What is Physical Delivery in Commodity Trading?

The commodities market is an integral part of domestic and international trade. It facilitates the exchange of various types of goods such as agricultural products, metals, and crude oil. Although several market participants use the commodities market for hedging or speculation, it is also used often for buying and selling commodities. This is where physical delivery comes into play.

In this blog, we will understand what physical delivery in commodity trading is and how the process works.

Introduction to Physical Delivery

Commodities are often traded through derivative contracts like futures and options. At times, these contracts have an expiry day on which the underlying asset needs to be physically delivered.

After the physical delivery of a commodity is completed, the trade is settled. Keep in mind that not all contracts require physical delivery upon expiry. While some contracts do offer optional physical delivery, there are some which are cash-settled by default.

For example, if a trader purchases a futures contract of cotton, he agrees to purchase the underlying asset at a fixed price on a predetermined date. Similarly, the seller of the futures contract is obligated to provide delivery of the commodity.

When the futures contract expires, the trader has to take physical delivery of the underlying commodity upon which the trade is settled.

Alternatively, trades can be settled through cash settlement. Through a cash settlement, the trade is settled by calculating the difference between the spot price and the futures price.

For example, Trader A expects the price of cotton to rise, so he purchases futures contracts of cotton. Meanwhile, Trader B believes that the price of cotton will decline, so he sells or shorts futures contracts of cotton. On expiry, the price of cotton increased as per Trader A’s expectations. Instead of opting for physical delivery, the traders settle the trade through a cash settlement. The difference between the spot price and futures price is calculated, and the amount is debited from Trader B and credited to Trader A, settling the trade.

Why Does Physical Delivery Exist?

Although the process of physical delivery is relatively complicated, it is extremely helpful.

The commodities market plays a significant role in facilitating the exchange of goods. Market participants like businesses and large corporations rely on the commodities market to meet the physical demand for goods.

Physical delivery is also important as it allows manufacturers and producers to lock in the price at which they want to purchase a commodity.

Physical delivery of commodities also helps curb excessive speculation since traders are required to take or give delivery of the underlying asset. Since the physical delivery process can be time-consuming and costly, it deters traders from excessive speculation.

Commodities Eligible for Physical Delivery in India

Whether you are a trader or a business, it is important to know the commodities that are eligible for physical delivery in India.

Before opting for the physical delivery of a commodity, it is crucial to check if the platform you are trading through allows the physical delivery of commodities or only offers cash settlement.

It is also vital to check the rules of exchanges such as the Multi-Commodity Exchange (MCX) and National Commodity & Derivatives Exchange (NCDEX).

Although there are several commodities that are traded commonly, like gold, silver, crude oil, and zinc, physical delivery is primarily available for agricultural commodities like cotton, wheat, and soybeans.

Process of Physical Settlement

Commodity exchanges settle trades based on how they’re classified. Some contracts have to be compulsorily delivered physically. Contracts may be delivered physically if the seller of the contract opts for it. Finally, contracts may be settled through intention matching.

Under the intention, the commodity exchange matches parties that agree to take and give physical delivery of the commodities.

After the parties agree to physical delivery, the process of physical delivery includes selecting a delivery centre, quality checks, grading of the commodity, and logistics & transportation.

Roles of Clearing Corporations and Depositories

Clearing corporations and depositories play an integral part in the process of physical delivery and settlement of trades in the commodity market. A clearing corporation acts as a mediator between two parties and facilitates the exchange of commodities or funds. The clearing corporation is also helpful as it reduces counterparty risks.

A commodity custodian service is similar to a depository. While a custodian physically stores  commodities and may issue warehouse receipts, depositories maintain digital records of securities. This enables efficient settlement of commodity trades.

Benefits of Physical Delivery

Physical delivery can be highly beneficial for the following reasons:

• One can have physical possession of the commodity. Physical delivery helps producers, businesses, and corporations meet the demand for the physical commodity.
• Through physical delivery, producers and manufacturers can lock in a price at which they want to purchase an input commodity. This allows them to hedge against price risks.
• Since physical delivery requires traders to physically deliver commodities, it prevents excessive speculation or leverage, promoting transparency in pricing.

Also Read : Key Differences Between Cash Settlement and Physical Delivery

Risks and Considerations

• The primary risk of physical delivery of commodities arises from the storage and transportation of commodities. The process of transporting and storing goods can be time-consuming and complicated.
• The quality of goods may vary, especially if proper quality checks are not done before taking physical delivery. Moreover, improper storage or transportation can damage the commodity and impact its quality.
• The capital requirements for physical delivery are higher. Additionally, transaction costs, storage costs, and logistics costs make the process more expensive.