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Introduction:
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:
Forward and
future 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,
Futures and Options, 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. ([1966] 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. [1966] 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. [1973] 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;
http//www.rb-trading.com/begin.html
). 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
inflation
It 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 Farmers
It 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.
Conclusion:
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.
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Ban On Futures Trading In Certain Agricultural Commodities: An
Impact Analysis
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author can be reached at: deepakelanthoor@legalserviceindia.com /
