Policy Brief Series No.

1/2013

Banks’ Participation In
The Indian Commodity Derivatives
Market:
An Indispensable And Immediate Economic Need

Academic literature, critical policy briefs, and global experiences acknowledge that within
an appropriate regulatory structure, commodity derivatives markets can be leveraged to
provide benefits to market participants, and the economy as a whole. There is no doubt that
participation of multiple and diverse entities in such a market not only strengthens the
institution, but also endows participants with huge benefits, and consequently affects the
economy as a whole, positively. However, presently, in India, banks are not allowed to
participate in the commodity derivatives markets. Such non-participation of the most
important financial institutions of the country—banks—is an important missing link in the
evolution of this market in India.
Banks need to manage risks arising from commodity price volatility
Increasing Commodity Price Risk in a liberalised regime: While participation of financial
institutions such as banks in the commodity derivatives market will undoubtedly contribute
to the depth and width of the market, the availability of an unparalleled risk management
platform for the banks themselves is of bigger significance . Thanks to globalisation of the
Indian economy and business expansion of the nation’s banks, their exposure to the rising
commodity price volatility is significantly high—19 per cent as per one estimate (Table 1). Yet,
while banks have been allowed to manage other risks in their portfolios, they do not have

APPROXIMATE COMMODITY RISK EXPOSURE OF INDIAN BANKS Table 1

Sectors Outstanding Credit % Annualised Volatility (2011-12) Risk Exposure

Agricultural & allied activities 522,623 12.19 (MCX Agri index) 63,708
Commodity-related industry sectors
Agricultural commodity based 152,310 9.5% (Sugar) to 64.3% (cotton) 63,368
Non- agricultural commodity based 376,051 17.5 % (gold) to 25.6% (energy) 75,114
Total outstanding credit 1,050,984
Total annual price risk exposure of banks in commodities 202,191
Price risk as percentage of outstanding credit = 19%
Note: All figures above are in `crore, unless mentioned; outstanding figures are as on March 31, 2012;
Source: RBI, MCX, Bloomberg
How an agriculture- any mechanism to hedge commodity price risks in an effective
and transparent manner, as they are barred from entering the
focused bank
commodity derivatives market.
facilitates commodity
Banks may act as Intermediaries: At another level, banks can
hedging in the act as intermediaries, facilitating the risk management actions of
developing countries farmers and other small players who on their own may face
considerable barriers in entering this market. World over, there
Rabobank (a leading bank are many examples of how banks have enabled farmers better
headquartered in the manage their risk exposures and increase their incomes by
Netherlands), in association participating on commodity derivatives exchanges. Mention
with the World Bank, has may be made of Rabobank’s intervention in Tanzania and
been involved in various Nicaragua, and Banco do Brasil’s intervention in the Brazilian
interventions in the agricultural market through issue of exchange-traded Cédula de
developing countries to Produto Rural (CPR) contracts. Many of these interventions are
enable farmers and made by designing and offering customised hedging solutions
agricultural co-operatives fulfilling requirements of farmers. Besides, by aggregating small
manage commodity price participants, banks enable even small farmers to reap the
risks. The Commodity Price benefits of hedging.
Risk Management (CPRM)
Hedging facilitation to SMEs
unit, a global unit of the
bank, provides customers Like the farm sector, the non-farm sector, especially the small and
with price risk management medium enterprises (SMEs), too has been a significant
tools, including swaps and beneficiary of the commodity futures market, which can be
options for various increased manifold by allowing banks to provide a facilitative
commodities such as grains, role. Given the recent broad-based volatility in commodity prices,
cotton, sugar, cocoa, coffee maintaining profitability has emerged as a major challenge for
and fertiliser. SMEs that generally grapple with the problem of rigid end
In Tanzania, Rabobank product price. Price volatility also compels them to seek
worked with a large coffee increased working capital to mitigate risks. Due to the small
co-operative. The quantum of purchase, SMEs are also unable to get into long-term
co-operative purchased contracts with suppliers. Hence, hedging appears to be
price insurance to extremely necessary for the survival of SMEs. However, as
manage its risk in hedging involves developing suitable risk management
October, November and strategies and taking well-timed market decisions, the limited
December 2002/03 Arabica capital base and wherewithal at the disposal of SMEs poses
coffee selling season and challenges for these businesses .
sold back the insurance
Moreover, the inability to hedge results in a decline in their credit
when physical sales
worthiness. Using over-the-counter derivatives is out of bounds
contracts were committed.
for small stakeholders such as SMEs due to the high cost of these
Such hedging transactions
instruments and lack of knowledge on their usage.
by the Tanzanian...
 It is, therefore, imperative that banks act as facilitators by
enabling SMEs exposed to price volatility of inputs such as
agricultural commodities, metals, energy and bullion, hedge
their risks using commodity derivatives. Their facilitative role will
not only enable producers to access risk management markets,
which are otherwise inaccessible or costly, but also open
...co-operative benefited
opportunities for banks themselves. Banks can have a greater
several thousand small
guarantee of the credit offered to small borrowers—such as
coffee farmers.
SMEs—being repaid, if they are hedged.
Similar transactions
were undertaken Hedging releases scarce resources for better deployment
by the bank in It is important to realise that the core economic rationale for
Nicaragua (in central banks’ participation in the commodity derivatives market is to
America) too, at around the either manage their own risks or facilitate users’ participation.
same time, involving some
At a micro level, with a comprehensive risk management policy
250 coffee growers. The
that encompasses commodity price risks, banks’ financial and
period of coverage ranged
from one to six months human resources can be freed to cater to more important
consistent with physical strategic functions. Under the evolving international regulatory
transactions. All initial regime, wherein norms on credit and provisioning are
transactions were put increasingly being linked to risk assessment of banks’ portfolios,
options and premiums hedging against commodity price movement will actually
ranged from 2-9 per cent of contribute to freeing of financial resources. This will enable the
the strike price. Rabobank Indian banks achieve their priority sector targets and facilitate
executed most of these overall business expansion.
transactions on The focused deployment of appropriate products for credit,
behalf of the growers. could, at a macro level, go a long way in smoothening and
It was observed that shortening the credit cycle. This could be particularly relevant for
thousands of African credit deployment in sectors with high exposure to commodity
farmers, who were
price risks, which get transmitted to the banking sector as a result
members of one specific
of their credit exposure in them.
large co-operative, saved
half their lending fee of Such efficient cycling of credit through appropriate products,
18 per cent. would in turn contribute to enhancing the Indian banking
Another major result of industry’s credit productivity, in general.
hedging was that local Better risk-adjusted-returns for the Banks
banks extended credit to
Another important reason for banks to participate in this market
counterparts they had
is the investment opportunity it provides. Banks’ search for safe
refused earlier.
investment opportunities, typically forces them to opt for fixed-
Source: Case Study of World Business income instruments. This is why the banking industry, on the
Council for Sustainable whole, has kept no less than 29.5 per cent of their deposits in
Development (WBCSD), 2004
EFFECTS ON A PORTFOLIO’S RETURNS AND SHARPE RATIOS AFTER ADDING COMMODITIES TO IT: Table 2
AUGUST 31, 1959 THROUGH APRIL 30, 2009
60% equities,
Parameters/portfolio 100% 60% equities & 80% equities & 40% bonds &
composition equities 40% bonds 20% commodities 20% commodities
Total return 9.05% 8.45% 9.51% 8.94%
Standard deviation 15.34% 10.46% 12.86% 8.98%
Sharpe ratio 0.29 0.31 0.35 0.40
Sources: Vanguard calculations, based on Commodity Research Bureau; Datastream, Thomson Reuters

government bonds, although they are mandated to park a minimum of just 24 per cent.
While equity as an asset class appears too risky for banks, commodity derivatives would be
an ideal asset in their portfolio with higher ‘risk-adjusted returns’ vis-à-vis stocks. Finally, it is
empirically established from worldwide examples that inclusion of commodities offers
great portfolio diversification benefits, as prices of most commodities move in a different
direction from that of asset classes such as equities (Table 2).
A powerful idea, whose time has come
The tremendous growth of the commodity derivatives market in India since inception in
early 2000s, is reflective of the large and growing unmet demand for a risk management
platform amongst millions of stakeholders exposed to commodity price volatility. This
growth has created enormous demand for risk management solutions apart from support
services such as storage, logistics, inputs and extension services, much of which has been
created through banks’ financing. Sadly, the Indian banking industry is not yet a part of this
growth story and has not been able to either unlock or exploit the latent values that remain
submerged in India’s commodity derivatives market. Non-participation of banks is
particularly conspicuous in the Indian scenario, as banks’ participation can bring about
greater benefits to all stakeholders connected to the commodity economy in our country.
Additionally, banks need this market for their own risk management and investment needs.
Banks’ participation will result in a “win-win” situation from all perspectives. On the one hand,
it will be in the interest of banks’ own sustainable growth. On the other hand, it will help them
achieve the goal of inclusive growth through market inclusion of millions of commodity
producers. Thus, banks’ participation in the commodity derivatives market should not be
treated merely as a policy option; it should be treated as a fundamental economic need
of the day.

This Policy Brief is an outcome of an ‘Occasional Paper’, published by the Department of Research and Strategy, MCX.
The ‘Occasional Paper’ and this Policy Brief can also be viewed on www.mcxindia.com/knowledgehub.

Comments and suggestions may be sent to: