Wednesday, January 10, 2007

Futures in the Stock Market - Ila Patnaik


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By Ila Patnaik

To curb malpractice on the agricultural commodity futures market, we need a judicious blend of competition, market design, policy and supervision. Address the problems, don’t ban the market

Are commodity futures markets responsible for inflation or for fluctuations in the price of agricultural commodities and distress among farmers? Will banning these markets help address the woes of Indian farmers?

Looking back, commodity futures trading was taking place in India for hundreds of years. When economic policy shifted into the control of the raj, commodity futures trading was almost entirely banned. In the last decade, this has gradually come back to life.

In some ways, there is nothing more innocent than futures trading. In a spot market, the buyer and seller agree to do trade at a certain price, and the settlement is done on the spot. In the futures market, the price is agreed upon, but the settlement takes place at a prespecified future date. The classic application involves a farmer who is planting in June and wants certainty about the price at which his goods will be sold at Dussehra. Nobody forces a farmer to use the commodity futures market, but a farmer who chooses to use the futures market in this fashion is happier because of greater certainty.

Normally traders in a region surrounding a town would be the major players in purchase of the product of this region. This trade would typically be dominated by 10 or 20 families. These families would often determine purchase prices. Farmers would have little choice vis a vis the price at which they can sell; indeed farmers might not even know prices elsewhere in the country.

The futures market is a powerful tool for breaking the market power of these families. Futures trading — taking place on a transparent, electronic exchange with nationwide access — brings in a host of new players. Indeed, there are hundreds of people in India who are watching world markets, processing information, and putting trades onto overseas commodity futures markets. Physical proximity to the market becomes a non-issue once an electronic exchange is in operation. Someone in Orissa can be trading guar seed, even though he may have never been to Bikaner which is the traditional trading centre for guar.

These new market participants engage in buying and selling; the futures market becomes liquid and the traditional families are less able to control the prices at which farmers sell. Further, futures prices tend to be highly visible at thousands of locations all across India. This information exerts a subtle influence on the power structure in transactions where a farmer sells to a trader. When both the trader and the farmer know the futures price, it is harder for the farmer to get cheated.

Particularly with participation by banks and other sophisticated financial participants, the control that a few families exert on prices is often substantially diminished. The spot market and the futures market, operating in unison, become more like a genuine market where supply and demand by a large number of participants makes the price. But as with all economic reforms, liberalisation involves removing restrictions, getting the government out of the role of banning transactions, and opening up market participation to a wide class of heterogeneous participants. It is not surprising that this is inimical to the interests of families which were earning easy profits in the previous regime and they resist change and want to go back to the ‘good old days’.

It is claimed that there is a great deal of malpractice on the commodity futures market. On one hand, it is important to maintain a sense of perspective about the incidence of difficulties. There is perhaps one episode of difficulty associated with every hundred contract expirations. The media tends to emphasise the one plane crash, while being silent about the 99 flights which flew smoothly.

These difficulties can be further reduced by strengthening public policy. The regulation and supervision of derivatives markets has many complex issues which require a correspondingly sophisticated apparatus in government. Consider one example of these issues: the problem of a dominant trader who can manipulate market prices. In order to stop this, there are ‘position limits’. However, it is easy for a person to spread his position across many securities firms and thus stay below the limit with any one securities firm. In order to combat this, a universal identity number needs to be given to all market participants, and a central surveillance facility needs to add up the position seen for a person across all securities firms, in order to verify that the position limit is not violated. Further, positions need to be aggregated across family members, which requires corresponding sophistication in the database for tracking family members. Such a system is in the process of being created for stock markets. It will need to be created for commodity futures markets as well.

The correct response lies in addressing problems, and not banning the market. As we have seen with stock markets, the sound functioning of markets requires complex institutional structures, which requires sustained efforts over decades on drafting of law and regulations, building human capital, inspection capacity, an appeals process, and arriving at a judicious blend of competition, market design, policy and supervision.

Every mature market economy in the world has active commodity futures trading, either on domestic exchanges or offshore exchanges. Every successful agricultural economy in the world involves an intimate role for commodity futures. As India grows into a mature market economy, we have to learn how these markets function, and build commensurate legal and institutional structures. When faced with difficulties, the correct response is to diagnose and solve problems, not retreat into 1970s style economic policy.

In addition, banning futures exchanges will merely send this business underground and overseas. For many decades, while the GOI thought that futures trading was banned, it was actually flourishing in a “number 2 market”. In addition, hawala money is used all over India to do trading on offshore exchanges. As an example, a full range of commodity futures are traded in London, where they are regulated by the Financial Services Authority (FSA) — one of the most respected financial regulators in the world. The London financial sector will be the one to rejoice if India goes back to the control raj.

The writer is senior fellow at the National Institute of Public Finance and Policy, New Delhi [email protected]

Source :

Indian Stock Market News


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