In its recent report, the expert committee on commodity futures concludes that futures trade in India has increased the price volatility of largely traded commodities (urad, chana, wheat) during periods of excess liquidity. It finds an increase in prices for commodities that have small market sizes and scarce deliverable supplies (mentha oil, wheat). In contrast, futures trading has led to a reduction in volatilities and aided better discovery for other commodities (soya oil, hessian). It appears that futures trade in agricultural commodities is beneficial for only those commodities that fulfil the basic selection criteria for futures trading accompanied by stringent and timely regulatory actions.

The views expressed in this article are personal.

Tulsi Lingareddy (tulsi_lr@hotmail.com) is with the Clearing Corporation of India, Mumbai.

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However, there was a strong difference of opinion among the members of the committee. The chairman of the committee, Sen, opined that the terms of reference were not comprehensive and did not cover the broader question of the usefulness and need for commodity futures markets, whereas Sharad Joshi indicated that terms of reference were ambiguous.

Selective Inquiry

Let us look at the data series and commodities chosen for inquiry.

Data: In order to find the impact of futures trading on price trends and volatility, the committee has used wholesale price index (WPI) data as it is considered “a closer proxy of producer prices than retail pri ces”. The point to be noted here is that the price series used in the study were weekly and monthly averages across the markets. For the daily price analysis, instead of making any independent attempts, the committee has quoted the findings of an NCDEX study.

Commodities: Of the total 24 prominently traded agricultural commodities in futures markets, the committee has excluded three commodities, viz, guar seed, guar gum and mentha oil, as they do not feature in the WPI basket.

However, trade volumes in guar seed and guar gum accounted for more than 50 per cent of total volumes in futures markets during 2004 and remained one of the most traded agricultural commodities. On the other hand, mentha oil also gained a significant share of about 5 per cent in 2006-07 (Table 1, p 36). Omission of such significant volume contributing commodities from the detailed price analysis may overlook some important information that may aid in understanding the impact of futures.

Contrary to this, the futures volumes in non-basmati rice were negligible and never actually picked up but the committee has extensively analysed its impact on spot markets and understandably concluded that there was no significant impact of futures trade on their prices.

Thus, the approach of the committee was apparently not comprehensive in terms of the selection of data series as well as commodities. Consequently, the results and conclusions arrived based on the selective inquiry could have missed out some potentially important information.

Focus on Price Trends

Prior to looking at the price analysis carried out by the committee, it is important to note that the economic objective or purpose of futures trading is to reduce price fluctuations that primarily arise from s easonality in production and consumption of commodities by providing hedging instruments. While serving the purpose, futures markets also disseminate price signals that may provide the direction of the future spot prices and aid in the integration of spot markets across the country. Beyond this, the futures markets, theoretically and logically, have no role in either and irregularities from the purposive influence of prices. While the purposive i nfluence of prices taking advantage of market inefficiencies may increase volatility, a scarce supply situation may lead to unidirectional increase in prices.

weekly WPI data was carried out for 21 commodities. The results indicated that 14 of them (chana, pepper, jeera, urad, chillies, wheat, sugar, tur, raw cotton, rubber, cardamom, maize, raw jute and rice) witnessed a rise in their prices, while the remaining seven (soy oil, soy bean, rape seed/mustard seed, potato, turmeric, castor seed and gur) posted a fall in their prices in the post futures trading period. Thus, the impact is adverse in the case of an increase or decrease in prices if there was no corresponding change in fundamental factors.

The committee drew a conclusion that the apparent trends (rise or fall) in prices in the post-futures trading period could simply be on account of “normal cyclical adjustments” but the report did not provide enough empirical evidence to that extent.

On the other hand, the report has attem pted to find the extent of contribution by the rise in prices of selected commodities to the total acceleration in inflation during the post futures trading period. Based on certain discretion criteria on the rate of change in inflation, the report noted that the price rise in the case of chana, chillies, urad, wheat and rubber had shown clear evidence that inflation did accelerate following the introduction of futures trading. Though these five commodities accounted for about 32 per cent of total volumes in agricultural futures, they have only a 1.9 per cent share in the WPI. Hence, though the rise in prices was substantial, it was not reflected in an

Source: Nath and Lingareddy (2008).

increasing or reducing prices under normal conditions as they cannot change production or consumption (demand-supply).

That being said, one cannot rule out the potential adverse impacts that futures trading can have by sending wrong signals to the spot market due to the inefficiencies growth (rise or fall) and volatility growth in the periods of pre- and post-futures trading but the focus was apparently on trend growth rather than volatilities.

In addition, the committee analysed the impact at the aggregate level using the weighted average WPI of the selected 21 commodities and various other WPI aggregates and concluded that it was not possible to make any general claim that had a higher inflation acceleration in commodities with futures trading.

However, if the significant changes in price trends brought by futures trade at individual level are not reflected at aggregate levels (primary articles or WPI, consumer price index (CPI), etc) due to their negligible weight in the aggregate indices, as it happened in the cases of urad and mentha oil, then it cannot be said that the

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futures trade has no significant impact on spot prices. It can only be implied that the observed impact of futures was not passed on to overall inflation due to their insignificant weight.

Volatilities in Spot Prices: On the other hand, the primary objective of futures trading is to bring down volatilities and help in price discovery. Towards this, the findings of the committee indicated that 11 of 21 commodities have shown an increase in volatilities during the postfutures trading period based on weekly as well as monthly WPI data series (Annexure I, p 42).

Contrary to this, the findings of the volatility analysis by the NCDEX based on daily data indicated that 15 of the 24 t raded commodities posted a decline in volatilities in the post-futures trading p eriod while only three recorded an increase in volatilities. The category of reduction in volatilities included wheat, chana, maize, urad, jeera, pepper, etc, the “sensitive” items as the committee r eferred them.

Table 2: Volatilities in Urad (FAQ) Daily Prices, Mumbai

2003-04 2004-05 2005-06 2006 (Jul-Dec)

Standard deviation (SD) 94 143 543 413

Mean 1347 1597 2719 3470

Coefficient of variation (CV) 7 9 20 12

Historic volatilities (annualised SD) 21.2 25.3 38.5 31.2

Similar results were found using the price data compiled by the TV 18 Commoditiescontrol.com. Source: CMIE.

Taking account of those contradictory findings of the NCDEX, primarily because “clearing takes place on a daily basis, monitoring daily volatility is not only preferable but also necessary for purposes of futures market operations and day-today management of credit risk”, the committee concluded that “no general or d efinitive association can be claimed b etween introduction of futures and spot price volatility”.

At this juncture, a few important points need to be noted. Firstly, if the committee believed that the volatility analysis of prices would be more relevant using the daily data series, then why was the WPI series analysed and not the daily data? Secondly, the source provided by the NCDEX was the NCDEX itself, even for the pre-futures analysis. How could this be

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Cases of Rise in Price Volatilities

Thus, while studying the impact of futures trade, the committee has largely focused the price analysis on the WPI and to some extent on the CPI confined mainly to the inflationary impact with a little a ttention on price volatilities and the a ccompanying fundamental factors.

Excluded Commodities

The price analysis of the report did not cover guar seed and mentha oil as they do not come under the WPI basket but acknow ledged the findings of the IIMB study indicating a fall in volatilities of guar seed.

In this context, it is worth mentioning the results of a study conducted on mentha oil by Sahadevan (2008). Results indicated that mentha oil price rose to Rs 662.45 in 2006 from Rs 352.5 in 2005. The trend showed that the spot prices have strengthened after futures trading began in April 2005. At the same time, there was no decline in the supply but in fact a significant and steady increase in the production of mentha oil from 14,000 metric tonnes in 2004 to about 22,000 metric tonnes in 2006, with a substantial increase in acreage from 31,000 hectares to 40,236 hectares during the same period (a change in cropping pattern).

Further, the volatilities in mentha oil have increased during the periods of high liquidity and the surge in volumes and prices declined to a significant extent

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Contact Address: Prof. V. Upadhyay, Department of Humanities and Social Sciences, Indian Institute of Technology, New Delhi – 110 016.

Similarly, the study conducted on guar seed prices by the IIM indicated that the volatilities in guar seed declined while seasonality in prices increased in the post-futures trading period [IIMB 2008; Lingareddy 2007]. Hence, the exclusion of commodities that distinctly contributed a significant share in futures volumes for a considerable time led to the omission of important information.

On the whole, it was evident from the results of the committee’s report and a number of recent studies that the volatilities in prices have increased with a spurt in futures volumes. A unidirectional i ncrease in price was also witnessed in the conditions of scarce supply and small size of the market or deliverable supplies.

there should be a fair consonance between The committee, since it unanimously con-improvements in physical trade and the cluded that there was no clear evidence on pace of growth of futures markets. an adverse impact of futures on spot, has recommended measures to reduce Improving Farmers’ Parti cipation: The p otential risks and to improve farmers’ committee has recom mended a number of participation. Nonetheless, there was noth-measures for impro ving farmers’ particiing new in the measures and most of them pation in futures markets, directly and had been suggested in earlier reports. indirectly, through the development of

more suitable derivative products, a well-For Minimising Potential Risks: The organised price dissemination system. committee has recommended some spe-Though the recommendations were highcific measures for minimising potential ly appreciable, participation of farmers risks, through upgrading the quality of in futures, parti cularly in direct trading, regulation by both the Forward Markets appears to be wishful thinking under the Commission (FMC) and exchanges, with present circumstances in view of not only an emphasis

Figure 1: Spot Prices and Volumes of Urad

on designing of Prices Rs/Q

Volumes Rs lakh contracts that 4500

351000

encourage the

301000 4000 Spot price

participation of

251000 3500

hedgers. Par

201000 3000

ticular emphasis

151000 2500 Volume

needs to be put

101000 2000

on avoiding the

51000 1500

approval of such

1000 28/7/ 28/9/ 28/11/ 28/1/ 28/3/ 28/5/ 28/7/ 28/9/ 28/11/ 28/1/ 28/3/ 28/5/ 28/7 28/9/ 28/11/ basis risk is likely 2004 2004 2004 2005 2005 2005 2005 2005 2005 2006 2006 2006 2006 2006 2006 Source: NCDEX, CMIE.

contracts where 1000

to exceed spot price risk so that approved futures con-the current state of the functioning of tracts are less subject to the valid criticism f utures markets but also the constraints on made now that some contracts favour only the farmers such as lack of awareness, speculators but not those who wish to small market size, suffi cient capital hedge. The committee has recommended t owards margins and other fees at the the setting up of a consultative group and e xchanges, etc. a high level committee that would help in enhancing domain knowledge and the Other Issues Addressed regulatory system respectively. The committee also addressed trader con-

In this context, it may be appropriate to cerns and speculative activity in certain mention that the contracts need to be de-commodities. signed based on the criteria suggested by the previous committees (sufficiently large Traders’ Concerns: The committee has market size, no substantial government in-also brought to focus the apprehensions of tervention, etc) in order to ensure the effi-trade associations (cartels) existing in ciency of futures trading. Towards this, the various commodities, indicating that their case of abnormal price b ehaviour subject-criticism on futures markets was to take ed to purposive influence on prices due to advantage of the fragmented spot markets small market size was noted in case of prevalent with information asymmetry, urad (Appendix I). Further, the case of which would not be possible when the f utures markets turning inefficient with prices are discovered through the elecsubstantial government intervention was tronic platforms of futures exchanges.

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INSIGHT

Although there may be an element of to help bring efficiency in agriculture mar-other commodities. The pattern is evident exploitative motive in some cases, there keting and increased benefits to all the from Table 3; initially, the share of guar may be genuine cases of concern as well. stakeholders. seed was the highest with more than 50 Because reports indicated that when there per cent, later they shifted to commodities was a steep surge in urad (imported vari-Speculative Activity: The committee has like urad, mentha oil, pepper, jeera, ety) prices in futures during 2005-06, the also acknowledged the presence of high c hillies, etc, following various regulatory exporters in Myanmar had raised the ex-speculative activity in certain commodi-measures implemented. The details port prices taking signals from the futures. ties. “Speculators tend to take position p rovided in Appendix II of the EC report, Similarly, in the case of mentha oil, the where there is more liquidity and volatili-also supported this shifting pattern of volsudden jump in futures prices without a ty. This is the reason for high trading in umes and the consequent fall in volatilicorresponding support from the funda-commodity with low economic size like ties in response to the regulatory actions. mentals have constrained the availability

Table 3: Shifting Pattern of Trade Volumes in Agricultural Commodities

of the mentha oil for exporters at pre-January 05 March 05 July 05 October 05 January 06 March 06 July 06 October 06 January 07 March 07

agreed prices and importers from other Chana 9 4 29 21 25 28 29 24 19 18

countries did not agree to the increased Urad 4 8 4 25 29 32 1 8 4 0 Guarseed 57 42 46 36 16 14 42 31 23 13

prices. As a result, the exporters had either

Menthaoil 0 0 1 1 13 3 5 6 8 3

to lose the export contracts or fulfil the

Tur 0 0 3 4 3 8 0 0 4 0

commitments incurring losses. Moreover,

Ref soy oil 16 31 7 4 3 5 7 6 14 12

it is not the farmer producer of mentha

Soybean 5 5 1 3 2 2 1 1 4 4

leaves who got the benefit but the stockists

Pepper 4 2 1 1 1 1 5 2 14 16

who process the oil and store it, as it can Jeera 0 3 1 0 1 1 4 10 6

be stored for five years or more with minimal loss and maintenance.

Thus, there were some genuine cases of concern, if not all, which the regulatory system needs to address in order to bring those stakeholders of physical markets into the system of futures trade instead of bypassing them. Further, one needs to remember that, historically it was the traders who invented and practised trading in commodity derivative instruments. Historically, all derivative exchanges London Metal Exchange, Chicago Board of Trade, Bombay Oilseeds and Cotton exchange, etc, were initiated by trade associations. Considering this, traders should be more willing to participate in futures markets rather than protesting, provided the prevailing instruments and system are encouraging for them.

An interesting question that comes up in this context is that if the large sections of traders in the largely traded commodities do not participate, while the farmers’ participation is anyway minimal, who is hedging in futures markets? Towards this, the committee has recommended advocacy and strong regulation of the futures market so as to generate confidence among all groups of stakeholders, which can be done by upgrading the regulatory capacity and capabilities of the FMC rather than undermining the very need of trading and depriving the economy of the benefits of these institutions and the instrumentality

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august 23, 2008

Redchillies 0 0 0 1 1 2 2 5 2

Source: FMC, NCDEX, MUX.

gaur seed, mentha oil, chilli, jeera, pepper, etc. Trading interest is generated because of high speculative interest during the bullish phase in such commodities, thereby resulting in high volumes.”

While it is well accepted that the role of the speculator is critical in bringing liquidity to the futures markets, one cannot ignore the adverse impacts of excess speculation witnessed in the domestic as well as international futures markets. Speculators, like in any business, operate with a profit motive by accepting risk. Understandably, they always try to take advantages of opportunities in the form of loopholes in the system and make profits out of it. Hence, excess speculation is the result of inefficiencies in the regulatory system but not the presence of speculators or the futures trading per se. It is the regulatory system that needs to be foolproof.

To this extent, a particular pattern of trade volumes shifting from one commodity to another over the period is presented in Table 3. A spurt in volumes in commodities/contracts of relatively narrow size that can allow purposive influence is generally accompanied by a rise in volatilities. In order to reduce the volatilities, the regulator (FMC) directs exchanges to introduce certain measures such as high margins and position limits. Following this, the trade volumes and volatilities shift to

This apparently suggests that large f utures volumes accrued from a set of speculators who are not interested in the underlying commodity but the liquidity and quick bucks from it and keep on shifting from one to another responding to the regulatory actions (Table 3). To this extent, previous reports indicated that a large chunk of volumes in national exchanges (40 per cent) were contri buted by only a few (about 10) members.

Thus, an efficient regulatory system needs to be put in place for persistent monitoring and moderating speculative activities through stringent and timely actions. In order to make this process easier, at least until markets are stabilised, care should be taken to introduce contracts only in those commodities or products that prove to have a large enough market size as well as deliverable stocks, no substantial government intervention, uniform quality, etc. Following such criteria would enhance the credibility of the exchanges, build confidence among the stakeholders, encourage their participation and lead to strong and stable growth of futures markets.

Disagreements among Members

With the consensus of all the members, the committee concluded that “the committee has been unable to determine any conclusive causal relationship in view of the short time period during which the futures markets have functioned and the complexities that arise because a large number of variables impact spot prices. The committee has, therefore,

3100

2800

2500

2200

Figure A1: Trends in Spot and Futures Prices of Urad

February 2006 January 2006 Spot

Prices Rs/Q

2/1/06 9/1/06 16/1/06 23/1/06 30/1/06 6/2/06 13/2/06 orderly growth and Source: , Tulsi Lingareddy (2006), ‘An Open Letter to the FMC – 3’, TV18 Commoditiescontrol.com Ltd, available at

diversification in

http://www.commoditiescontrol.com/eagritrader/issue_popup.php?cid=&varid=&id=7&opt=ISS&userid=&login=

c oncentrated on the steps necessary to make futures markets accessible to farmers and most of the recommendations relate to this. The committee decided not to express any view on the delisting of commodities done in 2007, since this is not part of its terms of reference.”

However, as noted earlier, there was a difference of opinion among the members of the committee even with regard to the terms of reference. The disagreement among the members was apparently on the issue of delisting and hence, they did not provide any view on that in the summary of the report but presented it in their individual notes.

Chairman Sen has elaborately presented domestic wheat prices (futures and spot) movements in relation with i nternational prices and concluded the following:

– “(T)hough no clear causality can be established, it is evident that the transmission of international price pressures on domestic wheat prices was much lower after wheat futures were delisted”.

– “(T)he main reason why futures exchanges have seen such spectacular growth is because they are serving contracts to meet a demand from speculators that has far outpaced the connection with the physical markets”.

– “In view of the inconclusive findings of this report on whether futures’ trading has fuelled increase or volatility in the prices of agricultural commodities, it is not possible to rule this out entirely.

– “Combining prudence with benefit of doubt, the suspension of futures trading

in the four sensitive commodities should continue and in the case of sugar and edible oils, discussions with processors held on how much hed ging benefits they c urrently derive from futures markets, and a decision taken accordingly”.

He has suggested increasing food grains production in “mission mode” and that the policy on futures trade should f ocus on creating conditions for

other segments of the market for agricultural commodities in a manner that will provide benefits to farmers and ensure more stability in crop prices.

Contrary to this, Sharad Joshi, quoting some of the findings of the report, concluded the following:

– “Since the committee came to the c onclusion that there was no evidence linking the functioning of the futures market per se with inflation, it did not need to study methods of mitigating the inflationary effects. Strictly going by the terms of refe rence, all that the committee had the mandate to do was to make recommendations to the increased association of farmers in the futures market.”

– “On the basis of our analysis of the available Indian data both in terms of the behaviour of agricultural commodity prices pre- and post-futures trading and the direction of causality between futures and spot prices, there is no indication of any unambiguous direction of impact. For some commodities, post-futures price inflation appears to have accelerated while for some it has slowed down.”

– “Similarly, the direction of causality also does not emerge in its clear unambiguous manner. It must also be kept in mind that this behaviour in the spot market is also subject to significant influence of supply factors.”

In line with this, P G Apte and Sidharth Sinha, the other members of the committee, concluded that banning futures trading in agricultural commodities including basic foodgrains is not a desirable policy action.

Thus, there was a divergence of opinion among the committee members, particularly on the delisting of futures contracts in 2007. However, there was a consensus on the issues of existing functional i rregularities in the futures markets.

What Was Not Addressed?

The expert committee report has taken into account a majority of the issues. However, a few important and relevant aspects that missed a mention in the report apart from the selective approach are discussed below.

Trend Post- Volatility Post-Trend Post- Volatility Post

Pre-Futures Futures Pre-Futures Futures Pre-Futures Futures Pre-Futures Futures

Guar seed – – – – – – – – –

Chana/gram 0.22365 -9.2 20.9 10.6 11.3 -9.1 20.8 9.2 9.7

Soy oil 0.17838 21.8 -1.6 14.1 6.1 21.4 -0.9 17 7

Pepper 0.02292 -22.5 8.9 27.4 30.9 -22.3 9 26.1 30.6

Jeera/cumin 0.10288 -5 8.1 12.9 16.1 -5 8.8 17.7 17.7

Urad 0.09619 -7.9 32.9 9 15.7 -7.7 32.7 10.9 18.4

Mentha oil ---------

Chillies 0.18866 -16.4 42.9 15 17.1 -16.3 42.3 15.1 21.5

Soybean/seed 0.44614 12.2 -11.3 15.1 21.5 12.1 -11.4 3.6 4 stock norms. The rise in futures continued up

Rape seed 0.58066 18.3 0.1 12.6 9.4 18.2 0.2 11.5 8.6

Wheat 1.38408 2.3 9.6 5.3 7.3 2.3 9.5 4.9 6.1

Potato 0.25647 28.9 11.7 49.6 47.5 29 11.3 44.8 41.5

Turmeric 0.0765 20.2 -8.2 13.7 8.5 20.2 -8.2 18.5 16.6

Castor seed 0.08572 2.5 -2.2 13.5 12.7 2.4 -1.5 21 14

Sugar 3.61883 1.2 3.2 7.7 7.6 1.3 3 5.9 6

n ear-month (January) contract. While the Guar gum ---------F ebruary 2006 futures prices remained at Gur 0.05979 25.4 -0.6 9.6 11.6 21.6 -0.6 17 12 h igher level, the January 2006 futures Tur/arhar 0.13466 2.8 5.8 9 7.7 2.9 5.8 9.1 10 p rices were settled after losing 4 per cent in

Raw cotton 1.35674 -21.7 5.2 12.9 10.6 -21.4 5.2 9.5 15.9 the last four days of trade. Corresponding to

Rubber 0.1508 10.5 20.1 16 21.1 10.4 19.9 16.5 21

Cardamom 0.02494 -20.3 4.6 11.7 19.5 -20.2 4.7 25.7 29.9

Maize 0.18501 -2.4 9.6 11.4 6.8 -2.3 9.7 10.4 9.2

Raw jute 0.10868 -11.4 10.8 13.4 13.6 -11.3 10.7 17.5 13.9

Rice 2.44907 -0.4 3 3.6 2.5 -0.4 2.9 3.1 2.3