Why futures are yet to deliver: Financial Express 18th August 2010

Commodity futures were revived in 2003 with much fanfare, ostensibly to lead to efficient price discovery. Six years later there is need for some serious introspection as the enactment of the play has varied from the script.

First, the good parts of the story. There has been manifold increase in business volumes; in FY10, volumes at Rs 78 lakh crore were 1.25 times India's GDP at current market prices. MCX is now one of the leading commodity exchanges in bullion. Second, the awareness of commodity futures has spread with wide scale participation. Electronic trading has helped, with exchanges like NCDEX having over 20,000 terminals and a similar number at other national level exchanges. Third, the improvement in logistics on account of futures trading has been remarkable. NCDEX has created warehousing space of over 1.3 million tonnes and enables deliveries of assayed and certified farm products to the extent of 50,000 tonnes a month. As a corollary, the concept of grades and standards has been established and traders are more quality conscious.

Fourth, there has been some migration from the grey market to the organised trading platform. Fifth, futures prices have provided fairly accurate signals about crop prospects—wheat in 2006 and 2007, sugar in 2009, soybean and chana in almost all the years. This should be leveraged by the government to formulate policy. Sixth, significant number of corporate hedgers trade in farm products on NCDEX thus making the system credible. Seventh, price information has percolated to farmers in certain pockets for specific commodities. Last, trading has been orderly and disciplined for which the credit goes to the exchanges and the regulator, FMC.

While this has been the better part of the story, the road has been uneven. To begin with, there is limited price discovery in farm products. Metals and energy products constitute a large part of the volumes traded, where price discovery is global. While there is nothing amiss, the fact that less than 15% of the trade is leading to domestic price discovery questions the success of reintroducing futures trading. The regulator has been banning trading in certain farm products, ostensibly on grounds of their relationship to inflation, which has pushed the market back. The credibility of the regulator has been questioned as, even though it vouched for futures trading and assured that no bans would be enacted, the FMC has been forced to do so and is hence viewed as a weak regulator. To be fair, the FMC has tried hard to preserve these contracts but, after a point, extraneous compulsions have overridden their authority.

The FMC has not been able to revive the regional exchanges, which are marginal players and can close down any day. So, while the focus is on allowing more national level exchanges, little has been done for integrating these niche players. Also, the market has become stagnant in terms of number of players. Banks, FIIs and mutual funds are out as there is a regulatory issue involved. In 2004 there was debate on whether the FMC should be merged with the markets regulator, but that was resolved in favour of the present structure. Some feel that this has kept the market behind.

A lot has been done to educate farmers, but once again the approach has been incorrect. While a novel form of PPP awareness programmes are undertaken by the FMC along with a cost-sharing agreement with the exchanges, the programmes have not delivered. In fact, they cannot, because there has been no move to facilitate actual farmer participation through aggregation. Thus, holding programmes without facilitating trading makes the whole effort quite futile and resembles an unfortunate trait in some government programmes, where the focus is only target attainment. Also, the FCRA Amendment Bill has become farcical as it has never come up for discussion so far. So, any policy level change looks unlikely. Lastly, a regulatory (and now legal) spat with a participant on the issue of trading fees has virtually made the market a monopoly with the other national level exchanges just about surviving.

Futures trading in commodities will always remain an enigma. When prices go up, futures trading is blamed, while it is not applauded when prices decline. Further, the market is governed by two conflicting ministries—the ministry of agriculture that wants the farmer to get higher prices and the ministry of consumer affairs that is upset when consumers pay higher prices. Finally, the unresolved issue will be whether futures trading affect spot prices—a catch-22 situation. If it does, it will be blamed for fuelling inflation—fundamentals notwithstanding. If it does not, then what price discovery are we talking of. Therein lies the rub.