Foundation — The three-tier regulatory structure

A single stretch of road in Kochi may be maintained by the corporation, policed under state law, and carry vehicles registered under a central act. Three authorities, one road, each with a defined slice.

⚠️ Commodity regulation is arranged the same way. "The THREE-TIERED REGULATORY FRAMEWORK comprises GOVERNMENT OF INDIA, SEBI AND EXCHANGES."

• ⚠️ The Central Government "FORMULATES THE BROAD POLICY with regard to THE RECOGNITION OF COMMODITY EXCHANGES AND THE LIST OF COMMODITIES that are permitted for trading"
• ⚠️ SEBI is "THE REGULATOR for commodity derivatives markets", with "TWIN OBJECTIVES OF PROTECTING THE INTERESTS OF THE INVESTORS AND TO PROMOTE THE DEVELOPMENT OF THE MARKETS"
• ⚠️ The exchanges make their own bye-laws — but "SUBJECT TO PRIOR APPROVAL BY SEBI"

Note who is not on the list: the Forward Markets Commission. It was the commodity regulator until FCRA was repealed on 28 September 2015, and the exam offers it precisely because older textbooks are full of it.

A sack of wheat sold in a mandi in the morning and a wheat futures contract traded that afternoon are, economically, about the same thing. Legally they are worlds apart.

⚠️ "The SUBJECT OF SECURITIES IS UNDER THE UNION LIST IN SCHEDULE VII OF THE CONSTITUTION OF INDIA, whereas THE SPOT MARKET TRADE IN COMMODITIES — PARTICULARLY AGRICULTURE COMMODITIES — IS IN THE STATE LIST."

Follow the consequences through the syllabus and it is remarkable how far this one constitutional line reaches:

• Spot markets sit outside SEBI's purview, so exchanges must poll spot prices rather than read them off a screen
• Polling is "highly manual and prone to sampling errors", which is why Options on Goods carry a seven-strike CTM band
• Options on spot commodities were "very challenging" to implement and arrived only in 2020, while options on futures came in FY2017-18
• GST subsumes excise, sales tax, octroi and mandi tax but not mandi cess — a State levy on a State subject

A schedule of the Constitution ends up dictating an exercise rule on expiry day.

Two men betting on tomorrow's price in a tea shop have made an agreement no court will enforce. The same bet, routed through a recognised exchange and settled by its clearing house, is a legally binding contract.

⚠️ Section 18A of SCRA draws exactly that line: "CONTRACTS IN DERIVATIVE SHALL BE LEGAL AND VALID IF SUCH CONTRACTS ARE (a) TRADED ON A RECOGNIZED STOCK EXCHANGE and (b) SETTLED ON THE CLEARING HOUSE OF THE RECOGNIZED STOCK EXCHANGE, in accordance with the rules and bye-laws of such stock exchanges."

Both limbs must be satisfied — traded on a recognised exchange and settled through its clearing house. This is why the separation of exchange and clearing corporation, and the requirement that settlement pass through a clearing corporation, are not merely operational conveniences. They are what makes the contract enforceable at all.

And the Act's stated purpose sits behind it: SCRA "PREVENTS UNDESIRABLE TRANSACTIONS IN SECURITIES BY REGULATING THE BUSINESS OF SECURITIES DEALING AND TRADING", and includes among its powers "THE POWER TO PROHIBIT UNDESIRABLE SPECULATION."

A vehicle is a "motor vehicle" for legal purposes only if it fits the statutory definition. A bullock cart is a vehicle in ordinary speech and not one in law, and no amount of arguing changes that — only an amendment does.

⚠️ "Securities" works the same way. "The term SECURITIES HAS BEEN DEFINED IN SECTION 2(h) OF SCRA", and the list runs from shares, scrips, stocks, bonds and debentures through derivatives, collective investment scheme units, security receipts under SARFAESI, mutual fund units, government securities, rights or interests in securities, and — added specifically for this market — ⚠️ "OPTIONS IN GOODS."

⚠️ The list is open-ended, but only by a specific route: "SUCH OTHER INSTRUMENTS AS MAY BE DECLARED BY THE CENTRAL GOVERNMENT TO BE SECURITIES."

So a monsoon derivative is not a security today. It would become one the moment the Central Government declared it so — which is exactly how Electronic Gold Receipts entered the definition in December 2021.

And the exclusion worth remembering: unit-linked insurance policies are expressly carved out, being combined benefit-risk products issued by an insurer.

A shop that once needed separate licences to sell groceries and medicines, and separate premises for each, is eventually allowed to run both from one counter under one registration. The goods have not changed; the paperwork around them has.

⚠️ That is the integration of the commodity and securities markets, and it came in two steps:

• ⚠️ SEPTEMBER 2017 — the intermediary level: SEBI's circular on "INTEGRATION OF BROKING ACTIVITIES IN EQUITY MARKETS AND COMMODITY DERIVATIVES MARKETS UNDER SINGLE ENTITY"
• ⚠️ 1 OCTOBER 2018 — the exchange level: SEBI amended the SECC Regulations and "PERMITTED TRADING OF COMMODITY DERIVATIVES AND OTHER SEGMENTS OF SECURITIES MARKETS ON A SINGLE EXCHANGE"

The order is logical and examinable: brokers first, exchanges second. And the whole sequence began with the repeal of FCRA on 28 September 2015, after which the old commodity exchanges were "DEEMED TO BE RECOGNIZED STOCK EXCHANGES UNDER SCRA."

The tidiest evidence that the merger is complete: the CDMRD, created specially to supervise the commodity segment, "has been MERGED INTO THE MARKET REGULATION DEPARTMENT OF SEBI."

A bank lending against stock in a godown insists the borrower insure it. The bank is not being difficult — its own security is that stock, and an uninsured fire wipes out the collateral as surely as the goods.

⚠️ The RBI has taken the same view on price risk: "RBI ALSO ISSUED DIRECTIVES TO BANKS TO ADVISE THEIR BORROWER CLIENTS TO HEDGE THEIR COMMODITY EXPOSURES, IF THE LENDING IS BEING DONE AGAINST COMMODITIES AS COLLATERALS."

A 30 per cent fall in the commodity's price impairs the bank's security just as a fire would — and unlike fire, it is a risk the borrower can lay off on an exchange for the cost of a margin.

⚠️ The same instinct runs through the other measures in this section: "SEBI, vide its circulars dated 21ST AND 22ND MAY 2019, has allowed MUTUAL FUNDS AND PMS respectively to participate in commodity markets"; "it allowed ELIGIBLE FOREIGN ENTITIES ALSO TO HEDGE THEIR INDIAN COMMODITIES EXPOSURES"; and under LODR, listed companies must disclose "commodity risk management/policies, commodity risk exposures and THE EXTENT TO WHICH THESE ARE HEDGED in domestic and international markets."

Each of these does the same thing from a different direction — bringing genuine exposure holders into the market, which is what a derivatives market needs in order to work.