Do we need commodity futures?

India's economic growth in the coming years will be commodity-intensive. The major growth sectors namely food, textiles, housing and infrastructure as well as energy are all essentially commodity sectors — agricultural commodities (food and non-food), fibres (cotton, jute, synthetics), metals (steel, base metals) and energy products such as oil & gas etc.

So, it is necessary that commodity markets receive focussed attention of policymakers to ensure that production, distribution and consumption of commodities take place in a conducive and competitive environment. By their very nature, commodity markets are volatile. Price fluctuations often hurt stakeholders, especially those who take trading positions for forward months.

Almost a decade ago, policy for encouraging commodity futures market was designed with the clear understanding that such a system of trading would help price discovery and help market participants manage their price risks.

It must be clearly understood that while cash or physical market can exist without a futures market, the latter cannot exist independent of or without the former.Given the existing skew in the country's economic growth and income distribution, it is imperative that commodity derivatives trading must sub-serve the larger economic and social objective of advancing stakeholder interest, especially those who are vulnerable to market vagaries. If judged from this perspective, there are serious doubts about the usefulness and contribution of commodity futures markets in our country over the last seven-eight years.

Speculative players

Theoretically, commodity futures trading is said to help price discovery and price risk management. However, in practice, neither of these is achieved. Currently, the futures markets are dominated by speculators rather than genuine hedgers who have exposure to the physical commodity market.

If anything, hedgers continue to shy away from this market for a variety of reasons including lack of confidence in the systems and processes of exchanges. No wonder, we find low level of corporate hedger participation in commodity futures market. Price discovery in such a market is unlikely to be truly reflective of the reality.

Leveraged trading

Our regulatory systems are such that too much speculative capital is allowed to flow into the futures market. Margin trading allows speculators tremendous leverage. This generates artificial demand for commodities wholly unrelated to market fundamentals and prices begin to spikeWith the flow of speculative capital, price volatility is exaggerated and the effect on market prices is disproportionately larger. It is a pity the regulator is unable to crack down on rampant speculation.

Ultimately, neither the primary producer nor the end consumer benefits from commodity futures trading. The end consumer is invariably forced to pay higher prices caused by flow of speculative capital, but the primary producer does not obtain even a decent share of the premium. So, the system as administered at present allows speculators to milk the market.

One of the responses to the ills of commodity futures markets is to encourage delivery-based forward trading instead of futures trading which is nothing but a paper contract. Deliver-based forward trading will encourage genuine producers and consumers to participate. It will also draw in traders with exposure to the physical market.

World over now, there is hue and cry over sharp spike in the prices of a wide range of commodities covering agricultural crops, industrial and base metals as well as energy products. One of the reasons is rampant speculation. In a report sometime ago, the FAO highlighted the risks of financialisation of commodity futures trading.

Closer home, a panel of Chief Ministers tasked to examine the causes and suggest remedies to address food inflation had recently demanded strict control of commodity futures trading.

New asset class

Globally, commodities have become a new asset class. Speculators, euphemistically called investors, are pouring money into commodity markets as many commodities have outperformed other asset classes.

In 2010, as much as $376 billion was employed in the commodity markets as asset under management. This represented an increase of $100 billion from the previous year.

It is fashionable for proponents of commodity futures trading in India to talk about the United States as a shining example of support to derivatives trading.

In so far as agriculture is concerned, the US is a surplus economy. Almost two-thirds of corn, wheat, soyabean and cotton produced in the US are for the export market. In a surplus economy, it makes commercial sense to allow speculative capital into the market.

India is an economy of pervasive shortage including shortage of food, metals and energy products like crude. It is unwise to allow speculative capital to chase commodities in short supply.

This imprudence creates artificial demand (not physical, but paper demand) and pushes prices higher in the futures section. Often, the physical market takes a cue from futures prices and behaves in a manner not justified by demand-supply fundamentals.

For India, futures trading is not a priority, nor is it a panacea for the ills of the physical market. Food security, nutrition security and energy security are critical issues for the country.

We have to channel our energies to strengthen the production and distribution of physical goods. Unless we have a reformed and strong cash market, we cannot hope to have a transparent and healthy futures market.

In the US, the Dodd Frank Act has proposed drastic changes to financial market regulation.

The US commodity futures market regulators CFTC is working on new rules and regulations for the commodity market. Hope Indian policymakers take a cue from the US.

(Excerpts from a speech at the Bombay Management Association’s convention).