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Forward
trading has a long history in the country, but it has
never been a matter of much public concern. Till recently,
that is. When the search for explanations for the increase
in the prices of food began a few months back, some
observers turned their attention to the massive increase
in forward and futures trading in commodities. What
emerged was revealing.
According to Bloomberg, quoting the Forward Markets
Commission, volumes on the National Commodity Exchange,
which trades futures contracts in 48 commodities, reached
$226 billion in the year ended March 31, 2006. That
was more than the $184 billion of shares traded on the
Mumbai stock exchange in the same period. Forward and
futures trading had been promoted on the ground that
it helped traders deal with market uncertainty by hedging
their transactions, and stabilized prices for the final
producers. However, the surge in futures trading could
not be explained by pure hedging requirements, and obviously
reflects an increase in speculative activity.
Leaders of the Left parties saw in this speculation
an explanation for the spike in food prices. Their view
was endorsed by Sonia Gandhi, who reportedly told a
meeting of Congress Parliamentary Party members in early
August: ''The prime minister and I had a meeting with
our chief ministers. They were unanimous that forward
trading, particularly in wheat, has had an adverse impact
and called for a more effective regulatory framework
to deal with speculation.'' As a result of these interventions,
the government has now decided to amend the Forward
Contracts (Regulation) Act 1952 (FCRA) and strengthen
the regulatory powers of the Forward Markets Commission
(FMC). What form those amendments will take is yet to
be seen.
Forward contracts have historically been a feature of
commodity markets, partly because while the demands
of actual users of many commodities is continuous across
the year, supplies come into the market at specified
points in time such as harvest time. Producers of commodities
have to make production decisions based on expectations
of the price that they would receive when the output
arrives, and purchasers of commodities as inputs or
final goods must make judgments of the availability
and cost of the commodity at different points of time
during the year. To guard against price volatility and
uncertainty in production and availability, sellers
and buyers often enter into forward contracts, specifying
the quantity, quality and price of the commodity they
would deliver for sale or acquire for purchase at a
pre-decided date in the future.
It should be clear that forward contracts are means
of hedging against the risk of price volatility or uncertainty
of supply. But hedgers cannot function without the presence
of speculators. If the market is restricted to hedgers,
who are actual producers or users of the commodity,
the volume of many contracts could be so low that on
some days a trade cannot occur, because a buyer cannot
find a seller or vice versa. This is where the speculators
step in. They buy or sell in forward trades, not with
the intention of actually making or taking delivery,
but with the idea of transferring the concerned contract
to an actual producer or user at a profit. They can
therefore, buy and sell a large number of contracts,
enabling the hedger to transfer risk with ease by injecting
liquidity into the system. But the moment speculation
begins, there is the risk that prices could be manipulated
to move consistently in one direction for significant
periods of time, inflicting losses on some and gains
for the others.
Forward contracts, however, are cumbersome. It requires
intending sellers of specific quantities of specific
quality at specified times to find the appropriate number
of buyers. This entails costs of search and inspection.
Further, since there is no centralized market or exchange
where the contract is drawn up, prices tend to vary
and there is uncertainty about delivery. It is for this
reason that futures contracts were evolved.
Futures contracts differ from forward contracts in important
respects. Futures contracts are standardized contracts
to buy or sell a standard quantity of a standard quality
of a commodity. These are traded in exchanges, through
brokers, with no need for the buyer and seller to meet
and negotiate. An important feature is that a contract
need not be settled by actual delivery. It can be matched
by an offsetting contract taken by the buyer or seller,
and the two can be squared at any point at some gain
or loss. The administration of the exchange guarantees
that contracts would be settled, and requires traders
to pay up margins to cover ongoing losses, if any, to
secure the viability of the exchange. To avoid paying
margins, traders can buy an option to offer or acquire
a contract at some specified future date. If the option
is not exercised, because price movements are contrary
to expectations, the loss is restricted to the premium
paid to hold the option and the transaction costs of
acquiring it.
The existence of futures contracts allows sellers or
buyers to hedge against risk by buying offsetting futures
contracts that would protect them against losses if
the market moves against them. But hedging is not the
sole driver of futures markets. The emergence of futures
contracts and derivatives such as options in commodity
markets, allows the implicit trade in commodities to
be many multiples of the explicit trade. The volume
of implicit trade is only restricted by the extent of
liquidity in the market, whereas the volume of explicit
trade is limited by the actual availability of the commodity
from different sources. If liquidity in the market fed
by speculation is high, prices in futures markets can
move in ways that could influence the spot or ready
prices at which the commodity is actually sold.
However, if the futures market is predicting a rise
in the price of a commodity say, and those holding stocks
of the commodity want to benefit, the actual supply
and demand for the commodity must be such that spot
prices can move in ways that reflect that trend. This
depends upon the ability of stockholders to regulate
supply in an appropriate manner. Three things are necessary
for this: (i) the government should not have large stocks
in its hands to dampen spot prices; (ii) the private
trade must have stocks to deliver and the capacity to
hold on to it till such time prices rise; and (iii)
there should be no danger that cheap imports could be
resorted to, as and when domestic prices rise.
It transpires that liberalization of the trade in agricultural
commodities within the country had ensured the realization
of the first two of these conditions. Liberalization
has involved the removal of controls on the inter-state
movements of agricultural commodities (from surplus
to deficit regions); the liberalization of rules relating
to the operation of private traders and agribusiness
firms, which has brought in large players into commodity
markets; and some weakening of the procurement programme
of the government as a prelude to the dismantling of
the PDS.
According to reports, private firms such as Cargill
India, Adani Exports, ITC and the Australian Wheat Board
have together purchased as much as 30 lakh tonnes of
wheat this year. While some of this is for conversion
into processed goods in their own facilities, a significant
part is for resale at a profit. Private firms have also
been involved in trading in other commodities. This
indicates that large trading firms have cornered supplies
of many commodities at prices higher than minimum support
price offered by the government.
One consequence of these trends has been a decline in
government stocks from record levels and a rise in stockholding
by the private trade for speculative purposes. Thus
the government has managed to procure only 92 lakh tonnes
of wheat this year as compared with 147 lakh tonnes
last year. As a result, wheat stocks with the government
stood at 93 lakh tonnes on June 1, having declined continuously
when compared with the level on the same date of the
last few years, starting at 413 lakh tones on June 1,
2002. Overall, food stocks with the government stood
at 223 lakh tonnes on June 1, 2006, close to a third
of their peak level of 648 lakh tonnes on June 1, 2002.
These declines are far more than warranted by trends
in production, indicating that private trade has managed
to corner a significant volume of stocks.
These developments on the availability front have provided
the basis for speculative trading in commodity futures.
Trading on India's commodity exchanges totaled $460
billion in the year ended March 31, a fourfold jump
from the year before. There is sufficient ground to
believe that the recent surge in the prices of certain
essentials, including wheat, seems to be driven by such
speculation.
This has been aided by a policy of freely allowing exchange-based
trading in futures and commodity derivatives. Commodity
futures trading had been banned for much of the post-Independence
period, so that the commodity derivatives market was
virtually non-existent. At present, the country has
3 national level electronic exchanges and 21 regional
exchanges for trading commodity derivatives. As many
as eighty (80) commodities have been allowed for derivatives
trading.
The process of liberalization began after the Government
set up a Committee under the Chairmanship of K. N. Kabra
in 1993 to examine the role of futures trading in the
context of liberalization and globalization. The Kabra
Committee, while cautious, recommended allowing futures
trading in 17 selected commodity groups. It also recommended
strengthening of Forward Markets Commission (FMC) and
amendments to Forward Contracts (Regulation) Act, 1952.
However, this cautious approach was dropped in 1998,
which saw the adoption of a major reform package involving
the FMC and the Exchanges, spurred by a World Bank-funded
grant. The reform included the introduction of futures
trading in edible oils, oilseeds and their cakes, which
was a turning point in the development of commodity
futures contracts in India. The National Agricultural
Policy announced by the Government in the year 1999
declared that the Government will enlarge the coverage
of the futures market to minimize the wide fluctuations
in commodity prices, as also for hedging their risk.
In the Budget for 2002-03, the Finance Minister announced
expansion of futures and forward trading to cover all
agricultural commodities. These initiatives have paved
the way for the speculative price increases that have
forced the government to import as much as 39 lakh tonnes
of wheat and ease imports of other commodities, which
can have damaging consequences in the long run. It is
perhaps time to reverse some of these policies, starting
with a ban on forward trading in essential commodities.
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