by Nidhi Aggarwal and Susan Thomas.
Commodity derivatives markets are the unsung song of the Indian reforms that started in the 1990s. The National Agriculture Policy, announced by the government in 2000, advocated the development of futures markets so that consumers and producers of commodities could use these contracts to procure commodities at a more rational price than at the Minimum Support Price (MSP) set by the government, which came with a large cost to the exchequer. This set in place a drive of reforms in these markets, following the reform model that had lead to the development of the Indian equity markets previously.
In 2003, commodity futures contracts started trading on electronic exchanges with a nation-wide reach. Counterparty credit risk, that was a serious problem in the older exchanges, was eliminated using netting by novation at clearing houses similar to their more visible equity derivatives cousins. Total traded volumes of commodities derivatives increased by more than 100 times between 2003 and 2013, with agricultural commodity derivatives increasing by nearly 15 times.
These markets have been subject to a great level of mistrust and criticism, and a slew of negative interventions from policy makers, politicians and other financial sector regulators. From outright banning of contracts to restrictions by RBI, SEBI, IRDA and PFRDA on participation by their respective constituencies in this market, the mistrust from policy makers about the commodity derivatives markets is pervasive. Most of these interventions do not identify a clear market failure that they are attempting to address. The consistent and stated reason for these bans is to reduce high commodity price volatility. This is despite evidence, including some government reports, to the contrary.
In a recent IGIDR working paper, which was created as a part of DEA's D. S. Kolamkar Committee, we examine the commodity markets in India in the two required roles: price discovery and hedging. In this analysis, we use daily futures and spot prices for eight commodity futures markets (six agricultural and two non-agricultural) between 2004-2014. We have two main findings.
We measure price discovery using the Information Share (IS) of futures prices. The IS can be between 0 (no price discovery) and 100 (sole price discovery) percent. An IS of 50 percent or above implies that futures prices dominate price discovery. We find that the IS of the Indian commodities futures prices is greater than 50 percent. This is evidence that futures help price discovery for all these commodities, both agricultural and non-agricultural. The futures market is the venue of more than half the information production of the market process.
It is often claimed, in India, that futures price movements are driven by market manipulation, because prices of these leveraged products can be manipulated with greater ease than spot market prices. If this were the case, futures prices would have a low relation to the actual demand and supply of the underlying commodity. In a persistently manipulated futures market, we would expect that futures prices would be persistently de-linked from the spot and there would be no price discovery in the observed futures prices. Our analysis provides evidence contrary to this outcome.
Another role of a well-functioning derivatives markets is that the derivatives are useful as hedges -- financial contracts that provide protection against price volatility (Sahadevan, 2012). For the same eight commodities under study, we measure hedging effectiveness by comparing price risk faced by two types of individuals who have a financial exposure to the commodity: one who does not have a futures position (unhedged), and the other has a futures position (hedged). We find that there is some reduction in the risk faced by the hedged individuals, but that the amount of risk reduction varies widely the different commodities. For example, a rubber farmer can use futures to reduce 61 percent of price risk of selling rubber in the future. But the sugar farmer can only reduce 8 percent of price risk. The amount of risk reduction is observed to be even lower for the non-agricultural commodities.
With this evidence, the glass is half full on the role of the futures market for price discovery (the futures market is an important venue for information production). But the glass is half empty in that in many cases, the futures contracts are not too useful for hedging.
Price discovery across markets is measured by which price moves first in response to new information and which follows Hasbrouck, 1995. Hedging effectiveness, on the other hand, is the extent of price convergence between the two markets over longer horizons, and depends on how tightly the two markets are tied by arbitrage (Garbade and Silber, 1983). Arbitrageurs ensure that futures market prices are linked to spot market prices through the cost of carrying forward the delivery. The cost of carry, which is also known as the futures basis, typically includes storage costs and capital costs (interest cost for deferred payment on maturity of the futures contract). If hedgers are to get insurance through buying and selling futures, the basis needs to be predictable. Garbade and Silber (1983) say: To the extent that the lower storage and transactions costs and greater homogeneity of the underlying cash commodity encourage arbitrage activities, the linkages between the two markets will be enhanced, thereby improving the risk transfer functions of the futures market. To improve the hedging effectiveness of the futures contracts, we need to make the world safer for arbitrageurs.
Commodity derivatives markets are the unsung song of the Indian reforms that started in the 1990s. The National Agriculture Policy, announced by the government in 2000, advocated the development of futures markets so that consumers and producers of commodities could use these contracts to procure commodities at a more rational price than at the Minimum Support Price (MSP) set by the government, which came with a large cost to the exchequer. This set in place a drive of reforms in these markets, following the reform model that had lead to the development of the Indian equity markets previously.
In 2003, commodity futures contracts started trading on electronic exchanges with a nation-wide reach. Counterparty credit risk, that was a serious problem in the older exchanges, was eliminated using netting by novation at clearing houses similar to their more visible equity derivatives cousins. Total traded volumes of commodities derivatives increased by more than 100 times between 2003 and 2013, with agricultural commodity derivatives increasing by nearly 15 times.
These markets have been subject to a great level of mistrust and criticism, and a slew of negative interventions from policy makers, politicians and other financial sector regulators. From outright banning of contracts to restrictions by RBI, SEBI, IRDA and PFRDA on participation by their respective constituencies in this market, the mistrust from policy makers about the commodity derivatives markets is pervasive. Most of these interventions do not identify a clear market failure that they are attempting to address. The consistent and stated reason for these bans is to reduce high commodity price volatility. This is despite evidence, including some government reports, to the contrary.
In a recent IGIDR working paper, which was created as a part of DEA's D. S. Kolamkar Committee, we examine the commodity markets in India in the two required roles: price discovery and hedging. In this analysis, we use daily futures and spot prices for eight commodity futures markets (six agricultural and two non-agricultural) between 2004-2014. We have two main findings.
Q1: Does the futures market matter in price discovery?
We measure price discovery using the Information Share (IS) of futures prices. The IS can be between 0 (no price discovery) and 100 (sole price discovery) percent. An IS of 50 percent or above implies that futures prices dominate price discovery. We find that the IS of the Indian commodities futures prices is greater than 50 percent. This is evidence that futures help price discovery for all these commodities, both agricultural and non-agricultural. The futures market is the venue of more than half the information production of the market process.
It is often claimed, in India, that futures price movements are driven by market manipulation, because prices of these leveraged products can be manipulated with greater ease than spot market prices. If this were the case, futures prices would have a low relation to the actual demand and supply of the underlying commodity. In a persistently manipulated futures market, we would expect that futures prices would be persistently de-linked from the spot and there would be no price discovery in the observed futures prices. Our analysis provides evidence contrary to this outcome.
Q2: Is the futures market an effective tool for hedging?
Another role of a well-functioning derivatives markets is that the derivatives are useful as hedges -- financial contracts that provide protection against price volatility (Sahadevan, 2012). For the same eight commodities under study, we measure hedging effectiveness by comparing price risk faced by two types of individuals who have a financial exposure to the commodity: one who does not have a futures position (unhedged), and the other has a futures position (hedged). We find that there is some reduction in the risk faced by the hedged individuals, but that the amount of risk reduction varies widely the different commodities. For example, a rubber farmer can use futures to reduce 61 percent of price risk of selling rubber in the future. But the sugar farmer can only reduce 8 percent of price risk. The amount of risk reduction is observed to be even lower for the non-agricultural commodities.
With this evidence, the glass is half full on the role of the futures market for price discovery (the futures market is an important venue for information production). But the glass is half empty in that in many cases, the futures contracts are not too useful for hedging.
What are the bottlenecks?
Price discovery across markets is measured by which price moves first in response to new information and which follows Hasbrouck, 1995. Hedging effectiveness, on the other hand, is the extent of price convergence between the two markets over longer horizons, and depends on how tightly the two markets are tied by arbitrage (Garbade and Silber, 1983). Arbitrageurs ensure that futures market prices are linked to spot market prices through the cost of carrying forward the delivery. The cost of carry, which is also known as the futures basis, typically includes storage costs and capital costs (interest cost for deferred payment on maturity of the futures contract). If hedgers are to get insurance through buying and selling futures, the basis needs to be predictable. Garbade and Silber (1983) say: To the extent that the lower storage and transactions costs and greater homogeneity of the underlying cash commodity encourage arbitrage activities, the linkages between the two markets will be enhanced, thereby improving the risk transfer functions of the futures market. To improve the hedging effectiveness of the futures contracts, we need to make the world safer for arbitrageurs.
In India, several of these factors cited as important for healthy arbitrage activity are missing. These are the bottlenecks that disrupt the ability of arbitrageurs to ensure that the futures and spot market relationship holds over longer horizons. Addressing these bottlenecks will, in turn, improve hedging effectiveness. These bottlenecks fall into three main categories: those relating to the legal and regulatory uncertainty in the market, those relating to settlement of contracts and those related to availability of products.
- Legal and regulatory uncertainty: Among all financial contracts, commodity derivatives have been especially vulnerable to micro-management by the government. These include price and quantity interventions in the underlying spot market, banning of futures contracts and regulatory restrictions on participation. There is interference from the central government (through the Essential Commodities Act and MSP on the underlying commodities), state governments (because agriculture is on the state list) and the other financial sector regulators (who restrict wide participation of institutions and foreign participants and create barriers to development and innovation). These increase the uncertainty about the spot price, derivatives price and the cost of carry in commodities markets.
Since such interventions affect both the quality of prices in the spot and derivatives markets, and the availability of the spot commodity, they hurt both the price discovery function and the hedging effectiveness of the futures. For example, in our analysis, the IS of sugar futures dropped to 10 percent in the 2010-2014 period, aligned with the ban on sugar futures between May 2009 and September 2010. Similarly, after the restrictions on gold imports imposed by the RBI in mid-2013 we see a drop in the information share of gold futures.
When a market is vulnerable to hostile actions by the government, such as arbitrary increases in margin requirements or arbitrary reductions in position limits or arbitrary contract bans, this deters the development of organisational capability in financial firms. Arbitrage requires building systems, processes, and sources of capital. Financial firms are unwilling to invest in building a serious organisational capability in commodities arbitrage as the regulatory risk -- of getting shut down by the government -- is high.
- Settlement problems: Derivatives markets work better when there is certainty of settlement of the underlying, irrespective of whether it is cash settled (Indian equity derivatives) or physically settled (Indian commodity derivatives). Uncertainty of settlement in the form of quantity and quality of commodities delivered at exchange-registered warehouses or about the warehouse receipts issued, create uncertainty in the link between the futures and spot price.
Regulation and governance of warehouses is in the ambit of the Warehousing (Development and Regulation) Act, 2007. The Warehousing Development and Regulation Authority, which this Act established as an independent regulator of warehouses, became operational only in the end of 2010, It is yet to develop a clear regulatory role. Once it starts functioning effectively, delivery related problems in the functioning of commodity derivatives, may get mitigated.
- Problems of product structure: Commodity derivatives today are very similar to their older and more successful equity market cousins in contract terms and form. However, commodities have different characteristics. Unlike equities, commodities have seasonal cycles in prices, are non-standardised with significant regional differences across the country, with varying supply in different years. In order to improve the efficiency of commodity futures for price discovery and risk management, deep insights into the spot market have to find their way into contract design.
For example, contract maturity ought to mimic the seasonality of the underlying crops for agricultural commodity derivatives. Commodities with wide variation in available grades ought to have contracts on multiple categories rather than just a fixed grade each year. Once that is in place, index contracts ought to be constructed that proxy the risk of the single commodity (this is hampered today by the FC(R)A which prohibits index contracts). There may be a case to consider a wider range of number and location of delivery centers depending upon the commodity. Such features require focussed knowledge development about the specifics of each commodity and what will increase the utility of the futures for traders with positions in the underlying spot.
Moving forward
Now that FMC is part of the Department of Economic Affairs, and now that major changes have taken place in the ownership and governance of commodity futures exchanges, the process of building trust in FMC and in commodity futures exchanges can commence. For a series of commodities, particularly agricultural commodities, India is potentially a global player in the field of commodity futures. The emergence of a well regulated commodity futures ecosystem will make possible a new phase in Indian finance in terms of exporting financial services.
This requires a work program at FMC comprising eight elements:
- Foundations of public administration. The foundations are laid by public administration reforms as envisaged in the FSLRC Handbook that is being implemented at all financial regulators. This will reshape the internal working of FMC and its interactions with the economy. There should be a design of a report card about how well FMC is faring, including the concept of the annual report from FSLRC. A quarterly report card can also be constructed of the working of commodity futures market around measurement of liquidity, market efficiency, the information share of commodity future and the hedging effectiveness.
- Improvements in information. FMC should lead the work of improving the statistical system on all issues connected with commodity futures trading. This includes better measurement of spot prices e.g. through polling. FMC should construct, and release, high quality data about the field, which will foster better thinking by financial firms and better analysis of policies.
- Improvements in research. In order to do regulation, a clear scientific understanding is required about the market failures in the field, and the minimum interventions through which those market failures can be addressed. This requires constructing a body of literature on these questions. At present, there is a negligible flow of academic research papers on commodity futures in India. Initiatives need to be undertaken through which there are (say) 12 high quality papers which are produced per year by the research community.
- Market failure 1: Consumer protection. FMC needs to measure and understand the ways in which consumers are being mistreated when they become customers of commodity futures exchanges. This should lead to drafting and enforcing regulations that prevent this.
- Market failure 2: Micro-prudential regulation. FMC needs to establish a scientific foundation for margin rules and position limits through which the failure probability of clearing members goes down.
- Market failure 3: Systemic risk. FMC needs to establish a scientific foundation for margin rules so as to drive down the failure probability of a clearinghouse to near-zero levels. FMC must get away from the methods used for manipulating margins in the past based on opinions of the government on the level of the price or of price volatility.
- Market failure 4: Market abuse. FMC needs systems to detect and enforce against market abuse. There is much value in utilising the notions of market abuse as defined in the draft Indian Financial Code.
- Problems of coordination. FMC needs to work with other financial regulators to remove the barriers which have been placed, that hamper participation in commodity futures exchanges by a broad array of financial firms. This will require trust in FMC and in the commodity futures ecosystem. FMC must also coordinate work on strengthening WDRA, as warehousing is a critical industry that enables the working of commodity futures markets in general and commodity arbitrage in particular. FMC must coordinate work with all agencies in the government that have the power to ban commodity futures trading, and put an end to such practices.
After a better policy regime is put into place, it will take many years for financial firms to come to trust FMC and the commodity futures ecosystem, and then commit resources to develop organisational capabilities in the field. Hence, there is urgency in implementing these changes.
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