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Commodity Hedging – Revamped Laws For Commodity Derivative Transactions

Commodity Hedging

In modern times, market conditions are dynamically volatile as business entities which are involved in buying, selling and producing commodities need to deal with equal instability in profitability figures. One effective method to manage this unpredictability is to indulge in commodity hedging techniques to reduce potential risks. Commodity Hedging is a risk management activity that invariably helps companies to reduce their exposure to unwarranted and unwanted risks.

Typically Hedgers are either manufacturers of a product / commodity or they have to buy a commodity in the future. Hence they want to keep the potential risks as low as possible by indulging in hedging in the commodities market. Hedging comes with associated costs and the reason why investors’ hedge is not because they want to earn money or profits but because they want to safe-guard against probable losses.

What have been the commodity hedging realities in India?

  1. The Reserve Bank of India defines hedging as an activity where a derivative transaction is undertaken to decrease specific and quantifiable risks.
  2. There are two ways through which Indian residents can undertake hedging activities in India – through the Delegated Route using Authorised Dealers and through the RBI’s Approval route.
  3. The Reserve Bank of India permits hedging in commodities in domestic as well as overseas market only through Authorised Dealer Category – I banks also known as AD Category – I.
  4. All Indian residents who are facing risks due to fluctuating prices in the commodity market can hedge in the International Commodity Exchange/Markets using futures and options.
  5. As on July 4, 2014, the commodities that are permitted for hedging in international exchanges include – petroleum and petroleum products, purchase and sale of aluminum, copper, lead, nickel, zinc and all other products except gold, silver and platinum.
  6. In context of hedging facilities meant for oil companies in India, oil price hedging is permitted for crude oil importers and exporters of petroleum products that work on underlying contracts.
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What has been the price hedging scenario in India till 12th March 2018?

The Reserve Bank of India has been very vigilant of this particular market. In 2003, it allowed for limited hedging activities to resident Indians, interested in cross border commodity trading. As per the directive only those Indians were allowed who have had relevant exposure in the export/import market after receiving approval from RBI on the same. Later the approach was made more flexible when people having exposure in commodity trading in the domestic scenarios could enter into such transactions. In 2012, Authorised dealer category I banks in India were granted permission to facilitate such hedging related transactions.

In 2016 realizing that the commodity hedging market needed much more progressive reforms in terms of new products and new participants who can be involved in commodity derivative transactions, it formed a Working Group Committee to work on building a refined framework in this context.

On 12th March, 2018, the RBI issued the Hedging of Commodity Price Risk and Freight Risk in Overseas Market Directions that came into force from 1st April, 2018.

What is the changed hedging scenario in India and the implications?

There are number of modifications that can be summarized as follows:-

  1. Eligible entities for commodity hedging in the new scenario include residents other than individuals.
  2. The nature of exposure has been defined into two types – Direct and Indirect exposure.
  3. Direct exposure includes all commodities except for gold, gems and precious stones. It can happen under two conditions –
  4. When the entity sells or buys commodities in India or overseas, the price of which has been fixed by an international benchmark.
  5. When the entity sells or buys commodities in India or overseas, the price of which is linked to an international benchmark.
  6. Indirect exposure is related to products which contain commodities whose price has not been linked or determined by an international benchmark. In this category hedging is allowed only for aluminum, copper, lead, zinc, nickel and tin. This list of commodities is subject to annual review.
  7. Exposure to freight risk was defined as risks by such entities that are involved in refining oil business or are in the shipping business.
  8. Permitted products involve generic products and structured products where generic products include futures and forwards, vanilla options (Call and pull option) and swaps. Structured products include (a) a combination of cash instruments and generic products, (b) combination of two or more generic products.
  9. The rule also says that all eligible entities who have exposure to price risks can indulge in commodity hedging in the foreign market by making use of any of the permitted products mentioned above.
  10. The amount that can be hedged and the hedging tenure will be determined as per the exposure.
  11. Those entities that are liable to have freight risk may indulge in price hedging in the overseas market by making use of any of the permitted products mentioned above.
  12. Structured products can be used by entities that are listed on an approved domestic stock exchange or they are the fully-owned subsidiaries of such entities or if unlisted, they are worth Rs. 200 crores or above.
  13. Banks will facilitate only such entities that are exposed to price or freight risk, when such exposure has been contracted or is anticipated.
  14. Banks are also supposed to make sure that the entity has a proper risk management policy in place.
  15. Before remitting foreign exchange, banks also need to ensure that the entity understands the likely risks associated with the products being used for hedging. Banks need to maintain complete record of all transactions made by the entity related to hedging and remittances.
  16. Banks can issue standby letters of credit (SBLCs) only for a period upto one year for remitting margin money in such transactions.
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The Working Group prepared a report based on which draft guidelines were issued on 12th January 2018. Only after receiving conclusive feedback on the draft, the Directions were finalized.

In the same breath in September 2018, the SEBI took a decision to allow foreign companies that have risk exposure in the physical commodity market in India to indulge in commodity hedging excluding sensitive commodities and commodities wherein they do not have exposure.

While the industry and trade experts have rationalized the reason behind the issuance of these guidelines, many are seeing this as positive move towards developing the Indian as well as the foreign commodity derivative segment. The RBI decided to tighten the hedging guidelines in the overseas market after the largest banking fraud in the country in the past few decades was exposed. The limit on the tenure of banking instrument, necessity of banks to obtain audit certificates on an annual basis from statutory auditors and the directive that banks need to take corrective actions on immediate basis when irregularities or misuses are highlighted are seen in good light by the industry.

The move by SEBI is definitely going to edge more foreign investments in the country, as per trade experts. In this context, foreign entities working in the agriculture industry, auto components, metal and textiles will now be able to hedge in the Indian market under the Eligible Foreign Entities. This particular category will encompass only overseas residents and their net worth need to be $ 500,000 to hedge in the commodity derivates market.

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