Bank participation in commodity futures market

Abstract

History of commodity trading is as old as history of trading itself. It's a popular belief that the commodity exchange evolved from ancient fairs and open-air markets. Modern forms of commodity markets started in 19th century and have evolved since then with huge volume of trade worldwide. Though having a very rich history and tradition, commodity futures markets are largely underdeveloped in India. It has been largely attributed to extensive government intervention in agriculture sector and restrictions on Banks and FIs participation. Bank's across the world has contributed significantly to the growth of the commodity markets. They were not only able to manage their risk better but also helped in overall development of the economy. Currently, in India, banks role is primarily limited to providing financing, bank guarantee, warehouse receipts and clearinghouse. However, banks are one of the largest custodians with asset under custody of several crores. Current regulation under Banking Act 1949, section 8, prohibits banks from participating in commodity trading. Several other reasons are cited such as: Loose monitoring and control mechanism Inflation concern Benefit only to speculators Lack of expertise of Banks Adding to risk of the banks However, based on our study and analysis on various data and markets, we can see that those arguments do not have any causal relationship and can be mitigated. Additionally, since banks extend credits to various sectors of the economy, the volatility in those sectors creates a significant exposure for the banks. Allowing banks to participate will help several stakeholders of the economy. It will help banks in mitigating risk, comply with Basel II regulation, diversify and improve their portfolio, and provide better mechanism for priority sector lending. Similarly, farmers will benefit from banks participation in the form of more developed markets for better price discovery, larger share of the production price and more information for them to take educated decisions. In our report, we have highlighted several other benefits to commodity markets, other sectors and overall to the Indian economy. We have done comparative analysis with other developing countries where banks have been successfully involved in participating and developing the commodity markets. This analysis substantially complements our arguments on allowing banks to participate in the commodity market in India for overall development of the ecosystem.