By KUSHANKUR DEY
Setting up an independent Product Advisory Committee (PAC) to deepen the benefits of commodity derivative markets to commodity value chain actors is a timely move by Sebi. It will address issues in the contract design of commodities and cater to needs of physical market participants. Based on Commodity Derivatives Advisory Committee’s (CADC) advice, Sebi has directed each recognised exchange, including stock and commodity, to “constitute a PAC for each group/complex of commodities having common stakeholders/value chain participants, on which derivatives are traded or being proposed to be traded”. This requires PAC to:
work on contract design for new commodities, explore a right mix of liquid and hedge contracts, review design of existing contracts, and ensure these are as per industry’s needs;
work on aligning quality/grade and quantity specifications of the product with spot/physical ready-cash markets;
provide a choice-set of basis variety, propose additional delivery centres which are exchange-accredited warehouses, and review existing delivery centres;
review performance of existing contracts on various explicit and broad-based parameters;
discuss the state of markets for the commodity during meetings or at least twice a year
But, how will PAC extend benefits of futures to the value chain stakeholders? Will it effectively assess the state of the market for commodities under the chairmanship of independent advisor—devoid of any principal and agent dichotomy?
Performance review of existing futures/options contracts, changing the contract design, and exploration of opportunities for new contract could be an up-hill task.
Fundamental factors of commodities should be studied by assessing the local demand and supply. Stock-to-use ratio is essential from liquidity viewpoint of futures/options contract. In the case of guar gum, a derivative of guar seed, the stock-to-use ratio of the seed determines the liquidity position, price and spread of gum contracts. Also, convenience yield benefits to commodity-holder should be appraised before PAC decides frequency of contract, delivery and stack and roll hedging.
Identifying close substitutes or rival contracts can help explore avenues for inter- or intra-commodity spread and/or calendar spread. Selection of basis variety and tenderable varieties for futures/options contract, too, is important, to encourage and sustain participation of physical market actors.
Delivery schedule should mirror the agricultural cycle of the produce while spot price could be depressed. So, in presence of liquid and efficiency futures/option, producers can offload risk, to secure income and stimulate investment in agriculture.
Market micro-structure parameters—bid-ask spread, margining, contract size, contract duration, price band, etc—are critical to assess performance of futures/options contract. A research body aligned with PAC should review historical and stochastic performance of competing/completing contracts.
PAC’s expected role, is at both at the micro and meso-levels. At the micro-level, PAC can observe heterogeneity in participation between physical and derivative market actors, helping exchanges and regulators take measures to bring parity in trade and maintain a healthy hedger-to-speculator ratio. At the meso level, it can help internalise the altruistic benefits of commodity derivative markets among market participants. The advisory body can contribute to the commodity/stock exchange utility and management in reliable price discovery, price dissemination, and effective hedging against basis risk. PAC, in its review meeting, should disclose speculator-to-hedger ratio, to help discover optimal number of derivative contracts (liquid) for each group of commodities and rationalise transaction fees.
The membership criteria and margining system for FPOs should be revised in view of financialisation of commodities. PAC and Regulatory Oversight Committee, in consultation with CADC, should enable trading, settlement, and delivery. Exchange of futures for physicals/alternate settlement mechanism should be promoted along with early pay-in facility.
PAC should facilitate index trading to access annualised average yield and volatility from the disclosure of commodity exchanges. In FY19, the average yield at N-Krishi of NCDEX and MCX-Comdex was 6.6% and 12.5%, respectively, while their volatilities varied from 19% to 37.4%. It should adopt good governance practices from international exchanges and regulators.
The committee’s right intention, autonomy, directed effort in facilitating and designing broad-based contracts can help accommodate a diverse group of commodity stakeholders—from producers and processors to traders.
The author is Professor of Finance, IIM Bodh Gaya