Market needs speculators to bear the risk

Nidhi Nath Srinivas, ET Bureau Apr 12, 2012, 04.03AM IST

Trouble is again brewing in commodity futures. Companies that process farm produce - think of bread and biscuits, potato crisps, cooking oil, cola, ice cream and poultry - are up in arms because a spike in futures prices has made their raw material expensive. Equally alarmed at what this bodes for inflation, government has slammed the brakes on speculators. But does it help? ET helps you join the dots.

Two kinds of people deal in commodities: producers and processors. Producers and farmers already own the commodity; processors want to buy it. Both are at a risk from unfavourable price movements. So, they must pick price zones to place large orders to enter and exit the market.

Since producers own the commodity, that makes them net long the market. To hedge against prices dropping, they sell futures contracts to lock in higher prices. Processors don't possess the commodity, which makes them net short the physical commodity. So, they must buy futures contracts to lock in lower prices for future delivery.

Suppose a soyabean producer wants to lock in higher prices to protect the crop he will own. He places an offer to sell the soyabean contract at, say, around the 3,500-3,700 price zone. A cooking oil company will need soyabean for crushing some months later and posts a bid to buy in the 3,000-3,200 zone.

If there were no other participants except these two, then the current bid would be 3,200 and the current offer would be 3,700. For the market to make a trade, they both have to agree on a price. But there is no way they can make a trade with a bid/ask spread that far apart since both would lose money.

This is where speculators step in. They tug prices from one price zone to another so that producers and processors can hedge risk. Once speculators see prices moving up from the 3,500 level, they start buying. The buying will keep coming into the market and farmers will keep selling to meet it. When no more buyers are left, the price will start to fall.

This causes the trend to turn down and speculators now want to sell until, finally, the price is pushed to where the cooking oil company is waiting to buy. Once processors have absorbed all the supply in the market, prices will begin another uptrend. Speculators will jump on board that trend too. This continuous cycle, fuelled by speculator interest, allows physical market players to hedge their risks.

The system blows a fuse when the ask/bid prices lose touch with the physical market. Suppose an edible oil company decides to corner the soya market and puts a bid for 3,400. Obviously, everyone will rush to sell. Those who don't own soyabean will buy from the mandi and sell to the company.


The spiral will continue as long as the company is willing to buy. Meanwhile, there will be mayhem in the mandi where prices soar as beans disappear into exchange godowns as property of the cooking oil company. Mustard seed futures got a taste of this in 2010. Rival cooking oil companies will be forced to either shut shop or pay inflated bean prices.

Alternatively, two punters could decide to lift prices through 'circular' trading. One punter keeps raising the offer price which the other matches, until all other players have exited - no one can afford to buy or sell beans physically at these prices. Left with no connection to the physical market, both trading price and volume become a flight of fantasy. But the physical market is nonetheless disrupted because it no longer has a credible indicator of price movements. This is what happened in guarseed.

How does one correct such situations? If the soyabean contract is allowed to run its course, the cooking oil company will have to take delivery of hyper-expensive raw material and find no takers for the equally-expensive oil. Similarly, one of the two circular traders would lose because future trading is a zero-sum game. So, halting trade only helps the baddies go laughing to the bank.

Producers and processors bear the real burden of a ban because it upsets market psychology and sentiment. Farmers are left with no price indicator at planting time. Nervous processors reduce trading volumes that hampers correct price discovery.

The other option is to deter speculators by making it expensive to trade. This too has limited use. Farmers and processors need speculators to bear their risk. Herein lies the real conundrum of commodity futures. Speculators are like the engine of a fast-paced car. How to drive safely is the question. Regulators across the world are still searching for answers.