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Working of Commodity Futures Markets

Working of Commodity Futures Markets MADAN SABNAVIS, SHILPA JAIN The commodity futures market has been viewed quite unfavourably by Kamal Nayan Kabra in his article titled,

Discussion

Working of CommodityFutures Markets

MADAN SABNAVIS, SHILPA JAIN

T
he commodity futures market has been viewed quite unfavourably by Kamal Nayan Kabra in his article titled, ‘Commodity Futures in India’ (March 31, 2007). The issues which have been put forth by Kabra are also general misconceptions regarding the operation of these markets. There are broadly 10 issues or misconceptions and the purpose here is to provide detailed clarification with both facts and global parallels.

Speculation and Participation

The first misconception is that futures markets are purely speculative ones where there are very few end-users of commodities. The fact is that there are several endusers who trade on the exchanges as Table 1 shows (as of February 28, 2007, when wheat and rice were delisted). The participation of end-users can be gauged by the hedge limits that have been utilised by players wherein these limits are allotted to those participants who are able to prove to the exchange that they are users of the commodity. This being the case, they are allotted higher position limits for trading in the relevant specific commodities. It must be remembered that there are several other end-users who do not ask for these enhanced hedge limits. Hence, the numbers provided here are on the conservative side. The second point here is that speculators are essential in any market as they have risk-taking ability and provide liquidity to the market. Suppose we had only end-users, i e, farmers operating on one side and processors on the other, then equilibrium would never be reached since the farmers would want the highest prices and the processors the lowest prices. Speculators offer liquidity on both sides. Speculation should not be confused with manipulation where a section of the market is able to distort the prices by cornering a large share of the market and artificially moving prices. Here, exchanges have real time market monitoring mechanisms in place wherein the open interest of any player is monitored and it also ensured that no group manages to push up prices by taking similar positions. These positions are reported to the Forward Markets Commission (FMC), the regulator of these markets.

The second misconception is that the markets have not served any purpose since farmers are not participating. This misconception is only partly true. It is a fact that small farmers are not directly participating on the exchanges because the contract sizes are too large for them and that they do not understand the finer intricacies of margining and concepts of mark-to-market, etc. Besides, there is the issue of awareness of the existence of such markets where the farmers need to know the prices that are determined on the commodity exchanges. Therefore, only large farmers are using the exchange platforms. However, the important thing is that there is a sea change taking place where the awareness of these markets is spreading quite rapidly.

However, farmers in certain geographies have been using the futures prices of the NCDEX to take selling decisions, which is significant considering that these markets are just three years old. A C Nielsen’s study (2007), ‘Executive Report on Brand Awareness’ for the NCDEX shows that farmers in vicinity of commodity-centric towns are aware of the NCDEX and futures trading and do find the futures prices a useful tool when deciding when to sell their produce as well as to bargain in the ‘mandis’. This has been enabled by the investments made by the NCDEX and FMC in price dissemination where prices are made known through different routes: TV channels, radio channels, electronic price ticker boards displayed in high farmer footfall centres in rural areas, newspapers, news agencies, etc.

Prices, Volume and Delivery

The third issue raised has been price volatility. It is widely believed that prices have become more volatile with the advent of futures trading in the country. However, data presented in Table 2, which compares price volatility for a comparable period before and after futures trading shows that price volatility has actually decreased after futures trading. Annual volatility has been defined as the standard deviation of the daily percentage changes in prices.

The fourth area of confusion is with respect to the volumes traded on exchanges. Often, a high futures trading multiple is used to erroneously conclude that there is something amiss in the market. The fact is that volumes traded in the futures market would theoretically be several times the underlying because the value chain, particularly in agriculture, is very long with there being 8-10 participants along the way. Therefore, a high multiple is not alarming. Closely related to this issue is another – we need to distinguish between volumes and open interest. If trader A buys 10 tonnes of wheat and sells this to B who sells to C and so on till E, the volume would be 50 tonnes while the open interest would be 10 tonnes. These 10 tonnes are those which can be potentially delivered on the exchange at the time of settlement, which is monitored on a real time basis by exchanges. Now, the ratio of overall open interest to total availability of the commodity in the country has been very low at less than 1 per cent (Table 3). The limits are even lower for clients where it comes down to one-third that of a member. This being the case, it is not possible for these high volumes to have an impact

Table 1: Share of End-Users in Futures Trading on NCDEX

As of February 28, Share of End-users 2007 in Business*

Sugar 40 Soybean 67 Soy oil 39 Mustard seed 24 Wheat 38 Pepper 21

* Ratio of utilised hedge limit to open interest. Source: NCDEX.

Table 2: Annual Average Price Volatility(2001-04 and 2004-06)

Annual Average Price Volatility (Per Cent) Pre-Futures Post-Futures

Wheat 37.08 15.62 Sugar 10.44 8.65 Chana 22.41 19.52 Maize 26.52 14.90

Source: NCDEX.

Economic and Political Weekly May 5, 2007 on price movement as it is the open interest position that ultimately drives the prices. As can be seen, the total control which a member can take on the exchange is a very small proportion of the total production. Further, the ratio of near month limit to total production, which is more critical is even smaller than the overall limit. The near month limit is more pertinent since this is what can be potentially delivered during the present month and has to be under control.

The fifth misconception highlighted in the paper relates to the perceived nonexistence of deliveries in the futures markets. Low deliveries are taken to be indicative of futures trading being a speculative business. Table 4 provides data on the deliveries recorded on the NCDEX over time. Two issues are to be highlighted here. The first is that globally not more than 1-2 per cent of the volumes traded get converted to delivery as futures trading platforms are not efficient delivery platforms. This is so because the cost is high as delivery entails costs such as transportation, porterage, taxes, warehousing, assaying, interest foregone, etc. Therefore, even genuine users of commodities use the exchanges for hedging and not delivery. The second is that the NCDEX witnesses deliveries of around 30,000-40,000 tonnes per month which has led to the creation of warehousing capacity of around 10 lakh tonnes across over 550 centres in the country.

The sixth issue raised relates to futures trading in certain commodities, which are insignificant in value terms as a proportion of India’s GDP. It must be noted here that these commodities, which are termed as regional commodities, have been introduced based on an objective formula which looks at their importance in terms of area under cultivation (a proxy for the number of farmers), share in agriculture GDP, number of states growing them, share in world production, exportability and price volatility. Therefore, there is a strong economic rationale for having futures trading in these commodities.

Table 5 provides data on the so-called regional commodities, which are very important from the point of view of the country.

Spot Prices and Futures Trading

The seventh area of debate has been so as to whether or not spot prices are driven by futures prices or vice versa. This has been a fairly controversial issue as there is a belief today that prices of commodities have gone up on account of futures trading. Theoretically, futures prices have been defined as spot prices plus cost of carry.

Futures prices also reflect the expectations of production and hence, supply flows. Spot prices are dependent on actual demand-supply balances in the country and hence, are quite divorced from the futures markets. Econometric analyses of these relationships have been inconclusive but there is evidence to show that higher spot prices have been associated with supply shortages in the last two years or so. This holds for wheat and pulses, the two sets of commodities which have been in news of late. Table 6 provides information on the reasons for increase in prices of commodities in the current year while Table 7 gives information on production trends.

Tables 6 and 7 show quite clearly that inflation in these specific commodities has been caused by shortfalls in production which is not a single year phenomenon but one observed over the years:

  • (i) Wheat production has been sub-optimal for two successive years with stocks being inadequate as in FY06 to control rise in prices. Curiously, wheat price inflation was at the double digit level in FY97, FY99 and FY06.
  • (ii) Pulses and maize production has been lower than optimal for three years now.
  • The significant part here is that futures prices in 2005 and 2006 have always shown the right direction for future crop prospects, which unfortunately were not heeded by the government due to this preconceived notion that futures’ trading is only speculative.

    Kabra has stated that futures cannot provide an answer to post-harvest problems of storage, financing, etc, which is the eighth issue. This line of thought goes ahead to say that the price risk management function cannot be bettered by the futures market as the traders are the ones who actually garner the benefits of seasonal movement in prices by buying at low prices at the time of harvest and selling when supplies weaken and prices rise.

    Now, commodity exchanges do make provisions for deliveries for all contracts that are traded on their platforms. The NCDEX provides multiple delivery centres for this purpose and each and every warehouse is accredited by the exchange. Further, reputed assayers are brought in to provide services of assaying and grading the commodities so as to ensure that they meet the exchange specifications. Variations in quality within tolerable limits are

    Table 4: Deliveries on NCDEX

    Period Deliveries (MT)

    Q4' FY05 43,214 Q1 ‘FY06 109,562 Q2 FY06 83,081 Q3 FY06 77,160 Q4 FY06 134,260 Q1 FY07 103,444 Q2 FY07 125,989 Q3 FY07 94,128 Q4 FY07 52,063

    Source: NCDEX.

    Table 3: Open Interest Levels for Members

    Member Level Overall PL Near Month Production Pos Lt/Total Near Month Lt/ (MT) (MT) (Mn MT) Production Production

    Wheat 30,000 3,000 72.5 0.04 0.004 Chana 30,000 3,000 6.16 0.5 0.05 Urad 15,000 1,500 1.09 1.4 0.14 Tur 15,000 1,500 2.64 0.5 0.05 Maize 30,000 6,000 13.56 0.2 0.02

    Source: NCDEX.

    Table 5: Basic Data on Six Parameters

    Commodities Share in No of States Share in World Share in Total Price Volatility Export/ Agri- GDP Production Acreage* Production

    Rubber 1.57 1 8.5 1.4 45 5.76 Pepper 0.10 1 12.4 0.5 21 15.47 Jeera 0.18 6 80.0 1.2 31 9.59 Jute 0.36 8 66.3 1.6 31 38.41 Cardamom 0.07 5 29.0 0.2 32 12.09 Mentha 0.17 1 72.0 0.3 50 0.07 Guar$ 0.27 6 80.0 6.6 34 87.00 Gur 2.78 7 0.0 2.8 32 0.00 Cashew 1.87 8 19.6 1.8 13 21.97 Chillies 0.85 4 34.0 1.7 51 0.80 Coffee 0.55 4 3.6 0.9 13 51.66

    Notes: #: Quick rough estimates. $: Guar gum exports of $ 235 mn have been converted to INR and used to get export quantity. The conversion factor from seed to gum is 3:1. *: Share of acreage in non-foodgrain, fruits and vegetables acreage. Sources: CMIE, NCDEX, DGFT and private research sites.

    Economic and Political Weekly May 5, 2007

    permitted and trade at a premium or dis-delisting announcements were made. count on the exchange. Lastly, the com-Wheat, urad and tur are the three commodimodity balances are dematerialised and ties which have been delisted by the govbecome an electronic warehouse receipt. ernment and the trading area of the same Against this, receipt loans are possible have been highlighted on the dates when from banks. Intuitively, it can be seen that the ban was imposed. farmers could actually sell forward on the It can be seen from the tables that the exchange on harvest so as to manage their open interest is well spread between the price risk effectively. Against the ware-long and short sides and there is no manihouse receipt, they could procure loans fest concentration of positions. Also from banks on favourable terms since the

    Table 8: Number of Members Holding

    credit risk carried by the bank now dimin-

    Long and Short Positions

    ishes as the produce has been sold forward

    Commodity Members Members Total

    with the exchange, guaranteeing servicing

    Holding Holding Number of

    of the loan. In 2005-06, an associate

    OI-Long OI-Short Members

    company of the NCDEX, National

    Wheat as on Feb 27, 2007 207 250 302

    Collateral Management Services, had

    Urad as on Jan 23, 2007 194 270 313

    actually arranged for Rs 360 crore of lend-

    Tur as on Jan 23, 2007 290 270 349

    ing against the warehouse receipt for farmers.

    Source: NCDEX.

    The ninth misconception is that futures

    Table 9: Number of Clients Holding Long

    trading does not have widespread partici-and Short Positions pation and hence, caters to the needs of

    Commodity Clients Clients Total

    a select group of persons. Trading is con-

    Holding Holding Number

    ducted from across the country through OI-Long OI-Short of Clients nearly 20,000 trading terminals in over

    Wheat as on Feb 27, 2007 459 744 995

    550 locations. There are over two lakh

    Urad as on Jan 23, 2007 412 638 890

    users on the NCDEX. Also, the open

    Tur as on Jan 23, 2007 951 643 1315

    interest for each and every commodity is

    Source: NCDEX.

    monitored on a real time basis to check whether there are a large number of buyers Table 10: Location-wise Tradingand sellers as well as the locations from

    Commodity Number of Locations

    where trade takes place. Tables 8-10

    provide information on such dispersion of Wheat as on Feb 27, 2007 7 2 Urad as on Jan 23, 2007 111

    trading for specific commodities which

    Tur as on Jan 23, 2007 123

    have been in the news with the time period being chosen based on the day when Source: NCDEX.

    Table 6: Inflation for Commodities Traded on the Exchange as on February 3, 2007

    Weights Point to Point Inflation Reasons

    Foodgrains 5.01 10.0 Shortfall since the last three years Cereals 4.41 8.0 Shortfall of around six lakh tonnes Wheat 1.38 11.6 Two successive years of sub-optimal production falling stocks Maize 0.19 16.1 Set to fall by one million tonnes Pulses: 0.60 23.5 Shortfall since the last two years

    Gram 0.22 28.4 Two successive years of fall Arhar 0.13 19.0 Fell by 10 lakh tonnes Masur 0.04 5.8 Urad 0.10 24.1 Fall in production

    Sugar 3.62 -10.0 Increased by six lakh tonnes

    Note: *: February 3 has been chosen as this was the time when the highest inflation rate was recorded. Source: Office of Economic Advisor, CMIE.

    Table 7: Production of Important Agricultural Food Crops

    (Mn tonnes)

    FY01 FY02 FY03 FY04 FY05 FY06 FY07
    FoodgrainsCereals 196.8 185.7 212.9 199.5 174.8 163.7 213.2 198.3 198.4 185.2 208.6 195.2 209.2 194.7
    Wheat 69.7 72.8 65.8 72.2 68.6 69.4 72.5
    Maize 12.0 13.2 11.2 15.0 14.2 14.7 13.6
    Pulses: 11.1 13.4 11.1 14.9 13.1 13.4 14.5
    Gram 3.9 5.5 4.2 5.7 5.5 5.6 6.1
    Arhar 2.3 2.3 2.2 2.4 2.4 2.7 2.6
    Masur 1.1 0.9 0.9 0.9 1.0 0.9 1.0
    Urad 1.3 1.3 1.6 1.5 1.3 1.3 0.9
    Sugar 18.5 18.5 20.1 13.9 13.0 19.3 24.0

    Source: Ministry of Agriculture, CMIE and Agriwatch.

    trading was well dispersed across over 100 locations.

    Lastly, Kabra is opposed to the introduction of options as they would open the floodgates for far more speculation. This thought is again misplaced as options are really the tool that farmers are looking out for. An option gives the holder the right but not the obligation to buy or sell at the time of settlement. Hence, if a farmer sells at future price Rs 100 and realises at the time of harvest that the actual price is higher, then he need not sell on the exchange and could instead only forego the premium which has to be paid upfront. In fact, curiously, the entire minimum support price programme of the government is a veiled option. Farmers know that the government will buy their produce at a preannounced price. In case the market price is higher, they are not bound to sell to the government. The only difference is that in case of an option, there is a cost which is involved in the form of the option premium. Therefore, if there is concern that farmers are not participating on the exchanges, then a mitigant would be the introduction of options which would be the ideal instrument for them. We must certainly not think of keeping them out of the ambit of trading which is the case today.

    In conclusion, it may be said that the futures market in commodities, which is only three years old should be allowed to grow with the regulatory processes in place. Contrary to the belief in certain quarters, futures prices are very important signalling devices which should, in fact, be the foundation of government policy. The regulator, FMC and the exchanges have processes in place to ensure that there is no scope for manipulation of markets and that the prices are behaving in an orderly manner. Higher prices in the cash markets have been caused by economic fundamentals and there is evidence to show that price volatility has come down in the postfutures trading era. There are a large number of users of commodities and more importantly, farmers have benefited considerably, though this effort has to be proliferated to make a difference to their lives. For this to happen, markets should be allowed to grow rather than be restrained. Markets everywhere in the world provide efficient solutions, which is also the requirement in our country.

    EPW

    Email: Madan.Sabnavis@ncdex.com

    [The authors are with the commodity exchange NCDEX. Views expressed are personal and not those of the organisation to which the authors belong.]

    Economic and Political Weekly May 5, 2007

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