Thursday, April 03, 2008

Derivatives in Commodities: Some Issues

The issue over commodities exchanges and trading of futures and options in respect commodities has been brought to the fore with the Left parties deciding not to support the Forward Contracts (Regulation) Amendment Bill.

By way of background, commodities trading can occur in two ways. One is spot trading, where a buyer and seller of commodities enter into a contract, and settle the same by delivery of the commodities and the corresponding payment within a predefined time period (usually up to 11 days). The second is forward trading, where the delivery and/or payment occurs beyond such pre-defined period. Under the Constitution, spot trading is left to States to legislate, while forward trading is within the domain of the Parliament. It is under the latter powers that the Parliament enacted the Forward Contracts (Regulation) Act, 1952 (FCRA) that governs forward trading in commodities. Under the FCRA, while forward trading was permitted in some commodities and restricted in others, options were prohibited. To explain an option, it is a contract under which one party has the option or right (but not the obligation) to buy or to sell a commodity at a predetermined price. The administrative authority under the FCRA was the Forward Markets Commission (FMC), which was a government body.

With the development of the commodities futures markets over the last few years, the Government proposed an overhaul of the FCRA to take these recent developments into account. The principal changes relate to the allowance of options in commodities (that were earlier prohibited), the reestablishment of the FMC as an independent regulator (on similar lines as SEBI) rather than as an arm of the Government itself, and the organisation of commodities exchanges (to enable commodities futures trading) on corporate lines similar to stock exchanges. While these issues were part of the Forward Contracts (Regulation) Bill, 2006 that was pending in Parliament, the Government accelerated the reform process by ensuring the promulgation of the Forward Contracts (Regulation) Ordinance, 2008. The key features of the Ordinance are set out in a press release issued by the Government.

While there could be some questions as to the way in which the Government secured the changes through an Ordinance just two weeks before the Parliament commenced its session, there is little doubt that these changes were long overdue. Like the stock markets in India, the commodities markets too have been developing in a structured fashion over the last few years. Two large electronic exchanges in the form of the Multi Commodity Exchange of India Limited (MCX) and the National Commodities and Derivatives Exchange Limited (NCDEX) have been established and they now handle a significant portion of futures trading that occurs in commodities in India.

Economically, futures trading provides several benefits; it creates liquidity in the markets, enables price discovery by signaling the best price to the rest of the market participants, and most importantly, it provides traders with an avenue to hedge their risks. But, we must bear in mind that derivatives (such as futures and options) are complex instruments and hence are inherently risky. They are largely based on movements in commodity prices, and wrong bets on market movement can prove to be very costly, sometimes even to sophisticated players.

The Left has largely attacked the Ordinance by attributing the recent surge in commodity prices to extensive futures trading. However, that seems somewhat misdirected, as there is no correlation established between futures trading and increase in prices. Price increases could possibly arise due to myriad other factors.

I find that an important aspect that the Ordinance has failed to tackle is the issue of complexity of derivatives. It is not sufficient if the law merely provides a platform for derivatives trading in commodities. There needs to be a proper mechanism for disclosure, which requires persons that are selling futures and options in commodities to disclose all details (the risks in particular) relating to these products in a manner that the buyers of such products are able to appreciate the risks involved before they decide whether to participate in that market or not. In relation to derivatives in the stock market, the detailed rules issued by SEBI largely serve that purpose. It is also to be noted that the commodities futures market is likely to be patronised primarily by traders (some of them who may be of medium to small-scale) who may not possess sufficient sophistication to comprehend the risks involved in such complex instruments. The experience with derivatives in the financial markets (where the level of sophistication is somewhat higher) has not been good either, what with several companies now filing suits against banks (with whom they entered into derivative transactions) to renege on their commitments, including on the grounds that they did not fully understand what they were entering into. For details, see here and here on the Indian Corporate Law Blog). Therefore, a proper disclosure regime is called for in commodities trading so as to ensure informed trading in commodities derivatives, and thereby a transparent market.

The Left has also opposed foreign direct investment (FDI) in commodities exchanges. Although the press reports (referring to the Left objections) indicate that the FDI has been permitted under the Ordinance, it is not the accurate position. FDI is governed by various policies issued by the Department of Industrial Policy and Promotion (and not the Ordinance). The Press Note 2 of 2008 allows foreign investment of 49% in commodities exchanges (with 26% FDI and 23% FII investment) with the prior approval of the Government. Further, no foreign investor/entity, including persons acting in concert, will hold more than 5% equity in such companies. This appears to me to be a balanced approach towards foreign investment. While it allows major world players in this industry to participate in the Indian market and thereby introduce their expertise and business practices, it guards domestic interests as well. It is fairly restrictive as (i) investment is possible only with prior Government approval, (ii) majority shareholding still remains with domestic owners; and (iii) there is no risk of dominance by a single foreign player (or group) on an exchange as individual investments are capped at 5%.

It is likely that these issues will be the subject of heated debate in the near future, especially as the Bill comes up for discussion in Parliament.


V.Venkatesan said...

Dear Umakanth,
Thanks for explaining the issue. The main concern of the Left seems to be that the Bill/Ordinance permits futures/forward trading (are they one and the same?) in 24 essential commodities identified by the Commission for Agricultural Costs and Prices. Evem the Parliamentary Standing Committee (whose report is available in the PRS website), has separately demanded ban on futures trade in 25 commodities. Govt. has so far removed pulses, rice and wheat from the forwards market. The Left says that all essential items including edible oil, must be prohibited from speculative trading. You also seem to admit that there are significant risks involved. Can you explain whether this concern is justified?

Umakanth V said...

Mr. Venkatesan, thank you for your comments. In a general sense, futures and forwards are interchangeable terms, wherein there is a contract between two parties to buy and sell at a future date based on a predetermined price. In forwards, the contract is usually settled by delivery of goods, while in case of futures it may also be possible to settle the contract by payment of differences (between the strike price of the contract and the market price on the future date at which the contract is settled).

Under the FCRA, 1952, forwards can be restricted in certain commodities as determined by the Central Government. Using this power, the Government from time to time makes available commodities for trading in the forward markets. Although the Government, at one point, had made all commodities (including essential ones) available for forward trading, restrictions were imposed in August and September 2006 on wheat and pulses (as you have mentioned) to control rising prices and prevent hoarding. This power of the Government to include and exclude commodities from the list continues even after the amendment of FCRA by the Ordinance. Hence, what the Left seems to be challenging has more to do with the exercise of the power by the Central Government under the FCRA (as amended by the Ordinance) rather than the amendment itself, because the amendment only extends the available derivative transactions by including options in addition to forwards.

As to whether all essential items need to be included in the negative list (as the Left has sought), that is a factual matter to be determined based on available data. At a conceptual level, derivatives in commodities are healthy if they are used genuinely for hedging and price discovery purposes. But, if these markets are being driven by speculators who have no underlying interest in commodity prices thereby causing market frenzy, then there may be a genuine case to impose some curbs on forward trading in essential commodities. So, it largely depends on whether there is a correlation between speculative activity and the price surge.