Futures trading works

Deepender Singh Hooda recently argued in a Business Standard debate that a genuine free market for the underlying commodity is a pre-condition for futures trading. He argues that since such a genuine free market is neither desirable nor prevalent, commodity futures trading should be banned. He is wrong, and this can be shown in two ways. Proof by existence: crude oil. There is a powerful cartel (the Organisation of Petroleum Exporting Countries) which exerts the mighty energies of many governments in manipulating crude oil prices. Opec interferes with the global crude oil market far more effectively than the Government of India is able to do with most commodities. Yet, that has not changed even slightly the case for futures trading in crude oil. Energy futures trading at NYMEX (in New York) and IPE (in London) is highly successful. Every Indian firm which buys or sells crude oil suffers from risk owing to fluctuations of global crude oil prices, and it ought to be doing futures and options trading on NYMEX or IPE in order to manage this risk.

If someone plans to buy wheat at a future date, he suffers from price risk because the price of wheat is not certain. This fact holds regardless of why the price of wheat might change. It might respond to genuine market forces, or it might be responding to the manipulation of a government. The reasons do not matter; the fact remains that if a buyer of wheat is unsure of the wheat price next month, he is better off obtaining a locked-in price for a wheat purchase next month. This holds regardless of whether the wheat spot market is a "genuine free market" or not. It might be argued that someone operating in a futures market could exploit control of an imperfect or thin spot market, but that would be a fit case for the market regulator to get into.

Similarly, a speculator forecasts the price of wheat or crude oil next month. Whether the spot market is a vibrant free market, or it is vibrantly manipulated by a government, the fact remains that if a speculator predicts that the price will go up and adopts a buy position, and then the price does go up, the speculator makes a profit. The arithmetic of futures trading works whether the spot market is genuine or manipulated by a government.

The deeper reason why futures trading is extremely important lies in a strategic sense of Indian agriculture. Where is India going on the terrible distortions of the agricultural sector? Is India ever going to move away from the knee-jerk responses of hurting milk farmers one day by banning milk export, and then trying to set up a minimum support price for milk because milk farmers are unhappy? If India is going to make progress towards a well-functioning agricultural sector, then there is no question that futures trading belongs in it. Futures trading is as much a part of modern agriculture as fertilisers, drip irrigation and bio-technology.

Mr Hooda is not alone in his views. The political and bureaucratic establishment that deals with agriculture is deeply steeped in the mindset of a government that prevents agricultural markets from functioning. For this reason""if not for any other""the regulation of commodity futures trading needs to be moved to the ministry of finance, merging it with all organised financial trading, as is the case with all other mature market economies.