The Hindu Business Line : Speculation yes, manipulation no

Speculation has always been looked upon as a bad word in the investment dictionary. However, speculation, by the English dictionary is defined in a more innocuous manner as it is all about guessing and theorising in order to make a profit. This does not sound that bad now. Making profit is after all the centre piece of all free market economies, and has been the driving factor of capitalist societies, thus vindicating Adam Smith's invisible hand. If all this sounds paradoxical, there is evidently a lot of explaining to do.

Intent & means

Speculation is a bad word today because it gives us a feeling of someone who is driving prices in a certain direction through dubious means. But, if the intent is to make a profit and the means used are legitimate, with the overall market benefiting in the process, then speculation would actually be an essential ingredient for the market to function in an efficient manner. Exchanges should, therefore, welcome speculators to maintain efficiency. But, they have to ensure that prices are not driven by them with a mala fide intention, i.e. prices are not manipulated by them. Therefore, while speculation is desirable, manipulation is not. It is necessary to distinguish between the two terms. The job of an exchange is to ensure that the rules of the game are set and are assiduously pursued in practice.

Why are speculators essential in the market? Let us think of a wheat contract being launched today. If all the farmers want to sell at the highest possible price, and all the buyers want to buy at the lowest possible price, then no deals will take place.

We need to have people who are willing to conjecture that if they are paying a farmer a high price today, they'll get higher price in future, thus giving them a profit. They are taking on the risk and are either making or losing money.

They are adding liquidity to the contract to ensure efficient price discovery and are hence critical to the exchange. This is why these people are needed in the market or else contracts would never be liquid and the system would be inefficient.

But then, can we think of a situation where these speculators are able to rig or manipulate the market. Theoretically, they can corner a large part of the market and direct the movement in prices.

But, it should be remembered that if they buy and sell the same day, they add liquidity and volumes but do not exercise any control over price movements. What is more critical is the open interest built up. This is indicative of the quantity of the commodity which can be potentially delivered or hoarded (in the perverse case); and has to be monitored by the exchanges.

Ground rules

The commodity exchanges, therefore, set the ground rules in the form of position limits for each and every commodity and further for every member and client.

This means that if we have a total of X millionn tonnes of production of a commodity in the country, a member cannot have more than a small fraction of the total production as an open interest position at any point of time.

Further, these limits have been prudently brought down for the near month to further eschew the possibility of cornering of the market. And similar norms are set for clients who have a unique identification code to ensure that they cannot rig the market by operating through a series of members. This being done, the possibility of manipulating the market is virtually ruled out by the system. There are similar caps placed on price variations during the day, which maintain a great degree of stability in the markets.

In conclusion it may be said while speculators are essential to the system given their risk-taking ability, manipulation has to be controlled by the Exchanges through strict surveillance.

(The author is an economist with NCDEX . The views expressed are personal.)

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