These markets have seen spectacular growth. Commodity futures traded volumes rose from $29 billion in 2003 to $3.33 trillion in 2013. But instead of a sense of achievement, there are rampant concerns. There are concerns that the settlement process is not robust. There are concerns that a lot of the turnover is fake: mere circular trading to artificially inflate turnover. A persistent, widely held belief is that there is widespread market manipulation. All this, in a context where there is a history of scandal.
As a consequence, commodity futures are not well-accepted as an important part of the market economy. The knee-jerk policy response to inflationary pressures in commodity prices is to impose restrictions on derivatives markets, bans which can quite easily do more damage than the market manipulation that they seek to prevent.
After the Forward Markets Commission (FMC) moved into the department of economic affairs, the DS
Kolamkar Committee was setup to examine the basic questions on the workings of these markets. As part of this work, we wrote a research paper Do futures markets help in price discovery and risk management for commodities in India. This examined prices of six agricultural and two non-agricultural commodities between 2004 and 2014.
If futures prices are systematically manipulated, they would have a low relation with the spot price. This is not the case: we find that the futures prices are strongly linked with spot prices. The futures market has a high information share: new information about these commodities is generally first reflected in the futures prices. This runs counter to the outcome expected from markets that are driven solely by manipulation. The futures market is working fairly well in its first task: that of impounding forecasts about the future through the process of speculative trading.
Are the futures useful for risk management Commodity price risk can be reduced using the futures, but the amount of reduction ranges between 61% (rubber futures) to only 7% (sugar futures) of the commodity price risk.
Why is there such a wide variation in the hedging effectiveness of these futures The hedging effectiveness of futures markets are shaped by the actions of arbitrageurs. Arbitrage ensures that futures and spot prices move together. This makes the futures a good hedging instrument. Thus, to make the futures market useful for hedgers, we have to make the futures market safe for arbitrageurs. This requires low and reliable costs of transactions and costs of storage. The Indian commodity derivatives ecosystem fares poorly on this.
Commodity storage mechanisms in India have involved a large, dispersed set of warehouses across the country, providing varied quality of services and costs. The Warehousing Developing and Regulation Authority (WDRA) which became operational only at the end of 2010, and is yet not an effective influence on most warehouses in India. This raises the costs and the uncertainty faced by arbitrageurs.
Arbitrageurs suffer high costs in doing transactions, of which spot and futures market illiquidity is just one. The biggest problem is legal uncertainty and regulatory restrictions. This matters in two ways. Random and frequent bans of futures trading disincentivises long-term investment of capital and human resources, which is critical if financial firms are to engage in arbitrage. Secondly, regulations by RBI and Sebi actively prevent financial firms from participating in these markets, by explicit mandate or implicitly. For example, banks which have significant exposure to both agricultural and non-agricultural price risk, are prohibited from trading commodity futures to hedge this risk. Sebi doesnt include commodity derivatives as permitted to trade for foreign institutional investors. This eliminates the participation of the key persons who would do commodity futures arbitrage.
How can these problems be addressed The first element of the solution is to build a strong regulator. FMC should be focussed on the Financial Sector Legislative Reforms Commission (FSLRC) goals of consumer protection, micro-prudential regulation, systemic risk regulation and market abuse. FMC needs to be substantially transformed to become more effective.
Regulatory uncertainty can be reduced by adopting the regulation-making process designed by the FSLRC. This is in the process of being adopted in the Indian financial system through the Handbook of non-legislative governance-enhancing measures from the FSLRC report. These formal processes will both reduce the risk of low quality regulations and reduce the surprise associated with new regulations. Such a low uncertainty environment will encourage firms to build up organisational capital.
Trust will be enhanced by creating a transparent and reliable information base about Indian commodities, and enable a flow of research in this field. This research would make possible better quality regulations, support the thinking of practitioners, and help dispel the rumours and conspiracy theories which bedevil the field today.
Through FSDC, FMC will need to work with all regulators to remove provisions through which financial firms are presently prevented from commodity futures trading. Arbitrage will become effective when these firms build organisational capital about commodities and their futures. It is particularly important to remove barriers to cross-border activities. Participation by foreign financial and commodity trading firms can significantly strengthen Indian commodity futures, and help realise the strong potential that India has to be a key player in the world commodities markets.
These changes, coupled with special efforts at the finance ministry, should take us away from the knee-jerk response of banning futures trading every time a commodity price goes up. This would benefit the food economy: higher prices are the required stimulus for increased production. It would also benefit the working of commodity futures: in an environment where the markets work consistently across rain and shine, floods and droughts, firms will build up organisational capabilities and move markets closer to achieving what was sought in the reforms of 2003.
Nidhi Aggarwal & Susan Thomas
Thomas is faculty, IGIDR, and Aggarwal is a research scholar at the Finance Research Group, IGIDR