The Hindu Business Line : A remedy worse than the malady

The persistent demand of the Left parties to ban futures trading in commodities, backed by the Union Railway Minister, will actually result in a further rise in prices, as futures trading, if properly regulated, moderates the movement of prices. It will prove to be a remedy worse than the malady. Prices of tur and urad, trading in which was banned in January 2007, have not come down.

The prices of commodities, as of any other item, are determined mainly by the forces of supply and demand. Futures trading actually results in better price discovery, evening out distortions in prices prevailing in different mandis of the country, as electronic price tickers displaying the prices in the futures markets are splashed across the mandis by the leading commodity exchanges.

This actually gives proper guidance to farmers for realisation of better prices, and, above all, acts as a hedge instrument to several functionaries in the spot market, such as producers, exporters, importers, stockists and traders by transferring their risks arising out of adverse movements to speculators.

Role of speculators

Contrary to the common perception, speculators help in stabilising prices, and not in aggravating either a bullish or a bearish trend. They act not only as long purchasers, i.e., buying without any intention of taking delivery but also as short sellers, i.e., selling without owning the commodities.

Ceteris paribus, speculators act as purchasers when, as per their assessment, prices are depressed, and this acts as a check on the falling prices. As a result of their operations, when prices rise, and they feel that prices have risen high enough, they liquidate their positions by selling. This, in turn, helps to ensure that prices do not rise too high.

In the reverse direction, when prices rise steeply, as is the case presently in some commodities, speculators turn short-sellers, and this operation of short selling helps in arresting the price rise. When they feel that prices have fallen sufficiently, they liquidate their short sales by buying which, in turn, helps in checking the downward drift.

It also needs to be noted that speculators are neither permanent bulls nor permanent bears. They are speculators simpliciter, taking a view of the market at every level of price, and taking a bullish or bearish view of the market depending upon their perceptions. Speculators do not also act in concert.

The current rise in prices, particularly in oils and wheat, is due to the rise in the global markets and not due in any way to the operations in the commodity futures markets.

Thumbs-up from expert committees

The above averments have been backed by all the three expert committees appointed by the Government of India viz., the Dantwala Committee in the mid-1960s, Khusro Committee in early 1980s and the Kabra Committee (of which I was a member) in the mid-1990s. The Abhijit Sen Committee set up by the Government in March 2007, the report of which is not yet released, has also reportedly come to the same conclusion.

Apart from these committees, several empirical studies conducted world over, including India, by researchers, have clearly and unequivocally come to the conclusion that trading in futures and options has exercised a steadying influence on prices, moderating the troughs and peaks, and not aggravating in any way the volatility of the market.

Regulators must play dual role

The Forward Markets Commission (FMC) and commodity exchanges also need to alter slightly their approach to regulating the market. Presently, a neutral stand is adopted with regard to the level of prices, putting checks and balances on both the bulls and the bears to the same extent in a rising market as also in a falling market and thereby, in a way, reducing liquidity of the market and also in not achieving the objective of moderating the prices, as the restraints on both the bulls and bears are the same. It is necessary to take a view of the market at every level of the ever changing movement of prices.

When it is felt that prices are rising unduly, as is currently seen, the rates of margins, filters on rise, etc., have to be higher on the purchasers, to act as a deterrent, and lower on the sellers just to cover the likely loss in adverse movement of prices.

In a like manner, when prices drift downwards unduly, rates of margins, filters, etc. on prices, have to be higher on sales to check the slide and lower on purchases to cover the likely losses.

Regulatory instruments need to be sharpened to have a dual role, both as price protective and price deterrent. This was a well accepted concept when commodity markets started buzzing in the last four years.

Crack down on ‘dabba’ trading

What needs to be curbed, indeed eradicated, is the flourishing ‘dabba’ trading, i.e., trading outside the recognised commodity exchanges by some brokers who match the buy and sell orders of clients, saving thereby transaction cost.

The volume of turnover in ‘dabba’ trading is estimated to be about Rs 40 lakh crore per annum, equivalent to the total turnover in all the recognised commodity markets.

Bereft of any prudential norms, ‘dabba’ trading can, and in fact does, exercise a harmful influence on the movement of prices in the recognised markets.

China example

It is also relevant to observe that, globally, almost all the market-driven economies have thriving commodity markets in derivatives both futures and options, the size of which is twice or thrice the size of derivatives in shares and stocks.

Apart from countries such as Russia, Romania and Serbia, China has been trading in commoditiy futures right from 1993. Zhenghov Commodity Exchange has a thriving futures market in wheat, cotton, sugar, rapeseed oil and green beans, while Dabian Commodity Exchange trades in futures contracts in soyabean, soyabean oil, soyabean meal, corn, palm oil and barley.

Shanghai Futures Exchange has a thriving futures market in copper, aluminium, natural rubber and fuel.

The solution is not to close the recently structured commodity markets opened after over four decades, but to strengthen the system by opening the options market, as futures and options are twins operating in synergy in the twin tasks of price discovery and hedging facility.

Needless to say, closure of the market will not solve the problem of rising prices. Markets will then go underground and tackling the illegal trading that will spring up all over the country will be a serious problem. Let us foster commodity futures markets and not take any knee-jerk action due to pressures from some political parties that may not understand the utility of these markets.

(The author is former Executive Director, Bombay Stock Exchange.)

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