Commodities Market – An Overview

 

In a new era of trading environment, commodities exchanges offer innumerable economic benefits by facilitating efficient price discovery mechanisms and competent risk transfer systems.

Ever since the dawn of civilization commodities trading has become an integral part in the lives of mankind. The very reason for this lies in the fact that commodities represent the fundamental elements of utility for human beings. The term commodity refers to any material, which can be bought and sold. Commodities in a market's context refer to any movable property other than actionable claims, money and securities. Over the years commodities markets have been experiencing tremendous progress, which is evident from the fact that the trade in this segment is standing as the boon for the global economy today. The promising nature of these markets has made them an attractive investment avenue for investors.

In the early days people followed a mechanism for trading called Barter System, which involves exchange of goods for goods. This was the first form of trade between individuals and even nations. The absence of commonly accepted medium of exchange has initiated the need for Barter System. People used to acquire those commodities which they lacked in exchange of those commodities which are in excess with them. The commodities trade is believed to have its genesis in Sumeria. The early commodity contracts were carried out using clay tokens as medium of exchange. Animals are believed to be the first commodities, which were traded, among individuals. The internationalization of commodities trade can be better understood by observing the commodity market integration that occurred after the European Voyages of Discovery during the 15^th century. The development of international commodities trade is characterized by the increase in volumes of trade among the nations and the convergence of price related to the identical commodities in different markets. The major impetus for the commodities trade was provided by the changes in demand patterns, scarcity and the supply potential both within and across the nations.

Development of Commodities

In the context of the development of commodities markets, integration plays a pivotal role in surmounting the barriers of trade. The major drive for the integration of commodities trading was given by the European discoveries and the march of the world trade towards globalization. However, the commodities trade among different countries was originated much before the voyages of Columbus and Da Gama. During the first half of the second millennium, India and China had trading arrangements with Southeast Asia, Eastern Europe, the Islamic countries and the Mediterranean. The advancements in shipping and other transport technologies had facilitated the growth of commodities trade. The unification of the Eurasian continent by the Mongols increased the flow of people, ideas and goods. Later, the Black Death of 1340s, the killer plague that reduced the population of Europe and Middle East by one-third, has resulted in more per capita income for individuals and thus increased the demand for Eastern luxuries like precious stones, spices, ceramics and silks. This has augmented the supply of precious metals to the East. This entire scenario resulted in the increased reliance on Indian Ocean trade routes and led to the discovery of sea route to Asia.

The second half of the second millennium is characterized by the connectivity of the markets related to the Old and the New Worlds, which saw the the light in the aftermath of Europen Discovery. In the year 1571, the city of Manila was found, which linked the trade between America, Asia, Africa ad Europe. During the initial stages, because of the high transportation costs, preference of trade was given to those commodities, which had high value to weight ratio. In the aftermath of the European discoveries huge volumes of silver was pumped into world trade. With the discovery of the Cape route, the Venetian and Egyptian dominance of spice exports was diluted. The introduction of New World crops to China lead to the increased demand for silver and a growth in exports of tea and silk. Subsequently, Asia became the prime exporter of spices and silk and Americas became the prominent exporter of silver.

Trading in Commodities

Earlier investors invested in those companies, which specialized in the production of commodities. This accounted for the indirect investments in commodity assets. But with the establishment of commodity exchanges, a shift in the investment patterns of individuals has occurred as investors started investing directly in commodities rather than in the companies which produced them.

The establishment of these exchanges has benefited both the producers and traders in terms of high profits and low transaction costs. Commodity exchanges play a vital role in ensuring transparency in transactions and disseminating prices. The commodity exchanges ensured the standard of trading by maintaining settlement guarantee funds and implementing stringent capital adequacy norms for brokers. In the light of these developments, various commodity based investment products were created to facilitate trading and risk management. The commodity based products offer a huge array of benefits that include offering risk-return trade-offs to investors, providing information on market trends and assisting in framing asset allocation strategies.

Commodity investments are always considered as defensive because during the times of inflation, which adversely affects the performance of stocks and bonds, investments in commodities enabled the investors to defend the performance of their portfolios.

The commodities trade in the 18^th and 19^th centuries was largely influenced by the shifts in macro economic patterns, the changes in government regulations, the advancement in technology, and other social and political transformations around the world. The 19^th century has seen the establishment of various commodities exchanges, which paved the way for financing and warehousing facilities in this arena. In a new era of trading environment, commodities exchanges offer innumerable economic benefits by facilitating efficient price discovery mechanisms and competent risk transfer systems.

Trading in Commodities Derivatives

Another major leap in the development of commodities markets is the growth in commodities derivative segment. Derivatives are instruments whose value is determined based on the value of an underlying asset. Derivatives are useful for both the producers and traders for the mitigation of risk in their business. Forwards, futures and options are some of the well-known derivatives instruments widely used by the traders in commodities markets.

Derivatives’ trading has a long history. The first recorded incident of commodities derivatives trade can be traced back to the times of ancient Greece. In the year 1688 De la Vega reported the trading in 'time bargains' which was commonly used term for options and futures in those days. Though the first recorded futures trade was said to have happened in Japan during the 17th century, evidences reveal that the trading in rice futures was existent in China, 6000 years ago. Trading in futures is an outcome of the mankind's efforts towards maintaining the flow of supply of seasonal commodities throughout the year. Farmers derived the real benefits of derivatives contracts by assuring the desired prices are paid for their products.

The volatility of prices made the commodity derivatives not only significant risk hedging instruments but also strategic investment assets. Slowly, traders and speculators, who never intended to take the delivery of goods, entered commodities trading. They traded in these instruments and made their margins by taking the investment asset advantage of price volatility in commodity markets.

The dawn of the 21^st century brought back the good times for commodity markets. With the end of a 20 year bear market for commodities, following the global economic recovery and increased demand from China and other developing nations, has revitalized the charisma of commodities markets. According to the forecasts given by experts commodities markets are likely to experience a bright future with the depreciation in the value of financial assets. Furthermore, increasing global consumption, declining U.S. Dollar value, rising factor-input costs and the recent recovery of the market from the clutches of bear trend are considered to be the positive symptoms, which contribute to the acceleration of growth in commodity markets segment.

The Indian Connection

Coming to the Indian scenario, despite a long history of commodity markets, commodity markets in India are still in their initial stages of development. The reasons for this can be attributed to stringent regulatory interventions, intermediate ban on commodity trading and policy interventions by the government. Commodity markets have a huge potential in the Indian context particularly because of the agri-based economy. With the government's initiative for agricultural liberalization, commodities' trading in India has gained increased momentum in activities. To increase the efficiency of the markets the Forward Markets Commission (FMC), the governing body of commodities trading in India has taken several initiatives for the establishment of national level multi-commodity exchanges in India. These exchanges serve as platforms for facilitating transparent trading, trading in multiple commodities, electronic delivery systems and efficient regulatory mechanisms, creating a world class environment for Indian traders. In order to sustain the increasing volumes in commodities trade, the need for proper clearing and settlement systems, warehousing facilities and efficient pricing mechanisms has been identified. With the recent boom in commodities markets, Indian participants are gearing up for exploiting the potential opportunities in the future.

Commodity markets are of great help not only for their participants but also for the economy as a whole. The twenty year bear market for commodities has drastically reduced the prices of many commodities to their lowest levels. The present shift in trend in commodity trading coupled with the global increase in demand will certainly hold a promising future for the investments in this segment. This book provides the impetus for the readers to understand the evolution and development of commodities markets and their significance in the arena of strategic investments.

N Janardhan Rao, Lead Economist.