The Agricultural Futures Market: Benefits and Concerns

1. Role of Commodity Exchanges

A central problem of agricultural markets in India has been price instability which adversely impacts economic growth, income distribution and poverty. Futures markets provide a platform for risk mitigation, price discovery, arbitrage and clearing and settlement. It helps sellers and buyers hedge against future price risk. It provides liquidity by bringing together the buyer and the seller of agricultural produce and enabling traders to quickly transact their business at a fair price. Finally, for speculators, hedgers, and other traders, trading in the futures markets offers an opportunity for financial leverage. Participants in the exchange are able to control large quantities of a commodity with a comparatively small amount of capital, because of the small margin, normally set at 2-5 % of the value of the commodity. In a futures exchange, trades are made and prices are discovered on the basis of current market information and expectations of future price movements. This does not however mean that futures exchanges set prices. Futures markets are barometers, not referees. They enable the market to reach the equilibrium price but they do not dictate it. Of course, that equilibrium price keeps changing continuously. Futures market prices thus have become the most widely used pricing reference in agricultural markets. Once prices are discovered, electronic exchanges enable the real-time dissemination of these prices to the public, across the country and around the globe. Forward contracts do not have these advantages. Futures exchanges act as a magnet, attracting risk avoiders (hedgers) and risk takers (speculators) alike. Driven by potential profits, speculators provide the market place with the essential element of liquidity. With only forward contracts possible, there would be no liquidity. In such a situation, hedgers attempts to buy and sell contracts would immediately drive prices up or down in response. Having this liquidity is crucial to processors of commodities, farmers and other firms that buy or sell hundreds of futures contracts to hedge cash market positions. Although speculators usually have no commercial interest in the commodities or financial instruments underlying the futures contracts they trade in, the potential for profit motivates them to gather information regarding supply and demand and to anticipate its effect on prices. In practice, there is always a mismatch between the time when the short and long hedgers approach the market and the speculators are needed to fill in this gap. A key advantage of futures contracts over forward contracts is that the exchange provides a guarantee system that protects futures users from contract default. The guarantee system used at futures exchanges also severs the direct relationship between buyer and seller, so that each is free to buy and sell independently of the other. The system does this by placing a third party between the buyer and seller the clearing house. Buyers and sellers of futures contracts thus do not have any financial obligations towards each another, but, only to their clearing member firms, which in turn have obligations towards the clearing house. Several countries that attempted to deal with commodity price volatility by relying on direct government intervention measures, for example, through minimum support

prices (MSP), as in India, have had limited success. Although there may be a case for limited direct intervention in some circumstances, with the liberalization of markets several countries are now exploring the use of market-based instruments for commodity risk management. Commodity exchanges have come a long way since the establishment up of the national electronic commodity exchanges. NCDEX has remained the leading commodity exchange for agricultural commodities with a market share of around 80 per cent. The share of leading commodity exchanges in respect of agricultural commodities is shown graphically below for the year 2006-07 and for the period April-August in 2007-08. Box 1:
Market Share for Futures Trading in A gricultural Com odities m A pril - A ugust 2007
2% 8% 9%

M CX N CDEX N CE M N BOT

Total Volume: 394800 crores

81%

Market Share for Futures Trading in A gricultural Com odities m 2006-07

6% 8% 12%

M CX NCDEX NM CE NBOT

Total Volume: 1286726 crores

74%

2. Futures Trading: Myths and Reality 2.1 Price Volatility

There have been several studies using a wide array of theoretical approaches on how speculative trading, the introduction of futures and options might affect price stability. Empirical evidence suggests that the introduction of derivatives does not destabilize the underlying market; either there is no effect or there is a decline in

volatility. Further, the literature strongly suggests that the introduction of derivatives tends to improve the liquidity and informativeness of markets. Keynes and Hicks argued that if hedgers tend to hold short positions, and speculators tend to hold long positions, the futures price of an asset (Fo) will be below its expected future spot price (ES) as speculators require compensation for the risk they are bearing, i.e Fo<ES. The situation would be reversed if hedgers hold long positions and speculators hold short positions. This has been empirically tested by several researchers and the results are mixed. Most studies point to Fo=ES, while some recent studies seem to suggest that Fo<ES. In any case there does not appear to be any case for suggesting that speculators could consciously take long positions at contracts above ES and influence spot prices to increase. An exhaustive literature review of the impact of speculation has been that by Stewart which commences with Adam Smiths observation that speculators help prevent extreme shortages (and by implication, extreme price movements) by buying and storing grain in periods when they forecast a shortage. The overwhelming literature seems to corroborate that speculators trading based on market information with the objective of making speculative profits will lead to prices gravitating to the demandsupply equilibrium, though there can be certain situations where speculative losses can lead to instability. To the extent that carrying costs are predictable, price smoothing through storage becomes an arbitrage activity. If agents are risk averse, this should lead to increased inter-temporal price smoothing. Futures markets may also influence spot prices if they have an effect on the behavior of producers. Since futures markets allow producers to hedge price risk, the existence of futures may affect a producers decision of what to produce, how much to produce, and what production techniques to use. In addition, the futures price may contain information about anticipated demand that can feed back into production decisions. Studies based on empirical evidence of the impact of commodity futures also almost conclusively show that price volatility gets lower with the introduction of futures. NCDEX recently conducted an in-house study for wheat, maize, sugar, urad and chana to determine the impact of futures trading on price volatility. The annual average price volatility for these commodities in the period prior to the launch of futures trading for these commodities has been compared with the post introduction phase. The study concludes that price volatility in case of these commodities has come down with the advent of futures trading and this is attributable to more efficient price discovery.
Box 2: Pre and post futures price volatility of selected commodities on NCDEX 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

Futures market, as observed from the cross-country experience of active commodity futures markets, helps in efficient price discovery and does not impair the long-run equilibrium price of commodities. At the same time, it is recognized that futures markets do not always function perfectly. At times, price behaviour of a commodity in the futures market might show some aberrations reacting to the element of

speculation and the bandwagon effect inherent in any market, but it quickly reverts to long-run equilibrium price, as information flows in, reflecting fundamentals of the respective commodity. A question that has been asked is whether the main players on the Indian exchanges are only speculators or whether there are also producers and users of the product who are also there for hedging risks. In theory, hedgers and speculators are two sides of a coin, and one cannot exist without the other. This issue has been empirically examined by NCDEX. The exchange provides special hedge limits to those who are actual users of the commodity which is higher than for non-end-users. The table below gives the hedge limit utilized by hedgers. It shows that hedgers make for a considerable part of open interest on the exchange and the volumes are not driven solely by speculators and there is significant participation of end-users in certain agricultural commodities. The table shows the minimum end usage as participants who are actual users may be much more as they maybe trading within normal limits. Apart from speculators and hedgers, the arbitrageurs contribute a large part of the trading volume, and look at arbitrage opportunities all the time, ensuring that the futures price of an asset never gets out of line with the cash price. Box 3. Participation of end users
Commodity Share of endusers in business+* Sugar 40 Soy bean 67 Soy Oil 39 Mustard seed 24 Wheat 38 Pepper 21 Ratio of utilized hedge limit to open interest as on February 28, 2007 Source: NCDEX

Analysis of actual trading data from NCDEX also shows the following: Trading has been well dispersed across participants and centers. The overall open interest to physical volumes has been very low to influence in any decisive manner the upward price movement. Individual open interest positions are also very low to significantly influence prices.

2.2 Speculation in Futures Markets and Inflation

It is widely recognized that prices of several agricultural commodities have been rising at the global level in recent years, and India has been no exception. To attribute the price increase to futures trading is much like the widespread opinion through the 60s, 70s and 80s that hoarding and speculative trading caused price rise. Attention was thus focused on enforcing rigid stock limits and other measures under the Essential Commodities Act. It also needs to be emphasized that even in the absence of futures markets; spot market prices will reflect the market participants view about future demand and supply. Futures markets only seek to link the present scenario and the future prospects in a transparent and efficient manner in the presence of a large number of participants.

Inflation in India was at its two year peak on 3 February 2007. It is widely recognized that effective containment of inflationary pressures is best served by a combination of fiscal, external and supply management policies, supplemented and complemented by ongoing implementation of monetary measures. Though the rise in the prices of primary articles (with a weight of 22% in the WPI) has been high, manufactured products with a weight of 64% have significantly contributed to overall inflation. A comparative analysis of commodities traded on the exchange platform and those not traded shows that inflation rates have been much higher in several commodities which are not traded on the exchange platform. The inflation contribution of agricultural commodities traded on the exchange was 0.3% with a weight of 2.06%, while the inflation contribution of commodities not traded on the exchange was 0.83% with a weight of 2.63%. For instance price inflation in cardamom was 81%, ground nut oil was 40.8%, moong dal was 25.6%, while in non-agricultural commodities such as metals and alloys inflation has been as high as 57%. Apart from the increase in money supply which has contributed to the price rise, inflation in food articles has been primarily due to continuous shortages on the supply side and increase in demand which has led to an upward thrust to prices. Further, global shortages in agricultural commodities such as wheat and maize have also got translated into higher domestic prices with the correlation between international and domestic prices being very strong. It needs to be noted that the annual average inflation in both pulses and cereals has been generally higher than the overall inflation rate even in the period prior to the introduction of futures trading in these commodities. It also needs to be noted that prices of agricultural products as a group have not increased more than the general wholesale prices since the introduction of future trading. In the period since futures trading was introduced in 2004-05, the WPI moved from 187.3 to 205.1 while the index for agricultural products moved from 186.7 to 202.0. An in-house NCDEX study shows that the present value to the farmer benchmarked against the MSP is considerably lower than the potential return from the sale of the land and there is need, perhaps, for even higher prices to the farmer. Further, during 2004-05 and 2005-06 terms of trade had moved in favour of manufactured products and against agriculture. In this sense, the increase in prices in primary products during 2006-07 represents a correction.

2.3 Low Participation by Farmers: Need for Aggregation Models

Commodity exchanges have a tremendous potential to benefit the vast multitude of Indian farmers by serving as a price discovery, delivery and hedging platform. The experience the world over has been that while the entire farming community benefits from price discovery through futures exchanges, only a miniscule proportion are able to hedge their risks through the exchange. The obvious solution would be to reduce the contract size, but this may not be feasible due to cost and viability considerations. It is in this context that there arises an urgent need for developing innovative aggregation models to ensure that even small players benefit from futures trading. The following constraints confronting small farmers present a strong case for aggregation in the Indian context.

Liquidity and price risk: The farmer often requires immediate cash before the harvest season. He sells his produce in the procurement season when prices are generally low. He is very vulnerable to price volatility. Small quantity: The large lot size requirements for futures trading specified by commodity exchanges have deterred the small farmer from using the futures trading platform. The minimum lot size specification for futures market trading is 100 quintals which is too large for farmers to produce. Demat requirement: A necessary eligibility requirement for participation in the futures market is a sales tax number and a Demat account which in turn requires a PAN number. It is difficult for small farmers to fulfill these formalities. Margin requirements: Futures trading rules of exchanges stipulate various type of margins such as initial, exposure and mark to margin. For a small farmer, it is not possible to meet these margin requirements. Delivery requirements: Stocks also require approval from approved assayers after quality tests. Commodity exchanges have quality specifications for all the commodities they trade in. In certain cases, these stocks are rejected which makes it difficult for farmers to meet their delivery obligations. Stringent rules and heavy penalties: There are very strict rules and regulations governing futures trading which also keep changing from time to time. In case of violation, heavy penalty is involved. Often small farmers do not have complete information about these rules and in such cases they cannot bear the burden of default. Infrastructure costs: In addition there are infrastructure and connectivity costs such as warehousing and transport which are often too high for the small farmer to bear.

Thus there is an imperative need for an entity which can consolidate individual farmers produce and allow them to participate in futures trading. This aggregator would aggregate the produce of different farmers and provide the required logistical support services including transportation, grading, assaying and warehousing. Aggregators can be agro-extension service providers, producers cooperatives and corporates using the end product or banks. The Working Group set up by the RBI has also recommended that the Central Government may consider issuing a notification under Section 6(1)(o) of the Banking Regulation Act, 1949 permitting banks to deal in the business of agricultural commodities including derivatives.

Box 4

2.4 Inadequate Awareness about Futures Trading

For the futures platform to benefit the farmer, the legal and operating environment would require certain reforms. The major benefit to farmers is price discovery which is directly relatable to information dissemination and transparent futures markets. Futures contracts benefit the farmers by enabling him to lock in prices so that he is protected if prices for his produce happen to fall in the future and also help him in crop selection through futures prices. The availability of a futures price not only improves the bargaining power of farmers but also gives him the choice to decide on the timing of his sale. Some observers have noted that the benefit of futures trading to farmers has been limited due to lack of awareness. It is true, that the direct participation of farmers on the futures trading platform has been limited in India as elsewhere. A recent study undertaken by AC Nielson found that NCDEX was a common source of information for around 70% of the farmers in the narrow area sample (NAS); and over a quarter of the respondents found it to the most preferred source. In commodities such as wheat, castor, mustard etc. farmers in the NAS sample received a higher range of prices compared with the wide area sample (WAS) sample. This implies that being better informed on account of price knowledge did help farmers in the areas i.e. NAS to realize higher prices. As these areas were those where awareness of NCDEX prices was very high, it may be concluded that a correlation does exist. Farmers in the NAS areas tended to sell a larger part of their produce at a later date compared with WAS sample. In case of WAS, farmers did tend to sell most of their crop immediately after harvest. The study further concluded that the arthiya was the main source of information on futures prices in WAS while NCDEX and computers were the major sources of information in NAS. There were a number of benefits that farmers perceived in both the samples on reference to NCDEX prices such as cropping pattern, negotiation, overall realization being better etc. Around 80% of the NAS farmers sampled said that they benefited from NCDEX while only 12% said so in case of WAS. Benefits perceived were fair prices being offered, availability of

information through computers, and checking prices of futures with mandis before selling.

2.5 Need for Regulatory Reforms

Futures trading in India is governed by an elaborate regulatory system. A central problem is that the physical market, the commodity futures market and capital market is governed by its own regulations as may be seen in the box below. Box 5:

The Forward Contract Regulation Act (FCRA), 1952 envisages a three-tier regulation. The Exchange which organizes forward trading can prepare its own rules and byelaws and regulate trading on a day-to-day basis. The Forward Markets Commission (FMC) approves these rules and byelaws and provides regulatory oversight, though the Central Government is the ultimate regulatory authority. Only government recognized associations are allowed to organize forward trading in regulated commodities. Presently, the recognition is commodity-specific. The government has original powers to suspend trading, call for information, require the exchanges to submit periodical returns, nominate and supersede directors on the Boards of the exchanges etc. Most of these powers are delegated to the FMC; otherwise the role of FMC is recommendatory in nature. The government has full control over the FMC, which is a subordinate office of the Department of Consumer Affairs. FMC has put in place some of the worlds best regulatory systems and practices. These include daily mark to market margining, time stamping of trades, demutualization of exchanges, 1/3rd representation of independent Directors on the Boards of exchanges, on-line trading, novation of contracts and creation of trade guarantee fund. At the trading platform, exchanges have taken several measures to ensure that there is no cornering of the markets by a group of players. Position limits are imposed and monitored for each and every commodity for both near month contracts as well as all the contracts on a real time basis. The position limits worked out are such that they constitute only a very small proportion of the total commodity available in the country. Further, it is also ensured that this amount is spread across the country. In NCDEX, for example, in case there is suspicion of any sort of concentration, the concerned members are asked to unwind their positions. The

same kind of limit, albeit at a lower level, is set at the client level too. These limits leave no room for anyone to control and monopolize the market in anyway. The exchanges have also put in place several mechanisms at the pre-trading, trading and post-trading stages to ensure manipulation is avoided and there is full transparency. All sensitive commodity contracts have been moved to a compulsory delivery mode whereby all outstanding open interest has to be physically delivered. For a period of 3-5 days prior to the expiry of every contract, margins on the open positions in the contract are hiked. This enables only those who want to take or give physical deliveries to remain with the open interest. The margin levels are continuously back tested to ensure that these are more than adequate. Circuit filters in the shape of price bands have also been put in place for each commodity. Exchanges have a stringent system of fines and penalties for any type of violations and violators can be disabled from further trading. Further reforms Greater autonomy of the FMC The FMCs role has been largely advisory. There is an urgent need to bring a comprehensive set of amendments to strengthen the FMC and put it on par with SEBI. FMC needs to be given much greater autonomy in its functioning for greater market credibility and efficient functioning. Treatment of transactions in commodity exchanges as legitimate business There is a need to legitimize a significant part of the trade in commodity derivatives that is being carried on in the illegal market because of non adjustment of profits and losses from the regular speculative business. Losses and profits from trading in commodity derivatives should be allowed to be set off against profits and losses from the other businesses of the person by a suitable amendment of the Income Tax Act. Weather derivatives Rainfall risk is one of the biggest drivers of systemic shocks for the Indian farmer. This risk can be covered by weather derivatives. This will enable the farmers and other participants to hedge their price risks through cash settlement, without getting involved in the logistics of physical delivery. The weather derivative can complement the crop insurance provided by the government. Similarly, derivatives of commodity price indices will facilitate participants to hedge price risks through a basket of commodities. Weather insurance contracts have been launched in a limited way in the country by insurance companies such as ICICI Lombard along with the Commodity Risk Management Group (CRMG) of the World Bank, and later by IFFCOTokyo and AIC. NCDEX through the National Collateral Management Services limited (NCMSL) is setting up weather stations in few parts of the country. As of now NCMSL has installed 88 weather stations in 10 states. Options trading The Forward Contracts (Regulation) Amendment Bill, 1998 pending in Parliament, inter alia, proposes to permit options in goods through recognized exchanges. At present, only futures contracts are permitted in India. The RBI Working Group has observed that farmers may not find it easy to buy futures contracts. Options would be a simpler alternative for them. It will give farmers the right to sell, without having the obligation to sell their produce at a predetermined price at a small premium. It will help farmers take advantage of upside price movements. In

situations when there are unfavourable price movements, farmers can exercise their option to sell the underlying asset. In the event of favourable price movements, they can decide against exercising the option and would only lose the premium paid. Farmers can limit the potential loss due to lowering of price of their produce at the time when the crop is ready for sale. The only loss will be the option premium which will be known at the time of sowing itself. Options can be a substitute for Minimum Support Price (MSP). The government can save on the costs and huge subsidies associated with procurement and handling agricultural produce, especially for crops such as mustard, copra, potatoes, etc. which are not a part of the PDS. Government may subsidise the option premium payable by the farmers for entering into option contracts.

Box 6: The Forward Contracts (Regulation) Amendment, 2006

A central government notification under the FCRA Act in April 2003 lifted the ban on forward trading in all 54 commodities that had restrictions. The Bill seeks to transform the role of the Forward Markets Commission (FMC) from a government department to an independent regulator of the commodity forward and derivatives market as SEBI is for the securities market. The Bill amends the definition of ready delivery contract to include all contracts that provide for delivery of goods and payment within 30 days (earlier 11 days). Therefore, forward contracts will include only contracts with delivery period exceeding 30 days. Trading in commodity derivatives has been permitted. Options trading has been permitted. The Bill requires all exchanges to be corporatised and demutualised by a date to be decided by FMC. The Bill proposes separate regulators for the securities markets (SEBI), commodity derivatives (FMC), underlying commodity markets (state governments through APMCs) and warehousing (WDRA). This could result in regulatory overlaps. The penalties applicable for various offences are significantly lower than that under the SEBI Act, 1992. The lack of Value Added Tax (VAT) facility for inter-state sales, and limitations of Cenvat facility could deter delivery-based trading in commodity derivatives.