Sebi sets eyes on commodity index derivatives, works on guidelines

Securities and Exchange Board of India Chairman Ajay Tyagi has said in an annual report “there are plans to consider more commodity options contracts to be launched, besides working on guidelines for index products”. Sebi will have to first finalise guidelines, which, according to sources, will suggest common standards for preparing commodity indices and later there will be regulations regarding trading.

Hence it will be a long wait before trading in index-based derivatives’ much-awaited indices starts.

Experts say preparing indices for commodities is most complex, unlike equities. In equities most of the volumes come from index derivatives and index options. Sources said the guidelines would include how to consider the weight of the components of the index and some technical parameters on index preparation. 

Commodity contracts, instead of commodities, which are the underlying, will be components of the index. Second, it will be a future price index and not a spot price index. Futures prices will be considered in the index because in several international commodities traded on commodity exchanges, an efficient spot market is not developed.

Both the MCX and NCDEX, two leading commodity exchanges, have different indices for various segments like metals and agri commodities, and the composite. However, they should meet the Sebi index norms and standards whenever finalised. Usually International Organisation of Securities Commission (IOSCO) index standards have to be complied with.

In equities, the market cap of the company and its floating market cap are important criteria for deciding the weight of the firms in the index. However, there is no such data for commodities. For example, the market cap or size of the market of wheat can be only notional. There are several varieties and different prices based on the quality for all varieties. They change with changes in crop size. Final crop estimates come late.

The MCX launched indices, including the composite index prepared by Thomson Reuters a year ago. They are for base metals, bullion, single commodity indices for gold, copper and crude oil and the composite index. The composite index is for all actively traded commodities and the methodology has two criteria, which are physical market size and liquidity in the respective contract on the exchange. In a composite index, caps have to be set for physical market size and liquidity.

Illustration: Binay Sinha

For example, if a highly liquid commodity on an exchange is small in size, its liquidity component will be capped and a commodity like crude oil has a cap on the physical market size when it is part of the index.

However, the MCX composite index has only two agri commodities and total weight less than 5 per cent. Crude oil is heaviest with 35 per cent weight.

The NCDEX has the ‘dhanya’ index since 2011 but not a truly representative index of the agri commodity market. The components include sugar, soyabean, chana and cotton seed, which have very high weight. Agriculture commodities in general are not trading in a big way in futures. In other agri commodities there are frequent government policy interventions by way of stock limits, minimum support price, quota and duty changes.

Vijay Sardana, a noted agriculture market expert, said: “An efficient commodity delivery market should have a delivery threat to keep speculation in check and hence there has to be an option of physical settlement in commodities. Also, what is more important than indices for derivatives are that spot markets should be free of controls. In India, especially in agriculture, there are several government protections and interventions. In agriculture, a state subject, several state policies will affect an efficient market-based price discovery and hence making markets efficient is more important.”

The trading question

•  Sebi will have to draft guidelines to suggest common standards for preparing commodity indices
• This will be followed by regulations for trading
• Guidelines likely to suggest how to consider weight of components of index, technical parameters on index preparation
• Futures prices to be considered in index, given lack of efficient spot markets in several global commodities traded on exchanges
• MCX and NCDEX have different indices for various segments