Talking Point. Finding an anchor for derivative prices

Commodity exchanges do spot polling to discover the underlying price, but this is not a permanent solution

At the board meeting of SEBI held in February, the regulator had listed the priority areas that have to be tackled in fiscal year 2017-18. One of the areas highlighted was improving the integration between the commodity spot and derivative markets.

With new regulator of commodity exchanges, SEBI, has been burning midnight oil, issuing guidelines to tackle all aspects of commodity trading. One of the persisting concerns of the regulator and users in commodity exchanges has been the price volatility. The manner in which the prices of these contracts surge or crash, showing no linkage to their fundamental value, has lent an air of notoriety to these contracts.

Since there are just handfuls of large traders in each commodity who understand the nuances of the commodity’s market, price manipulation was earlier quite rampant. SEBI is attempting to control these malpractices by imposing limits on the open positions of traders but there is still a long way to go in curbing these misdoings.

Anchoring the prices of future contracts to the underlying spot prices is one way in which these excessive price movements can be checked. But this is easier said than done.

Futures’ prices are typically derived from the spot price adjusted for the net cost incurred in carrying the asset till maturity. But the problem with the agri-commodity futures market in India is the absence of a unified organised spot market.

Trading takes place in a dispersed manner all over the country in various mandis. Certain commodities are traded only in certain markets close to the area where they are produced.

There is also a great variation in the quality of products sold in various mandis and there are no standard sizes in which trading takes place. Therefore, matching the price of the future contract to commodity of similar quality and lot size is not easy.

Experts in commodity trading opine that the genuine users of commodity futures do not really need to know the spot price since they will be associated with the relevant spot market anyway. It is the commodity trader who will need a reference price to know if the future contract he is trading in is too much out of sync with its underlying.

To arrive at a reference spot price for other agri-commodities, the exchanges follow a price discovery mechanism called spot polling mechanism.

The objective of spot polling is to discover a spot price that can be tracked by the users, traders as well as exchanges. Commodity exchanges such as NCDEX and MCX conduct a survey of the spot price of the commodity traded in spot market from a panel of stakeholders, across the value-chain (farmer, commission agent, transporter, etc). The regions from where the spot prices are polled could vary depending on the commodity. The prices are polled at regular intervals through the day, typically twice during the trading day.

These polled prices are then bootstrapped (removing the outlier prices) and subjected to further smoothening through statistical means to arrive at the spot price that is published on the exchange. This ‘discovered spot price’ is then disseminated on the exchange websites.

Other factors affecting the cost of a commodity, such as mandi tax, local and government taxes, processing charges, labour, transportation costs, etc, are also checked by exchanges to ensure that the polled prices aptly reflect the cost at which the underlying is transacted.

SEBI, in a circular issued in September last year, laid down rules regarding the disclosure needed to be made by exchanges in terms of the methodology followed, the centres and panelists used for each commodity.

The spot prices thus polled are used by the exchanges to arrive at the final settlement price of the contract. Besides giving an indicative price to traders, the spot prices are also useful to exchanges in surveillance of price movement.

While the regulator and the exchanges have found a solution around the problem of finding a reference price for agri-future contracts, it is a mere stop-gap arrangement. It will be ideal to have spot price disseminated live while future contracts are traded, similar to the equity market. That will ensure that future prices reflect the demand and supply in the underlying market. Arbitration trades will then be possible, which will ensure that the difference between the spot and derivative price is not too wide and does not persist.

While matching the quality and quantity of goods traded on future and spot market for agri commodities will not be easy, the proposed Electronic National Agriculture Market (e-NAM), can help make some progress in this direction. This pan-India electronic platform that will connect all the APMC mandis to create a unified spot market for agricultural produce can provide spot market data live.

If e-NAM is able to trade in lot sizes similar to the future contract sizes, exchanges could move away from the current system. But for now, that is a distant dream.

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