How Commodity Markets Evolved in India & Why They Exist

Commodity trading in India is much older than commodity exchanges.

Long before there were trading terminals or futures contracts, cotton, spices, grains, gold, silver and metals were already moving through Indian bazaars, ports and trading centres.

As trade expanded, the systems around it became more sophisticated too. During the Mughal period, merchants used instruments such as hundis for payments, credit and transferring money between trading centres. Coinage, recognised weights and established commercial routes made it easier to do business across regions.

So organised commodity markets did not suddenly appear one day. They grew out of a much older problem: how do you make buying and selling physical goods easier when the quantities get larger, the distances get longer and the money involved becomes more serious?

Suppose a merchant wants to buy a large quantity of cotton.

“Cotton” is not enough information.

What quality? How much? Where will it be delivered? When? What happens if what arrives is different from what was promised? And, of course, what price are the two sides agreeing on?

These details become increasingly important when the buyer and seller are not standing next to each other inspecting the goods.

“Good-quality cotton” may work in casual conversation. It is less reassuring when tonnes of cotton and a large payment are involved.

As trade grew, markets needed clearer standards around quality, quantity, location and delivery.

But even if all of those things were agreed upon, one problem remained. Nobody could guarantee what the commodity would be worth later.

Imagine a farmer growing a crop that will be harvested three months from now.

At today's price, the crop may look profitable. But today's price is not necessarily the price available after harvest.

If prices fall sharply, the farmer may earn much less than expected.

A business buying the same crop can have the opposite problem. It may know it needs the commodity three months later, but a sharp rise in price could push up its costs.

The same issue appears across commodity markets.

A jeweller cares about future gold prices. A manufacturer may worry about copper or aluminium becoming more expensive. Airlines care about fuel costs. Oil producers worry about crude prices falling before future production is sold.

Whether it is gold, crude oil or cotton, the problem is similar: a business may know that it will need to buy or sell something later without knowing what the market price will be when that day arrives.

That gave producers and buyers a reason to agree on prices or other terms in advance.

A producer could gain greater certainty over a future selling price. A buyer could gain greater certainty over future costs.

Agreeing on future terms did not eliminate price risk, but it gave businesses a way to manage some of the uncertainty. That need eventually became one of the foundations of commodity derivatives.

We will get into futures and options properly in Chapter 7. For now, the important thing is why instruments linked to future commodity prices became useful in the first place.

Private agreements helped, but they created another problem.

If every deal had a different quantity, quality standard, delivery date and location, every transaction still had to be negotiated separately.

That may be manageable between two parties, but it becomes increasingly cumbersome when hundreds or thousands of participants want to trade. Standardised contracts allowed them to work with a common set of terms instead.

The commodity, quantity, accepted quality or grade and relevant delivery conditions could be defined in advance. Participants could then trade around the same recognised specifications.

India reached an important milestone in 1875, when the Bombay Cotton Trade Association was established. It is widely associated with the beginning of organised commodity derivatives trading in India.

Organised futures markets later developed around cotton, oilseeds, jute, bullion and other commodities.

By the early twentieth century, India already had a fairly active organised commodity-trading ecosystem.

Then Independence changed the direction of the market.

The early years of independent India brought food shortages, inflation and concerns around hoarding and speculation.

Commodity prices were not simply something traders watched. Sharp moves could affect the cost and availability of essential goods.

The government therefore took a much more interventionist approach.

The Forward Contracts (Regulation) Act, 1952 created a legal framework for forward trading, while the Forward Markets Commission, or FMC, became the commodity-market regulator.

The Essential Commodities Act, 1955, gave the government powers to intervene in markets for important commodities.

Futures trading in several products was restricted or banned at different times over the following decades.

So despite India's long history of organised commodity trading, the futures market remained relatively constrained for much of the post-Independence period.

The market that today's trader would recognise arrived much later.

The early 2000s were a major turning point.

Nationwide electronic commodity exchanges emerged, including MCX and NCDEX in 2003.

Participants no longer had to gather around a particular physical trading centre. Orders from different parts of the country could meet in the same electronic market.

Standardised contracts, visible market prices and better trading and settlement infrastructure made it much easier for participants across the country to access the same market.

India finally had the foundations of the nationwide electronic commodity market we know today.

The NSEL crisis in 2013 exposed serious settlement and regulatory problems in parts of the commodity ecosystem.

Two years later, in 2015, the FMC was merged with SEBI, bringing commodity derivatives under SEBI's regulatory framework.

Today, SEBI oversees commodity derivatives, while exchanges operate within rules covering areas such as margins, position limits, surveillance, risk management and investor protection.

We will look at the present-day Indian market structure properly in Chapter 6.

Seen in that context, an exchange is much more than a place where prices flash on a screen. It gives a large market a common structure, with standardised contracts that establish what is being traded and a common marketplace where orders from buyers and sellers interact.

That interaction is what helps with price discovery.

The price can still be wrong. Markets have never required an invitation to get carried away.

But it is being formed through competition between many participants rather than a private negotiation between two people.

Exchanges also provide greater transparency, because prices and trading activity are visible to market participants.

Then there is clearing and settlement, the systems and rules through which trades are completed and obligations are handled.

We can leave the plumbing for later. The important thing is that exchanges allow large numbers of participants to trade around common rules.

Commodity markets were not built simply to give traders another chart to speculate on.

A farmer may worry about crop prices falling. A jeweller may worry about gold becoming more expensive. A manufacturer may be exposed to the cost of metals or agricultural inputs. An airline cares about fuel prices, while an oil producer cares about what future crude production will be worth.

These participants already have commodity-price risk because of the businesses they run.

When they use commodity markets to reduce or manage that exposure, they are broadly called hedgers.

Then there are speculators, including traders.

A trader may have no intention of growing cotton, refining crude or manufacturing jewellery. They deliberately take price risk because they believe a commodity will move and there may be an opportunity to profit.

One participant may therefore be trying to reduce price risk while another is willing to take it.

Speculators also contribute trading activity and liquidity, while their orders form part of the price-discovery process.

Now that we know why these markets developed, we can look at what actually trades inside them.

That takes us to Chapter 3: The Commodity Universe.

• Commodity trade in India goes back centuries, long before modern exchanges and financial markets.
• As trade expanded, buyers and sellers needed clearer standards around quality, quantity, location, delivery and price.
• Future price uncertainty created a need for contracts and mechanisms that could help producers and buyers manage price risk.
• Organised commodity trading in India evolved through major milestones such as the Bombay Cotton Trade Association in 1875, post-Independence restrictions, nationwide electronic exchanges in 2003 and the shift to SEBI regulation in 2015.
• Commodity markets serve both hedgers and speculators, while organised exchanges provide standardisation, price discovery, transparency, clearing and settlement.