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What ails the commodity futures market

Madhoo Pavaskar

THE need for a futures market in commodities, especially primary commodities, can hardly be over-emphasised. Such a market not only provides ample opportunities for effective management of price risks through `hedging', but also assists in efficient disc overy of prices, which can serve as `reference' for trades in physical commodities in both the internal and external markets.

Before the Second World War, India too had a thriving futures market in almost all major agricultural commodities. But the British banned futures trading in most commodities during the War. After Independence, the Forward Markets Commission (FMC), establ ished under the Forward Contracts (Regulation) Act, 1952, initiated efforts to revive futures trading. But even as trading resumed in the late 1950s and the early 1960s, the market was shut down suddenly -- on the misconceived notion that it was inimical to the socialistic pattern of society.

For almost three decades thereafter, the major commodity exchanges clamoured for the revival of futures trading. The reports of the expert committees appointed in 1966 and 1981 underlined the need to reopen the futures markets in major farm commodities a nd their products. But their efforts were of no avail. The report of yet another committee, appointed under the chairmanship of Dr Kamal Nayan Kabra, would also have met a similar fate had it not been for a World Bank-UNCTAD report, which strongly urged the government to start futures trading in major cash crops, especially in view of India's membership to the World Trade Organisation (WTO).

Owing to World Bank pressure, the mandarins in New Delhi opened the futures market, allowing trading in as many as 34 commodities -- and a few more are reported to be in the pipeline. At this rate, the country could soon have a futures market with the la rgest range of commodities in the world.

Unfortunately for the trade exchanges, the futures contracts being traded are bereft of any worthwhile volumes. The trading halls of most exchanges are virtually deserted. And even when there is some trading, it is speculative with scarcely any hedging. It is, therefore, naive to think that commodity exchanges would assist in price discovery, let alone risk management. Without doubt, the commodity futures market has failed the physical market.

In fact, with imports freely allowed in cotton, edible oilseeds, and so on, the price risks in them have tended to rise, because of the domestic and international factors of supply and demand. Therefore, market functionaries trading in physical commoditi es need effective instruments of risk management and price discovery. Disappointingly, the barriers to their entry in the futures markets are far too many, which seem to deter them from trading in commodity exchanges.

Types of impediments

The impediments to the growth of the futures market can be divided into three categories: i) statutory, ii) institutional, and iii) operational. Statutory impediments: The most notable amongst these are restrictions on the ready and non-transferable spec ific delivery (NTSD) forward contracts under the Forward Contracts (Regulation) Act, 1952. Currently, only ready-delivery contracts (where delivery of goods and payment of price are to be made within 11 days) are permitted in most agricultural commoditie s and their products. NTSD forward contracts (providing for delivery and/or payment after 11 days) are prohibited, except in a few commodities such as cotton -- which are also subject to stringent regulations with respect to contract duration, periodical reporting, and so on, under the auspices of a few select associations.

Not surprisingly, even in cotton, not more than 5 per cent is reported to be sold through NTSD forward contracts. The rest is presumably sold through all its marketing stages by way of ready-delivery contracts. In other commodities such as oilseeds and t heir products, sugar, gur and spices, marketing at all stages is required to be undertaken solely through ready-delivery contracts.

Given the long distances between the producing areas and consuming centres, transport bottlenecks and transshipment problems, congestion at octroi and border check-points, lengthy banking procedures and practices, and frequent postal delays, it would be surprising if the up-country ready-delivery contracts are fulfilled within 11 days.

Incidentally, because of the obsolete Essential Commodities Act, 1955, which empowers the authorities to restrict and control stocks of the market functionaries, merchants and others are wary of accumulating large stocks, and this prevents them from hedg ing. In the circumstances, the least that the authorities can do is to do away with all the restrictions on the ready and forward delivery contracts and also remove the commodities in which futures trading is permitted from the purview of the Essential C ommodities Act. Market functionaries would then be free to pick up large purchases during the peak marketing period to prevent a glut in supplies. They can also enter into a wide range of diverse forward contracts for physical deliveries for distant peri ods at prices that may be fixed either immediately or on deferred basis in relation to certain agreed reference prices.

It is only when such flexibility is built into the physical market will the futures market become strong and vibrant. Among the derivative contracts in the physical market, the `on call' and `unfixed' (or janged in local market parlance) contracts are by far the most essential, which the authorities need to permit forthwith. Derivative contracts in the physical markets are not free from price risks. In fact, many of them depend on the futures market for their pricing and, hence, need to be hedged.

The prohibition of futures contracts has not only rendered the physical markets disjointed, weak and imperfect, but also reduced their efficiency and, in the process, affected the growth of commodity exchanges. The growth of the futures market depends no t so much on the confidence building measures (necessary though some of them are) as on the need and utility of such markets for the physical trade. Paradoxically, considering the way the physical trade is allowed to function, it can hardly make use of t he futures markets.

The existing definition of ready-delivery contracts prohibits even tendering of documents of title to goods acquired by purchase, exchange or otherwise. This runs counter to the efforts of the authorities to promote the use of warehouse receipts from acc redited independent storages. Of course, any attempt to enforce such a warehouse receipt system under the prevailing conditions is fraught with perils for the commodity exchanges. Moreover, warehouse receipts are currently neither tradable nor negotiable .

One other major obstacle is the statutory ban on `options'. As the gains from competition is an increasing function of the number of market participants and their turnover, excessive speculation, which implies greater competition, is essential for improv ing the price discovery and risk management functions of commodity futures markets.

Options are a vital adjunct to futures contract. A futures market in unlikely to survive without it for long. Contrary to popular belief, options do not fuel speculation in a futures market. Options boost the futures contract and enable the market to run smoothly. It is indeed strange that options continue to be disallowed in the very country of their origin.

Another statutory impediment is the tax law, which fails to recognise trade in futures as a legitimate business activity. Tax authorities do not permit any loss in a futures market to be set off against gains accrued in other businesses. Similarly, losse s arising from the outstanding futures contracts at the end of each financial year are not allowed to be deducted from the profits already accrued on the contracts fulfilled during the year. Tax liabilities, therefore, tend to increase for those who trad e in futures, and escalate as a consequence the cost of both hedging and speculation, rendering such transactions uneconomical most of the time.

Institutional impediments: Legal impediments apart, the commodity exchanges and the government must also to a large extent share the blame for the current dismal state of affairs. Little groundwork was done either by the commodity exchanges or the FMC be fore commencing futures trading. They relied blindly on the Kabra Committee report for identifying commodities suitable for futures trading. Unfortunately, the report was not a substitute for assessing the techno-economic viability of operating successfu lly futures markets in different commodities.

The exchanges should have sponsored detailed market surveys and techno-economic feasibility studies. Had such studies been conducted, quite a few commodities would have been found to be unsuitable for futures trading.

The need for a futures market varies directly with the amplitude and value of price risks, their duration, the number of market participants who are required to bear such risks and the volume of their physical market commitments. There is little case for establishing a futures market when only a handful of functionaries have to bear small risks for short periods. Such a market in unlikely to attract trading volumes. And a narrow and thin futures market not only raises the cost of hedging, but also disto rts its price discovery mechanism.

In addition, most commodity exchanges have a poor capital base and are non-profit companies limited by guarantee only. Consequently, these exchanges lack commercial culture and are run on shoe-string budgets. Often, these are viewed by their members as m ere outlets for venting the trade grievances.

Most brokers operating on the exchanges usually run tiny personalised businesses and lack adequate financial strength. Capital adequacy norms are conspicuous by their absence. There are, usually, no client protection measures, and client servicing is non -extant. It is, therefore, difficult for large corporate clients, either hedgers or speculators, to rely on such brokers. Not surprisingly, the futures market is neglected by both corporate hedgers and institutional speculators, without whose operations such markets are unlikely to grow. It is against this background that there appears a prima facie case for developing a `National Commodities Exchange' on the lines of the National Stock Exchange.

Neither the recognised exchanges nor the FMC has full-fledged market intelligence and research cells. They have not developed any worthwhile education and training programmes for the potential users either. There is also the need for greater transparency and accountability in the functioning of the FMC, which would call for major changes in its present organisation and structure.

Operational impediments: These include mainly contract specifications, trading and clearing practices and regulations on trading. In the initial stages at least, futures trading requires support and encouragement, not narrow contract terms and harsh regu latory curbs. Moreover, to attract more market participants and improve trading volumes, transaction costs must be kept as low as possible, while averting counter-party risks and ensuring the solvency of the market. At the same time, it should be recogni sed that hedgers and speculators are not altogether averse to risks.

Disappointingly, in the efforts to globalise the commodity exchanges rapidly and to bring them on a par with international exchanges, the authorities have placed far more operational hurdles and, therefore, the nascent commodity exchanges in the country are unable to take off.

The contract specifications in several commodities seem to be far too narrow and rigorous, and unrelated to the norms and practices prevailing in the physical markets. In several commodities, contract specifications seem to favour buyers more than seller s. True, while specifications need to reflect primarily the requirements of buyers so that supply responds correctly -- in terms of both quantity and quality -- to the price signals emanating from the demand parameters, the exchanges must also ensure tha t producers and merchants buying from them are not excluded from delivery against the futures contract.

To be fair, the basis variety should represent the most widely traded variety in the physical market, while all other popular varieties akin to it should be deliverable against it at appropriate premia or discounts for quality variances as prevailing in the physical market at the time of delivery. It is feared that quite a few contracts traded in different commodities are too marrow to have broad and liquid futures markets, and also do not appear to conform to the prevailing quality parameters and stand ards as are in vogue in the physical markets. Not surprisingly, the prices in the futures and physical markets do not seem to reveal significant co-relationship.

On the other hand, with too broad a contract, futures prices often rule at a discount below the spot prices, failing to reflect the positive storage costs even when both prices represent the crop of the same season. Such a backwardation in the futures pr ice in hardly conducive to either effective risk management or price discovery. Small wonder, most potential hedgers prefer to avoid such commodity futures. Even speculators would be wary, as these add to uncertainty.

To cap this long list of unending impediments to the growth of commodity futures are the stiff regulatory restrictions imposed by, and at the behest of, the FMC. Heavy admission and annual membership fees, high security deposits, ordinary and special mar gins, brokerage and transaction fees, daily clearings and clearing fees, and so on, have all tended to raise the operational costs of trading in the futures markets, while limiting the possible gains due to narrow limits on price fluctuations.

These have led to the mushrooming of illegal futures markets. Attempts at curbing these have proved futile. The solution really rests in removing quickly the diverse impediments in the way of recognised associations.

Thus, unless the authorities take immediate steps to clear the various roadblocks that have impeded the growth of the commodity futures market, the overseas international exchanges (in which the RBI has already allowed the commodity trade industry to hed ge) may soon replace our own exchanges, leaving them high and dry to acquire just symbolic heritage statue.

(Edited extracts of a paper presented at the conference on ``Commodities: The next step,'' in Mumbai. The author is a consulting economist.)

Pic.: The Kochi Pepper Exchange... What is the future?

Picture by K.K. Mustafah