Why banning commodity derivatives trade is like throwing baby out with bathwater

A Amarender Reddy

Last week, market regulator Securities and Exchange Board of India (SEBI) issued directions to suspend trade in futures and options contracts of selected agricultural commodities, including paddy (non-basmati), wheat, chana, mustard seeds and its derivatives, soya bean and its derivatives, crude palm oil and moong. The suspension comes with immediate effect, plausibly in response to rising food prices, and the directions are applicable for one year.

Such a scenario raises two preliminary questions: What is the role of derivatives trading in inflation? And, what are the implications of such sudden suspension on commodity derivatives markets?

Commodity exchanges provide trading platforms for commodity derivatives contracts that can help the stakeholders in the commodity value chain to hedge their price risk, apart from providing transparently discovered prices signals. Globally, exchange-traded vibrant commodity derivatives markets have proven to be facilitating efficient price risk management processes for over 170 years, since the start of Chicago Board of Trade (CBOT) in the mid-19th century.

Although the Indian commodity futures market has a similar extensive history with the start of the Bombay Cotton exchange in 1875, it is prone to frequent ban in agricultural commodities. As a result, the development and outreach of commodity futures market is still nascent particularly in case of agricultural commodities with scanty development of necessary infrastructure such as warehousing, assaying, quality testing, etc.

The latest ban came after the wholesale price index jumped 14.2 percent, while the consumer price inflation for edible oils and fats crossed 29 percent in November 2021. But, the current rise in prices, particularly edible seeds and oils such as soybean, mustard and palm, is primarily due to supply concerns of global and domestic scenarios.

Domestic edible oil derivatives are perceived to be one of the successful cases of agricultural commodity derivatives contracts, providing hedging opportunities and transparent price signals in line with evolving global price scenarios from benchmark international exchanges such as CBOT (CME) for soybean and derivatives, Bursa Malaysia Derivatives Exchange (BMD) for palm oil, etc, while reflecting the domestic demand-supply scenario. Moreover, past experiences and the available evidence suggest that banning futures trading has little or no impact on prices in the physical market and inflation.

Towards this, the report of the committee headed by Professor Abhijit Sen, set up in 2007 to study the extent of the impact of futures trading on wholesale and retail prices of agricultural commodities, did not find any evidence suggesting that the futures trading was responsible for the inflation.

Commodity futures are market instruments to achieve price discovery, market price stabilization and can be used as price insurance for the farmers. Ours is an agricultural economy and fluctuation in prices during the harvesting period has always been a major concern for the farming community.

The only policy instrument to insure price risk of the farmers during the harvest period is Minimum Support Price (MSP) in case the open market prices fall below MSP. However, reach of MSP procurement is restricted to a few commodities like paddy and wheat and also effectively implemented in only a handful of states. The farmers are exposed to price risk for remaining all the 21 crops for which MSP is announced but there are no wider procurement operations by the government.

Futures trading, if widely used by the farmers for hedging their price risk, can act as an effective instrument for alleviating price risk and act as a price insurance mechanism.

But, the recent ban on futures trade by regulators is like throwing the baby out with the bathwater – instead of creating an atmosphere to encourage wider participation of small farmers through promoting and linking Farmers Producer Companies to the commodity futures markets to hedge their price risk and use them as the price insurance instrument. Such frequent suspensions hamper healthy growth of these markets disrupting the development of necessary support infrastructure and services such as warehousing, assaying, quality testing and standardization, financing etc.

Although, wider participation of farmers will take time and effort, which requires a lot of patience and nudging of both farmers and futures markets towards a healthy futures market so that the futures markets help in better price discovery and hedging instruments for farmers.

In the absence of a futures market, farmers will be forced to sell their produce in the cash market at the prevailing price, which may be lower than their expected price. Alternatively, they have to store their produce and wait for a higher price at a later period, which is mostly beyond the capacity of small farmers to hold the produce for such a long period as they have to spend on the next crop and meet household expenditure.

Hence, instead of banning arbitrarily, the government should align futures market development with the current ongoing government schemes like Formation and Promotion of 10,000 new Farmer Producer Organizations (FPOs) to aim for twin objectives of better price discovery and insuring price risk of the farmers.

The article Why banning commodity derivatives trade is like throwing baby out with bathwater first appeared in firstpost.com

Read another piece on growing demand from a section of farmers’ organizations for guaranteed MSP by A. Amarender Reddy titled Why a price insurance policy makes sense in IMPRI Insights

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About the Author

A Amarender Reddy

A Amarender ReddyPrincipal Scientist, ICAR-Central Research Institute for Dryland Agriculture, Hyderabad.