India - Managing price risks in India's liberalized agriculture : can futures markets help?

Report No. 15453-IN India Managing Price Risks in India's Liberalized Agriculture: Can Futures Markets Help? November 27, 1996 Agriculture and Water Operations Division Country Department II South Asia Region World Bank Conimnoditv Division United Nations Conference on Trade and Development Document of the World Bank  CURRENCY Rs/ US$ Currency Official Unified Market a Prior to June 1966 4.76 June 6, 1966 to mid-December 1971 7.50 Mid-December 1971 to end-June 1972 7.28 1971-72 7.44 1972-73 7.71 1973-74 7.79 1974-75 7.98 1975-76 8.65 1976-77 8.94 1977-78 8.56 1978-79 8.21 1979-80 8.08 1980-81 7.89 1981-82 8.93 1982-83 9.63 1983-84 10.31 1984-85 11.89 1985-86 12.24 1986-87 12.79 1987-88 12.97 1988-89 14.48 1989-90 16.66 1990-91 17.95 1991-92 24.52 1992-93 26.41 30.65 1993-94 31.36 1994-95 31.40 1995-96 33.46 April 1996 34.24 May 1996 34.99 June 1996 34.99 July 1996 35.52 Aug 1996 35.69 NVote: The Indian fiscal year runs from April 1 through March 31. ,Source: IMF, International Finance Statistics (IFS), line "rf"; Reserve Bank of India. aA dual exchange rate system was created in March 1992, with a free market for about 60 percent of foreign exchange transactions. The exchange rate was reunified at the beginning of March 1993 at the free market rate. Vice President D. Joseph Wood Director Robert S. Drysdale Division Chief/manager: Shawki Barghouti Staff Member : Benoit Blarel, Senior Economist  Abbrevations & Acronyms BOOE Bombay Oilseeds and Oils Exchange Ltd. EC Act Essential Commodities Act, 1955 EICA East India Commodity Association, Ltd. ELS Extra-long Staple FC(R) Act Forward Contracts (Regulation) Act, 1952 FMC Forward Markets Commission GOI Govermment of India IPSTA India Pepper and Spice Trade Association NTSD Non-transferable specific delivery (contracts) RBI Reserve Bank of India TSD Transferable specific delivery (contracts) UNCTAD United Nations Conference on Trade And Development   Table of Contents CURRENCY ABREVIATIONS & ACRONYMS ACKNOWLEDGEMENTS ECONOMIC DEVELOPMENT DATA EXECUTIVE SUMMARY Chapter 1: The Role & Contribution of Commodity Futures Exchanges .................. 1 Commodity Futures Markets: A Historical Perspective ........................................2 Economic Benefits from Using Commodity Futures Markets ...............................4 Role of Speculation in Futures Markets .........................................................,,,.6 Relationship Between Futures and Physical Markets .......................... .................6 Domestic vs. Foreign Commodity Markets ..........................................................7 Summary .........................................................7 Chapter 2: Structure and Organization of Indian Commodity Exchanges .................9 History of Commodity Futures Markets in India .................................................9 The Regulatory Framework ........................................................ 10 The Structure of Commodity Exchanges ........................................................ 19 A Brief Overview of Selected Commodity Exchanges ........................................ 19 The Cotton Commodity Exchanges ........... ........................................... 20 The Gur Commodity Exchanges ..........................,. 20 The Oilseeds Commodity Exchanges ......................... 21 The Pepper Commodity Exchange ............................................ . 21 User Composition of Indian Commnodity Exchanges .21 Summary .. 23 Chapter 3: The Performance of Commodity Futures Trade 25 Operational Performance of Commodity Exchanges .25 Market Liquidity .2............................................... 25 Suitability of Indian Futures Contracts .26 Trading Practices .27 Clearing Operations .28 India's Unique Delivery System... 29 Supporting Infrastructure .30 Brokerage Industry .32 Promotional and Development Capacity .33 Impact of Government Interventions .34 Direct Government Interventions .34 Indirect Government Interventions .35 Summary .39 Chapter 4: Opportunities & Options: Policy Implications .41 Commodity Exchanges in a Changing Policy Environment 41 Creating the Enabling Environment for Commodity Futures Trading .42  General Rules for a Permissive Government Policy ............................... 42 Improving the Policy Framework of Commodity Exchanges ................... ........... 44 Legal & Regulatory Framework of Futures Trading .................. ........... 44 Exchange Regulations & Operations ............................................. 47 Institutional Development Assistance Required ..................................... 49 Potential for Internationalization of Indian Commodity Exchanges .................... 50 The Pepper Conmmodity Futures Market ............................................. 51 Introducing New Contracts ............................................. 53 General Considerations ............................................. 53 The Potential for New Cotton Contracts ............................................. 55 Potential for Oilseed, Oil and Oilmeal Contracts .......................... ......... 61 Summary ............................................. 65 Annexes Glossary of Terms Used in Risk Management ............................................. 67  List of Tables Table 2.1 Commodities Regulated by the Forward Contracts (Regulation Act), 1952 ................................... 13 Table 2.2 Recognized Associations for Castorseed, Cotton, Gur & Potatoes by States, 1995 .................... 14 Table 2.3 Special Margins for Castorseed, September 1994 .15 Table 2.4 Recognized Cotton Associations in India .19 Table 2.5 Recognized Gur Associations in India .20 Table 2.6 Active Oilseed Commodity Associations .20 Table 3.1 Bombay Castorseed Hedge Contract 1990-1993: Amounts Tendered and Settled .................... 30 Table 4.1 Correlation Coefficients Between Week-end Cotton Seed & Raw Cotton Prices in Bathinda, 1990/91 to 1994/95 .................... 56 Table 4.2 Intra-year Correlation Coefficient Between Cotton Lint & Cotton Yarn (60s carded) Prices, 1990-1994 . 57 Table 4.3 Major Types of Cotton Produced in India, 1992-93 .58 Table 4.4 The Correlation of Monthly Average Spot Prices Between Main Cotton Varieties, 1984-1995 ............................. 59 Table 4.5 Correlation Coefficient between Oil Prices, January 1989 - April 1995 ................ 61 Table 4.6 Correlation of Weekly Edible Oil Prices, by Year 1989 - 1994 ...... 62 Table 4.7 Correlation Coefficient of Oilseeds & Oils Prices, 1990 - 1995 ...... 63 Table 4.8 Correlation Coefficients of Groundnut Prices in Rajkot, Hyderabad, and Bombay, 1989-1994 .............................. 63 Table 4.9 Correlation Coefficients Between Castorseed & Groundnut Prices, 1990-1994 .................. 63 List of Figures Figure 2.1 Indian & International Classification of Forward & Futures Contracts .12 Figure 2.2 Organizational Structure of Commodity Associations .17 Figure 4.1 Instability in Indian Oilseeds Gross Crushing Margins .64 List of Boxes Box 3.1 Is Open Outcry Outmoded? .27 Box 3.2 A Typical Broker on the Bathinda Gur Exchange .32 Box 3.3 Contribution of Futures Markets to a Comprehensive Agricultural Strategy: Potential & Limits of Governnent Market Interventions - The American & European Experiences. 38 Box 4.1 Lessons From China's Experience .45 Box 4.2 Should Companies Be Protected From Futures Trade? .46 Box 4.3 Should Options Be Introduced? .54   Acknowledgements This report is based on the findings of a joint mission by the UNCTAD and World Bank which visited India between April 17 and 28, 1995, and recent UNCTAD studies. The mission was composed of Messrs. Lamon Rutten (UNCTAD) and Beno^it Blarel (World Bank). The report was produced by Lamon Rutten, Dina Umali-Deininger (World Bank), and Benoit Blarel (Task Manager). Contributions have been made to this report by M.L. Debatisse and P. Varangis (World Bank). Peer reviewers are R. Henry (IFC), A. Valdes and G. Feder (World Bank). Arrangements for the mission to India were made by Marilyn Chatterji and Padma Gopalan. Production assistance was provided by Roko Morith. We gratefully acknowledge the cooperation of government officials, in particular the Ministry of Civil Supplies, the Forward Markets Commission, and the Department of Economic Affairs. The document was discussed with the Indian authorities on April 27, 1996. We wish to express our gratitude to the staff and members of the Commodity Exchange Associations, in particular the Bombay Oilseeds and Oils Exchange, the East India Cotton Association, the India Pepper and Spice Association, the Northern India Cotton Association, the Vijay Beopar Chamber Ltd (Muzzafarnagar), for their support and assistance in the production of this report, and for sharing with the mission members their knowledge and expertise about Indian futures markets. We also gratefully acknowledge Dr. K.N. Kabra for sharing with the mission members his views on Indian futures markets.   ECONOMIC DEVELOPMENT DATA GNP Per Capita (US$, 1994-95): 330 Gross Domestic Product (1994-95) Annual Growth Rate (% p.a., constant prices) % of 70-71- 75-76- 80-81- 85-86- 92-93- 93-94- US$ Bln GDP 75-76 80-81 85-86 90-91 93-94 94-95 GDP at Factor Cost 272.0 90.3 3.4 4.2 5.4 5.9 5.0 6.3 GDP at Market Prices 301.2 100.0 3.3 4.2 5.6 6.2 3.9 6.3 Gross Domestic Investment 69.7 23.2 5.3 3.7 5.7 9.5 -5.8 19.8 Gross National Saving 67.0 22.3 4.4 2.6 3.5 8.7 -1.1 17.2 Current Account Balance -2.7 -0.9 -- -- -- -- -- -- Output, Employment and Productivity (1990-91) Value Added Labor Force b V. A. per Worker USS Bln. % of Tot Mill. % of Tot. USS % of Avg. Agriculture 82.5 31.0 186.2 66.8 443 46.4 Industry 78.0 29.3 35.5 12.7 2195 230.0 Services 105.7 39.7 57.2 20.5 1849 193.7 Total/ Average 266.2 100.0 278.9 100.0 954 100.0 Government Finance General Government c Central Government Rs. Bln. % of GDP Rs. Bin. % of GDP 1994-95 1994-95 90-91-94-95 1994-95 1994-95 90-91-94-95 Revenue Receipts 1809.0 19.1 19.5 910.8 9.6 10.1 Revenue Expenditures 2219.0 23.5 23.5 1221.1 12.9 13.3 Revenue Surplus/ Deficit (-) -409.9 4.3 -4.0 -310.3 -3.3 -3.2 Capital Expenditures d 337.9 3.6 4.3 266.8 2.8 3.5 Extemal Assistance (net) ' 51.5 0.5 0.7 51.5 0.5 0.7 Money, Credit, and Prices 89-90 90-91 91-92 92-93 93-94 94-95 95-96p (Rs. billion outstanding, end of period) Money andQuasi Money 2309.5 2658.3 3170.5 3668.3 4344.1 5308.0 6005.0 BankCredittoGovernuent(net) 1171.5 1401.9 1582.6 1762.4 2039.2 2224.2 2626.7 Bank Credit to Commercial Sector 1517.0 1717.7 1879.9 2201.4 2377.7 2896.6 3386.4 (percentage or index numbers) Money and Quasi Money as % of GDP 50.6 49.6 51.4 52.0 54.2 56.1 54.7 Wholesale Price Index (1981-82 = 100) 165.7 182.7 207.8 228.7 247.8 274.7 295.8 Annual Percentage Changes in: WholesalePriceIndex 7.4 10.3 13.7 10.1 8.4 10.9 7.7 BankCredittoGovemment(net) 20.3 19.7 12.9 11.4 15.7 9.1 18.1 BankCredittoCommercialSector 14.4 13.2 9.4 17.1 8.0 21.8 16.9 a. The per capita GNP estimate is at market prices, using World Bank Atlas methodology. Other conversions to dollars in this table are at the prevailing average exchange rate for the period covered. b. Total Labor Force from 1991 Census. Excludes data for Assam and Jammu & Kashmir. c. Transfers between Centre and States have been netted out. d. All loans and advances to third parties have been netted out. e. As recorded in the government budget.  Balance of Payments (USS Millions) 1992-93 1993-94 1994-95p Merchandise Exports (Average 1990-91-1994-95) Exports of Goods & NFS 23,585 28,925 34,141 Merchandise, fob 18,869 22,700 26,857 US$ Mill % of Tot. Inports of Goods & NFS 26,825 29,433 39,450 Merchandise, cif 23,237 23,985 31,672 Tea 415 2.0 of which Crude Petroleum 3,711 3,468 3,428 Iron Ore 480 2.3 of which Petroleun Products 2,208 2,285 2,500 Chemicals 1,679 8.1 Trade Balance -4,368 -1,285 4,815 Leather & Leather product 1,382 6.7 Non Factor Service (net) 1,128 777 -494 Textiles 2,483 12.0 Garments 2,542 12.3 Resource Balance -3,240 -508 -5,309 Gems and Jewelry 3,449 16.7 Engineering Goods 2,674 13.0 Net factor Incomea -3,422 -4,002 -3,905 Others 5,536 26.8 Net Transfersb 2,773 3,825 6,200 Total 20,641 100.0 Balance on Current Account -3,889 -685 -3,014 External Debt, March 31, 1995 Foreign Investment 587 4,110 4,895 US$ Mill. Official Grants and Aid 363 370 390 Public & Publicly Guaranteed 87,880 Net Medium & Long Term Capital 1,636 1,716 278 Private Non-Guaranteed 1,709 Gross Disbursements 4,586 5,884 5,091 Total (Including IMF and Short Ter 98,990 Principal Repayments 2,949 4,169 4,814 Debt Service Ratio for 1994-95 Other Capital Flowsc -961 2,086 3,462 Non-Resident Deposits 2,001 940 847 % curr receipts Net Transactions with MF 1,290 190 -1,174 Public & Publicly Guaranteed 19.6 Private Non-Guaranteed 1.2 Overall Balance -263 8,537 6,858 Total (Including IMF and Short Ter 25.3 Change in Net Reserves 263 -8,537 -6,858 IBRD/ IDA Lending, March 31, 1995 (USS Mill Gross Reserves (end of year)d 6,749 15,476 21,160 IBRD IDA Rate of Exchange Outstanding and Disbursed 11,120 17,666 Undisbursed 4,227 4,663 End-March 1996e USS 1.00 = Rs. 34.45 Outstanding incl. Undisb 15,347 22,329 - Not available. a. Figures given cover all investment income (net). Major payments are interest on foreign loans and charges paid to IMF, and major receipts is interest earned on foreign assets. b. Figures given include workers' remittances but exclude official grant assistance which is included within official loans and grants, and non-resident deposits which are shown separately. c. Includes short-term net capital inflow, changes in reserve valuation and other items. d. Excluding gold. e. The exchange rate was reunified at the market rate in March 1993. f Total exports (commerce); net of crude petroleum exports.  India mNe Sa_ reufwim grow Nd2s LatesJt s gla kwr nwca.r hi, Une of .ssLa,a Semth 'lw. incom Indicator rnwmr 1970-75 191045 1919-94 Asia bima group Resources and Expenditures HUMAN RESOURCES Population (mre-1994) thousands 613,459 765,147 913,600 1.220.285 3,182.221 1,096,881 Age dependency rato raio 0.77 0.72 0.66 0.71 0.66 0.63 Urban % of pop. 213 243 26. 26.0 283 55.9 Populauion growth rae ennual % 23 2.0 1.7 13 1.7 13 Urban 3.7 3.0 2.7 3.1 3.2 2.7 Labor force thousands 260.515 329.606 394330 528.101 1590.533 488.647 Agricultum % of labor farm 70 67 64 63 67 36 Industy ' 13 14 16 16 14 26 Female - 31 32 32 32 39 40 Labor parcpaton rams Total % of pop. 42 43 43 43 50 45 Fmanle 13 14 14 29 41 36 NATURAL RESOURCES Ama thou. sq. km 3.27.59 3.27.59 3.27.59 5.133.49 40391.42 40.59443 Daiqty pop. per sq. km 13660 232.74 273.21 233.41 77.44 26.66 Agnculturaland %ofilndarea 60.83 60.86 60.Q9 59.11 52.42 41.05 Change m agncuiWral lad annual * 0.47 -0.07 40.05 .002 0.16 -138 Agnculursl land under iriganon * 18.65 23.09 25.96 29.63 17.84 11.40 Forests and woodland thouL sq. km .. 551.19 517.29 65832 7.632.00 5.969.25 Deforestaton (net) * change. 1980-90 _ .. 0.63 INCOME Household income Share of top 20* of houseboks % of inmo 49 41 43 _ Share of bonom 40* of households 16 20 21 _ Shre of bottorn 20* of housebolds 6 3 J _ EXPENDrrURE Food * of GDP 43.6 35.3 .. Sapbs - 20.6 12.4 .. _ Meat fish milk. ches eggs 6.5 7.4 _. Ceral impor tbou. metoe ous 7.669 205 694 6.211 36,922 68.936 Food sad in ceeals 1.5I2 304 276 1.624 8.516 5.771 Food producion percapta 197 -100 94 104 115 113 115 102 Ferilizer consumption kgzba 193 47.0 67.5 69.7 58.5 463 Share of agriculture in GDP of GDP 36.6 29.5 26.9 26.6 27.6 14.0 Boning * of GDP 4.4 7.1 .. Average household size person per househol 5.2 5.6 _. Urban 4.1 5.5 Faxed investment housing * of GDP 23 2.8 Fue and power * of GDP 2.4 23 _. Energy consumption per cia kg of oil equiv. 124 170 243 219 373 1.602 Households with electieity Urban % of households _ -_ Rural Transport and cmamumiadoo % of GDP 4.7 5.1 _ _ Fixed investment tanisport equipment 1.4 23 Toal road length thoL kmn 1.375 1.546 2.962 _ DiVESTMENT IN HUMAN CAPITAL Helith Populuaon per physician penons 4.900 2.522 .. .. .. 3.064 Population per nurse 3.710 1.701 Population per hospiual bed 1.700 1300 1.371 1.675 1.034 592 Oral rehydyraion therapy (under-5) V. of cases .. .. 37 37 38 Education Gros enrollment rtios Secondary * of school age pop. 26 37 49 45 48 63 Female 16 26 38 35 42 62 Pupil-teacher rtio: pnmay pupils per teacher 42 58 63 61 39 Pupil-teacher raio: secondary 21 21 26 26 20 Pupils reaching grade 4 * of cohort 51 58 _. - Repeater rate: prinmry * of total eno 17 .. _ illiteracy * of pop. (age 15.) 66 56 48 51 35 Female * of fen. (age 5I+) _ 71 62 64 46 Newspacer circulation per thou. vo. 15 26 31 26 .. 236 World Bank International Economics Departnent. April 1996  India Most S . r ri,.gincem. grw Neut Last gLw yhr rhnt , highw UVtR of udmazz Smag& 'Lw- e... Ii cater mewurr 1970-75 1950-15 19S94 Auia incoeme aromp Priority Poverty Indicators POVERM Upper povery line local .. ..c.. HNedtt iida % of pop. Lower povaty in localcn. .. ,. ._ Headcoem index % of pop. .. GNP p-ap iu USS ISO 280 310 320 390 1,670 SHORT TERM INCOME INDICATORS Unskilld ban wga loca cur. - Unsked twa wa. . Rul mm of trade . 84 94 Conaumr pnce inex 1987-100 45. 85 139 _ Lower income Food' 27 _ _ _ Urban - 83 176 SOCMAL INDICATORS Public expenditure an bac socu services % of GDP .. .. .. GM" umllmntranos Primay % school ge pop. 79 96 102 98 105 104 Male 94 110 113 110 112 105 Female 62 80 91 37 98 101 ;.dty Infant morlity per tbou. Ive birdh 132 108 70 73 58 36 Under 5 mortality ' .. 97 106 101 47 lmmuizadcn meail"s V. %ge group _ .. 85.8 84.2 86.2 77.4 DPI .. 41.0 90.2 83.6 89.1 82.0 Child ralmtition (under-5) .. .. 63.0 61.5 38.2 Ufc expectancy Tot years 50 55 62 61 63 67 Female advange -1.9 40.4 1.3 1.2 2.4 6.4 Total feaity ratc births per woman 5.6 4.8 3.3 3.6 3.3 2.7 Matde morality me per 100,000 live birds .. 460 437 _ Supplementary Poverty Indicators Expenditwa on a0a secunty % of total gvt cap. .. .. .. SoCial secuty covetw V. eo alVe pOp. .. .. .. _ .. .. Access to afe waew. o %of pop. 31.0 56.3 .. Urban 80.0 76.0 .. Rural 18.0 50.0 Acc:ess to health came. 75.0 . Population growth rate GNP per capita growth rate Development diamondb (average anual, percent) 5 (average Annual, pcnt)Lif 4 5 2 0 ______________________ U~~~~~~~~~~~~~NP Gros 2 * ' O- lG1\u+ perI nw capita enrollment 0 -5 -2 -10 1970-75 1980-85 1989-94 1970-75 198045 1989-94 tosdhwm - Low-incom - Lowincome a. Sce the technical nooes, p.387. b. 7he devclopment diamnd, based on four key indicators, shows the averae level of development in the country compaed with its income group. See the introduction.  EXECUTIVE SUMMARY MANAGING PRICE RISKS IN INDIA'S LIBERALIZED AGRICULTURE: CAN FUTURES MARKETS HELP? 1. Context of Study in India's Agricultural Liberalization Agenda. Indian agriculture is now gradually opening-up to world markets. While trade liberalization creates new economic opportunities, it also poses new challenges. Notably, price volatility and the capacity to cope with it are again becoming major policy concems. Price volatility creates uncertainty and risks which can threaten agricultural performance, and negatively impact the income and welfare of farmers and the rural poor. Indian policy makers have traditionally coped with the uncertainty and risks associated with price volatility by resorting to policy instruments to minimize or eliminate price volatility: a virtually closed external trade regime, pervasive government controls on private sector activities, extensive market interventions, and crop insurance. These instruments, because of their fiscal and economic costs, are now progressively and selectively being relinquished by the Government of India (GOI) in an effort to spur agricultural growth. An alternative strategy to manage the uncertainty and risks inherent in agricultural markets remains to be devised, and the stalling of agricultural reforms avoided. The Kabra Committee recently submitted its report (September 1994) to GOI, recommending the introduction of futures contracts in basmati rice, seed cotton, cotton lint, raw jute and jute products, most oilseeds and their oils, major oilcakes, linseed, onions, gold and silver. 2. Rationale & Organization of the Study. Agricultural futures markets are a market-based instrument for managing risks that, potentially, could form part and contribute to the orderly establishment of a more open and liberalized agricultural sector. Unlike most other developing economies, India has a long experience in operating and managing commodity futures markets. Indian futures markets, however, have been operating under highly restrictive policies, providing them little chance to contribute in any significant way. The present study is part of a larger set of studies undertaken by the World Bank in collaboration with GOI to review the constraints, opportunities and options to the improved performance of Indian agricultural markets; it complements companion studies that analyze the marketing performance of individual agricultural markets --rice and wheat, oilseeds and its derived products, cotton, and sugar. It is not the purpose of this study to justify the use of futures markets for individual commodities; this larger question is addressed in the context of the companion, individual commodity studies. Instead, the present study concentrates solely on the steps and actions needed to ensure the orderly development of agricultural futures markets as a generic risk management tool to improve the performance of agricultural markets. The study (1) describes the generic roles which futures markets play in agricultural marketing (Chapter One); (2) describes the current structure and operations of Indian futures markets (Chapter Two); (3) assesses the performance of Indian futures markets, and identifies its key policy determinants (Chapter Three); and (4) examines the policy, regulatory and institutional conditions and options for expanding and improving the contribution of commodity futures to agricultural marketing, including the potential for the internationalization of Indian exchanges and the introduction of new futures contracts (Chapter Four). This study has been prepared on the basis of a review of available literature, including recent UNCTAD studies, field visits to a representative cross-section of commodity  - ii - exchanges, and interviews with governnent officials, industry participants, and representatives from commodity exchanges. 3. Economic Roles of Commodity Futures Markets. Futures markets have emerged out of the need to deal with the risks associated with agricultural production, storage, trade and processing; they have emerged also in response to the counterparty default risk associated with forward markets, another risk management instrument developed earlier (paras 1.7 to 1.10). Commodity futures markets, initially concentrated in a small number of developed economies, are now being established in newly liberalizing, developing economies and economies in transition -- such as China, Brazil, Poland, Hungary, South Africa and Turkey. Futures markets are used to hedge --i.e., cover for-- commodity price risks, by providing a vehicle for market participants to exchange risks. Futures markets also serve as a low cost, highly efficient and transparent mechanism for discovering prices in the future, by providing a forum for exchanging information about supply and demand conditions. The hedging and price discovery functions of futures markets promote more efficient production, storage, marketing and agro-processing operations, financing, and overall agricultural marketing performance. Participation in futures markets is not restricted to those directly involved with the actual, physical (spot) commodity market. In fact, speculators play a critical role by providing for much of the needed liquidity in futures markets, and generally represent the largest group of users. In contrast, farmers are rarely active on futures markets, even in the USA; instead, farners benefit indirectly from the existence of futures markets through easier access to better information about future prices, and through higher prices resulting from lower marketing and processing costs (paragraphs 1.13 to 1.24). Main Findings 4. Long, Well-Established Tradition of Regulating and Operating Commodity Futures Trading in India. Unlike many other developing economies, India has a long history of commodity futures markets. Futures trading was first introduced on the Bombay Cotton Exchange and the Bombay Oilseeds & Oils Exchange as early as 1921 and 1926, respectively, and expanded rapidly to other commodities as well as to options trading (paras 2.1 to 2.6). The Forward Contracts (Regulation) Act, 1952 provides GOI with a well-developed, three-tier framework for regulating futures trading activities (paragraphs 2.7 to 2.12). The Forward Markets Commission (FMC), a statutory body under the administrative control of the Ministry of Civil Supplies, Consumer Affairs and Public Distribution, monitors futures markets and controls the operations of the recognized commodity exchanges associations (paragraphs 2.13 to 2.14). The recognized associations, in turn, organize futures trading in selected agricultural commodities, which they regulate under their trading by-laws, generally modeled after the British and American commodity exchanges. The structure of commodity exchanges and their user composition are also very much similar to that of other, international exchanges, although they provide fewer public services and their capacity to design and introduce new contracts is limited (paragraphs 2.15 to 2.26). 5. Most trading practices of Indian exchanges are sound: the open outcry system functions well and is cost effective, and trade recistrati otn procedures are well lald-out; other procedures, such as the weekly clearing operations t r thc absei ( e of time-stamping of transactions, differ from international practice and reflect the small scale of operations of most Indian exchanges (paragraphs 3.10 to 3.17). One major weakness of Indian trading procedures lies in its unique delivery system. Delivery to exchange warehouses is possible but not mandatory, and financial settlement is allowed. The arbitrariness of the financial settlement system undermines the economic usefulness of Indian futures markets by breaking their link with the underlying physical  - iii - markets, and supports the artificial backwardation --i.e., futures prices fall below spot prices-- of futures markets whenever ceilings on futures prices are imposed (paragraphs 3.18 to 3.21). 6. Usefulness of Indian Futures Markets is Severely Reduced by the Selective and Restrictive Implementation of the Regulatory Framework. Direct government regulations are a major factor determining the access to, and potential usefulness of futures markets. GOI, through the FMC, directly intervenes extensively and selectively to restrict access to futures markets. Futures trading is currently allowed for only six, mostly minor agricultural commodities,' and forward contracts for three commodities. Futures and forward trading is prohibited or suspended for over 100 commodities including all cereals, pulses, sugar, all edible and nonedible oilseeds --except castorseed-- their oils and meals, cotton seed and yam, coffee, etc. Option trading is altogether prohibited (Table 2.1). 7. When permitted, the limits imposed by the FC(R) Act on contract specifications, such as its transferability, have often become so stringent to make futures trading an unattractive and risky operation. For example, in the case of cotton lint--the most significant commodity for which forward trade is permitted-- only Non-Transferable Specific Delivery (NTSD) contracts are allowed (paras 2.27 to 2.32). Because of their non-transferability, NTSDs do not qualify as futures contracts according to intemational definition, but come closer to forward contracts. In response to the legitimate risk management needs of commercial users, significant illegal trade in futures contracts --seed cotton (kapas) and cotton lint, groundnut and mustard oils-- is reportedly taking place across several Indian locations using standardized trading rules and open outcry (paras 3.6 to 3.9). 8. Regulations and controls imposed by the FMC on the operation of commodity exchanges -- e.g., recognition of commodity exchanges, contract approval process, price ceilings, margins, and positions limits-- cause most Indian futures markets to suffer from poor liquidity (paras 3.2 to 3.5), and seriously hamper the economic usefulness of futures trade (paras 3.36 to 3.39). The discretionary implementation of controls contrasts sharply with the initial intent of the FC(R) Act and intemational practice. Additional regulations that limit the access to, and usefulness of futures exchanges include: income tax rules which do not recognize hedging, creating a taxation asymmetry between physical and futures markets transactions for potential users (para 3.40); or the ban imposed by the Reserve Bank of India (RBI) on the participation of large, institutional investors --pension funds, insurance companies-- which, elsewhere, provide market liquidity as natural counterparts to the large hedgers. The participation of intemational users and some domestic users, such as agricultural cooperatives, is also made virtually impossible as a result of regulatory barriers (paras 2.41 to 2.46). The Indian brokerage industry, in contrast with other countries, is small, poorly capitalized, highly fragmented, and remains un-regulated. While consistent with the stringent constraints on the size of operations of commodity exchanges, the current structure of the brokerage industry is likely to become a serious impediment to the orderly development of futures markets (paras 3.27 to 3.35). 9. Economic Usefulness of Indian Futures Markets Further Reduced by Government Interventions on the Physical Commodity Markets. Government interventions include storage and movement controls embodied in the Essential Commodities Act (EC Act), 1955, the selective 1 Futures trading is currently allowed in: raw jute and jute goods, black pepper, castorseed, gur (a non- centrifugal sugar), potatoes, and turmeric. Forward trading is allowed in cotton lint, jute goods, raw jute and hessian.  - iv - credit controls issued by the RBI, external trade policies, and government market interventions which are particularly relevant in the case of rice, wheat, sugar, and to a lesser extent cotton, oilseeds and their products. The selective and ad-hoc controls on storage, movement and access to trade credit severely restrict the economic usefulness of futures trade by preventing the arbitrage of agricultural commodities across space and seasons in an efficient and competitive fashion (paras 3.41 to 3.48). 10. In the case of rice, wheat and sugar, government interventions on the physical markets eliminate most price risks for private operators by dominating procurement and distribution (the Food Corporation of India is estimated to procure about 40% of rice and wheat marketed surplus), implementing pan-seasonal and pan-territorial pricing through price interventions (rice and wheat procurement and issue prices, sugarcane State Advised prices, and sugar issue prices) with subsidized transport and storage by the Food Corporation of India (rice and wheat), and the administrative setting of processing margins (sugar). The absence of any reported illegal futures trading activities in rice, wheat and sugar suggests the lack of interest by private operators in risk management tools under existing policies on the physical market; even if GOI were to allow futures trade, little interest from the pnrvate sector is likely to emerge. For other agricultural commodities, direct market interventions by government are much less significant, allowing prices to clear the market --within the confines imposed by the storage, movement, selective credit controls, and external trade restrictions. The presence of more active legal futures trading in the case of castorseed, gur, pepper, and illegal futures trading in the case of groundnut and rapeseed oils, suggest a strong, inverse relationship between the extent of government interventions on the physical markets and the demand for futures trading (paras 3.49 to 3.53). Main Recommendations 11. Futures Markets Need Not Hinder Achievement of Existing Policy Goals Provided Government Policies on Physical Markets Follow a Few Rules. Government interventions should not eliminate price risks; they should not strongly restrict the normal flow of commodities in the economy, should leave a sufficiently large part of the physical trade in the hands of the private sector, and let prices clear the market; they should also provide for a stable and predictable external trade environment (paras 4.5 to 4.7). Indian agricultural policies for rice, wheat and sugar do not satisfy any of the above minimum rules, making futures markets impossible. For other agricultural commodities, notably cotton, oilseeds and their derived products, several minimum conditions are satisfied. In their case, spot and futures markets can be allowed to develop in synergy. Remaining imperfections in the physical markets imposed by current government restrictions on storage, movement and access to credit should not prevent commodity futures markets from operating for those commodities. Instead, the presence of a futures market will encourage those active in physical trade to improve their market practices every time a government restriction is relaxed (para 4.8). The contrasting experience of American and European agricultural policies shows the potential and limits which government interventions impose on the performance of futures markets, and the latter's contribution to a strategy for risk management in agriculture (Box 3.3). 12. Regulatory and Institutional Environment Governing Operations of Futures Markets Needs to be Improved to Ensure Orderly Development. China's disappointing experience with the introduction of futures markets underscores the central importance of a good regulatory and institutional framework for the orderly development of futures trading (Box 4.1). Unlike many developing economies, India enjoys a strong regulatory system for commodity exchanges and  -v - experience that will facilitate the development of its futures markets. Several measures are, however, needed to optimize the potential contribution of futures markets to the agricultural economy. These measures should aim at providing the framework for futures markets to realize their full potential, while controlling abuses in the functioning and use of futures trade. 13. On the legal and regulatory front, the FMC should curb its discretionary interventions -- associations should be recognized on a permanent basis, renewal of contracts should be automatic, regulatory measures standardized and price ceilings withdrawn-- and revert to the original intent of the three-tier regulation model provided by the FC(R) Act (paras 4.9 to 4.12). Under such a model, the government would still approve exchanges, and set the general legal and regulatory framework. GOI would need to introduce a two-tier national brokerage regulation for the specific purpose of consumer protection (para 4.23), and prudential rules for the use of risk management instruments by companies to ensure that companies install proper internal control systems before starting the use of futures exchanges (Box 4.2). The FMC would play a monitoring role, approve requests for the introduction of new futures contracts emanating from the commodity exchange associations, and intervene when the situation warrants it. The participation of commercial hedgers, including cooperatives, and large institutional investors should be promoted through changes in incomes tax rules, tax registration requirements, and bans on participation (paras 4.13 to 4.14). On the institutional front, the FMC would need to be strengthened to fulfill its new responsibilities (paras 4.25 to 4.26). Commodity exchanges would need to up-grade their rules and regulations -- trading procedures, delivery system, trade supervision -- clearing operations, and promotional and development activities and their implementation and monitoring capacity (paras 4.15 to 4.24). 14. Low Volume of Trade and Regulatory Concerns Will Likely Limit Internationalization of Indian Commodity Exchanges to a Few Commodities, Like Pepper, Some Oilseeds and Oils. Indian commodity exchanges would benefit from foreign participation. It would enhance market liquidity, bring-in valuable foreign exchange, as well as promote the development of a warehousing and financial service industry. From the point of view of foreign entities, participation in Indian commodity exchanges can provide new portfolio investment and risk management opportunities. Accommodating foreign accounts in Indian exchanges will not be difficult: by-laws were formulated in accordance with international standards. The limited trade volume of Indian exchanges, and the fragmented, under-capitalized domestic brokerage industry, are likely, however, to deter foreign participation. Attracting foreign participation will, in addition, raise new policy concerns. Besides the lifting of the ban on their participation, changes in tax and profit repatriation regulations will be required. The potential detrimental effects of short-term capital outflows, and problems of possible money laundering will arise if foreign participation is allowed; practical solutions from other countries are however available (paras 4.27 to 4.34). The practical implications of the internationalization of the Cochin pepper exchange, being contemplated by GOI, are briefly reviewed (paras 4.35 to 4.41). The willingness of the concerned agencies to reevaluate some of their regulations attests to the renewed government interest in futures markets. 15. Cotton Industry: Short Run Prospects for National Futures Contracts Higher for Cotton Lint than Seed Cotton (kapas) and Yarn. Immediate prospects for the introduction of futures contracts in seed cotton (kapas) and cotton yam appear very limited (paras 4.49 to 4.56). Prospects for the successful re-introduction of futures contracts in cotton lint are very good in the short run, as testified by the reported active illegal futures trading. To succeed, cotton lint futures contracts would need to carefully develop an appropriate delivery system which balances the trade-  - vi.- offs between liquidity and basis risks among and within the large number of cotton varieties produced across India. Available evidence suggests that cotton sector policy reforms, by improving the performance of cotton physical markets and their stable integration with world markets, would go a long way towards alleviating the current, apparent trade-offs between liquidity and basis risks. At the national level, the introduction of one futures (hedge) contract which allows the delivery of the main superior medium and long staple cottons throughout the country could be considered. The delivery of one or more extra-long staple cottons against this national contract could be allowed, subject to the proper determination of quality premia and discounts payment system (paras 4.57 to 4.67). 16. Oilseeds Industry: Complementary Introduction of Groundnut Oil and Rapeseed Oil Futures With Corresponding Seeds Futures Contracts in a Few Regional Exchanges is a Likely Successful Strategy. Access to oilseeds and oils futures contracts will raise the competitiveness of the Indian oilseed industiry now facing foreign competition from imported edible oils. This, together with the presence of large illegal futures trading in oilseeds, points to the large demand from the industry for the introduction of futures contracts in the oilseed complex. In an open trade environment, futures contracts facing little competition from abroad are likely to stand a greater chance of success. This implies that groundnut and rapeseed-mustard futures contracts should stand a greater chance of success than soybean contracts which will compete with the Chicago Board of Trade contracts. The available evidence points at the absence of a common, domestic physical market for the oilseed industry, but better integrated regional physical markets. This strongly suggests that a few regional exchanges will be better suited to the needs of an initially imperfect physical market situation (paras 4.68 to 4.81).  1 The Role & Contribution of Commodity Futures Exchanges 1.1 Futures markets have traditionally been concentrated in a few countries heavily engaged in world commodity trade. Over the last decade, futures markets have expanded into many other countries as diverse as Russia, China, Poland, Hungary, Brazil, Singapore and the Philippines. The reduction of govemnment interventions in agricultural pricing together with the opening-up to world markets leads to the need for price discovery mechanisms. These policy changes also expose many actors to risks they did not face previously, raising the need for new mechanisms to manage risk. In recent years, many countries have found it worthwhile to promote the creation of new, domestically-oriented futures markets. During that process, however, many of these countries encountered problems, the most significant of which are the absence of a proper regulatory framework and a lack of understanding of and experience with futures trade. India, however, is well-off on both accounts. India has a multitude of commodity exchanges, decades of experience with market regulation, and a strong legal base. India's commodity exchanges are becoming increasingly vocal in their desire to expand their operations. This appears to fit well with India's economic liberalization and its wish to increase exports. Is such an expansion indeed desirable, and if so, what factors would make it possible? 1.2 Futures contracts are standardized forward contracts that are tradable, and futures markets --or commodity exchanges- are where trading of these contracts occur'. All futures contracts are standardized in their obligations to make or take delivery of a fixed quality and quantity of a commodity, at a specific location, on a specific future date and time. In contrast, forward contracts are not standardized. Two institutional features, margins and the clearinghouse, distinguish futures from forward contracts. Margins are security deposits made by both the buyer and seller to the clearinghouse when trading; the clearinghouse, which is either a division of an exchange (as is the case in France, India, Japan and the United States of America), or an independent service provider (the case for Australia, Malaysia, and the United Kingdom), records and acts as the third party to all transactions in order to ensure contract performance. In principle, the margins eliminates the risk of default, while the clearinghouse eliminates counterparty risk, thereby increasing liquidity of futures markets. 1.3 The Forward Contracts (Regulation) Act, 1952 (FC(R) Act) regulates futures markets in India. The FC(R) Act, and its corresponding Rules and Notifications, do so by defining several types of futures contracts, the commodities for which individual types of futures contracts are allowed, and by providing for the rules of operation, control, and enforcement of futures markets. By introducing a classification of contracts that is unique to India, it should be noted that the Indian terminology provided in the FC(R) Act differs from the intemational terminology. This report will use the intemational terninology, which means among other things that it will refer to as futures contracts -- as intemationally understood -- those contracts defined as transferable specific delivery contracts and hedge contracts in India by the FC(R) Act and its subsequent interpretations. The intemational reader should know that the FC(R) Act splits commodity contracts into two categories: those which provide for the delivery of goods and full payment either immediately or within a period of less than eleven days after the date of the contract, at a price fixed at the date of entering the contract (these are called "ready delivery contracts"); and all other contracts, which are called forwvard contracts. Within the group of forward contracts, the Act defines i For a definition and explanation of the technical terms see Annex 1, and Risk Management in Liberalizing Economies: Access to Futures & Options Markets, by M.L. Debatisse et al, EMENA Technical Departmnent Report Number 12220 ECA, World Bank, 1993.  2 non-tradable specific delivery contracts, and tradable specific delivery contracts. The first are close to what in international terminology are called forward contracts; the second are similar to futures contracts but with the restriction to only one basis delivery vanety, and possible limitation on transferability. In its implementation, the Act also regulates trade in contracts that are virtually identical to the futures contracts traded in other courtries (that is, with vanous tenderable grades and without limitations on transferability), known in India as "hedge contracts"; although the Act does not define this category, they can by implication be considered as transferable non-specific delivery contracts. Chapter Two will provide a more detailed explanation of Indian definitions and their international equivalents. 1.4 Futures contracts in hxdia are currertly traded in only six, minor agricultural commodities. The recent Kabra Report2, recommends the introduction of futures contracts in basmati rice, kapas (seed cotton), cotton, raw jute and jute products, a number of oilseeds and their oils3, major oilcakes, linseed, onions, gold and silver. The Kabra Committee bases its recommendations largely on an analysis of the supply/demand conditions in the various markets, and the perceived risks of allowing futures trade for the public interest. 1.5 This study assesses the general benefits and risks of futures markets trade, examines the performance of existing futures markets, evaluates the reforms and investments needed to improve their performance, and reviews possibilities for introducing new futures contracts. This report is written on the basis of a review of the available literature, field visits in April 1995 to Bathinda, Bombay, Delhi and MuzaIfmagar, and interviews with government officials, industry participants and exchange staff 1.6 The report is divided into four chapters. This chapter discusses the generic roles which futures markets play in agricultural marketing. Chapter Two describes the current structure and operations of Indian futures markets. Chapter Three assesses the performance of Indian futures markets, and identifies the factors which influence it. Chapter Four concludes by examining the conditions and options for expanding and improving the contribution of commodity futures to agricultural marketing. The potential for the internationalization of India's exchanges and the introduction of new contracts is also explored. A. Commodity Futures Markets: A Historical Perspective 1.7 Commodity production, processing and trade are fraught with risks. Agricultural production is subject to the vagaries of weather and other natral conditions. At the time of planting, the prices at which the final product can be sold are not known. Processors buy raw commodities, and sell ther in processed form at a later date; in the mean time, the price of the processed product may have declined resulting in unprofitable operations. Traders make sales commitments without having the commodities at hand, in the hope of buying low and then selling high, and in the process earn reasonable returns. 1.8 Conmmodity producers, traders and processors are not in their respectve businesses to speculate on pnce movements, but are simply forced to do so. Their real business is to add value, through production, transformation, and logistics services. But within the marketing chain, price risk is one of the many factors they have to cope with in order to secure their margins. Volatile prices are a hindrance to adding value; the time involved in choosing the right moment to buy or sell and the effort needed to 2 Report of the Comrnmittee on Forward Markets, Ministry of Civil Supplies, Consumer Affairs & Public Distribution, September 1994. 3 These include groundnuts, rapeseed/mustardseed, cottonseed, sesamumseed, sunflower, safflower, coconut, soybean and rice bran.  3 avoid overly large risks takes away from the effort to become more effective in the value-adding process. It is not uncommon for firms, successful at creating value, to go bankrupt due to adverse price movements. 1.9 Instruments for Managing Price Risks Appeared Early. Price risk management instruments were developed by traders in response to the burden that volatile prices create. Processors, end-users and producers became involved at a later stage. Contracts which enabled the improved management of price risks have been a fixture of commodity markets since the sixteenth century, when forward delivery contracts for grains were first developed. In the seventeenth century, the first options appeared, fixing a price for future delivery without the obligation of the buyer to actually take possession of the goods. Selling "short" -selling an option on a commodity while one does not possess the underlying product-- soon became popular in such commodities as grain, cocoa and coffee. Tradable forward contracts became important after the late seventeenth century. Most of these transactions are what is now called "over-the-counter", i.e., directly between two parties. Even with tradable forward contracts, contract performance remained the responsibility of each party involved. While these instruments reduced price risks, they created a new source of risk, namely counterparty risk. 1.10 Futures Markets Eliminate Counterparty Risks. In the mid-nineteenth century, futures markets developed as an effective means of managing price and overcoming counterparty risks. Trade in these "tradable" forward contracts became centralized in organized commodity futures exchanges, where contract performance was guaranteed by a clearinghouse collecting margins, rather than by individual traders or a trading house's "good name". Everyone could henceforth secure future prices without any real risk of counterparty default. The first futures exchange established in 1848 was the Chicago Board of Trade. At the end of the nineteenth century, futures contracts in commodities such as grains, arabica coffee, cocoa, cotton, copper, silver, and tin were already being traded. By the early 1980s, active commodity futures exchanges existed in Australia, Canada, France, Japan, Malaysia, New Zealand, the United Kingdom, the United States of America, and of course, India. 1.11 Renewed Interest in Commodity Futures. In the second half of the 1980s, several developing countries estabhshed their own commodity futures exchanges; exchanges in Brazil and China have now taken their place among the world's largest. Some newly liberalized economies, such as Russia and Hungary, have also opened commodity futures exchanges. In the last two years, many more developing countries are studying the possibility of creating a futures market. 1.12 Two factors contribute to the sudden interest in commodity futures markets. First, futures markets assume special relevance m an increasingly competitive world market, where commodity production and trade responsibilities are shifted from the State to the private sector, and where the private sector is increasingly exposed to the vagaries of the world market. Second, commodity futures markets remain the most efficient price formation mechanism, providing reliable benchmarks for physical trade. Because a wide group of participants can use the market, each participant brings into the price formation process the information he/she possesses about future demand and supply conditions. In contrast to a cash market, a futures market is highly transparent, yet anonymous, making price manipulation more difficult. Futures markets, as institutions, have an interest in making their prices as widely available as possible, thus providing many smaller market players with the price information they require.  4 B. Economic Benefits from Using Commodity Futures Markets 1.13 Price Discovery and Hedging: the Two Main Economic Roles of Futures Markets. While the supply of primary agricultural commodities, for example cotton, oilseeds, sugarcane, is concentrated at the time of harvests, their consumption is spread out throughout the year. If markets are to function properly, some entities have to be willing to hold stocks. Storage, however, not only freezes up working capital, but it also exposes the stockholder to downside price risks. In the absence of risk management tools, traders will not only reduce their seasonal stocks, contributing to price volatility, but they will also build-in a risk premium in their seasonal storage margins. Futures trading allows stockists to hedge against price risks associated with storage. This process reduces the risk premiums added to storage margins. Futures markets also provide a mechanism for the discovery of prices in the future, facilitating production, processing, storage and marketing decisions. Futures prices serve as reference prices for forward purchases and sales. Futures markets can also be very helpful for processors and traders in case they want to sell (buy) on the physical market, but do not have a buyer (seller) immediately. 1.14 Improve Export Competitiveness. By allowing exporters to hedge price risks when short- selling to foreign buyers, futures markets enable exporters to reduce their margins, improving their export competitiveness. In physical trade, especially international trade, buyers often wish to buy forward. For instance, Indian textile mills export 3 months forward, because their buyers need this security; in the oilseeds sector, large international buyers prefer to buy at least one year forward. Exporters who enter into such forward deals generally do not have all the required commodities in stock. They will have to buy them on the physical market. The risk is, of course, that physical market prices will increase, forcing the trader to accept a loss. To avoid such risks, exporters may refuse demands for long-term contracts -hurting their own competitive position-- or hold working stocks higher than otherwise necessary. Futures markets will allow exporters to hedge their anticipated purchase by temporarily substituting for an actual purchase until the time is appropriate to buy on the physical market. Experience from other countries suggests that the absence of access to risk management tools forces traders to increase, often double their working stock requirements, over and above what would be required from a logistics point of view, making them less cost-competitive. In India, the risks of selling forward to foreign buyers in the absence of futures trade have caused many cotton exporters to either disappear or to convert into brokers. 1.15 Reduce Processing Margin Risks, Futures markets allow agro-processors to lock in profitable margins, promoting competition and reducing nsk premiums. Agro-processors often work on slim margins: raw material costs can equal 90 per cent of the output price. Output and raw material price movements often result in negative processing margins. This is a common phenomenon for sugar and edible oils. Futures markets allow sugar refineries and oilseeds crushers, through anticipatory hedging, to secure a profitable processing margin by giving them the flexibility to fix their input and output prices at the most favorable time. In the absence of futures markets, processors can only achieve this through careful, time-consuning and costly timing of their physical transactions--indeed a main occupation of many oilseeds crushers and cotton gins, and government agencies in the case of sugar in India. Futures markets will allow Indian oilseeds crushers to reduce their marketing and processing margins, and to compete more effectively with the now free imports of edible oils; by the same token, reduced margins will enable crushers to offer higher prices to oilseeds growers. 1.16 Good consumer-oriented marketing is difficult if no futures market exists for domestic processors. The demand for India's edible oils is highly price-elastic; to protect their market shares with the free entry of imports, manufacturers have to keep prices fairly stable. With the use of futures contracts, domestic prices can be made predictable, and manufacturers can smooth out the influence of  5 changes m their input prices quite easily. If there are no futures markets, and in particular if there are also limits on stockholding (as of mid-1995, manufacturers were only allowed to hold up to 45 days worth of consumption in stock), the manufacturer can be caught in between severe short-term price movements of oils and the need to keep the product price stable. This conflict can only be resolved if the manufacturer keeps sufficient financial reserves, funds that otherwise could have been used for investment. 1.17 Farmers Benefit Indirectly Through Better Information, Lower and More Stable Marketing and Processing Margins. Farmers are likely to benefit from the existence of futures trade, even without using futures markets directly. In the absence of a well-functioning forward or futures market, farmers bear the brunt of price instability. With a futures market, traders or processors (e.g., oilseed crushers) need not build as large a cushion to protect themselves against unfavorable price movements. As a result, they will reduce the risk premiums in their marketing or processing margins and be able to pay farmers more for their products, sell cheaper, store more and be more active in the markets. The degree to which traders or processors increase prices to farmers depends on the level of competition, and on the price information available to farmers. As futures exchanges have an interest in making their prices as widely available as possible, there is a good chance that farmers will indeed be able to benefit. In addition, because of the lags between planning and production, farmers can benefit from the market-determined price information available from futures markets, which serves as an important basis for their production decisions. In India, there is active competition among traders and processors of agricultural commodities. 1.18 Facilitate Access to Credit. In the absence of risk management tools, agricultural marketing and processing becomes an unnecessarily risky business activity to lend money to. Relatively small changes in prices can wipe out a large part of the capital owned by traders, and even make it impossible for them to reimburse their loans. Banks are thus hesitant to lend to commodity traders, in particular those who do not manage their price risks. If they do lend, they are likely to do so at a high price. This in tum hinders the proper functioning and competition of agricultural markets. Hedging lowers the discount rate in lending for commodities. For example, in countries where futures markets are allowed, a bank will advance 80-90% of the value of the transaction if hedged, but only 50-60% if hedged. 1.19 Improve Product Standards. The existence of exchange warehouses with grading facilities coupled to the extra flexibility that traders have to make delivery to such warehouses creates strong incentives for the upgrading of qualities to a level acceptable to the exchange. It also facilitates the standardization of commodity trade, including in terms of standard qualities: the quality certificates delivered by exchange warehouses have the potential to become the norm for physical trade -- as has indeed happened in a number of countries. 1.20 In summary, commodity futures not only play an important role in price discovery and managing price risks, but they also assume other economic roles: financial stability for market operators; standardization of quality for deliverable commodities; flexibility for traders and processors by replacing the need for storage or providing new market outlets; reduction of storage costs; and finally, improved access to finance. C. Role of Speculation in Futures Markets 1.21 Several concerns remain about the functioning of commodity futures markets and their effects on the distribution of market power. One common concem has to do with speculation. Futures mnarkets cannot function without the extra market depth and fluidity which speculation provides. Since the  6 physical availability of commodities and a commercial firm's decision to buy or sell commodities may not always coincide with each other, the futures market will be extremely illiquid if firms have to wait until a compatible bid or offer arose. Thus, speculators in futures markets play a vital role in absorbing the frequently unbalanced supplies and demands of commercial buyers and sellers. 1.22 Speculation is also often mistaken for gambling or with manipulation. Both speculators and gamblers seek to profit from assuming risk. But while a gambler creates risk where none exists, a speculator assumes risks which already exist in the market, fulfilling an economically useful role. While success in gambling is purely a matter of chance, success in speculation is dependent on the proper understanding of fundamental market forces. The interest that speculators have in gathering information on the underlying commodity is what makes futures markets such a viable price discovery mechanism. Speculation is also not the same as manipulation: a speculator tries to forecast how prices will move, and his actions will indeed make prices move closer to the market equilibrium. A manipulator tries to move prices away from their market equilibrium. Thus, futures markets which do not serve the legitimate risk management needs of traders or processors have no chance of survival because such a market would soon lose its relationship with the underlying physical market. D. Relationship between Futures and Physical Markets 1.23 Despite the above economic roles, concerns are widespread that commodity futures markets magnify price increases or falls, leading to lower farmers' prices and higher consumer prices. Research in many countries suggests that commodity futures markets follow, at least in the long term, the demand and supply conditions of the underlying physical market, and improve the functioning of the physical market by reducing seasonal price volatility. This is true irrespective of whether a market is in excess- supply or excess-demand situation. With adequate contract specifications and regulations, any aberrations by futures markets are likely to be short-lived. Futures markets are also more difficult to manipulate than physical markets. Because futures markets are more transparent than physical markets, when prices move away from their market equilibrium, market participants will react, effectively dragging prices back towards their equilibrium level. 1.24 At the same time, futures market help to improve the efficiency of the physical market. When a commodity is in short supply, futures market prices will increase; whether or not the futures market is closed-down, physical market prices will also increase anyway. If the government considers the price rise to be socially unacceptable, the only viable option is to change the basic supply and demand situation. E. Domestic vs. Foreign Commodity Exchanges 1.25 There is no economic reason for a country to insist that all its risk management activities take place through a domestic exchange. International markets could provide similar services. In fact, if a well-functioning international market already exists which adequately reflects Indian market conditions, Indian companies would gain little from the creation of a futures market in India. At least in theory, valuable foreign exchange may be saved if the local rather than the foreign market is used. On the other hand, interest in this market may well be limited, reducing its usefulness. However, risks associated with exchange rate fluctuations will generally involve trade-offs between basis and liquidity risks, unless instruments are available to hedge against exchange rate risks. 1.26 A stronger case can be made for commodity futures markets that offer risk management opportunities not available elsewhere. This may indeed be the case for most of India's agricultural  7 products. Domestically-oriented futures exchanges provide a price discovery and risk management mechanism where none would exist otherwise. Moreover, they can play important logistics functions, as an assembly point for physical products, or a guarantor of quality standards. While domestically focused futures contracts may be of litfle interest to foreign users, regionally-oriented contracts are, in such an instance, contracts would need to be defined to balance the interest of both domestic and international players. Summary 1.27 Commodity futures markets provide farmers, traders, processors, and exporters a mechanism for hedging their risks and improving price discovery in their forward planning decisions. At the same time, the benefits of futures trading extend beyond the boundaries of individual firm activities. Marketing, storage and processing margins will narrow as a result of the reduction of the costs associated with uncertainty and risks, to the benefit of growers and consumers. Futures markets promote inter seasonal and intra-seasonal price stability. By providing a mechanism for price discovery, futures markets help growers, traders and agro-processors make better production decisions. India was one of the first developing countries in which commodity exchanges were established.   STRUCTURE AND ORGANIZATION OF INDIAN 2 COMMODITY EXCHANGES A. History of Commodity Futures Markets in India 2.1 The Early Years. Commodity futures markets have a long history in India. The first organized futures market for vanous types of cotton, the Bombay Cotton Exchange, was established in 1921. A second exchange, the Seeds Traders Association Ltd. in Bombay, which traded oilseeds and their products, including castorseed, groundnuts and groundnut oil, followed in 1926. Several other exchanges were subsequently created, trading futures contracts in raw jute, jute products, pepper, turmeric, potatoes, sugar, foodgrains and gold. Many of these exchanges traded the same commodities, and some had formal trading links. Users were quite sophisticated; for example, traders in the cotton market undertook arbitrage with other major international cotton markets, such as Liverpool, New York and Alexandria. At the same time, a number of foreign companies used the Indian markets. A complete regulatory framework for futures trade was drafted, including rules and conditions for trading in futures, a broker's licensing system, and a clearing house structure. Options on a number of commodities were also traded; for example, options on cotton were traded up to one year out, until their ban in 1939. 2.2 Introduction of Regulatory Controls. In the 1940s, trading in forward and futures contracts and options was discouraged by pnce controls and in some instances was outlawed, as part of the Government's drive to contain inflation. These controls were maintained until 1952, when the government passed the Forward Contracts (Regulation) Act, which up to this day controls all futures contracts. Although restrictions on futures trade in essential foods, such as sugar and foodgrains remained, the Act allowed futures market trade in a very limited number of commodities. The Act stipulated that futures markets should normally be self-regulating, through the governing bodies of recognized associations, in which the government had the right to place several representatives. For all practical purposes, it outlawed futures contracts other than between, with or through the members of these recognized associations. The Forward Markets Commission (FMC) was created to supervise and regulate futures markets in the public interest, but in effect, gradually absorbed the exchanges' self- regulatory powers. 2.3 Increasing Government Intervention. The government's role in the commodity exchanges grew more intrusive during the 1960s, when futures trading in several commodities, including cotton, raw jute, edible oilseeds and their products, was either banned or suspended. In the 1970s, futures trading in non-edible oilseeds like castorseed and linseed was forbidden. Even non-transferable specific delivery contracts were prohibited for a number of commodities. Other commodities were also brought under the purview of the Forward Contracts (Regulation) Act. The crackdown on futures markets was attributed to the Government's concem that these markets helped to drive commodity prices up by giving free reign to speculation. To further combat speculation, other restrictive measures were imposed on the activities of the tiirty-one "recognized associations". For example, speculators were asked to pay extra margins whenever regulators deemed it necessary, and trade in contracts was simply stopped for prolonged periods (skipping one or more normal delivery months) when prices reached certain ceilings. 2.4 Evolving Policy Environment. Government policies softened somewhat in the late 1970s, when futures trade in gur -a non-centrifugal sugar as important as centrifugal sugar on India's sweetener market- was temporarily allowed. Castorseed futures were reintroduced in 1982. Two government-  10 appointed committees' in 1966 and 1979 recommended the revival of futures trading in a wide range of commodities, but little action was taken. 2.5 Despite the burdens imposed by heavy government interventions, there is a large interest for risk management tools by the business community in India. Turnover in those commodities for which futures trade is allowed is large, and the exchanges attract a wide variety of participants --large farners, domestic traders, exporters, brokers and speculators. Futures contracts are actively traded for periods up to 6 months out, and, as expected, most contracts are used for hedging purposes, not for physical delivery. "Underground" futures and options trade for commodities, such as cotton and a number of oils, are widespread. 2.6 This interest is likely to increase as a result of trade liberalization. Exporters are increasingly confronted with highly competitive world markets where they are forced to work on slimmer margins, but also to sell further forward to remain competitive. Against this background, the role of commodity futures market is being reconsidered by the government. B. The Regulatory Framework 2.7 The Forward Contracts (Regulation) Act, 1952. Commnodity forward and futures trade is regulated by the federal government through the FC(R) Act, 1952. The FC(R) Act differentiates and classifies the following types of contracts: a Spot or "ready" Contracts which provide for the delivery of goods and the full delivery contracts payment of the value of the goods at the price settled when the contract was entered into either immediately or within a period of eleven days after signature of the contract. - Forward contracts These are contracts for the delivery of goods and which are not "ready" delivery contracts. *Non transferable These are forward contracts between two parties in which a specific delivery (NTSD) commodity, of a specific grade, has to be delivered to a specified contracts location during a pre-determined time frame at a predetermined price.2 Neither buyer nor seller can transfer the contract to another party, and financial settlement is not allowed. Grade, location and delivery dates can not be renegotiated after the contract has been signed. Originally, NTSD contracts were not regulated under the Act, since they were considered a normal part of trade. However, in practice, it was found that buyers and sellers did at times make amendments to contract clauses, and that delivery did not always take place in order to cope with lThe Dantwala Committee, Forward Markets Review Committee, 1966; and the Khusro Committee, Committee on Forward Markets, 1979. 2 Regulations do not provide for contracts where the price is separated from quantity and quality. Such contracts, also known as "executable orders" or price-to-be-fixed contracts, do not set the price at the time the contract is signed. Instead, one of the contract parties can fix the price at the time desired in relation to a certain reference price. This type of physical market contracts is common internationally, and facilitate forward planning of supply and delivery, without the risk that price developments endanger contract performance.  11 unforeseen but unavoidable developments, such as shipping or harvest difficulties or a lack of a specific desired grade.3 This meant that NTSD contracts were effectively used as transferable specific delivery (TSD) contracts falling under control of the Act. Also, trade in NTSD contracts in some commodities was used to camouflage trade in other commodities. To close the resulting loopholes, an ever increasing number of NTSD contracts were brought under the purview of the Act from the 1950s onwards, and most were in effect prohibited. Transferable specific These are defined as forward contracts that are not NTSD delivery (TSD) contracts contracts. In actual regulation, a difference is made between TSD and hedge contracts. Hedge contracts are not defined as such in the FC(R) Act, but can be considered as both delivery contracts that are both transferable and non-specific. 0 Transferable specific delivery contracts specify a specific (basis) grade, quantity and delivery location of a commodity, just like NTSD contracts do. However, the buyer can tansfer the contract to others, often up to a predetermined number of times -six times in the case of oilseeds, for example. Contracts can in principle even be transferred back to the original seller implying the financial closing out of the contract. 0 Hedge contracts specify the basis and tenderable delivery grades, and a range of delivery centers. Both buyers and sellers can close out their positions, and delivery is not obligatory. Hedge contracts are not defined as such in the FC(R) Act, but can be considered as delivery contracts that are both transferable and non-specific until entered into. Option contracts Option contracts give the right, but not the obligation, to make or take delivery of a commodity (or a futures contract) at a given price; for this right, one pays a premium. Options can thus be likened to insurance, but they can also be used for speculation: the premium paid can be quite low in relation to the possible profits if prices move in the anticipated manner. These contracts, widespread earlier, were banned for all commodities under the FC(R) Act. 2.8 The FC(R) Act regulates the Non-Transferable Specific Delivery contracts (NTSD); the Transferable Specific Delivery contracts (TSD) and the Hedge contracts (Figure 2.1). The "ready" contracts are not subjected to the FC(R) Act. 3 Forward trade between two parties is quite common in other countries, but in contrast to India, considerable flexibility is normally built into these contracts. For example, a seller is normally allowed to deliver products of comparable quality if his/her own production has fallen short. Contracts can be liquidated ("washed out"), with final payment between buyer and seller (representing price movements over the life of the contract) taking the place of contract delivery. Postponements are not a real problem, with premiums or discounts on the original price often directly calculated from futures market prices.  12 Figure 2.1 Indian & International Classification of Forward & Futures Contracts Contracts R eady ......... ........ ............... Readay deliv r y............ ......... & payment within - -~d i-.-E 11 days) - - i%|@ ide0i : igiv1 il02ll W l- |t 0 Forward Contracts Futures Contracts in international terminology *J Contracts regulated under the India Forward Contracts (Regulation) Act, 1952 2.9 Correspondence Between Indian and International Terminology. By introducing a classification of contracts unique to India, it should be noted that the Indian terminology provided in the FC(R) Act differs from the international terminology. Figure 2.1 indicates the correspondence between the Indian classification as defined by the FC(R) Act and the international terminology. According to the F C(R) Act, futures contracts have not been defined; instead, three types of forward contracts in India are defined: the Non-Transferable Specific Delivery contracts (NTSD); the Transferable Specific Delivery contracts (TSD) and the Hedge contracts. These three forvard contracts offer different degrees of flexibility to the buyer and seller, wvith NTSDs providing the least, and hedge contracts the most. Because NTSD are not transferable, they would not qualify as futures contract according to international definition. TSDs, because of their transferability, would qualif~y as futures contracts; they present, however, other limitations (e.g., extent of transferability, specific delivery) which do not make TSDs useful as risk management tool. The introduction of different degrees of flexibility reflected the attempt by Indian legislators to balance their regulatory concerns about speculation on the one hand, and the need to satisfyv genuine demands for risk management tools by private operators on the other. 2.10 Commodity futures and forward trading is allowed for only eight, mostly minor commodities. The FC(R) Act specifies the commodities for which futures and forward trading is allowed, as well as the type of contract that can be traded (Table 2.1). It allows NTSD trading for cotton, hessian, raw jute and jute goods; TSD trading for raw jute and jute goods; and hedge trading for hessian, black pepper, castorseed, gur, potatoes and turmeric. Futures trading is prohibited or suspended for over 100 commodities, except for contracts entered into by a number of federal or state entities. Suspended commodities differ from prohibited commodities in the sense that, for the former, futures  13 Table 2.1 Commodities Regulated by the Forward Contracts (Regulation) Act, 1952 Non-transferable 79 commodities, including Castorseed, coconut oil, copra, Colton, jute goods, hessian and Specific Delivery wheat, maize, mung beans, cottonseed, gur, groundnut, raw jute. Contracts rice, paddy, sugar; mustard groundnut oil, kardiseed, seed, rapeseed, linseed, rice kardiseed oil, sesamurn, bran, sunflower seed and their sesamum oil, and kapas. oils and oilcakes, as well as castor oil, cotonseed oil and vanaspati; gold and silver. Transferable Specific Idem as under Non- Coconut oil, copra, cottonseed, Raw jute and jute goods. Delivery Contracts transferable Specific Delivery groundnut, groundnut oil, Contracts, with 24 kardiseed, kardiseed oil, commodities added - sesamum, sesamum oiL kapas, including khandsari, cotton cotton and staple fiber yarn. yarn and cloth, a number of spices, and copper, zinc, lead and tin. Hedge contracts Idem as under Transferable Coconut oil, copra, cottonseed, Black pepper, castorseed, gur, Specific Delivery Contracts. groundnut, groundnut oil, hessian, potatoes and turmeric. kardiseed, kardiseed oil, linseed, sesamum, sesamum oil, kapas, cotton and staple fiber yam. trading is legally recognized, but either no associations have been recognized for trading4, or the recognized associations have not been granted the pernission to trade5. 2.11 Several entities, however, are exempted from the provisions of the Act. They include the Government of India and State Governments and their corporations and agents; groundnut famners, for the sale of groundnuts produced by them; and exporters, for contracts signed with foreign buyers. 2.12 The FC(R) Act establishes a three-tier system of cortrol: 6 * the Government of India, * The Forward Markets Commission, and * the recognized and registered associations. 2.13 The Forward Markets Commission. The Forward Markets Conmission (FMC) was established by the Government of India as a statutory body, in which GOI appoints its members. The 4Forward contracts in sesarnum, sesamum oil, copra, kardiseed, kardiseed oil, cotton seed and staple fiber yarn are in principle allowed, but the Government has not yet granted recognition to any association for trading these contracts. 5This is the case for groundnut, groundnut oil, coconut oil, cottonseed, and linseed; castorseed for NTSDs 6 This is simnilar to regulatory policy in Europe and the United States, where there are two major tiers of regulatory organizations. In these countries, government regulatory bodies oversee the establishment of exchanges, the approval of contracts, the setting standards for market participants, creation of market oversight, and sometimes the setting of position limits. The trade-related or commodity-exchange bodies focus their control at the exchange operations level, to prevent market manipulation, trading outside the ring, illicit trading practices, and exceeding position limits, etc.  14 FMC is under the administrative control of the Ministiy of Civil Supplies, Consumer Affhirs and Public Distribution. The main functions of the FMC are to: * Advise the central government regarding the recognition of associations; * Monitor forward markets and take necessary actions; * Collect and publish information regarding trading conditions for commodities to which the Act is applicable, and submit periodical reports to the Government on the operation of this Act and the functioning of the forward markets; * Make recommendations with a view to improve the organization and functioning of forward markets; and * Inspect the accounts of recognized associations. 2.14 The FMC has broad powers to inspect the associations and their functioning. The Act empowers the FMC to access all books, accounts and correspondence held not only by the management and members of the exchanges, but also all Table 2.2 persons or groups who have had dealings Recognized Associations For Castorseed, with the management or members. It can Cotton, Gur & Potatoes by Stas, 1995 suspend a memnber from his/herCotnGr&PtaesLas,19 membership of a recognized association, or prohibit such members from entering into Andhra Pradesh 1 new contracts. Gujarat 2 3 2.15 Exchange Associations. There are Haryana I 29 active associations recognized under the Madhya Pradesh 2 1 I Act to organize and regulate forward Maharashtra I I trading in various commodities (Table 2.2). Punjab 1 3 Only one association is to be recognized in Tamil Nadu I a city or region for forward contracts in any Uttar Pradesh 4 3 single commodity group, with the view to Source: Forward Markets Commission, Bombay minimize competition between associations. Several commodities are traded by only one exchange: pepper in Cochin, Kerala; turmeric in Sangli, Maharashtra; and jute, jute goods and hessian in Calcutta, West Bengal. Other commodities, such as castorseed, cotton, gur and potatoes, are traded by a large number of associations spread over the countiy, with potatoes and gur generally being traded on the same exchanges. 2.16 An association has to apply for recognition from the central government. Taking into account public and the industry's interests, the government may or may not approve the application. In general, recognition is granted for only a short period at a time -six months to three years. The central government also retains the right to withdraw its recognition at any time. 2.17 The recognized associations and their members must submit periodical reports upon request of the FMC. The associations also send regular reports to the FMC on prices, open positions, and margin payments, generally on a daily basis (by telegraph), as well as its annual report, according to a fornat prescribed by the FMC. The members of recognized associations submit trading returns on a weekly basis, indicating their volume of transaction, open positions, and names of clients (if it wishes, the FMC can request these returns on a daily basis). 2.18 The Associations' Rules and Regulations. Recognized associations are responsible for the day-to-day operations of the futures markets: they set the standards and rules of trade; register prices;  15 work as clearing houses, including the collection of margin moneys and settlement of closed transactions; distribute delivery notices; etc. All associations have their trading-by-laws, memorandum and articles of operations generally modeled after British and American commodity exchanges. They have the power to vet new members, and redraft the bye-laws on condition of approval by the government, which also has the right to direct an association to amend its bylaws. 2.19 For most commodities, trading in futures contracts is only allowed in the exchange trading ring during official trading hours. Those in the ring (the "ring traders") represent firms that are members of the association. These ring traders can be appointed on an ad-hoc basis by a member, and each member is allowed to have several ring traders (up to a maximum, of 7 on the BOOE). Members are fully responsible for all transactions entered into by the nrng traders nominated by them. 2.20 Several instruments are used by the associations to regulate the behavior of traders. These regulatory instruments can only be applied with the concurrence of the FMC, although they can be recommended by the board of the exchange. These include: * Ordinary margins. These are deposits paid by members on their outstanding or "open" positions. Margins are payable at a government-specified rate per unit, which is revised periodically. These margins are collected by the clearing house as a financial safeguard against possible default by a member if prices move adversely. * Special or automatic clearing. This serves to protect the clearing house against the risks involved in abrupt and sharp price fluctuations and is stipulated in bye- laws of the exchanges. * Special margins. These margins seek to restrain price movements beyond certain levels of prices known as the "margin lines". Table 2.3 illustrates an example for the castorseed Table 2.3 September 1994 Special margins for castorseed, contract. For most September 1994 (Rs/100 kg) new contracts, exchanges have to propose a schedule | of special margins, 850 170 1300 260 that is often 800 240 1350 405 tightened by the 750 375 1400 700 FMC. In the case of Source: The Bombay Oilseeds & Oils Exchange Ltd., 67th Annual castorseed, if prices Report & Accounts, Year 1993-1994. fall below 850 Rs/100 kg and the speculative shorts are unable to pay the required special margins, they are forced to liquidate their positions, thus pushing up prices through their purchasing operations. Conversely, when prices increase beyond 1,300 Rs/100 kg, speculative longs are forced out of the market. Exporters who can submit an export contract hedged by futures contracts and stockholders who show they are hedging an inventory can receive an exemption from the payment of special margins. * Withholding outward payment of profits. This makes it more difficult for speculators to use their profits on their open trades to expand their positions.  16 * Limits on open positions. Operators in futures market are pefmfitted to hold or control an open position in excess of the limit only when they are legitimate hedgers, such as exporters who can show export contracts, stockists after submitting inventory statements. Even then, they are confronted with higher margin payments for their open positions exceeding the open position limit. * Suspension of trading. When an emergency arises in the market, it takes some time to judge its character, ascertain its causes and devise measures. During that time, the regulatory authorities can suspend trading. * Prohibition offresh trading. If serious difficulties are anticipated, members can be prohibited from entering into fresh commitments with each other; they can only liquidate outstanding positions. * Skipping of trading in some delivery months. Whenever there are serious doubts about the smooth and orderly running of a futures contract, the posting of a new delivery month can be prohibited. * Limits on pricefluctuations. These can be imposed either when prices rise or fall or both, on a daily or weekly basis. * Maximum and minimum prices. The government can prescribe these to prevent futures prices from rising above the levels not warranted by what the government considers as genuine supply and demand factors, or from falling below levels considered as unremunerative. * Changes in the tenderable varieties. The varieties tenderable against futures contract are generally laid down in the bye-laws. If it appears a certain group is tying to comer the market, the list of tenderable varieties can be expanded. Similarly, some of the varieties which are tenderable can be deleted from the list to counteract a possible "bear raid". This regulatory tool is rarely used, most recently in the turmeric market in 1988. * Closure of contracts. If the market cannot be controlled by any of the above methods, the closure of the outstanding contracts in the market at the time of the crisis can be ordered. * Prohibition offutures trading. When prices are rising continuously without any immediate sign of a reversal, the govermnent may decide to prohibit futures trading altogether. It is believed that this will help control the increasing price trend. C. The Structure of Commodity Exchanges 2.21 Commodity exchanges in India are organized as so-called "recognized associations" of traders. The associations have a partly elected Board of Directors, who supervise a number of exchange commnittees (Figure 2.2). The secretary, who is appointed by and reports to the Board, is responsible for daily operations and administration. Most of the recognized associations are without share capital, with members paying an admission fee, a membership deposit, and an anmual subscription. Some are set up as profit oriented ventures, owned by a number of shareholders, and earning their income by providing  17 trade facilities to members. Most exchanges have membership limited to those who have their place of business in the city or state where the association is located. 2.22 The Board of Directors. The Board of Directors enforces the various rules and regulations of the exchange. The Board is empowered to fix the margin rates, upon approval by the FMC; to prohibit trading on any day if the prices of a futures contract change by more than a predetermined level; close the market for up to 3 days; with the concurrence of the FMC, to fix limits on the open positions of members and non-members; to prohibit trade above specified maximum or below minimum prices; and to forcibly close out all outstanding contracts. Figure 2.2 Organizational Structure of Commodity Associations Association Board of Directors Secretary Admninistration * Accounts and Finance * Personnel & Administration * Publications Department * Margin and Clearing Departnent * Intemal Audit leag Non- Ring House Daily Rates Arbitration Vigilance member Inquiry Appellate _Committee _Committee Cmmitee Committee Conmitee Com itee Committee Committe e 2.23 The Board of Directors is generally divided into two or more panels, each representing the various stakeholders in the exchange. The Bombay Oilseeds Exchange (BOOE), for example, has four panels: brokers, dealers, crushers and exporters. The India Pepper and Spice Trade Association has panels of exporters and dealers. For each panel, Directors are elected to one year terms in general. The elected Directors then co-opt one or more outside Directors, while the Ministry of Civil Supplies may nominate a number of Directors to represent farmers' interests, often officials of the Forward Markets Commission, and "eminent economists" to represent the public at large. In many instances, the Government has failed to nominate Directors, and these posts have remained vacant. 2.24 The Exchange Administration. The secretary is charged with managing the day-to-day operations of the exchange. The administration of a few exchanges includes a margin and clearing  18 department and an internal auditing department, although the books of all exchanges are also audited amually by external accountants.. The former is responsible for collecting margins from members after each clearing and managing the member accounts. It does so through the clearing house account of the exchange, which is used only for clearing settlements. 2.25 The Committees. The committees are set up by the Board of Directors to perform specific functions. They are composed of association members, and one or more Directors. The responsibilities of the various committees are described below: * Ring Committee Oversees activities in the trading ring, with a ring superintendent who records the opening, highest, lowest and closing rates of the contract. * Daily Rates Committee Fixes the daily settlernent prices of the futures contract, as well as the daily spot prices. * Clearing House Committee Oversees clearing house operations, can meet daily, but most exchanges only have weekly clearing. * Arbitration Committee Also called the "conciliation committee" in the BOOE, decides on disputes among members or between members and non-members (with the appellate tribunal, or in the case of the BOOE, the arbitration committee, providing the possibility of recourse). * Vigilance Committee Empowered to verify the books and accounts of members and non-members, and to investigate any reported violation of the provisions of the exchange's bye-laws, rules, regulations, orders, etc. - Inquiry Committee Verifies hedge exemptions claimed by members on the payment of special margins. * Non-Member Committee Decides whether individuals which wish to trade through members can indeed do so. 2.26 Exchanges Provide a Number of Public Services. All the exchanges collect daily statistics on commodity prices in their markets, which are widely published in India's press. Normally, the associations also monitor spot trade. They play a more general role as forum for traders and processors. Most gather and distribute information and market intelligence for their commodities, while a few publish trade journals, statistical overviews, yearbooks, and other materials. They generally provide facilities for quality surveys and contract arbitration. They also represent the interests of their constituency in discussions with the government.  19 D. A Brief Overview of Selected Commodity Exchanges The Cotton Commodity Exchanges 2.27 Cotton lint was the first commodity for which futures contracts were introduced in India, with the first organized market forned in 1921. In the 1920s and 1930s, futures and option contracts on several types of cotton lint were actively traded in two different associations, and futures trade in the largest of these, the East India Cotton Association (which organized export-oriented trade) was of international irnportance. Futures trade in cotton again became important after a short interval in the 1940s in which all futures trade was banned. From 1952 to 1966, several exchanges in the country showed an active trade in futures in cotton and also, between 1964 and 1970, in kapas. 2.28 Currently, only NTSD contracts in cotton are allowed, and regulated by nine recognized associations spread over the country (Table 2.4). 2.29 Contract Specifications. Six contract Table 2.4 periods are traded every year, each covering two Recognized Cotton Associations in India months. Contracts can only be traded up to six l_ months out. Aside from NTSD contracts in Ahmiedad Cotto Memats Association Ahnedabad cotton, only the non-regulated "ready" (cash) AmndhPradesh Coton Association Guitur trade is allowed. Being non-transferable, the Central Gujarat Cottonu Deales Associaion Vadodara NTSD contract specifications are not Central ianCdCton Association Ujain standardized. Trade does not take place in a Coton Association Indore trading ring, but directly between members; East India Cotton Association Ltid (EICA) Boibay however, standard forms supplied by the Nothernm idia Cotton Association Ltd Bathida exchange are used, and all trade has to be Sod India Cotton Association Coinbatore reported. No margins are deposited. Southem Gujarat Cotton Dealers Association Swat 2.30 The Bombay exchange has a nationwide mandate with cotton varieties from all over the country being traded, while the others have a more regional mandate with trade only allowed in a small number of cotton varieties. The largest exchanges -Bathinda, Bombay and Coimbatore-- have over 400 members, while the smaller ones, such as in Indore and Guntur, have over 200 members. Most Indian cotton traders, be they brokers, merchants or commission agents, are mernbers of one or more associations. 2.31 Contracts' Turnover is Small, Highly Seasonal, and Trade For a Few Months Forward. The total volume of NTSD contracts reportedly traded at all recognized exchanges has remained more or less stable since 1990, at an average of 1.8 million bales (each of 170 kg) a year, or about 15% of India's cotton production. Significant unreported trade in NTSD contracts is said to take place. The Bathinda, Bombay and Coimbatore exchanges account for about 90% of NTSD contracts turnover. Both in Bathinda (in the Punjab, in the heart of one of India's cotton producing centers) and Bombay (the traditional transit point for both domestic and external trade), trade in NTSD contracts is highly seasonal. In Bathinda, during the period 1990 to 1993, on average 52% of the year's trade is in only two of the annual six contracts, namely the contracts for November-December and January-February delivery. In Bombay for the same period, the two delivery periods plus March-April, account for 64% of total volume. Trade in Coimbatore's exchange, serving the sizable textile industry in and around this southem Indian town, is better distributed, with only the November-December contract being minimally traded.  20 2.32 NTSD contracts allow delivery up to six months out. However, most trade is in nearby delivery months, with the vast majority being no more than three months forward. For example, in the most liquid months, up to 50-60% of NTSD contracts are in the nearby months. In contrast, only 10-15% of NTSD contracts are entered into more than two months before the start of the contracts' delivery period. The Gur Commodity Exchanges 2.33 Eleven exchanges are recognized for trade in gur hedge contracts (Table 2.5). The most active exchanges are in Bathinda (31 % of total turnover in the May 1992-April 1994 period), Muzaffarnagar (26%), Hapur (20 %) and Agra (11 %). The exchanges in Ludhiana and Meerut, each with around 4% of the total trade volume, are also reasonably active. The other five exchanges share less than 3% of the hedge contracts turnover. 2.34 High Market Turnover. Table 2.5 Turnover in all the exchanges totaled on Recognized Gur Associations In India average 9 million MT of gur a year in the period 1990-1994. This can be compared Aapa Agro Product Mandi Pvt Ld Deb to a physical production of 7.7 million Bathinda Om and Oil Exchange ld, Bathinda MT on average. In value terms, trade in Bullon and Agnicultral Produce Exchange Ltd Agra gur hedge contracts is the second largest Central India Comnmercial Exchange Lid Gwalior in India --after the hessian contract traded Chamber ofCommerce Hapur in Calcutta- with a 1994 turnover worth Indian Exchange Ltd. Amritsar Rs 5,000 million. The three main Ludhiana Grain Exchange Ltd Ludhiana exchanges trade over 2,000 contracts per Meent Agro Commodities Exchange Company LtId Meenut day each on most days. Trading is fairly Rajdhani Oils & Oilseeds Exchange Ltd Delhi well distributed over the year. MAk Kishna Trading Company Ld Rohtak 2.35 Contract Specifications. Four Vijai Beopar Chamber Ltd Muzaffamagar contract months are traded each year, for delivery in March, May, July and December, In principle, contracts for up to 8 months out can be traded. Each contract is for 4 metric tons, with the basis variety varying according to the exchange. Each exchange has between 4 and 12 delivery centers. The Oilseed Commodity Exchanges 2.36 Futures contracts in oilseeds, oils and meals were introduced not much later than cotton, and were actively traded until the early 1960s. They were banned gradually during the 1960s, and the last two remaining contracts, in castorseed and linseed, were disallowed in 1977. In 1985, the ban on the castorseed hedge contract was lifted. 2.37 Four Recognized, Active Associations. Nine exchanges are recognized for trading futures contracts in oilseeds, including castorseed, coconut oil, cottonseed, groundnuts, groundnut oil and/or linseed. However, hedge contract in Table 2.6 castorseed only is permitted, restricting Active Oilseed Commnodit Associations trading to only four recognized exchanges ...... ....... .... . (Table 2.6). The other five recognized 7A_uM__e associations are inactive. Among the active AaWd SePdu MandsAoitiLha exchanges, the Bombay and Abmedabad i~~~Abtedabad Seeds Merchants' Association Ltd Ahmnedabad exchanges, the Bombay and Ahmedabad Bmbay Oilseeds and Oils Exchage L Bombay exchanges are tme oldest, dat og aack to pre-Independence times. The Rajkot andu aktSesOladBiir ecat'Rio  21 Delhi exchanges were recognized for trade in castorseed contracts only in 1991 and 1992, respectively. 2.38 Contract Specifications. Four hedge contracts are traded per year, for March, June, September and December delivery. Contracts can only be traded up to six months forward. The unit of trading is 5 MT, and each of the exchanges defines specific basis and deliverable qualities. The exchanges have from 11 to 56 delivery locations. In the case of BOOE, they are spread around the country. 2.39 High Market Turnover. Trading in castorseed hedge contracts is very active in the four exchanges. Despite its recent establishment, trading on the Rajkot exchange expanded considerably to rival within a year with the Ahmedabad exchange. Between 1992 and 1993, the Ahmedabad exchange accounted for about 46% of total turnover, against 40% for the Rajkot exchange, and 10% for the Bombay exchange. The Delhi exchange accounted for the remainder. In relative terns, the volume of castorseed trading is very large --3.6 million MT were traded on average per year during 1990 to 1994, reaching a peak of 5.5 million MT in 1992- far exceeding the annual production which ranges between 500,000 and 750,000 MT. In general, the Ahmedabad and Rajkot exchanges each transact over a thousand contracts per day. The Bombay exchange has a nationwide mandate, with 56 delivery centers throughout the country: in Gujarat (including Ahmedabad and Rajkot), Andhra Pradesh, Maharashtra, Bihar, Kamataka, Rajasthan, Uttar Pradesh and Madhya Pradesh. The delivery centers in Ahmedabad and Rajkot allow effective arbitrage between the three exchanges. The Pepper Commodity Exchange 2.40 India's pepper futures market trade is the only surviving pepper market in the world. In the 1930s, an early attempt in New York failed. The India Pepper and Spice Trade Association (IPSTA), which manages the Cochin pepper futures exchange, reports an annual futures tumover of between 100,000 and 110,000 MT, more than double India's black pepper production. The exchange is used for pepper futures trading by some larger farmers, town dealers, the larger interstate dealers and exporters. Most of India's major pepper exporters are members of the exchange and use it regularly. H. The User Composition of Indian Commodity Exchanges 2.41 The Indian User Composition Users Mirror International Exchanges. Indian commodity exchanges which were visited during our field survey present a user composition similar to that of western exchanges.7 Half of the trade is estimated to be speculative, half of which is conducted by day- traders or "scalpers"8. Scalpers earn their income through their daily trading transactions, and contribute significantly to the liquidity of the exchange. The remaining half of the trade is hedging, with traders being the most active. The various categories of users are discussed in more detail below. 2.42 Farmers Rarely Use Futures Markets, But Stand to Benefit Indirectly. Farmers in India rarely use futures markets directly. This is similar to the United States, where futures markets have operated for a long time, and where only a small percentage of farmers use futures or option contacts directly. Indian farmers would benefit indirectly from using cooperatives or other iteriaries, or 7It should be noted that no detailed records of categories of users are kept or made public by the exchanges, unlike in the case of the Commitment of Traders Reports in the United States. 8 Day-traders buy and sell during the same day, trying not to keep any positions open overnight.  22 simply from better deals with traders using futures markets. The conditions exist for the indirect participation of Indian farmers on futures markets, since in most states, farmers sell their commodities through the "regulated markets." In the regulated markets, key commodities are auctioned-off, and the price information is displayed. Commission agents operating in regulated markets could play a useful role in providing information and intermediating risk management transactions. Farmers' cooperatives could also intermediate risk management transactions for their members. Apart from lack of familiarity with futures trade, regulatory barriers prevent cooperatives from using commodity exchanges: i) the sales tax registration requirement for members of exchange, and ii) the fact that most cooperatives are in effect state organizations, and accordingly are not supposed to "speculate." It is unlikely, however, and not even desirable that farmers trade directly in futures markets. 2.43 Traders Are the Largest Users, But The Extent of Their Involvement Remains Marginal. Traders, both large and small, are the main users of futures contracts in India. For gur, oilseeds or pepper, there is an active participation of town dealers. For castorseed and pepper, most exporters are active in the exchanges. Nevertheless, for most traders, the percentage share of trade they hedge through the futures market remains small. Large exporters are confronted at times with low exchange liquidity, while smaller traders, because of poor access to credit, cannot afford to tie their funds in futures markets for long periods. 2.44 Regulations Limit Speculation to Small Speculators. Virtually all speculators in Indian commodity exchanges are relatively small, either day-traders or individuals trading through brokers. Large, institutional investors, such as pension funds, insurance funds, and mutual funds are conspicuously absent. Their participation in commodity exchanges is not allowed under the Reserve Bank of India regulations which stipulate the prudential norms for banks and non-banking financial institutions. This is similar to the policy of the Securities and Exchange Board of India (SEBI) which regulates participation by mutual funds on the stock exchange. In addition, commodity exchanges regulations, by requiring all members to acquire a local sales tax registration, also serve as an obstacle to participation of the large, institutional investors. Funds are unlikely to be interested in trading through the generally small and poorly capitalized brokers who dominate Indian commodity exchanges. 2.45 Agro-Processors Rarely Use Commodity Exchanges Because of Their Deficiencies of Commodity Exchanges. Processors and manufacturers use the exchanges to a limited extent for two main reasons. First, some of the manufacturers, especially in the oils sector, are so large that they would not be able to lay off a significant part of their risks on domestic exchanges, which suffer from chronic illiquidity. Second, the range of commodity futures contract offered is too small resulting in incomplete risk management markets. Under such incomplete markets, companies do not find it worthwhile to manage risks in a highly imperfect manner. For example, many firms do not find the castorseed contract useful, since few manufacturers use castor oil and it is an imperfect risk management instrument for other oils. 2.46 International Users of Indian Commodity Exchanges Are Banned. Foreign trading firms participated in some of India's commodity exchanges, until their participation was banned. Currently, Indian exchanges are not allowed by the FMC to accept foreign members, and they would need to seek permnission from the Forward Markets Commission and amend their bye-laws if they wish to change this situation.  23 Summary 2.47 Commodity futures exchanges have a long history in India. From the rapid multiplication of exchanges in the 1920s, the changing economic, policy and regulatory environment has since drastically reduced the number of active exchanges, agricultural commodities, and types of contracts which can be traded. Presently, futures trading is permitted for nine, mostly minor agricultural commodities. Three types of futures contracts can be traded: (i) NTSD contracts--cotton, raw jute and jute goods (sacking); (ii) TSD contracts--raw jute, jute goods and hessian; and (iii) hedge contracts--castorseed, gur, hessian, pepper, potatoes, and turmeric. The changing composition of agricultural production and the evolving policy and regulatory framework have also significantly influenced the pattem of development of the exchanges. The following chapter examines the performance of commodity futures trade in India and the factors which influence its performance and development.   3 THE PERFORMANCE OF COMMODITY 3 FUTURES TRADE 3.1 Commodity exchange performance in India vanes considerably across exchanges trading the same commodity contracts, and across commodities. This chapter will first examine the operational performance of commodity exchanges. Their operational performance will be assessed in terms of market liquidity, suitability of contracts, fairness and efficiency of trading practices, security provided by clearing procedures, effectiveness of delivery procedures in linking physical and futures markets prices, supporting infrastructure, and adequacy of their current promotional and developmental capacities. In the second section, the report will examine successively the impact of direct and indirect government policies on the observed operational performance of commodity exchanges. A. Operational Performance of Commodity Exchanges. Market liquidity 3.2 Definition. Markets have to allow commercial hedgers to lay off their risks without undue problems. A market is liquid if normally-sized transactions can be executed within a short period, without significant impact on price levels. If transactions can be filled reasonably only over a period of several days, or immediately result in price movements or "slippage", the market is said to be illiquid. 3.3 The Main Gur and Castorseed Futures Markets are Liquid. The gur and castorseed futures are both liquid, but differ in their degree of market liquidity. The gur market is highly liquid. While most physical trade in gur is in relatively small quantities, the market trades over 8,000 MT per day. Thus, an order of 100 MT is unlikely to cause any problems. In contrast, the castorseed market is not as liquid. The two larger exchanges only trade some 5,000 MT per day. This trading volume poses problem for exporters since equivalent to the amount needed to hedge the price risks of a typical single export cargo of castor oil --4,000 to 5,000 MT. To overcome this constraint, exporters execute orders for large quantities by combining various markets and proper planning. They also report that it is not difficult to roll-over positions of some 5,000 MT into a next contract month'1. 3.4 Poor Liquidity Has Caused Problems on the Bombay Castorseed Market. Strong market movements, combined with insufficient financial strength of market users, resulted in severe liquidity problems in castorseed trading in the BOOE in March 1994. Prices for the March delivery contract started increasing strongly in January 1994, and on January 18 the BOOE Board of Directors wamed brokers to exercise restraint in building up large open positions, in particular for the account of potentially unreliable non-members. Two days later, trade in the BOOE halted completely as two of the main non-members holding open positions communicated to their brokers their inability to meet their obligations. The heightened fears for defaults stopped trade and the brokers were unable to liquidate their positions. The physical market prices continued rising, and there were fears that when the short positions could finally be closed out, brokers would be unable to assume the losses. On January 22, the I That is, a hedge is extended by buying or selling the nearby contracts, and undertaking the opposite transaction in the next contract month; if roll-overs work well, one can get price protection, say, 1 year out even if futures contracts are only offered up to 6 months out.  26 Board decided to declare a state of emergency in the market, and closed out the outstanding contracts in the March delivery month at a negotiated settlement price. 3.5 Inadequate Regulations Compound The Poor Liquidity of Indian Exchanges. The poor liquidity of Indian exchanges is compounded by inadequate regulations. In particular, no rules govem the relationship between brokers and their clients. It is entirely up to the brokers to collect margin moneys from their clients. Financial safeguards between brokers and the exchange are also inadequate. The BOOE responded to the above crisis by establishing a Rs. 50,000 security deposit for every broker, and by increasing the security margin deposit for larger positions. Despite these increases, the security deposits and security margin deposits for, say a 500 MT position, would equal only about 5% of the market value of this position, somewhat low by international standards generally around 10%. Suitability of Indian Futures Contracts 3.6 NTSD Contracts Are Highly Imperfect Risk Management Tools. The stringent limnitations imposed on NTSD contracts by the FC(R) Act make them highly imperfect risk management tools. This explains the small share --15%- of physical trade covered by NTSD cotton contracts, their highly seasonal nature, and the fact that most contracts are only for up to three months. NTSD contracts tum out to be rather risky forms of forward contracts under present regulations. Once a company has entered into a NTSD contract, say for delivery in six months time, it cannot get out of the contract or even renegotiate its specifications. Cotton ginning mills, for instance, often sell their lint forward in the expectation that they will be able to buy the seed cotton at an attractive price. If the harvest turns out to be lower than expected, the mills who entered into forward contracts have no choice but wait until the contracts' due dates. The only exception to this is when a general production crisis would cause a general default, a situation in which the commodity exchange board can decide to forcibly close out and settle all outstanding contracts, at a negotiated price. Such a forced closure of contracts --experienced by the Northem India Cotton Association in Bathinda in late 1994-- causes significant distress and results in large financial losses. It also reduces public and government confidence in futures markets. 3.7 Such a default crisis would not occur under standard, international futures contracts definition. As soon as the news of a disappointing harvest is known, futures prices increase. Those who sold contracts will have to close them or pay extra margins. The clearing house of the exchange guarantees contract perfonnance and secures itself through the margin payments it receives. Default will be avoided automatically: speculative mills would be forced out of the market relatively fast and will be unable to stay with an open position until the situation becomes unbearable. 3.8 The Poor Suitability & Limited range of Permitted Futures Contracts Prompts an Active IUegal Futures Trading. In response to the legitimate hedging needs of cotton gins, a significant illegal trade in seed cotton and cotton futures is reported to have developed with its main center in Surendranagarin, where V-797 cotton futures are traded primarily around harvest time, but also in other centers. This illegal trade appears to be relatively well-organized: participants pay margins in case their positions move against them, and default rates are reportedly quite low. This futures trade takes place outside of the law, exposing participants to counterparty risks. Moreover, the general public loses the benefits associated with price discovery. 3.9 The risk management needs of commercial users also spawned illegal trading in oilseeds futures contracts, notably for groundnut oil (in Rajkot, Jamnnagar, Dhoraji and other centers) and mustard oil  27 (such as Delhi, Hapur and Agra). According to a 1986 study, 2it was found that somne 60 operators actively traded in oil futures in Rajkot, prior to its recognition by the Forward Markets Commission, closely resembling formal exchange operations, with standardized trading rules and open outcry. Most of the business served the risk management needs of genuine groundnut oil traders, millers and wholesalers; speculation was relatively unimportant. This illegal trade worked quite efficiertly, with rules for cash-settlement, weekly margin payments, and significant investment in tele-communications. Most offices in the market were linked through internal telephones, with each office having at least six telephones. The market also had 30 telex machines. About 70,000 calls were reportedly made each working day between this exchange and other mnain cities. Trading practices 3.10 The Open Outcry Trading System Is Appropriate. All conmmodity exchanges in India function through open outcry, a seemingly chaotic but highly efficient and low-cost form of futures market trading. Traders in a trading ring make bids and offers through shouts and hand-signals, and the first to react gets the deal. Trading orders come in from outside, through telephone clerks who represent brokers who, in tum, are in contact with hedgers and speculators, often nationwide and in continuous contact with the trading floor. BOX 3.1 IS OPEN OUTCRY OUTMODED? Ope outy stil prvails through the wods ages exa s, although in Japan, Chti, New Zealad, and South Afhica, trade is predominantly through an electronic trading system. In electronic exchanges, market uses are connced thrgh computer terminals with a trading system that automatically matches bids and offem. Large exchanges in the ULnited States ad Europe have also developed electronic wading systems to twade outside of their normal trading hours. Elecironic trading systems have high set up costs, but make it very cheap to introduce new contracts. Some stock exchanges, including the one in Bombay, use a mixed elecronic/open outcry system. Under this nixed system bids are relayed by monitor, and its reactions by open outcry, ring officials ar reponsible for constantly matching the two parts of trade. This trading system could also be used for linking two open-outcry exchanges in the same time zone. Is the open outcry system of India's exchanges out-moded? There is no compelling reasm for te eXisting, open outcry exchnges to shift to another system. Whether new contracts should be traded electronically is a moe complicabtd queation, For opet outcry trading one needs trading infrastnrcture: a trading ring, oesby offices and good teeconcatiom systeis. Electronic trading can be done from the offices of the members; if there is an efficient telephone system, these offices can then be linked using one of the electronic trading systems already developed by other exchanges. Open outcry tading atracts smalt floor traders, who are key in prviding for market liquidity, on the other hand, electronic trading attact larger users beceise of te anonymity it provides. In India, it would still appear that the open outcry system is the most efficient even for new contracts. In most instances, the physical facilities already exist, along wi the corresponding concentration of traders and bmroen, Moreover, the scope of increasing the number of floor brokers remains large. It would be erroneous to elect an electronic trading system only because of its high-tech image. A mixed system could be introduced for linking commodity exchanges. Even in this instance, however, it should be noted that the existing system of information gathering and order placement by telephone appeas to finction well. The gur markets which are all open at the same time, for instance, appear to be well integrated, with some key tradern and broken in each exchange remaining in constant touch with the other markets and undertaking arbitrage when the situation warrants it. In principle, there is no reason why, fir example, a number of cotton markets could not be effectively integrated through a brokerage networl. A mixed system would make more sense for an international linkage; the charges of a leased line between two exchanges would then have to be compared with the charges of individual telephone calls by potential market users. 3.11 Open outcry in the exchanges visited functioned well (Box 3.1). Market participants showed all the required skills. The trading sessions were fast and competitive, with participants engaging in a rapid play of hand-signals and shouts; deals were registered instantaneously on standard forms. Participants understood the principles of arbitrage, put on straddles over two contract months if the price diffrential between months became too large or too small, and engaged in other more sophisticated trading strategies. 2 Reported in V.P. Gulati and S.J. Phansalkar, Oilseeds and Edible Oil Economy of India, Delhi 1994.  28 3.12 Futures Trading Skills Are Being Lost. One major difference with European and American exchanges is the age of participants. Indian exchanges have a much older active membership. For example, most of those with experience in cotton futures trade are close to retirement age. Indian universities have not given priority to futures trade in their curricula. As a result, most of the newer generation of professionals involved in commodity trading and those employed in supporting institutions such as banks, have little knowledge and familiarity about futures markets. These indicate a serious loss of interest in exchanges and a loss of valuable skills, a reflection of the strict policy constraints governing futures markets, as well as a their poor iiage in India. They also underscore the strong need for training programs. 3.13. Trade Registration Procedures Are Well Laid-out.' Although they differ from international exchanges, Indian commodity exchanges have clear and adequate rules for the registration of transactions. Contracts and procedures need to conform to the trade practices customary in the market, and it would be unwise to copy the rules and procedures of a major international market. For instance, the Vijai Beopar Chamber Ltd., in Muzaffamagar, Uttar Pradesh, prescribes the following trade registration procedures: * A broker (anyone active on the exchange) has to record a trade immediately on a duplicate form (called a "Kachhi Bahi") as prescribed by the exchange; these Kachhi Bahis resemble in form and purpose the trade confirmation slips used by western exchanges. All such forms have to be kept for a period of three years. * A transaction not duly recorded is considered illegal. * Each broker is supplied a number of serially numbered Kachhi Bahis, countersigned by the secretary of the exchange. * Every broker has to provide the exchange with the original pages of the Kachhi Bahi on which the transactions are recorded, immediately after the closure of the market; upon receipt, the secretary, or his designated officers, signs the duplicates. * At the end of the trading day, each broker has to record all transactions entered into during the day on a separate form provided by the exchange, in duplicate; he then has to obtain the signatures of the buyers and sellers, as confirmation, and send a copy to the exchange before noon of the next trading day. Clearing Operations 3.14 Clearing Requirements Vary Across Exchanges Reflecting Differences Across Contracts. Clearing requirements differ markedly across commnodity exchanges. The cotton exchanges, because they trade exclusively NTSD contracts, only provide a forum for their members to meet and draw up contracts, and do not provide any performance guarantees. Exchanges trading TSD or hedge contracts 3 Note that on some exchanges, trade outside the ring is allowed, and this would largely fall outside of normal controls. In the gur market, trading members are allowed to enter into direct hedge contracts (called "rubru" contracts) outside of the official trading sessions. Forms provided by the exchange have to be used, transactions registered within a day, and trade has to take place at a price falling within the price band prevailing on the day the contract was signed. This is not an unprecedented system. It is standard practice on the London Metal Exchange. As long as this practice remains limited to traders and does not include brokers, problems should remain small. Vigilance is however needed to ensure that client orders do not end up in this secondary circuit.  29 should have clearing houses to guarantee contract performance, with both buyers and sellers required to pay a margin to the clearing house account. The larger exchanges, such as the pepper exchange in Kochi, the turmeric exchange in Sangli, the gur exchanges in Muzzafimagar and Hapur, and the three main exchanges in Ahmedabad, Bombay and Rajkot, all have clearing houses or arrangements which would require improvements. Many of the other exchanges, however, do not collect margins other than the initial security deposit. 3.15 Weeldy Clearing Differs from International Norms, Reflecting the Small Scale of Operations of Most Indian Commodity Exchanges. The clearing houses are departments of the exchange, not independently capitalized entities. They are owned and guaranteed by all exchange members --not just the larger ones. The castorseed exchanges and most other Indian exchanges which operate clearing arrangements have weekly clearing. A few of the gur markets and the Cochin pepper exchange have daily clearing, a common practice with most intemational exchanges. Exchanges with weekly clearing have the possibility of intra-week clearing ("automatic clearing"), if the day's closing price moved more than a certain amount away from the last clearing price. Automatic clearing ensures that the margin payments are sufficient to cover possible losses. For example, the margin deposit is 3 per cent in the BOOE. If the day's closing price is more than 1.5 per cent away from the last clearing price, a special clearing takes place. 3.16 The speed at which members have to pay clearing margins also varies across exchanges. The BOOE determines the clearing payments after the close of trade on Friday, and margins have to be paid before the opening of the trade on Tuesday. Positive margins are paid out a few days later, on Friday. In the Muzaffnaagar gur exchange, the clearing margins established at the end of the trading day have to be paid before the next trading day starts. 3.17 As an additional measure, special deposits can be requested from large market participants. Extra security is also built-in during the delivery period of the contract, when those to whom delivery has been assigned to have to pay a relatively high margin -30% in the case of castorseed. In addition, at times of volatile prices, special security deposits can be instituted during the delivery period. For example, for the June, September and December 1993 contracts in the BOOE, those holding open positions during the delivery period were required to deposit Rs. 75,000 as guarantee, if they held between 5 and 500 MT, and Rs. 150,000 if they held between 505 and 1500 MT India's Unique Delivery System. 3.18 Delivery is Not Mandatory. Indian commodity exchanges follow a mixed system at the time of maturity -either delivery or financial settlement- which is left at the option of those holding contracts. This is unlike international exchanges where no choice is provided to those holding contracts at maturity: international futures contracts always specify the exact method of settlement at maturity -either physical delivery, or financial. Delivery procedures of Indian exchanges, when they apply, are adequate. Delivery can be done either on the seller's option (e.g., for castorseed), or on the option of both buyer and seller (e.g., for gur). Two approaches are followed in matching buyers and sellers. In some exchanges, contracts are assigned on the basis of the holding time (the longest-held short contract is matched to the longest-held long contract, and so on.), which is similar to the one used in American or European exchanges. In other exchanges, each contract is tracked from the net seller to the final buyer. 3.19 Financial Settlement Is Allowed. Contracts which do not go to delivery and remain open until the maturity date, are closed out and settled financially. Outstanding positions are settled at a rate fixed  30 by the Board of the exchange. Table 3.1 gives an indication of the relative importance of the two types of Table 3.1 conract close-out on the BOOE. Bombay Castorseed Hedge Contract, 1990-1993: Amounts 3.20 The Rules on Contract Settlement lack in Tendered And Settled Clarity and Transparency. According to the exchanges' = regulations, the Board of Directors has considerable leeway . in fixing the settlement price. For example, the Board of _ B ' S m the BOOE can fix the settlement price after taking account 1990 several variables, including: March 10 Nil * Opening price of the contract; June 50 Nil * Highest and lowest price of the contract September 135 130 December 30 Nil during its life; 1991: * Highest and lowest spot prices during the March Nil 375 contract life; June 70 Nil Maturity day's closing price; September 235 320 * Contract prices and spot prices during the last 1992: 15 days of the delivery month; March 210 95 * Tenders issued during the delivery period; June 210 660 Outstanding positions on the maturity date September 200 365 * Highest and lowest outstanding positions 1993: during the contract period; March 1,085 855 * Spot prices at three major upcountry centers; June Nil 105 and, ~~~~~~~~September 75 Nil and, December 1,220 70 * Due date rates of the last four matured contracts. 3.21 The actual implementation process, however, appears more transparent. Settlement prices are determined keeping in view the spot market prices prevailing in key delivery centers for 3 to 4 days before the contract is to mature, and after deducting the expenses incurred in making and taking delivery. The settlement price so arrived remains subject to the weekly limit on price variations prescribed by the FMC. 3.22 The Imperfections in the Indian delivery and contract settlement systems causes the artificial backwardation of Indian futures markets. Backwardation --usually a short-lived phenomenon- occurs when futures prices fall below spot prices. On the gur futures markets where ceilings on futures prices are set below spot prices, artificial backwardation is allowed to be maintained by the flexibility which the Indian delivery system helps provide, enabling sellers to avoid physical delivery, and instead to settle outstanding contracts at a price taking into account futures contract prices. Supporting Infrastructure 3.23 Commodity Exchange Infrastructure is Adequate to Support Current Needs. The physical infrastructure of the commodity exchanges, although old, appears adequate to support the existing volume of futures trade. As membership declined over the years, many exchanges have seen their incomes declined, making it difficult to invest in new facilities. Nevertheless, the basic infrastructure of the exchanges visited ( Bathinda, Bombay and Muzaffarnagar) is proper for trade in futures contracts. The exchanges in Bombay have large trading halls --a new facility in the case  31 of the BOOE, with recent investment in computer and communications equipment.4 The EICA also plans to undertake the necessary investments, once the govemment approves cotton futures trade. The exchanges in Bathinda and Muzaffamagar are not as spaciously housed, but their facilities are perfectly suitable for a well-functioning futures trade. Their facilities include a central trading ring, surrounded by brokers' and traders' offices, and telecommunications that operate well, allowing easy arbitrage with the other markets as well as contact between users, brokers and traders. 3.24 Supporting Warehousing, Banking and Legal Infrastructure is Good. India possesses a good warehousing, banking and legal system which can facilitate futures trading. The country has a good public warehousing system, with warehouse receipts --legally recognized5-- issued by Central and State Warehousing Corporations, rural godowns set up under government schemes, and godowns set up by Regulated Market Yards, which would discourage manipulation. The banking system is reliable, and apparently, sufficiently fast and efficient for the purposes of futures trade. The Indian legal system, such as Bankruptcy law, is also supportive of the development of futures trading in the sense that contracts can be effectively up-held in court, although delays continue to undennine the effectiveness of India's strong legal system. 3.25 Supporting Marketing Infrastructure in Transport, Telecommunications, and Grading is Weak. Weaknesses in the current supporting infrastructure for commodity exchange operations lie mainly in the telecommunication and transport system. The domestic telecommunication system is not very efficient, although most exchanges seem to have found ways to overcome this. Transport, especially by rail, is slow, which could potentially hinder the efficiency of futures trade if a corner is attempted: it becomes more difficult for market players to bring commodities to the delivery locations of the exchange. Ports are slow and their timing unreliable. This will discourage foreign companies from using Indian commodity exchanges if allowed to do so. 3.26 Another major weakness of India's marketing system lies in the under-developed grading practices, in spite of the efforts by agricultural marketing cooperatives to introduce and develop more systematic grading management techniques. The overwhelming majority of agricultural commodities traded on the regulated markets only undergo visual inspections. Sample testing of physical attributes, for example in the case of cotton and oilseeds, remains the exception on regulated markets. In the case of rice and wheat, the public management of vast procurement operations does not provide the market with the needed incentives to develop an appropriate and reliable system of grading and quality management. A weak grading system undermines the reliability and confidence of users in futures markets. In the absence of reliable, standardized grades, agricultural commodities cannot be valued properly and accurately on the physical markets, undermining the relations between spot and futures prices and making difficult the determination of price premiums and discounts to account for quality differences. The absence of grading practices --and corresponding infrastructure-- stems from inadequate agricultural price 4 This includes a computer link with KnightRidder, one of the world's major information services, which will make it possible for foreign companies to have instantaneous access to Bombay futures market prices. 5Warehouse Acts exist at both the federal and state levels allowing for the issuance of negotiable warehouse receipts by recognized warehouses, which could then be pledged to obtain cheaper credit. Appropriate legal conditions appear to be in place: in case of default, the lender has the power to take possession of the commnodities; responsibilities of warehouse operators are specified; and provisions are made for a range of potential problems (e.g., loss of warehouse receipt, death, dispute, etc.).  32 policies which do not provide for the needed economic and financial incentives in the agricultural marketing chain. Brokerage Industry 3.27 A Small-Scale Industry. A large number of brokers are active in India's commodity exchanges. Brokers are persons paid a fee or commission for executing buy or sell orders for a customer. Brokers are also used for arbitrage transactions, in which a trader or speculator takes simultaneous positions in two different exchanges to benefit from price discrepancies. In many respects, the brokers active on the exchanges are quite similar to their counterparts in western countries. Box 3.2 provides a description of the types of transactions a typical broker in a small-town market undertakes. Box 3.2 A Typical Broker On The Bathinda Gur Exchange This broker, active for over 10 years in the gur market, trades on behalf of clients. His relations with clients are thl same as elsewhere in the world: clients pay deposits and margins when their positions move against them, and in this way, the broker is ifly secured. The bye-laws of the exchange provide all the provisions necessary for this type of policy. His tumover is only some 2,000 to 2,400 MT; a month, and most of his clients are hedgers, mostly small traders in the region. Through him, his clients could: sell gur etsst. when they have acquired a large stock of gur and cannot immediately sell it, thus protecting the value of their inventory. Altenatively, they nught buy futuires when prices appear low but cannot obtain gur on the physical market, the broker would then liquiae e& tpositions once they have obtained the gur they need. Clients even undertake cash-and-carry operations, simultaneous ftwes and hysicl0 marketitansactions that help stabilize prices. Although commodity exchanges in India operate in much the same way as exchanges in other patts of the warld, commodity trading is generally not considered a highly respectful career, particularly when the exchanges are subject to frequent police raids. Indian brokers find it hard to believe that, elsewhere, such an occupation is viewed as perfectly normal and even econonically useful actv1ty. 0 3.28 One major difference between brokers in India and those in Western countries is the scale of their operations. Brokers in India usually operate small-scale, personalized businesses. In other countries, commodity brokerages are often large enterprises, and they undertake a whole range of activities. Companies, such as Merrill Lynch, Goldman Sachs or Refco, are active in many commodity markets, in financial futures markets and often in various other financial markets. Even smaller brokers are active on many exchanges, and the persons in contact with the clients would not typically execute the orders on the floor. Rather, the orders are passed to another broker (working for the same or another brokerage company). In contrast, brokerages in India are typically a one-person enterprise or at the most family businesses. As in most of India's commodity trade sector, women's participation is absent. The broker is active only on one market, and is responsible not only for contacts with clients, but also for order execution on the floor of the exchange. Contrary to the situation on most other exchanges, all brokers -including small ones-- have the status of clearing member; i.e., they are themselves responsible for payments to the clearing department of the exchange, and the clearing department depends on them to ensure its financial security. 3.29 The Brokerage Industry is Fragmented. The fragmented character of the brokerage industry creates several problems that are likely to grow with the growth of the commodity futures industry. One problem is the lack of financial strength of many individual brokers. The limited financial base can reduce the confidence of potential clients and complicates the creation of a fidelity fund, which would protect clients against brokers' defaults. 3.30 A second problem relates to the difficulty potential clients face in finding a good broker. Personal contacts play a large role, but distance and lack of information are, at least under current  33 conditions, a major obstacles for many potential users. A third problem is that brokers are not in a position to provide full services to their clients, in particular the provision of infornation and market analysis, and the handling of some aspects of futures trade (e.g., physical delivery). If commodity futures trade is allowed to expand, brokerage companies able to overcome these problems will have a competitive advantage. Such potential gains should be sufficient to provide the needed incentives for the consolidation process of the brokerage industry into larger, nationwide entities. However, the current system of regulation, tailored to the requirements of small-scale and fragmented brokerage industry, would need to be overhauled. 3.31 Lack of a National Brokerage Regulation. The absence of a national brokerage regulation system represents a major regulatory deficiency. Brokerage regulation is now entirely under the control of the associations, which generally have fairly strict rules and are strengthened by some financial safety nets. The recognized associations provide for vetting procedures for new brokers; contribution of brokers to a collective safety net; and rules for the contacts between brokers and their clients. 3.32 This regulation system has worked well so far, partly because of the strong social controls which the relatively small size of exchange tumover and the limited number of brokers actually involved help provide. If futures markets are allowed to grow, the financial stakes in client-broker relationships will increase correspondingly. With more trade coming from out-of-town brokers, existing social controls may break down. If futures markets are allowed to grow, a new framework for brokerage regulation should be allowed to develop gradually. This should be phased so that undue hardships are not placed on established brokers. Promotional and Development Capacity 3.33 Most Indian Exchanges Would Need to Strengthen their Capacity to Support the Orderly Development of Futures Markets. Indian Exchanges are inward-looking, a characteristic common in many exchanges in other countries. They focus on the needs of their existing members, rather than the possibility of increasing their business. Their institutional capacity has clearly been stunted by the restrictive policy environment under which they had to operate. 3.34 Currently, many exchanges get-by by keeping a low profile, and only make their prices available to newspapers and to some extent, radio. A few larger exchanges, in Bombay, Calcutta, Cochin and Coimbatore, are more vocal, provide a wider range of services to their members, including policy dialogue with the Govemment. Even the larger exchanges, however, have no active policies to recruit new floor traders, train market users, or to promote the exchanges and futures trade to the public. They also lack research departments which, in other countries, investigate possibilities for introducing new contracts. This directly reflects GOI's long-standing policy stance against the introduction of new contracts. 3.35 If futures markets are allowed to play a more dynamic role, these weaknesses are likely to become critical. Those exchanges with an established capacity will need to take the lead in developing training programs and undertaking public promotion efforts. Other exchanges could pursue these programs once they have the means. Commodity exchanges will also need to develop strong research departments to identify those contract specifications offering the greatest possibility of success.  34 B. Impact of Government Interventions 3.36 Government policies influence the performance of, as well as the usefulness of futures markets. These policies can be classified into direct and indirect government interventions. While the former correspond to those interventions which directly regulate the operations of the exchanges, the latter correspond to those which influence the overall performance of the physical agncultural markets. Direct government interventions relate mostly to the provisions of the FC(R) Act. Indirect government interventions, instead, relate to the legal and regulatory environment of agricultural commodity trade embodied in the provisions of the Essential Commodities Act, 1955 (EC Act) and the RBI's selective credit controls, and agricultural price and trade policies. Direct Government Interventions. 3.37 The Regulatory Objectives Have Been Lost in Over-Regulation of Futures Contracts. The limits on contract specifications imposed by the FC(R) Act, originally intended to prevent speculation, have often become so stringent to make futures contracts an unattractive and risky proposition. A clear relationship can be observed between the extent of restrictions imposed on futures contract and their level of use. The more flexible hedge contracts --e.g., castorseed, pepper, gur-- are widely used by and acceptable to operators, while the inflexible NTSD contracts --cotton-- are barely used. All hedge contracts report high market turnover, are highly liquid on the main exchanges, and cover more than 100% of the physical trade. This is not so in the case of cotton NTSD contracts which suffer from small turnover, low liquidity, and cover only a marginal share (15%) of physical trade. Furthermore, the reported presence of active illegal in cotton futures trading would appear to confirm the interest by operators in more flexible risk management instrument. 3.38 Futures Price Ceilings Regulations are Ineffective in Stemming Speculation; They Also Represent a Major Impediment to Efficient Futures Trade. In India, ceiling prices are often set too low so that market backwardation -futures market prices trade below physical market prices- takes place. Although intended to stem speculation, this regulatory instrument is made ineffective by the flexibility the Indian delivery system provides (see para 3.23). More importantly, market backwardation has a negative and damaging effect on hedge effectiveness by breaking the normal process of arbitrage between the physical and futures markets. It also reduces market transparency by encouraging futures traders to operate outside the exchanges. In order for futures markets to fulfill their price discovery and hedging roles efficiently, and to minimize the risks of manipulation, ceiling prices regulations should be substituted by other, less market-distorting tools. 3.39 The Contract Approvals Process Hinders the Usefulness of Futures Trade. Every contract for a new delivery month has to be approved by the FMC. This approval in some instances arrives late, and always comes with a specific set of conditions, in terms of margining rules, margin lines, position limits, etc. At times, the market situation may have changed between the time of the determination of these conditions and the start of the contract trading, in such a way that the conditions largely prevent futures trade. For instance, in the June 1994 castorseed contract on the BOOE, the FMC had established a margin line (above which special margins have to be paid) at 1,100 Rs/100 kg. By the time the contract was introduced, prices had increased beyond that level, and the resulting high margin obligations kept market operators from trading. The exchange board was able to revise the margin lines upward, but this took time. Such a discretionary process creates unnecessary uncertainty among users of the exchanges and only serves to discourage users.  35 3.40 Tax Rules Do Not Recognize Hedging. Existing tax rules do not allow hedgers to deduct hedging losses from their ordinary income, unlike investors in financial derivatives. According to the Income Tax Act, tax rules treat hedging losses as speculative capital losses which can only be deducted from speculative gains -and can be deferred up to 8 years. This regulation creates taxation asymmetry. Unrealized profits on a hedge contract should be allowed to be deferred until the underlying physical transaction has been realized. While it appears that many companies manage to get such a "hedge treatment" through direct negotiation, the legal situation is far from clear. Such asymmetrical tax treatment of physical transactions and their hedges only serves to discourage legitimate hedging. Participation by traders in exchanges, especially those from outside the area, is further deterred by exchange rules which require that all members be registered in the town where the exchange is located, which is also often a lengthy process. Some exchanges, however, are already attempting to change their bye-laws to pernit participation by entities registered anywhere in the country. Indirect Government Interventions 3.41 Government interventions in agricultural commodity markets have been designed to protect the welfare of producer, processors and consumers, with the view to promote adequate food supplies and price stability. These interventions include storage and movement controls embodied in the EC Act, the selective credit controls issued by the RBI, external trade policies, and government market interventions particularly relevant in the case of rice, wheat, sugar, and to a lesser cotton and oilseeds. These policies have a considerable impact on the use, performance, and feasibility of futures trading. 3.42 Essential Commodities Act, 1955. The Essential Commodities Act, 1955 (EC Act) confers GOI with the powers to control the production, supply, and distribution of essential commodities. Virtually all agricultural commodities can fall under the provisions of the EC Act. The EC Act provides GOI with considerable powers including: * issuance of licenses and permits for the production and processing of specific crops; * setting of buying and selling prices; * regulation of storage transport, distribution and use of commodities; * prohibition of sale; * forced sale of inventories to the government, its agents or representatives. 3.43 In practice, the EC Act is applied arbitrarily and selectively to individual agricultural commodities by GOI. It currently applies to virtually all major agricultural commodities. The powers conferred by the EC Act may, by notified Order, be delegated to state governments, an authority or officer subordinate to the state. As a result, state govemments, have also developed their own series of Orders. Various components of the EC Act have a significant impact on the operations of exchanges as well the feasibility of establishing new ones. 3.44 Storage Controls Restrict the Economic Usefulness of Futures Trade. Commodities such as foodgrains, sugar, kapas, cotton, oilseeds and oils, are subject to strict stock limits. Storage controls prevents temporal arbitrage from taking place efficiently, thus restricting the potential contribution of futures markets to more efficient storage decisions. Storage limits are regularly revised, even during the crop season, creating additional uncertainty. For example, in April 1994, the maximum cotton stock of mills was restricted to the three month average consumption (an increase from 45 days restriction in  36 1993). Traders and ginmers were also prevented from storing in excess of 110% of the quantity held on the last day of the corresponding month of the previous year. Small traders and ginners are normally exempted from stock limits; so are the state trading companies and cooperative federations. Revisions regularly occur such as the kapas and cotton exemption from controls in the October 1993-February 1994 period. In the case of oils and oilseeds, trader stock limits were reduced by 50 percent in October 1993. 3.45 Commodity futures markets function best when efficient storage is possible and supported by a well-functioning credit system. Storage charges wvill keep in check the price differentials between spot and futures prices. If spot market prices are considered low in relation to futures market prices, operators will arbitrage: buy commodities now, pushing up spot prices, sell futures contracts, pushing futures prices down.; after a period of storage, commodities will be sold, pushing down spot prices, and buy back futures contracts. Arbitrage contributes to greater seasonal price stability. Such arbitrage strategies freeze up working capital, but because the value of the commodities is protected through the hedging futures markets provide, it should not be difficult to obtain bank finance.6 3.46 Selective Credit Controls Further Reduce the Demand for Futures Trade. The Reserve Bank of India (RBI), as part of its selective credit controls, sets "minimum margins" on commnercial bank advances against a range of "sensitive" conmmodities; for example, with a "minimum margin" of 40 percent, a bank is allowed to advance only up to 60 percent of the value of commodities to a stockholder. In addition, lending to each single party is subject to credit ceilings, with the maximum credits in a given year limited to a function of the peak level reached during the three previous years.' Sensitive conmmodities include foodgrains, pulses, oilseeds, vegetable oils, sugar, gur and khandsari, and kapas and cotton. Processing units normally come under less restrictions than traders. Minimum margins are revised regularly, at least twice a year. The rationale for this policy is that, such credit controls will help stem price increases. Central and state government agencies, those acting on their behalf of the Government, and cooperatives are generally exempted from this policy. Other exemptions are only possible with Reserve Bank of India approval. The RBI has lifted its selective credit controls for several comnmoodities in Ocotber 1996: coarse cereals, pulses, oilseeds and oils, sugar, guar and khandsari, cotton lint and kapas. 3.47 Storage controls together with selective credit policies severely restrict the capacity of private operators to undertake storage, reducing their need to cover price risks through hedging on futures markets. The link between storage and credit control policies, and their stated purpose of preventing hoarding of commodities and inflation is not very strong, except possibly in the short run. In practice, it is likely that such policies increase the vulnerability of markets to sudden shocks, making agricultural prices more volatile, and requiring greater, costlier government interventions on agricultural markets than would be otherwise necessary. Alternative policies may be more effective in reaching the same anti- inflationary goals. 6 It should also be noted that through this function, the private sector can take over a large part of the storage function, relieving government agencies of much of their burden: in order to reach certain price stabilization goals, buffer stocks can be much lower with a futures market than without. Also, as the experience of some international buffer stock operations has shown, the existence of a futures market will ensure that buffer stock operations are more effective: because of the transparency of the market, open market operations will be reflected in the prices, while if no futures market exists, private sector operators can just purchase (sell) whatever quantities the government wishes to sell (buy), without the rest of the market becoming really aware of it. 7 The maximum level is equal to this peak level, or 15 per cent higher or lower, as a function of the Government's desire to limit credits.  37 3.48 Movement Controls Also Restrict the Economic Usefulness of Futures Trade. Conunodity movement is critical for efficient spatial arbitrage as well as making delivery on a futures contract. Under the EC Act, however, movement controls or bans can be imposed by the GOI or state governments at any time. In Gujarat, for example, the transport of groundnut oil was banned seven times between 1990 and 1995. Andhra Pradesh exercised the same powers in 1992. Such commodity movement restrictions make futures trading impossible by simply facilitating the manipulation of futures contracts. 3.49 Government Market Interventions May Make Futures Trade Impossible. Futures markets cannot work when market interventions by governnent do not allow market forces to operate. This is the case for sugar where the government administratively sets prices of the sugar sold through the Public Distribution System, regulates open market prices by controlling stock releases on the open domestic market, and strictly manages foreign trade. It is also the case for rice and wheat where the Food Corporation of India (FCI) acts as the "dominant" supplier by accounting for the bulk of trade and storage. Pan-seasonal and pan-territorial pricing policies for rice, wheat, and sugar further discourage private storage, the risk management benefits and arbitrage possibilities futures markets would offer to private operators. In the case of rice and wheat, the absence of futures markets also implies that most storage costs and risks are bome by the Government and its associated agency, the FCI. The absence of any reported illegal futures trading activities in rice, wheat and sugar would appear to confirm the lack of interest by private operators in futures trading for these three commodities. 3.50 For other agricultural commodities, direct market interventions by government are much less significant, leaving greater room for market forces to operate --within the confines imposed by the storage, movement, selective credit controls, and other extemal trade restrictions. The extent of market interventions varies, however, from one crop to another. Government market interventions are greater in cotton than in castorseed and other minor agricultural commodities such as gur, pepper, and potatoes. The presence of much more active futures trading in the case of castorseed, gur, pepper than for cotton would suggest a strong --and inverse--relationship between the extent of govemment interventions on the physical markets and the operation and performance of futures trading. 3.51 Futures Markets Do Not Necessarily Hinder the Achievement of Existing Policy Goals. One possible policy concem is that futures markets would prevent GOI from pursuing its price stability and production objectives. In practice, however, a conmmodity futures market does not prevent a Government from subsidizing producers or consumers, or from controlling the extemal trade of products. Instead, a futures market will reflect the policies in place, as part of the general market conditions under which it operates, either the world market, or the local market screened off from world market influences. In the USA, for example, two raw sugar futures contracts are traded. One reflects world market conditions while the other reflects domestic conditions; the latter therefore trades at a considerably higher level, reflecting the US govemnment's objective of stimulating sugar production. Even the cotton and the wheat contracts traded in the US which attract signuficant international participation reflect US conditions -including government interventions-- rather than the world market's supply/demand conditions. 3.52 The govemment could still avail of the many useful functions a commnodity futures market performns, without giving-up control over the underlying physical market. Governent interference in the pricing and trading of commodities is not necessarily a hindrance to the functioning of futures markets. Throughout the world, commodity futures markets operate behind tariff and non-tariff barriers, and play their price discovery and risk management roles for local market participants. But while govenmment  38 interference in itself does not need to be a problem, heavy-handed intervention and discretionary, unpredictable interference is. 3.53 Provided a physical agricultural commodity market is not under direct government control, prices are set by market forces, and that commodity movement and storage are allowed, futures markets can continue to operate as long as there are clear rules on trade, including government interventions. Sudden, discretionary government interventions --e.g., imposition of movement restrictions on inter-state trade, changes in storage limits and credit controls, immediate ban on exports, changes in import tariffs, or unpredictable operations of parastatals or state trading enterprises-- fundamentally alter the supply and demand conditions on the physical markets, creating higher and unhedgeable risks. They also make Box 3.3 Contibution of Futures Markets to a Comprehensive Agricltural Strategy: Potential & Limnits of CGovernment Market Interventions The American and European Experiences The otrasting eperince of the American and Common Agcultural Polices of the European Uniob shows that producer poetn policy objectives can be maintained while allowing successful fiures trading activities. The simplification of the two policy models described below, highlights the presence of alternative foms oftmaetr interventnto achieve similar policy goals. Policies that have an indid effect on: the performance of futures market trade need to be evaluated in light of their respective costs and benefits, and the pOssibilities hy offer for less disruptive alternative risk management instrument. * erican lt polices protect producers, but do not eliminate price risks. Consequently, American commodity fuilies markets are active and atract large international interest, bringing with it a significant financial and commodity warehousing service industry. Storage by the private sector remnains econormially ataive,f and the government is not burdened by large stocks. Th 'LiUS experice also shows the limnits of government interventions in allowing futures rmarkets to perform effectively. :In the case of the United States, over the last ten years, strong arguments have been made that wheat futures no longer represent a good hedging tool for international prices due to USC Government interference through export enhancement program and other instruments, very much affecting thelinka between domestic and international prices. By contras0, in the Euiopean Union, the same goal of protection of agncultural piroducers as been pursued by policies that elimninated most price risks. As a consequence, virtially no futures contracts for the commodities produced in the European Union were traded, and very large, publicly financed stocks :accumuated over the years. Recent Common Agicultural Polcy changes now allow agncultural markets to be subjetd to price risks, prompting the introduction of new futures contracts -e.g., oilseeds contracts in on the Pans exihnge (MATIF) with the delivery points in France and Gemany. Futures contracts for cereals are also underdpreparation at the MATIF. it very difficult for speculators to operate; and with speculative participation drying up, hedgers will find it difficult to continue using the markets for lack of liquidity. Finally, they increase the risk that managers of state companies abuse their control over marketing and pricing decisions.8 Government interventions can go quite far --including targeted subsidies, an active role for state trading enterprises, 8 For example, the manager of a state-trading company could decide to take a hidden position on the futures market on his own account, and then takes a physical trade decision which costs his company money, but brings him a profit in his personal account. This type of abuse can be prevented by taking away from individual managers the discretionary power to make trading decisions; state-trading companies could instead sell according to a pre- determined, automatic schedule, at prices that reflect the market prices (e.g. the exchange-published prices).  39 external trade restrictions and even controls on storage activities by market operators. What matters is that interventionist policies remain stable and credible, that changes are publicly announced long in advance, and that government agencies abide by the market rules in their operations. The US and European experiences illustrate the potential and limits that government agricultural policy interventions impose on the performance of futures market, and their potential contribution to a comprehensive agricultural strategy (Box 3.3). When government interventions are achieved only through private sector operations and in a predictable manner, and if prices are still able to clear the market, then futures trading might co-exist with Government policy. Summary 3.54 Indian commodity exchanges do not perform as poorly as could be expected from the adverse and restrictive policy environment under which they are required to operate. Their trading practices and clearing procedures are generally adequate to handle the limited scale of most commodity exchanges. The arbitrariness of the financial settlement undermines the delivery system and therefore the viability of futures markets. Market liquidity on the majority of Indian exchanges leaves much to be desired, a direct reflection of the very restricted access to futures trade, and the unfavorable policy environment on the physical markets. The access to as well as the performance of Indian commodity exchanges are strongly influenced by government policies with respect to physical trade and financial flows, including in price, trade, storage and credit policies. The absence of proper government policies to regulate the conmmodity brokerage industry could also hinder future growth of futures market trade. There is considerable scope for enhancing the contribution futures markets can make to the agricultural sector, both through initiatives at the exchange level, and initiatives by the government. These policy options are discussed in greater details in the following chapter.  I  4 OPPORTUNITIES & OPTIONS: 4 POLICY IMPLICATIONS A. Commodity Exchanges in a Changing Policy Environment 4.1 Greater Exposure to Price Volatility As Indian Agricultural Markets Become More Open. The policy environment governing the Indian agricultural sector is rapidly evolving, offering new opportunities, but posing new challenges as well. Significant external trade liberalization has been initiated over the last couple of years. Common rice can now be freely exported, exposing hidian growers, traders and exporters to international prices and competition. Oilseeds crushers and growers now have to compete with edible oils imported under relatively modest tariff levels, in addition to the already existing competition on the oilseed meal market. This recent, gradual opening-up of Indian agriculture to world markets brings new economic opportunities. It also poses new challenges. In particular, price volatility and the capacity to cope with it become major policy concerns. Price volatility creates uncertainty and risks which can threaten agricultural performance through reduction in investments and export earnings, and greater dependence on imports. Indian policy makers have traditionally coped with such uncertainty and risks by resorting to policy instruments aimed at minimizing or eliminating price volatility. These include pervasive extemal trade restrictions, price controls, price support operations, procurernent and distribution schemes, buffer stock operations, crop insurance, and restrictions on storage, movement and trade credit. These instruments are proving fiscally costly and create serious price and market distortions which reduce growth and competitiveness of Indian agriculture. These instruments are now progressively being either reformned or abandoned by the GOI in an effort to spur agricultural growth. 4.2 Need for Commodity Price Risk Management Strategy. In this increasingly liberalized environment, futures markets offer a market-based instrument for managing risks and uncertainty. Futures markets can complement or substitute for the traditional policy instruments used to cope with price volatility. Commodity futures markets provide a powerful tool for efficient price discovery and risk management to a wide range of market players, which would help improve Indian agriculture's competitiveness. The existence of futures markets provides small players, such as farmers or local traders, access to the same information as large players on likely futures market developments. Thus, they help create a more level playing field for commodity trade that would benefit both consumers and farmers. 4.3 Demand for Futures Markets is Strong and Growing. There is a strong demand, not only from commodity exchanges and their members, but also from agro-processors and farmers' associations, for the expansion of the number of commodities eligible for futures trade. The Kabra Committee, appointed by the Govermment of India, has proposed a long list of commodities in which futures trade should no longer be banned. Even though the Kabra Committee found that futures contracts in all of these commodities might not be viable, it was also argued that the introduction of new contracts would benefit many groups. Some of the exchanges appear ready to invest in this expansion or have already invested; others are interested, but have not generated enough resources during the recent lean years to implement their plans. 4.4 Building on the earlier chapters, we now derive a set of recommendations for the establishment of an enabling environment to the orderly development of futures markets. Three sets of recommendations are successively developed. First, we will address the set of conditions on the  42 physical markets that need to be in place for futures markets to perform. The second set of conditions relates to the policy, regulatory and institutional environment governing the operation of futures markets. Finally, we will explore the feasibility of developmental options, such as the internationalization of India's commodity exchanges and the introduction of new contracts. B. Creating the Enabling Environment for Commodity Futures Trading 4.5 For futures markets in any commodity to be viable, minimum conditions need to be met, among others: the prcing of the commodity must be by free market forces, without monopolistic or direct govemment control of prices; price fluctuations need to be sufficiently large to warrant the use of risk management techniques; there has to be a sufficiently large group of speculators to provide the needed liquidity; the spot market has to function reasonably, with sufficient standardization of trading practices, few barriers to movement, and a proper storage system, to enable commodity exchanges to formulate contract specifications that would make market manipulation difficult. If any of these conditions is not met, a futures market is impossible. In India, government policies prevent these conditions from being met for a number of agricultural commodities. General Rules for a Permissive Government Policy 4.6 Futures markets wiOl be able to function effectively even when government policies strive to establish remunerative prices for producers or affordable prices for consumers, provided that govenmment interventions foOlow a few rules: * Government interventions should not, in a direct or indirect manner, eliminate price risks. The govenmment should not set prices on the marketing chain, nor processing margins. Minimum or maximum prices could be set, provided prices can clear the market. Minimum (or maximum) price interventions should provide a protection against distress sales (or price spikes), allowing market price movements to take place. Price volatility should not be eliminated through pan- territorial or pan-seasonal policies. Government policies for rice, wheat and sugar currently make futures markets in these products non viable. * Govemment interventions should not strongly restrict the normal flow of commodities in the economy. Traders should be allowed to undertake the arbitrage transactions that are worthwhile, and not be hindered by restrictions on storage, movement and access to trade credit. Such restrictions would need to be either permanently lifted or significantly relaxed for conunodities such as oilseeds and cotton and their derived products, as well as other agricultural commodities for which govemrnment restrictions hinder the normal flow of commodities across seasons and within India. * Government interventions should leave a sufficiently large part of physical trade in the hands of the private sector. Government market operations should be kept to the minimum required to achieve policy goals. This is particularly relevant in the case of rice and wheat where the government dominates the market. * Government should provide for a stable and predictable external trade policy environment. Changes in foreign trade policies alter fundamentally the supply  43 and demand conditions of the physical market. Policy changes that reduce or eliminate trade distortions, such as the recent freeing-up of edible oils trade, go a long way towards providing a more stable and predictable extemal trade policy environment. However, sudden, unannounced policy changes introduce shocks in the physical market, creating un-hedgeable risks that will deter participation on futures markets. Examples include the recent (1995) decisions to free-up vegetable oils imnport, to lower edible oils import tariff levels from 65% to 30% overnight, and to offer a preferential tariff (20%) to state trading enterprises and the National Dairy Development Board (NDDB) for an unspecified time. The arbitrary release of cotton export quotas is another example of un-predictable and un-stable external trade policy that would undermine the viability of futures markets. 4.7 Exchange associations in India are generally rather optimistic about the possibility of introducing new futures contracts. Even though some of the conditions mentioned above appear to be met in India, not all conditions are in place. While a filll assessment of the potential of new futures contracts is beyond the scope of this report, the link between government policies affecting physical trade and the opportunities for a futures contract should be stressed. For example, India is the world's largest sugar producer and consumer -not counting the production of non-centrifugal sugar, gur and khandsari. If a gur contract functions well, one would expect that an Indian sugar contract serving an even larger market will also function well. The existing sugar contracts in New York, London and Paris are not particularly useful for trade in Indian since basis risks are too high. However, the extensive government interventions --PDS procurement, storage and distribution of sugar; free market releases controls; setting of minimum sugar cane and sugar issue prices; international trade controls- make for the time being an Indian sugar futures contract non-viable. Similarly for wheat and non- basmati rice, pan-territorial and pan-seasonal prices are also achieved through price intervention, with transport and storage subsidized by the intervention agency. Even if government were to allow futures trade in these commodities, there would be no or little interest from the private sector. For basmati rice destned for exports, a futures contract could potentially work. 4.8 Spot & Futures Markets Can be Allowed to Develop in Synergy. In the rice, wheat and sugar sectors, government policies do not satisfy any of the conditions listed above. In the case of cotton and oilseeds, government policies meet some of the above conditions: price risks prevail on the domestic market; government interventions allow prices to clear the market within the confines of government restrictions on external trade, the storage and movement of goods, and access to trade credit. For these commodities, a commodity futures market and its underlying physical market can well develop in a symbiotic fashion. Imperfections in the physical market should not prevent a commodity futures market from operating, and indeed do not as indicated by the widespread illegal futures trading activities in cotton and oilseeds. In many instances, the presence of a futures market will encourage those active in physical trade to improve their market practices. For example, information on future prices should improve storage decisions; the need to deliver specific grades of a commodity to an exchange warehouse will encourage improvement in grading performance on the physical market. As the physical market becomes more efficient, the futures market will also become more efficient. Efficiency improvements are only possible within the bounds posed by government restrictions, but every time a restriction --e.g., on storage and movement controls, access to trade credit, bank financing of hedging operations, foreign trade - is relaxed, the interplay of futures and physical markets will ensure a speedy adaptation of the private sector to the new environment. To survive and operate, comnmodity exchanges do not need to perform at their full potential. Indeed, most Indian commodity  44 exchanges operating today do not. Participation is often limited to some of the larger traders; futures prices, at times, move in strange ways, reducing the effectiveness of hedges; arbitrage, which ensures that physical markets are well integrated, hardly takes place. Such imperfections can be expected when spot markets do not function properly as a result of government policies. C. Improving the Policy Framework of Commodity Exchanges 4.9 The regulatory and institutional environment governing the operations of futures markets needs improvements for them to develop in an orderly fashion. Commodity exchanges policies, including exchange regulations, should be focused on optimizing the contribution of futures markets to the agricultural economy. These policies should provide the framework for futures markets to realize their full potential, while controlling abuses in the functioning and use of futures trade. Commodity exchanges should aim at avoiding abuses by their members, widening access to the risk management functions performed by futures markets, and collecting and disseminating price information. This raises legal, regulatory and institutional issues that are being addressed successively in this section. Legal & Regulatory Framework of Futures Trading 4.10 The FC(R) Act and Legal System Provide a Sound, Initial Basis. Government regulations of commodity exchanges are major determinants of their performance. Contrary to many other countries, India enjoys a strong regulatory system for commodity exchanges and considerable experience that will facilitate significantly the development of its futures markets, as the China example (Box 4.1.) amply illustrates. 4.11 Discretionary Interventions Would Need to Be Curbed. The FMC applies extensive discretionary controls, predicated upon the concern that the rules and regulations will be by-passed by some individuals. When resorted to on a regular basis, discretionary controls cause insecurity among market users, and hinder the functioning of futures markets. Discretionary controls should be restricted to emergency situations, with standard procedures guiding the day-to-day functioning of exchanges. Standard procedures should be applied to the following regulatory areas: * The recognition of associations should either be permanent, or at least on a long-term (at least 10 years) basis, rather than on the current 2 years or even 6 months basis. If an association breaks government regulations, its recognition can always be withdrawn. * The introduction of new contracts should be automatic, that is, at least three or more contracts should always be traded simultaneously, and if one contract expires, the next contract should be introduced automatically. Regulatory measures --special margins, margin lines, position limits, etc.- should be standardized to the extent possible, rather than set differently from one contract to the next. Ceiling prices should be withdrawn altogether. * The role of the FMC should be largely a monitoring one, with occasional interventions if abuses take place on a market.  45 Box 4.1 Lessons from China's Experience With the ihealisation of Chinas internal market, the need arose for forward and fitures trading. The Chinese government started to study this possibility in 1988. Tle concept that was adopted foresaw the development process with the wholesale makets as a first phase, forward mreketa as the second phase, and fixtures markets as the final phase. This concept was, however, rapidly bypassed by rethty and alnost as rapidly, things started to go wrong. The Zhgwhou Grain Wholesale market in Henan was the first to begin operations, in October 1990. Three years later, over SG tnw exchanges were cated, of which 30 traded fiutures contracts. By late 1993, the largest exchange -the Shanghai Metals En*anga- had become the worlIS thid largest lutures exchange in terms of contrac turnover. In 1993, tot futures trading approah -US$ 90 billion. At the samne time, the Chinese governmt faced increasing difficulties with somne aspects of futures markets trading. With local 4uthoities competing vigorously over a slice of the fitures pie, it took some time for the Chinese governent to get the sector uder control. ventually, drastic measures were taken in late 1994. Moat exchanges were dlosed 4own or bamned from forward or liAnies trdgi: while only 15 restructured fixtures exchanges received formal government approval. Futures tade in a number of stnicw products -steel, coal, gasoline, sugar and cotton- was banne4, Additional, subsequent restrictive measures were also imposed: othe fitures contracts were banned; price controls were introduced; cash settlement was prohibited, and henceforth, all Wettlenei had to be through physical delivery. For a time, all contracts over three months forward were forbidden; in October 1995, traders were forbidden from dosing positions and building new ones on the me day. What went wrong? - Sowne practical errors were made in setting-up the exchanges. Many were created without the involventent of those active in physical tra4e, resulting In poor trading arrangements. Operating Cos were too high; several tines higher than the western open- oitcry exchanges. Most exchanges chose the expensive electronic trading systems, which also reduced market liqutdity by piventing floor traders from trading. Exchanges hardly co-operated, even within the same town. More importantly, fitures markets faced thre f _undmentl shortcomings; * Arbitrage between Futures and Physical Markets Did Not Work. With Chinese exchanges, the necessary arbitrage link between futwus and physical markets did not work properly. Firs, many of the so-called futures exchanges traded what in India would be known as TSD contracts which are easily prone to market manipulation. Second, failures on the physical nmrket made the futwes markets' delivery rmeaism non viable: transport of commodities was difficult to atange, exchange warehouses were often corolld by few meibers who could manipulate the market. Third, the weak monitoring and accountancy systems of state trading companies provided