Selection Criteria of Commodities for Trading on Derivatives Exchanges

SEBI (Securities and Exchange Board of India) is the apex regulator that empowers recognised commodity exchanges to list contracts after satisfying prescribed conditions. The regulations, notably the SEBI (Commodity Derivatives) Regulations, 2019, mandate that an exchange must obtain prior approval from SEBI before introducing any new commodity.

The exchange itself conducts a detailed feasibility study and submits a dossier to SEBI, covering aspects such as market demand, physical delivery infrastructure, and risk‑management mechanisms. SEBI reviews the dossier for compliance with its guidelines on transparency, investor protection, and systemic risk.

For the NISM exam, remember that the regulator’s role is not limited to granting permission; it also monitors ongoing compliance, imposes position limits and ensures that the underlying physical market is robust. Questions often ask which authority approves a new commodity – the answer is always SEBI, acting through the exchange’s application.

The exchange evaluates each commodity against a set of quantitative and qualitative criteria. The four pillars are liquidity, price volatility, market depth (open interest), and regulatory/physical‑market readiness.

Liquidity ensures that participants can enter and exit positions without causing large price swings. It is measured by average daily turnover and the ratio of open interest to turnover. High liquidity reduces transaction costs and slippage, which is a key exam focus.

Price volatility is required so that futures contracts provide meaningful hedging and speculative opportunities. Too little volatility makes the contract unattractive, while excessive volatility may raise margin requirements and risk concerns.

Liquidity reflects how quickly a contract can be bought or sold at a price close to the prevailing market rate. Exchanges calculate average daily turnover (in contracts) over the preceding 30‑day window. A higher turnover indicates a broader participant base and tighter bid‑ask spreads.

Another useful metric is the Liquidity Ratio, defined as average daily turnover divided by total open interest. A ratio above 0.2 is generally considered acceptable for listing, though the exact threshold may vary by exchange.

Exam questions may present turnover figures and ask whether a commodity meets the liquidity requirement. Remember to compare the computed ratio against the typical benchmark and watch out for traps where the turnover is reported in rupees rather than contracts.

Volatility measures the magnitude of price fluctuations over a period. Exchanges typically compute the annualised standard deviation of daily price changes for the underlying spot market.

A commodity with a historical volatility of 15‑20 % per annum is usually deemed suitable for futures trading. Very low volatility (e.g., <5 %) offers limited hedging benefit, while volatility above 30 % may trigger higher margin requirements and affect contract design.

In the exam, you may be given a volatility figure and asked whether it satisfies the “minimum volatility” rule. The rule of thumb is that a minimum of 12 % annualised volatility is expected for most listed contracts.

Market depth refers to the volume of orders at each price level in the order book. A deep market has substantial buy and sell orders close to the current price, which stabilises price movements during large trades.

Open interest represents the total number of outstanding contracts that have not been settled. High open interest signals sustained participant interest and contributes to price discovery.

For exam preparation, remember that both depth and open interest are evaluated together. A commodity may have high turnover but shallow depth, which could be a red flag for listing.

Step 1 – Data Collection: Gather 30‑day average daily turnover, historical price series, open‑interest trends, and details of the physical market (storage, logistics, grading).

Step 2 – Quantitative Filters: Apply liquidity ratio ≥0.2, volatility ≥12 % p.a., and open‑interest ≥10 % of turnover. Commodities passing all three filters move to the next stage.

Step 3 – Qualitative Review: Assess regulatory compliance, delivery infrastructure, and market participant feedback. The exchange’s committee then prepares a recommendation for SEBI.

• Remember: Failure in any quantitative filter disqualifies the commodity outright.
• Qualitative factors can override marginal quantitative shortfalls if justified by strong market demand.

The physical market’s robustness determines the feasibility of cash‑settlement versus physical delivery. Commodities with well‑established warehousing, grading, and logistics (e.g., crude oil, gold) are preferred for physical delivery contracts.

If the physical market is fragmented or lacks standardisation, the exchange may opt for cash‑settlement to avoid delivery disputes. This choice influences margin requirements and the type of participants attracted to the contract.

Exam questions often link the delivery mechanism to the underlying market’s infrastructure. A correct answer will match a commodity with strong physical market support to a physical‑delivery futures contract.

Before answering any question on commodity selection, run through this mental checklist: (1) Has SEBI approved the commodity? (2) Does the commodity meet the liquidity ratio ≥0.2? (3) Is the annualised volatility ≥12 %? (4) Are open interest and market depth sufficient? (5) Is the physical market capable of supporting delivery?

Remember that the exam may present data in mixed units – convert turnover to contracts, volatility to percent, and ensure consistent time frames (daily vs annual). Mis‑interpreting units is a frequent source of error.

Finally, link each criterion back to its purpose: liquidity for ease of trading, volatility for hedging value, depth for price stability, and regulatory/physical readiness for compliance and settlement. This logical mapping will help you eliminate wrong options quickly.