Do comexes play their relevant roles?

The Ministry of Finance set up a Committee to suggest steps to fulfil the objectives of price discovery and risk management in commodity futures markets in December 2013. By the end of April, the Committee submitted its report.

The report is significant from the perspective that the national level commodity derivatives markets have completed a decade of their operations, and the time is opportune to take stock of various issues, as also report on a performance appraisal of the commodity exchanges.

While this report does just that, at instances, it has gone deeper into various nuances to make a succinct statement on how microstructure issues are related to policy issues. This type of reporting, so far unprecedented in the Indian policy and academic literature, has been made possible because of a judicious choice of erudite experts from diverse domains, all of whom have deeply witnessed the financial or the commodity markets from diverse perspectives.

Apart from being a policy report, this report somehow has an academic flavour built into it. This becomes more prominent when one reads chapter 2, which provides the policy backdrop, and then moves to chapter 3, which presents the central questions as is often presented in rigorous academic dissertations. The central question looms large here: To what extent are commodity futures markets in India delivering on the economic objectives of price discovery and hedging? The chapter 4 presents the econometric results.

Price discovery has been evidenced through the Information Share framework as was presented by Hasbrouck in his paper published in Journal of Finance in 1995. This measure essentially reflects on the spot-futures relationship as the percentage of information that arrives about the commodity emanating from the futures market. Of course, quite a sophisticated measure, for the first time in any policy report such a measure is being used.

However, what would have been even more appreciable is an explanation of the choice of this measure, as there are various other ways of measuring price discovery (e.g. Garbade-Silber framework, or literature emanating from the time-series econometrics, like Granger causality tests).

In any case, Hasbrouck’s Information Share framework has yielded some very interesting results in this report. The main finding is that the information share of the futures markets for all the commodities is higher than 0.5, indicating that when information about the commodity arrives, the futures prices dominate the spot prices in reflecting that information.

However, the exact choice of the measure of hedging effectiveness could not be properly understood from the analyses. There are various measures of hedging effectiveness used in the literature. Pennings and Meulenberg presented a survey of such measures in their paper published in The Journal of Futures Markets in 1997. While Ederington method has often been used for measuring hedging efficiency, in traditional measures, the very cost of participating in the hedge is not considered; but in some more recent ones, this is being considered.

It is not really clear which specific measure has been considered here, and whether the transaction cost of the notional hedge is also being a component of that measure. A bit more description of the method would have helped in understanding the exact rationale of the measure used.

As such, both price discovery and hedging efficiency of a contract are functions of regime changes marked by external trade policies (changes in duties, curbs in imports, etc.). Only in the utopian classical economics regime with no interventions, one may come up with more uniform measures across time.

This is something that this report has adequately recognised, and acknowledged. The report finally emerges with an interesting inference: “the futures market is faring relatively well on price discovery and relatively poorly on hedging effectiveness.”

Apparently, this seems to be a conflicting statement, as often price discovery is defined in terms of the causal relations between futures and spot prices, and hence a high hedging efficiency should also be a reflection of price discovery. But, the implications of this inference are much deeper than what meets the eye. They have deeper social relevance indicating the important role of futures price dissemination mechanisms, as is emphasised by the exchanges and the regulator.

Finally, the report comes up with some very important recommendations in terms of contract design and participation. Though seemingly at the micro-structure level, both these concerns have a social relevance: at the micro-level in the context of hedging, and at the macro-level in the context of price discovery. What is also important is the emphasis of this report on measuring liquidity.

There is hardly any analysis on liquidity measurement conducted for the Indian commodity markets so far, and the report has rightly pointed out this gap.

No doubt, the Committee indeed deserves to be congratulated for having brought out a relevant performance appraisal of the working of the Indian commodity markets at the right time.