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Chapter 5

Role of Warehousing in Commodity Futures Trading

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While currency futures are necessarily settled in cash only, the commodity futures market offers the facility to settle futures in cash or against actual delivery. While the exchanges like the NCDEX or the MCX are not directly involved in the delivery (as spot markets are outside its purview), they do get involved in the process of facilitation of the entire warehousing ecosystem including standardization, additional margins, certification etc. This makes the entire process of delivery much simpler and transparent. Since commodities are bulky and need to be moved in bulk quantities, the actual transaction cannot wait till the physical movement since it is too cumbersome. Hence, they use a proxy called warehouse receipts and these warehouse receipts form the core of the commodity warehousing system. We shall look at warehouse receipts as a concept in detail later in this chapter.

A. UNDERSTANDING THE PROCESS OF WAREHOUSING IN COMMODITY MARKETS

Futures are derivative instruments (their value is derived from the underlying commodity) containing leverage, that allow for hedging. Commodities prices tend to be volatile even over a short timeframe. The issue of warehousing is relevant only for hedgers who have an underlying exposure. Warehousing and delivery is not relevant for traders who are just playing on the price movements. How do hedgers operate for delivery? For example, the copper manufacturer may use the commodity futures market to sell futures in advance and they will give actual delivery against the sell contract on the stipulated date. Similarly, an electrical goods supplier uses copper as an important input and they can buy copper futures in advance and lock in the price. On the date of delivery, they can just pay and take delivery at the price fixed. This way they are immune to any adverse price movements.

Futures markets with delivery (like the commodity futures market) work well and smoothly because they allow for the smooth convergence of derivative prices with prices in the physical markets. The convergence of the two prices occurs by the delivery mechanism that exists in the futures market. It is here that warehousing plays a role in bulky commodities. Risks in the delivery are protected by additional margins. When the buy or sell position is taken in the commodity futures, the initial margin is paid with the ELM margins. In addition, MTM margins are collected for price movement that are unfavourable. Till this point, the margins are common for all futures position. When delivery has to be taken, then actual delivery margins also have to be paid by the trader to cover the risk of actual delivery.

Futures exchanges work with industry to develop standardized quantities, qualities, sizes, grades and locations for delivery of a physical commodity. While many commodities have different characteristics, the delivery process often includes premiums and discounts for varying grades and distribution points for specific raw materials. In addition, the exchanges like the NCDEX and the MCX also designate warehouse and delivery locations for commodities. The exchange also sets up the relevant rules and regulations for the delivery period depending on the product.

From an exchange point of view, delivery entails the submission of a warehouse receipt or warrant representing a certain quantity and defined quality of a commodity in a specific location. At that point the full payment for the actual delivery has to occur for the trade to be considered to be good. Once the payment is made the buyer has the right to remove the commodity from the warehouse. Quite often, the buyer leaves the commodity at the storage location in exchange for demurrage or storage fee.

B. UNDERSTANDING THE ISSUE OF WAREHOUSE RECEIPTS

From the beginning, India has adopted the system where the warehouse receipts can be held in depository form with the NSDL, being the major DP for commodity warehouse receipts. Only warehouses that have entered into an agreement with NSDL and the commodity exchanges can issue depository eligible warehouse receipts. Currently, NSDL has agreements with the NCDEX and MCX and about 20 warehouses that hold 35 different commodities in custody. An account holder who wants warehouse receipt balances in its demat account, will have to quote the demat account number specifically opened for this purpose. Warehouse will credit warehouse receipts in the demat account using "corporate action" facility offered by NSDL. The balances so created can be used for transfer or settlement of commodity futures trade. This makes it transparent and less prone to frauds.

What is the procedure for giving delivery of warehouse receipts? In fact, it is similar to giving delivery in securities market. Warehouse receipts can be transferred to the Clearing Member's account using Delivery Instruction Slip (DIS), just as in the case of equities. The only difference is that while equities and other securities use unique ISIN as the identifier, the Commodity Identifier (C-Id) is used in case of transfer of warehouse receipts.

What about taking delivery with warehouse receipts. Commodities in the warehouse receipts can also be claimed for delivery by submitting a request in "Physical Delivery Request Form" (PDRF) for the desired quantity. Such request will be transmitted to the Registrar electronically through depository system. Registrar will send the details of the accountholder, including signature, to the warehouse to enable the warehouse to release the delivery. The account holder needs to submit to the warehouse, the acknowledgment given by the DP for the purpose of taking delivery. Warehouse can then deliver the commodity after verifying details given in the "Physical Delivery Request Form".

Just as the depository identifies securities with ISIN code, commodities are identified by a 12 digit commodity identifier (C-Id). The C-Id will include details of the commodity and its quality grade. The commodity descriptor includes details related to the commodity exchange, warehouse, commodity name, grade of commodity, expiry date (validity) and unit of measurement.

C. WHY WAREHOUSE RECEIPTS PLAY A CRITICAL ROLE IN COMMODITY MARKETS

An efficient settlement system is at the core any successful market functioning. Commodity futures contracts can be settled either by cash or by delivery of commodity depending upon the terms of trade, demand of the buyer and rules of the exchange. If the trade is expected to be settled by way of delivery of commodity, the clearing house of the commodity exchange will receive warehouse receipts from the seller instead of actual commodities and pass such warehouse receipts over to the buyer. In case of national commodity exchanges, buyers and sellers could operate from different parts of the country and if warehouse receipts are in physical form, the warehouse receipts have to be delivered across the country from the seller to the buyer which could lead to systemic inefficiencies. A much simpler way to do this will be to use warehouse receipts in demat form.

Remember, warehouse receipts (WR) are title documents issued by warehouses to depositors against the commodities deposited in the warehouses. These goods in the warehouse are valued by an assayer and verified and certified by a statutory auditor. These documents are transferred by endorsement and delivery. Either the original depositor or the holder in due course (transferee) can claim the commodities from the warehouse. It is always safer and easier to operate warehouse receipts through the NSDL demat system as physical movement of WRs have some clear demerits. Here, a few such demerits are enumerated.

  • Since demat balances are fungible, it is much easier to give split delivery from the warehouse based on demat WRs. In case of physical WRs there is the need for splitting the warehouse receipt in case the depositor in case he has an obligation to transfer only a part of the commodities. This can be quite cumbersome.
  • Physical WRs need to be mailed / transferred from one place to another with risk of theft, loss in transit, mutilation, etc. This problem is more acute if the transferor and the transferee are in two remote locations that are not well connected.
  • Finally, there is the common risk of forgery of physical documents which can be overcome in case of demat documents since they are authenticated at multiple levels.

D. ADVANTAGES AND CHALLENGES IN THE USE OF WAREHOUSE RECEIPTS (WRS)

Use of WRs as a proxy for physical goods is a globally accepted and fine tuned practice. There are some distinct advantages in a solid system of WRs prevalent to encourage the commodity market trading. Let us look at the role of WRs with specific reference to the agriculture products where the application can be best made.

  • Warehouse receipt systems allow agricultural producers (farmers in this case) to access credit by borrowing against receipts issued for goods stored in independently controlled warehouses. As a result, farmers are able to delay the sale of their products until after harvest, when prices are generally more favourable.
  • WRs also bring the added benefit of scientific and sophisticated product handling and storage by warehouses, especially when they are licensed and controlled according to mandatory standards. This can play a crucial role in reducing postharvest losses for farmer.
  • There is another related advantage of a well developed WR system. The increased storage of agricultural commodities after the harvest season can contribute to stabilizing commodity price volatility. Countries normally struggle with problems like the prices of most agri commodities and ensuring adequate supply at a reasonable price.

What are the key challenges to the WR system? Actually it is a mix of various items. There are challenges pertaining to credit, process flow and also pertain to legislation. Let us look at some of the key challenges.

  • The major challenge to the WR system is the lack of suitable storage infrastructure, legal and regulatory issues as well as the lack of requisite skills for verifying and authenticating before issuing the WRs.
  • A network of secure, well-run warehouses which are accessible to various depositors is an essential pre-requisite for successful WRs. That is where most WRs have a problem. For the WR system to be successful, the warehouses should be at least physically accessible at reasonable cost with good infrastructure and labour support.
  • Warehouses are increasingly going into private hands and that means the government is reducing its investments in warehouses. This is not just a problem in India but the phenomenon is worldwide. Post-liberalisation there has been a major challenge of inadequate investments made by the government on a proper warehousing infrastructure. Most private warehouses make the economics of warehousing unviable for smaller players and that has limited the spread of WRs.
  • Another major challenge with private warehousing is that this storage infrastructure tends to be concentrated in the urban markets or at best in semi-urban markets. This has limited the utility of WRs for players who are more spread or concentrated in non-urban centres. In most case the cost of transport itself becomes prohibitive.
  • In many cases, lack of political will appears to hamper outright sale of state-owned storage facilities to private warehouse operators as a means of attracting private investment in improving the physical conditions of under-utilised facilities in producing areas. Here again the process can be smoothened with adequate legislation.
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