Commodity Derivatives Exchanges


Enrich Broking: Functions Of Commodity Exchange

A commodity exchange (also called bourse) is an organized physical or virtual marketplace where various tradable securities, commodities and derivatives are sold and bought. 

They appeared much before financial derivatives in the world.

Clay tablets appeared in Mesopotamia around 2000 BC as contracts for future delivery of agricultural goods.

The story of Thales of Miletus (624-547 BC) in Aristotle’s writings is considered as the first account of an option trade whereby the price of the spring olive from the oil presses was negotiated in winter without an obligation to buy the oil.

The idea was to offset the price risk and maintain a year-round supply of seasonal agricultural crops in the markets.

During the 12th century, merchants began making commitments to buy or sell goods even before they were physically available to reduce the risk of looting while traveling along dangerous routes. 

The central function of these contracts, later called derivatives, was to guarantee a future price and avoid the risks of unexpected higher or lower prices.

The late 19th century witnessed a spurt in commodity futures trading with the creation of exchanges. 

The main focus was reduction of transaction costs. 

Organizing a marketplace where buyers and sellers could find a ready market. 

Chicago emerged as a major commercial hub where derivatives were traded and harvest could be delivered, with the best of rail, road and telegraph line connections to attract wheat producers, dealers and distributors. 

The prices on the Chicago Board of Trade, e.g. for wheat futures, are still important price references and price indicators used worldwide. 

Some commodity exchanges were established in the rest of the world. 

Set up in 1854, Buenos Aires Grain Exchange in Argentina is an example of one such old exchange in the world. 

After the liberalization of agricultural trade in the 20th century, many countries withdrew support to agricultural producers and prices became more volatile. 

Commodity exchanges helped the price discovery and hedging function and facilitate physical trading. 

Initially, these exchanges were located mainly in developed countries but soon the developing countries followed. 

The key functions of the commodity derivatives exchanges include:

Providing and enforcing rules and regulations for uniform and fair trading practice.

Facilitating trading in a transparent manner

Recording trading transactions, including circulating price movements and market news, to the participating members

Ensuring execution of contracts

Providing a system of protection against default of payment (clearing)

Providing a dispute settlement mechanism

Designing the standardized contract for trading which cannot be modified by either party.

It should have a suitable risk management mechanism, normally in the form of a clearing house (owned by the exchange or by another operator) that ascertains the credit-worthiness of the parties of a contract and ensures the execution of contracts. 

It especially serves as a legal counter-party between each buyer and each seller of a derivatives contract on the exchange and, therefore, is called a central counter party (CCP). 

The exchanges should also maintain a Settlement Guarantee Fund (SGF) to ensure a high level of protection against the risk of default by a trader. 

The clearing house (the CCP), or the SGF of the exchange has to be used in case of default by a buyer or a seller to pay the other party. 

In order to guarantee that the parties will execute the contract and to maintain reserves to deal with default, the clearing house or SGF requests the parties to provide collateral (called margin) in the form of cash or securities. 

The margin money changes daily with the change in prices of the contracts on which traders have taken positions. 

In an event of adverse price movements, the traders are requested to increase their margin amount (‘margin call’).

Modern electronic commodity exchanges offer fast, secure, transparent and regulated platforms for transactions along with public display of prices and trading. 

The exchange designs the standardized contract for trading which cannot be altered by the either party.

The exchange provides a seamless trading platform and competitive trading as well as facilities for clearing, settlement, and arbitration. 

Most importantly, the exchange guarantees a financially secure environment for risk management and guaranteed performance of contract.

The price rises if purchase volumes outnumber sales volumes, and vice versa. 

The bargaining (bids and offers) for commodity derivatives contracts converge at the trading floor on the expectations of different stakeholders about prices of a particular commodity on the specified maturity date in the future. 

The prices in a futures market are determined from the bargaining, namely the interaction of buy and sell ‘quotes’ from different participants having different expectations from the physical and financial markets. 

Buying and selling by speculators when they engage in excessive speculative trading that is unrelated to the physical market influences the futures prices. 

Frequently Asked Questions

Peak Margin-Enrich

.

Commodity markets or exchanges are a great medium for various investors to buy and sell commodities through price discovery. It propagates commodity news to help traders make decisions. These exchanges act as mediators of disputes between traders. The other role and functions of commodity exchange include providing grading to the raw materials that can be used for trading. This allows the dealer and all parties involved to conclude a contract in the shortest possible time. In addition, the commodity provides similar benefits to brokers, farmers, intermediaries and clients, thus guaranteeing an organized platform for trading their commodities.

.

Commodity exchanges allow traders and investors to pass on risk to professional risk takers. These exchanges provide a fair market for the price discovery process and free commodity producers from intermediaries. Commodity markets guarantee trade continuity, so financial firms and bankers are fine in providing credit to commodities. Commodity market performance is in contrast to equity performance, and investors can make up for the low margins of the capital sector, making investing in the commodity market more profitable. In addition, these commodity exchanges are considered to be excellent protection against inflation as commodity prices tend to rise during inflation. This helps maintain purchasing power parity.

.

The presence of commodity markets helps the suppliers of commodities from falling prey to the unstable and falling price. With these exchanges, the producers can settle for a price which they think is suitable for their products. This helps in having a reasonable supply of commodities across the country. Furthermore, they prevent suppliers succumbing to the price middlemen thus offering them an organised medium where their commodities can be traded at an adequate price. The investors can hedge against losses from other asset classes thus mitigating the loss and further diversifying the portfolio. This helps in the overall development of the commodity sector.

.

Both traders and processors need a commodity exchange to negotiate prices for commodities and buy and sell commodities. Instead of selling goods in one place, the buyers and sellers of the commodity market enter into trade agreements that represent the quantity of each goods. It is these commodity markets that determine the prices of livestock and grains. Therefore, regardless of location, the commodity market provides a single platform for sellers and buyers to negotiate prices and conduct transactions. These exchanges also allow physical participants to hedge price increases.

.

Commodity exchanges are places where commodities are traded, such as exchanges that buy and sell stocks and bonds. The main purpose of these exchanges is to make a profit from various changes in the commodity market by buying and selling commodities.

The various types of commodity markets in India are:

Spot market or cash market or physical market where physical goods are traded for prompt delivery

Derivatives markets including futures and forwards. Futures are standardized and traded on exchanges, but futures can be adjusted and traded over-the-counter.

Top