Don’t ban our futures: Financial Express 22nd April 2011

The growth of the commodity futures markets has been quite amazing in the last few years. Forward Markets Commission (FMC) data shows that volumes have been around Rs 120 lakh crore in FY11, which is almost 1.5 times India’s GDP at current market prices. Does this mean that commodity futures trading has finally arrived?

Let’s go back to the basics. When futures trading were revived in 2003, the idea was to bring in a price discovery mechanism that would finally help the farmers get higher prices for their produce. But for these prices to be determined, we needed to have active trading to generate the requisite liquidity. Therefore, we required the arbitrager, investor and speculator to take contrary positions.

The market has been mired in controversy as every bout of inflation has been associated with futures trading. The conundrum is that futures prices are supposed to tell us what lies ahead, in case the market is efficient. However, when futures prices of, say, tur or urad or wheat indicated a crop failure, these price signals were taken to be proof of futures’ role in fuelling inflation, leading to a ban. The banning of futures products and their subsequent reintroduction has not really helped as traders are wary of future bans. It is not surprising that contracts in wheat and sugar, which were extremely robust before the ban, are quite muted after their reintroduction.

The question now is, how can we evaluate the market as it stands today? The first is that the share of farm products in total volume traded has come down to a low of 12.2% in FY11. These are the only products where price discovery takes place within the country and hence add value to the pricing system. The canvas is limited with noteworthy volumes in soybean, soy oil, mustard and chana, and some of the spices during the season besides guar, which is traded more as a proxy for weather.

The second issue is whether the farmers are gaining from such trading. The answer is yes and no. No, because they do not trade. Yes, because the price information is available to a large cross-section of the community, thanks to the development role taken on by the FMC and the exchanges in price dissemination. The Indore oilseeds mandi or the Delhi chana markets commence daily trade based on the National Commodity & Derivatives Exchange (NCDEX) futures prices. Therefore, futures prices do get used in the spot market.

The third is whether there has been any use of futures trading in metals and energy, which constitute around 88% of volumes, especially when there is virtually no price discovery taking place in India and where deliveries are non-existent. Crude prices are determined on the New York Mercantile Exchange (NYMEX) or Intercontinental Exchange (ICE), bullion on the Commodities Exchange (COMEX) and copper on the London Metal Exchange (LME). The answer is that these commodities have now become alternative investment classes and offer opportunities to investors. While there is no direct value for the economy, investors can diversify their portfolio as these commodities do not have a relationship with stocks or interest rates. Regulation must change so that the retail investor can harness these benefits through commodity funds where the mutual fund can invest in these products. Currently, regulatory overlap does not permit such an option.

The fourth is whether the market needs multiple exchanges when most of the terms of operation are fixed by FMC. Today, FMC data shows that there are 21 operating exchanges. However, the Multi Commodity Exchange of India (MCX) has a market share of over 80% and NCDEX a little over 10%. The National Multi Commodity Exchange of India (NMCE) is the third while the Indian Commodity Exchange (ICEX), the Ahmedabad Commodity Exchange (ACE) and the National Board of Trade (NBOT) are players around the fringe. The broader issue is what is being done to revive the age-old exchanges. While two of the new exchanges are operating and one more is on the anvil, will these exchanges really survive? This is important because anecdotal experience shows that liquidity gravitates towards an exchange and then gets stuck to it. Moving liquidity away is a challenge and exchanges are natural monopolies. This being the case with a firm demarcation between the original electronic exchanges (besides NBOT, which has its own loyal members), there is a need to reconsider making the system well knit. In the stock market, only two exchanges dominate, and a similar picture appears to have emerged here. The FMC needs to work towards consolidation or enabling measures like market-making to ensure that they survive.

So what does this all mean? It is hard to think of futures trading changing the architecture of farming in the context of what has transpired in the last few years. Trading in farm futures will continue to remain on the periphery as it can no longer be pursued as a goal by exchanges that have to return a profit to their shareholders. It will evolve to be analogous to the equity market as a platform for investors who look at non-farm products. Here, it will be a challenge to the FMC to get in end-user and retail participants so that a wider audience can draw benefits from this investment alternative. Along the way, the market, too, will attain more respectability.