Death Trap for Commodity Futures A government task force recommendation to integrate the securities and commodity futures markets will, if implemented, sound the death knell of the latter. Madhoo Pavaskar
http://www.epw.org.in/showArticles.php?root=2005&leaf=01&filename=8105&filetype=html While presenting the union budget for 2004-05, the finance minister, P Chidambaram, an-nounced the new governments intention to integrate the commodity futures markets with the securities markets. This was probably in tandem with the report of the Inter-Ministerial Task Force on the Convergence of the Securities and Commodity Derivatives Markets, appointed by the union ministry of consumer affairs of the former government in May 2003. The idea of convergence of the securities and commodity derivatives markets, players and regulators was actually mooted in a communication by the then union minister of finance to the union minister of consumer affairs in early 2003, in response to which the task force was set up. Interestingly, facing a rather absurd and irrational task, the task force was constrained to put logic on its head to justify, this ill-conceived concept of convergence, emanating from the ministry of finance, which seemed ever eager to have a finger in each pie of every other ministry. The feeble Forward Markets Commission (FMC), dissatisfied with its own inferior status without any significant powers, being a subordinate office of the department of consumer affairs was also keen to hug SEBI in the fond hope that such a marriage would enhance its status in the new family, notwithstanding that in the process it would eventually lose its independent identity. The sole representative of the FMC on the task force, who also happened to be the secretary of the task force, therefore also seemed to have lent his support to the recommendations of the task force, ignoring that the convergence of the two types of markets, and more particularly their regulators, would sound the death knell of the commodity exchanges in the country. The task force listed several possible gains from the proposed convergence. It believed that the convergence would provide, inter alia, opportunities to speed up the development of commodity markets and make them available to farmers, as also help accelerate the growth rate of the agricultural sector, if the institutions of the securities markets, which are available off the shelf, are used. Unfortunately, this belief was more in the nature of an untested hypothesis, with little theoretical basis or even a priori logic, than a scientifically derived conclusion based on either rational arguments or empirical analysis. An illusion rather than a vision a fiction that the task force has drawn from its wishful dream. But, more on that later. Rationale for Convergence The rationale for convergence should hinge upon its capacity to ensure growth, liquidity and safety of the market as well as to improve its accessibility to the public by spreading the network and reduction in transaction costs, is the burden of its song of, which the task force repeats throughout its report. It assumes that the inter-marriage of the two types of markets would open new avenues of business opportunities to the securities market participants, thereby deepening and broadening the commodity derivatives markets, especially since the stock exchanges are fully automated exchanges, providing anonymous order matching facilities through their network of over 5,000 branches as well as internet trading. The merger, it is argued, will also benefit from the economies of scale, because the infrastructure of the stock exchanges, built at enormous investment cost, can be used to obtain trading in commodity derivatives at a small incremental cost, and the Settlement Guarantee Fund can benefit from the diversification of risks involved in the commodity derivatives and security markets, which will reduce the capital requirement of the single clearing corporation, guaranteeing the performance of contracts traded in both the markets. Moreover, a single, simple set of rules and procedures for a broad range of derivative products in both the security and commodity derivatives markets too can reduce the overhead costs associated with executing transactions on these markets. As a result, the transaction costs for trading in commodity derivatives will be reduced, giving further impetus to the growth and liquidity of their markets. And, once the legal markets migrate onto sophisticated, liquid, low cost platforms, convergence may even curb informal (illegal) trading. The long and short of this entire rhetoric of the task force is that convergence can enhance liquidity of the commodity futures market. And since liquidity helps price discovery, convergence would facilitate the design of public policy by signalling in advance the shortages or gluts of commodities. This is not all. Insofar as the convergence helps speed up the migration of commodity futures markets into screen-based, anonymous order matching, it can also indirectly assist the strengthening of agricultural spot markets, which are currently fragmented. Not that the task force was unaware of some of the perils of convergence, though it preferred to describe these as mere concerns and apprehensions rather than the real threats. To be fair, the task force even knew of some of the major differences between the securities markets and the commodity derivatives markets. Thus, it admits, Because financial futures generally have actively traded cash markets, cash prices are generally not discovered in the futures market(italics added). The task force also recognises that the delivery and settlement process of the commodity exchanges is different. A particularly useful function of exchanges is the facilitation and oversight of contract expirations and the related settlement by delivery or exchange of physicals for the maturing futures. Exchanges not only set the terms of delivery, but also oversee the actual delivery as well as the credit verification of members making or taking delivery. For financial derivative transactions, exchange delivery mechanisms and oversight are less necessary and can be alternatively accomplished as cash transactions through other institutions or inter-institutional arrangements. More importantly, the task force clearly perceived that unlike the securities market, where the impact of the price volatility is on the willing participants in the market, namely, the investors in securities, the impact of the sharp rise or fall in price in commodities is borne by the entire economy, i e, largely by innocent by-standers. Going a step ahead, the task force perhaps unwittingly states that the most important policy goal, and policy concern (of the commodity exchanges), is safeguarding of the interests of the producers farmers in particular, consumers as well as manufacturers and other functionaries in the supply chain (words in parenthesis added). The focus of stock exchanges, in contrast, is on providing liquidity to securities for enabling companies, government and other organisations to raise finances through stock and bond issues. In fact, the task force even realised that the possibilities of convergence are limited, insofar as commodity futures trading requires highly specialised knowledge, which is different from that required for securities trading. Unlike the securities market, the factors affecting commodity prices are more complex and commodity specific. And although it did not say so in so many words, the task force did not deny that as against the commodity futures, the stock exchanges are more influenced (especially from day to day, as also in the short run) by the technical and general macroeconomic factors than the fundamental factors relating to the specific stocks and securities. Commodity Exchanges vs Stock Exchanges After thus virtually dismissing the case for the proposed convergence between the security and the commodity derivatives markets and even while admitting that there are some major differences between the stock exchanges and the commodity exchanges, the task force favoured convergence between the two, because commodity derivatives resemble securities, since commodity futures contracts are tradable and fungible, and are mostly squared off. Thus, commodity futures are largely used for financial purposes. Moreover, the two markets have close resemblance insofar as trade practices and mechanism are concerned. Alas! Nothing is further from the truth. For, to be sure, commodity exchanges are not stock exchanges. Somewhat hesitant assertion to the contrary by the task force notwithstanding, there is far little resemblance between the two markets, except that speculation, which helps promote liquidity, is the common denominator in both. But for this, the security and commodity derivatives markets differ from each other significantly in their nature and functions. Though commodity futures contracts are fungible, the underlying commodities are actually not. Unlike securities, not only are different commodities not interchangeable and cannot be substituted for one another, but also different varieties of the same commodity are not easily exchangeable inter se, owing to their diverse quality characteristics and end-uses. Moreover, even if commodity futures contracts were squared off mostly, delivery is the essence of such contracts; otherwise these would be termed as wagering contracts and would automatically become void ab initio under the Indian Contract Act. Surely, the option to issue or demand physical delivery during the maturity month of a commodity futures contract is essential for its smooth functioning so as to ensure that the futures price moves in close alignment with the physical market prices. Even the task force recognises that the delivery mechanism and the contract settlement process emerging out of it distinguishes a commodity exchange from a security derivatives market, in which all contracts are cash settled. In a commodity futures market, however, the absence of any delivery option necessarily impairs the healthy relationship between the physical and the futures prices, affecting adversely the price making and risk reduction functions of the futures. Attempts at cash settlement in the commodity futures contracts (such as the one tried at the International Petroleum Exchange, London) have failed miserably in the past. The proposed convergence may lead to repeating a similar mistake in India. Although the task force argues, cash settlement is preferable since the costs of settlement are eliminated, and chances of short squeezes can be avoided, it is also aware that it is difficult to adopt cash settlement in commodity market, when spot market is fragmented and commodities are not sufficiently standardised. Therefore, it agrees that. In such cases, the threat of delivery is the best alternative to achieve convergence of spot and futures price, and thereby link futures market to physical market. As a matter of fact, had the physical markets been not fragmented and commodities perfectly standardised, cash settlements would have been still unsuitable for commodity futures, as they necessarily tend to distort the spot-futures price relationship. Cash settlement, however, is possible in derivatives of commodity indices, composite or otherwise. But the reliability of these indices may often be in doubt, owing to not only untrustworthy data sources and erroneous selection of commodities and markets, but assigning improper weights to them as well. The possibility of such unreliable indices being liable to easy manipulation, by the agencies compiling them, also reduces the economic utility of trading in their futures. In fact, trading in commodity index futures only provides an alternative avenue of investment or speculation to the security market operators, with little benefit to the physical market functionaries in commodities for either price discovery or price risk management. Functions of Commodity Futures To be sure, the twin functions of a commodity futures market are price discovery and price risk management, both of which have little relevance to the securities market. Stock market speculators as well as investors are more interested in price escalation than price discovery. Similarly, they deal in securities to profit from their transactions, and not to avoid risks. Even security futures and options provide additional low cost platforms for speculation rather than serve as worthwhile risk management instruments. In contrast, commodity producers, processors, manufacturers, as also merchants, need to discover prices not only to plan their production, stocking and marketing schedules, but also to enter into forward purchases and sales, including import and export deals, at proper prices. As the physical market transactions, barring those in primary produce at the up-country regulated markets, are mostly shrouded in secrecy between the parties to such transactions, their prices are often not known to all. Moreover, the supply-demand situation in commodities changes so rapidly, in response to the varied and complex factors influencing it, that price determination from time to time tends to be a difficult exercise for even the most astute market men. The futures market price, which represents a consensus of a large number of buyers and sellers from different sections of a commodity economy, offers the best way out. Yet another major distinction between the securities market and the commodity exchange rests in the price stabilisation influence of the commodity futures market. A futures market that reduces the abnormal seasonal and intra-seasonal price fluctuations is welcome by all commodity players, producers as well as consumers and even the market intermediaries (so long as their transport and storage costs, as also the normal processing/manufacturing and marketing margins, are covered). Price stability, however, is anathema to the securities market operators. Similarly, commodity futures markets assist in bringing about the requisite geographical, vertical and inter-temporal price stability as well as more equitable inter-variety and inter-commodity price relationship. Since for the securities market players, such price stability or price relationships across regions and securities are irrelevant, regional stock exchanges saw their demise, following the growth of electronic exchanges like the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) with their countrywide computerised networks. However, a large continental size country like India, having wide regional differences in commodity varieties, production, consumption and price patterns, calls for regional commodity exchanges or regional trading platforms with regional commodity contracts. Convergence may simply kill regional commodity futures without offering any compensatory gains. Short Selling A Must Another marked difference between the trading features of the stock exchange with those of a commodity exchange is that while short selling is abhorred by the securities market investors and speculators alike, constraining the regulators not infrequently to intervene with deterrent measures, such selling is a must for risk management by merchants and manufacturers, acquiring commodity stocks or, entering into long-term purchases in the physical markets. In fact, paradoxical though it may seem, short selling in commodity exchange benefits farmers, albeit indirectly, insofar as it facilitates traders, processors and agro-industries to absorb the rushing market arrivals during the peak marketing season, and hedge the resulting stocks in the futures market. In the absence of such short hedging, or without it, agricultural prices may crash in the post- harvest period to the detriment of the farmers. One more distinction, and by far the most important, is in the area of price impact. The stock market players regard a boom in the stock market as a boon, and the regulators do not even bat an eyelid over it. Not so with the commodity exchange. The abnormal firmness in commodity prices more often than not forebodes an impending crisis. Not only does it hurt manufacturers and consumers badly, but also may fuel inflation in the economy, bringing in the wake the much-dreaded recession, with the authorities losing their sleep overnight. At the other end, a slump in the securities exchange, no doubt, burns the fingers of reckless investors and speculators, who fail to look before they leap, and may even, incur the wrath of the helpless regulator. But a sharp slide in commodity prices, though benefiting consumers, impoverishes cultivators, leading frequently to a spate of suicides among them, apart from the fact that it may cause needless shifts in the cropping pattern, and, at times, may be a forerunner to a depression in the economy at large too. Commodity prices therefore need to be monitored carefully not so much by financial analysts (like those in SEBI) as by competent economic and agricultural price analysts. Convergence clearly cannot mend the matters in this regard. One plea, rather naive advanced in support of the convergence, and which probably may have weighed strongly with the finance ministry in proposing it to the ministry of consumer affairs, is the surplus infrastructure capacity with NSE and BSE, built at huge investment, which can no longer be utilised any further, given that the business in the secondary securities market has almost reached the saturation level. Forgotten is the fact that the commodity exchanges, more particularly the new national exchanges, were mandated by the government, as admitted by even the task force in its report, to set up modern infrastructure for organising futures trading. These exchanges have expended huge physical, financial and manpower resources to build the desired capacity. The proposed convergence will lead to a colossal waste of these resources acquired at great effort and cost. Moreover, since the securities trading volumes are currently several times those in all the commodity exchanges put together, business in commodity futures will just wither away once the securities market absorbs commodity exchanges. For one thing, the security market players may not lend much support to the unknown and intriguing commodity futures business in preference to their familiar securities trading activity. On the other hand, the securities market too is unlikely to rear the complex commodity derivatives trading with care, and will continue to favour its more remunerative securities business. It is equally naïve to believe that the migration of commodity futures markets into the screen-based, anonymous order matching could indirectly assist the strengthening of the agricultural spot markets, as the task force argues. True, a commodity futures market can act to a small extent as a catalyst for the strengthening of the physical markets through proper designing of the futures contracts and developing appropriate delivery mechanisms, which can promote increased usage of such a market by the diverse physical market functionaries, bringing in the process some change in the cash market practices as well. But the real development of the physical markets in commodities calls for an all-round improvement in the entire marketing infrastructure that includes grading and quality certification, pre-processing and packing, transport and storage, financing and, of course, merchandising. The fact is that the physical markets in commodities are fragmented in India over regions, mainly because of the varietal differences in different agricultural commodities, following the widely varying geo-climatic and soil conditions in different areas and lack of adequate research in agricultural technology. A commodity futures market can do little to improve matters in so many areas of agricultural marketing and production. Need for Open Outcry The concept of convergence appears to rely on a single assumption that computerised electronic trading with automatic anonymous order matching, as practised at the NSE and BSE, will generate huge trading volumes and bring in liquidity in the commodity futures contracts. Not only does such simple assumption lack credibility, but also it is altogether erroneous, for developing futures trading of economic utility in commodities, the spectacular success of such trading practice in the securities market notwithstanding. Though computer savvy managers and technologists may frown at it, there is really no effective substitute to the traditional floor based open outcry auction system for the efficient functioning of a futures market in commodities, especially those of agricultural origin. This is because the floor based trading is more visible, transparent and fair than the invisible and somewhat mysterious and secretive automated anonymous order matching. The bids and offers on the floor are not only heard, but also viewed by all the market participants, and the deals are struck in open for all to see. The diverse and up to date market information affecting the supply and demand for commodities and their products also flows rapidly on the trading floors of the commodity exchanges than through the computer network. This is not to suggest that the traders on the floor need not be linked to the computer network. Such a network can at best assist them in their trading activity, but cannot supplant the open outcry system as a mode of trading in commodity futures. As a matter of fact, the new national commodity exchanges have already introduced the electronic trading system, but, belying the expectations of the task force, have as yet failed to build worthwhile trading volumes, except in bullion and soyabean oil to some extent. In comparison, some of the old exchanges, having the open outcry system, trade relatively better volumes. The world over too, in all major reputed commodity exchanges such as the Chicago Board of Trade, the Chicago Mercantile Exchange, the New York Board of Trade, the New York Mercantile Exchange, the Winnipeg Commodity Exchange, the London Metal Exchange and several others in South America and Japan, almost 90 per cent of the trades in all commodities, not only agricultural, but also metals, crude oil and other energy products, are executed in the trading halls or pits by the traditional open outcry system. Traders resort to the electronic online system, installed at these exchanges, only in the event of urgency after the official trading hours. No doubt, the financial futures are traded online. But options in the financial futures too are traded in the pits by open outcry. Clearly, the proposed convergence, entailing the compulsory use of solely the anonymous online order matching system available at the NSE, will spell disaster to the commodity futures trading in the country, especially for agricultural commodities. The Liquidity Problem Not that the open outcry system by itself can resolve the liquidity problem in the commodity exchanges. The open outcry system is essentially needed to improve the economic utility of derivative trading in commodities, though it assists in efficient decision-making for such trading as well. Liquidity, however, is a function of several different factors, including the suitability of a commodity selected for derivative trading, the need and demand for such trading, the contract specifications, the trade rules and restrictions, the exchange and the government regulations, and, above all, the transaction costs, besides, of course, the mode or system of trading. At present, several commodity exchanges lack liquidity in many of their futures contracts. The reasons for that are many. Commodities have often been selected for futures trading, without any assessment of demand for such trading in them. Contract specifications have hardly been drawn after a careful study of the market requirements. As a result, the futures contracts are either too narrow with just a few deliverable varieties and delivery centres, or too broad covering divergent varieties deliverable at far too many centres throughout the length and breadth of the country. In either event, most of the physical market functionaries shy away from such contracts. The fear of manipulation looms large when the contract is narrow, apart from the fact that such a contract does not serve the interests of those who do not trade in deliverable varieties at the prescribed delivery centres. A broad contract, in turn, creates considerable uncertainty amongst the buyers, with the possibility of being saddled with unwanted varieties at undesirable centres. Unsurprisingly, such contract turns unnecessarily bearish for want of adequate buying interest, affecting adversely the price discovery function of the futures market, as also distorting the cash-futures price relationship to the detriment of the risk management function. The trade rules too restrict liquidity. Limits on size of orders, trading, positions and daily price fluctuations dissuade traders from transacting large volumes. Besides the normal initial and variable margins, the government regulations require payment of heavy special margins at various price levels so as to restrict the movement of futures prices, distorting consequently their relationship with the physical market prices. Moreover, these different margins, together with the high admission, security deposits and annual subscriptions, raise transaction costs immensely, rendering both hedging and speculation in most commodity futures markets far from cost-effective. Small wonder, both the potential hedgers and speculators have neglected the recognised commodity exchanges, and many of them prefer to trade in the illegal markets mushroomed in many parts of the country. Be that as it may, with these rules and regulations, it is indeed wishful day dreaming on part of the task force to imagine that the convergence of the commodity derivatives markets with the anonymous electronic order matching security exchanges will lead to migration of traders from the informal markets to the official channels. Far from it, such convergence will encourage the growth of even more illegal markets to avoid the harsh regulations of SEBI. What is needed now is not the integration of the commodity exchanges with the securities markets, as proposed by Chidambaram, but their planned development by according them independent status of self-regulatory organisations with minimum government regulation, and recognising simultaneously the commodity futures trading activity as industry with suitable tax and financial benefits for research and training. Incidentally, it is rather erroneous to contend that electronic automated trading has brought liquidity to the secondary markets in various securities listed at the NSE and BSE. More than 5,000 stocks are listed at the two exchanges. But, even at the NSE, the top 100 stocks account for over 95 per cent of the total trading. Things are probably worse at the BSE, where the volumes are relatively less. Clearly, most of the stocks listed in the securities markets are hopelessly illiquid. Derivative trading in securities is also confined to a few scrips. At the BSE, such trading has failed to pick up altogether. As a matter of fact, the present much hyped liquidity in selected stocks in the stock exchanges is due to the disproportionately large share of intra-settlement or day trading, which accounts for nearly 85 per cent of the total volumes. To be sure, the stock exchanges in the country are characterised by speculation bordering on gambling. Why on earth then should the commodity derivative markets be converged with these virtual gambling dens? Restructure FMC While the convergence at the institutional or exchange level is decidedly undesirable, that at the regulatory level will be actually disastrous to the commodity futures trading in the country. For one thing, SEBI has neither any expertise nor even knowledge of the working of both the physical and futures markets in commodities. For the other, the regulatory norms and standards practised by SEBI are too severe and rigid for the commodity exchanges to adopt. Far from developing liquidity, these will reduce even the prevailing meagre volumes. Moreover, despite SEBIs strong-arm tactics, even the securities markets are not free of scams, adding to the woes of the millions of investors, who otherwise too suffer from time to time due to the erratic and unwarranted price fluctuations in the stock exchanges. Verily, SEBI has hardly any lessons to teach the much older institution like the FMC, which has half a century of experience in selecting commodities and exchanges suitable for futures trading and regulating trading in them. The FMC is, of course, weak, as stated by the task force. But that is no reason to merge it with SEBI. The truth is that the FMC has been made weak by the obsolete Forward Contracts (Regulation) Act, passed way back in 1952. This almost outdated act does not confer any major powers to the FMC. These vest solely with the central government, which can act even independently without consulting the FMC. As FMC does not wield any worthwhile statutory powers, it functions at present as a subordinate unit of the department of consumer affairs in the ministry of food and agriculture of the government of India. The chairman and members of the FMC do not have high-ranking status in the central bureaucracy. In comparison, SEBI has wide-ranging statutory powers and its chairman is of the rank of secretary in the central government. Not that the FMC cannot be restructured and strengthened like the SEBI. To be true, the commodity futures markets are crying for development, and not SEBI-like regulation. What is needed for such development is a new and innovative law in the form of Commodity Futures Markets (Development) Act, which should replace the age-old Forward Contracts (Regulation) Act. The new act should provide for constituting an independent and autonomous statutory Commodity Futures Markets Commission (CFMC), drawn mainly from outside the bureaucracy, with adequate financial and manpower resources not so much to regulate commodity futures exchanges as to develop them as economically useful markets, to serve the price discovery and risk management functions effectively and efficiently, for the diverse physical market functionaries from farmers to consumers at large. The chairman of CFMC must be a non-official economist or agricultural economist of repute, with high qualifications and significant research experience in commodity economics in particular and agricultural marketing in general. He should be accorded the status equivalent to that of union minister of state in the ministry of food and agriculture in the central government. The members of the commission need to be economists and management professionals with commodity marketing, price analysis and finance as background, drawn partly from civil service, but mostly from outside the government. All of them may be of the rank of either secretaries or additional secretaries in the central government. The appointment of the chairman and members of the proposed CFMC should be for a minimum period of five years at a time. These conditions will strengthen the independent and autonomous status of the commission. The commission should be entrusted with mainly the developmental functions, with minimal regulatory powers to be exercised in the event of serious irregularities and market manipulations in the nature of corners, squeezes and bear raids. The commission must have the responsibility of developing the different commodity exchanges as independent self-regulatory organisations, and monitoring their activities on a continuing basis to assess their economic utility. Of course, it is not the purpose of this article to delineate either the salient features of the proposed new Act or the CFMC. Suffice it to say that not the integration of the commodity derivatives markets with the securities markets, as proposed by the finance minister, P Chidambaram, but the enactment of a new law, and the constitution of an autonomous Commodity Futures Markets Commission as a powerful developmental body, can strengthen the commodity futures markets in the country. At any cost, the commodity futures must be saved from the death trap of convergence, and allowed to grow freely so as to facilitate the commodity players in the country to meet with the challenges of international competition. Note The author is an independent consulting economist. The views expressed in this article are his personal. The references in the article to the report of the Inter-ministerial Task Force on the Convergence of Securities and Commodity Derivatives Markets have been drawn from the Draft Report of the task force, as posted on the web site of the Forward Markets Commission, since the final report seems to have not been released. --------------------------------- Do you Yahoo!? New and Improved Yahoo! Mail - 1GB free storage! [Non-text portions of this message have been removed] «¤»¥«¤»§«¤»¥«¤»§«¤»¥«¤»§«¤»¥«¤»§«¤»¥«¤»§«¤»¥««¤»¥«¤»§«¤» This is ZESTEconomics. Post economics-related articles and event info to [email protected] If you got this mail as a forward, subscribe to ZESTEconomics by sending a blank mail to [EMAIL PROTECTED] OR, if you have a Yahoo! 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