Myths and Realities of Commodity Derivatives Markets

The commodity derivatives market is going through a topsy-turvy situation, which is attributed to the ban or intermittent suspension of futures trading on a basket of commodities. While financialization has impacted market contours, uncertainty and elevated regulatory risks have hurt market sentiment. This would result in an under-traded market, leading to poor price discovery and ineffective hedging against price risk.

One such commodity futures contract is cotton and its derivatives that should attract the attention of the regulator. Traders and the Cotton Federation of India are calling for a suspension of futures trading as speculative activity appears to be responsible for the price spike.

Cotton futures trading dates back to the founding of the Bombay Cotton Trade Association in 1875, and the humble fiber has long been traded on the derivatives platform. Thus, suspending cotton futures trading may not produce the desired outcome for market participants.

You have to understand the fundamentals and how the market works. Unraveling myths and realities through a data-driven approach is necessary for informed policy-making.

Myths and facts

The first myth is that exchange-traded derivatives are driven by speculative intent. The reality is that the exchange-traded cotton futures contract is a binding delivery contract, and convergence between spot and futures prices is sometimes observed.

Exchanges reported active participation from hedgers, namely producers (agricultural producer organizations), ginners, millers and exporters.

For example, open interest (OI), which measures the depth of the cotton futures market, saw a 37% increase in 2021–22 (April 21, 2021 to January 6, 2022) compared to 2020–21. Consumers, producers and processors represent 93-94% of the IO, with buyers and sellers representing 41% and 52-53% respectively.

The average trading volume is 1,769 lots and ₹120 crore, and the average reported open interest is 6,056 lots between April and December 2021.

From a delivery perspective, an average of 8,600 lots (one lot equals 25 bales) were delivered on the exchange with an average dispersion of over 5,000 lots between 2016-17 and 2021-22 ( until December 2021). Comparing a three-month delivery (October, November, December) of 2019-2020 and 2021-2022, it is observed that the exchange recorded a 256% and 93% increase in deliveries from October to December 2020 and 2021.

The second myth is that there is no correlation between domestic and international prices. The analysis shows a correlation coefficient of 0.97 between changes in cotton futures prices traded on the MCX and the Intercontinental Exchange (ICE). The co-movement of average cotton futures prices between the two exchanges was observed from December 2017 to December 2021.

The third myth is that futures trading has led to price increases. Cotton is a global commodity, and its futures and options have been traded on ICE in the United States and the Zhengzhou Commodity Exchange (ZCE) in China. India is one of the main producers and exporters of cotton. Despite this, India holds an insignificant share of the world cotton futures market and has remained a price taker (see Table 1).

Furthermore, the stock-to-use ratio calculated from total cotton supply and demand shows that the proportion has increased from 36% in 2020–21 to 32% in 2021–22 (until December 2021), which indicates that the price may be increased due to reduced inventory in the market.

The fourth myth is that the margin is lower in the domestic futures market. The margins charged on domestic exchanges are higher than on their global counterparts. The margin applicable to MCX is 11.5% — which will be increased by 3% as of January 12, 2022 — whereas it is 6% and 10% respectively for ICE and ZCE.

The fifth myth is that the futures contract serves very little. It is learned that contracts are reviewed prior to launch each season, and the Product Advisory Board comprised of experts and value chain representatives discuss contract issues at least twice or more each year.

As of November 2021, the cotton futures contract in the MCX has been amended to introduce the RD value for color grade, and this amendment has received positive feedback from market participants as understood through the scale of delivery.

Thus, by dispelling myths through incisive analysis, systematic anticipation of the right mix of policies for the proper functioning of commodity derivatives markets and cotton futures markets is needed.

The author is the CFAM Chairman of IIM Lucknow. The computer support of the MCX research division is recognized. Views are personal

Published on

January 20, 2022

About Mallory Brown

Check Also

Varcoe: Oil spending is rising, but labor shortages are preventing growth

Breadcrumb Links Energy Columnists Business Publication date : May 14, 2022 • 18 minutes ago …