Exchange for Physicals will ensure that Agricultural futures markets succeed in India!

The Indian futures markets has had a reasonable 'success story' however this success has been restricted to only precious metals,some base metals and crude oil contracts which has been due to significant retail and investor participation.

However it is to be noted that Agricultural futures has not succeeded and as a matter of fact the recent drop in volumes on major agricultural futures exchange in India has got many a stake holders worried.

Although it is very easy for us to say that it was the fault of policy makers and recent bans etc however that is not the real truth.

We at Altos Research believe that the real reason for failure of agro contracts in the India context is the absence of an offset method which is extremely popular in many global exchanges namely the EFP or the Exchange for Physicals(not to be confused with the SPOT exchange, and an electronic spot exchange is not the panacea of all ills of the commodity market).

What is an EFP ?


There are four ways to close out a futures contract:

1] Offset is the transaction of a reversing trade on the exchange. If you are short 20 March soybean futures traded on the Chicago Board of Trade, you can close the position by taking an offsetting long position in 20 March soybean contracts on the same exchange. There will be a final margining at the end of the day, and then the position will be closed.

2] Cash settlement is simply the holding of a cash settled future until expiration. At that time, there is a final margin payment, and the contract expires.

3] Delivery is the holding of a physically settled future until it physically settles according to exchange rules.

4] Exchange for physicals (EFP) is a form of privately negotiated physical settlement of long and short futures positions held by two parties.This aspect has been completely ignored in the Indian context and this is what we believe is required for the success of Agricultural Contracts in the Indian derivatives exchanges.

Every futures contract has a last trade date and a delivery period specified by the exchange. In the case of a cash settled future, the delivery period is the last trade date. On that date, the settlement price is set equal to the cash price of the underlier. There is a final margining based on that settlement price, and then the contract expires.

For physically settled futures, exchange rules depend upon the specific underlier. Usually, there is an entire month—called the delivery month—during which delivery may occur. The last trading day for the future falls towards the end of that month. A party that is short a future may elect to deliver the underlier on any business day in the delivery month. Typically, notice of delivery must be made to the exchange say two-five business days prior to delivery. The date on which notice is given is called the notice date. The first possible date for notice comes towards the end of the month preceding the delivery month. It is called the first notice date. Upon receiving notice of delivery, the exchange selects a party that is long the future to take the delivery. This may be the party with the largest long position in the future. Alternatively, the party to take delivery may be selected by lot.

The vast majority of futures contracts are traded by hedgers or speculators with no interest in taking or delivering the underlier. Such parties holding long futures will offset them prior to the first notice date. Those with short positions will offset them by the last trade date. Most futures are closed out by offset.

Exchanges specify conditions of delivery. These include acceptable locations for delivery, in the case of commodities or energies. It includes specifics about the quality, grade or nature of the underlier to be delivered. For example, only certain Treasury bonds may be delivered under the Chicago Board of Trade's Treasury bond future. Only certain growths of coffee may be delivered under the Coffee, Sugar and Cocoa Exchange's coffee future.

In many agricultral commodity or energy markets, parties want to settle futures by delivery, but exchange rules are too restrictive for their needs. For example, the New York Mercantile Exchange requires that natural gas be delivered at the Henry Hub in Louisiana. Suppose two parties need to buy/sell gas at some other hub and have transacted futures to hedge against price movements prior to the transaction.
What should they do?

One answer is that they could privately negotiate the trade(OTC) and then reverse their futures positions by offset. This requires that they take price risk during the period between closing the physical trade and offsetting their respective futures positions. Many exchanges offer an alternative called exchange for physicals (EFP).
The mechanics of EFP vary by exchange. Generally, the parties privately negotiate their physical trade. Then, instead of offsetting their futures hedges with trades on the exchange, they inform the exchange that they want to transfer the futures from one party to the other, closing out their respective positions.
Essentially, EFP is customizable physical delivery.

An Exchange of Futures for Physical (EFP) is a transaction negotiated off-market in which one party buys physical assets and sells futures contracts while the opposite party sells the physical market products and buys futures contracts.

EFPs provide a mechanism to:

1]swap from a futures to a physical position or vice versa
2] off market price certainty for large physical vs futures transactions
3] fulfilll delivery commitments

The physical and futures components must be 'substantially similar' and equal in terms of either:

--> value (ie the value of the physical being similar to the value of the futures); or by
--> quantity (the quantity of the physical being similar to the quantity of the futures)


An Example of an EFP contract is the one on the Australian Futures exchange at Sydeny.


Commodity contracts (wool, electricity) can provide a hedge either for the quantity or amount (value) of a physical transaction.

If a trader is holding 20 tonnes (20,000 kilograms) of greasy wool and wished to exchange it for SFE Greasy Wool Futures contracts, the exchange could be made either:

1)at any reasonable price for 8 contracts (each of 2,500 kilograms), or
2) for an equivalent value of futures. If the physical is trading at 600 cents/kilogram and the futures contract is priced at 670, the hedge could be made against the ($6.00 x 20,000 =) $120,000 worth of wool by using ($120,000/($6.70 x 2,500 kg) = approx.) 7 futures contracts.

Either trade would be deemed by SFE to be a valid EFP.

Note that the physical wool should have a micron measurement within that allowed for in the futures. For example SFE Fine Wool Futures includes 19.6 – 22.5 microns and therefore the physical component of an EFP involving SFE Fine Wool Futures should include a physical of a similar size. If the wool traded is in a greasy state, the yield of the physical wool should also be submitted.

For commodities with variable quality, some allowance can be made for variation from SFE contract-specified quality, but this must be justified to SFE on enquiry.(EFB Exchange for Basis)

My 2 cents on this and Sincerely hope that Agro contracts suceed in our country because honestly that is going to determine the future of futures in our country for time to come.


(Note: This is an abstract of Research on "Success formula for Agricultural Futures in India" You can order the complete copy of this research paper from http://www.research.altostrade.com)
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