The Hindu Business Line : Commodity futures market: The right path

THE COMMODITY futures market in India is at a critical juncture. Three new National Multi-commodity Exchanges (NMCEs) with electronic trading and de-mutualised ownership have been in operation for about two years. The volume of trading has reached substantial levels, and is growing, and there is much expectation in the market. Some of these exchanges have initiated steps in bridging the disconnect between the spot and futures markets by disseminating price information from both the segments. Ancillary institutions such as warehouses, banks, clearing and settlement agencies have joined the bandwagon, providing value added services and solidity to the institutional framework towards making a sustainable, robust futures market.

The road to freedom

The road to freedom for commodity futures was long, of almost four `lost decades'. However, the speed of reforms, once the need for them was appreciated, seems to make up for these lost decades. The entire commodity spectrum opened up for futures trading by April 2003, when the Kabra Committee Report (of 1994) had, in fact, advised resumption of futures markets only in 17 low-volume commodities.

Similarly, while this Report as well a World Bank's that followed (1996) cautioned strongly against the introduction of options, the government moved amendments to the Forward Contracts (Regulation) Act, 1956, proposing, among other things, removal of the ban on options in commodities. Clearly, the policy-makers need to be congratulated for their dynamism and vision in opening up the sector and the institutional innovations that followed.

However, while laying out such a path the government has reposed faith in the futures market institutions in achieving real price discovery for the benefit of the ultimate segment in the chain — the producer — and making India a `hub' matching the status and size of the country's commodity economy. In effect, we wanted to play the role of a `price setter' for our major commodities rather than remain just a `price taker'.

While that is indeed commendable, some caution is called for on the dangers and the pitfalls of some of the moves by the market participants in their eagerness to expand their growth boundaries.

Trading volumes and delivery-based settlement

In the commodity futures exchanges the peak value of trading have touched Rs 15,000 crore on some days with the average around of Rs 6,000 crore. Open interests in certain commodities such as gold, silver, rubber, pepper, soya are also substantial. But they do not translate into physical delivery, the hallmark of a robust futures market in commodities.

In fact, except NMCEL, which is promoted, among others, by the Central Warehousing Corporation of India, no other exchange had even a formal technical tie-up with any major warehousing company when they went into operation. Without the backing of accredited warehouses how do you make physical delivery in commodity futures market?

Wider participation and real price discovery

Further, trading interest is controlled mostly by speculators with hedgers playing a limited role. Thus, the price discovery process is vitiated drawing a big question mark on the `reality' of the `discovered prices'.

One needs only to look at the `guar effect' where the daily trading volumes doubled the annual physical production of the commodity and prices doubling in the futures market in a few trading sessions to see how speculators can `front run' a shallow futures market in the absence of genuine hedger interest and delivery-based settlement mechanism.

Thus, without a delivery-based model, the market is being promoted as a speculator driven one with little producer participation, except in the case of the plantation products in Kerala, described as the `Kerala model' of commodity futures market.

Internationalisation of settlement prices

The policy vision of the Indian commodity futures markets is converting India into a global hub at least in the major commodities in the economy. Or it foresees globalisation of the Indian futures exchanges.

Here some of the exchanges are entering into agreements with major global futures exchanges, such as the London Metals Exchange, and the Chicago Board of Trade, basically by using their prices as the settlement prices for the Indian contracts. The policy vision is to make India a `price setter' and these exchanges are turning the country into a `price taker'.

The real sector implication of this one single move is so disastrous that we will have equalisation of global prices without taking into account the domestic supply-demand factors.

The Indian exchanges may be smiling about their achievements, and their ability to circumvent the lack of capital account convertibility, but the global exchanges are, no doubt, grinning away at converting these `infant exchanges' into `franchisers' of their global contracts.

Market development and healthy competition

The Government of India recognised three nation-wide multi commodity exchanges to promote a healthy, competitive futures market. It was rightly presumed that there is room for multiple players to grow in size and stature in the huge commodity economy of India.

Moreover, even the commodity spectrum is being widened to include near commodities such as electricity and non-commodities such as weather, carbon certificates and so on. It was also expected that these exchanges, along with the brokerages would be able to pool resources, particularly HR, in extending awareness to all parts of the country advocating both the advantages of futures trading as well as the required due diligence.

However, given the diverse models being followed by the various exchanges and their desire to create `niche' instead of cooperative advocacy and market promotion unhealthy competition is the outcome.

Freedom in the commodity futures market was won after long, pitched battles. It is hoped that by trying to achieve faster growth and personal ambitions, by attempting too much `financial engineering' in this real sector market, this freedom is not lost or the potential gains surrendered to the global players.

(The author is Managing Director, National Multi-Commodity Exchange of India Limited. The views are personal.)

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