Despite the tremendous success of Indian commodity exchanges in a decade of their operations, suspicions shroud trading, and have given birth to unsubstantiated myths, thereby flouting realities. This has emerged primarily from lack of understanding of the operation and the utility of the commodity derivatives market.

The first misconception is with associating commodity futures with inflation. Opinion makers, in many cases, are confused between “futures” trading and “forward” trading, and use these terms interchangeably.

A forward contract is an agreement between two parties to buy or sell a commodity on a future date at a pre-agreed price. On the other hand, a futures contract is a standardised contract, traded on a futures exchange, to buy or sell an underlying commodity at a certain date in the future, at a specified price. Contrary to a standardised futures contract, a forward contract can be customised. Incidentally, both markets are supposed to serve the purpose of price risk management, but the futures market performs this function more effectively, and additionally helps in “price discovery”.

Price discovery

With participation of a large number of heterogeneous stakeholders, information from innumerable sources culminates in the futures market, leading to the emergence of a futures price. An efficient and mature futures market is one which discovers future prices through participation of large numbers of geographically dispersed market participants. Such a scientific price discovery is not found in the physical market (or the forward market) which is mostly fragmented and far less perfect than the exchange-traded futures market. Worldwide, such discovered futures prices act as reference for physical market transactions. Today, global benchmark prices for crude oil (ICE-Brent or NYMEX-WTI) or gold (COMEX) are actually futures prices, from which physical markets all over the world take cues.

Theoretically, under assumptions of “efficient market hypothesis”, the futures price is the expected physical market price that will prevail in future. Hence, futures prices are useful predictors of future market conditions, enabling physical market stakeholders to take appropriate action. Therefore, theoretically, it is wrong to associate futures market with inflation. Empirically, this position is vindicated in India by various studies (e.g. Expert Committee, chaired by Prof. Abhijit Sen; Assocham Report of 2008, etc). This is one critical ground reality to refute a myth emerging from the misconstrued role of the futures market.

Speculation

The other myth that looms large is about the role of “speculators”. ‘Speculation’ is generally understood as the action of the participants who do not deliver, neither have matching cash market position to hedge price risk, and yet takes a price call. It is important to understand that by taking the price call against a hedger, the speculator agrees to bear the risk of meeting the price expectations of a hedger. Without speculators, the futures market will not be able to perform the risk management function. The speculators take up the hedgers’ risk, provide liquidity to the market, reduce transaction cost, smoothens the entry and exit process of the participants, and helps in price discovery function.

If another hedger takes call against the former one, the risk essentially remains within the commodity ecosystem, while moving from one hedger to another. If this risk from a hedger is borne by many speculators, risks are thinly spread into the economy and hence do not reveal as increased return expectations of the economic agents. Hence, rather than being “evil”, speculation has an essential economic function to perform in the market.

The third misconception is that futures trading do not help farmers, as farmers do not participate in it. However, studies conducted internationally and nationally reveal that farmers derive indirect benefits in various ways. While futures prices enable farmers to take informed decisions about production and marketing related activities, commodity pool operators/processors/traders can participate on the exchange platform and deliver risk hedged prices to farmers in advance. Moreover, futures contract specifications and the collateral management agency of the exchanges not only improves awareness about quality testing and scientific storage, but also improves infrastructure by developing sound commerce around such infrastructural facilities.

Mentha oil

The 2009 UNCTAD Study on Emerging Commodity Exchanges found that in India, cardamom planters are getting improved prices from intermediaries as well as auction centres as there are futures prices available as reference prices. Futures trading in mentha oil led to improved sources of price information for mentha farmers, reduction in the price spread in the marketing channel, and helped India in becoming a leading exporter, displacing China.

These are not the only myths about the Indian commodity futures markets. There are many more that need to be clarified. In an era when the world economy understands the need for such a market in the backdrop of increasing price risks, doubting its necessity in India does not hold ground.

The writer is Chief Economist at Multi Commodity Exchange of India Limited. Views are personal

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