Proceed with caution: More players in commodities derivatives can be risky

Sebi will essentially be dealing with entities without deep pockets

The Securities and Exchange Board of India’s (Sebi’s) plan to open the commodity derivatives market to more participants and add new trading products is well advised, even though extreme caution is imperative while implementing it. The idea broadly involves roping in institutional participants, such as banks, insurance companies, mutual funds and financial institutions, and allowing additional commodities and products like options contracts to be transacted through commodity exchanges. Greater alignment between spot and futures trading is also on the cards to facilitate farmers and end-users of farm goods to use these markets for better price discovery and risk management. The overall objective of all these propositions, apparently, is to increase liquidity and promote structured and knowledge-based trading on the commodities exchanges.

 
Indeed, many of these measures are not wholly novel. The former commodities regulatory body, the Forward Markets Commission (FMC), which has since merged with Sebi, had also wanted to introduce such changes but could not do so for dearth of adequate powers to take independent decisions. Besides, the previous United Progressive Alliance (UPA) government nurtured some unwarranted apprehensions about the role of futures trading in fanning inflation and was, therefore, disinclined to expand it further. The Bill to amend the Forward Contracts Regulation Act, which was drafted in 2010 but not converted into law, had also provided for options trading apart from allowing institutional players, including foreign institutions, to operate on these exchanges. Now that the present commodities regulator, Sebi, has developed interest in upscaling the commodities market to global standards, it should receive wholehearted legal and policy support from the government.

 
Interestingly, despite having a long, albeit checkered, history dating back to 1875, futures trading in commodities has seldom been allowed to flourish to its full potential. The Indo-China war and subsequent scarcity of essential items due to drought and other natural calamities in the 1960s led to a prolonged bar on futures trading. Yet, when it was reintroduced in 2002, it witnessed an instant boom with trading volumes and the turnover of commodity exchanges outstripping those of equity and financial markets. Nevertheless, the underlying objective of reviving this mode of marketing – that of helping farmers in price discovery and risk hedging – has remained largely unfulfilled. The average farmer, being a small producer in the unorganised sector, has been unable to operate on commodity exchanges dominated by big players who prefer to deal in large volumes.

 
However, Sebi will need to tread cautiously as it will essentially be dealing with entities without deep pockets. Moreover, commodities are distinctly dissimilar from equity and financial derivatives because each commodity has a market dynamics of its own, depending on its production, demand, exports, imports and other factors specific to it. Any laxity in supervision could prove extremely costly as cash-rich speculators would miss no opportunity to rig the market and turn it into a commodity casino. Sebi may, therefore, need to further consolidate its commodity-specific expertise to foresee the scope for undue speculation and stem it instantly to be able to effectively regulate derivatives trading in commodities.