The Hindu Business Line : Commodity futures — A spot of teething trouble

The ills of the commodity futures are merely teething troubles that will vanish as a larger share of the physical trade is pulled in and the market matures.

"People are not apologising anymore for using derivatives. They have realised that they are not the evil instruments they have been made out to be."

— Sarah Orsay

Commodity futures exchanges in India have remained the favourite whipping boy of those opposed to such markets and blame them for the rise in the prices of essential commodities. Are these the teething troubles of a nascent futures market, or signals that something is fundamentally wrong?

In the three years since their inception, have the national commodity exchanges accomplished what they set out to — providing a better price discovery mechanism, lowering the volatility in the physical market, and a hedging mechanism for producers and users?

Select commodities

Gold, chana, wheat, urad and refined soyabean oil are `futures traded' on the Multi Commodities Exchange of India (MCX), and these commodities were selected because of their liquidity in the exchange and the maturity of their physical markets to reflect clear fundamentals to participants. Besides, all these are freely tradable across borders except for a variable quantitative tariff barrier. Hence, the futures market participants in these commodities are expected to reflect the international and domestic market fundamentals in both their speculative and hedging activities.

An analysis indicated that the futures market in all the commodities influenced the spot prices but the reverse was only to a limited extent (see Tables). While this highlights the integration of the spot and the futures market, it does not indicate if the futures market's positive effects would rub-off on the spot market. Theoretically, futures prices are expected to move smoothly than in the spot market, as the convergence of information and the actions of the participants are expected to be more rational compared to the spot market, where prices face a variety of triggers with participants representing only a part of the ecosystem.

Higher liquidity

As the futures market generates higher liquidity and attracts physical players, it is more likely to integrate well with the spot market and lead to beneficial effects. At this stage, physical players would be attracted (by the higher liquidity) to trade in the futures market given the arbitraging opportunity between the two markets as also to hedge their risks.

Apart from this, the wide and instantaneous dissemination of information helps in integrating the spot and futures markets; also aiding this process are the traders' workstations to which are the farmers visiting the local spot markets have access.

Price rise

Yet, why are the prices of essential commodities rising? A critical look at the physical market would reveal much about the evils of the existing mechanism that is to blame. An analysis of producer prices for most primary items reveals that the producers are not even compensated for inflation, thereby reducing their purchasing power and affecting their living standards. The consumer cost expands in large part due to the multiple levels of intermediation and inefficiencies in marketing, transportation, and storage.

With the emergence of futures, the exchanges, through the participation of multiple stakeholders, and with more efficient storage, delivery and handling systems are providing long-term price signals, allowing producers, consumers, and traders to take more informed decisions on timing their sale or purchase. Trade, for the first time, is becoming free from quality and counter-party risks.

Electronic markets are shortening the pipeline and thereby providing better prices to both producers and consumers. Such markets are also attracting more intermediaries and consumers for direct procurement from producers, thereby shortening the supply chain and passing benefits directly to the producers.

Incremental new participants

Since there is incremental intervention in the physical market value chain by new participants, marginal additional demand is created and this can impact spot market prices initially. However, as the physical commodities have a definite shelf-life and have to be consumed with a time frame, the spot and futures market reach an equilibrium over a period.

Once all the elements of physical trade get actively involved in futures the number of intermediaries in the value chain shrinks, reducing the share of the intermediaries in the consumer rupee proportionate to the risk premium being charged by them. This would result in better prices for consumers even while not short-changing the primary producers.

The current ills in commodity futures are nothing but the teething troubles which will vanish as a larger share of the physical trade is pulled in and the market matures, with producers provided multiple OTC (over-the-counter) options by the intermediaries.

Generation of higher liquidity

To make this happen, commodity exchanges must generate higher liquidity, aided by appropriate policy instruments.

Such liquidity-generating policy measures could include allowing banks and mutual funds to participate in commodity futures, allowing government procurement agencies in domestic futures exchanges, making warehouse receipts "negotiable", setting off of losses against the income of the commodity derivatives market participants, as available in the equity derivative markets under Section 45 (3) of the Income-Tax Act, 1961, and providing tax holiday to outreach expenditures of the exchanges.

(The authors are, respectively, Chief Economist and Executive, Multi Commodity Exchange of India Ltd , Mumbai. The views are personal and do not reflect those of the organisation.)

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