The future of futures markets: Business Standard: 18th November 2007

Thanks to the ban on four commodities, trading volumes are down to a trickle.

A pertinent question to ask today is whether or not the commodity futures business is viable under the present circumstances? This issue is quite compelling, given that trading volumes are stagnant at not more than an average of Rs 15,000 crore a day, which is a far cry from the equity segment, where volumes are around Rs 100,000 crore a day. Historically and globally, commodities trade a multiple of that of equities (commodities include financial derivatives too on global exchanges); therefore this question.

Futures trading was revived with much fanfare, and the expected happened. The long repressed market exploded with significant trading taking place in most commodities. This is a necessary prerequisite for robust price discovery and it did not matter who traded as long as the rules were obeyed and orderly, which the system ensured. But, then suddenly, somewhere along the way, it was felt that futures trading was responsible for inflation, and while the experts have been quoted as saying that this is ‘utter nonsense’, the ban on futures trading in four commodities pushed the market on to the back foot. Needless to say, there are signs that trading may have shifted to the informal market.

In fact, one of the main motivations for reviving these markets was to provide a hedge for farmers, and today, agri-trading volumes have diminished to less than 20 per cent of total traded volumes. This happened just at the time when liquidity was building up and prices were mirroring quite accurately the supply-demand conditions. Instead, it is the non-agri commodities which dominate the trading terminals, even though this is also stagnant at a higher level. However, it must be remembered that price discovery here is strictly not determined in the domestic market as they are images of international contracts and developments. The domestic price of gold or copper or crude is an image of that on, say, the NYMEX or LME. Does this mean that the core business faces the threat of stagnation, if not gradual disappearance?

This is important because, while the market has become risk averse and appears to be satiated with the current level of volumes, there is need to develop the markets. It must be remembered that presently we have only one instrument called futures with only retail participation, as institutions such as mutual funds and FIIs are out of this ambit. While there are some large-scale hedge positions in certain commodities, it is the trading community which had basically provided liquidity. Quite clearly, there is need to use this opportunity to widen the canvas to grow the market.

An issue which has been raised amid all the controversy is whether farmers are participating in the market. The answer is an honest ‘no’, because there are several hindrances in terms of accessibility and minimum lot size as farmers may not be in a position to bring an economic size lot to the exchange for delivery. Farmers can trade if there are convenient lot sizes and they cannot be offered unless there is enough liquidity — the classic chicken and egg problem. While the exchanges can offer 1 tonne contracts and 10 tonne contracts, from a buyer’s perspective, the 1 tonne contract is not economical as it would entail higher costs. So, the willing seller may not find a buyer. Therefore, liquidity would be missing and the price discovery process would be retarded.

There is need for two entities to step in quickly. The first is the consolidator who can represent the farmers on the exchanges who consolidates the produce of, say, 10 farmers and puts in the contract. The other is to have market makers who would actually offer buy and sell quotes so that liquidity is generated and the two processes buttress one another. The regulatory processes need to be addressed with urgency to put the market back on track.

The other major concern here is that we do not see too many corporates participating in the markets. These entities have the ability to provide large doses of liquidity to the contracts as they deal in large numbers and also are interested in the physical aspects of the goods. Presently, most of them work on forward contracts where the product prices and terms of sale are decided beforehand. They need to be brought onto these platforms through a round of awareness so that they are able to hedge and trade. On the regulatory front, the hedge limits to be offered could be reconsidered because they need to be looked as not just hedgers, but also some kind of market-makers with an interest in physicals.

The present punctuation in the growth of the commodity trading business should be used to rediscover the strengths of this market. Hopefully, the expert committee set up to analyse the relationship between inflation and futures trading will exculpate the market, and restore confidence in futures trading of commodities. It also must be mentioned that all agri-commodities have faced similar problems on other exchanges like CBOT and CME in the past and with time being the great healer, as Shakespeare had said, equilibrium will be established along the way.

What are needed are suitable amendments in regulatory structures in four areas. Firstly, FCRA needs to be amended to bring in options and recognise intangibles as commodities. Secondly, the concept of consolidator needs to be implemented so as to bring in the farmers. Thirdly, market-makers need to be brought in to revive the markets. Lastly, institutional players like mutual funds and FIIs must be allowed to participate with well defined frontiers to add liquidity. Awareness amongst end users such as corporates must run alongside to add weight to these efforts. Or else, interest would dwindle further given that the capital market is spiralling upwards quite relentlessly.