Drawbacks of

Trading in
Agricultural
Commodities
Futures in India

APRIL 18,2024

Gokhale Institute of Politics & Economics

Authored by:
Anidhya Singh (AE2209)
Moho Ray Chaudhuri (AE2226)
Tushar Mishra (AE2255)
Shrey Goyal (AE2241)
Shruti Deo (AE2245)
Vrinda Krishnatray (AE2260)

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Abstract
This paper examines the drawbacks and limitations inherent in agricultural commodity trading and
commodity derivatives markets in India, with a comparative analysis to other countries. Through an
extensive literature review and empirical analysis, the study identifies several key challenges hindering
the efficiency and effectiveness of these markets. Among the highlighted limitations are the
inefficiencies in risk management, including the inability of commodity derivatives to adequately hedge
against price risks, aggravated by factors such as low market depth and regulatory constraints.
Moreover, the paper explores the impact of increased price volatility and market manipulation by
dominant traders on market integrity and participant welfare. By drawing comparisons with
commodity markets in other countries, the study sheds light on the unique challenges faced by India's
agricultural commodity markets and underscores the importance of regulatory reforms, improved
market infrastructure, and enhanced risk management practices to foster market development and
ensure fair and transparent trading environments.

Introduction
It is well-known that commodities serve as the cornerstone of the economies of many developing
nations, offering sustenance, generating income, and driving export earnings for those engaged directly
in agricultural pursuits.The agriculture and related sectors remain pivotal in India, securing the food
needs of approximately 1.3 billion individuals, engaging about 50% of the labour force, and accounting
for roughly 15.4% of the nation's gross domestic product.
Commodity markets, encompassing agricultural commodities, operate in two primary formats: spot
markets and exchange-based markets. In spot markets, transactions involve immediate payment and
delivery, constituting over-the-counter (OTC) transactions. Conversely, "futures" represent
standardized financial contracts for specific commodities traded on exchanges.

Pre-independence period
In the latter part of the nineteenth century, organised trading in commodity futures commenced in
India, notably with the establishment of the Bombay Cotton Trade Association Ltd. in 1875.
Subsequently derivatives trading expanded to include oilseeds in Bombay, raw jute and jute goods in
Calcutta, wheat in Hapur and bullion in Bombay. However, concerns about speculation’s impact led to
restrictions, with options business in cotton banned in 1939, and forward trading prohibited in oilseeds
and various other commodities including foodgrains, spices, vegetable oils, sugar and cloth in 1943.
During this period, trading lacked unform regulations and guidelines, relying instead on mutual trust
and social control. The Bombay Forward Contracts Control Act of 1947 was subsequently enacted by
the Bombay State to regulate and facilitate trade.

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Post-independence period
The legal standardised framework for organising forward trading and recognizing exchanges emerged
following the adoption of the Constitution, culminating in the Forward Contracts Act of 1952. A
significant shift occurred in 1969 when a government notification, authorized by the Securities
Contracts Regulations Act of 1956, restricted forward trade in numerous commodities, leaving only
seven open for such trading. This restriction led to reduced trading volumes on stock markets and
prompted the Bombay Stock Exchange to establish an informal forward trading system in 1972,
resulting in frequent payment crises. In the 1980s, futures trading in select commodities like potato,
castor seed and jaggery was permitted, followed by recommendations from the Kabra Committee in
1994 and subsequent expert committees like the Shroff, Dantwala and Khusro Committees, which laid
the groundwork for futures trading revival. In April 1999, futures trading in various edible oilseeds were
allowed and in May 2000, sugar futures trading was permitted. A notable milestone occurred in 2000
with the announcement of the national agricultural policy, which acknowledged the positive role of
forward and futures markets in price discovery and risk management.

Current trend

Source: Journal of Operations and Strategic Planning

The highest volume of trading occurred in 2012–2013, while the peak value of trading was recorded
in 2011–2012.

Literature Review
The evolution of agricultural commodities futures markets in India, along with their regulatory
framework, has been extensively documented in scholarly literature by Minakshi Kar (2021). Empirical
evidence as documented by Dr. Kedar Nath Mukherjee (2011) consistently underscores the
comparative advantage of futures markets in disseminating information, facilitating significant price
discovery, and enhancing risk management practices. Studies by Sahadevan (2002) and Salvadi and
Ramasundaram (2008) indicate that the market struggles to effectively hedge against price risk, citing
factors such as limited participation, shallow market depth, and government intervention as
hindrances. Furthermore, Nath and Lingareddy (2008) and Ali and Gupta (2007) found that futures
trading can exacerbate price volatility in certain commodities, potentially contributing to inflationary

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pressures. Market imperfections, including low awareness among farmers and thin trading volumes, as
identified by multiple researchers, impede efficient price discovery. Additionally, concerns regarding
market manipulation by dominant traders, as highlighted by Chandrasekhar (2006) and Patnaik (2007),
underscore the need for greater regulatory oversight. Connecting farmers to futures markets can be
helpful for both the farmers and the market. It can help the farmers to make planting decisions based
on futures market prices rather than the previous year’s prices (Chatterjee et al 2019). Factors such as
efficient price discovery, healthy relationship between spot and futures market, price dissemination,
understanding of the socio-economic and exchange-related issues of the commodities, demand and
supply factors and futures market access are important for participation in the futures market (Dey et
al 2019).

Drawbacks of Agricultural Commodities Futures Trading in India:

1. Price Volatility

Price Fluctuations happen in markets for things like crops and animals. Sometimes these changes
are so big and surprising that they can cause problems for people who buy food, farmers, and even
whole countries. Since 2007, markets around the world have had a lot of big and sudden changes
in the prices of things people buy and sell. In India, agricultural markets often experience significant
price changes. When food prices go up, consumers complain, and when they drop, farmers struggle
and ask for loan forgiveness. Eg. imagine a situation where there's a year with a lot of sugarcane
produced, causing prices to drop sharply. In response, producers reduce the amount of land and
resources they allocate to sugarcane farming, leading to a decrease in output. This, in turn, causes
prices to rise again. This cycle repeats itself, creating a continuous pattern of fluctuating food prices,
like a never-ending rollercoaster of ups and downs.

2. Lack of Awareness and Education Among Farmers

The lack of trust and understanding of the futures market is widespread, extending even to
policymakers in the country. There's a general perception of the futures market as a mysterious
and opaque system. Without adequate training or knowledge sharing initiatives in this field,
farmers find themselves confused and hesitant to trust this platform. Many view it as akin to
gambling and prefer to avoid involvement altogether. Moreover, instances of farmers experiencing
significant losses due to fraudulent activities have only reinforced negative perceptions about
market participation.
Additionally, the distance between NCDEX delivery centers and Farmer Producer Organizations
(FPOs) presents a logistical challenge. In our agricultural markets, which are characterized by
diverse and dispersed crops varying even within individual farm plots, the limited number of
delivery centers proves to be a significant obstacle to farmers' adoption of futures markets. This
challenge is further exacerbated by the lack of nearby FPOs, which serve as the primary channel for
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farmer participation in futures markets. Even though hedging benefits can be extended to farmers
without FPO involvement, FPOs are reluctant to engage in pre-harvest hedging contracts due to
various concerns.
3. Market Manipulation and Speculation:
• Instances of market manipulation: The Indian agri-futures market has witnessed instances of
manipulation, often involving cartels or large players cornering the market and artificially inflating
or deflating prices. This can be achieved through coordinated buying or selling, spreading false
information, or creating artificial demand/supply imbalances.
• Effects on market integrity: Market manipulation erodes trust and discourages genuine
participation, hindering the market's ability to reflect true supply and demand. This can lead to:
o Unrealistic price discovery: Prices become detached from fundamentals, making it
difficult for farmers and consumers to make informed decisions.
o Increased volatility: Manipulation can trigger excessive price swings, creating
uncertainty and risk for genuine market participants.
o Loss of confidence: Repeated manipulation can damage the market's reputation and
deter potential investors.
• Speculation and price volatility: While some speculation is inherent to any market, excessive
speculative activity can exacerbate price volatility. Speculators often trade based on short-term
trends and market sentiment, rather than underlying fundamentals. This can lead to:
o Excessive price fluctuations: Speculative buying can drive prices up beyond sustainable
levels, while selling can cause sudden price drops.
o Difficulty in price forecasting: Increased volatility makes it challenging for farmers and
businesses to plan and hedge effectively.
o Negative impact on farmers: Volatile prices can leave farmers vulnerable to income
fluctuations and hinder their ability to invest in long-term improvements.

4. Regulatory Challenges:
• Regulatory framework: The Securities and Exchange Board of India (SEBI) regulates commodity
futures trading in India. SEBI has implemented various measures to curb manipulation, including
position limits, margin requirements, and surveillance mechanisms.
• Limitations and gaps: Despite existing regulations, challenges persist:

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 o Limited resources: SEBI may lack sufficient resources for effective monitoring and
enforcement, especially in a vast and complex market like India's.
o Sophisticated manipulation tactics: Market manipulators can devise new methods to
circumvent existing regulations, requiring continuous adaptation and improvement of
regulatory measures.
o Information asymmetry: Small farmers and traders often lack access to timely and
accurate market information, making them vulnerable to manipulation tactics.
5. INFRASTRUCTURE & TECHNOLOGICAL CONSTRAINTS:
a. Storage Facilities: Inadequate storage facilities for agricultural commodities can lead to challenges in
delivering commodities against futures contracts. Insufficient storage infrastructure can result in
logistical issues, quality deterioration, and increased costs.

b. Transportation: Limited transportation infrastructure, especially in rural areas, can impede the
smooth movement of agricultural commodities from production centers to trading hubs. Delays in
transportation can disrupt delivery schedules and affect futures trading activities.

c. Market Infrastructure: In some regions, the absence of well-developed commodity markets and
exchanges may hinder efficient price discovery and liquidity in agricultural futures markets. This lack of
market infrastructure can deter participation from both hedgers and speculators.

d. Access to Information: Limited access to real-time market information and data in remote agricultural
areas can hinder informed decision-making by market participants. Uneven technological adoption
across the agricultural sector may exacerbate information asymmetry. Lack of education and training on
utilizing these tools effectively can expose participants to higher levels of risk.

6. FINANCIAL RISKS TO PARTICIPANTS:

a. Price Volatility: Agricultural commodities are prone to price volatility due to factors such as weather
conditions, supply-demand dynamics, and government policies. Sharp price fluctuations can lead to
significant losses for market participants, especially those without adequate risk management strategies.

b. Liquidity Risk: Illiquidity in agricultural futures markets can pose challenges for participants looking to
enter or exit positions at desired prices. Thin trading volumes may result in wider bid-ask spreads and
increased transaction costs.

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c. Counterparty Risk: Participants face the risk of default by counterparties, including brokers,
clearinghouses, or other market participants. Weak risk management practices and inadequate
regulatory oversight can exacerbate counterparty risks in agricultural futures trading.

Addressing these drawbacks requires concerted efforts from various stakeholders, including government
authorities, commodity exchanges, market participants, and technological providers. Improving
infrastructure, enhancing technological accessibility, promoting risk management education, and
strengthening regulatory oversight can help mitigate these challenges and foster the development of
robust agricultural futures markets in India.

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Comparative Analysis with Other Countries

In summary, while the US has the largest and most diverse futures commodity market when compared
globally its nominal worth is highest, China follows closely with a rapidly growing market driven by its
economic importance. India's commodity market is comparatively smaller and more focused on
domestic agricultural commodities, with room for growth and development.

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Recommendations
Farmers have less involvement in commodities futures trading in comparison to other parties (Kumar
2010; Sumalatha 2019). Facilitating the connection between farmers and futures markets can benefit
both parties. It can assist farmers in making planting decisions by using futures market prices instead of
relying on prices from the prior year.Farmers have limited access to storage facilities.Farmers' Producer
Organisations (FPOs) are important for procuring and consolidating commodities for farmers, ensuring
they meet the necessary quantity and quality criteria for trading in the futures market (Chatterjee et al.,
2019).
Banning futures market is not a rational approach to addressing increasing prices. It hinders the creation
of a system to oversee the markets and deter harmful speculation. Develop futures markets in
conjunction with spot markets and integrate them efficiently to increase involvement from producers
and consumers of the underlying assets. The prohibition on futures trading may not have had a significant
impact on farmers, as only a minority of them are actively involved in the futures market. However, the
restriction does not effectively manage inflation. Enhancing the connection between spot and future
markets through increased farmer involvement is essential to improve the effectiveness of futures
markets in price discovery and enable beneficiaries to utilise the market for risk hedging.
Gulati et al (2017) established criteria for commodities eligible for trading in futures markets: (i) should
not be sensitive to government intervention and food security concerns; (ii) exclusion from staple food
commodities; (iii) significant global market share; and (iv) the country being a major consumer and
producer of the commodities.
The positive thing that happened is that recently, there has been a significant increase of hedgers
participating in agricultural commodity trading, leading to a substantial portion of trade volume being
accounted for by them. Anticipated technical advancements in the trading system have the potential to
enhance the efficiency of exchanges and trading in agricultural commodities despite future uncertainties
(Chawla and Padmanaban, 2019). Increasing participation in commodity futures markets can be achieved
by conducting more awareness programmes for stakeholders like traders, MSMEs, and farmers. These
programmes should focus on the benefits and effective utilisation of commodity futures markets for
price discovery and risk management goals (Expert Committee 2018).

Conclusion
Despite the establishment of structured commodity futures markets in India two decades ago, the
market for trading agricultural commodities is still not completely established. The price discovery and
risk management roles of futures markets range among commodities and have varying effects on spot
market pricing. Unlike non-agricultural commodities, it is challenging to determine whether the futures
market has a stabilising or destabilising effect on spot market prices of agricultural commodities.
Research indicates that farmers have minimal involvement in the commodities futures market. Various
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factors such as speculation, high margin requirements for futures trading, limited quantity and quality of
produce, lack of information about how futures markets work, inadequate warehouse facilities, limited
knowledge about the market, etc., all contribute to the low involvement of farmers as hedgers in futures
market exchanges. Periodically, prohibitions on futures trading in certain agricultural commodities have
been implemented based on their impact on general inflation and price volatility. This highlights the
necessity for government rules to prevent futures trading on commodities with excessive price volatility.

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