Lift the ban

The need for lifting the ban on commodity options has been felt ever since futures trading was officially permitted in April 2003. Now, the parliamentary standing committee on food and consumer affairs has formally recommended to the government that the ban on commodity options should also be lifted.

The reason for this is amply clear. If the real purpose of allowing commodity futures trading was to safeguard the farmers against price volatility and distress sales, it has not been met. That's because the farmers (barring rubber and pepper planters) have not come forward to participate in futures trading.

In their absence, traders, middlemen and even speculators have virtually taken over the commodity futures trading. A large number of these, in fact, are the stock brokers who switch over to the commodity exchanges in the evenings after the end of the trading in the stock markets.

The farmers generally lack knowledge about the functioning of the futures market and believe its systems and procedures to be too cumbersome. Consequently, futures trading cannot even be expected to play a direct role in preventing distress sales.

In any case, the commodity futures contracts, in their present form, permit the parties only to lock into a pre-determined price to be paid at the expiry of the contract.

While this provides protection to the seller of a product against any fall in prices at the time of the settlement, it does not give him any room to gain from a spurt in prices or any likely subsequent price surge.

From that point of view, options are relatively suited as a risk management tool for the farmers. But, right now, options are permitted only in the securities markets but not in the commodity exchanges, for inexplicable reasons.

In options, the seller would have the right, but not the obligation, to sell at the end of the contract for which an option premium is paid. Thus, by paying a small amount a seller can open an avenue for benefiting from a future price increase.

In the process, the farmer would not only be able to hedge his price risk, but actually be in a position to improve the returns and adjust the timing of cash flow from the sale of his produce.

However, no mode of marketing, be it futures, options or spot, can serve a useful purpose unless certain pre-requisites are met. The most significant among these include transparency in operations, a wider dissemination of prevailing spot and future prices, and an availability of reliable market intelligence regarding likely demand-supply equations and other relevant details.

Concepts like e-chaupals of ITC or collective marketing through cooperatives can come in handy to link the farmers with the commodity exchanges. Indeed, equally important is the creation of a network of warehouses and involvement of the banking and other financial institutions to finance the hedged crop kept in accredited warehouses.

Unless a legally valid and tradeable warehouse receipt system is in place, the incidence of distress sales during the prime harvesting and marketing season cannot be prevented. Nor can the advantages of futures trading be fully tapped.