The Hindu Business Line : Futures markets: Facing the heat

It is currently the burning question. Are futures markets the cause of high energy and commodity prices? A large section of economists, lawmakers and public opinion thinks so.

Thus the calls to tighten regulation and, indeed, in some cases, to ban them.

What is their origin? They started as a way of insulating farmers from crop price fluctuations between sowing and harvesting.

It is no coincidence that one of the world’s biggest futures exchanges is in Chicago in the American Midwest, which is the granary of the US. A number of agricultural products (‘agris’), both of the food and non-food variety, are traded on the Chicago Board of Trade (CBOT).

With futures, farmers are able to lock in a price for their harvest. They are assured the futures price, irrespective of the spot price for the commodity at harvest time.

In other words, they are (or supposed to be) hedged. (‘Supposed to be’ because recent experience has shown several agri futures are inefficient hedges and the cost of hedging outweighs the benefit of price certainty).

Exponential growth

In recent times, futures have grown to embrace practically every known currency, interest rate, precious metal, base metal, energy product in crude and refined form and agricultural commodity. Trading volumes are huge. Producers and consumers are the least of the market players. They are dwarfed by hedge funds and speculators playing the ‘get rich quick’ game. Has it all been for the good is the billion dollar question.

Ostensibly, futures market activity not only reflects the spot demand-supply picture but also inventories and consumption and availability patterns in coming times. It has been stressed, for example, that crude oil’s ‘super price spike’ is not only because of the spurt in demand but also the falling ratio of reserves to production and slowing new discoveries.

Biggest problem

The biggest problem with futures markets is that they attract ‘non-stakeholders’, i.e., those with no interest or physical presence in the underlying. Often, their activity exacerbates price movements in either direction – volatility without purpose.

How would markets look without futures? If spot prices are expected to go up, speculators should buy spot from producers, store and sell when prices have risen, collecting a profit after providing for interest and storage cost. Falling spot prices would attract short sales. Sellers must borrow inventory from producers or consumers to deliver. In either case, the obligation to physically deal in the market imposes costs akin to those borne by stakeholders. Wall Street ‘refining’ – the term used to describe oil traders and speculators with no physical interest in the market - will not be possible.

Time for review

Finance theorists have long known spot and futures markets are equivalent (after adjusting for the cost of capital and storage). The ingenuity of market players has pushed futures markets far beyond their original role of hedging and price smoothening.

Maybe it is time to take a step back, assess and if necessary correct their functioning so that they do not conflict with public interest.

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