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COMMODITY FUTURES TRADING Thulasamma Lingareddy Trading in commodity futures, though started with the economic objectives of price discovery and price risk management, has become an important component of the present day investment portfolio promising quick and attractive returns. Consequently, trade volumes have expanded rather quickly and surpassed volumes of stock markets within three years of their start. The total value of trade that took place, across all the exchanges, reached Rs. 21.34 lakh crore between 1 April 2005 and 31 March 2006 from Rs. 5.71 lakh crore during 2004–05 recording a growth of 274 per cent (FMC, 2006). Commodities derivatives trade value relative to GDP (at current price) in India went up to 66 per cent during 2005-06 from 20.14 per cent in 2004–05 and 5.81 per cent in 2003–04. The rapid expansion in volumes has not only attracted participation from diversified sections of people but has seemingly induced dynamism into the agricultural marketing system as a whole. On the other hand, the price volatilities in commodities contributing major volume such as guar, urad, tur and gram have gone up significantly instead of coming down, as expected under normal circumstances. The general price levels of these …there is evidently a largely traded commodities have also surged to a considerable extent. Further, there huge gulf between the is evidently a huge gulf between the volume traded and total market supply; volume volume traded and traded has been recorded many times higher than the total market supply total market supply; (Table 1). This signals the apparent presence of circular trading. The dramatic volume traded has growth in commodity futures trading has drawn the attention of the government been recorded many and regulators and the FMC has already directed that brokers expelled from securities exchanges cannot step into commodities. Further, FMC has advised times higher than the exchanges to collect information on members and clients suspected to be operating total market supply. for people like Ketan Parekh as market participants, if they sense the presence of such groups in the commodity futures trading. FMC has advised In view of these rapid developments, an attempt is made here to study the current exchanges to collect state and future prospects of commodity futures trading in the country. information on members and clients suspected to be TABLE 1 Market Supply and Trade Volume operating for people Estimated supply Volume of futures trade in Commodity Exchanges (up to Dec’05) like Ketan Parekh as (2005-06) Commodity (lakh tonnes) (in lakh tonnes) (in Rs.crore) market participants, if Guar Seed 6 1692.6 2,92,664.59 they sense the presence Gram 60 742.55 1,39,864.15 of such groups in the Urad 2 20.42 1,02,108.86 commodity futures Source: Forward Markets Commission. trading. 211 212 Alternative Economic Survey, India 2005–06: Disempowering Masses EVOLUTION Organised trading in commodity derivatives was initiated in India way back in 1875 with the setting up of the Bombay Cotton Trade Association Ltd. Following this, the Gujarati Vyapari Mandali was set up in 1900 to carry out futures trading in groundnut, castor seed and cotton. Forward trading in raw jute and jute goods began in 1919 with the establishment of the Calcutta Hessian Exchange Ltd. in Calcutta. Later the East Indian Jute Association Ltd. was set up in 1927 to organise futures trading in raw jute. These two associations amalgamated in 1945 to form the present East India Jute & Hessian Ltd., to conduct organised trading in both raw jute and jute goods. The Chamber of Commerce at Hapur, the most notable of the wheat futures markets, was established in 1913. The futures market in bullion began in Mumbai in 1920 and later similar markets came up in Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and Kolkata. Futures trading was prohibited during the Second World War. After independence, the Constitution of India brought the subject of ‘Stock Exchanges and Futures Markets’ into the Union list and in December 1952, the Forward Contracts (Regulation) Act, 1952, was enacted. The ECA, 1955 gives powers to control production, supply and distribution etc., of essential commodities for maintaining or increasing supplies and for securing their equitable distribution and availability at fair prices. Until the early 1960s India had a thriving commodities futures market but it was prohibited thereafter for economic and political reasons. In the 1870s, most of the registered associations became inactive, as futures as well as forward trading in the commodities, for which they were registered, came to be either suspended or prohibited altogether. The government initiated futures trading in potatoes during the latter half of 1980, in a few markets in Punjab and Uttar Pradesh, following the …there are three recommendations of the Khusro Committee (June 1980). national level Subsequently, the Committee on Forward Markets under the Chairmanship exchanges and of Prof. K.N. Kabra, submitted its report in September 1994. Following this, 21 regional exchanges the Government of India issued notifications on 1 April 2003 permitting recognised for futures trading in commodities. Although, trading in commodity options is commodity futures still prohibited. trading. Futures At present, there are three national level exchanges and 21 regional exchanges trading is allowed in recognised for commodity futures trading. Futures trading is allowed in 103 commodities. 103 commodities and recently, permission was granted to trade in furnace oil, crude oil, mentha oil, PVC, polypropylene and natural gas. Further, onions have Of all the largely also been notified for futures trading. traded commodities, CURRENT STATE OF COMMODITY FUTURES TRADING only four are Huge Trade Volumes: Trade volumes have been growing rapidly and a systematic agricultural analysis of volume composition reveals that only about six commodities have been commodities and the actively traded and contributed for a large chunk (80 per cent) of the total volume. rest include precious Of all the largely traded commodities, only four are agricultural commodities and metals and crude. the rest include precious metals and crude (Table 2). Commodity Futures Trading 213 TABLE 2 Volume Contributors of Major Commodity Derivative Exchanges MCX NCDEX NMCE Gold 41.8 Chana 27.9 Guar seed 28.6 Silver 38.1 Guar Seed 19.3 Chana 24.2 Crude oil 5.8 Urad 18.4 Kilo gold 12.8 Urad 2.8 Silver 9.2 Urad 10.3 Soy Oil 1.8 Gold 5.5 Soy Oil 9.6 Mentha Oil 1.2 Ref. Soy Oil 3.0 Castor seed 10 MT 7.3 Chana 0.8 Lemon Tur 2.9 Rubber 3.6 Guar Seed 0.1 Sugar M 2.6 Source: Market Review, 16–29 April, Forward Markets Commission. Extreme Price Volatilities: Price volatilities, to some extent, attract trading by providing liquidity, but the largely traded commodities have been witnessing extreme price volatilities (Table 3). The trends in mentha oil futures have been volatile ever since trading started on domestic exchanges, but the fluctuations turned rather wild during the first week of December 2005. Prices of near-month contract shot up by about 35 per cent in a span of four trading days (from 30 November to 3 December 2005), but turned around immediately and slumped by 15 per cent during the subsequent two trading days. A similar pattern of price trends is also seen in the case of Burmese urad and guar The trends in mentha as presented in the Table 3. Guided by these trends, cash markets have also turned oil futures have been volatile and witnessed steep fluctuations, as traders take the futures prices as a volatile ever since the benchmark. trading started on The highly volatile trends, understandably, have resulted from overspeculation by a few participants with large stakes in the market. This has accrued huge losses for domestic exchanges, small traders in futures as well as in spot markets. Futures markets, aimed at price but the fluctuations discovery and price risk minimisation processes, are actually sending wrong signals turned rather wild to spot markets and turning them more volatile. The turnover in spot markets has during the first week of also declined considerably. December 2005. FACTS BEHIND EXTREME VOLATILITIES The highly volatile The apparent price fluctuations are not supported by any fundamental factors. The trends, understandably, driving forces behind the prevailing trends do not seem to be any of the futures trading strategies (hedging, speculation and arbitrage) that are aimed at price discovery and have resulted from price risk minimisation. over speculation by a A critical analysis of facts responsible for the apparent extreme volatilities indicate few participants with that the current nature of trading, especially trading in selected commodities, is large stakes in the occurring completely incongruently with the specifications given by the FMC. market. Futures markets, aimed at TABLE 3 Price Volatilities of Selected Commodities price discovery and Price fluctuations (%) price risk minimisation Upward Period Down Period processes, are actually Mentha oil 35 30 Nov to 3 Dec 2005 15 4 Dec. to 9 Dec. 2005 sending wrong signals Burmese urad 67–74 20 Sept to 9 Nov 2005 16–17 9 Nov. to 9 Dec. 2005 to spot markets and Guar seed 63 10 June to 26 July 2005 – – turning them more Source: CSO, MCX and NCDEX. volatile. 214 Alternative Economic Survey, India 2005–06: Disempowering Masses TABLE 4 A Comparative Picture of the Specifications and Facts Specifications of the FMC Prevailing situation Commodities: All the commodities are not The market size of commodities in question is suitable.To be suitable for futures trading, there very small at about Rs. 500 to 900 crore at should be a large demand for and supply of current market prices. the commodity—no individual or group of persons acting in concert should be in a position to influence the demand or supply, and consequently the price, substantially. The market for the commodity should be free from In the case of urad, only imported Burmese urad substantial government control. is traded but not the desi variety. As a result, the government policies in Burma as well as India may affect the imports and subsequently the supply in India. Price fluctuations: Over speculation needs to be Extreme price fluctuations, driven by over- curbed. speculation are strongly prevalent. Functions: Two important functions, price Apparently sending wrong signals to spot discovery and price risk management. markets leading to more volatility and risk. Benefits: Farmers take advantage of the price The prevailing trends, that lack any fundamental A few big operators, signals emanating from a futures market. support, are actually sending wrong signals to physical markets and consequently affecting trading and broking farmers. See boxes for details houses are apparently taking advantage of the A comparative picture of the specifications and facts is given in Table 4. limited supply of these IMPLICATIONS AND ISSUES OF CONCERN commodities and jacking up the prices Despite the prevailing wide fluctuations, trading in these commodities continues in the familiar pattern. A few big operators, trading and broking houses are apparently purposely in both the taking advantage of the limited supply of these commodities and jacking up the prices futures as well as spot purposely in both the futures as well as spot markets. This is evident from the markets. This is highly volatile trends witnessed in spot markets just before and immediately after the evident from the highly expiry of futures contracts of commodities of small market size such as urad and volatile trends mentha oil. witnessed in spot A similar strategy of over speculative trends, exhibited by consecutive commodities markets just before suggests the possible involvement of the same set of people, although distinct and immediately after evidence to any extent cannot be discerned, except by a regulator. the expiry of futures The highly volatile trends in futures markets are spreading wrong signals not only to the spot markets but also affecting exports and ultimately production in the long run. Cases contracts of with serious implications, resulting from extreme price volatilities are presented in commodities of small boxes 1 and 2. market size such as A systematic and logical examination of the above-mentioned facts raises certain urad and mentha oil. fundamental but very important questions on the functioning of futures markets in the country: The highly volatile What is the basis for allowing the commodities with such a small market size trends in futures (supply)? markets are spreading For whose benefit are these commodities traded in futures markets? (Neither wrong signals not only the farmers nor the genuine traders in the physical markets seem to benefit to the spot markets but from it). also affecting the Why are exchanges offering futures trading only in imported urad but not in exports and ultimately desi urad? production in the long What kind of measures is the regulator taking to control these fluctuations run. apart from directing the raising of margins? Commodity Futures Trading 215 Box 1: Case of Extreme Volatilities sending Wrong Signals to Spot Markets The spot as well as January futures contract prices went up Volatility in Burmese Urad Prices rather steeply by about 12.5 per cent, during the last few 3200 trading days of the January contract. But, the spot prices come down more sharply, registering a 13 per cent fall 3000 12.50% 13% within four trading days (21–25 January) immediately after 2800 Prices Rs/Q expiry of the January 2006 contract as revealed by Chart. A similar pattern of sudden spiralling of prices can be seen in 2600 spot as well as February contract from 11 February 2006 onwards. 2400 These trends, particularly in the spot market, are beyond 2200 the logic of any normal trading practice, especially when there is no significant increase in demand and no 2000 1/2/2006 1/9/2006 1/16/2006 1/23/2006 1/30/2006 2/6/2006 2/13/2006 proportionate rise in dall prices. As a result, this has been accruing huge losses to small traders in futures as well as in spot markets and the processors who operate for normal profit margins. Futures spot Feb-06 Jan-06 markets, aimed at price discovery and price risk minimisation processes, are actually sending wrong signals Under such a volatile situation, how can a small trader or to spot markets and turning them more volatile. miller who works for normal profit margin sustain himself? Box 2: Case of Extreme Volatilities and Implication to Farmers A similar trend of volatilities instigated by market Mentha Spot manipulators was witnessed in mentha oil trading as well 900 and prices have gone up by about 60 per cent in a span of 800 20-25 days as shown in the chart. 700 600 Implications 500 Slowdown in exports: Steep rise in mentha oil in a short span has rendered the mentha oil exports unprofitable for 400 exporters, as the prevailing market price is much higher 300 than the agreed export price. As a result, exporters are 200 resorting to default in order to avoid losses. 100 One of the leading agencies involved in mentha oil trading 0 8/1/05 8/16/05 8/31/05 9/15/05 9/30/05 10/15/05 10/30/05 11/14/05 11/29/05 12/14/05 12/29/05 1/13/06 1/28/06 2/12/06 2/27/06 3/14/06 3/29/06 4/13/06 4/28/06 in the US has expressed similar concerns (as we have expressed in our previous letters) over the functioning of futures exchanges in mentha oil trading. It stated, ‘The spot position—given the uncertainties of importer of mentha oil from India. pricing and deliveries from origin—continues to be incapable of keeping pace with demand. From what we Excess supply in the coming season: Steep rise in prices hear from India, crude arvensis oil is now controlled by the has resulted in: MCX exchange (and the other futures market run by the Huge expansion in acreage of about 60 per cent . National Commodity & Derivatives Exchange). The oil is in Consequently the production is also estimated to reach very strong hands which appear to be aiming to push the record levels. price much higher than at present.’ Carry over stocks are already at a high of about 30 per Further, to quote the website, ‘Everyone buying mentha oil cent (6000 tonnes) of last year’s production due to from India has a horror story to tell.’ This will ultimately slowdown in exports. spoil the image of the Indian mentha oil exports and As a result, a further crash in prices and losses for the render them unreliable, as the US has been the major farmer in the current marketing season. 216 Alternative Economic Survey, India 2005–06: Disempowering Masses Is it in compliance with international practices to trade in commodities of a small market size? CONCLUSIONS AND FUTURE COURSES OF ACTION FMC as well as exchanges are taking the credit for having the largest number of commodities traded and for swelling volumes. Towards this end, the exchanges are competing with one another and in the process they seem to be in a hurry to introduce as many commodities as possible without taking a complete account of their long-term implications on the markets and the agrarian system as a whole. Further, one needs to know why CBOT, one of the largest and oldest commodity exchanges in the world, does not offer trade in so many commodities In this context, it is appropriate to remember the apprehensions expressed by Prof. K.N. Kabra. He had suggested that futures trading should be selective and initially should be restricted to non-essential commodities rather than giving immediate permission for all commodities across the board. He opined, ‘Futures trading in essential commodities might amount to introducing an additional destabilising and escalating factor in prices.’ The current nature of futures trading and price trends particularly, in pulses and wheat, corroborate his predictions. However, considering the important role futures trading can perform particularly in the agricultural marketing system, there is an urgent need for correcting the existing irregularities in futures trading. To bring an efficient and smooth functioning of futures markets and to fulfil the economic objectives, FMC and …the exchanges are exchanges must bring in suitable guidelines after thorough evaluation of the present nature of derivatives trading and its implications on various facets of commodity competing with one markets in the country. another and in the A few suggestions in that direction include: process they seem to be in a hurry to 1. Selective trading: Trading in commodities with a small market size may be introduce as many stopped. If they need to be traded then there should be limits on positions pro- portionate to their deliverable market supplies. commodities as 2. Delivery centres: The number and coverage of delivery centres needs to be possible without taking expanded. a complete account of 3. Quality specifications: Common grades and varieties will facilitate arbitrage their long-term between exchanges as well as spot markets. implications on the 4. Price settlement: There is no unique price prevailing for final settlement of markets and the futures contract. To facilitate this, there should be a common and uniform agrarian system as a settlement process to derive the price, by an independent external agency, or a whole. government agency. 5. Contract specifications: The number of contracts can be limited and lean season Futures trading in contracts can be restricted. essential commodities Contract open position should be proportionate to the marketable surplus and might amount to deliverable supplies. introducing an Season specific: Need to be modified with crop season in order to include additional destabilising seasonal varieties. and escalating factor in Wider coverage: Futures contract must include as many varieties as possible prices. so that the maximum amount of supply becomes fit for delivery.
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