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

Asset-backed trading becoming the norm in commodity market

Helps companies link market and financial intelligence to remain competitive

From the middle of the last decade, large banks world-wide got involved in business far removed from their traditional lending activity – trading in physical commodities.

Currently, these banks are retreating from this activity. The shift is empowering commodity trading houses to consolidate their control over supply chains for food, oil and metals.

Commodity traders are rapidly expanding from the traditional intermediary business model of buying and selling, where margins are very thin, to “asset-backed trading models”, where they are investing in production, processing, and logistics.

This new trend has been triggered because across the traditional commodity market, the competitive advantage from superior price information has largely disappeared, and to protect margins, the traders are seeking to own and operate physical assets and arrange an end to supply chain solutions. These supply chains provide unique profit pools.

Some traders are also venturing into territorial specialisation such as distribution system supply and operatorship which gives them unique access to exclusive and unpublished market information.

Integrated framework

By developing deep insights into all the fundamental value-drivers in a trading portfolio, an integrated framework is providing the radar to identify the market and credit developments to which the firm’s financial performance and liquidity are particularly sensitive.

As trading houses are investing greater amounts in industrial and agricultural assets, they are being forced to raise more capital from outside investors, which in turn is threatening the private ownership model, historically favoured by the industry. In some cases sovereign funds and para-statal agencies are investing in the large trading houses. A few traders are already publicly-listed companies while others are considering floats. A few of the companies are using hybrid strategies of tapping capital markets and simultaneously seeking strategic investors while maintaining the flexibility.

The asset-backed trading is a style of commodity trading which is used to seek and exploit market volatility in order to monetise the operational assets owned by the trading entity.

It views physical assets as portfolios of traded instruments. Today, companies are linking manufacturing excellence to market and financial intelligence to remain competitive. No doubt, it poses a challenge on the business process as well as on the IT landscape.

An asset-backed trading strategy consists of control over the production (e.g. mining, plantation), processing (e.g. extraction, refining) and logistics (warehousing, tankage, railway, shipping) along with control over physical commodity.

Along with an appropriate set of financial hedges not necessarily subject to physical risk, this contributes to margin through operating efficiency and flexibility, utilisation and turnaround. Taking all these together, it is intended to extract value from market price movements and add to the valuation of trading entities.

Published in the Business Line on June 5, 2014

Why there is no perfect strategy for hedging in commodity markets

The key to optimal decision making is to understand the trade offs that are occurring

Inventories for storable commodities have always played a crucial role in price formation. It acts as a buffer that helps absorb shocks to demand and supply affecting spot prices.

However, there is a possibility of a stock-out implying that the basis can surge in times of shortages. In case of importable commodities, such situations are sometimes created by squeezing the supply lines for a time period.

On the other hand, larger processors of soyabean, mustard and maize hold commodities to reduce costs of adjusting production over time and also to reduce marketing costs by facilitating production and delivery scheduling and avoiding stock outs.

If marginal production costs increases with the rate of output and if the demand fluctuates, processors can reduce their costs over time by selling out inventory during high-demand periods and replenishing inventories during low-demand periods. Selling out of inventory during high-demand periods can reduce the adjustment costs.

Processors most often try to determine their own production levels with the expected inventory drawdown or build-ups. However, the information on the real stock and inventory level is never available from a reliable source in India.

It is mostly hearsay or a trade rumour. Prices and inventory level fluctuate considerably from time to time which may partly be predictable due to seasonal production and the unpredictability part is generally brought by the market players in response to demand expectations.

Very often the decisions are made in light of two prices – a spot price for sale of the commodity itself, and a price for storage.

Thus there are two inter-related markets for a commodity, the cash market for immediate, or “spot,” purchase and sale and the storage market for inventories held by both producers and consumers of the commodity. Because inventory holdings can change, the spot price does not equate production and consumption.

Instead, it characterises the cash market as a relationship between the spot price and “net demand,” i.e., the difference between production and consumption.

Total demand in the cash market is a function of the spot price and other variables such as weather, aggregate income and random shocks reflecting unpredictable changes.

Processors and consumers often seek ways of hedging in the markets in response to the price volatility. Whether this is done by way of financial instruments such as futures contracts or by physical instruments such as inventories depends on the appetite of entities in the value chain.

Rarely is there one perfect strategy, hence the key to optimal decision making is to understand the tradeoffs that are occurring in deciding on the actual strategy.

Published in Business Line on 22 May 2014

The importance of storage rates in commodity trade

Having variable rates will promote convergence of prices in spot and futures markets

Commodity futures market convergence is the process where prices in the spot and futures markets come together or converge at futures market expiration.

Convergence occurs at the expiry date of every futures contract because of arbitrage. If spot prices remain below futures prices, a market participant could buy in the spot market and sell in the futures market and make a risk-free profit.

Similarly, if the spot price is above the futures price, a market participant can buy in the futures market, take delivery and sell in the spot market and earn a risk free-profit.

Storage space crunch

Convergence can be problematic whenever a commodity is in oversupply relative to available storage space which is often the case in India.

Spot prices may be at a discount to futures prices during a delivery, when there is a lack of warehouse space and the spot price discount to futures is tied to the cost of putting the commodity into storage.

When a warehouse is full with a certain allotment for commodity storage, the cost to store an additional quantity of commodity can increase significantly due to the lost opportunity of using that space for other commodities.

To address this issue, if the cost to store a commodity changes, one needs to examine how to also change the returns from storage to keep the costs and benefits in alignment. The benefits from storage are discovered in the price spreads between different expiration months in the futures market.

However, this has got restricted in India on account of exchange pre-determined storage rates which are not market-driven.

Variable rates

This creates a fundamental market flaw as the exchanges, in order to keep the transaction cost low, keep the real storage cost artificially lower than the market for exchange delivered commodities and thus affecting the convergence of the prices.

CME has already introduced variable storage rates (VSR) to promote convergence from July 2010. The results of this implementation have had a positive impact on convergence during expiration.

In case of CME contracts, if the market expects storage rates to increase following the current contract expiration, the spread between current to further month contract can widen. Now, storage rates can change under VSR mechanism.

It is rather interesting to observe that in India, participants on futures platform are given a fixed rate of storage while market driven rates are offered to the spot market user which is ever changing, market determined and dynamic in nature.

We need not ignore a situation where sustained non-convergence would make hedging less effective, send confusing signals to the market, threaten the viability of a contract and ultimately lead to a misallocation of agricultural resources.

Published in The Business Line on May 7, 2014

Of commodities trade & corruption

In new and scarier forms, entities that own either the whole or a small part of supply chain activity manipulate physical business

In India, check posts, multiplicity of taxes, awarding of supply contracts, granting of licenses, dealing with State procurement agencies, determination of customs policies often increase the chances of dealing with systemic corruption.

A large number of companies camouflage these with payment of consultancy fee whereby the agent takes all these expenses into the books and companies remain clean by the corporate governance standards. 

The scope for corruption may be declining but it is still widespread.

Commodities trade encounters corruption at various stages. A large number of unaccounted cash gets transferred without a trail in the physical market. There is no special authority to check the legality of such practices while there are many such touch points of corruption. Many large trade houses have taken up Trade Practice Compliances as an area of added importance.

This area is responsible for policies and controls for the avoidance of corruption and making sure that the companies refrain from any such business activity that does not uphold the ethical standards.

Last year, one very large US-based trading company got enmeshed in the US anti-bribery law. Some say it may not be the last one …. Others were simply not caught for the time being.

Though large fines are still unheard of here, it has been given a new spin with newfound political shenanigans.

Earlier, the trade-based money laundering allowed an opportunity to earn, move and store proceeds disguised as legitimate trade. Through this process over-invoiced and under-invoiced commodities were imported or exported around the world in restrictive and over licensed countries which allowed companies to make unethical profits.

The practices over the years have changed and more sophisticated methods are being used now. These are purely financial schemes. In these new and scarier forms, manipulations are been undertaken by entities that own either the whole or a small part of supply chain activity of the physical business. Some of them have been caught rigging prices industry-wide.

With several Indian entities entangled in headline grabbing scams, it is clear that commodity wealth not only poisons democracy, it entrenches corrupt elites and worsens inequality – it also hobbles the country.

Published in Business Line dated April 24, 2014

Addressing the hedge gap on commexes

Final expiry date delivered commodity remains unhedged

The product specifications of agricultural contracts on exchanges do not mention the year of production; yet all the safeguards are built to ensure that no old crops are delivered at the exchanges.


Creation of FED (Final Expiry Date) category of stock on commodity exchange forces a situation where liquidity will continue to be only for the near month contracts and far month contracts will hardly be traded.

A recipient of the exchange-delivered FED stocks does not have any hedge facility available. Since the last decade this has created a major “Hedge Gap” in the Indian commodity market, yet the issue remains unaddressed.

There is lot more backwardation these days to actually encourage destocking in the market. If backwardation intensifies, not only will it be less logical to store new inventories, old inventories already financed by the market (therefore hedged from the perspective of producers) will become ever more valuable.

Yet, from the perspective of the commercial users on the other side, the loss associated with the position only grows larger by the day.

Once the FED stocks are delivered, the recipient beneficiary has two choices: First, either to take delivery of the commodity in question, being fully aware of the fact that he can no longer hedge or the second choice is to financially settle the exposure at a big loss. Naturally, the second choice is not an option for most commercial users (e.g. processors), which implies that in this situation one may most likely be exercising the first choice.

This has been a major reason why the real hedgers are not participating on the commodity exchanges in India.

The current arrangement not only leaves the producer holding profitable cash, it also leaves the recipient with an ongoing commodity long in a market environment that no longer allows him to hedge it without significant cost.

One of the recurring issues that arise is lack of clarity over what precisely one is trying to achieve. The doctrine of “hedge interest” needs to be more deeply deliberated at the product designing stage to prevent and curtail the contracts from any misuse.

Published in Business Line on April 9, 2014

Will the stagnant demand in commodities encourage hedging?

The market may be responsive to fundamentals rather than any momentum trading

The commodity market, which had defied gravity during the last few years, is showing signs of slowing down.

It is not a breather but a shift to a bear cycle.

No doubt the “investors” have vanished and the herd mentality has gone out.

The standard explanation during the period of price surge was that the booming demand, particularly from China, was clashing with stagnant supply of energy, metals and agricultural produce. Talks of stagnant or falling demand are now in the favour.

The bull phase saw “weight of the money effect” where the participants took positions so large compared to overall position that they could move the prices.

However, with money becoming scarce for such activity, the market is likely to become more responsive to market fundamentals rather than any “momentum trading”. Even an oilseed trader who would have tried his hand on the trends of the gold or crude market during the last few years will increasingly restrict himself to core business by avoiding such daredevil acts.

During the past decade, “financialisation” of the commodity market had almost destroyed the information flow of the physical market adjustment mechanism. Commodities which became “basket of assets” will now be viewed more for its uniqueness and S&D (Supply & Demand) gaps.

Businesses involved in the origination, processing, merchandising, trading, handling, storage and shipment of commodities will get a flip compared to the companies who were promising investors with short terms large returns.

The acceleration and amplification of the price movement which was witnessed in the market during the last several years have come down substantially during the last six months in almost all the commodities.

The changed scenario would also encourage the long term hedge requirement of physical players in the futures market who need not be worried about frequent variation margin calls.

Companies in the physical commodities domain are likely to react to such situations by consolidating specialisation and getting back to the fundamentals of business.

As the saying goes often in commodity market “Bears will make money. Bulls will make money. Pigs will get killed” would be proven correct once again.

Published in Business Line on  March 27, 2014