Today commodity derivative markets in India will enter a new era under SEBI that promises integration into the mainstream finance sector. That makes it a good moment to pause, and ask ourselves what is it all for? What is the purpose of commodity exchanges? And how do we measure its success?
The answer is to see what role commodity exchanges can play in the lives of the 18 crore rural families in India, whose economic prosperity is critical. And the difference they can make to every consumer.
Farmers face three hurdles in the search for better income. First, they are forced to sell in fragmented markets. This distorts price signals, creates buyer cartels and encourages rent-seeking behavior. Second, farmers can’t offload risk. The risk of drop in prices, the risk of not finding a buyer, the risk of the buyer reneging, the risk of lacking funds to produce the crop and invest in next year’s crop, and the risk of government import/export policies affecting profitability. Third, modern agriculture needs finance. Banks are reluctant to give post-harvest credit because crops can’t be priced accurately or stored safely. Farmers are charged commercial interest rates for post-harvest loans against negotiable warehouse receipts. The one asset every farmer has – his harvest – fails to bring formal credit.
India’s 25 crore households want staple foods to be available on demand. This is possible only when crops harvested annually are safely stored for the rest of the year by someone willing to make an upfront cash investment. No brave heart wholesaler or grocery chain will venture without an inkling of the crop’s value in the coming months.
Industrial consumers, such as food and FMCG companies, and exporters/importers face the risk of fluctuating prices. With no mechanism of insurance available in physical markets, this risk is passed on to consumers in the form of higher prices.
How can commodity exchanges improve this situation? By just doing their job. Commodity exchanges contribute to society and the economy in three ways: a means of insurance against price risk, a venue for investment that makes commodities liquid and mobile, and price discovery through the breadth of the market and the close interrelationship of the exchange and physical markets dealing in the same commodity throughout the world so that every factor which can be reasonably anticipated is reflected in the current prices of the commodity.
In performing these functions, exchanges help in three wider ways: facilitate physical commodity trade, direct financing to agriculture, and promote market development. So, their utility needs to be measured by the degree to which they are advancing these six functions.
There has been little recent empirical assessment of the impact on farmers. But they are receiving price signals for wheat, pulses, coarse grains, oilseeds, sugar, cotton, rubber, guar, and spices. The influence on orderly marketing is evident. Farmers would sell up to 70% of their castorseed, chana, soyabean, and mustard harvest immediately. Now, it is 45%.
There was no formal mechanism to collect and disseminate live prices in spot markets across India. Futures trading led to an independent automated spot price polling mechanism that became the reference for over 7,000 mandis.
Transparent price discovery and risk management allowed guar production to shoot 175 times in two years to grab the top slot in India’s farm export basket without any government support.
Andhra’s chilli, turmeric and maize farmers faced the problem of caveat vendor (let the seller beware) because traders had superior market information. Availability of continuous, day-to-day futures prices removed this information asymmetry.
Chana, refined soya oil and mustard seed prices are less volatile than urad, tur, onion, and groundnut where future trading is not available. Arbitragers on the exchange platform keep prices in normal alignment between different physical markets and between months.
Business has jumped in mandis designated as exchange delivery centres. Gondal and Unjha in Gujarat, Gulab Bagh in Bihar, Akola in Maharashtra are witness to this.
Commodities traded on the exchange meet FSSAI quality parameters. This has enhanced agri-product standards, benefiting consumers, processors and farmers. Private investment is increasing in cleaning, grading and assaying of spices and oilseeds.
Anecdotal evidence and NCDEX exchange data suggests that the risk insurance function is gathering pace. In export-oriented commodities, such as castorseed, almost fifth of the crop is being hedged. A sugar miller may not be able to sell at a profit, but his sugar now need not be left unsold. He has an active, ever ready exchange market, functioning daily, which will not only absorb a large quantity but also let him hedge his sales. No wonder RBI has mandated banks to ensure their borrowers hedge agri-commodity exposure.
Transaction costs are lower because the exchange platform makes it easy to find a reliable buyer/seller, negotiate contract terms, secure finance to fund the transaction, manage credit, ensure timely cash and product transfers, and resolve any dispute.
Warehouses are springing up to meet the demand for storing 2 million tonnes of exchange-delivered commodities. Rs 1,000 crore has been invested in Rajasthan alone. Commercial banks are coming forward to lend against liquid stocks of exchange-traded commodities. Yet, this is just the start.
Success will be complete when majority farmers and consumers palpably benefit. And that, ultimately, is also SEBI’s challenge. SEBI needs to now embrace a wider responsibility. It has to be the tireless cheerleader, promoter and protector of this new segment that also performs other vital economic functions not served by stock exchanges. And while it supervises and regulates market participants, at all times its focus must be on delivering benefits to the market’s actual users – farmers and consumers. That is how history will judge both SEBI and commodity exchanges.