Clearing House puts in place a sound risk-management system to be able to discharge its role as a counter party to all participants.
85. How does an exchange ensure the guarantee of the performance of the contract ?
The performance of the contracts registered by the exchange are guaranteed either by the exchange or its clearing house. The exchange interposes itself between each buyer and seller thereby becoming a seller to every buyer and a buyer to every seller. The Exchange In order to safeguard its interest by imposing mark to market margin (which is clearing all the transactions at the closing price of the day. All the profits and losses are either paid in or paid out). This minimises the chances of default as buyer or seller is exposed to one day of price movements. The Exchange also maintains its own TGF / SGF which can be used in case of a default. The Exchange also puts in place a membership criteria and some of the new Exchanges have also prescribed certain minimum capital adequacy norms.
V. MEMBERSHIP OF EXCHANGES
86. Does a member / broker need to register with the Forward Markets Commission?
No; but the Forward Contracts (Regulation) Act, 1952 is proposed to be amended to provide for registration of brokers with the Forward Markets Commission.
87. At what rate does the Forward Markets Commission charge its fee on the turnover of the members/brokers?
Forward Market Commission does not charge any regulatory fee from the Exchanges or its members and users. It is an office of the Government of India and sources its finances from the budget.
88. Can a security broker obtain the membership of a Commodity Exchange?
The Forward Contracts (Regulation) Act, 1952 does not prohibit security broker from obtaining membership of a Commodity Exchanges. Certain restrictions are however, imposed on a security broker from participating in the Commodity Exchanges under Securities Contracts (Regulation) Rules, 1952. Notification is being/has been issued removing such a restriction. The security broker will however have to set up a subsidiary – a separate legal entity – with separate capital adequacy and minimum networth for being able to trade on a commodity exchange.
89. Can a member enter into the options in goods ?
Options in goods are presently prohibited under Section 19 of the Forward Contracts (Regulation) Act, 1952. No exchange or no person – whether he is a member of any recognized association or not - can organize or enter into or make or perform options in goods; it constitutes cognizable offence, which is punishable under section 20(e) of the Act.
90. What is the present system of regulation in commodity forward/future trading in India?
At present, there are three tiers of regulations of forward/futures
trading system exists in India, namely, Government of India, Forward
Markets Commission and Commodity Exchanges.
The FC(R) Act, 1952 prohibits options in commodities. For the purpose of forward contracts in certain commodities can be regulated by notifying those commodities u/s 15 of the Act; forward trading in certain other commodities can be prohibited by notifying these commodities u/s 17 of the Act.
91. What is the need for regulating futures market?
The need for regulation arises on account of the fact that the benefits of futures markets accrue in competitive conditions. The regulation is needed to create competitive conditions. In the absence of regulation, unscrupulous participants could use these leveraged contracts for manipulating prices. This could have undesirable influence on the spot prices, thereby affecting interests of society at large.. Regulation is also needed to ensure that the market has appropriate risk management system. In the absence of such a system, a major default could create a chain reaction. The resultant financial crisis in a futures market could create systematic risk. Regulation is also needed to ensure fairness and transparency in trading, clearing, settlement and management of the exchange so as to protect and promote the interest of various stakeholders, particularly non-member users of the market.
92. What is Forward Markets Commission and where is it located?
Forward Markets Commission is a regulatory body for commodity futures/
forward trade in India. This was set up under the Forward Contracts
(Regulation) Act of 1952. It is responsible for regulating and
promoting futures/ forward trade in commodities. The Forward Markets
Commission's Head Quarter is located at Mumbai and Regional Office at
Kolkata. The Address of the contact person is as follows :-
The Chairman, Forward Markets Commission, Ministry of Consumer Affairs, Food and Public Distribution, (Department of Consumer Affairs), Government of India, “Everest”, 3 rd floor, 100, Marine Drive, Mumbai – 400 002 . Tel : (022) 22811262/22811429, Fax : (022) 22812086, E-mail :- firstname.lastname@example.org , Web-site :- www.fmc.gov.in
93. What are the functions of the Forward Markets Commission ?
• FMC advises Central Government in respect of grant of recognition or withdrawal of recognition of any association.
• It keeps forward markets under observation and takes such action in relation to them as it may consider necessary, in exercise of powers assign to it.
• It collects and publishes information relating to trading conditions in respect of goods including information relating to demand, supply and prices and submit to the Government periodical reports on the operations of the Act and working of forward markets in commodities.
• It makes recommendations for improving the organization and working of forward markets.
• It undertakes inspection of books of accounts and other documents of recognized/registered associations.
94. What are the powers of the Commission?
The Commission has powers of deemed civil court for (a) Summoning and
enforcing the attendance of any person and examining him on oath; (b)
Requiring the discovery and production of any document; (c) Receiving
evidence on affidavits, and (d) Requisitioning any public record or
copy thereof from any office.
The following powers are vested in the Central Government, most of which are delegated to the Commission:
The powers of approving memorandum and articles of association and Bye-laws; powers to direct to make or to make articles (Rules) or Bye-laws; powers to suspend governing body of recognised association, and, powers to suspend business of recognised association.
95. Why and what are the regulatory measures prescribed by Forward Markets Commission?
Forward Markets Commission provides regulatory oversight in order to
ensure financial integrity (i.e. to prevent systematic risk of default
by one major operator or group of operators), market integrity (i.e. to
ensure that futures prices are truly aligned with the prospective
demand and supply conditions) and to protect & promote interest of
The Forward Markets Commission prescribes following regulatory measures:
(a) Limit on net open position as on the close of the trading hours. Some times limit is also imposed on intra-day net open position. The limit is imposed operator-wise, and in some cases, also member-wise.
(b) Circuit-filters or limit on price fluctuations to allow cooling of market in the event of abrupt upswing or downswing in prices.
(c) Special margin deposit to be collected on outstanding purchases or sales when price moves up or down sharply above or below the previous day closing price. By making further purchases/sales relatively costly, the price rise or fall is sobered down. This measure is imposed only on the request of the Exchange.
(d) Circuit breakers or minimum/maximum prices: These are prescribed to prevent futures prices from falling below as rising above not warranted by prospective supply and demand factors. This measure is also imposed on the request of the Exchanges.
• Skipping trading in certain derivatives of the contract, closing the market for a specified period and even closing out the contract: These extreme measures are taken only in emergency situations.
96. What are the legal and regulatory provisions for customer protection?
The F.C(R) Act provides that client's position cannot be appropriated by the member of the Exchange, except a written consent is taken within three days' time. Forward Markets Commission is persuading increasing number of Exchanges to switch over to electronic trading, clearing and settlement, which is more customer-friendly. Commission has also prescribed simultaneous reporting system for the Exchanges following open out-cry system. These steps facilitate audit trail and make it difficult for the members to indulge in malpractices like, trading ahead of clients, etc. The Commission has also mandated all the Exchanges following open outcry system to display at a prominent place in Exchange premises, the name, address, telephone number of the officer of the Commission who can be contacted for any grievance. The website of the Commission also has a provision for the customers to make complaint, send comments and suggestions to the Commission. Officers of the Commission have been instructed to meet the members and clients on a random basis, whenever they visit Exchanges, to ascertain the situation on the ground, instead of merely attending meetings of the Board of Directors and holding discussions with the office-bearers.
VII. ILLEGAL DERIVATIVE TRADING
97. What is FMC doing to curb illegal forward trading ?
Under the Forward Contracts (Regulation) Act, 1952 most of the
contravention of the provisions of the Act constitutes cognizable
offences. The powers of search, seizure and investigation are therefore
with the State Police Authorities. The role of Forward Markets
Commission is confined to communication of information relating to
offences under the Act to the police authorities and assist such
authorities in scrutinising documents referred to by them in rendering
such expert advice as may be required by them (Please see Rule 13 of
the Forward Contracts (Regulation) Rules, 1954).
Since the offences under the Act are technical in nature and it is difficult to prove the charges in accordance with the rules of evidence contained in the Evidence Act, beyond any reasonable doubt, the Forward Markets Commission periodically conducts training progammes, Seminars, Workshops etc. for the benefit of Police Officers/ Prosecutors and also Judicial Magistrates First Class/Metropolitan Magistrates. The officers of the Commission also accompany the police in conducting searches to assist in sifting incriminating documents. Commission also exhorts the office bearers and the members of the recognized exchanges to share information in respect of illegal forward trading.
98. What types of contracts are illegal?
The following contracts are illegal.
• Forward Contracts in the permitted commodities, i.e., commodities notified under S.15 of the Forward Contracts (Regulation) Act, 1952, which are entered into other than: a) between the members of the recognised Association or b) through or c)with any such members.
• Forward contracts in prohibited commodities, i.e., commodities notified under S. 17 of the Forward Contracts (Regulation) Act, 1952 (Presently no commodity has been notified under S. 17 of the Act.
• Forward Contracts in contravention of the provisions contained in the Bye-laws of the Exchange, which attract S. 15(3) of the Act.
• Forward Contracts in the commodities in which such contracts have been prohibited.Options in goods.
99. Who can be arrested and prosecuted under the Forward Contracts (Regulation) Act? For what offences?
The following persons attract penal provisions under the F.C.(R) Act, 1952:
• Owner or tenant of a place which is used, with the knowledge of such owner and tenant, for entering into or making or performing, whether wholly or in part, illegal forward contracts;
• A person who, without permission of the Central Government, organizes or assists in organizing or becomes a member of any association other than recognized association for the purpose of assisting in, entering into, or making, or, performing; whether wholly or in part, in illegal forward contract;
• Any person who controls, manages, or assists in keeping any place, other than recognized association for entering into, or making, or performing illegal forward contract, or for clearing or settlement of such contracts;
• Any person who willfully misrepresents or induces any person to believe that he is a member of a recognized association or that forward contract can be entered into or made or performed, whether wholly or in part through him.
• Any person who is not a member of a recognized association canvasses, advertises or touts in any business connected with forward contracts in contravention of the Forward Contracts (Regulation) Act, 1952.
• Any person who joins, gathers, or assists in gathering at any place other than the place of business specified in the bye-laws of the recognized associations for making bids or offers or for entering into illegal forward contracts.
• Any person who makes publishes or circulates any statement or information, which is false and which he either knows, or believes to be false, affecting or tending to affect the course of business in forward contracts in permitted commodities.
• Any person who manipulates or attempts to manipulate prices of forward contracts in permitted commodities are liable for punishment under the Act on conviction.
100. What is bucketing?
Broker is said to be indulging in bucketing, when he takes directly or indirectly, the opposite side of a customer's order either on his own account or into on account in which he or she has an interest, without executing the order on an Exchange. Appropriation of clients' trade without written consent constitutes contravention of S. 15(4) of the Act and is punishable under S. 20(e).
101. What is Options in goods?
Options in goods is an agreement by whatever name called, like, Teji-Mandi, Jota Fatak, Najrana, 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. When the buyer acquires right to buy, it is called as a “call” (Teji) and when he acquires right to sell it is called a “put” (Mandi) option. It is possible to acquire a 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 in goods are presently prohibited under section 19 of the Act. There is a proposal to amend the Act to allow options in goods under regulated conditions.