Chapter 16: Understand Legal and Regulatory Environment of Commodity Derivatives

The banks where you deposit money and avail various loans from; your mobile service providers; your investment in various asset classes, all of these are governed by the legal and regulatory environment. This is to ensure that each system and process works according to set rules and regulations. It also ensures you get equal rights in transacting. Likewise, commodity derivatives are also governed by rules and regulations.

Let us understand various legal and regulatory aspects of the commodity derivatives market in the following paragraphs.

Regulatory structure of commodities market

The major goal of commodity market regulation is to maintain and develop commodity markets' fairness, efficiency, transparency, and growth, as well as to protect the interests of diverse commodity market stakeholders, decrease systemic risks, and assure financial stability.

The Indian commodity derivatives market follows a three-tiered regulatory framework comprising the central government, SEBI and the exchanges.

The central government formulates policies with regard to the recognition of commodity exchanges and commodities to be listed for trading.

SEBI is the implementor of the central government’s policies with an objective of protecting the interest of investors and to promote development of markets.

Exchanges develop products in accordance with the rules and regulations of the securities market and create an online platform for various market participants.

Securities Contracts (Regulation) Act 1956

The Securities Contracts (Regulation) Act of 1956 (SCRA) gives the government direct and indirect supervision over almost every aspect of securities trading and stock exchange operations. It regulates securities dealings and the trading business to prevent unfavourable transactions in securities. This Act covers various issues, some of which are listed below:

1. Granting recognition to the exchanges
2. Corporatisation and demutualisation of stock exchanges
3. The power of the central government to call for periodical returns from stock exchanges
4. The power of SEBI to make or amend by-laws of recognised stock exchanges
5. The power of the central government (also exercisable by SEBI) to supersede the governing body of a recognised stock exchange
6. The power to suspend business of recognised stock exchanges
7. The power to prohibit undesirable speculation

Other regulatory norms to encourage commodity derivatives

Apart from regulating the operation of exchanges as well as member brokers, SEBI has come up with various other norms to regulate the working of other market intermediaries such as warehouse service providers, assayers, etc. The regulator has permitted participation of institutional participants such as banks, mutual funds and portfolio management services in the commodity derivatives market through various circulars. It has also allowed foreign entities to hedge their Indian commodity exposure in the commodity derivatives market.

SEBI's Listing Obligations and Disclosure Regulations require listed businesses to provide information on commodity risk management policies, commodity risk exposures, and the amount to which they are hedged in local and international markets. If the financing is secured by commodity collateral, the RBI has also given instructions to banks to urge their borrower clients to hedge their commodity risks.

Risk disclosure to client and KYC

As per the SEBI guidelines, KYC of all the clients is mandatory. With an advancement of technology, SEBI has issued guidelines to make online KYC registration possible, which is completed in a few minutes against paper-based KYC, which takes 5-7 working days.

 Since investment in the securities market carries a risk of loss, and erosion of capital invested because of market movement, you need to sign the risk disclosure agreement before start trading in commodity market.

The risk disclosure document should broadly specify all the risks while dealing in the commodity derivatives market and some of them are listed below.

1. Price fluctuation/Market risk in Spot, Futures, Options or any other derivatives markets
2. Macroeconomic scenarios leading to unexpected price movement arising out of foreign exchange movement, global demand supply, local demand supply, weather forecast, government policies related to commodities, tax related policies, etc.
3. Sudden drying out of liquidity on any contract leading to adverse movement in prices or higher transaction costs or inability to unwind position
4. Basis risk vis-à-vis Spot prices
5. Risks of position remaining unhedged
6. Risk in short positions in Options
7. Broker’s credit risk i.e., counterparty risk
8. Risks arising out of technical snags, operational issues or technology-related issues at the brokers’ end, exchanges’ servers or connectivity related issues in web trade
9. Risks relating to quality of commodities or rejection of commodities at the warehouse after short selling the commodity leading to delivery failure

Investors grievance redressal mechanism

If you have any grievances against your broker member for initiating or squaring of positions without your consent, delay or non-remittance of pay out within the stipulated time, you have the right to approach the Investor Grievance Redressal Mechanism/Investor Service Department at the exchange level. The exchange has a mechanism of resolving disputes by coordinating with the member and the complainant.

Dos and Don’ts for clients/investors in commodity derivatives

Investment in any of the financial instruments carries risks such as market risk, price risk, geopolitical risks etc. Hence, it is of utmost importance to take calculated risks while making investment decisions. Here are some of the dos and don'ts in the commodity derivatives market.

Dos

1. Trade only through registered members
2. Work on your risk bearing ability
3. Familiarise yourself with guidelines, rules, regulations, by-laws, circulars, etc.
4. Take an informed decision
5. Understand the delivery and settlement procedure
6. Understand and comply with taxation and other relevant laws
7. Pay all applicable margins. Pay mark-to-market margins on a daily basis
8. Insist on documentation with the member such as member-client agreement and KYC
9. Read and understand the Risk Disclosure Document
10. Insist on signed Contract Notes containing all relevant information such as member registration number, order details, trade rate, quantity, etc.
11. Insist on a periodical statement of your ledger account

Don’ts

1. Don't get misled by rumours, luring advertisements and promises, and market sentiments
2. Don't trade any contract without knowing the associated risks
3. Don't undertake off-market transactions
4. Don't accept/pay cash
5. Don't sign blank Delivery Instruction Slips 
6. Don't delay payment/deliveries to members.

Summary

• The commodity derivatives market is regulated by Securities Contracts (Regulation) Act 1956 through the central government, SEBI and exchanges.
• SEBI formulates various rules and regulation to ensure fair trading and protect investor interests. It also amends them periodically to match market requirements.
• As an investor, you are required to comply with KYC norms as well as sign the Risk Disclosure Agreement.
• If you are not satisfied with services of your member broker or find non-authenticated transactions, you have a right to approach the Investor Grievances Department of the exchange for amicable solutions.
• Before starting your commodity trading journey, understand the pros and cons as well as dos and don’ts of trading.

We hope you've gained a firm footing and a solid foundation to begin your journey into the commodity market. Revisit any of these chapters at any time to familiarise yourself with the basics and boost your understanding. Happy investing!