Handle with care

Commodities options trading needs tight monitoring

By formally approving the introduction of options trading in commodities, the Securities and Exchange Board of India (Sebi), the common regulator for both the capital and commodities markets, has fulfilled a long-pending need for a cost-effective risk management tool for farmers and commodities-based small businesses. The move will also deepen the commodities market, improve liquidity and consolidate the price discovery process. Options trading, if competently regulated, can be a game changer for farmers for whom futures trading was relaunched by the Atal Bihari Vajpayee government in 2002 after a hiatus of nearly four decades. The idea was to let risk-averse farmers and small entrepreneurs hedge against price volatility and look for better returns by selling their produce at a future date when prices generally tend to rule higher than in the peak marketing season. However, it was soon realised that futures trading remained handicapped without being complemented with options trading, which provides participants the leverage of futures with the safety of options. The Forward Contracts Regulation Act, 1952, which guided commodity futures then, did not have any provision for options trading and, therefore, needed to be amended. Oddly enough, the Bill introduced in Parliament for this purpose in 2006 — and again in 2010 — was never discussed and passed. Thankfully, when Sebi was given charge of regulating the commodities market, it was legally empowered to introduce new products, including options trading, which it has decided to do now.

The biggest advantage of options is that it provides players the right — but without the obligation — to buy or sell futures contracts on or before the specified date to suit their interests. Thus, for risk management, options trading serves, in some respects, the same purpose as an insurance policy, though at a lower cost. However, some of the existing entry barriers will need to be relaxed to allow farmers and small businesses to capitalise on this facility. These include, among others, the stipulated minimum size of the tradable lot and the eligibility criteria for membership. These norms are beyond individual small producers to fulfil. Farmers, therefore, will need to be incentivised to organise themselves into cooperatives or producers’ companies or go through aggregators to participate in exchange-based transactions.

However, the norms for options trading will have to be framed with utmost diligence to guard this market against undue speculation. Such caution is particularly essential in view of Sebi’s decision to issue a single licence for stockbrokers to deal in both equities and commodities and, later on, a single licence also for exchanges, thus blurring the distinction between capital and commodities bourses. The apprehension is that doing so may allow players with deep pockets, but without any serious interest in commodities, to manipulate prices. One of the welcome precautionary measures mooted by Sebi is that options contracts that are not squared off will turn into futures deals to be settled through delivery — and not cash-settled like in equities. Sebi will need to put in place reliable delivery arrangements for this purpose. What also needs to be appreciated is that each commodity has its own market dynamics, depending on demand, production, import, export, and local and global prices, apart from government interventions through minimum support prices and curbs on movement and stockholding. Sebi will, therefore, need to build an extensive commodity-specific expertise to prove a worthy watchdog for futures and options trading in commodities.