Incredible India Formidable Futures

By Michael Gorham

There is a campaign to promote tourism years before the creation of the New Orleans in 1952 the new Forward Contracts in India called Incredible India. This nicely Cotton Exchange. Cotton was hot in that Regulation Act prohibited all commodity alliterative slogan appeals to our quest for the period—cotton futures markets were also set options and cash settlement on all commod- different, for the exotic. There is a lot of the up in Egypt (1861), England (1882) and ity forwards. In the midst of the shortages exotic in India, but are Indian futures really France (1882). But India continued to add caused by both drought and the Indo- all that different than those traded in futures, including oilseeds in 1900, gold in Chinese border clash in the 1960s, farmers Chicago or London? Well to a corn-and- 1920 and a host of others in those early years. defaulted on forward contracts, a few com- bean Midwesterner, or even a jaded New Then, less than 70 years after the cotton mitted suicide, and futures trading was Yorker, guar seeds, chana and urad sound exchange started, there was a reversal in banned for virtually all commodities. The pretty exotic and they just happen to be the government policy. During WW II, options premise was that futures lead to speculation, first, second, and fifth most actively traded on cotton and forwards on oilseeds, food high prices, and shortages. physical commodity products in India. Over grains, spices, and sugar were banned. Then the next few pages we will explore the main features of futures markets in India by con- trasting them with their siblings in the Indian Futures Timeline United States. We do this not to make judg- ments about one being better than the other, ● 1875 Cotton futures start but rather to help us to know something new ● 1900 Oilseed futures start by comparing it to something already known. ● 1920 Gold futures start ● 1939 Cotton options prohibited ● 1943 Oilseed, food grain, spices, sugar forwards prohibited Birth, Death and Rebirth ● 1952 Forward Contracts Regulation Act ❍ Prohibits all commodity options As in the U.S., the history of derivatives ❍ Prohibits cash settlement of forward contracts in India goes back to the period after the ● 1960s Forwards in primary and essential commodities prohibited American Civil War. A cotton futures ● 2000 BSE and NSE list index was started in Bombay in 1875, just ● 2001 BSE & NSE list index options, options and stock futures a decade after the creation of the Chicago ● 2002 NMCE opens as a National Commodity Exchange Board of Trade, five years after the creation of ● 2003 MCX & NCDEX open as National Commodity Exchanges the New York Cotton Exchange and five

1 Futures Industry Now there still were futures markets dur- has substantially less than a 1% market share market, which has six exchanges listing 33 ing this period in the desert. They were just (if that’s possible). The BSE was hurt even index futures contracts and seven exchanges illegal and underground and small. It is diffi- worse by the 2001 government-mandated offering 100 index options contracts. Despite cult to stay underground and hidden if you switch from one-week settlement sessions to the apparent competition in the U.S., one get too big. The rebirth started slowly. In the the rolling settlement used in the rest of the exchange, the Chicago Mercantile Ex- e 1970s futures were again allowed on seven world and a ban on its beloved badla trading. change, still accounts for 92% of all index non-essential commodities, though trading Second, futures dominate the scene, futures trading. was still sparse. Finally, between 2000 and accounting for 76% of equity derivatives trad- India tried to establish a broader base. 2002 all restrictions on commodity futures ing, while options play a weak second fiddle The BSE, for example, had listed seven trading were lifted and the framework for a with a 34% share (by value as of July 2006). indexes and the NSE another 17. But only set of national-level commodity exchanges Third, despite their poor performance in one index still hangs on at the BSE with a was put in place. most the rest of the world, and especially the shred of activity and this is its banner SEN- U.S., individual stock futures are wildly pop- SEX index. The SENSEX in India has the Equity Derivatives ular and account for almost half (47%) of all same place in the popular imagination as The story of modern derivatives in India equity derivatives trading. The huge success the Dow in the U.S. And the S&P CNX really starts on the financial side of the of stock index futures is due partly to the fact NIFTY appeals to the professional crowd aisle. In the second half of the 1990s, the that they were launched at about the same just as the S&P 500 does back here. But National of India (aka time that traders were being deprived of the looking at the volumes, it is clear that India NSEIL or more commonly NSE) got the traditional synthetic futures with the elimi- is really a one-index country, with the S&P notion that the country should have finan- nation of one-week settlement periods and CNX NIFTY accounting for over 99% of all cial futures markets. Its much older, but not badla. Index futures is the second most pop- index futures volume. necessarily wiser, cousin, the Bombay Stock ular instrument, with a 39% share. But this Exchange, disagreed and argued that India 39% share is essentially in one product, the Other Financial Contracts already had a home-grown, tested and true S&P CNX NIFTY, while individual stock The United States has the full array of version of stock futures built on a couple of futures is spread over 123 individual issues. financial derivatives contracts—equity, , traditional features of Indian equity mar- So from an individual product point of view, and foreign exchange, but like the rest of the kets. The first feature was a week-long set- the NIFTY rules. Rounding out the product world, debt futures account for just over half tlement period which allowed traders to buy mix is index options with 11% and stock of all futures trading (53% of U.S. trading, and sell all they wanted and deliver or options with only 3%. 54% of rest of the world trading in 2005). receive only their net position as of the end India has futures or options on only four Indian financial futures is all equities all of the settlement period. Add to this a indexes listed at two exchanges. This is good the time. The NSE attempted an interest unique Indian practice referred to as badla, when compared to other emerging markets, rate contract in the summer of 2003, but it which allowed traders to roll a net position but substantially narrower than the U.S. traded for only three months—9,768 con- over to the next settlement period and traders could obtain stock market exposure for days, weeks or even months, without Monthly Derivatives Trading at the NSE ever having to make or take delivery, very June 2000 - June 2006 much like a . The government did what governments are wont to do; they appointed a commit- tee, known as the LC Gupta Committee, to look into the question. Dr. Gupta is a thoughtful, scholarly man who lives in Delhi, but his Committee went on for a long time and the government took even longer and in June 2000, both the BSE and NSE launched stock index futures. Index and stock options were approved a year later in July 2001, followed by stock futures in November 2001. So the whole portfolio of products was rolled out over a 17-month period ending almost five years ago—long enough to see the dust settle. And what do we see? First, there is only one survivor from the equity derivatives wars—the NSE. The BSE never wanted the products, never had its heart in it, and today Source: National Stock Exchange

September/October 2006 2 tracts in June, 963 in July and 50 in August, contracts are physically delivered—corn, Naturally this created uncertainty for the then nothing. The problem, in part, appears wheat, soybeans, cattle, coffee, cocoa, etc. buyer since he didn’t know if he was receiving to be due to poor contract design. And the There are a few exceptions like feeder cattle product or not. In addition, some relatively Reserve Bank of India has not yet given the and hogs at the CME and all of the new thin markets seemed to have problems with green light for foreign exchange futures, nor NYMEX swap contracts. But in every case, false reporting of cash market prices in order have capital controls been adequately liber- the contract is designed so that all partici- to benefit futures positions. The result is that alized. So there is still a lot of growth poten- pants remaining at contract expiration do there seems to be a strong trend toward the tial as contracts are eventually added in the the same thing—participate in a physical U.S. style of mandatory physical delivery. Cur- debt and foreign exchange areas. delivery or get settled in cash at a final settle- rently, of NCDEX’s 61 listed products, only ment price determined in the cash market. eight still have matching of interested buyers Physical Commodity In India, contracts were initially designed and sellers, 26 give the sellers the , and Contract Design so that the exchange attempted to match 27 have mandatory physical delivery. interested buyers and sellers and cash settled In the design of physical commodity con- the rest. The problem was that few people Measuring Turnover tracts, Indian exchanges have taken a very had similar interests and most got cash set- Making turnover comparisons between different direction than their U.S. cousins. tled. Another method tried was to give the The U.S. tradition has been that commodity India and the U.S. is a bit difficult. Volume seller the option to cash settle or deliver. data for the U.S. is generally given in num- ber of contracts traded, while Indian turnover is always given in value terms. The Top 10 Contracts in U.S. and India. reason for the difference is simple. U.S. Number of Contracts Jan-July, 2006 exchanges and intermediaries quote their fees and commissions based on the number of FINANCIAL FUTURES contracts traded, while Indian exchanges U.S. India and brokers set fees and commissions as a Rank Contract Exchg. Volume Contract Exchg. Volume percentage of value of the transaction. Both 1 Eurodollar CME 244,634,316 Stock futures NSE 50,766,737 brokers and exchanges want to see the num- ber that drives their revenues. 2 E-mini S&P 500 Idx. CME 129,451,013 NIFTY NSE 38,696,395 However, to allow a comparison in 3 10-Year Treas. Note CBOT 124,918,400 BANKNIFTY NSE 129,241 terms familiar to American readers, we have 4 5-Year Treas. Note CBOT 63,605,673 CNXIT NSE 25,346 converted the Indian volume data into 5 30-Year Treas. Bond CBOT 49,425,212 SENSEX BSE 459 number of contracts traded. In the accom- panying table we list the top 10 futures con- 6 E-mini Nasdaq 100 CME 41,011,615 Stock futures BSE 12 tracts on both the financial and physical 7 Euro FX CME 20,177,480 commodity side for both India and the U.S. 8 E-mini Russell 2000 CME 19,652,232 Several things jump out. Of course Indian volumes are smaller, but the gap is greater 9 Two-Year Treas. Note CBOT 18,101,016 for financials (the U.S. is 17 times larger) 10 Mini DJ Ind. Index CBOT 13,951,804 than for physical commodities (the U.S. is only 3 times larger). This is not a big sur- COMMODITY FUTURES prise given the massive size of the Indian U.S. India agricultural sector. Rank Contract Exchg. Volume Contract Exchg. Volume Second, there are not enough Indian 1 Crude Oil NYMEX 33,291,628 Guar Seeds NCDEX 8,896,428 financial products to even fill out the Top 10 list. Despite attempts by both the NSE and 2 Corn CBOT 21,108,665 Chana/Gram NCDEX 8,545,451 BSE to create new products, most of them 3 Natural Gas NYMEX 11,230,651 Gold MCX 6,111,258 have just not taken hold and we find only 4 Soybeans CBOT 10,936,239 Silver MCX 5,732,683 four indexes and two groups of stock futures 5 Gold COMEX 9,756,660 Urad NCDEX 3,468,018 products. In addition, the BSE market share is tiny—.001%. 6 Henry Hub Swap NYMEX 9,314,169 Wheat NCDEX 2,393,144 Third, by switching from Indian-style 7 Sugar #11 NYBOT 8,211,887 Copper MCX 2,180,023 value to American-style (number of contracts 8 Wheat CBOT 7,798,739 Crude OilMCX 1,966,872 traded), we knock gold and silver out of the top two slots and replace them with Guar 9 No. 2 Htg. Oil, NY NYMEX 6,684,341 Silver MCX 1,413,743 seeds and Chana. Indian readers will be quite 10 Unleaded Reg. Gas. NYMEX 6,302,473 Mentha Oil NCDEX 1,366,415 shocked to see a top 10 list without bullion at the top. What’s going on is that there are Sources: NSE, NCDEX, MCX and FIA.

3 Futures Industry fewer gold and silver contracts traded, but in 10 U.S. products are energy products. Only contract. This is misleading given that half the Indian numbers the fact that they are large one of the Indian top 10 is an energy product. the top 10 U.S. contracts are debt contracts, contracts pushes them to the top of the list. Also, though not shown in the table, whose nominal value ranges from $100,000 Incidentally, guar, also called cluster beans Indian commodity markets are less diversified. to $1 million. The average of the four stock in Texas, is used for food in India, for cattle In the U.S. the top 10 physical commodity indexes that made the U.S. top 10 is feed in other Asian countries and as a stiffener contracts account for 40% of all physical com- $56,000, only about eight times the average in soft serve ice cream, cheeses, instant pud- modity trading. In India, the top 10 account size of the Indian stock indexes. dings, cloth and paper in the U.S. And chana for 80%, leaving only 20% of the volume to be U.S. commodity contracts are also larger is a lentil that is split, boiled, pureed and spread around all the other contracts. than their Indian cousins, but only about five mixed with spices to make one of the many times larger. The average top 10 U.S. com- types of dal, a staple of many Indian meals. Indian Contracts are Smaller modity was worth $45,975 compared to Finally, urad is another kind of lentil used to As can be seen from the table, the top 10 $8,368 in Mumbai. Indian agricultural con- make another type of dal, called urad dal. U.S. financial contracts have a single con- tracts tend to be quite small $2,000 to Fourth, Indian commodity markets are tract value averaging $188,508—almost 30 $6,400, while Indian precious metal con- less dominated by energy. Fully half of the top times the average size of an Indian financial tracts range from $12,000 to over $20,000.

Size of Top 10 Contracts in U.S. and India

U.S. India Value of one contract Value of one contract Rank Financial Contracts Exchange on 16 Aug’06 (USD) Financial Contracts Exchange on 16 Aug’06 (USD) 1 Eurodollar CME $1,000,000 Stock futures NSE $6,005 2 E-mini S&P 500 Index CME $64,950 S&P CNX NIFTY NSE $7,238 3 10-Year Treasury Note CBOT $100,000 BANKNIFTY NSE $9,560 4 5-Year Treasury Note CBOT $100,000 CNXIT NSE $4,700 5 30-Year Treasury Bond CBOT $100,000 SENSEX BSE N/A 6 E-mini Nasdaq 100 CME $31,525 Stock futures BSE N/A 7 Euro FX CME $160,838 8 E-mini Russell 2000 CME $71,010 9 Two-Year Treasury Note CBOT $200,000 10 Mini Dow Jones Index CBOT $56,760 Average Size $188,508 $6,876

U.S. India Value of one contract Value of one contract Rank Commodity Contracts Exchange on 16 Aug’06 (USD) Commodity Contracts Exchange on 16 Aug’06 (USD) 1 Crude Oil NYMEX $71,890 Guar Seeds NCDEX $4,072 2 Corn CBOT $11,075 Chana/Gram NCDEX $5,810 3 Natural Gas NYMEX $67,660 Gold MCX $20,772 4 Soybeans CBOT $27,613 Silver MCX $12,349 5 Gold COMEX $63,900 Urad NCDEX $6,431 6 Henry Hub Swap NYMEX $16,915 Wheat NCDEX $2,079 7 Sugar #11 NYBOT $14,336 Copper MCX $7,739 8 Wheat CBOT $18,575 Crude Oil MCX $7,423 9 No. 2 Heating Oil, NY NYMEX $84,710 Silver NCDEX $12,400 10 Unleaded Gasoline NYMEX $83,080 Mentha Oil MCX $4,606 Average Size $45,975 $8,368

Source: Contract sizes calculated using information from relevent exchanges, Forward Markets Commission and FIA.

September/October 2006 4 Regulation value of commodity derivatives trading takes trader’s screen. The three national commod- place on the three national exchanges, and ity exchanges also use satellite technology to Derivative markets in India are overseen 92% of the trade takes place on the two reach remote agricultural areas. by two regulators—the Securities and exchanges located in Mumbai—MCX and There is a problem, however. Satellites Exchange Board of India for financial prod- NCDEX. The third is the NMCE located in are slow. From a given location, it might take ucts and the Forward Markets Commission Ahmedabad, the capital of Gujarat, and 700 to 800 milliseconds to send an order to for futures on physical commodities. SEBI is despite the fact that Gujaratis have a reputa- the exchange. A land line could handle the an independent agency created in 1992, tion for being excellent traders, the NMCE task in 35 to 50 milliseconds. Even the inter- while the FMC, created in 1953, is a depart- has only a 6% market share. net is faster at 300 to 350 milliseconds. Now ment in the Ministry of Consumer Affairs while satellite speeds are still fine for hedgers Food and Public Distribution. Physical com- and the occasional trader, serious traders are modity regulation by a department within a starting to use landlines and the internet to larger ministry is actually the same model pur- Governance connect to the exchanges, though these sued in the U.S. prior to the creation of the In India, board composition has a unique alternatives are much more expensive. Commodity Futures Trading Commission in feature. The regulator actually has a person 1974. Before that time the Commodity sitting in on the board meetings. The law Exchange Authority was a relatively weak allows the FMC to place its own representa- Conclusion department buried in the very large U.S. tive on the board of each exchange and up to In a relatively short period of time, barely Department of Agriculture. three additional directors who represent more than a decade, Indian derivatives have interests that are not directly represented by burst on to the international scene. They Exchanges exchange members. U.S. exchanges would offer an interesting array of trading opportu- find it pretty intrusive to have a CFTC or nities. Unfortunately it is still awkward for How many derivatives exchanges are SEC staff member or commissioner sitting in international entities to gain access to Indian there in India? There are actually 26 on their board meetings. It also puts the gov- financial derivates and impossible for them to exchanges that list derivatives in India—two ernment in the awkward position in that if an gain access to physical commodity products. for financial products regulated by SEBI and exchange does a stupid or illegal thing, the Recently, the FMC has indicated its willing- 24 listing physical commodity products and government is at least partly to blame. ness to allow international futures brokers to regulated by the Forward Markets Com- Initially, the same FMC representative served broker only domestically originated transac- mission. However, in the financial deriva- on the boards of two highly competitive tions in India. While we on the outside may tives arena, as mentioned above, the BSE has exchanges—MCX and NCDEX—which was be impatient to be invited to participate, the all but quit the business, leaving the NSE a bit awkward, but recently the two leading Indian authorities have many considerations with over a 99.99% market share. commodity exchanges have been assigned to balance. During the past spring and sum- As a way to bring order to the highly frag- two separate FMC directors. mer, commodity prices in India rose very dra- mented system of regional commodity matically, and many people including exchanges, the national government decided Congress Party leader, Sonia Gandhi, that it would be wise to create one or more Electronic Trading pointed fingers at the futures exchanges. It exchanges that would operate on a national Let’s face it. India was wired (or more appears as though reason has ruled, the mes- level and list a large number of commodities. accurately wireless) since the early 1990s. sengers have not been shot and commodity The FMC required certain high standards of Once the NSE came out as a fully transpar- futures will continue to operate unfettered, any entity applying to become a national ent electronic exchange, the BSE fell quickly though the regulator, the FMC, will end up commodity exchange, including fully trans- in line and did the same. When the new being strengthened, which is a good thing, parent electronic trading. Only three national commodity exchanges were created but this incident reminds us that politics in exchanges qualified—the National Multi in 2003, they came out of the box electronic. India is never far away from the action. ■ Commodity Exchange of Ahmedabad So India has lived in a screen-based (NMCE), the Multi Commodity Exchange of exchange world for over a decade. The U.S. India (MCX), and the National Commodity was brought into it kicking and screaming Michael Gorham is industry professor and director of and Derivatives Exchange of India (NCDEX). and it was only the reality of serious foreign the Illinois Institute of Technology Center for Financial While most of these names do not trip off the competition that got the Chicago exchanges Markets and also serves on the board of the National tongue, the exchanges have been hard at work to start seriously converting. The New York Commodity and Derivatives Exchange of India. Thanks building a large customer base and even offer- exchanges have lagged even further behind. to Poulomi Kundu of IIT, Ravi Varanasi of NSE, ing services such as wide-spread publication of When India started, it had a much worse Madan Sabnavis and Meher Baburaj of NCDEX and spot prices and improvements in the ware- land line infrastructure than did the U.S. So Saptak Gangopadhyay for research support. house receipts system. it went to the sky. The NSE was able to con- Aside from these three exchanges that nect all over India in very short order. Today met the FMC’s criteria to be labeled a the NSE is in 296 cities with 2740 VSATS national commodity exchange, there are (very small aperture terminals). A VSAT another 21 exchanges that act as regional consists of a transceiver which sits outdoors commodity exchanges. According to the in direct line of sight with the satellite most recent two-week figures collected by the transponder and is connected to inside FMC (last half of July 2006), 98% of the equipment that brings the market to the

5 Futures Industry