The market in Commodity futures started in India long before the coming of other forms of derivative trading. In India, active futures markets exist in tea, cotton, pepper, coffee, castor oil. Most of the participants in the market are commercial and institutional users of the commodities they trade. For instance, a firm or individual who holds an asset such as coffee, corn, Soya beans, pepper, tea, a portfolio of stock, etc. would like the price of the asset to rise while wanting to limit any possible loss in value if possible. The company or individual may use the commodity market to take an opposite position which can minimize the risk of financial loss from holding those assets as and when the price of that commodity/asset you hold changes. This is referred to as "hedging". These type of traders are called hedgers.

Futures and forward contracts are contracts to buy commodities, such as livestock, agricultural products and precious metals. They usually attract two different types of investors -- "hedgers" and "speculator," according to "The Investing Kit" (Dearborn Financial Publishing, Inc., Chicago). Hedgers want to minimize their risk of price changes for the products they produce or harvest, such as gas, oil, cattle, coffee, corn, cotton, hogs, orange juice, sugar and wheat. Some hedgers are portfolio managers who want to minimize risk by hedging their bond or stock portfolios. World currencies are used as a hedge against dollar fluctuations. Speculators, on the other hand, trade futures and forward markets in an attempt to profit from price movements. A futures market can't really exist unless someone wants to hedge a risk.

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.

Forward markets worldwide are affected by several problems:

1. lack of centralisation of trading,

2. illiquidity, and

3. counterparty risk.

In the first two of these, the basic problem is that of too much exibility and generality. The forward market is like the real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradeable. Also the "phone market" here is unlike the centralisation of price discovery that is obtained on an exchange.

Counterparty risk in forward markets is a simple idea:

• when one of the two sides of the transaction chooses to declare bankruptcy, the other suffers.

• Forward markets have one basic property: the larger the time period over which the forward contract is open, the larger are the potential price movements, and hence the larger is the counter-party risk.

• Even when forward markets trade standardised contracts, and hence avoid the problem of illiquidity, the counterparty risk remains a very real problem. A classic example of this was the famous failure on the Tin forward market at LME.

Futures markets were designed to solve all the three problems of forward markets. Futures markets are exactly like forward markets in terms of basic economics. However, contracts are standardised and trading is centralised, so that futures markets are highly liquid. There is no counterparty risk (thanks to the institution of a clearinghouse which becomes counterparty to both sides of each transaction and guarantees the trade). In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counter- party risk.

• Organized futures market evolved in India by the setting up of "Bombay Cotton Trade Association Ltd." in 1875. In 1983, a separate association called "The Bombay Cotton Exchange Ltd." was constituted.

• Futures trading in oilseeds was started with the setting up of Gujarati Vyapari Mandali in 1900. A second exchange, the Seeds Traders' Association Ltd., trading oilseeds such as castor and groundnuts, was set up in 1926 in Mumbai. Then, many other exchanges trading in jute, pepper, turmeric, potatoes, sugar, and silver, followed.

• Futures market in bullion began at Mumbai, in 1920.

• But, in the 1940s, trading in forwards and futures was made difficult through price controls till 1952 when the government passed the Forward Contract Regulation Act, which controls all transferable forward contracts and futures.

• During the 1960s and 70s, the Central Government suspended trading in several commodities like cotton, jute, edible oilseeds, etc. as it felt that these markets helped increase prices for commodities

• Two committees that were appointed - Datwala Committee in 1966, and Khusro Committee in 1980, recommended the reintroduction of futures trading in major commodities, but without much result.

• One more committee on Forwards market, the Kabra Committee was appointed in 1993, which recommended futures trading in wide range of commodities and also upgradation of futures market. Accepting partially the recommendations, Government permitted futures trading in many of the commodities.

Achieving hedging efficiency is the main reason to opt for futures contracts. For instance, in September 2000, India had to pay $32 per barrel more for importing oil than what they had to pay a week ago. The utility of a futures contract for hedging or risk management presupposes parallel or near-parallel relationship between the spot and futures prices over time. In other words, the efficiency of a futures contract for hedging essentially envisages that the prices in the physical and futures markets move in close unison not only in the same direction, but also by almost the same magnitude, so that losses in one market are offset by gains in the other. Of course, such a price relationship between the spot and futures markets is subject to the amount of carrying or storage costs till the maturity month of the futures contract. Theoretically (and ideally), in a perfectly competitive market with surplus supplies and abundant stocks round the year, the futures price will exceed the spot price by the cost of storage till the maturity of the futures contract. But such storage cost declines as the contract approaches maturity, thereby reducing the premium or contango commanded by the futures contract over the spot delivery over its life and eventually becomes zero during the delivery month when the spot and futures prices virtually converge. The efficiency of a futures contract for hedging depends on the prevalence of such an ideal price relationship between the spot and futures markets.

commodity futures were introduced in 1998 in India. Coffee, cotton, oilseeds, tea, rubber, wheat, spices, edible oils, crude and petroleum products; agricultural commodities like rice, bajra, etc. are some of the commodities traded in the commodities exchanges.

The basic difference between commodity and financial Futures is the nature of the underlying instrument. In a commodity Futures, the underlying is a commodity which may be Wheat, Cotton, Pepper, Turmeric, corn, oats, soybeans, orange juice, crude oil, natural gas, gold, silver, pork-bellies etc. In a financial instrument, the underlying can be Treasuries, Bonds, Stocks, Stock-Index, Foreign Exchange, Euro-dollar deposits etc. As is evident, a financial Future is fairly standard and there are no quality issues while a commodity instrument, quality of the underlying matters.

Forward Markets Commission (FMC) headquartered at Mumbai is a regulatory authority which is overseen by the Ministry of Consumer Affairs and Public Distribution, Govt. of India. It is a statutory body set up in 1953 under the Forward Contracts (Regulation) Act, 1952. The Act Provides that the Commission shall consist of not less then two but not exceeding four members appointed by the Central Government out of them being nominated by the Central Government to be the Chairman thereof.

The functions of the Forward Markets Commission are as follows:

1. 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.

2. 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.

3. 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;

4. To make recommendations generally with a view to improving the organization and working of forward markets;

5. 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 considers it necessary.

Presently futures trading is permitted in all the commodities . Trading is taking place in about 50 commodities through 22 Exchanges/Associations located at different parts of the country. After assessing the market situation and taking into account the recommendations made by the Board of Directors of the Exchange, the FMC prescribes various regulatory measures from time to time, for prudential regulation of futures/forward trading. Govt. has recently removed prohibition on further 81 more items, thereby removing prohibition on all commodities. Similarly NTSD Contracts in commodities are also taken out of the purview of FC(R) Act.

In order to prevent excess speculation, certain regulatory measures were introduced:

• Limit on the open position of an individual to prevent over trading.

• Limit on the price fluctuation to prevent abrupt upswing or downswing in prices.

• Special margin deposits on outstanding purchases or sales to curb excessive speculative activity through financial restraints.

• Minimum/maximum prices prescribed to keep the future prices within a band.

[Source: ACTM Research Center- Website of ACTM - http://www.actmindia.org/pages/drhedge2.pdf]

With the gradual withdrawal of the government from various sectors in the post-liberalization era, the need has been felt that various operators in the commodities market be provided with a mechanism to hedge and transfer their risks. India's obligation under WTO to open agriculture sector to world trade would require futures trade in a wide variety of primary commodities and their products to enable diverse market functionaries to cope with the price volatility prevailing in the world markets.

Under a World Bank aided Grant Scheme to support development of commodity futures markets in India, a number of consultancy assignments, training programmes, study tours, office automation of FMC etc. have been undertaken. The project was successfully completed on 31st October, 2000. A Plan Scheme under the 10th Five Year Plan for generating awareness about the activities, mechanism and benefit of futures trading among farmers is being implemented.

In enhancing the institutional capabilities for futures trading the idea of setting up of National Commodity Exchange(s) has been pursued since 1999. Recently on the basis of comprehensive examination of various applications/expressions of interest received from 16 parties, four exchanges/proposed exchanges have been identified for giving the " National Status". While the Online Commodity Exchange of India Ltd (OCEIL) ( later on renamed as National Multi-Commodity Exchange of India Ltd., NMCE) has been given final approval, others National Board of Trade (NBOT), Indore, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and Multi Commodity Exchange (MCX), Mumbai have been given in-principle approval. "National Status" implies that these exchanges would be automatically permitted to conduct futures trading in all approved commodities, exempting sensitive items such as rice, wheat, gold & silver, subject to clearance of bye-laws and contract specifications by the FMC. While the NMCE, Ahmedabad has commenced futures trading in November,2002, and NBOT, Indore has been trading as a regional exchange since 2000, its up-gradation to national level and NCDEX and MCX, Mumbai commencing operations etc. are likely by end of October/early November, 2003.