Link directly to Volume Tables.
There is a campaign to promote tourism
in India called Incredible India. This nicely
alliterative slogan appeals to our quest for the
different, for the exotic. There is a lot of the
exotic in India, but are Indian futures really
all that different than those traded in
Chicago or London? Well, to a corn-and-bean
Midwesterner, or even a jaded New
Yorker, guar seeds, chana and urad sound
pretty exotic and they just happen to be the
first, second, and fifth most actively traded
physical commodity products in India. Over
the next few pages we will explore the main
features of futures markets in India by contrasting
them with their siblings in the
United States. We do this not to make judgments
about one being better than the other,
but rather to help us to know something new
by comparing it to something already known.
Birth, Death and Rebirth
As in the U.S., the history of derivatives
in India goes back to the period after the
American Civil War. A cotton futures
exchange was started in Bombay in 1875, just
a decade after the creation of the Chicago
Board of Trade, five years after the creation of
the New York Cotton Exchange and five
years before the creation of the New Orleans
Cotton Exchange. Cotton was hot in that
period—cotton futures markets were also set
up in Egypt (1861), England (1882) and
France (1882). But India continued to add
futures, including oilseeds in 1900, gold in
1920 and a host of others in those early years.
Then, less than 70 years after the cotton
exchange started, there was a reversal in
government policy. During WW II, options
on cotton and forwards on oilseeds, food
grains, spices, and sugar were banned. Then
in 1952 the new Forward Contracts
Regulation Act prohibited all commodity
options and cash settlement on all commodity
forwards. In the midst of the shortages
caused by both drought and the Indo-Chinese border clash in the 1960s, farmers
defaulted on forward contracts, a few committed
suicide, and futures trading was
banned for virtually all commodities. The
premise was that futures lead to speculation,
high prices, and shortages.
Now there still were futures markets during
this period in the desert. They were just
illegal and underground and small. It is difficult
to stay underground and hidden if you
get too big. The rebirth started slowly. In the
1970s futures were again allowed on seven
non-essential commodities, though trading
was still sparse. Finally, between 2000 and
2002 all restrictions on commodity futures
trading were lifted and the framework for a
set of national-level commodity exchanges
was put in place.
|Indian Futures Timeline|
1875 Cotton futures start
1900 Oilseed futures start
1920 Gold futures start
1939 Cotton options prohibited
1943 Oilseed, food grain, spices, sugar forwards prohibited
1952 Forward Contracts Regulation Act
· Prohibits all commodity options
1960s Forwards in primary and essential commodities prohibited
2000 BSE and NSE list index futures
2001 BSE & NSE list index options, stock options and stock futures
2002 NMCE opens as a National Commodity Exchange
2003 MCX & NCDEX open as National Commodity Exchanges
· Prohibits cash settlement of forward contracts
The story of modern derivatives in India
really starts on the financial side of the aisle.
In the second half of the 1990s, the
National Stock Exchange of India (aka
NSEIL or more commonly NSE) got the
notion that the country should have financial
futures markets. Its much older, but not
necessarily wiser, cousin, the Bombay Stock
Exchange, disagreed and argued that India
already had a home-grown, tested and true
version of stock futures built on a couple of
traditional features of Indian equity markets.
The first feature was a week-long settlement
period which allowed traders to buy
and sell all they wanted and deliver or
receive only their net position as of the end
of the settlement period. Add to this a
unique Indian practice referred to as badla,
which allowed traders to roll a net position
over to the next settlement period and
traders could obtain stock market exposure
for days, weeks or even months, without
ever having to make or take delivery, very
much like a futures contract.
The government did what governments
are wont to do; they appointed a committee,
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
has substantially less than a 1% market share
(if that's possible). The BSE was hurt even
worse by the 2001 government-mandated
switch from one-week settlement sessions to
the rolling settlement used in the rest of the
world and a ban on its beloved badla trading.
Second, futures dominate the scene,
accounting for 76% of equity derivatives trading,
while options play a weak second fiddle
with a 34% share (by value as of July 2006).
Third, despite their poor performance in
most the rest of the world, and especially the
U.S., individual stock futures are wildly popular
and account for almost half (47%) of all
equity derivatives trading. The huge success
of stock index futures is due partly to the fact
that they were launched at about the same
time that traders were being deprived of the
traditional synthetic futures with the elimination
of one-week settlement periods and
badla. Index futures is the second most popular
instrument, with a 39% share. But this
39% share is essentially in one product, the
S&P CNX NIFTY, while individual stock
futures is spread over 123 individual issues.
So from an individual product point of view,
the NIFTY rules. Rounding out the product
mix is index options with 11% and stock
options with only 3%.
India has futures or options on only four
indexes listed at two exchanges. This is good
when compared to other emerging markets,
but substantially narrower than the U.S.
market, which has six exchanges listing 33
index futures contracts and seven exchanges
offering 100 index options contracts. Despite
the apparent competition in the U.S., one
exchange, the Chicago Mercantile Exchange,
still accounts for 92% of all index
India tried to establish a broader base.
The BSE, for example, had listed seven
indexes and the NSE another 17. But only
one index still hangs on at the BSE with a
shred of activity and this is its banner SENSEX
index. The SENSEX in India has the
same place in the popular imagination as
the Dow in the U.S. And the S&P CNX
NIFTY appeals to the professional crowd
just as the S&P 500 does back here. But
looking at the volumes, it is clear that India
is really a one-index country, with the S&P
CNX NIFTY accounting for over 99% of all
index futures volume.
Other Financial Contracts
The United States has the full array of
financial derivatives contracts—equity, debt,
and foreign exchange, but like the rest of the
world, debt futures account for just over half
of all futures trading (53% of U.S. trading,
54% of rest of the world trading in 2005).
Indian financial futures is all equities all
the time. The NSE attempted an interest
rate contract in the summer of 2003, but it
traded for only three months—9,768 contracts
in June, 963 in July and 50 in August,
then nothing. The problem, in part, appears
to be due to poor contract design. And the
Reserve Bank of India has not yet given the
green light for foreign exchange futures, nor
have capital controls been adequately liberalized.
So there is still a lot of growth potential
as contracts are eventually added in the
debt and foreign exchange areas.
In the design of physical commodity contracts,
Indian exchanges have taken a very
different direction than their U.S. cousins.
The U.S. tradition has been that commodity
contracts are physically delivered—corn,
wheat, soybeans, cattle, coffee, cocoa, etc.
There are a few exceptions like feeder cattle
and hogs at the CME and all of the new
NYMEX swap contracts. But in every case,
the contract is designed so that all participants
remaining at contract expiration do
the same thing—participate in a physical
delivery or get settled in cash at a final settlement
price determined in the cash market.
In India, contracts were initially designed
so that the exchange attempted to match
interested buyers and sellers and cash settled
the rest. The problem was that few people
had similar interests and most got cash settled.
Another method tried was to give the
seller the option to cash settle or deliver.
Naturally this created uncertainty for the
buyer since he didn't know if he was receiving
product or not. In addition, some relatively
thin markets seemed to have problems with
false reporting of cash market prices in order
to benefit futures positions. The result is that
there seems to be a strong trend toward the
U.S. style of mandatory physical delivery. Currently,
of NCDEX's 61 listed products, only
eight still have matching of interested buyers
and sellers, 26 give the sellers the option, and
27 have mandatory physical delivery.
Making turnover comparisons between
India and the U.S. is a bit difficult. Volume
data for the U.S. is generally given in number
of contracts traded, while Indian
turnover is always given in value terms. The
reason for the difference is simple. U.S.
exchanges and intermediaries quote their
fees and commissions based on the number of
contracts traded, while Indian exchanges
and brokers set fees and commissions as a
percentage of value of the transaction. Both
brokers and exchanges want to see the number
that drives their revenues.
However, to allow a comparison in
terms familiar to American readers, we have
converted the Indian volume data into
number of contracts traded. In the accompanying
table we list the top 10 futures contracts
on both the financial and physical
commodity side for both India and the U.S.
Several things jump out. Of course Indian
volumes are smaller, but the gap is greater for
financials (U.S. is 17 times larger) than for
physical commodities (U.S. is 3 times
larger). This is not a big surprise given the massive size of the India agriculture sector.
Second, there are not enough Indian
financial products to even fill out the Top 10
list. Despite attempts by both the NSE and
BSE to create new products, most of them
have just not taken hold and we find only
four indexes and two groups of stock futures
products. In addition, the BSE market share
Third, by switching from Indian-style
value to American-style (number of contracts
traded), we knock gold and silver out
of the top two slots and replace them with
Guar seeds and Chana. Indian readers will
be quite shocked to see a top 10 list without
bullion at the top. What's going on is that
there are fewer gold and silver contracts
traded, but in the Indian numbers the fact
that they are large contracts pushes them to
the top of the list.
Incidentally, guar, also called cluster beans
in Texas, is used for food in India, for cattle
feed in other Asian countries and as a stiffener
in soft serve ice cream, cheeses, instant puddings,
cloth and paper in the U.S. And chana
is a lentil that is split, boiled, pureed and
mixed with spices to make one of the many
types of dal, a staple of many Indian meals.
Finally, urad is another kind of lentil used to
make another type of dal, called urad dal.
Fourth, Indian commodity markets are
less dominated by energy. Fully half of the top
10 U.S. products are energy products. Only
one of the Indian top 10 is an energy product.
Also, though not shown in the table,
Indian commodity markets are less diversified.
In the U.S. the top 10 physical commodity
contracts account for 40% of all physical commodity
trading. In India, the top 10 account
for 80%, leaving only 20% of the volume to be
spread around all the other contracts.
Indian Contracts are Smaller
As can be seen from the table, the top 10
U.S. financial contracts have a single contract
value averaging $188,508—almost 30
times the average size of an Indian financial
contract. This is misleading given that half
the top 10 U.S. contracts are debt contracts,
whose nominal value ranges from $100,000
to $1 million. The average of the four stock
indexes that made the U.S. top 10 is
$56,000, only about eight times the average
size of the Indian stock indexes.
U.S. commodity contracts are also larger
than their Indian cousins, but only about five
times larger. The average top 10 U.S. commodity
was worth $45,975 compared to
$8,368 in Mumbai. Indian agricultural contracts
tend to be quite small $2,000 to
$6,400, while Indian precious metal contracts
range from $12,000 to over $20,000.
Derivative markets in India are overseen
by two regulators—the Securities and
Exchange Board of India for financial products
and the Forward Markets Commission
for futures on physical commodities. SEBI is
an independent agency created in 1992,
while the FMC, created in 1953, is a department
in the Ministry of Consumer Affairs
Food and Public Distribution. Physical commodity
regulation by a department within a
larger ministry is actually the same model pursued
in the U.S. prior to the creation of the
Commodity Futures Trading Commission in
1974. Before that time the Commodity
Exchange Authority was a relatively weak
department buried in the very large U.S.
Department of Agriculture.
How many derivatives exchanges are
there in India? There are actually 26
exchanges that list derivatives in India—two
for financial products regulated by SEBI and
24 listing physical commodity products and
regulated by the Forward Markets Commission.
However, in the financial derivatives
arena, as mentioned above, the BSE has
all but quit the business, leaving the NSE
with over a 99.99% market share.
As a way to bring order to the highly fragmented
system of regional commodity
exchanges, the national government decided
that it would be wise to create one or more
exchanges that would operate on a national
level and list a large number of commodities.
The FMC required certain high standards of
any entity applying to become a national
commodity exchange, including fully transparent
electronic trading. Only three
exchanges qualified—the National Multi
Commodity Exchange of Ahmedabad
(NMCE), the Multi Commodity Exchange of
India (MCX), and the National Commodity
and Derivatives Exchange of India (NCDEX).
While most of these names do not trip off the
tongue, the exchanges have been hard at work
building a large customer base and even offering
services such as wide-spread publication of
spot prices and improvements in the warehouse
Aside from these three exchanges that
met the FMC's criteria to be labeled a
national commodity exchange, there are
another 21 exchanges that act as regional
commodity exchanges. According to the
most recent two-week figures collected by the
FMC (last half of July 2006), 98% of the
value of commodity derivatives trading takes
place on the three national exchanges, and
92% of the trade takes place on the two
exchanges located in Mumbai—MCX and
NCDEX. The third is the NMCE located in
Ahmedabad, the capital of Gujarat, and
despite the fact that Gujaratis have a reputation
for being excellent traders, the NMCE
has only a 6% market share.
In India, board composition has a unique
feature. The regulator actually has a person
sitting in on the board meetings. The law
allows the FMC to place its own representative
on the board of each exchange and up to
three additional directors who represent
interests that are not directly represented by
exchange members. U.S. exchanges would
find it pretty intrusive to have a CFTC or
SEC staff member or commissioner sitting in
on their board meetings. It also puts the government
in the awkward position in that if an
exchange does a stupid or illegal thing, the
government is at least partly to blame.
Initially, the same FMC representative served
on the boards of two highly competitive
exchanges—MCX and NCDEX—which was
a bit awkward, but recently the two leading
commodity exchanges have been assigned
two separate FMC directors.
Let's face it. India was wired (or more
accurately wireless) since the early 1990s.
Once the NSE came out as a fully transparent
electronic exchange, the BSE fell quickly
in line and did the same. When the new
national commodity exchanges were created
in 2003, they came out of the box electronic.
So India has lived in a screen-based
exchange world for over a decade. The U.S.
was brought into it kicking and screaming
and it was only the reality of serious foreign
competition that got the Chicago exchanges
to start seriously converting. The New York
exchanges have lagged even further behind.
When India started, it had a much worse
land line infrastructure than did the U.S. So
it went to the sky. The NSE was able to connect
all over India in very short order. Today
the NSE is in 296 cities with 2740 VSATS
(very small aperture terminals). A VSAT
consists of a transceiver which sits outdoors
in direct line of sight with the satellite
transponder and is connected to inside
equipment that brings the market to the
trader's screen. The three national commodity
exchanges also use satellite technology to
reach remote agricultural areas.
There is a problem, however. Satellites
are slow. From a given location, it might take
700 to 800 milliseconds to send an order to
the exchange. A land line could handle the
task in 35 to 50 milliseconds. Even the internet
is faster at 300 to 350 milliseconds. Now
while satellite speeds are still fine for hedgers
and the occasional trader, serious traders are
starting to use landlines and the internet to
connect to the exchanges, though these
alternatives are much more expensive.
In a relatively short period of time, barely
more than a decade, Indian derivatives have
burst on to the international scene. They
offer an interesting array of trading opportunities.
Unfortunately it is still awkward for
international entities to gain access to Indian
financial derivates and impossible for them to
gain access to physical commodity products.
Recently, the FMC has indicated its willingness
to allow international futures brokers to
broker only domestically originated transactions
in India. While we on the outside may
be impatient to be invited to participate, the
Indian authorities have many considerations
to balance. During the past spring and summer,
commodity prices in India rose very dramatically,
and many people including
Congress Party leader, Sonia Gandhi,
pointed fingers at the futures exchanges. It
appears as though reason has ruled, the messengers
have not been shot and commodity
futures will continue to operate unfettered,
though the regulator, the FMC, will end up
being strengthened, which is a good thing,
but this incident reminds us that politics in
India is never far away from the action.
|Monthly Derivatives Trading at the NSE|
June 2000 - June 2006
Includes index futures, stock futures, interstate futures, index options and stock options
Source: National Stock Exchange
|Top 10 Contracts in U.S. and India|
Number of Contracts Jan-July, 2006
Sources: NSE, NCDEX, MCX and FIA
|Size of Top 10 Contracts in U.S. and India|
Source: Contract sizes calculated using information from relevant exchanges, Forward Markets Commission and FIA.
Michael Gorham is industry professor and director of the Illinois Institute of Technology Center for Financial Markets and also serves on the board of the National
Commodity and Derivatives Exchange of India. Thanks to Poulomi Kundu of IIT, Ravi Varanasi of NSE, Madan Sabnavis and Meher Baburaj of NCDEX and Saptak Gangopadhyay for research support.