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Thursday, February 10, 2011

Regulation and Governance of Commodity Markets in India-amazing lecture by Mr BC Khatua(Chairman, FMC)

Even at IIM-A, IAS officers and regulators do not drop in daily! So when the 1976 IAS batch officer Mr. B C Khatua visited IIM-A to deliver a guest lecture for an elective course, I decided to attend come-what-may. And the lecture was fabulous and entertaining(some of his pithy analogies described here) . This post tries to encapsulate the learnings from that session but is not a verbatim transcript. Some parts have been transposed for logical flow.  My analysis is in Italics.

Given that most attendees(2nd yr PGP-ABM students) had attended 15+ lectures on this topic, Mr Khatua plunged into his talk with the wry observation that he had returned from a Parliamentary hearing where he found it difficult to educate people about the basic distinctions between commodities futures, commodities spot and equities markets.

Piercing the common misconception that all futures markets are alike, he explained the following differences between commodities and other future markets.
  1. In commodities markets, someone is affected at any point of time(in high price scenario consumer in low price scenario producer) so the chance for discontent/lobbying is more. In equities market, as Buffet puts it, 'a rising tide lifts all boats' so people are generally happy with higher prices
  2. Commodities can never touch zero(intrinsic value>0) but equities can touch zero. Equities will have some residual value('call option' value in finance theory sense) so this point is not strictly right.
  3. One can generalize across stocks but each commodity is very different with its own idiosyncrasies. There are much more variables(so scope for detailed econometric modeling)
  4. Due to India's inadequate transportation, spot markets/financing(for agricultural commodities only), there is no common spot market which is more like 28 spot markets! GST and APMC reforms may close this gap though. Till that happens, these local imperfections will magnify any national/global trends. For example, inability to transport perishables may magnify effect of frost/rains.The FMC works around these issues by polling prices(mechanism similar to how LIBOR rates are calculated),
  5. Imagine 2 tug-of-war teams There are diverse interests with contrasting views(long/short) and so the market should be in finely balanced equilibrium. Even if rumors/speculation etc come, it is easier to confirm/disprove than for equities/securities. So the intra-day volatility is higher than in equities but the trend is more stable. Exception was for the high oil bubble seen in 2008(explained here)
  6. The virtual market is much more affected by the vagaries of the real market. No one bans a stock future if the stock tanks but as the case of sugar futures(described here) shows, the futures market was blamed for the intrinsic spot market issues.
  7. Unlike stock markets(no comparative advantage in opting for stock settled futures),physical delivery in the commodities futures market is preferred by quality conscious buyers(compared to taking from spot market)  because
    1. Their contracts are better enforceable(penalties for opting out besides MTM)
    2.  Quality is more much specified and warehousing conditions are good
 He concluded by stating that besides the FMC Amendment bill before Parliament, the spot market reforms(GST, APMC reforms, bank credit, warehouse facility, transport improvement) was needed before the commodities futures market could really take off. His hope was that one day, the farmer would aggregate enough to actually trade on the exchange platform(This seems unlikely but who knows?)

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