MUMBAI – A decade into its evolution, India’s commodity futures market finds itself at a crossroad, with a slew of recent developments leading to loss of confidence among market players and resulting in a continuous downtrend in volumes.

The need to strengthen market regulations was recognised long ago but never addressed.

The National Spot Exchange scam, in which investors are feared to have lost nearly 56 bln rupees, is probably the result of the various regulatory gaps in the commodity futures regime.

The levy of Commodity Transaction Tax since last year is another incident that has taken a heavy toll on business volumes across commodity exchanges. Trade volume, which was rising quite fairly in the first nine years, fell by a hefty 40% in 2013-14.

Now, with Narendra Modi elected as the country’s new prime minister, the market, along with other stakeholders such as banks and regulators, is being haunted by a Working Group report of 2011.

The report, prepared under the chairmanship of Modi, the chief minister of Gujarat then, suggested ways to reduce the gap between farm-gate and retail prices and to better implement the Essential Commodities Act.

One of the suggestions of the Working Group committee–comprising of chief ministers of Gujarat, Andhra Pradesh, Maharashtra, Tamil Nadu–was to prohibit futures trading in essential commodities.

The worry is that Modi may honour his recommendations. Interestingly, a careful reading of the report shows that a ban on futures trading in essential commodities was recommended “for the time being”, without a set timeframe or conditions needed for lifting of such a ban.

Since the Working Group addressed itself to prices of essential commodities, it may be recalled that in 2008, a panel headed by Abhijit Sen, a member of the Planning Commission, had found no clear evidence of either reduced or increased volatility of spot prices due to futures trading.

Nevertheless, there are some market participants who believe that the Modi government has a strong commitment to economic growth. And towards this objective, it may tilt towards reforming existing dispensation in various fields, including commodity futures trading.

In that case, the passage of the long-pending Forward Contract Regulation Act amendment should be the first test of the new government’s intent.

But then again, as far as commodity futures market is concerned, there is an additional point that needs attention. A recent report (“Report of the Committee to suggest steps to fulfil the objectives of Price-discovery and Hedging in Commodity Futures Market”, April 2014) has hit at the very basis of futures trading in commodities.

Futures trading in commodities was introduced with two clear objectives: price discovery and hedging. The panel found that while the commodity futures market has faired “relatively well” on the price discovery objective, its performance is relatively poor on improving hedging effectiveness.

This is quite a revealing observation. It throws doubts on the wisdom of policy makers, or at least on the wisdom of those who designed the system of commodity futures. It is also possible that they failed to understand the changing dynamics of the market in the last 10 years and therefore failed to bring in necessary changes.

Fortunately, after presenting the results of its econometric exercises, the committee report has gone on to identify the weaknesses in the futures market domain and suggested ways to overcome these weaknesses. In brief, the proposals include making banks and financial institutions, both Indian and foreign ones, an integral part of commodity derivative trading; use of scientific storage and grading systems; modernisation of warehousing facilities; exempting arbitrageurs from holding restrictions under the Essential Commodities Act; and making the regulator, the Forwards Market Commission, more effective.

While many of these suggestions have been made earlier in different contexts, they make a lot of sense in the context of the committee’s findings.

Put together, these recommendations should help make spot markets more transparent, reduce transaction cost, bring more players and depth to the market, make more finance available to participants, and ultimately bring commodity prices to more realistic levels.

The committee’s suggestions cover a long canvass, hence not easy for any government to implement in a jiffy. But in the meantime, the government has to grapple with price issues. So, where does that leave the market?

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Free Press Journal