Renowned economist Abhijit Sen, who passed away recently, was known for his passion for ensuring the welfare of farmers by offering remunerative prices. So when he was asked to study the extent of the impact of future trade on agricultural commodity prices as chairman of a committee of experts in 2007, many were unsure of what that the nice teacher would recommend. However, the panel’s verdict was clear: the available evidence provided no conclusive proof of a causal link between futures trading and rising agricultural commodity prices.
Conventional wisdom says that the report should have been enough to prevent any government or regulator from considering another futures ban, which is essentially a promise to buy or sell something at a pre-determined price at a future date. It allows buyers to lock in future supplies at a known rate and sellers to get an idea of their product, thus spreading transactions throughout the year, unlike the spot market.
But India has taken a unique path: derivatives on multiple commodities have been banned/suspended up to 19 times in the past two decades, with some facing multiple suspensions. The latest was the banning of one-year futures on seven agricultural commodities on December 20, 2021.
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In the past, Sebi had banned futures trading in a single commodity, but banning seven commodity futures contracts at once was unprecedented and made no sense except to comply with the populism bearing in mind endless elections.
We are on the verge of a new marketing season or the arrival of the kharif crop in two months. So maybe it’s time to lift the ban once and for all. Commodity market volatility is a global phenomenon that has intensified during the pandemic due to supply chain barriers and geopolitical tensions. Regulators around the world have recognized this disruption and have supported physical market participants by approving tools to hedge their risks.
While no contracts have been suspended in the commodity derivatives market anywhere in the world in the past two decades, Indian markets have faced the exact opposite: the suspension of commodity derivatives raw materials, leaving the value chain uncovered.
A September report from the NCDEX indicates that the suspension of futures contracts in the past has not had the desired impact on price control. At best, there were minor short-term corrections. For example, chana futures was suspended on July 28, 2016, attributing the price rise to futures. But the upward trend of chana continued even after the suspension, and prices soared to Rs 12,000 per quintal from Rs 8,000 per quintal at the time of the suspension.
Similar trends were observed at urad and tur even earlier. Prices fell in the short term, but started to recover later due to strong fundamentals. In addition, other commodities, such as sugar, potato, etc., remained sensitive although they were never traded in futures.
The suspension of the futures market is often justified by speculative activities emanating from trading in the futures market. However, an independent study conducted by Nidhi Aggarwal, Tirtha Chatterjee and Karan Sehgal revealed that there is no relationship between the two. The study found no role of futures trading on price changes, nor any empirical evidence of the impact of the trading suspension on price behavior in the post-suspension period. On the contrary, before the suspension, the futures market had a dominant 64% share in discovering the true price of mustard seed. This role ceased because of the ban.
One of the biggest ironies is that such a ban negatively affects the target group it is meant to protect. For example, price discovery. When a derivatives contract is suspended, it results in the absence of a built-in pan-India price discovery mechanism. When a commodity is traded in the futures market, its price discovery is efficient and the supply-demand relationship automatically settles for a longer period. So suspending contracts is like shooting the messenger.
NCDEX rightly pointed out that frequent bans lose the opportunity to become a price maker. Many countries have developed by fixing the prices of different commodities. A recent addition to this is China which has experienced a major commodity market boom over the past 15 years. It has also become the price benchmark for many commodities such as iron ore, eggs, polymers, etc.
Despite being the largest producer and consumer of many agricultural products, India has failed to fix prices. The absence of robust derivatives trading therefore forces domestic players to refer to prices from international markets such as CBOT, ICE, etc., which impacts domestic price discovery. An example of this is the sugar contract in which market participants should refer to the ICE sugar contract.
The government also encourages agricultural producer organizations (OPF), so that they can use their collective power to obtain better conditions in the market. Many OPAs have started using the exchange platform for the benefit of member farmers.
However, such suspensions can erode farmers’ confidence in the market mechanism and force OPAs and their farmers back into the mercy of intermediaries in physical mandis. In the absence of derivative contracts, it is safe to interpret that there is 100% speculation in the physical market as there is no way available for participants to hedge resulting in a huge amount of risks due to price volatility and resulting trading losses.
A ban on futures trading shows a lack of faith in the mechanisms of the market, while the declared policy of the government has been to let the market play its rightful role in solving various problems in the agricultural sector. An uncertain policy, oscillating between prohibitions and incentives, should give way to functional futures and options on commodities. The earlier, the better.