R Ravimohan: Heads up on commodities

With a fully developed futures market, the underlying cash market for commodities will reform and become efficient.

Commodities exchanges, like the NCDEX, are silently ushering in a revolution. A couple of decades back the financial community was besotted with the mission of spreading the equity culture throughout the length and breadth of the country. While a considerable penetration of the equity cult has been achieved, trading futures of commodities have made impressive strides as a financial market. However, the impact of an exchange, like the NCDEX, is well beyond simply creating another financial market. Of course, it will do it in such style that will leave equity markets well behind in trading volumes and investment opportunities. However, the true impact of these exchanges has to be measured in the real markets and in getting better prices for farmers for their agricultural products. The NCDEX appears well on its way to achieving this goal.

First, let us look at the value chain of agricultural commodities. The farmer produces agri-commodities, which go through either a government-controlled channel or a privately controlled network, before reaching the end consumer. Sometimes, these channels are multi-layered; sometimes bound by various state and central government policies; sometimes subject to non-transparency; and sometimes plainly inefficient. As a result, neither the producers nor the end consumers are certain about the fair price of selling or buying these products. Also, the government may be uncertain whether the subsidy amount is accurate and not inflated due to market vicissitudes.

The NCDEX plays two important roles that address some of the above concerns. The most important contribution of the NCDEX is the creation of a single trading platform spanning the entire country, which, by virtue of being liquid, is able to discover the true market price. Undoubtedly, there are wrinkles that need to be ironed out in the price discovery process, but clearly the true value of this market-determined price is phenomenal in addressing the issues outlined above. Second, the NCDEX allows both producers and consumers to proactively safeguard their interests, as opposed to being hit by wild swings in prices, by trading or hedging into sensible future positions. For instance, if a farmer finds an attractive future price of rice or wheat, he can simply do a lock-in by selling his production quantum on the futures market. When the farmer's rice is finally ready, he is certain of realising the desired price, unlike today, when he faces the risk of not selling or realising a good price as the market reacts downward to the final influx of produce from all farmers at the time that he is also in the market. Similarly, the consumers of these products can lock into prices ahead of designing their sales prices, therefore being certain about their profit margins.

Staying with agri-commodities, it is obvious that the first degree of impact will be positive for real sector players if they use these markets smartly. There is already a good talent pool that can help farmers, governments, consumers, etc., and understand and incorporate the commodities markets in their day-to-day operations. But the benefits of these markets extend well beyond this level. For instance, with the financial and corporate communities also involved in these markets now, and they being globally linked, it is possible for the real sector players to get best prices on a global basis. Further, the government can use these exchanges to fine-tune its procurement and subsidy costs, including minimum support prices, and achieve cost efficiencies. Indeed, over time, the government can reduce the physical procurement process and all the ills of that system, including leakages, crop damages, and the like, by using the future prices to hedge its own position to reduce its outflow.

Similar benefits are also possible for players in the metal, oil, and energy sectors. For example, steel producers can lock in the most beneficial price they can get through their production cycle; a copper mine can also reap the best price by being vigilant on the commodities exchanges. Further, the additional dimension is the absence of weather-related risks, which make these products more amenable to financial engineering. For instance, a steel producer can construct paper that captures the differential between the NCDEX-quoted price for his grade of steel and the interest rate of his borrowing, and float a commercial paper with this differential as the financial yield for the investors. From the producer's point of view, the cost of borrowing vis-à-vis realisations is fully protected. At the same time, the lender is secured against the margin for his lending, while also reaping the upside of price movements of interest rates and steel prices. Such instruments, apart from providing an incredible variety of investment opportunities, also spread the price risk across communities rather than leaving it for the traditional sector players only. This reduces the impact cost, increases liquidity, and broadens the market for more efficient and fair price discovery.

Of course, all these are possible if the markets are efficient. Market efficiency depends keenly on the presence of a large number of players and the availability of news and information on a symmetrical basis to all participants. This is where a commodity newswire comes in. CRISIL MarketWire has recently launched a commodity newswire, which brings the latest information from all the mandis, foreign markets, corporate players involved in commodities, financial markets, policy makers, and the weather bureau on a real time basis. This allows participants to take informed views on their commodity trading, whether they are real sector players, commodity traders, financial sector players, or regulators and government agencies. The fact that the news will appear on a real time basis and will be authentic and supported with data and analysis, makes this an important element in the development of the commodities markets.

With a fully developed futures market, the underlying cash market for commodities will reform and become efficient. This will offer considerable investment opportunities for market participants. Ultimately, these markets will exert pressure on the real sector players to become more efficient, thereby improving our agricultural and mining yield. It will also bring much-needed investments to shore up the falling yield on agriculture produce. Thus, the commodities exchanges will bring comprehensive benefits for our country by making agriculture efficient, getting better price recovery for farmers and producers, and providing commodities at fair and more realistic prices for the consumers, while allowing traders and financiers to make decent financial gains.