Indian commodity options: Just the right dose for the markets

A year after Forward Markets Commission (FMC) was merged with Securities and Exchange Board of India (SEBI), the latter allowed commodity derivative exchanges to launch options contracts for trading. The objective was to provide more variety of hedging instruments, increase liquidity and attract more investors to the commodities market.

Earlier, only futures on commodities were allowed to trade on the exchange. Now commodities exchanges will also be able to launch commodity options products. Launch of options will increase the risk management alternates for market participants.

The impact of commodity price volatility on different stakeholders can be very high in India. Especially in the agricultural sector we have seen severe human consequences of this as well. Crop insurance is helping to offset some of the challenges. However it largely covers risks like loss of crop but does not cover the price risk that farmers are exposed to. Imagine a farmer who can hedge his/her produce in the options market before the growing season by paying a premium and buying a put option (an option to sell produce at a pre-defined price on a future date by paying a fixed premium now). This will ensure that the farmer gets a guaranteed minimum price for his produce. Given that is an option and not an obligation the farmer can choose not to exercise the option and sell his produce at a higher price if the market price is higher when he harvests the crop. This creates a floor for prices and removes a lot of risks while still allowing the farmer to benefit from the upside in case the prices increase. This is a simple instrument which can hedge the risk with a one-time payment and unlike futures does not involve complex daily mark to market/ margin management etc..

The Minimum Support Price by government for some agri-products also ends up playing a similar role. However, it is not as cost effective and not driven based of efficient market dynamics.

Similar positive impact will pan out for manufacturers and consumers who have significant raw material risk. Option trading will increase their ability to hedge against this risk. Whether it is an airline company hedging price of Jet fuel or a steel mill hedging price of iron or coal, they can focus on their core business rather than worrying about the impact of input price changes etc.

Before an option on commodities can be launched, each exchange will have to get approval from SEBI. SEBI is yet to detail out how these will be managed and some of the key open questions are around how will ‘options exercise’ be managed. There are typically 3 methods – cash delivery, physical delivery or delivery into futures of the underlying commodity. Indian equity options are primarily cash settled however in the commodities world physical delivery or delivery into futures are more common models Delivery into futures or cash settlement makes management of options easier. Financially settled contracts reduce expenses and can streamline operations. It may also help broaden the market participation as folks do not have to worry about the physical delivery. On the other hand, adding support for efficient physical delivery will go a long way in maturing the markets and ensuring appropriate price discovery. Another key item to look out for will be:- what kind of options are allowed. Will it be European Options that can be exercised only on maturity date or American Options that can be exercised on any date? Also expect to see some stringent norms for options writers as they will have to manage a bigger risk.
One would expect options to first start from more liquid products like Gold and Crude Oil and slowly move to other categories. Getting it to agricultural markets may take a little longer because of the delivery challenges. Lack of warehouse infrastructure is a bottle-neck and continued focus on that from both central and state governments is helping bridge the gaps. Warehousing regulation, registration, support for electronic negotiable warehouse receipts etc. can go a long way in building an ecosystem to manage the physical product, improve collateral management, and reduce risk of poor quality and physical delivery default. Rollout of Goods and Services Tax (GST) will also help with cross state trading and ease some of the capacity to manage physical delivery.

Accessibility of farmers to this platform may be a challenge. It will be interesting to see if any of this gets tied to the eNAM (electronic national agricultural market) to create a common platform for interfacing with farmers at the mandis. Another idea would be to allow financing players like rural banks, micro finance service firms etc. to facilitate sale of these products along with crop insurance or crop financing.

Market participants will also be eagerly waiting to hear more from SEBI on its intent to allow more products in commodity trading. Recently, products like diamond, cocoa, pig iron etc. were also added to the approved list. There is a long outstanding demand to allow trading in commodity indexes, weather derivatives etc. and participants having been hoping for change in rules for these. Market is also keen to know whether asset managers, banks and mutual funds etc. will be allowed to participate in options trading. This can help increase liquidity and make the markets more robust.

Multi Commodity Exchange of India Ltd (MCX) and National Commodities Exchange (NCDEX), the two largest commodities exchanges in the country expect to launch options contracts in the first quarter of 2017. As options are cheaper to trade and provide higher leverage compared to futures, this should lead to some short term revenue cannibalization. There could be some hiccups due to decrease in revenue initially, as some participants move from futures to options. However, in the long run with increased participation, this should be a big positive for the exchanges and brokerages.

Overall this move will increase the depth of the market, provide more cost effective hedging options and ensure liquidity for various participants including farmers and SMEs.

(This article is authored by Aditya Gandhi, Director- Technology, Sapient Global Markets)