Futures delivery norm seen aiding price discovery

Forward Markets Commission's (FMC) proposal to make delivery compulsory on settlement date may help in better price discovery, inter-exchange and inter-calendar arbitrage, and may increase the volumes on commodity futures exchanges, analysts said.

The FMC, which regulates the commodities futures market in India, has been contemplating compulsory delivery of any commodity on the settlement date by sellers on their open positions.

Many traders are of the view that this move will curb the excessive downward pressure on prices in the futures market just before the contract settlement date.

Some traders said, currently, most of the contracts are tilted in favour of sellers. As a result of the contract specifications, the sellers can choose whether or not to give the delivery of the commodity. Again if a seller fails to give delivery, the penalty levied is hardly of any consequence, analysts said.

As a result, sellers can drive prices down sharply and then cover their open positions by buying at extremely low levels. The fall in futures prices tend to affect spot markets in some commodities adversely.

If the compulsory delivery on settlement date were to become effective, it would reduce this excessive pressure on futures prices.

Such a directive will also promote plenty of arbitrage opportunities between different contract months on the same exchange and also promote inter-exchange arbitrage, said Alex Mathew, analyst, Geojit Financial Services.

Elaborating on the positives of compulsory delivery on settlement day, Mathew said for example one could buy a July pepper contract on the National Multi Commodity Exchange-based in Ahmedabad for Rs 5,850 per 100 kilogram and at the same time sell a July pepper contract for Rs 6,295 on the National Commodity and Derivatives Exchange.

NMCE contracts expire on 15th day of every month, while those on NCDEX on 20th day.

Thus one could take delivery on NMCE and give delivery on NCDEX. In doing so one could earn a risk-less profit of around Rs 374 or an annualised return of around 177 per cent after considering the transportation and warehousing cost.

However, at present, delivery is not compulsory, one may find it difficult to get the physical commodity from one exchange for delivery on other.

According to Kishore Narne, manager and head of research at Anand Rathi Securities, if the delivery were to be made compulsory on settlement date, the futures prices would correctly reflect the cost of carry cost over spot prices.

Narne said that as more arbitrageurs would exploit the calendar spreads in commodity futures in and among the exchanges, the margins between spot and futures markets would reduce considerably and thereby encourage more players to participate on futures exchange as well as help in better price discovery.

However, Narne also pointed out that there were some existing concerns that needed to be addressed before such a directive was to be bought in to force.

These included increase in penalties in case the seller failed to deliver on settlement date, warehouse charges, contract specifications with respect to quality of physical commodity, among others.

Narne said that there would be a scenario where even if the delivery were compulsory on settlement date, the seller may default and be required to pay penalties.

However, the current penalties are so low that the profit gained through by not delivering easily exceeds the penalties paid.

Besides this, the warehouse costs also have to be taken into consideration, Narne said. If one were to deliver the physical commodity only for one hour, warehouse charges for entire week have to be paid.

Also, the contract specifications differ with respect to the variety of physical commodity acceptable as deliverable among various exchanges, he said.

Narne said that ideally the quality of physical commodity should not differ for identical contracts on various exchanges.

This will allow greater arbitrage opportunities and add depth to the volumes traded on various exchanges, he said.

However, some traders oppose this proposed directive and argue that such a step cannot be taken uniformly with respect to all agricultural commodities.

A Jalgaon-based trader pointed out that if such a directive were to come in force, there would be immense volatility in spot markets on the settlement date.

Again, in case there is a shortage of physical stocks in the markets as is the case with chana this year, the spot prices would zoom on settlement date, as sellers would rush to buy physical stocks.