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
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
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.

212     Alternative Economic Survey, India 2005–06: Disempowering Masses

                                     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
                                     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
                                                                                                        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.
                                                                                                        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
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

                                                                  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







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
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

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
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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