Neha Malik & Saon Ray
The commodity futures market was mainly set up to serve the functions of price discovery and risk management. The main participants in this market are the hedgers, speculators and arbitrageurs. The value of trade in Indian commodity markets has risen by more than 30 times in the period between 2004-05 and 2011-12 with MCX and NCDEX comprising of the highest percentage of the total value. Bullion (comprising gold, silver and platinum) and other metals have dominated the market in terms of the percentage of value of total trade, accounting for 72% of value of total trade in 2011-12 as against 31% in 2004-05. The other major groups traded are agriculture and energy.
A commodity transaction tax (CTT) of 0.017% on sale and purchase of a commodity derivative contract (futures in case of India) was proposed by the government of India (GoI) in the 2008-09 budget with a view to mobilise additional revenue and check speculation. It had been felt that the market had been dominated by speculators who were responsible for causing inflation in some commodities. The proposed CTT, however, was not notified and subsequently withdrawn in the following budget. Though most countries, including India, have introduced the Securities Transaction Tax (STT), the only country to impose CTT till date is Taiwan. Apart from this, Brazil also imposed a uniform tax of 2% in 2010 on all exchange traded instruments traded in foreign currency. The tax, however, was rolled back in the next year.
The impact of CTT, if it is reintroduced has to be seen in terms of likely quantity and price effect of CTT along with its impact on speculation. It is possible that CTT will lead to a decline in the overall volume of trade by way of an increase in transaction cost for market participants. The decline might also happen due to migration of volumes to other international exchanges, which involve futures trading in the same grade of the underlying commodity/commodities. Empirical evidence suggests high co-integration between futures prices for certain set of commodities in Indian commodity markets with those of their international counterparts. Along with this, there could also be migration to illegal platforms in the absence of other alternatives in the domestic market. Migration is not always possible for agricultural commodities due to differences with respect to quality/grade etc. Migration of volumes, hence, is subject to available domestic or international substitutes of commodity derivatives.
Price discovery is best achieved when futures prices are a good estimator of expected future spot price. Hedging is considered effective only when the two prices i.e. spot and futures exhibit proximate trends so that the profits/losses in the futures market are offset by the resulting losses/profits in the physical market on the day of the maturity of the contract. Risk management and price discovery are hence, in a way, two sides of the same coin. Though price discovery has been achieved for most commodities/commodity groups, it has yet to be attained fully for others such as agricultural commodities. Futures prices are a reflection of the expectations formed by the market participants; hence, the presence of the latter is one of the pre-requisites in determining the future price. An increase in the transaction cost by way of CTT will most likely lead to a withdrawal of the market participants, thus, lessening liquidity and making trade costlier. This may then lead to further withdrawal causing a feedback loop effect which may deter the process of price discovery.
As for speculation, it has been argued by some that speculators are pivotal to the efficient functioning of the commodity futures market since they assume the load of the hedgers. In every market, there is a certain range within which price oscillation has a destabilisation effect while outside that range it has a stabilising effect. Speculation in futures can be price stabilising or not depending on the elasticity of expectations (i.e. a quantitative change in the expected price of a commodity in response to a change in its current price) and also the elasticity of speculative stocks of the underlying commodity (which depends on various factors including the marginal cost of carrying which differs for different commodities). So, in order to determine the effect of speculation, it is imperative to estimate an approximate figure for elasticity of speculative stocks for a certain set of commodities or commodity groups (also sub-groups) traded on an exchange such as metals, energy and agriculture.
What is thus, of utmost importance is to analyse the market microstructure for commodities. One of the many factors that the market microstructure is composed of is the role of information on price discovery. Information for each commodity group depends on the market fundamentals, which are further determined by the elasticity of each such commodity group and/or sub-groups. Earlier research on some commodities has indicated a negative relationship between transaction cost and trading volume and a positive relationship between transaction cost and volatility. It is thus, important to estimate the elasticity of the underlying commodity groups/sub-groups of the futures contract and also the elasticity of futures contract itself for and with respect to a change in variables of the Indian commodity market. The variables could be transaction cost or the bid-ask spread as its proxy, future/spot price volatility, etc. In the absence of recent estimates of elasticity and an understanding of the market microstructure, which has changed over the last few years, the impact of imposition of CTT in future, on futures contracts will be difficult to predict.
Neha Malik is a consultant and Saon Ray is a senior fellow at ICRIER