In today’s Finshots, we talk about the Securities and Exchange Board of India (SEBI) extending a ban on futures trading in certain commodities.
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SEBI just doesn’t want people to trade in 7 commodities!
In December 2021, it banned futures trading in agricultural commodities such as wheat, chana, and soybean for a year. In 2022, it extended the ban. And a few days ago, it decided to keep the ban in place for yet another year.
To fight inflation.
But wait…how does trading in futures affect commodity inflation, you ask?
Well, before we answer that, we need to first know why futures are important in the first place.
Okay, so imagine you’re a farmer growing wheat. You plant the crop and it’s going to take a few months before you can harvest it. You’ve incurred some costs of labour, fertilisers, seeds, and all that. But now you’re unsure what the price of wheat will be 4 months down the line. What if there’s a bumper crop and the prices drop drastically? You just don’t know.
Now what you could do is find a counterparty or a buyer who fears the opposite. Someone who wants wheat in 4 months but is afraid that the price could shoot up. Maybe they’re worried about a possible disease outbreak that kills supply and increases prices.
So the two of you shake hands. You agree upon a predetermined price. And promise that in 4 months, the exchange will take place at that price. No matter what the actual price of wheat in the market might be. Both sides are trying to play it safe.
This folks, is a “Forward contract”.
Now imagine a stock exchange-like entity that can help connect sellers and buyers for such commodity trades. The contract is standardized. There will be rules on the minimum quantity of wheat that can be traded per contract. There will be certain fees to be paid in case one person backs out of the contract. Stuff like that. And this is called a “Futures contract”.
You can see why this is quite important for farmers, right? While the crop is growing and the prices fall, the futures contract could make up for potential losses. It’s like an insurance for the farmer.
But there’s a problem that people point to. Anyone can trade in the futures market. It’s not just farmers and other commodity folks who’re trying to hedge their business. There could be ones who’re speculating on prices and trying to make a quick buck. They don’t care about actual demand-supply dynamics. They’re just speculating. And that could end up pushing prices of commodity futures higher. Now that’s a problem. Because when people see these futures prices head north, they might hoard physical commodities in the hope of higher price later. It could lead to profiteering. And that could stoke inflation on the ground.
That makes intuitive sense, right?
So you can see why SEBI has banned futures trading in these commodities for another year. They don’t want speculators driving up prices.
But here’s the thing. We really don’t have concrete evidence that these bans actually work.
You see, back in 2007, the government faced a similar dilemma of rising commodity prices. They set up a committee to find an answer. And the learned folks came back with their answer, “Sorry, we don’t have statistical proof that trading in commodity futures stokes inflation."
Yup, what made intuitive sense didn’t seem to hold water in the real world.
But, the government didn’t heed the advice of the committee back then. It banned futures trading in commodities such as chickpea and potato. The end result? Despite the ban, the prices in the markets rose.
Then in 2010, the Reserve Bank of India (RBI), the ones in charge of keeping inflation in check, decided to dive into the matter too. They wanted to see for themselves if there was some cause-effect phenomenon happening. So they took 5 years worth of data for a few commodities and crunched the numbers. And what did they find? Nothing conclusive.
So yeah, despite a study by an economic committee and then one by RBI revealing nothing useful, SEBI still went ahead with a futures trading ban again in 2021. It didn’t make sense.
And yet again, the ban didn’t seem to help in any way. An article in BQPrime in May 2022 looked at wheat prices for instance. And the authors found that wheat prices which were stable for two months before the ban continued to remain stable for two months after that. On the other hand, prices of Moong actually rose after the ban. In fact, the ban might’ve hurt farmers instead. And even hurt the government.
How, you ask?
Well, wheat prices had surged in 2022 thanks to the Russia-Ukraine war. So farmers used the opportunity and sold a large chunk of their wheat in the open market. That meant that the government didn’t have to buy that much wheat from them at the Minimum Support Price (MSP). Ergo, the government saved money.
Now if there was a properly functioning futures market, the farmers could’ve capitalized on this and they might’ve been able to lock in even more wheat trade at a higher price. And the government might’ve been able to save even more money. Everyone would’ve won.
But alas, that wasn’t to be.
And despite the ban being in place, Mint says that the retail prices of chana daal and moong daal have risen by 11% in the past year. So we’re going to say that the ban didn’t do full justice in 2022 either.
So, why on earth do we continue to impose this ban?
That’s something SEBI has to answer. Not us. But it does seem to have political undertones. Or at least, that’s what an official in the ministry told Mint. Elections are around the corner and they want to do whatever it takes to keep food prices in check. Even if it doesn’t work, they can at least say. “Hey, we tried to stop the darn speculators,” no?
Some sort of action is better than nothing.
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