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Do futures make sense if spot market’s ‘rigged’?

Do futures make sense if spot market’s ‘rigged’?

The Abhijit Sen committee is unanimous that there is no evidence to link futures trading with rising food prices, but at the same time the committee chairman has said that futures trading may not work in commodities such as wheat and rice where the spot market is highly controlled.

The argument goes thus: The government announces a minimum support price (MSP) for several commodities, including wheat and rice, pulses, and oilseeds. This works like an open-ended tender where the government guarantees the purchase of whatever amount of crop any farmer has to offer. In order to provide essential commodities such as wheat, rice and sugar to the poor at subsidized rates through its public distribution system, the government also happens to be the largest buyer of these commodities.

Does it make sense to have futures trading where price discovery in the underlying spot market is lopsided? After all, one of the primary functions of a futures market is efficient price discovery. With MSP though, the government effectively puts a floor on the prices at which these commodities trade. But there could still be reasonable price discovery above MSP. For the large number of market players who deal in these commodities, this price discovery along with the ability to hedge price risk is an important tool.

Soon, India will have a currency futures market. Note that the Reserve Bank of India is a large player in the spot market and doesn’t allow the exchange rate to move freely. Going by the same argument, currency futures may not work, considering that the spot market is highly controlled. But few expects it to be a non-starter—a look at the thriving rupee-dollar forward market should dispel such notions.

According to an expert, as long as there are buyers and sellers other than large manipulators, there is a case for a derivatives market for these players to hedge their price risk. The function of price discovery is also fulfilled—for a commodity or currency that is not manipulated, futures traders try and arrive at a fair price based on underlying fundamentals; in cases where there is manipulation, one of the important factors that influences price discovery is the market’s judgement of what the manipulator may do. Just because a large player distorts price discovery in the spot market doesn’t mean that there isn’t a need for hedging or price discovery through derivatives markets. For instance, the rupee-dollar rate may be rigged, but that doesn’t mean exporters needn’t hedge their dollar exposures.

Having said that, there is a complication that arises with having MSP for commodities such as wheat and the transparent price discovery mechanism of a futures exchange. If farmers see the futures trading at a higher rate than MSP, they wouldn’t offer their crop to the government, but look to offload it in the open market. In fact, this is the reason the government had a problem procuring enough wheat last year—its MSP of Rs850 per quintal (0.1 tonne) was significantly below the price of about Rs900-1,000 per tonne according to the futures market. The government ended up importing more than the usual quantities of wheat, which raised the issue that the futures market runs in conflict with the government programme of procuring at MSP.

Some experts suggest that the price discovered in the futures market can be used as one of the parameters for arriving at MSP. Currently, the government tries to arrive at the cost of production through a complicated formula for fixing MSP. This leaves out underlying market realities of demand and supply, of which the futures price can be a good indicator.

What’s more, with a look at what the futures market is indicating for year-ahead prices, the government can be better prepared to tackle inflation.

If the argument is that the futures market is running into conflict with the government’s MSP programme, the way out could be to align the two by including futures prices in determining MSP.

In The Money runs every other Tuesday. We welcome your comments at inthemoney@livemint.com

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