The risk factor

Cautious stand needed on commodity derivatives

The Securities and Exchange Board of India (Sebi) will be well-advised to revisit its plan to allow mutual funds and portfolio managers to deal in commodity derivatives following the misgivings expressed by the finance ministry about this move. The Sebi board had approved the move to offer investors additional tools to hedge against inflation and facilitate efficient price discovery in a transparent manner. However, the economic affairs department of the finance ministry thinks otherwise. It is wary of opening up the commodities market to institutions that have no direct exposure to underlying commodities. The danger is that this could lead to speculative bids, thus, heightening the risks for the investors. The price volatility may actually accentuate if these institutions use their financial muscle for manipulative trading instead of hedging — which may often be the case.

Such apprehensions are, in fact, shared by some independent analysts as well. Agricultural goods, being seasonal and perishable in nature and innately prone to unforeseeable price fluctuations, are particularly vulnerable to exploitation by speculators. The proponents of institutional involvement in the commodities sector, on the other hand, argue that their presence would lend greater liquidity and depth to this market and provide more avenues of safe investment, especially for retail investors. This plea rests on the assumption that the institutional investors would undertake well-informed and research-based trading for more credible price discovery. However, this may not happen all the time.

Sebi’s decision on the liberalisation of the commodity derivatives market was, actually, based on the counsel of its Commodity Derivatives Advisory Committee, wh­ich had mooted phased induction of domestic and foreign institutional investors into this sector. In the first phase, which is currently under way, specified types of alternative investment funds, portfolio managers, mutual funds and foreign portfolio investors are to be permitted to operate through commodities bourses. In fact, a few foreign entities, especially those having some association with the Indian commodity markets, and selected alternative investment funds (category III) are already active on these platforms. With the entry of the mutual funds and portfolio manag­e­rs, the first phase would be complete. Other institutions such as banks, insurance and reinsurance companies are slated to be roped in during the subsequent phases.

Though the futures trading in commodities resumed in India after nearly a 40-year hiatus way back in 2003, this form of commerce for all practical purposes is still in its infancy. Its track record in price discovery and price risk management has been quite indifferent thanks largely to rampant malpractices and ineffective supervision. The former commodities regulator, the Forward Markets Commission (FMC), was a toothless body which, being an appendage of the finance ministry, could not take any independent decisions. Though the present regulator, Sebi, is relatively more powerful and autonomous than the FMC, it, too, has yet to prove its worth as a commodities sector watchdog. A vigilant and strong regulator can stave off speculation-driven price aberrations by changing margin requirements, capping investments and prices, or halting the trade if the situation so warrants. In any case, it is imperative to tread cautiously and put adequate safeguards in place before allowing institutional investors with deep pockets an open access to the price-sensitive commodity derivatives sector.