The decision to allow mutual funds to trade in commodities is welcome as this has been a long-standing demand from the time futures trading was reintroduced in 2003. There is a lot of hope in the market now and this could just be a push which was required to reinvigorate futures trading which has plateaued in recent times.
Globally, mutual funds play an important role because of the volumes traded as well as knowledge on the subject. They help to enhance the price discovery process by adding liquidity thus lowering also the impact cost. As the markets are already refined with large volumes and delivery never being an issue, their role has been quite seamless with no glitches in operation. With mutual funds also active in stocks, they can enhance efficiency in their operations across the two markets by taking logical actions — countervailing at times, when relations between commodity and stock prices are established and firm.
If one looks at how mutual funds have become an integral part of the stock market, it is possible to conjecture the important role that can be played by them in the commodity space. While the demand existed since 2003, the regulatory disconnect between the erstwhile FMC and SEBI prevented this from happening.
Now with SEBI having full control of all these markets, it was only a matter of time before mutual funds entered the trading ring. Today while FPIs (foreign portfolio investors) play an important part in the growth of the stock market, their withdrawal does not lead to a decline or shock as domestic institutions have continued to stabilise things. The immediate thought that comes to mind is that mutual funds will be best able to bring the retail category into the commodity market and can add significant liquidity in the trading space. While individuals can trade in commodities, it is a relatively difficult terrain to understand as the fundamentals are not easy to grasp.
Individuals know everything about the companies that go into the Sensex or the Nifty and can trade on their own judgments as there is a plethora of information available on these companies. But when it comes to, say, soyabean one never knows what drives the prices and hence taking investment calls can be challenging.

Delivery issues

Besides, delivery issues can also be taxing. In fact, farm products have considerable volatility as we have seen in the last three years where even a good monsoon has meant volatile prices. Mutual funds with their institutional knowledge can channelise investment by taking calls on prices.
Mutual funds would, however, have to analyse the market and processes better before launching products. Currently, there are some commodity schemes in the market. These have no exposure to commodities per se, but to companies which are commodity intensive. Hence, one can invest in a scheme which has steel stocks, where the benefits are on the share prices of the companies rather than the price of the product.
From the point of view of mutual funds the main issues to be sorted out are: First is the case of delivery, which has to be made or taken in case the contract cannot be squared off before the maturity date. This is probably the most irksome problem as it can result in penalty and distortion in the market, especially if the market knows that the mutual fund is likely to be called to take or give delivery due to its inability to square off the contracts.
The second pertains to size of contract and position that can be taken. With the size being limited to what is allowed for members or hedgers at the upper end, the actual position held on to could be low to meet the requirements of the retail investors. Suppose there is lot of interest in sugar and positions have to be taken on, say, half million tonne.
This cannot be done today as the member limit is 6.5 lakh tonnes or 15 per cent of OI (open interest). This can be a dampener. A non-delivery-based contract for institutions can be thought of, with the caveats being that it should not lead to distortions in the existing contracts due to arbitrage opportunities.

Price influence

Third, the price influence can be significant in case there are several such funds that trade and move the price significantly. We may not be prepared for such changes as mutual funds would be investing to make money and not deliver benefits to farmers. This could become politically controversial.
While the stance today is that sensitive commodities will not be in the ambit, even non-sensitive products in the agri basket like guar or turmeric can cause upheaval. The commodity exchanges have been facing these challenges on an ongoing basis and this can enhance uncertainty. It is more likely that such permission will be more in products like bullion and oil where global factors come into play in price discovery.
Fourth, tax issues will be an important consideration. With GST coming in, the cost of trading will become volatile depending on whether or not there is delivery. This is something mutual funds have to take into account, which is not witnessed in shares and bonds.
This raises a broader question of whether the idea of getting in institutional players is to just get liquidity and encourage retail participation or more efficient price discovery. Restricting the play to non-farm products will enhance liquidity for sure but may add limited value to the price discovery process. This is an issue which has to be addressed along the way.
The progress of mutual funds will be closely watched as the next step will be to bring in FPIs which can be the final push for the markets. Therefore, the success of mutual funds will in a way be the template set for the FPIs. For both the regulator and FPIs the issues are similar with foreign trade considerations being an added dimension for the latter. It is therefore necessary that the narrative is positive.