Regulation of Commodity Derivatives in India – Securities and Exchange Board of India (SEBI)

Introduction

Commodity derivatives play a crucial role in India’s financial markets, serving as essential tools for price discovery and risk management in the commodities sector. These financial instruments derive their value from underlying commodities, ranging from agricultural products to precious metals and energy resources. The regulation of commodity derivatives in India has undergone significant changes over the years, reflecting the evolving nature of the country’s financial markets and the growing sophistication of its regulatory framework.

In 2015, a landmark shift occurred in the regulatory landscape of commodity derivatives when the Securities and Exchange Board of India (SEBI) assumed the role of the primary regulator for these instruments. This move brought both securities and commodity derivatives under a single regulatory umbrella, marking a new era in the oversight of India’s financial markets. SEBI’s regulation of commodity derivatives aims to ensure market integrity, protect investor interests, and facilitate the efficient functioning of these vital financial instruments.

Historical Context and Evolution of Commodity Derivatives Regulation in India

The history of commodity trading in India is deeply rooted in the country’s economic and cultural fabric, dating back to ancient times. However, the modern era of commodity futures trading in India began in the 19th century, with the establishment of the Bombay Cotton Trade Association in 1875. This marked the beginning of organized commodity futures trading in the country.

In the years following India’s independence, the government recognized the need for a comprehensive regulatory framework for commodity derivatives. This led to the enactment of the Forward Contracts (Regulation) Act, 1952, which was the first comprehensive legislation for commodity derivatives in independent India. This Act laid the foundation for the regulatory structure that would govern commodity derivatives for decades to come.

The Forward Markets Commission (FMC) was established in 1953 as the regulatory body for commodity derivatives under the provisions of the Forward Contracts (Regulation) Act, 1952. For over six decades, the FMC served as the primary regulator for commodity futures markets in India. During this period, the commodity derivatives market in India witnessed significant growth and evolution, with the introduction of new commodities and the establishment of national multi-commodity exchanges.

However, as India’s financial markets grew more complex and interconnected, there was a growing realization of the need for a more integrated approach to financial regulation. This led to discussions about bringing both securities and commodity derivatives under a single regulatory framework.

The year 2015 marked a watershed moment in the regulation of commodity derivatives in India. The government decided to merge the Forward Markets Commission (FMC​​​​​​​​​​​​​​​​) with the Securities and Exchange Board of India (SEBI). This merger, which came into effect on September 28, 2015, was a significant step towards creating a unified regulatory framework for India’s financial markets. The merger brought both securities and commodity derivatives under SEBI’s purview, allowing for more cohesive and comprehensive market oversight.

This consolidation of regulatory authority was aimed at achieving several objectives. First, it sought to bring about greater consistency in the regulation of various financial instruments, recognizing the increasing convergence between securities and commodity markets. Second, it aimed to leverage SEBI’s expertise and resources in market regulation to strengthen the oversight of commodity derivatives. Finally, it was intended to foster innovation and growth in the commodity derivatives market by aligning it more closely with the broader financial markets ecosystem.

Legislative Framework

The regulation of commodity derivatives in India is underpinned by a robust legislative framework that has evolved over time. The primary legislations governing commodity derivatives are:

1. Securities Contracts (Regulation) Act, 1956 (SCRA)
2. Securities and Exchange Board of India Act, 1992
3. Forward Contracts (Regulation) Act, 1952 (now repealed)

The Securities Contracts (Regulation) Act, 1956 (SCRA) is a cornerstone of securities market regulation in India. With the merger of FMC with SEBI, the SCRA was amended to include provisions related to commodity derivatives. The Act provides the legal basis for regulating securities transactions, including commodity derivatives.

Section 2(ac) of the SCRA defines “derivative” in a comprehensive manner:

“‘derivative’ includes—

(A) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

(B) a contract which derives its value from the prices, or index of prices, of underlying securities;

(C) commodity derivatives; and

(D) such other instruments as may be declared by the Central Government to be derivatives;”

This broad definition encompasses various types of derivatives, including commodity derivatives, bringing them under the regulatory ambit of the SCRA.

The Act further defines “commodity derivative” in Section 2(bc):

“‘commodity derivative’ means a contract —

(i) for the delivery of such goods, as may be notified by the Central Government in the Official Gazette, and which is not a ready delivery contract; or

(ii) for differences, which derives its value from prices or indices of prices of such underlying goods or activities, services, rights, interests and events, as may be notified by the Central Government, in consultation with the Board,

but does not include securities as referred to in sub-clauses (A) and (B) of clause (ac);”

This definition clearly delineates commodity derivatives from other types of securities, while also providing flexibility for the government to notify new types of commodity derivatives as markets evolve.

The Securities and Exchange Board of India Act, 1992, which established SEBI as the regulator for securities markets, now also covers commodity derivatives following the 2015 merger. Section 11(1) of the Act outlines SEBI’s functions:

“Subject to the provisions of this Act, it shall be the duty of the Board to protect the interests of investors in securities and to promote the development of, and to regulate the securities market, by such measures as it thinks fit.”

This broad mandate allows SEBI to take various measures to regulate and develop the commodity derivatives market, alongside other securities markets.

The Act also empowers SEBI to issue directions to market participants. Section 11B states:

“Save as otherwise provided in section 11, if after making or causing to be made an enquiry, the Board is satisfied that it is necessary—

(i) in the interest of investors, or orderly development of securities market; or

(ii) to prevent the affairs of any intermediary or other persons referred to in section 12 being conducted in a manner detrimental to the interests of investors or securities market; or

(iii) to secure the proper management of any such intermediary or person,

it may issue such directions,—

(a) to any person or class of persons referred to in section 12, or associated with the securities market; or

(b) to any company in respect of matters specified in section 11A,

as may be appropriate in the interests of investors in securities and the securities market.”

This provision gives SEBI significant authority to intervene in the market when necessary to protect investor interests or ensure market stability.

While the Forward Contracts (Regulation) Act, 1952 has been repealed, many of its key provisions have been incorporated into the SCRA and SEBI Act, ensuring continuity in the regulatory approach to commodity derivatives.

SEBI’s Regulatory Framework for Commodity Derivatives in India”

SEBI’s regulatory framework for commodity derivatives is comprehensive, covering various aspects of market operations and participant behavior. The key areas of SEBI’s regulatory focus include:

1. Registration and Regulation of Commodity Exchanges: SEBI is responsible for granting recognition to commodity derivatives exchanges and regulating their operations. This includes setting standards for governance, transparency, and risk management at these exchanges.
2. Approval of Commodity Derivatives Contracts: SEBI reviews and approves the specifications of commodity derivatives contracts before they can be traded on recognized exchanges. This process ensures that contract designs are appropriate and conducive to fair price discovery.
3. Regulation of Market Intermediaries: SEBI registers and regulates various market intermediaries involved in commodity derivatives trading, including brokers, clearing members, and depositories. This oversight helps maintain the integrity of the market ecosystem.
4. Surveillance and Enforcement: SEBI conducts ongoing market surveillance to detect and prevent unfair trading practices, market manipulation, and other violations. It has the authority to investigate suspected violations and take enforcement actions against errant market participants.
5. Investor Protection Measures: SEBI implements various measures to protect the interests of investors in commodity derivatives, including disclosure requirements, investor education initiatives, and grievance redressal mechanisms.

To carry out these functions effectively, SEBI has issued several regulations specific to commodity derivatives. These include:

1. SEBI (Stock Brokers) Regulations, 1992: These regulations, originally designed for securities brokers, have been amended to include provisions for commodity derivatives brokers. They set out the requirements for registration, code of conduct, and other operational aspects for brokers dealing in commodity derivatives.
2. SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003: These regulations, which aim to prevent market abuse, have been extended to cover commodity derivatives markets as well.
3. SEBI (Regulatory Framework for Commodity Derivatives) Regulations, 2021: This new set of regulations provides a comprehensive framework for the regulation of commodity derivatives exchanges and the approval of commodity derivatives contracts.

The SEBI (Stock Brokers) Regulations, 1992, in particular, play a crucial role in regulating the conduct of intermediaries in the commodity derivatives market.

Regulation 17(1) of these regulations states:

“Every stock-broker, sub-broker and clearing member shall abide by the Code of Conduct as specified in Schedule II.”

Schedule II of these regulations includes provisions such as:

“A. General

1. Integrity: A stock-broker, sub-broker and clearing member shall maintain high standards of integrity, promptitude and fairness in the conduct of all his business.”

These provisions ensure that market intermediaries adhere to high standards of professional conduct, which is essential for maintaining market integrity and investor confidence.

Recent Developments and Initiatives

In recent years, SEBI has undertaken several initiatives to further develop and strengthen the commodity derivatives market in India:

• Integration of Commodity Spot and Derivatives Markets: SEBI has been working towards better integration of commodity spot and derivatives markets. This integration aims to improve price discovery mechanisms and create a more efficient market ecosystem. By aligning spot and futures prices more closely, this initiative seeks to enhance the effectiveness of commodity derivatives as risk management tools for producers and consumers of commodities.
• Introduction of New Products: SEBI has approved the introduction of new commodity derivatives products to expand the market’s scope and utility. One significant development in this area is the introduction of options on goods. This move allows market participants to access more sophisticated risk management tools, potentially attracting a wider range of participants to the market.
• Enhanced Risk Management: Recognizing the unique risks associated with commodity derivatives, SEBI has implemented stricter risk management norms for commodity derivatives trading. These measures include revised margin requirements, position limits, and other risk mitigation tools designed to enhance market stability and protect against excessive speculation or market manipulation.
• Regulatory Sandbox: In a move to foster innovation in the financial markets, SEBI has introduced a regulatory sandbox for market participants to test new products and services in a controlled environment. This initiative allows for the testing of innovative ideas in commodity derivatives trading and risk management, potentially leading to the development of new products or trading mechanisms that could benefit the market.

These developments reflect SEBI’s commitment to creating a more robust, diverse, and efficient commodity derivatives market in India. By introducing new products, enhancing risk management practices, and fostering innovation, SEBI aims to increase the attractiveness of the Indian commodity derivatives market to both domestic and international participants.

Challenges and Future Directions

Despite the significant progress made in the regulation and development of commodity derivatives markets in India, several challenges remain:

• Market Depth and Liquidity: Enhancing the depth and liquidity of commodity derivatives markets remains a challenge. While some commodity contracts see active trading, others suffer from low liquidity, which can hamper efficient price discovery and risk management. SEBI is working on measures to increase participation in these markets, including efforts to attract more institutional investors.
• Technology and Cyber Security: As with other financial markets, ensuring robust technological infrastructure and cyber security for commodity derivatives trading is an ongoing challenge. SEBI is continuously working to upgrade market infrastructure and implement stringent cyber security norms to protect against technological failures and cyber threats.
• Investor Education: Increasing awareness about commodity derivatives among retail investors is crucial for broadening market participation. SEBI has been conducting investor education programs, but more efforts are needed to familiarize potential investors with the benefits and risks of commodity derivatives trading.
• Global Integration: Aligning Indian commodity derivatives markets with global best practices and standards is an ongoing process. This includes efforts to harmonize contract specifications, trading hours, and regulatory norms with international markets to facilitate greater participation by foreign investors and improve price correlation with global commodity markets.

Looking to the future, several key areas are likely to shape the evolution of commodity derivatives regulation in India:

1. Technology Integration: The increasing use of artificial intelligence, blockchain, and other advanced technologies in trading and market surveillance is likely to be a key focus area for regulation.
2. Environmental, Social, and Governance (ESG) Considerations: As ESG factors become more prominent in investment decisions, SEBI may need to develop frameworks for integrating these considerations into commodity derivatives markets.
3. Cross-Border Harmonization: With the increasing globalization of commodity markets, there may be a push towards greater harmonization of regulations across jurisdictions to facilitate cross-border trading and risk management.
4. Product Innovation: As market participants demand more sophisticated risk management tools, SEBI will need to balance innovation with market stability in approving new types of commodity derivatives products.
5. Market Accessibility: Efforts to make commodity derivatives markets more accessible to a wider range of participants, including smallholder farmers and MSMEs, are likely to continue.

Conclusion 

The regulation of commodity derivatives by SEBI represents a significant milestone in the evolution of India’s financial markets. By bringing both securities and commodity derivatives under a single regulatory umbrella, SEBI aims to foster greater market efficiency, transparency, and investor protection.

The journey from the early days of the Forward Markets Commission to the current SEBI-regulated regime reflects the growing sophistication of India’s financial markets and regulatory approach. The comprehensive legislative framework, coupled with SEBI’s proactive regulatory initiatives, has laid a strong foundation for the growth and development of commodity derivatives markets in India.

As these markets continue to evolve, SEBI’s regulatory approach will likely need to adapt to address new challenges and opportunities. The balance between fostering innovation and ensuring market stability will remain a key consideration. Furthermore, as India’s commodity derivatives markets become increasingly integrated with global markets, the regulatory framework will need to evolve to meet international best practices while addressing India-specific market conditions.

The future of commodity derivatives regulation in India looks promising, with potential for significant growth and development. As SEBI continues to refine its regulatory approach, the commodity derivatives market is poised to play an increasingly important role in India’s financial landscape, contributing to more efficient price discovery, better risk management for producers and consumers, and overall economic development.