The truth about futures trading

A drought is an issue which tends to lead to speculation on the future of futures trading in farm commodities. This is so as a drought is associated with crop failure and high prices. In the light of the present inflation scenario where prices are already high notwithstanding two good harvests in 2010-11 and 2011-12 this fear is palpable.

Some of the coalition partners in the government have already raised objection to the introduction of the FCRA bill in the parliament which really means that the expected reforms in this segment empowering the FMC and introduction of new products such as options and indices may be forgotten. We have already seen a ban on futures trading in contracts like guar, which is a commercial and not consumption product. But before any rash decision is taken we need to keep in mind certain facts.

First, futures trading and prices are only a reflection of reality. If there is a shortfall in production, prices will increase and this market tells us in advance that there will be a shortfall, and hence, these signals should be used to take pre-emptive policy action. In 2007 the futures market indicated a shortfall but we went and banned wheat futures, even though the open interest to output ratio was less than 2 percent. (Open interest for the running near month contract is the potential delivery that can take place and theoretically influence prices). Prices did not come down, and after a period of self denial we ended up importing wheat at progressively higher prices. Further in 2009 the same was witnessed in sugar when futures trading was blamed and banned. But prices increased even more so after the ban and we had to import more sugar. The lesson is that we should take heed of the prices and use it for policy rather than ban futures trading in the product.

Second, official studies have shown, by way of the Abhijit Committee Report, that there is no causal link between futures prices and spot prices. This said, we should not fall prey to populism on pulpits and destroy a very valuable tool for farmers and policy makers.

Third, the increase in prices witnessed in products not traded on futures platforms has been much higher as is the case of tur (10%), masoor (23.4%), bajra (15.7%), ragi (19.4%), eggs. Meat etc (16.0%) etc where supply shortages relative to demand has led to this phenomenon. Therefore, we need to not fall into the trap of being myopic and look only at the basket of commodities that are traded in the futures markets.

Fourth, futures trading should be viewed from the point of view of open interest and not volumes traded as it is the former that influences prices potentially while volumes traded only adds liquidity. Intuitively a trader can influence prices by actually physical delivery which is controlled by the open interest. With strong position limits being placed by the FMC along with the exchanges, and strong surveillance systems which have not revealed oligopolistic trading, which is revealed by the large number of participants in trade, there are no signs of manipulative trading. This means that the market is orderly.

Fifth, by banning futures trading in guar, the administration has actually hit the guar farmers. While the product is quite insignificant in terms of the total quantity produced and would not have received any attention, the ban has actually pushed us back as it is an exportable commodity and the US market has been shaken. There is now serious talk of growing more guar in countries like China and parts of Africa as the price of guar gum, the final product that goes into chemical formulations and machinery, is scarce.

If this happens, India would lose it’ monopoly position and the farmers would tend to be adversely affected. Curiously, even after the ban of futures trading, prices increased by as much as 31.2% for two months following the ban in March.

The basket of products that is now available for future trading has gotten compressed, with chana, mustard, spices, soybean and soy oil being the only significant products that are traded. Wheat and sugar, though reintroduced have never really caught on with the market players who are wary of bans. This is so because every time there is a ban, and contracts have to be closed, there are losses made by one section as decisions are taken with a time frame in mind.

The hope is that we behave in a rational manner when the impact of the drought sets in and we do not go around banning products - presently there are few liquid kharif products that are left to be banned. In fact, we should encourage such trades so that we get better signals and use them for taking policy decisions. The RBI did not go around banning players from trading in forex when the rupee fell nor do we stop stock market trading merely because share prices are falling, because the economy is not doing well.

We should not have a different standard for commodities merely because it is an effective political tool to score victories. As bans have never brought down prices since 2007 when this tool was used, there are really no gains from such action. Hopefully this message has been absorbed. Orderly markets are a reflection of the underlying and there is no point in smashing the mirror, if we do not like the image.

Sabnavis is chief economist, CARE Ratings. Views are personal.