Commodity futures markets: An interview

What is the role of commodity futures market and why do we need them?

One answer that is heard in the financial sector is `we need commodity futures markets so that we will have volumes, brokerage fees, and something to trade''. I think that is missing the point. We have to look at futures market in a bigger perspective -- what is the role for commodity futures in India's economy?

In India agriculture has traditionally been a area with heavy government intervention. Government intervenes by trying to maintain buffer stocks, they try to fix prices, they have import-export restrictions and a host of other interventions. Many economists think that we could have major benefits from liberalisation of the agricultural sector.

In this case, the question arises about who will maintain the buffer stock, how will we smoothen the price fluctuations, how will farmers not be vulnerable that tomorrow the price will crash when the crop comes out, how will farmers get signals that in the future there will be a great need for wheat or rice. In all these aspects the futures market has a very big role to play.

If you think there will be a shortage of wheat tomorrow, the futures prices will go up today, and it will carry signals back to the farmer making sowing decisions today. In this fashion, a system of futures markets will improve cropping patterns.

Next, if I am growing wheat and am worried that by the time the harvest comes out prices will go down, then I can sell my wheat on the futures market. I can sell my wheat at a price which is fixed today, which eliminates my risk from price fluctuations. These days, agriculture requires investments -- farmers spend money on fertilisers, high yielding varieties, etc. They are worried when making these investments that by the time the crop comes out prices might have dropped, resulting in losses. Thus a farmer would like to lock in his future price and not be exposed to fluctuations in prices.

The third is the role about storage. Today we have the Food Corporation of India which is doing a huge job of storage, and it is a system which -- in my opinion -- does not work. Futures market will produce their own kind of smoothing between the present and the future. If the future price is high and the present price is low, an arbitrager will buy today and sell in the future. The converse is also true, thus if the future price is low the arbitrageur will buy in the futures market. These activities produce their own "optimal" buffer stocks, smooth prices. They also work very effectively when there is trade in agricultural commodities; arbitrageurs on the futures market will use imports and exports to smooth Indian prices using foreign spot markets.

In totality, commodity futures markets are a part and parcel of a program for agricultural liberalisation. Many agriculture economists understand the need of liberalisation in the sector. Futures markets are an instrument for achieving that liberalisation.

But how equipped are the farmers to trade in the futures market, in terms of knowledge of the market and access to it?

I should point out that there were flourishing futures and options markets in India prior to the ban on futures trading in the 1960s. That was a time when there was much less literacy and knowledge of modern finance in India as compared with today. Hence I would not be so worried about the abilities available in India to trade on these markets.

In any case, the existence of a futures market does not involve forcing anyone to use it. It becomes an additional opportunity -- a new alternative -- that becomes available. To the extent that some people use it and become happier, that is good.

The second point is that even for people do not use the futures market directly, there are major benefits. Suppose is there are some people who are doing the hard work of trading in the futures market by arbitraging, forecasting market trends or holding stocks, then they will influence the way the prices move. Even if I am a farmer who is a pure spot trader, I would benefit from the effect of the futures market.

Does setting up seperate futures markets for each commodity like the pepper market, castor oil market make sense?

I can see a problem with setting up small exchanges. The trading volumes are small, the revenue stream is small, which leads to a lack of resources for exchanges to fund developmental work. In the olden days, markets used to be simple -- there was open outcry trading, there was no clearing corporation, there was no technology.

Today to build a market like NSE costs Rs 50 to Rs 100 crore -- it is not a cheap affair. Where is the money going to come from? If a new futures market is set up for each commodity, then each of them will be unviable.

There is some kind of deadlock here -- when the exchanges do a poor job, policy makers will be uncomfortable about having more futures markets. And, when major commodities are not tradable we will end up having small exchanges.

I believe that the castor seeds futures market in Vashi is asking that all oilseeds should be traded on its floor. This is a move in the right direction. Lets look back at the biggest and most successful commodity exchanges in the world, they are like CME or CBOT who trade hundreds of commodities, which builds up the critical mass to attract membership also.

Why would anyone go all the way to Cochin to trade in an exchange only for pepper? In the Invest India conference a suggestion was made that the regional stock exchanges, which have good trading infrastructure in place but tiny volumes, should be used for trading commodities. This is worth exploring. I believe that NSE has also offered that its facilities and its infrastructure can be used for trading in the futures market, that too is an excellent idea.

It is a historical accident in India that some of the best development of modern market institutions has happened on the equity market. These are institutions like NSE which does trading, the National Securtites Clearing Corporation (NSCC) which does clearing and the depository. When we look at the commodity futures area, we should harness these skills and infrastructure to get a jump ahead in terms of market development at low cost.

What about the problems of warehousing if commodity trading takes place on the NSE?

There is no modern commodity market in derivatives that does the warehousing. The way it works is that there are outside agencies that do warehousing who are depositories. When you submit one tonne of wheat to the warehouse, you get a receipt, which is submitted to the clearing corporation. So the clearing corporation only does risk management at a purely financial level. What we need is a developement of a warehousing industry to cope with physical goods and checking of grades, while clearing corporations cope with financial risk.

What about futures in bullion?

Futures in gold will be useful, since millions of people in India use gold as a financial asset and are exposed to fluctuations in the price of gold.

In addition, it's very easy to start a gold futures market. Gold is a natural commodity where we should be dealing with warehouse reciepts -- banks have already started giving gold depositories receipts, which clearing corporations would be comfortable relying upon. A market like NSE could start trading in Gold futures with just a few weeks of preparation.

Obviously the consent of regulators will be required to getting such trading off the ground. Remarkably enough, it may not be necessary that we should have a gold futures market in India. There are several well functioning gold futures market outside India. Maybe we should just use them.

But if people trade on foreign derivatives exchanges, won't that hurt the interests of India's exchanges?

From the viewpoint of India's securities industry, it would be great to trade gold futures -- it would yield revenues and it would raise sophistication. If that can be achieved, it would be great, but it looks like it will take a while for the regulatory apparatus to permit gold futures in India.

From the view point of the Indian economy -- and the economy is much more than the securities industry -- the important point is not the colour of the skin. It does not matter whether an Indian or a foreigner is running the exchange. The important point is to have access to these products. There are many situations where we would be better off by merely giving permissions to Indian to go abroad and trade in these markets.

Why do we take it for granted that we have to wait for India's markets to develop. Witness the two year delay in getting an index futures market started -- these delays force India's households and companies to continue to live with risk. India's economy will benefit from having access to derivatives, whether they are come about through India's regulators and exchanges or not. If the Singapore government is friendly to derivatives markets in a way that India's government is not, India's citizens should go ahead and reduce their risk by using futures markets in Singapore.

Hence we should not approach commodity derivatives looking only at the Indian securities industry. The interest of Indian consumers, households and producers is more important, as these are the people who are exposed to risk and price fluctuations. To the extent that foreign derivatives markets can reduce the risk for Indians, this is good.

The RBI has recently released the R. V. Gupta committee report on these issues. It is an excellent piece of work, which paves the way for Indians to benefit from using foreign commodity futures markets. I think that this report is going to be a milestone in the history of India's financial sector.

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