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The recent notification of the
Forward Market Commission imposing a ban on futures trading in a
number of agricultural futures has struck up discussions regarding
its probable impact on farmers and its effectiveness as a policy
measure to curb inflation. Against this background, this article
intents to examine the ban in terms of (i) its effectiveness in
attaining the stated goal of curbing inflation and (ii) its likely
impact on farmers. It will also discuss in brief the concept of
forward trading and risk hedging, need for regulation in a futures
market and the legal and institutional framework governing futures
markets in India with focus on commodity derivatives.
Derivatives, Forward Contracts, Futures And Options: Some Basic Concepts In Derivative Trading:and contracts are both contracts to meet a certain obligation, (usually, to deliver a specified quality and quantity of a commodity or a specified number of a financial instrument for a specified price, Vohra, N.D. & B.R. Bangri, , p.2) in specified manner on a specified date in the future. Both the parties are required to perform their obligations in a future date known as the maturity date of the contract. The essential distinction between a future contract and forward contract is that while forward contract is one to one covenant between the parties thereto, futures contract is a much more standardized agreement between the parties, which can be bought or sold to a third party (or between the parties) at any point of time, so as to alter or even reverse the rights and obligations arising under the original contract. This capability to altering positions, makes a futures contract an instrument with a higher level of liquidity than the forward contract. Moreover, in a forward, as the parties are the only persons involved in the transactions, there is a high level of counter-party risks, that is, the risk of non-performance from one of the parties. But this counter party risk is eliminated in a futures contract by the presence of clearance houses who take opposing positions in every alternate transaction and ensure the equality of long and short positions.
An option is the right, not obligation, to buy or sell a specified amount (and quality) of a commodity, currency, index or financial instrument, or to buy or sell a specified number of underlying futures contracts, at a specified price, on or before a specified a given date in the future (ibid p.7). An option confers upon its holder a right but not obligation to buy/sell the underlying commodity/ contract/ index/ instrument/ currency at a pre-specified price on or before the said date. An option that gives its holder a right to buy is called a call option while one that confers upon its holder a right to sell is called a put option. Options, like futures, can be traded in an exchange so as to alter or reverse positions. An option appears to the general rule that an offer can be revoked any time before it is accepted. In an option the option writer (the one who grants the option) is not free to revoke the offer before the specified date though the option holder has not accepted the offer by the exercise of the offer. There appears to be an ancillary agreement between the parties by which the offeror undertakes to keep the offer open till the specified date. It appears to the researcher that where there is a payment of an advance or earnest money between the parties, it acts as consideration for the ancillary agreement and makes it a contract. Where there is no such payment, the obligation of the option writer to keep the offer open arises from the doctrine of promissory estoppel.
Futures and options guarantee certain economic advantages to the parties thereto in terms of risk hedging, speculative benefits and arbitrage opportunities. As futures and options ensure a high level of liquidity, parties can alter their obligations and rights arising from the contract by buying or selling contracts in the exchange. Thus a party can reduce losses or earn profits by transferring the rights and obligations under the contract by a deal in the exchange, when performance on his part would mean lesser profits or greater losses. Similarly, even if one party is in a situation where performance on his part is either impossible or detrimental to his interest, the other party does not have to bear the counter party risks as the party not interested in performance can alter his position by trading in the exchange. Whatever counter-party risks remain are taken over by the clearance houses. Thus options and futures serve the purpose of reducing counter-party risks, which has been stated above as a vital function of the contract.
Similarly, parties entering into futures contracts fix the quantity, quality, price and other particulars at a prior date. This helps the parties to avoid (hedge) the risks of price fluctuations and also to plan out future activities.
Thus, if we are to agree to PS Atiyah's argument that the key aim of contracts is to facilitate economic transactions (Atiyah, P.S., An introduction to law of Contracts, p.6), futures and options help in attaining this aim to a large extent.
Forward contracts have often been confused with wagering agreements as fluctuations in the price of the subject of the contract, which is an uncertain event, will determine payoffs for the parties to the contract. In Garnac Grain Co. Inc v. HM Faure & Faireclough Ltd. ( 1 QB 650) the parties had entered into a contract for sale goods, delivery to be made in three months? time, and the price to be market price at the date of delivery. It was argued that this transaction was a wagering agreement as the parties stood to gain or lose from an uncertain event, that is, the fluctuation in prices. But this element of chance was held to be merely an incident in the larger transaction of a contract of sale of goods on certain terms; it did not convert that transaction into a wagering contract. (Garnac Grain Co. Inc. v HM Faure & Faireclough Ltd.  1 QB 650) If however both the parties use this means to gamble on future price differences and for no other purpose, it being in effect agreed between them that neither party should be entitled to call for performance, then the contract will be held to be a wager. (R. Pagnan & Fatelli v NGJ Schoten N.V.  Lloyd's Rep. 319)
In India, the Courts have held that mere presence of speculation in a contract does not make it a wager and that intention of the parties to wager is crucial. Every forward contract is speculative to some extend, but that does not reduce them to wagering agreements. (Mannalal v Beharilal AIR 1961 SC 268) If the parties intent merely to speculate in prices and in no circumstances perform the obligations under the contract, only then a futures contract becomes a wagering agreement. The mere fact that the parties have an option of paying the price difference and not actually performing the contract does not make it a wagering agreement unless it be the intention of both the contracting parties, at the time of entering into contracts under no circumstances to call for, or give delivery, from or to each other. (Tod v Lakshmi Das 16 Bom 441; Mathuradas v Narbadashankar 11 Bom LR 1997, 1004 as quoted in Moitra, A.C., Law of Contract and Specific Relief, p.408) There is no presumption that a forward contract with an option of cash settlement is a wager. On the contrary, the presumption is that such a contract is not a wager and it is the onus of the party alleging it to be a wager to prove his allegation. (Narandas v Ghanshyamdas 1933 Bom 348)
An accepted test to prove the real intention of the parties is a comparison between the value of the transaction and the financial condition of the party alleging wager (Meghji Vallabhdas v Jadhowji Moraji 12 Bom 1026 as cited in Moitra, A.C., Law of Contract and Specific Relief, p.408). As futures exchanges allow market players to trade in futures with the deposition of a very small margin compared to the total worth of the transaction, option of cash settlement (settlement by payment of the difference in prices) would give ample opportunities for speculators to enter into contracts of which the total worth is beyond the capacity of the parties and speculate on the fluctuations in prices and settle the transaction through payment of difference in prices. This test acts as an effective mechanism to check such wagering to some extent. But it is to be noted that wagering is done not only by parties with low capacity to pay.
Futures Market: The Agents And The Mechanism:Having defined the key concepts like derivatives, futures and hedging, an analysis of the working of a futures market can be undertaken. This section discusses who the agents in a commodities futures market are, what their strategies are, how an interaction of these strategies fix the price of futures and need or regulation.
It appears that the participants in a commodities futures market can be divided broadly into hedgers and speculators depending on their attitude towards risk (Babcock, Bruce, Commodity futures Trading for Beginners, Reality Based Traders. While hedgers are those risk-aversive agents who try to shift the price risks associated with volatile nature of prices in a deal by opting for a fixed price decided in the present by the means of futures, speculators are those who are willing to take risks and intend to reap benefits out of the speculated changes in price of the derivative itself. While hedgers are concerned about securing a fixed price for the commodity underlying the derivative speculators are concerned about possible fluctuations in the price of the derivative itself and the profits that can be reaped from them. Most of the times it is noticed in a real world market that though the same agent may act as a hedger at one instance and a speculator at another, the general rule is that hedgers form the two extreme ends of a chain of transactions (the persons who really intend to buy or sell the commodity as such and not merely the derivative, that is mostly the producers and the final demanders of the commodity) the intermittent roles are filled by a number of speculators who may further be divided into a number of categories like arbitragers, day-traders, etc. So, in a way, a futures market is a forum for trade offs in risk between the risk aversive hedgers and the risk taking speculators. Both speculators and hedgers have their own demand and supply schedules and it is an interaction between these market forces that fix prices in a future market, if they are given a free hand.
Though Speculators and hedgers account for the demand and supply equations in a futures market, they are not the only entities that matter. Clearance houses and brokers are the people who really appear in the pit. Clearance firms ensure that the contracts are complied with. In every deal between two parties, clearance houses stand between the parties, taking the stand opposite to what each party has taken. That is, the person taking short position sells the commodity to the clearance house and the person taking the long position buys the contract from the clearance house. Clearance houses require the parties to deposit a margin, proportional to the worth of the deal so that performance can be assured. Brokers are hired by parties to trade on their behalf in the market, in accordance to a range of orders that are exercised by the party from time to time.
An issue of theoretical and academic interest and of regulatory concern is the gap between future and spot prices. This is a concern or the policy makers because a huge gap between spot and future prices may create a tilt in favour of either future or spot market at the expense of the other thereby affecting the demand and supply equations in the macroeconomic picture and causing consequent fluctuations in the related macroeconomic variables.
The difference between future and spot prices is known as Basis. (Basis = Pt - P0 where Pt is future price and P0 is spot price). In a normal market Basis is positive while in an inverted market Basis is negative. The difference in prices tends to decrease and the prices tend to converge bringing down Basis to zero as the month of delivery approaches. The convergence of price occurs because any non-zero Basis at a period close to the month of delivery will provide the traders ample opportunities of arbitrage and as they reap these opportunities the Basis will come closer and closer to zero. (Vohra and Bagri (2001); pp. 34-35)
Another feature of futures markets that calls for regulation is that traders in futures markets need merely a small proportion of the money that the trade is worth to be deposited as margins. This enables traders to enter into deals which are worth many times more than the money they have at their disposal. Such transactions are indeed undertaken by speculators who act as retail investors or day traders with the plans of reversing the trade position before the maturity of the future. But if such a reversal becomes impossible owing to huge fluctuations, a number of traders may face bankruptcy and even the presence of clearance houses may not be able to eliminate counter-party risks. (Risk of non performance by the other party to the contract)
Part II: An Assessment of The Current Ban on Futures Trading In Certain Agricultural Commodities:
I. Effectiveness of the Ban on curbing inflationIt is quite undisputed that futures trading has a direct impact on inflation. This is brought about by the presence of basis (the difference between spot and future prices). In usual cases, the futures prices are higher than spot prices (In support of this proposition, see market data for different commodities and different dates available at www.ncdex.org). The cause of this phenomenon is the presence of speculation and positive expectations. However, in certain commodities where speculation is negative, futures prices are lower than the spot prices. This difference in spot and futures prices is capable of causing a shit in the demand-supply mechanisms in favour of a particular time period to the prejudice of the other. For instance, when futures prices are higher than spot prices for an agricultural commodity, the farmers would like to sell the commodity in future, bringing down the supply levels at present. However, the lower prices at present compared to future prices prompts a high demand for the commodity at present. This mechanism causes excess demand in the present time period and pushes up the price of the commodity in question, thereby causing higher levels of inflation. Given that the futures prices were almost always higher than the spot prices as far as agricultural commodities are concerned, the ban is likely to bring down the prices of food grains.
However, whether the ban will help in curtailing overall inflation or merely act as a stopgap measure bringing down prices of agricultural commodities alone, leaving the farmers faced with lower incomes and higher price levels for nonagricultural commodities is a question that can be answered only by an examination of real causes of the current inflation phenomenon. Between 2004-05 and 2005-06 there has been an acceleration in growth of broad money (M3) from 12.3% to 17%.. This rapid growth cannot be attributed merely to the presence of future traders. There are and fiscal factors like increased credit availability which are at the root of the phenomenon. Banning futures trading without attending to these real casuses will merely bring down price of agricultural products without causing a corresponding deflation for non-agricultural products. This will lead to a highly inequitable result, leaving the farmers at a worsened position.
II. Impact of the Ban on FarmersIt has been pointed out in the previous section how ban on futures trading in agricultural commodities, without initiating steps to attend to the real causes of inflation will leave the farmers in a worsened situation. However, it is to be noted here that the gains that the typical Indian farmer used to reap from futures trading are those that arise as a spill-over effect of futures trading (through the mechanism mentioned in the previous section) and not from the participation of farmers in forward markets.
Futures trading has been advocated as a tool to solve the market uncertainties by promising the farmers a fixed price for their future output. Given the market situation and volatility of prices of agricultural products in India, such an assurance is of extreme importance. Thus, futures trading, in theory, has the potential to solve a number of problems in the agricultural sector. But, in the present scenario, a forward markets are beyond the reach of a vast majority of Indian farmers. A huge chunk of Indian farmers fall within the category of marginal farmers. It is these farmers who are the most affected the most by the market fluctuations and the monsoon failures. Hence, it is these farmers who really need to hedge risks through futures trading. But the present regulations in the Indian commodity exchanges appear to exclude small farmers from the picture completely. A comparison between the average product per farmer and the minimum lot size to be traded in the commodity exchange throws some light on the situation. comparison of minimum lot size that can be traded in commodity exchanges in India with the production data for small and marginal farmers reveals that the minimum lot size in a commodity market is much larger than the total annual production of a small or marginal farmer. This keeps future markets outside the reach of marginal and small farmers.
Thus a major part of the gains that critics of the ban accuse the ban of snatching from the farmers, were in fact never enjoyed by the majority of agrarian community in India. The direct gains of futures trading in India were always cornered by speculators and large farmers who were able to meet the huge lot size requirements of the Indian commodity markets. Thus what the average Indian farmer stands to lose from the ban is the higher price lever arrived at as a spillover effect of forward trading and not any direct gain.
In the light of the above analysis, it can be safely concluded that the current ban on futures trading in certain agricultural commodities is a mere stopgap measure to curb inflation. It certainly will affect the farmers adversely by lowering the price level of agricultural commodities unaccompanied by a corresponding lowering in prices of non-agricultural products. However this does not mean forward trading, as it stood before the ban was helpful to the farmers. It is specially emphasized that the market regulations regarding lot size and other standards prevailing in the Indian commodity exchanges are not suited for the socio-economic realities of the Indian farming community.
Price Data for different commodities available at official website of National Commodity and Derivative Exchange: www.ncdex.org. Forward Contracts (Regulation) Act 1952Department of Agriculture and Co-operation, Government of India; Report Of The group on Forward and futures markets; 2001; available online at the official website of Forward Markets Commission: http//www.fmc.gov.in/htmldocs/reports/reports_list.htm
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