What role is played by the commodity futures in India?

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.

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.

1. 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.
   
2. 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.
   
3. 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:

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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.
8. 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.

Rebooting commodity futures

Once the subject of commodity futures moved into DEA, there was an opportunity to start afresh on all policy questions in this field. The first step towards that is a DEA committee report which got released today. This forms the intellectual framework through which regulation-making at FMC can be redone as is required for the implementation of the Handbook.

Food inflation: macro and micro perspectives

On 25 February, we have a one-day meeting on this subject. All are welcome.

Implications of bringing commodity futures into the Ministry of Finance

Essentially everywhere in the world, we see unification of trading in all kinds of products -- spot or derivatives, equities or currencies or fixed income or commodities etc., OTC or exchange. It makes too much sense to reap economies of scale and economies of scope, both in the private sector and in the work of regulation and supervision. The arrangement in India, where the Forward Contracts Regulation Act (1952) envisages the Forward Markets Commission that is a part of the Department of Consumer Affairs, is a silly one.

Everything we have learned about how to run the equity market is valuable for commodity futures:

• The regulatory governance process at SEBI including authority to issue regulations, enforcement process, appeals at SAT, etc.
• Governance problems of Infrastructure Institutions with three-way separation between shareholders, managers and trading members.
• Netting by novation at the clearing corporation.
• Not having `badla' trading.

It is likely that the Ministry of Finance would not give an exemption to any exchange from regulation. A lot of what we saw in this field in the last decade would not have arisen if commodity futures had been placed with SEBI and MoF. But then, we have had dubious finance ministers and one should not be too confident. The price of sound governance is eternal vigilance.

Merging FMC into SEBI began as controversial ideas:

• One markets regulator or three? in the Business Standard, 1997.
• An interview in the Financial Express, 1998.
• Rethink financial intermediation in the Business Standard, 1998.

Then it turned into a government committee process:

• On 14 May 2003, a committee was setup headed by Wajahat Habibullah, who was secretary of the Department of Consumer Affairs. Key persons who shaped this work were S. Narayan, who was Secretary at the Department of Economic Affairs, and Ashok Lahiri, who was Chief Economic Advisor.
• Percy Mistry's committee said: Redraft the legal foundations for organised financial trading, so as to unify all organised financial trading under SEBI regulation. This would include currencies, equities, sovereign and corporate bonds, and commodity derivatives.
• Raghuram Rajan's report said: all organized financial trading, spanning currencies, fixed income, equities, commodity futures, exotics (such as weather and decision markets), and spanning all trading venues and forms of trading should come under a single regulator, the SEBI.
• The draft Indian Financial Code has a general and sector neutral treatment of financial regulation where all organised financial trading is the work of the Unified Financial Authority.

In 2003 and 2004, we were well on our way on getting this done. However, once the UPA government came to power in May 2004, and Sharad Pawar became the minister in charge of Consumer Affairs, it became infeasible to shrink his turf. By that time, substantial commercial interests had developed which wanted to preserve the existing arrangement, with regulatory capture of FMC.

More generally, one of the most harmful instincts of bureaucrats and citizens in India is the notion that the boundaries of government agencies are somehow sacred. There is much resistance to changing the role and function of a government agency. But every employee of government exists to serve the people of India, and we need to continually change the block diagram of government so as to best cater to the fast changing requirements of the economy.

Now we have a crisis on our hands, and policy makers have resurrected the project. While there is a news item, the details are not yet visible. The first step would be a small change in the allocation of business rules, through which the subject of commodity futures trading would shift from the Department of Consumer Affairs to the Ministry of Finance. The big step would be to repeal the FC(R)A and modify securities law appropriately; until this is done, the gains would be limited. The draft Indian Financial Code is a natural source of ideas on how this drafting should be done.

In the short term, the FMC would become a part of the Ministry of Finance. Important decisions at FMC would go up to the Ministry of Finance and ultimately the Minister of Finance for approval. The knowledge on organised financial trading at the Ministry of Finance will give us improved decisions under the existing law. We may expect considerable porting of regulations and public administration practice from SEBI into FMC.

This seems to be a season for old policy projects working out. First the Pensions Act, and now this. Nothing like adversity to make India deliver.

The changes in taxation of transactions in futures on equity and commodity underlyings

Taxation of transactions in India began with the equity market in 2004. Prior to 2008, the securities transaction tax (STT) was allowed as a rebate against tax liability against Section 88E of the Income Tax Act. This treatment was withdrawn by the 2008 Budget announcement. After that, STT became a substantial influence on the equity market. In understanding the consequences of the STT, there is an absolute perspective and there is a relative perspective.

In absolute terms, suppose you embark on a spot-futures arbitrage and do an early unwind. In this, you buy shares (pay 10), sell futures (1.7) and then reverse yourself (10). Your tax burden is 21.7 basis points. This is a lot of money when compared with the typical bid-offer spread of the Nifty futures which is around 0.5 basis points. The dominant cost faced in doing spot-futures arbitrage is taxation.

In relative terms, there are two issues. The first is an intra-India comparison between equities and commodities. When activity on the equity market was taxed, eyeballs and capital moved to commodities trading. Commodity futures trading has grown by 3.5 times after 2008, while equities activity has stagnated. Most policy makers think this was an undesirable effect, particularly given the fact that India can free ride on global price discovery for non-agricultural commodities but must foster liquid markets in its own equities.

And then, there is an international dimension. When the activities of non-residents in India are taxed in any fashion, they favour taking their custom to places like Singapore, which practice `residence-based taxation' where the tax base comprises the activities of residents only. We got a sharp shift in equities activity towards locations outside India.

Putting these absolute and relative perspectives together, from 2008 onwards, equity market liquidity has fared badly. This yields an elevated cost of equity capital.

The budget speech has done two things. First, it has dropped the STT rate on futures on equity underlyings from 1.7 basis points to 1 basis points. This is helpful for certain kinds of trading strategies but not for others (e.g. the spot-futures arbitrage described above will gain little). HF strategies that do not involve the spot market will particularly benefit - e.g. imagine an options market maker who does delta neutral hedging on the futures market. Second, it has introduced taxation for non-agricultural commodity futures on an identical basis to the equity futures (i.e. at 1 basis points).

This will have the following interesting implications:

1. Capital and labour in securities firms will be less inclined to be in non-agricultural commodity futures. It will tend to move towards agricultural commodity futures, currency futures and equity futures.
2. The comparison between offshore venues and the onshore market will move in favour of the onshore market for certain kinds of trading strategies.
3. The bias in favour of equity options will reduce; some business will move to equity futures.
4. The pricing efficiency of futures will go up.

In this environment, there seems to be a fair arrangement between the equity futures and commodity futures. Conditions seem to be unfair with the equity spot (too high), equity options (too low) and currency derivatives (too low). The next moves on this may appear in July 2014 when the new government unveils its next budget.

One more announcement of the budget speech concerns currency futures: it was stated that FII activity on currency futures will commence. This will also give more activity on currency futures; we now have two reasons for expecting more activity on currency futures (the taxation of commodity futures and the entry of FII order flow). However, the shifting of FII order flow will be a slow process, and a lot of time will be lost on their due diligence of the exchange, safety of the clearinghouse, and so on. While, in the long run, removing capital controls against FII order flow in India is a good thing, it is not an effect that will kick in quickly. Apart from this, most of the action will take place fairly quickly, in early April.

Future finance ministers will need to navigate the difficult landscape of gradually scaling down taxation of transactions while retaining low taxation of capital gains (which has unfortunately come to be seen as a linked issue in the Indian discourse). Along this path, the first priority should be to remove distortions. Our first priority should be to achieve a low rate, a wide base, and the minimal distortions. Reduced rates will always yield welfare gains. The Budget 2013 announcement makes progress on two things (reduction from 1.7 to 1, and reduced distortions between equities and non-agricultural commodities). There is much more waiting to be done: integrating currencies and fixed income, bringing sense to options, and getting away from the very high rates on the equity spot market.

The two escape routes away from domestic formal-sector finance

Three problems afflict formal-sector finance in India today: capital controls, taxation, and financial policy. The most important financial products traded in the formal sector in India -- the stock market index (Nifty) and the exchange rate (the rupee) -- are under enormous pressure as a consequence.

One dimension, that has been emphasised in the existing discussions, is the flight to offshore markets. There is another: the trade goes off into underground markets. These come in two kinds. In the field of commodity futures, it appears that important price discovery and liquidity is found on unregulated markets. As an example, in Gujarat, the town of Bhabhar is famous for having a huge oilseeds and edible oil futures market. Babhar is a true market: it has liquidity and discovers the price.

A second mechanism is a class of market mechanisms which leech off the price discovery of a main market, do not really offer liquidity of their own, and let people achieve trades. In Indian parlance, these are called the `dabba market'. Here is how it works:

1. The main market where Nifty trades is NSE. But if a customer goes there, he has to suffer the full burden of the securities transaction tax, the charge by the NSE member firm, etc.
2. The dabba operator (`DO') sets himself up in business offering trading services in Nifty futures.
3. Many individuals place buy/sell trades with him. These are meticulously tracked; their profits and losses are calculated and money is exchanged w.r.t. each customer.
4. Through this, the DO is effectively accepting orders -- like an exchange -- and doing daily mark-to-market w.r.t. the customers.
5. On average, the sum total of trades by many customers adds up to zero. So the net exposure of the DO is roughly 0. If an exposure builds up, he might choose to lay off his risk on NSE.
6. The DO charges much less than the NSE member since he does not pay STT and his establishment costs are lower.
7. He is a big man in the community. He can break your bones. So you will not default on him. So he charges less margin. This is another attraction - but it means that some fraction of customers endup entangling with the underworld.
8. The DO will work with black money (i.e. cash). This is another attraction, compared with the all-cheques-and-PAN-numbers world of NSE. The short-term capital gains tax (or worse, ordinary business income treatment of winnings) is then avoided.

Bhavesh Shah, reporting from Ahmedabad in DNA, tells us that dabba trading has gotten bigger of late. He also points out that the DOs have been doing some system-building to make their business more efficient. Dabba trading is one response of economic agents to the problems of taxation and improper financial policy. It also happens to a varying degree with trading in India of international underlyings (e.g. crude oil or gold), where capital controls prevent locals from accessing the world market.

In summary, when India makes mistakes on three things -- capital controls, taxation and financial policy -- there are two kinds of responses on the part of onshore and offshore users of India-related financial markets. On one hand, users go off to overseas venues. On the other hand, users shift towards informality. In the limit, large scale mistakes on the three fronts will drive the bulk of customers away from the formal sector onshore market venues. RBI, the tax authorities and SEBI will then lord over an insignificant part of the market.

The first decision of UPA-II

Not a good start.

FMC vs. NCDEX, continued

Mobis Philipose has a good piece in Mint on FMC's order on NCDEX [background].

NCDEX vs. FMC

I wrote a piece in Financial Express titled Law and regulation shape the character of the regulated industry drawing on the recent court case filed by NCDEX against the Forward Markets Commission.

In the article, I describe this case in the context of the unique regulatory problems of for-profit exchanges [link, link]. I locate this discussion in the deeper problems of how weak legal and regulatory structures give out incentives for the wrong kinds of skills to succeed. While NCDEX/FMC/MCX is a live example of this problem, these issues are surfacing in many other areas such as telecom, electricity, etc, where malfunctioning government structures distort markets.

Fear of derivatives

See Tim Harford writing in the FT on speculators. And, the Financial Times has a very interesting story by Javier Blas and Joanna Chung on the recent backlash against commodity futures trading. I found fascinating new facts within it which I had not previously known, about the history of the fears about derivatives on the part of politicians, including facts about the ban on onion futures in the US in 1959 and the ban on wheat futures in Berlin in 1897. Within the article is this priceless story:

In 2002, when the US Congress was debating whether to close the "Enron Loophole" that is, to require that over-the-counter energy markets be brought under the full oversight of the US futures regulator Republican Trent Lott rose to his feet in the Senate chamber.

Brandishing a dictionary, the senator looked up a definition of "a derivative", a term referring to the complex futures contracts used in the energy markets to hedge the risks associated with holding physical supplies of commodities such as oil and natural gas. The dictionary told him that it was "the limit of the ratio of the change in a function to the corresponding change in its independent variable as the latter change approaches zero".

Mr Lott turned to his colleagues with a warning: "We don't know what we are doing here. I have serious doubts how many senators really understand [this] and it sounds pretty complicated to me."

I think recent events underline the importance of the appointments process. Faced with the complexity of the modern economy and particularly modern financial markets, you need people like Paulson, Bernanke in key positions of influence. The staffing challenge is particularly acute in emerging markets where we get a vicious cycle: financial markets are repressed, which impedes knowledge and experience about finance, which impedes human capital development, owing to which people more like Mr. Lott often endup running the show.

The impact of recent government measures on the edible oil industry

by Malay Makkar.

Recent events

India is one of the world's largest importers of edible oil. Soybean and palm oil account for a major share of Indian imports. India's oil consumption is roughly about 120 lakh metric tonnes (MT) of which about 70 lakh MT is imported. Of the oils imported by India, Soyabean and palm form the primary constituents, since these are produced in sufficient quantities to be exported by the US and Malaysia and hence, are relatively cheaper. Futures contracts on NCDEX and MCX had daily turnover of roughly Rs.400 crore a day and Rs.100 crore a day, respectively.

In early May 2008, soyabean oil prices were 30% higher than the level of the previous year. The government believes that futures trading has helped induce this price rise. Hence, on 7 May 2008, futures trading was suspended for soyabean oil for four months (along with this, futures on potato, chana and rubber were also banned). All existing futures contracts were liquidated at the closing price as on that date on the respective exchanges. Owing to fears that such a move was imminent, the open interest on NCDEX, MCX and NBOT in soyabean oil had already halved to 0.15 million MT. For a comparison, monthly consumption is roughly a million MT.

Using powers under the Essential Commodities Act, 1955, various state governments have imposed stock limits on the edible oil traders in their states. On 10 May, the UP government imposed an inventory ceiling of 25 MT for any trader of edible oil. Large traders who normally carried stock in excess of 250 MT are now forced to live within a tiny limit of 25 MT. Similar stock limits were also imposed by the Maharashtra Government the same week. The central government has also advised state governments to strengthen their enforcement machinery to act against `hoarding' edible oil.

How much risk does an oil importer carry?

The task of importing Soyabean and palm oil exposes the edible oil trade to fluctuations in prices occurring internationally. A fall in price of the commodity has a severe impact, since it leads to losses and lower valuations of even the existing inventory. Oil refiners in India quote a daily selling price for the oils based on the international trends. The benchmark exchanges for trade in these two oils are the Chicago Board of Trade for soya oil and the Malaysian Derivatives Exchange for palm oil. In order to derisk or hedge their future risks, importers short-sell futures contracts. Selling futures helps in assuring a constant return to the importer and removes the uncertainty that he might have faced without a similar contract.

A standard oil tanker usually ferries 30,000 MT of oil. For one such shipment, the value at risk for the importer is large. From January 2008 onwards, the standard deviation of change in daily prices of soy oil has been $44.2 per tonne of oil. In other words an importers shipment could vary in value everyday by about $1.33 million dollars a day. No importer is willing to take that big a risk; since the return on investments (if the company is lucky) is only about 1% (around $0.36 million). Thus it becomes essential for any businessman who imports edible oil to be able to lock in his future selling prices and hence assure himself of the returns. But by banning the futures products, the government has taken away this risk mitigation tool from importers. Bereft of hedging using futures, importers impose bigger markups upon the local economy, thus exacerbating inflation.

Impact of the ban

In absence of an avenue for price discovery, the entire trade channel consisting of distributors, wholesalers and retailers has lost a price signaling method. They are unable to observe market estimates of future prices. Due to this confusion, there is less long-term planning (through forward contracts) and there is more short-term cash trading. This in turn poses new problems for the business. Firstly, it increases the possibilities of stock outs occurring and forces the suppliers to frequently replenish the shelves of the retailers. Secondly, the oil refining companies are losing out since higher stocks have to be maintained in their own godowns for frequent replenishment requirements of the retailers and lesser stocks can be pushed down the supply chain. Additionally, increased transportation costs associated with repetitive distribution of small quantities of goods is expensive for the companies and reduces energy efficiency of the economy.

There are indirect effects also. Higher uncertainty has made firms involved in this trade more risky and reduced their access to borrowing. Firms are using their own capital for holding inventories which is adversely affecting new investment.

The importers are now forced to hedge their risks on foreign exchanges like Chicago and Malaysian derivatives exchanges. While this should work well in theory, in practice, there are many impediments against doing this correctly and fully owing to the system of capital controls that India has against use of offshore derivatives markets.

Indian finance professionals stand to lose since companies are reluctant to hire new traders and maintain on their rolls, since the ban has been imposed. This adversely affects the building-up of derivatives competence in India.

Due to lack of a pan India benchmark price, inter-regional arbitrage opportunities have appeared. The prices in spot markets have jumped and traders are making a killing by exploiting these informational asymmetries. Moreover, small time traders who cannot be out of business for a long time will now resort to forwards contracts (the `number 2' market that survives even though futures trading has been banned) and hence the risks in the whole system will be magnified as counter party risks will also appear. Finally, the prices will now align themselves completely to international markets. When our local crops are harvested price discovery will be difficult as the price discovery mechanism will take its signals from international exchanges.

Impact of imposition of stock limits

A short term effect will be that people will be forced to reduce their existing inventories of oil. This will please the policy makers who think hoarding is bad. But holding large inventories is essential to a well functioning trade. With lower stocks the overall business will go down and shortages will appear in a few months. Lower business volumes also imply loss in income for all the people involved in the process - the refiners, brokers, distributors (and lower tax revenues for the government). In order to circumvent the state wise stock limits oil companies will be forced to open oil depots in states which do not have stock limits. And then oil will be routed to other states through them.

Another way to circumvent the system is by opening a large number of firms by the same individual. For example a distributor earlier maintaining stocks of about 250 Tons on any given day will now open 10 firms in his name thereby fulfilling the condition of 25 Tons per firms stock limit also but maintaining his usual oil stock also. All this will simply lead to more corruption in the system; it constitutes a bias in favour of less ethical companies.

Government import of edible oils

The government has floated tenders for import of oil about 12 lakh MT of oil in the coming 12 months. By this action, the government, in one step, has replaced the private sector and emerged as the single largest importer of oil into India. This is inconsistent with the efforts in other industries in India, where the government has retreated from business into the core tasks of public goods. The decision of the government to move into this business reduces the incentives of firms to invest and build businesses.

Moreover, the imported oil will be available only to poor people through the public distribution channel but the remaining market (read the middle class) has to deal with the troubled private trade. Companies who were selling to poor people would lose market share.

It is possible that in order to lower the oil prices, the government may also release this imported oil in the markets by floating tenders in the Indian markets. In absence of clarity about the government's future policies, importers will remain unwilling to import oil. This could lead to acute difficulties in coming months.

Understanding food prices

I wrote an article in Business Standard titled Understanding food prices.

Measurement of LIBOR

The problem

In recent months, concerns have been expressed about LIBOR. Jayanth Varma's blog post on the subject reports on these issues. On 16 April, the British Bankers Association (BBA) announced that banks giving bad quotations will be banned from participation in the calculation of LIBOR. Immediately after that, LIBOR rose by 18 basis points.

BBA is believed to be reviewing the LIBOR methodology and is expected to come out with a report later this month. ICAP is believed to be launching a New York Funding Rate, as a response to the difficulties of LIBOR.

The statistical methodology that is employed for LIBOR could be a source of trouble.

Suppose there are N observations. There are two polar extremes in obtaining a location estimator: to compute the sample mean and to compute the sample median. The mean is statistically efficient, but vulnerable to outliers. The median is robust, but statistically inefficient.

For the longest time, LIBOR has used the strategy of deleting the two most extreme observations. Think of this as being mostly like the mean, with some safety thrown in. (Recall that if you deleted N/2 extreme observations, you'd be at the median).

This method has doubtless worked well for a long time. But the tradeoffs that determine how many observations should be deleted are not static. They depend on market conditions.

In an illiquid and volatile market, the dispersion of quotes is high and everyone is uncertain about what the true price is. (For an example: think of a typical illiquid product in India). For years and years, the strategy of deleting 2 for LIBOR worked well - under normal market conditions. That same strategy is unlikely to be optimal under stressed market conditions. The mistrust of LIBOR under stressed market conditions, that I am seeing out there, sounds a lot like the mistrust that I have seen with such polling-based reference rates in illiquid and volatile markets in India.

One element of a solution

Roughly a decade ago, J. Cita and D. Lien proposed that instead of fixed trimming procedures, `adaptive' trimming could be done. In a nutshell, their idea was: Use bootstrap inference to know the standard deviation of the estimated location estimator for a few alternative trimming schemes. Then pick the `best' trimming by examining these standard deviations.

The neat thing about this scheme is that when the market is liquid and tranquil, trimming can go down, but more trimming will kick in when market conditions change.

This strategy has been used in India for NSE's `MIBOR' reference rate, and for the commodity spot prices polled by CMIE for NCDEX. All these markets are much more troublesome than the situation faced for LIBOR for a long time - but perhaps more like the situation seen with LIBOR under stressed markets.

At this page is (a) a paper, (b) a frequently asked questions and (c) full R source code.

Gyntelberg & Woolridge, 2008

Jayanth Varma points to the paper Interbank rate fixings during the recent turmoil by Jacob Gyntelberg and Philip Woolridge of BIS. In it, they say:

To test the robustness of trimming procedures, we re-estimated the mean of the US dollar, euro and yen Libor panels using a bootstrap technique. This technique minimises the influence of non-random observations and outliers on the mean without disregarding any quotes (Efron and Tibshirani (1994)). The bootstrapped mean is not significantly different from Libor for any of the panels considered.

This I do not understand. We use bootstrap inference to compute the distribution of an estimator of interest (e.g. a mean, a median, a fixed trimmed mean, or an adaptive trimmed mean). Bootstrapping is not an alternative strategy for constructing estimators.

Gyntelberg & Woolridge feel that estimation procedures are not an important issue, and they may well be right. Estimation procedures may well not be of importance in the recent criticisms of LIBOR. However, the above text makes me feel the adaptive trimmed mean was probably not evaluated. If all they have done is bootstrap inference of the fixed-trim-by-2 procedure, that is not the core issue. The core issue is to question trimming by 2 as a fixed rule that is appropriate for all kinds of market environments.

As argued above, a fixed-trim-by-2 procedure that works well for many years of tranquil times might not be such a good engineering approximation in the unique market stress which was observed lately. It's an empirical question, and one that would be settled by applying the adaptive trimmed mean to the BBA database in recent times.

A small correction for them: On page 62, in the table showing reference rates in various countries, the Indian Mibor is not just a `trimmed mean', it is an `adaptive trimmed mean'.

Larger links to physical settlement and cash settlement

This discussion is linked to the efforts that product designers make in choosing cash settled vs. physically settled derivatives. Some documents written by government agencies in India say fanciful things about cash settlement. They reflect a lack of knowledge of derivatives. The correct arguments are as follows.

Whenever good quality measurement of a reference rate is possible, cash settlement is always superior. A small reason for this is that settlement of money is cheaper than settlement of the underlying. The deeper reason is that physical settlement is much more vulnerable to short squeezes, so position limits for physically settled contracts tend to be lower there, which imposes a cost on society of a missing market when the position limits are reached.

When the underlying is traded on an electronic exchange, there is no difficulty in obtaining a top quality reference rate, for the best buy and best sell prices in the entire market are visible off the limit order book. But when the underlying is an OTC market, you are down to polling in making a reference rate. For these underlyings, it boils down to the question : How bad is the problem of a short squeeze and a small cap on the open interest? versus How bad is the problem of measurement of the spot price? In most Indian settings, I have felt that it's cheaper to put time and money into improving measurement on the spot market, rather than running afoul of a short squeeze or reducing the limits on open positions sharply.

What happened to global food prices?

Before we get to the arguments, here's a picture with the key facts from Martin Wolf's recent FT column on the subject:

Explanations that don't persuade

Hypothesis: The spike in world food prices is caused by increased demand in China and India, particularly the shift towards consumption of meat as people get richer. My problem with this explanation is that it doesn't explain why the price index for major food crops was stable at 100 from 1990 till 2005, and spiked thereafter. China and India had a massive transformation of incomes and the structure of the food basket from 1990 to 2005.

Hypothesis: It's the evil speculators. Speculators who anticipated higher prices would have held more inventory. But the graph shows that inventories have dropped from 2000 onwards. There was less hoarding, not more. [Ken Rogoff]

The bulk of trading on futures markets is speculative: but for every buyer on a futures market there's an equal and opposite seller (by definition). A bigger futures open interest has no net effect on prices.

More generally, futures markets have been around for over a century and grown steadily over the 1990-2008 period: it's hard to blame them for the spike in prices starting in 2005.

Yes, there's a new phenomenon of commodity funds and hedge funds trading in commodities. But these numbers are just tiny when compared with the global agricultural trade. And if they had held a lot of inventory, it would have shown up in the inventory series above - but total global inventories went down and not up.

Hypothesis: As the world gets richer, price volatility of non-storable agricultural products gets bigger

Here's one phenomenon which could play a role in deciphering what happened. Suppose, for a moment, that a commodity is not storable. And, we know that given the lags between sowing and harvest, in the short term, a price innovation can induce no supply response. When an imbalance between supply and demand arises, prices move to clear the imbalance. How far do prices have to move? Prices have to move as much as is needed for demand to get crimped, so as to equalise supply and demand.

Now consider a product such as wheat. When there is an upward shock to the price of wheat, rich people just do not reduce their consumption. A naan or a baguette that weighs 0.1 kg has an embedded cost of wheat of USD 0.04 or Rs.1.6 (assuming wheat is at $400/MT). When an affluent person buys or makes a baguette or a naan, a very large change in the price of wheat generates no change in consumption. A 50% change in the price of wheat sounds like a lot: but it drives up the embedded wheat cost in the baguette/naan by USD 0.02 or Rs.0.8 - this would be insignificant for affluent people. Their demand is inelastic.

When demand is bigger than supply for a nonstorable commodity with zero short-term supply elasticity, prices would rise as much as is needed to close the gap. Demand can only shrink when some people get pinched and ease up on consumption. These are the poor. Poor people are the shock absorber that stabilise prices for non-storable agricultural commodities.

When potato prices went up in an Irish famine, poor people consumed more not less, because the income effect dominated. Could that happen with poor people and wheat? It is useful to think of three levels of affluence:

• The first would akin to 19th century Ireland, with poor people primarily eating wheat, and we can get odd effects. We could get such behaviour today with the really poor. In 1985, I happened to be an honoured guest at a hamlet in Western Maharashtra. The lunch they served me was: flat bread made of coarse grain. That's it. There was nothing else, just powdered red chili for flavour.
• The second case is a person who's rich enough to eat some meat, but would cut back on meat when it got expensive. This kind of person generates high price elasticity of demand for grain because of the 2:1 or 8:1 ratios between meat and grain, which imply that for each 1 kg of meat that he backs away from, 2 or 8 kg of grain is freed up. Hence, in the early stages of food-feed conflict, when people have started dabbling with meat but aren't yet price insensitive about it, the price elasticity of wheat demand goes up sharply.
• The third case is a person who is rich enough to eat meat and is price insensitive about it. A buildup of more people in this third case reduces price elasticity of demand.

My story is about a world where there are very few people in the 1st case, and an increasing transition from the 2nd case to the 3rd case. GDP growth yields fewer poor people who respond to higher wheat prices by purchasing less meat or wheat, i.e. we have less of a shock absorber. That generates a reduced elasticity of demand of wheat. So prices have to rise by more in order to clear a supply-demand imbalance than was required in the past when there were more poor people who would adjust.

In the bad old days, people in China and India supplied the world with a large shock absorber, a large mass of poor people who tightened their belts when prices rose. This gave higher global demand elasticity and reduced price volatility. From the late 1970s, economic reforms in China and India have given greater affluence and thus diminished this shock absorber.

Here's a picture of the moving-window volatility (calculated using four-year windows off weekly returns) for wheat:

This does seem to show a longer term phenomenon of increasing vol.

Storage

Now let's bring in speculators and storage. Suppose commodity volatility went up in this fashion when affluence increased. This should generate increased profitability for the speculative strategy of holding inventories of food and opportunistically waiting for the next great price flare-up. Call this hoarding or call it buffer stocks: the bottom line is that large inventories stabilise prices.

The cost of holding in recent years was unusually low given the low interest rates. (As an aside, the direction of effects here runs opposite to what Jeffrey Frankel has been talking about). But the data shows that hoarding didn't go up; on the contrary inventories have dropped from 2000 onwards.

The puzzle is : why is there so little speculation? Why did speculators in 2000-2005 do so little hoarding? Hoarding would have smoothed out prices: purchases in 2000-2005 would have given higher prices then and sale in 2008 would have given lower prices today.

To buy 10 million tonnes of wheat in 2005 and hold requires a bit of capital. At USD 300/MT, this would require putting down $3 billion plus a flow of storage costs. Who were the kinds of players who were setup to evaluate such a trade? What kinds of leverage was available to them, to juice up their return on equity? I don't know enough about the field: was there an abundance of such players and did they have enough leverage?

Were we hitting limits of arbitrage? Was insufficient capital being put into these speculative strategies for some reasons that are linked up to the institutional structures of finance? I am reminded of the difficulties of uncovered interest parity (UIP) on the currency markets. The `carry trade' is an equilibriating response; it would tend to make UIP work. Perhaps too little capital is put into the carry trade relative to the massive size of the currency market, thus generating violations of UIP.

Is a similar phenomenon going on here? Perhaps the massive pools of financial capital that are able to hold large inventories (a.k.a. buffer stocks) weren't being deployed into commodities on a scale required to have inventories that are large enough to stabilise the global food market. If so, the solution would involve more capital with commodity funds and hedge funds that trade in commodities.

Putting together

Perhaps what happened was like this. There was a string of supply shocks - things like ten consecutive droughts in Australia, a small switch towards biofuels.

If these shocks were anticipated in 2000-2005, then this points to institutional failures where the financial / commodity firms were not able to galvanise themselves to do enough hoarding. Alternatively, if these shocks were not anticipated in 2000-2005, then the future outlook had to be benign, which led to a rational drawdown of inventory, i.e. low buffer stocks, in the hands of the speculators.

Prosperity had risen over the years, giving unusually inelastic demand -- the consumers of China and India who have long contributed to elasticity of global demand by tightening their belts were less poor and less willing to tighten their belts. With fewer people willing to adjust, prices had to move a lot to clear supply and demand.

What comes next

I am optimistic about what the future holds.

High prices have a way of inducing far-reaching supply responses on the medium term and long term. We have been surprised, again and again in the past, at the cleverness with which producers responded to higher prices by producing more. When the Hunt brothers tried to corner the world market for silver, they were astounded at the quantities of silver that were brought into the market by way of a response to higher prices. High prices of petroleum products increases the use of camels in transportation.

In similar fashion, high wheat prices can even make Afghan poppy farmers switch to growing wheat! Vast tracts of land in Russia and India have low yields: High prices will give incentives to entrepreneurs to find ways to use this land better. Over the coming two years, a large supply response could come about. Something big might already be afoot: an 8.2% rise in world wheat output is projected for 2008-09, and surely some of it has to do with the incentives put out by high prices.

These events seem to have helped reduce the informational and institutional gap between finance and commodities. A greater convergence between the financial world and the commodities world, through new structures such as commodity funds or hedge funds that deal in commodities, would bring resources commensurate with the size of these markets into play. You choose whether you want to call this stabilisation, hoarding, speculation or buffer stocks.

1970s vintage inflation control

Yesterday, I wrote about 1970s vintage monetary economics breeding 1970s vintage inflation control. Today I read that FMC has banned futures trading in four products for four months.

Transaction taxes and commodity futures

Vineet Bhatnagar, a coalition of commodity derivatives exchanges, and Susan Thomas discuss transaction taxes in today's Economic Times.

The official and the illegal currency market

A Nigerian diplomat was recently found converting Rs.100 million in cash into USD in New Delhi. This hints at the existence of a substantial INR/USD market outside the reach of capital controls.

I think there are two factors shaping this black market. The first is the capital controls - rapidly globalising India is increasing chafing at the bit. The second is the incredibly bad market design of the currency market.

In India, the equity market sets the benchmark for transparency of financial transactions. There is pre-trade transparency (order books are visible in realtime) and post-trade transparency (exact transaction information is put out in realtime). In addition, equity market intermediaries separately reveal (a) the price at which a transaction was executed on the market as opposed to (b) the brokerage fees charged by the intermediary. On the equity market, liquidity resides in the public, nationwide market, and the broker is only a transactional pathway to the market.

In contrast, the Indian currency market fares poorly on all three counts. It is highly non-transparent from the viewpoint of customers, lacking post-trade and pre-trade transparency. This makes it difficult for customers to ensure that they are getting best-price execution. Banks do not unbundle the price on the currency market as opposed to their intermediation fees.

To look back into the history of the equity market, in the early 1990s, all these features were absent. When BSE brokers were first asked to separately show brokerage fees as opposed to the price at which a transaction was executed, they went on strike. In the early 1990s, BSE brokers would routinely lie to customers, claiming that a purchase was executed at a higher price than it really was. Lacking transparency, customers were not able to cross-verify these claims. These very abuses are found on the currency market today: customers are not able to cross-check prices owing to the lack of pre-trade or post-trade transparency, and customers are not told what they are being charged for financial intermediation services as opposed to market prices. The people who work on policy issues of the currency market have not adequately learned from the success story of the equity market.

Owing to the deficiencies of the market design, currency trading is extremely profitable for banks. Customers pay high prices for buying and get low prices when selling. If a bank gets a buy and a sell order which it is able to serve internally, it earns the full spread (that is shown to customers). Only the net imbalance at a bank reaches the interbank market.

The excessive intermediation charges imposed by banks on the currency market reach all the way to retail transactions. A traveller who seeks to buy or sell on the rupee-dollar market faces a bid/offer spread of roughly Rs.1.50 (3.67%). As a consequence, an extensive black market has sprung up all over the country. This involves a network of dealers who do run a book on the rupee-dollar. Your friendly neighbourhood paanwala is often a currency trader. They offer a bid/offer spread of roughly Rs.0.15 (0.37%). This black market helps undercut the intermediation charges of the banks, and on avoiding the constraints which prevent competing trading systems from emerging.

The equity market is able to deliver a spread of Rs.0.1 on a base of Rs.4500 for the Nifty futures - this is like a spread of Rs.0.001 for a base of Rs.45 (roughly the INR/USD rate). Like the Nifty futures, currencies are also "macro" underlyings with little asymmetric information. Currency vol is lower than Nifty vol. Hence, if the market design is done right, currency spreads ought to be lower than the Nifty spread - in other words the spread should be lower than Rs.0.001. Such a tight spread directly saves money for market participants who trade - for the spread is the round-trip transactions cost faced by the customer. In addition, fine spreads improve market efficiency by reducing the overheads faced by speculators.

In short:

1. There is much more convertibility than meets the eye;
2. The currency spot market is one of the most important commanding heights of the economy, and it's a real shame that it has a 19th century market design, aimed at perpetuating entry barriers, profits for banks, non-transparency and high transactions costs for customers;
3. If policy makers want more of the currency market to come above the ground, then an exchange-traded currency spot market is required, where brokers clearly unbundle their brokerage charge from the price seen on the public limit order book.

As an aside, with commodity futures also, there is a substantial `number 2 market', which competes with the official regulated markets. These parallel currency and commodity futures markets reflect an exit from the mainstream regulated markets by some players. If wise policy making is able to unify all liquidity into the public markets - as has pretty much happened with the equity market - we will be able to reap substantially more liquidity than is presently the case.

The future of trading

Roughly speaking, NSE has 50,000 trading screens and BSE has 25,000 trading screens. Over and above this, a growing share of orders have been coming into NSE and BSE over the Internet. Recent data shows that the share of Internet trading went up from 3 per cent in 2003-04 to 16 per cent in 2006-07. Given that the broadband expansion in India started only very recently, the outlook for future growth of Internet trading is very good.

The sources of order flow coming into the market, then, are these 75,000 trading screens coupled with a large number of users sitting on their web browsers. All these people add up to a massive virtual trading floor. Their information gets pooled into the price that is revealed, and their disagreements are played out in the order matching process. Their diversity is a key source of liquidity and liquidity resilience [link].

To a significant extent, the same securities firms are playing the same role with commodity futures trading. So even though there is an FMC vs. SEBI separation, there has been de facto convergence. As you walk around India, you routinely see roadsigns of securities firms offering both NSE/BSE and commodity futures trading.

The big puzzle now lies in bringing the potential of this enormous virtual trading floor to infuse life into the moribund fixed income and currency markets.

Outside India, there have been fascinating developments in going beyond the vanilla Internet trading system. The game lies in enhancing the information set of the user while supporting `dumb' transaction services, and in doing better than the awful discussion boards that have proliferated. See link and link. (I had blogged about Zecco before). These sites rely on network externalities - the larger the number of people using them, the more attractive they become. So there may be a tipping point - perhaps 100,000 users? - beyond which they could just explode.

As seen in those two URLs, in the US, the price of brokerage services with some brokerage firms has dropped to zero. In India, that progression cannot be achieved because of the massive government charges which are layered on top of the basic transaction -- see Box 2.8, page 29 of the MIFC report.

These developments have interesting implications for exchanges also. An article in The Economist discusses some of these changes. It talks in hushed tones about an exchange that will sell transactions at a price of $1.2 per trade. In my mind, that's not a big deal; the technology exists today to do much better. The key thing to latch into is economies of scale - by the time you have a factory pumping out 10 million trades a day, the costs get dramatically lower than those seen with small exchanges. As a consequence, I believe that the pressures in favour of low prices paid by customers which will propagate to low prices charged by exchanges will generate a more oligopolistic situation where a few giant exchanges - like NSE and BSE - will dominate the world's trading.

Complexities of government involvement in `food security'

Bharat Ramaswami has an excellent article on the complexities of governments trying to achieve `food security'.

MIFC - implications for the securities industry

I wrote an article titled Mumbai as an international financial centre: Implications for the securities industry for `BSENSEX', the new magazine launched by the BSE.