Commodity futures are not evil
Business Standard, 21 February 2007
The political class is in a tizzy about commodity futures trading. Much of this fear is an archaic mistrust of markets, and the losses that incumbents suffer when competition and transparency comes about. These fears do not hold up to careful scrutiny. The sensible strategy is to address the genuine difficulties of market design, regulation and supervision, so that futures trading is able to play its full role in a mature market economy. This requires breaking with policy decisions made in the 1950s.
In spot trading, a transaction is settled immediately after it is agreed. In futures trading, a transaction is agreed upon and settlement is contractually deferred to a predefined future date. Future-dated supply and future-dated demand generate the futures price. When comparing the spot and the futures, it is futures markets which have a superior institutional architecture, thanks to the transparency of electronic trading and risk management at the clearing corporation. If there is a market design which should be mistrusted, it is the spot market, for trading takes place in a highly non-transparent way through private negotiations and phone calls. In many commodity spot markets in India, the purchase or sale of 20 trucks can shake the spot price. The futures market tends to be more liquid and more transparent.
In a world with only a spot market, everyone lives in the present. Today's supply and today's demand is expressed in today's price. There is no tomorrow and there is no planning for tomorrow. Prices fluctuate from day to day and both buyers and sellers helplessly reel under their impact. Futures trading is about planning; it is about taking control of uncertainty. A farmer who sells goods at a future harvest date, at a locked-in price, is in a fundamentally superior position in terms of planning. Banning futures trading is about forcing people to not plan for the future.
It is claimed that futures trading drives up prices. But supply and demand on the spot market are not unidirectionally changed when trading for goods with future delivery takes place. It is claimed that futures trading drives up volatility. The international and Indian evidence shows that this is not the case. If anything, the advent of futures trading helps control the economic implications of price volatility. The more strongly a person thinks that market price fluctuations are bad, the more strongly this person should advocate futures trading.
A key source of mistrust is spot-futures arbitrage. When bad news about a future harvest comes in, the futures price goes up immediately. At this point, it is rational for private players to buy goods on the spot market, store them, and deliver them at future dates. These activities are the much-hated "hoarding". But they are the exactly correct responses that any sensible person would want. If a future harvest is going to be bad, what is needed most is stocks! A double standard is being applied where governments holding stocks - in an inefficient and politicised manner - is good, but the private sector holding stocks - based on nimble and dynamic adjustment of the size of stocks in response to information - is bad.
When bad news surfaces about the future, this spot-futures arbitrage induces all the correct responses: spot prices go up immediately (thus shrinking present consumption); stocks are built up; and future prices are pushed down thus stabilising prices. Conversely, when good news arises about a future harvest, the reverse set of responses takes place.
These directions of impact are exactly what are required in the economy. If bad news broke about the future, and the private sector did not do `hoarding' in response to changes in the futures price, then there would be calls for the government to hold buffer stocks.
In old India, a coherent trading community - often drawn from one jati - would dominate the business of one product. They would have a considerable influence on the price, an influence that veers on market manipulation. Nationwide electronic futures trading is a fundamentally new game, in that a whole new breed of players are competing in their business. The futures market tends to be quite liquid, and it is harder for the traditional traders to control the price.
It is not at all surprising that traditional traders are up in arms against the newcomers - sometimes even foreigners! - who have come into business owing to the futures market. This is no different from the feelings of Hindustan Motors and Premier Automobiles when johnny-come-lately firms - sometimes even foreigners! - started competing in the car business. These traditional traders often have the ears of MPs from agricultural constituencies, and this has helped generate bad blood in Parliament.
This is not to say that all is well on the commodity futures markets. The Forward Contracts (Regulation) Act is an abomination which prevents sound market design, sound regulation and sound supervision. The placement of policy functions in the Department of Consumer Affairs is a mistake. An agency that is primarily about consumer protection on issues like weights and measures is ill-equipped to deal with the complexities of electronic trading and novation at the clearing corporation. As an example, DCA has little experience with the three-way separation between owners of exchanges, managers of exchanges and members of exchanges, which is required for avoiding conflicts of interest.
The international norm is to merge the policy and regulation of all derivatives markets - regardless of whether derivatives trading deals with equities, currencies, interest rates, commodities, inflation, or anything else. In the US, policy issues on all these kinds of derivatives have been placed into a single agency which (for historical reasons) is called the Commodity Futures Trading Commission (CFTC). Outside the US, the separation between spot and derivatives markets is generally absent, and this is now considered the best practice.
Leo Melamed, one of the pioneers in the global derivatives trade, tells a fascinating story in his book Escape to the Futures, about a wise old man in the late 1960s who realised that the growing importance of derivatives could be a source of political trouble. "Don't let our futures markets get too successful," he ominously warned Melamed, "because futures markets tell the truth and nobody wants to know the truth. If the truth is too bad and too loud, they'll close us down". Sadly, this has already started happening in India.
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