Wrong option

The Securities and Exchange Board of India may have exercised the wrong option in its decision to allow options trading in commodities. There has been pressure from the commodities exchanges on the regulator to permit introduction of options, ostensibly to help farmers and improve trading volumes. Finance Minister Arun Jaitley had also referred to the possible introduction of new derivative products in commodities in the last budget speech. Viewed strictly from a financial markets perspective, the decision is probably justfiable as commodities exchanges suffer from illiquidity, and options are one way of addressing this problem. Options are a superior tool for taking a view on prices compared to futures, given that the initial outlay is smaller and the liability is limited. Yet, this is precisely why they may not be a good idea for commodities, especially food staples. If speculators dominate trading, the impact on prices could be significant.

The Centre has notified a list of 91 commodities eligible for derivatives trade including 17 cereals and pulses, and 12 oilseeds and oils. Given the experience with futures trading where cartelisation and price-rigging led to speculative excesses (SEBI had to actually ban new contracts in chana and bar select players from castorseed), the impact of the introduction of options in essential commodities needs to be watched closely. Though the move is justified on the grounds that it can help farmers discover remunerative prices, the fact is that it is traders and financial market participants who are likely to benefit, at least in the initial stages. It is hard to see how farmers, who are a disaggregated lot and deal in small, insignificant quantities of their produce, will master the nuances of options trading. For this to happen, farmers need to organise themselves into producer companies or cooperatives that will help them aggregate their produce and glean price intelligence. Such organisations will be better placed to acquire the technical expertise to trade in derivatives compared to the uninformed farmer.

It is hard to escape the feeling that SEBI has probably put the cart before the horse by focussing on the derivatives market even before the spot market is put in order through the National Agricultural Market (NAM) initiative. NAM, with a single electronic trading platform across the country, will enable fair discovery of spot prices for the farmer and for consumers without the interference of middlemen. Options trading based on prices discovered in NAM would have been the right way to go. Yet, having allowed options, the best that SEBI can now do is frame tight guidelines for exchanges and beef up its own monitoring and supervision mechanism. The regulator should insist on full disclosure of the trading volumes contributed by actual users and hedgers on their platforms. It should also broadbase participation by allowing mutual funds and banks into commodities trading so that the market is not controlled by speculators.

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