A new dawn in Indian commodity market; large knowledge gap biggest hurdle

By Kishore Narne

A healthy and vibrant commodity futures market has an enormous impact on any economy. Unlike other financial markets, commodity market place has a purpose and a role in enabling entrepreneurs to take risks without bothering about price volatility in raw materials, encourage a farmer to be sure of the price he is going to get when he harvests his crop and a miner to dig for minerals assuring that he shall be able to sell it at a price, which is discovered by an efficient market.

Commodity is a hedgers market, and in India, so far the dream of bringing genuine hedgers on to this platform has not been fulfilled due to the lack of products and depth in the market. Indian commodity market had acquired the reputation of a speculators' market and every industry organization has lobbied against listing of some commodity at some point of time without understanding the implications or the benefits. It would have been fruitful if those organizations could have asked the governments to give them better products, like options, rather than de-listing their commodity.

Since Sebi took over the charge of commodity markets, it has sent positive signals and started to think constructively to strengthen the exchanges, members and the entire ecosystem. Finally, the most anticipated development of introducing the options has become a reality and there is no doubt that it is the beginning of a new era in Indian commodity markets.

Hedging the price risk of commodities produced or used is the basic need of any business, but so far a very few firms in India have a defined hedging policy, and many of them try to find indigenous ways to hedge their risk by some agreements with their supplier or buyer. Most of such agreements are biased and one sided, and many times are not honoured, which leads to disputes and disruptions in business. Any entrepreneur would like to have a very efficient price discovery mechanism and simpler ways to hedge the risk. So far, we had futures market, which is an inferior tool to hedge, and requires managing huge cash flows in terms of MTM and margin requirements, which makes hedging costly and capital intensive for our corporate, which normally runs on a very tight working capital. In contrast, options make hedging very efficient as well as cost effective with less capital and lower risk. This should bring in the much needed corporate participation to the exchange that would increase the depth of the markets and help achieve better price discovery.

Apart from the corporates, commodity market has an important role of setting up efficient market space for the agricultural produce, on which a large percentage of the population depends. An efficient market place reduces the middlemen and passes the best possible price, and also provides signals through future prices to the farmers early enough to plant the crop, which is in demand or short in supply, helping them in crop selection and naturally adjusting the demand and supply of various products. This is the key for the country's growth and to allocate the scarce land and water resources to the crops, which are in demand, and reduce the dependency on imports and also reduces the burden on the government to subsidise the commodity, which is produced in excess than what is required through minimum support price mechanism. When the markets are efficient the demand supply is automatically adjusted and large variances doesn't occur unless until due to natural calamities. By introduction of options, small and marginal farmers should be able to access the markets with least the amount of capital without compromising on risk. A farmer can simply buy a put option of the harvest months and execute his option towards the harvest time if it is in his favour or rather chose not to if the prices are higher than what he started with. The only hurdle I see is that the large knowledge gap which the exchanges, members and regulators have to address together to educate and enable them to use the platform. Second, the technology is making it much simpler with many broking houses having mobile applications and most of the rural households having modern mobile phones taking the prices to every household is now easier and cheaper, which makes it easier to bring them on to the platform.

Last but not the least, a speculator, trader or investor is an essential part of any market place and even in commodities market he has an important role of risk mitigation. He is a risk taker and has been largely dominating the futures markets so far, but he is exposed to huge risks without much protection available. Now with introduction of options there will be low-cost and low-risk options to take on and also to use the options to hedge his futures position and mitigate some of the risks, which he was absorbing. This will breed new set of traders or investors to take the benefit of commodities and significantly contribute to the liquidity and efficiency of the market.

With the options now allowed, the natural progression would be towards indices and complex derivatives, like weather derivatives, which along with options would provide a highly efficient platform for institutions, like banks to hedge their exposures to various crops, or sectors or even the overall weather related risks on their balance sheets. With SEBI at the helm we are confident that the RBI would be willing to allow the banks to use this platform to hedge the risks on their balance sheet. Certainly this step is a new dawn for Indian commodity markets with endless possibilities of growth and prosperity.

(Kishore Narne is Head of Commodities & Currencies at Motilal Oswal Commodities Broker Private Limited. Views expressed are his own and do not represent those of ETMarkets.com)