Capital Markets: Challenges and Developments

SEBI suspends Futures Trading in key farm crops

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Derievatives, Commodity trading

Mains level : NA

Market regulator Securities & Exchange Board of India (SEBI) has issued an order suspending futures trading in paddy (non-basmati), wheat, Bengal gram (chana dal), mustard seeds and its derivatives, soyabean and its derivatives, crude palm oil and green gram (moong dal) for a year.

What are Derivatives?

  • A derivative is a contract between two parties which derives its value/price from an underlying asset.
  • The value of the underlying asset is bound to change as the value of the underlying assets keep changing continuously.
  • Generally, stocks, bonds, currency, commodities and interest rates form the underlying asset.

Types of Derivatives

The most common types of derivatives are futures, options, forwards and swaps:

(1) Futures

  • Futures are standardized contracts that allow the holder to buy/sell the asset at an agreed price at the specified date.
  • The parties to the futures contract are under an obligation to perform the contract. These contracts are traded on the stock exchange.
  • The value of future contracts is marked to market every day.
  • It means that the contract value is adjusted according to market movements till the expiration date.

 (2) Options

  • Options are derivative contracts that give the buyer a right to buy/sell the underlying asset at the specified price during a certain period of time.
  • The buyer is not under any obligation to exercise the option.
  • The option seller is known as the option writer. The specified price is known as the strike price.

(3) Forwards

  • Forwards are like futures contracts wherein the holder is under an obligation to perform the contract.
  • But forwards are unstandardized and not traded on stock exchanges.
  • These are available over-the-counter and are not marked-to-market.
  • These can be customized to suit the requirements of the parties to the contract.

(4) Swaps

  • Swaps are derivative contracts wherein two parties exchange their financial obligations.
  • The cash flows are based on a notional principal amount agreed between both parties without the exchange of principal.
  • The amount of cash flows is based on a rate of interest.
  • One cash flow is generally fixed and the other changes on the basis of a benchmark interest rate.
  • Swaps are not traded on stock exchanges and are over-the-counter contracts between businesses or financial institutions.

What are Agri-Futures?

Like equity, currency or interest rate futures, they allows to buy or sell an underlier at a preset price on a future date. All agri contracts end in compulsory delivery.

  • Agri products available for trade include wheat, sugar, chana, soyabean, castor, chilli , jeera futures, etc. Edible oil seeds and oils, spices and items like guar are among the more liquid contracts.
  • An objective of futures trading is gains reaching farmers, by establishing an efficient price-discovery platform.
  • This has been achieved to a large extent on NCDEX, in products such as castor, chana, soy complex, mustard, guar, cumin, etc.

National Commodity & Derivatives Exchange Limited (NCDEX) is an Indian online commodity and derivative exchange. It is under the ownership of Ministry of Finance.

What are the reasons for this ban?

(1) To cool off Food Inflation

  • India’s retail inflation rose to a three-month high of 4.91 % in November from 4.48 % in the previous month primarily because of a rise in food inflation to 1.87 % from 0.85 % over this period.

(2) Double Digits WPI

  • Wholesale Price Index-based inflation has remained in double digits for eight consecutive months beginning in April, mainly because of the surging prices of food items.
  • In November, the wholesale price-based inflation surged to a record high of 14.23 % amid the hardening of prices of mineral oils, basic metals, crude petroleum, and natural gas.

(3) To insulate future Price Shock

  • In view of Rabi Output that might be affected morbidly because of fertilizer shortage faced in many parts of the country.
  • By banning future’s trade, the government is trying to insulate any price shock the market might feel in the days to come in case the production is not up to par.

What will be the impact?

(1) The imports in such commodities, especially edible oils, would reduce in the short term as traders will not have a hedging platform.

  • Hedging, which is speculative in nature, has been made difficult.
  • This will lead to the release of blocked local produce supplies into the market, which should cool the prices.
  • Imports of commodities for speculative gains will be discouraged.

(2) It is believed that speculators have a role in jacking up prices and this needed to be discouraged to curb inflation and support growth as the economy is recovering from the COVID-19 impact.

(3) India is the world’s biggest importer of vegetable oil and this measure will make it difficult for edible oil importers and traders to transact business since they use Indian exchanges to hedge their risk.

(4) Agri-futures, driven mainly by NCDEX, have a checkered history with bans often pushing NCDEX back.

  • Such frequent bans are not a good development for the market as it affects confidence levels.
  • Often, a contract that is banned may not return to the table, which were very effective in price-discovery.
  • Even when the contracts are restored, traders hesitate because of the fear of bans.
  • As it involves losses for market participants with open positions as they must square off contracts before maturity.

What are the other steps taken?

  • Supply-side interventions by the Government had limited the fallout of continuing high international edible oil prices on domestic prices.
  • The Union Government substantially reduced taxes on imports of palm, soy and sunflower oil.
  • Union and State Governments had also recently reduced excise duty and VAT on petrol and diesel, aimed at bringing down inflation.
  • It has both direct effects as well as indirect effects operating through fuel and transportation costs.

Way Forward

  • The ban is expected to be lifted by March when the next mustard crop starts hitting the market and prices cool down.
    • If the weather remains benign in the coming weeks, India is on course to harvest a bumper 11 million tonnes of mustard in 2021-22, up from 8.5 million tonnes in 2020-21.
  • The way out is not to ban any contract, but make sure to correct any serious aberration through a combination of higher margins so that if at all the price is getting distorted due to market manipulation, the correction takes place immediately.
  • Further, talking to potential wrongdoers is another way out, provided trading patterns noticed by the exchange reveal such tendencies.
    • Position limits can be changed to ensure undue influence is not exerted by any set of traders.

 

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