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E - TRADING

Dr. Yogesh Singh

Agri. Business Manager

Haryana State Agricultural Marketing Board

Electronic trading, sometimes called e-trading, is a method of trading securities (such

as stocks, and bonds), foreign exchange, financial, & commodity derivatives electronically.

Information technology is used to bring together buyers and sellers through electronic trading

platform and networks to create a virtual market places such as MCX, NCDEX etc. which are

also known as electronic communications networks or ECNs.

Derivatives

A derivative is a product whose value is derived from the value of one or more

underlying variables or assets in a contractual manner. The underlying asset can be equity,

forex, commodity or any other asset.

The origin of derivatives can be traced back to the need of farmers to protect

themselves against fluctuations in the price of their crop. From the time it was sown to the

time it was ready for harvest, farmers would face price uncertainty. Through the use of simple

derivative products, it was possible for the farmer to partially or fully transfer price risks by

locking-in asset prices. These were simple contracts developed to meet the needs of farmers

and were basically a means of reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he would

receive for his harvest in September. In years of scarcity, he would probably obtain attractive

prices. However, during times of oversupply, he would have to dispose off his harvest at a

very low price. Clearly this meant that the farmer and his family were exposed to a high risk

of price uncertainty.

On the other hand, a merchant with an ongoing requirement of grains too would face a

price risk - that of having to pay exorbitant prices during dearth, although favourable prices

could be obtained during periods of oversupply. Under such circumstances, it clearly made

sense for the farmer and the merchant to come together and enter into a contract whereby the

price of the grain to be delivered in September could be decided earlier. What they would

then negotiate happened to be a futures-type contract, which would enable both parties to

eliminate the price risk.

In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and

merchants together. A group of traders got together and created the 'to-arrive' contract that

permitted farmers to lock in to price upfront and deliver the grain later. These to-arrive

contracts proved useful as a device for hedging and speculation on price changes. These were

eventually standardised, and in 1925 the first futures clearing house came into existence.

Today, derivative contracts exist on a variety of commodities such as corn, pepper,

cotton, wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of

financial underlyings like stocks, interest rate, exchange rate, etc.

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Evolution of Futures Trading and its Present Status

Organized futures market evolved in India by the setting up of "Bombay Cotton Trade

Association Ltd." in 1875. In 1893, following widespread discontent amongst leading cotton

mill owners and merchants over the functioning of the Bombay Cotton Trade Association, a

separate association by the name "Bombay Cotton Exchange Ltd." was constituted. Futures

trading in oilseeds was organized in India for the first time with the setting up of Gujarati

Vyapari Mandali in 1900, which carried on futures trading in groundnut , castor seed and

cotton. Before the Second World War broke out in 1939 several futures markets in oilseeds

were functioning in Gujarat and Punjab.

Futures trading in Raw Jute and Jute Goods began in Calcutta with the establishment

of the Calcutta Hessian Exchange Ltd., in 1919. Later East Indian Jute Association Ltd.,was

set up in 1927 for organizing futures trading in Raw Jute. These two associations

amalgamated in 1945 to form the present East India Jute & Hessian Ltd., to conduct

organized trading in both Raw Jute and Jute goods. In case of wheat, futures markets were in

existence at several centres at Punjab and U.P. The most notable amongst them was the

Chamber of Commerce at Hapur, which was established in 1913. Other markets were

located at Amritsar, Moga, Ludhiana, Jalandhar, Fazilka, Dhuri, Barnala and Bhatinda in

Punjab and Muzaffarnagar, Chandausi, Meerut, Saharanpur, Hathras, Gaziabad, Sikenderabad

and Barielly in U.P.

Futures market in Bullion began at Mumbai in 1920 and later similar markets came up

at Rajkot , Jaipur , Jamnagar , Kanpur, Delhi and Calcutta. In due course several other

exchanges were also created in the country to trade in such diverse commodities as pepper,

turmeric, potato, sugar and gur(jaggory).

After independence, the Constitution of India brought the subject of "Stock Exchanges

and futures markets" in the Union list. As a result, the responsibility for regulation of

commodity futures markets devolved on Govt. of India. A Bill on forward contracts was

referred to an expert committee headed by Prof. A.D.Shroff and Select Committees of two

successive Parliaments and finally in December 1952 Forward Contracts (Regulation) Act,

1952, was enacted. The Act provided for 3-tier regulatory system;

(a) An association recognized by the Government of India on the recommendation of Forward Markets Commission,

(b) The Forward Markets Commission (it was set up in September 1953) and

(c) The Central Government.

Forward Contracts (Regulation) Rules were notified by the Central Government in

July,1954 The Act divides the commodities into 3 categories with reference to extent of

regulation, viz:

(a) The commodities in which futures trading can be organized under the auspices of recognized association.

(b) The Commodities in which futures trading is prohibited. (c) Those commodities which have neither been regulated for being traded under the

recognized association nor prohibited are referred as Free Commodities and the

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association organized in such free commodities is required to obtain the Certificate of

Registration from the Forward Markets Commission.

In the seventies, most of the registered associations became inactive, as futures as well

as forward trading in the commodities for which they were registered came to be either

suspended or prohibited altogether.

The Khusro Committee (June 1980) had recommended reintroduction of futures

trading in most of the major commodities , including cotton, kapas, raw jute and jute goods

and suggested that steps may be taken for introducing futures trading in commodities, like

potatoes, onions, etc. at appropriate time. The government, accordingly initiated futures

trading in Potato during the latter half of 1980 in quite a few markets in Punjab and Uttar

Pradesh.

After the introduction of economic reforms since June 1991 and the consequent

gradual trade and industry liberalization in both the domestic and external sectors, the Govt.

of India appointed in June 1993 one more committee on Forward Markets under

Chairmanship of Prof. K.N. Kabra. The Committee submitted its report in September 1994.

The majority report of the Committee recommended that futures trading be introduced in

1) Basmati Rice

2) Cotton and Kapas

3) Raw Jute and Jute Goods

4) Groundnut , rapeseed/mustard seed , cottonseed , sesame seed , sunflower seed , safflower

seed , copra and soybean , and oils and oilcakes of all of them.

5) Rice bran oil

6) Castor oil and its oilcake

7) Linseed

8) Silver and

9) Onions.

The committee also recommended that some of the existing commodity exchanges

particularly the ones in pepper and castor seed, may be upgraded to the level of international

futures markets.

The liberalised policy being followed by the Government of India and the gradual

withdrawal of the procurement and distribution channel necessitated setting in place a market

mechanism to perform the economic functions of price discovery and risk management.

The National Agriculture Policy announced in July 2000 and the announcements of

Hon'ble Finance Minister in the Budget Speech for 2002-2003 were indicative of the

Governments resolve to put in place a mechanism of futures trade/market. As a follow up the

Government issued notifications on 1.4.2003 permitting futures trading in the commodities,

with the issue of these notifications futures trading is not prohibited in any commodity.

Options trading in commodity is, however presently prohibited. Futures contracts in Wheat

and Rice have been discontinued from 01.03 2007. Futures trade in Urad and Tur have been

banned from 23.01.2007.

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Structure of Indian Commodity Exchanges

Forward Markets Commission (FMC) headquartered at Mumbai, is a regulatory

authority which is overseen by the Ministry of Consumer Affairs, Food and Public

Distribution, Govt. of India. It is a statutory body set up in 1953 under the Forward

Contracts (Regulation) Act, 1952.

The functions of the Forward Markets Commission are as follows:

(a) To advise the Central Government in respect of the recognition or the withdrawal of recognition from any association or in respect of any other matter arising out of the

administration of the Forward Contracts (Regulation) Act 1952.

(b) To keep forward markets under observation and to take such action in relation to them, as it may consider necessary, in exercise of the powers assigned to it by or under the Act.

(c) To collect and whenever the Commission thinks it necessary, to publish information regarding the trading conditions in respect of goods to which any of the provisions of the

act is made applicable, including information regarding supply, demand and prices, and to

submit to the Central Government, periodical reports on the working of forward markets

relating to such goods;

(d) To make recommendations generally with a view to improving the organization and working of forward markets;

(e) To undertake the inspection of the accounts and other documents of any recognized association or registered association or any member of such association whenever it

considerers it necessary.

Commodity Exchanges A commodity exchange is a market where multiple buyers and sellers trade

commodity-linked contracts on the basis of terms and conditions laid down by the exchange.

Commodity Exchanges are the formal platform for trading, clearing & settlement,

warehousing and information dissemination for efficient price discovery mechanism for the

futures market.

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National Commodity Exchanges 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.

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.

Major Indian Commodity Exchanges

National Exchanges National Commodity & Derivative Exchange (NCDEX)

Multi Commodity Exchange (MCX)

National Multi Commodity Exchange of India Ltd. (NMCE)

Indian Commodity Exchange (ICEX)

Ace Commodity & Derivatives Exchange

Regional Exchanges Some of the regional exchanges are:

National Board of Trade (NBOT), Indore

The East India Jute & Hessian Exchange, Kolkata

The Chamber of Commerce, Hapur

First Commodity Exchange of India Ltd., Kochi

Bikaner Commodity Exchange Ltd., Bikaner

Bombay Commodity Exchange Ltd., Vashi

Central India Commercial Exchange Ltd., Gwalior

Cotton Association of India, Mumbai

India Pepper & Spice Trade Association., Kochi

Meerut Agro Commodities Exchange Co. Ltd., Meerut

Rajkot Commodity Exchange Ltd., Rajkot

Rajdhani Oils and Oilseeds Exchange Ltd., Delhi

Surendranagar Cotton oil & Oilseeds Association Ltd., Surendranagar

Spices and Oilseeds Exchange Ltd. Sangli

Role of commodity exchanges

a) Providing platform for trade b) Efficient price discovery c) Development of contract specifications d) Fixation of quality specification of commodities e) Price dissemination to ensure that farmers can view them f) Provision of delivery platform g) Warehousing logistics h) Quality assurance

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Market Participants

Participants who trade in the commodity and derivatives market can be classified under

the following three broad categories - hedgers, speculators, and arbitragers.

1. Hedgers: The farmer’s example that we discussed about was a case of hedging. Hedgers

face risk associated with the price of an asset. They use the futures or options markets to

reduce or eliminate this risk.

2. Speculators: Speculators are participants who wish to bet on future movements in the

price of an asset. Futures and options contracts can give them leverage; that is, by putting

in small amounts of money upfront, they can take large positions on the market. As a

result of this leveraged speculative position, they increase the potential for large gains as

well as large losses.

3. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy

between prices of the same product across different markets. If, for example, they see the

futures price of an asset getting out of line with the cash price, they would take offsetting

positions in the two markets to lock in the profit.

Commodity Transactions

Every transaction has three components - trading, clearing and settlement. A buyer

and seller come together, negotiate and arrive at a price. This is trading. Clearing involves

finding out the net outstanding, that is exactly how much of goods and money the two should

exchange. For instance A buys goods worth Rs.100 from B and sells goods worth Rs.50 to B.

On a net basis A has to pay Rs.50 to B. Settlement is the actual process of exchanging money

and goods.

Spot transaction: In a spot transaction, trading, clearing and settlement happens

instantaneously.

Forwards: A forward contract is an agreement between two entities to buy or sell the

underlying asset at a future date, at today's pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell the underlying

asset at a future date at today's future price. Futures contracts differ from forward contracts in

the sense that they are standardised and exchange traded.

Options: There are two types of options - calls and puts. Calls give the buyer the right but not

the obligation to buy a given quantity of the underlying asset, at a given price on or before a

given future date. Puts give the buyer the right, but not the obligation to sell a given quantity

of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of upto one year, the majority of options traded on

options exchanges having a maximum maturity of nine months. Longer-dated options are

called warrants and are generally traded over-the-counter.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset

is usually a weighted average of a basket of assets. Equity index options are a form of basket

options.

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Swaps: Swaps are private agreements between two parties to exchange cash flows in the

future according to a prearranged formula. They can be regarded as portfolios of forward

contracts. The two commonly used swaps are :

• Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.

• Currency swaps: These entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite

direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the

expiry of the options. Thus a swaption is an option on a forward swap.

Commodity Markets: Commodity Futures Why Commodity Futures Markets?

• Economic Liberalization

• WTO led Open Market Access

• Quality Standardization & Food Safety Issues

• Information Flow of Market Forces

• Farmers Concerns- demand supply mismatch led price fluctuations

• Deciding about the future- Planning in advance with known information

Characteristics of Spot, Forward and Futures markets

Market

Characteristics

Spot Forward Future

Trade Platform Over the Counter Over the Counter Exchange Platform

Price

Determination

Negotiated and

determined privately

Negotiated and

determined privately

Prices are market

determined and are

publicly available

Goods Delivery On the spot or up to

the 11 days of price

fixation

On a fixed date as

agreed by buyer and

seller

At the specified contract

maturity date

Sales

Specification

Customised

specifications

Customised

specifications

Standardized

Payment Immediate payment or

up to 11 days

On a specified date

i.e. on the date of

maturity

Required initial deposits

(margin), remaining

payment at the end of

maturity period.

Default Risk Liable to default by

either party

Risk depends on the

reliability of the

other party

Defaults are prevented by

clearing house through

initial margin and margin

calls penalties

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Major Commodities Traded

Exchange Commodities traded

NCDEX Chilli, chana, guar gum, guar seeds, gur, jeera, mustard seed, pepper,

soyabean, refined soya oil, crude oil, gold, silver, long steel, etc.

MCX Gold, silver, copper, lead, nickel, zinc, crude oil, natural gas, furnace oil,

mentha oil, kapas, raw jute, cashew kernels, maize, cardamom, jeera,

pepper, etc.

NMCE Gur, crude palm oil, mustard seed, soybean, copra, pepper, guarseed, gram,

nickel, copper, zinc, lead, etc.

ICEX Gold, Silver, Crude oil, Copper, Guar seed and Refined Soy oil.

ACE Chana, Soybean, Refined soy oil, Castor seed, Mustard seed

NBOT Refined Soy Oil, Soybean

NCDEX – Products

Guar Seed

& Guar Gum

Others

Bullion

Metal

Energy

Oil

& Oil Seed

Pulses

Spices

NCDEX

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Commodity Markets

• World over commodity markets are larger than stock markets.

• In India too, commodity futures markets are growing despite the prohibitions that had

been imposed on them.

• In the commodity futures market, the period after the set up of national level

exchanges witnessed exponential growth in trading. The turnover increased from 5.71

lakh crores in 2004-05 to 119.48 lakh crores in 2010-11.

• Commodities of different segments traded on commodity exchanges- Agri, metals,

energy etc.

Futures Trade in Commodities

Rs. Crore 2009-10 2010-11 Growth (%)

Total Value of Trade 77,64,754.05 119,48,942.35 53.89

Trade in Agri Commodities 12,17,949.04 14,56,389.62 19.58

Trade in Bullion 31,64,152.24 54,93,892.12 73.63

Trade in Metals other than Bullion 18,01,636.31 26,87,672.99 49.18

Trade in Energy 15,77,882.06 23,10,958.58 46.46

Trade in other commodities 3,134.40 29.04 -99.07

Critical components of a Commodity Futures Contract

• Commodity Specification – Contract Month

• Trading Unit , Additional Quotation

• Margins – Initial, Special, and Additional

• Price Quote (Basis), Tick Size, Price Circuit

• Maximum allowable open position

• Delivery – Center, Quality, Logic (sellers/buyers/both)

• Penal Provisions

Role of Futures Market

• Risk mitigation

– Risk transfer platform from actual users to traders/ speculators – Helps hedger concentrate on core activity i.e. production

• Price discovery

– Long term price signals helps farmers to decide cropping pattern based on future prices

• Improves bargaining power of stakeholders

• Warehousing and pledge loan

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Economic Benefits of Futures Trading

1. Price stabilization in times of violent price fluctuations: this mechanism dampens the peaks and lifts up the valleys i.e., the amplitude of price variation is reduced.

2. Leads to integrated price structure throughout the country 3. Facilitates lengthy and complex, production and manufacturing activities 4. Helps balance in supply and demand position throughout the year 5. Encourages competition and acts as a barometer to farmers and other trade

functionaries

There are, broadly, two types of trading in the markets:

• Business-to-business (B2B) trading, often conducted on exchanges, where large

investment banks and brokers trade directly with one another

• Business-to-consumer (B2C) trading, where retail (e.g. individuals buying and selling)

and institutional clients buy and sell from brokers or "dealers", who act as middle-men

between the clients and the B2B markets.

Role of an Exchange

• Anonymous auction platform

– Confluence of demand and supply: Price Discovery • Transparent real time, Pan geographic price Dissemination

– Benchmark reference price – Liquidity to participants

• Risk Management in a volatile market

– Robust Clearing & Settlement systems - counter party credit risk absorbed – Fair, Safe, orderly market - rigorous financial standards and surveillance

procedures

Trading on Exchange Platforms

• Standardized specifications - contract structure

• Standard delivery lots or multiples

• Standard settlement dates

• Standard margining system

Trading Structure

Customer – Member - Exchange

To start trading in commodity futures you will need only one bank account. You will need

a separate commodity demat account from the National Securities Depository Ltd to trade on

the NCDEX just like in stocks. You will have to enter into a normal account agreements with

the broker. These include the procedure of the Know Your Client format that exist in equity

trading and terms of conditions of the exchanges and broker. Besides you will need to give

you details such as PAN no., bank account no, etc.

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Brokerage and transaction charges- The brokerage charges range from 0.10-0.25 per cent

of the contract value. Transaction charges range between Rs 6 and Rs 10 per lakh/per

contract. The brokerage will be different for different commodities. It will also differ based on

trading transactions and delivery transactions. In case of a contract resulting in delivery, the

brokerage can be 0.25 - 1 per cent of the contract value. The brokerage cannot exceed the

maximum limit specified by the exchanges

Types of Members

Membership: Membership of is open to any persons, association of persons, partnership,

cooperative societies, companies etc that fulfills the eligibility criteria set by the exchange.

(FIs. NRIs, Banks, MFs etc are not allowed to participate in Commodity exchanges at the

moment).

1.Trading cum Clearing Member (TCM) : Members can carry out the

transactions.(Trading , settling , and clearing) on their own account and also on their clients’

accounts

2.Professional clearing members (PCM): Members can carry out the settlement and

clearing for their clients who have traded through TCMs or traded as TMs.

3.Trading member ( TM ): Member who can only trade through their account or on account

of their clients and will however clear their trade through PCMs/STCMs.

4.Strategic Trading cum Clearing Member (STCM): This is up gradation from the TCM

to STCM. Such member can trade on their own account, also on account of their clients. They

can clear and settle these trades and also clear and settle trades of other trading members who

are only allowed to trade and are not allowed to settle and clear.

Several already-established equity brokers have sought membership with NCDEX and

MCX. Tlikes of Refco Sify Securities, SSKI (Sharekhan) and ICICIcommtrade (ICICIdirect),

ISJ Comdesk (ISJ Securities) and Sunidhi Consultancy are already offering commodity

futures services. Some of them also offer trading through Internet just like the way they offer

equities

Electronic Trading Process Flow

• Customers may directly enter orders into the terminal or phone or through a broker

• Electronic order-matching systems, the host computer matches bids with offers as per

rules that determine an order’s priority

• Priority rules on most systems include price and time of entry

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Order and execution flows in electronic futures trade

E-trading systems are typically proprietary software (etrading platforms or electronic trading

platforms), Exchanges typically develop their own systems (sometimes referred to as

matching engines),

Trade Confirmation

• A trade confirmation is sent out by the host computer to the respective terminals of the

members

• Member shall issue contract notes to their constituents for trades executed in

prescribed format with all relevant details filled in within 24 hours from the close of

trading hours when the trade is executed

Clearing

• Clearing mechanism essentially involves working out open positions & obligations of

clearing members

• Clearing house guarantees the faithful compliance of trade commitments.

• Open position are arrived at by summation of proprietary open position & clients’

open position.

• TCM and PCM are responsible for clearing and settlement of futures contract traded

on NCDEX

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Settlements

Final Settlement

All contracts materializing into deliveries are settled in a period as notified by the

Exchange separately for each contract. The exact settlement date for each commodity is

specified by the Exchange through circulars known as “Settlement Calendar, all open

positions on expiry results into delivery settlement.

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Farmer’s Involvement

Benefit to Farmers

Farmers Concerns

& Futures Prices

as an Indicator

Pre-Harvest Concerns

• What to grow?

• How much to Grow?

Post-Harvest Concerns

• When to sale the produce

• Whether to sale immediately

• or store for sale in future

• How to meet cash requirement

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Electronic platform electronically connecting farmers and consumers could go a long

way in eliminating intermediaries and taming inflation. This would ensure higher farm gate

prices and lower consumer prices

These spot exchanges enable farmers to participate on their platforms for sale of agri

produce in lots as small as 10 quintals. They ensure farmers get best prices from across the

mandis/processors/retail players in the country. The Government should look at providing

enough support to these institutions to scale up rapidly and operate in every district. One can

look forward to a rapid deceleration in food inflation if such spot exchanges are, in turn,

connected to producer companies. The institutional innovations suggested would resolve

issues related to higher inflation and efficient distribution of perishables and also ensure

higher incomes for farmers.

Electronic Trading

• The driving factors are speed, efficiency and reduced cost of transactions

• Electronic trading systems enable remote investors to make transactions in real time

• Electronic trading is an automated trade execution system with three key components.

– Computer terminals, where customer orders are keyed in and trade confirmations received

– A host computer that processes trade – A network that links the terminals to the host computer

The increase of e-Trading has had some important implications:

• Electronic trading makes transactions easier to complete, monitor, clear, and settle

• Reduced cost of transactions - By automating as much of the process as possible (often

referred to as "straight-through processing" or STP), costs are brought down. The goal is

to reduce the incremental cost of trades as close to zero as possible, so that increased

trading volumes don't lead to significantly increased costs. This has translated to lower

costs for investors.

• Greater liquidity - electronic systems make it easier to allow different companies to

trade with one another, no matter where they are located. This leads to greater liquidity

(i.e. there are more buyers and sellers) which increases the efficiency of the markets.

• Greater competition - While e trading hasn't necessarily lowered the cost of entry to

the financial services industry, it has removed barriers within the industry and had a

globalisation-style competition effect. For example, a trader can trade at the click of a

button - he or she doesn't need to go through a broker or pass orders to a trader on the

exchange floor.

• Increased transparency – E trading has meant that the markets are less opaque. It's

easier to find out the price of securities when that information is flowing around the world

electronically.