By Kavaljit Singh, Madhyam, New Delhi

Because speculation with food commodity derivatives has been causing huge price spikes and price volatility that has affected the poor and farmers worldwide, international attempts have been made to regulate such speculation. Any new legislation on commodity derivatives trading is to be assessed as to whether harmful speculation will be prevented.

In India, the financial regulators at the Securities and Exchange Board of India (SEBI) have announced an ambitious plan to allow the entry of financial participants (such as mutual funds, banks, insurance companies, alternative investment funds and other financial institutions) and to introduce new products (such as options

Options are the right, but not the obligation, to buy (call option) or sell (put option) a specific amount of given stock, commodity, currency, index or debt at a specific price during a specific period of time. Each option has a buyer (called a holder) and a seller (known as the writer). The buyer of such a right has to pay a premium to the issuer of the derivative (i.e. the bank) and hopes the prices of the underlying commodity or financial asset to change so that he can recover the premium cost. The buyer may choose whether or not to exercise the option by the set date.
contracts) onto the Indian commodity derivatives markets. Detailed guidelines and necessary legal amendments are currently being worked out so that these measures can be introduced this year.

The purported objectives behind this plan are to increase trade on the Indian markets by opening them up to new participants while broadening them by introducing new products. There is definitely an upbeat mood among the policymakers to open up Indian commodity markets to new financial players – both domestic and foreign.

SEBI will phase in new participants, with mutual funds

Mutual funds are open-ended funds operated by an investment company, which raises money from shareholders and invests in a (diversified) group of assets, in accordance with a stated set of objectives . This way enabling small private investors to invest in a diversified portfolio of shares, bonds and other securities. Mutual funds are open-ended funds since there is no fixed amount of capital in the fund. If new investors want to invest, the fund can issue new units, accepting the money into the pool.
the first to trade in commodity derivatives contracts. This move is not well-advised.

It is difficult to understand the rationale behind allowing mutual funds (along with insurance companies and other institutional investors) to trade in commodity derivatives, since they have no direct business or commercial activities in the underlying physical commodities. In India, mutual funds may only invest in one commodity – gold – and only in companies that are engaged in the gold business (not in physical gold).

Even in the case of banks, while they lend money to farmers and commodity traders in India, they don’t have any direct relationship or business with physical agricultural commodities, such as wheat and rice.

Cash-rich players

For cash-rich financial players, commodity trading is an investment asset class rather than a consumption asset class. They attempt to profit from the speculative buying and selling of derivatives contracts by anticipating future price movements – yet have no intention of actually owning the physical commodity.

Allowing such players to trade in agricultural derivatives contracts will be extremely risky, as underlying agricultural commodities are mostly seasonal and perishable – and therefore subject to unforeseen price volatility. If SEBI does not impose limits on speculation by investors such as  mutual funds, these asset managers will prefer to invest a large chunk of pooled money in commodity contracts, due to the high risk-high return nature of commodity derivatives markets.

Herd behaviour

Not long ago, the Indian authorities suspended trading in several agricultural futures contracts in order to contain commodity price surges that were largely driven by speculators and herd behaviour among investors. The infusion of large sums of money by mutual funds in a commodity contract may cause prices to deviate further from their fundamental price signals, which will invite such drastic actions from the Indian authorities in the future as well. Hence, SEBI should also be duly concerned about the potential risks posed to small retail investors due to risky investments made by mutual funds in commodity derivatives.

At a time when interlinkages between the commodity derivatives markets and spot markets are weak and market abuse practices common, the policy priority should be to develop a robust regulatory framework that promotes market integrity and protects the interests of small producers.

For more detailed information, please refer to the more explanatory blog and briefing.

Kavaljit Singh works with Madhyam, a policy research organisation based in New Delhi.