SEBI Bans Derivative Trade in Agriculture Commodities

• 21 Dec 2021

For Prelims: Capital Market, Derivative Trading, Inflation, Options, Futures, Forwards, Swaps

For Mains: Reasons for Derivative trading suspension and its impact, Significance and concerns related to Derivative trading.

Why in News

Recently, the Securities and Exchange Board of India (SEBI) has banned the derivative trade of seven agricultural commodities on the future’s platform of National Commodities and Derivatives Exchange (NCDEX) for a year.

• The regulator has banned derivative contracts trade in chana, wheat, paddy (non-basmati), soyabean and its derivatives, mustard seed and its derivatives, crude palm oil and moong for a year with immediate effect.
• The commodity derivatives market has been prone to such sudden suspensions of trading in agriculture items ever since it was introduced under the erstwhile Forward Markets Commission (FMC).

SEBI

• It is a statutory body established on 12^th April, 1992 in accordance with the provisions of the Securities and Exchange Board of India Act, 1992.
• The basic functions of the SEBI is to protect the interests of investors in securities and to promote and regulate the securities market.

Key Points

• Reasons for Ban:
  • To cool off Food Inflation:
    • India’s retail inflation rose to a three-month high of 4.91 % in November from 4.48 % in the previous month primarily because of a rise in food inflation to 1.87 % from 0.85 % over this period.
  • Double Digits WPI:
    • Wholesale Price Index-based inflation has remained in double digits for eight consecutive months beginning in April, mainly because of surging prices of food items.
    • In November, the wholesale price-based inflation surged to a record high of 14.23 % amid hardening of prices of mineral oils, basic metals, crude petroleum and natural gas.
  • To insulate future Price Shock:
    • In view of Rabi Output that might be affected morbidly because of fertiliser shortage faced in many parts of the country.
    • By banning future’s trade, the government is trying to insulate any price shock the market might feel in the days to come in case the production is not up to par.
• Impact:
  • The suspension comes ahead of the rabi crop, sown in winter, hitting the markets in a couple of months. With no reference price, traders will be clueless on future sentiment.
  • Importers, who hedge on the derivative market to safeguard themselves from price moves, may be more vulnerable.
  • Impact on prices initially, the outlook will be bearish as traders rush to square off open positions on derivatives.

Derivatives

• About:
  • Derivatives are the instruments which include security derived from a debt instrument share, loan, risk instrument or contract for differences of any other form of security and a contract that derives its value from the price/index of prices of underlying securities.
  • In the finance field, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often called the "underlying".
• Types:
  • Forwards and futures:
    • These are financial contracts that obligate the contracts’ buyers to purchase an asset at a pre-agreed price on a specified future date. Both forwards and futures are essentially the same in their nature.
  • Options:
    • Options provide the buyer of the contracts the right, but not the obligation, to purchase or sell the underlying asset at a predetermined price.
    • Based on the option type, the buyer can exercise the option on the maturity date or on any date before the maturity.
  • Swaps:
    • Swaps are derivative contracts that allow the exchange of cash flows between two parties.
    • The swaps usually involve the exchange of a fixed cash flow for a floating cash flow.
    • The most popular types of swaps are interest rate swaps, commodity swaps, and currency swaps.
• Significance:
  • Hedging Risk Exposure:
    • Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks.
    • In this way, profits in the derivative contract may offset losses in the underlying asset.
  • Underlying Asset Price Determination:
    • Derivatives are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price.
  • Market Efficiency:
    • It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets.
    • Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.
  • Access to unavailable assets or markets:
    • Derivatives can help organisations get access to otherwise unavailable assets or markets.
    • By employing interest rate swaps, a company may obtain a more favourable interest rate relative to interest rates available from direct borrowing.
• Issues:
  • High Risk:
    • The high volatility of derivatives exposes them to potentially huge losses. The sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear a high inherent risk.
  • Speculative Features:
    • Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of derivatives and their unpredictable behaviour, unreasonable speculation may lead to huge losses.
  • Counterparty Risk:
    • Although derivatives traded on the exchanges generally go through a thorough due diligence process, some of the contracts traded over-the-counter do not include a benchmark for due diligence. Thus, there is a possibility of counterparty default.

National Commodities and Derivatives Exchange

• NCDEX is an online commodities exchange dealing primarily in agricultural commodities in India.
• It is a public limited company, established on 23^rd April 2003 under the Companies Act, 1956.
• The exchange was founded by some of India's leading financial institutions such as ICICI Bank Limited, the National Stock Exchange of India and the National Bank for Agricultural and Rural Development, among others.
• These include 25 contracts for agricultural products. NCDEX is run by an independent board of directors with no direct interest in agriculture.

Source: IE