Develop physical market for commodities

It will help futures market, suffering from lack of multiple pricing points, succeed.

Futures exchanges apparently have difficulty in predicting the success or failure of futures contracts. Only 15 per cent of the contracts that are introduced survive before they get delisted.

Physical market size, risk-reduction ability of the contract, cash price variability and liquidity costs influence the volume of trade and open interest of futures contracts.

During 1994-98, 140 new commodity derivatives were introduced across the world. During 2005-13 almost the same number were introduced in Indian commodity futures. In India, major farm commodities such as cotton, oils and oilseeds and jute have lost their importance in the futures market arena.

A few other agricultural commodities such as guar, chana, castor, cottonseed oil cake, rubber and mentha oil display volumes though metals (precious and base) and energy products continue to preponderate on the commodity futures scene.

The attributes of commodity that are considered crucial for qualifying for futures trade are: Commodity should be durable and it should be possible to store it; units must be homogeneous; commodity must be subject to frequent price fluctuations with wide amplitude; supply and demand must be large; supply must flow naturally to market and there must be breakdowns in an existing pattern of forward contracting.

Though the attributes mentioned above answers the question whether commodities are suitable for futures trade, however, it does not answer a more important complementary question whether the market will adopt a commodity contract for trade or not.

The economic utility of a commodity futures contract for effective price discovery and efficient price risk management depends on wide participation of the physical trade in the commodity and also non-commercial participation, giving it a desired equilibrium.

Lack of multiple pricing points in physical market and supplier concentration often causes contract failure. Energy futures contracts without the participation of the energy players (crude and natural gas producers and users) would have sufficient ingredient for failure. A market deserted by hedgers is unlikely to survive for long, as it will surely be neglected by speculators.

Without getting into the argument of “chicken or the egg”, we need to appreciate that a futures market for any commodity presupposes a close correlation between the prices in physical market.

And if the landscape of the country for the commodity has a controlled price mechanism or an oligopolistic market structure, the futures contract will have very remote chances of success beyond a certain time, however well the contracts may have been designed.

It is important that the country should direct its efforts toward developing active physical cash market with multiple players and multiple pricing points, the success of futures market will follow naturally.

Published in The Business Line on 3rd July 2014

What Modi recommended on futures trade in essential items

Heading a panel, the Prime Minister had called for integration of spot and futures markets

More than three year ago, Narendra Modi, chairing a working committee to suggest steps for reducing gap between the farmgate and retail prices and recommending an action plan for better implementation and amendment to Essential Commodity Act (ECA) had submitted a report.

This report is insightful, constructive and radical in its approach.

The highlights are: speedy reform of APMC Act across the country and liberalisation of agri-markets; explore unbundling of FCI operation in terms of procurement, storage and distribution functions; to set up a ministerial level coordination mechanism at the national and the regional level for coordinated policy making for evolving single national agriculture market; recommended that offences under Section 10-A under the Essential Commodities Act should be made non-bailable and special courts should be set up for speedy trial of offences under the ECA.

The report had touched on the issue of information asymmetry both on the demand as well as on the supply side.

Data flow

It had pointed that if the collation and capturing of data is supplemented with the flow of information then it would fundamentally change the face of market. If necessary, it could done by creating a dedicated agency for the purpose.

Needless to mention that India’s commodity futures market has brought in a significant change in the last ten years where “reference price” are often used by the trade for purchase as well as production decisions. The report had observed that “until effective integration of futures and spot markets is achieved, we should be cautious about the futures trade in essential commodities.”

The report further said: “Since food security being the utmost concern, for the time being there should be a ban on the trading of essential commodities in the futures market” ( Point 2.7, Page 8).

Futures market

Today, as Modi is the Prime Minister of the country and embarking on a paradigm shift what does one expect? Does this mean that the futures market should keep the essential commodities such as wheat on the watch list for possible trade suspension? The report has, however, said that futures of the other commodities can be permitted. (Page 17, Point e.4)

The report also mentions about the “market failure” and traders making excessive profits. However, no evidence or empirical data has been provided to substantiate the point.

The report talks about the creation of agri-infrastructure and, in its recommendation, has laid emphasis on post harvest linkages. It talks about the Government providing financial assistance for construction of godowns at village levels along with godowns at PACS (Primary Agricultural Co-operatives Societies). While it is appreciated that the recommendation has looked at “small is workable,” it has may have erred in recommendation of PACs in the role which does not have any specialised functional expertise.

This report is a document which gives 20 recommendations with 64 detailed actionable points that will facilitate expeditious implementation.

The report has largely been ignored till now, however, the committee needs to be complimented for taking the bull by its horns and addressing the issue which will have significant impact during the tenure of the current government.

Published in The Business Line on June 18, 2014

Futures Markets Are Helping in Price Dissemination Across India

Ten years ago, housewives trusted the neighbourhood shop for the price of grain and the family jeweller for the price of gold. Today, one can surf any channel or glance at any newspaper for commodity price information. Awareness about commodity prices has been made possible due to the unstated contribution of futures exchanges in India. The benefits that the country has derived by way of price dissemination promoted by futures exchanges remain unacknowledged. Traders can no longer fool consumers or producers.

The notion of nonmonetary benefits might sound strange but upon reflection, it makes perfect sense. Over the years, middlemen had greatly benefited by price opacity. However, the very fact that futures market in India has created an environment whereby everyone cannot be fooled about the price at all times is an acknowledgement of its contribution. The market has certainly moved towards a more transparent base.

Not many countries in the world can boast commodity market yards where computers installed at commission agents’ office disseminates crop price information. India is one of the few in the world. The price dissemination technology that is being used by the Indian commodity exchanges is the best price outreach programme in the world in contrast to many of the established exchanges in the world where it hardly gets out of the offices of the financial intermediaries.

Price discovery made on APMC yards, which are mostly fragmented over-the-counter markets, cannot deliver desired results because price discovery in spot market is affected by geographical dispersion, differential needs of buyers and sellers in terms of quality, quantity, place of delivery and difficulties associated with handling physical delivery and absence of option to settle the contract by payment of price difference. The spot market does not meet the need for price forecast felt by the participants in the physical markets. However, reference prices of commodities are reliably available on national future exchanges. Ten years ago, in the absence of such reference prices, deal structuring took more time or sometimes had to be abandoned.

We must acknowledge that the commodity futures market is an important vehicle for modernisation of the organised market. The primary social benefit from the commodity futures market is informed production, storage, and processing decisions. Well functioning markets can assist in stabilising prices by providing signals to producers to increase production of key commodities that are in short supply. Commodity price awareness of common man proves that the first stage of growth has already happened and the futures exchanges have contributed largely into this market evolution.

Published in The Economic Times

Serious players avoid commodity futures market

Commodity markets in India have become synonymous with the exchange-traded commodities on futures market for the last five years. However, after initial enthusiasm, the large players are no more serious about the roles of these exchanges, policy makers view this market with a doubtful look however perfect theoretical correctness it may have in price discovery.

Traders in commodity markets have benefitted from the opacity in price information from time immemorial. The transparency of prices on screen-based trading has not benefitted physical small-time traders and commission agents (aratiyas) and rather the most vociferous opponents are these interest groups. The indirect benefits of price transparency have percolated to the farmer community compressing the margin of these small-time traders. I recall, in a very comical incident, when the government was contemplating the ban on sugar contracts, one of these small-time traders was on a live show of a popular business channel, chastening the government for banning sugar. Within a few seconds of coming out of the live show, he was giving price execution orders on futures contracts contrary to the stance taken on the TV show. Sheepishly he told me 'desh ke sath sath, apna be khayal rakna parta hai' (along with the interest of the nation, I have to take care of myself).

Politicians have also benefitted by misrepresenting the reasons for the price rise and blaming the futures market for it. Incidentally, wheat futures were banned at a time when the government had decided to import wheat and there was a price spiral due to low perceived production. Even more surprising was the timing of the lifting of the ban on wheat. No logic, no reason.

Does that mean that one "discovers price" only when the agricultural commodity prices are going down? Unfortunately, the regulator, due to the lack of legislative teeth and regulatory mechanism, has often buckled under political pressures.

The regulators have often tried to control the market rather than trying to create a robust operating and governance mechanism for market growth. The focus should have been first to find out whether there is adequate representative participation from physical players rather than questioning the exchanges why prices have gone up or down and embarking on controlling prices through open interest and margin controls regimes. Secondly, to do a nationwide campaign to create an environment for broadbased participation rather than organising 'awareness programmes' in pockets.

While futures exchanges in India have seen a fantastic volumetric growth in monetary terms, the commodity futures sector lacks a clear policy roadmap. The lack of consistent policy, sudden ban on contracts, lack of active participation by commodity user groups and lack of legislative teeth for the regulator will make it a cesspool of financial market gamblers and keep the serious organised players away from this market. This is a point in case for not only for agricultural commodities but also for non-ferrous metals and energy contracts that are widely traded on commodity exchanges in India.

Published in The Economic Times 12 July, 2010