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The future of futures

    Nilanjan Ghosh
    Debojyoti Dey
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With futures trade, potato buyers feel assured of quality. — Ritu Raj Konwar
With futures trade, potato buyers feel assured of quality. — Ritu Raj Konwar

If mentha oil and potato trade are anything to go by, futures are changing physical markets for the better.

Way back in 1875, the Bombay Cotton Trade Association initiated commodity futures trading to India.

This happened just a a decade after trading in similar products began at the Chicago Board of Trade, the world’s first modern commodity futures exchange.

Underlying the booming futures trading in cotton was a spurt in cotton exports from India to Europe, after supply from the US was disrupted due to the Civil War.

Through an unenviable roller-coaster ride marked by high trading interests, enactments of regulations, bans and endorsements by several official and unofficial bodies, the commodity futures market — in the present electronic, demutualised avatar — saw the light of day only after the Centre allowed multi-commodity futures exchanges in 2002.

In 2003, India’s two largest commodity futures exchanges — MCX and NCDEX — began operations. A decade, therefore, has unfolded the institution in various forms, though a lot remains for the years to come.

Vehicles of development

It is said that institutions are vehicles of development. So, an institution’s worth, especially that of a commodity exchange's, must be measured not just by its commercial success, but also (possibly more) by its impact in the socio-economic contexts in which it operates.

On that cue, 10 years is possibly too short a period to evaluate the impact of Indian commodity futures market. Besides, the fragmented physical agri-commodity market with all its imperfections doesn’t help either, inasmuch as the success of commodity futures depends on the efficiency of the physical commodity market.

Yet, there is ample evidence of the potential of commodities exchanges to create a large-scale socio-institutional impact. These evidences are not merely anecdotal; they point towards a sustained trend in impact creation, established by scientific studies done by institutes of repute.

The mentha example

For instance, a 2012 study by IIM Calcutta and the National Institute of Science, Technology and Development Studies (NISTADS) in Delhi has discovered a profound impact of mentha oil and potato futures on the physical market of these crops. To the uninitiated, mentha oil is a high value commodity, produced primarily in a few regions of Uttar Pradesh. It was long characterised by localised and unorganised production and marketing. As a result, despite India being a world leader in mentha oil production, its export potential was left on the fringe, mostly confined to trade in raw mentha oil.

But the introduction of mentha oil futures changed all that. Soon, a highly efficient marketing chain in this commodity has been created, one which offers a competitive channel of marketing.

This has unlocked significant value in this commodity, benefiting mentha farmers, processors et al, all the way to exporters and consumers.

The benefit has been so substantial that it has encouraged the value addition of this crop and facilitated the rise of India as a major exporter of processed mentha crystals, displacing China, notes the study.

Mentha oil futures allowed processors to manage raw material risk — price, quantity and quality risks — all of which enabled Indian exporters to provide better price and delivery commitments to international buyers.

Such a facility helped them consolidate at a time when Chinese exporters were defaulting on export commitments. Moreover, the high export prices of processed mentha crystals have been transmitted back as high farm gate prices of mentha oil, due to the competitive structure of the trade channel, which has ultimately benefited farmers.

Future perfect

The study also covers the potato economy of western Uttar Pradesh and West Bengal, and finds that futures trading in potato has created a strong interface between futures market and physical trade, primarily through creation and accreditation of scientific warehousing facilities.

The delivery-takers are more assured on the quality front, while trading in the futures platform rather than platforms belonging to traditional marketing chains. Hence, both “adverse selection” and “moral hazard” problems are diminished substantially.

For both mentha oil and potato trade, the study notes, the shift of transactions to the futures platforms has brought the trade in these commodities under the tax net. Enforcement of various taxes is higher in the exchange-accredited, warehouse-intermediated trade channels.

Futures trading have yielded the Government tax revenues to the tune of about Rs 4.37 crore in the case of potato during 2005-06 to 2011-12, while mentha oil has provided Rs 24.34 crore in the same period, notes the study.

The Indian commodity futures market has admittedly a long way to go towards fulfilling its vision of heralding socio-economic changes.

This vision, however, is not merely wishful thinking: evidences in many developing countries and developed countries clearly indicate that such a possibility is indeed real, provided the right institutional framework is created by an enabling policy environment.

Documented evidence in the Indian potato and mentha oil commodity ecosystems shows the futures market in India is indeed moving in the right direction.

What is needed now is appropriate policy support that enables it to unlock its potential to be a powerful agent of socio-economic change.

This will entail the best governance practices (including risk management) from the exchanges, a strong regulator, more innovative products, better institutional participation, awareness programmes to enhance hedger’s participation, and policy advocacy.

(Ghosh is Chief Economist and Dey is Senior Economist at Multi Commodity Exchange of India.)

(This article was published on January 2, 2014)
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