Role of Commodity Futures in a Growing Economy

By

Aditya Pagaria
ITM Business School
Navi Mumbai
 

Just before the Union Budget 2007, the inflation every week was galloping like this … 5% … 5.5% ... 6% … 6.5% … & then just before the Budget we see leading business dailies flashing headlines "India bans futures trading in farm products", "High food prices threaten India's politicians and its futures markets" & so on.

But the big question that every trader asked was is this proper way to strangulate the inflation? The unanimous answer here was a stupendous NO. Everyone thought that instead of ban in Commodity Futures market, why doesn't the government look at the supply-side constraints?

This paper highlights the importance of Commodity Futures in a growing economy like India & why India should go a step forward in introducing the Commodity Options.

History of Futures Market in India

History of futures market in India suggests that futures trading started in India with an independent institution named "Bombay Cotton Exchange" in 1890. Hence needless to say that cotton as the first commodity to be traded in futures market. This was followed up by oilseeds, wheat, raw jute, Hessian & others.

It is noteworthy to state that the current ban on Commodity Futures is not the first one from the Government. The futures market for selected commodities was banned in 1963 & again in 1965. Co-incidentally, the reasons for those bans were similar to the current ban. The ruling Government at those times also thought that futures market helped in artificially jacking up prices of essential commodities. 

Futures Market – A Perspective

Put simply – a futures market is a market where, a seller & buyer enter into a transaction but it is settled a predefined future date & price. Hence future trading is all about planning. Depending on the price agreed upon, the seller can plan about production without worrying about the fluctuation in prices. This is not possible in spot market thanks to the design of this market prices of commodities can be rigged by a handful of persons like middlemen.

There are a few arguments against the futures market. Let me examine them & see if they hold true.

1. Futures Trading drives up prices: This is primary argument against this market. Critics say that in case of some bad news about the future, the speculators start hoarding the commodities & hence artificially driving up the prices. But common sense says that in case of some negative news about future, the prices are going to go up irrespective of whether futures market is there or not.

2. Futures Trading drives up volatility: There no evidence to support this view. On the contrary, A.S Naik, in her book "Effect of Futures Trading on Prices" clearly shows that the fluctuation in prices of commodities was higher when there was no futures trading as compared to prices when there was futures trading.

3. Futures Market are not transparent: Traditionally, poor Indian farmer is exploited by bigger & richer farmers by buying their produce at sub-market level prices. But a futures market ensures that he knows the market prices prevailing of his produce & can directly sell in the market at those prices.

Conclusion

Commodity market in India is still in a nascent stage. It should be given a helping hand by the concerned authorities to increase its depth. The infrastructure facilities like warehouses, transportation etc. should be improved so that the genuine buyers can take physical delivery of goods instead of settling transaction in cash. This may also control speculation to an extent.

There is also an urgent need for an independent regulator for these markets. Instead of bureaucratic Ministry of Consumer Affairs & Food, professional agency like Forwards Market Commission (FMC) needs to be at the helm.

Apart for these more products like Commodity Options need to be introduced. This will further help deepen the market & would help in increasing the popularity of such exchanges. This will finally lead to a wider investor base & lesser power in the hands of ruthless traders & speculators.

Taking these few but firm steps, I believe, there is a bright future ahead for the Futures Market.  
 

Aditya Pagaria
ITM Business School
Navi Mumbai
 

Source: E-mail April 2, 2007

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