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

Right Policy Response Crucial for Developing Spot Physical Market

There are around 30,000 spot physical markets, of which 15% function under the ambit of regulation. There is a large number of markets which are not regulated under marketing laws. The unregulated markets are in the hands of commission agents. The Indian commodity physical market is currently facing three major challenges -- production, transparency and regulatory blind spots.

In spite of overflowing government warehouses, yields have not improved substantially over the years. While the government may be declaring bumper production year after year, feeding the Indian population will be an enormous challenge in time to come. India does not grow sufficient quantites of pulses and oilseeds. The production challenge is likely to force India to be a large global importer in the next few years. We all may have to agree that we do not produce enough for our population. In terms of energy consumption, we have entered an era of high prices which is likely to cause transport cost escalation in the first mile of commodity movement (farm to market yard). The average reach of a single regulated market is 459 square km. Obviously, this cannot be covered in bullock carts. The central and state governments are in the process of creating more regulated markets so that the command area of each market does not extend beyond 80 square km.

Secondly, the most important gap in transparency in the physical market for agricultural commodities concerns information on stocks. What level of stocks do we really have in foodgrain? Official figures are unlikely to match available physical stocks and no government or any official can jeopardise the truth to come out. Very few countries in the world are capable of providing information on stocks (both government and private stock). Till a few years back, commodity traders’ interpretation of “good” and “bad” production and “high” and “low” demand used to influence prices in the local market. However, in recent times, with the growth of communication, there has been an institutionalised attempt by several trade bodies to influence the production and demand data to cause distortions in price outlook. Lack of transparency in global physical agricultural markets is also adding to price swings.

Lastly, spot physical markets continue to suffer from regulatory blind spots. Regulation does not mean controls, neither protectionism, nor does it mean administrative price-fixing. However, it is important to strengthen the oversight. Lack of credit flow to agricultural sector in India has always been cited as the biggest impediment. However, in recent times the physical market is being looked increasingly for investment opportunities by a large number of interest groups. In the absence of any commodity index funds in India, financial players are increasingly entering the physical markets by opening their own trading desks. How does one ensure prevention of “financialisation” of the physical markets? Abundant liquidity due to an expansionary monetary policy and low returns on other assets is one reason which is often given for an increased investment in physical commodities.

Price volatility in commodity markets is a function of liquidity available in the local market. When crores of rupees are put to work in small markets like agricultural spot commodities, it inevitably increases volatility and amplifies prices. When the enthusiasm of financial markets meets the reality of the relatively slow-growing real economy, an adjustment of exaggerated expectations of actors in financial markets becomes inevitable. The current spot market regulations have limitations and are not geared to regulate financial flows in large scale. In absence of regulation on financial flows in physical market, one needs to find a middle path -- one which may not lead to the law of the jungle (in the absence of regulations) or a paralysis of operations (with too many rules).

In times to come, the ability of the physical market to provide food security, access at affordable price would depend largely on the policy response to production, transparency and regulation of the spot markets.

Published in The Economic Times