Commodity exchange key to fair prices

The Bangladesh Securities and Exchange Commission (BSEC) has moved to set up a commodity market to provide a platform for producers to get fair prices and hedge risks of their products. The move came after an amendment to the Securities and Exchange Ordinance 1969 in November last year, allowing establishment of a commodity exchange in the country.
Derivatives and commodities market, a very new concept in Bangladesh, is a place for selling and buying of commodities. Here one issue is essential to come up with a decision of 'how to start developing such exchange trading facility' so that we may end up with a very effective beginning of such a well-accepted system to get the best benefits out of this. This system is so effective that several developing countries have been taking its advantages for long. In our country, we are expecting this market to be five times of the capital size of the current stock market.
Development of a commodity exchange would be more unlike than starting with derivative exchange. There are very thick lines in between because of the nature of the asset classes and types of contracts which use to be traded on each type of platforms and which needs to be described precisely.
Let's say, one potato grower is anticipating a huge price drop in coming season because of a good harvest. This is a definite scenario of our agricultural products in our country. If we would have well-organised 'Derivative Exchange' in our country, he might go to an investor to buy a 'Contract' on condition that 'if the price falls from Tk 10/kg, then someone at the other end (hedger and speculators/ investors) would buy his product at Tk 10 a kg (a pre-fixed price of contract).
He would do this to secure his profit from coming harvest. Now the question is: "Why would someone at the other end do this?'. Because there are a few more smart people who have more information and research which help them predict that in the coming season, a huge consumption of potatoes will actually raise potato prices. Thus they are projecting future profit by which they would make more money by buying potato from him with a less price (which is Tk. 10 a kg) selling it at higher prices later.
Now let's see what would happen if the prediction made by the people of other side goes wrong. Predicting the future loss, the investor would go to even larger investors to take more risks to get more rewards and so on and so forth. The contract trading could be made based on any asset class e.g. stock, index, bonds securities certificates, metals, livestock, agricultural commodity and carbon exchange for CO2 emission reduction certificate trading.
In stock exchange, pieces of ownership of any company are traded directly between the sellers and the buyers. There is the same type of market for physical commodity which is known as commodity exchange, more specifically Commodity Spot Market. For metal, it is Metal Exchange. Many of these are also called Multi Exchanges for their trading platforms of different classes of multi- commodities. A few are so big and significant that they actually control business of a single commodity worldwide like Sugar Exchange in New York, Cotton Exchange in London, Gold Exchange in Dubai etc.
Any type of contracts derived from any of these asset classes is called Derivatives.  Derivative market, which we call 'the 3rd market', is highly potential and risky as well. Potential, because it provides liquidity in commodity market and shed risks of primary traders and commodity producers. These contracts are basically three types depending upon its nature of trading and its participants--Forward, Future and Options. All the participants of this market are also basically three types - Individuals, Hedgers and Speculators.
If you want to buy a car, you may go to a 'show room' and buy a new one. If you are in budget constraint, you may pick a 'reconditioned' one taking risk of frequent maintenance expenses. If you still can't find a suitable one, you may also go for third market like 'car haat' as we locally call it or buy from www portals, keeping  in mind that you may find the car doesn't have its own engine but replaced one. So you must take an expert technician to the third market, just like the (Over the Counter) OTC market that we have now, less regulated and high risky market. This market is potential for higher returns though.
Here is an example how 'derivative exchange' works for stock and bonds. You've got news that ABC Company's financial status is little bit volatile and you are predicting the price of company share (which is Tk 15/share) may fall by next three months. Based on this anticipation you may still make profit from this share. How? At this time, you better call your broker to borrow ABC share for you. He then borrows the share from any available sources like from other brokers in the market. Then tell your broker to sell the borrowed share at current price which is Tk 15 per share and keep the money to your BO accounts. After two months, you find yourself right and the share price starts going down to Tk 10 per share. Then call your broker to say that you want to buy the same share and want to take it back from where your broker borrowed it. What you have done actually made profit of Tk 5 per share. Thus you're making profit when the price is going down. All you've to do is to pay some commission to your broker for doing it, which is absolutely logical.
So no matter how many types of contracts can be produced and traded as derivatives, there must be the primary market (IPO for Stocks and 'Spot Exchange for Commodity) to generate trading volume and originate securities to derive 'derivatives'.
Without forming any commodity spot exchange, a Derivative Exchange may be formed but that would not be 'Farmers' Cup of Tea'.  Because contracts derived from stock and bonds would be traded within. We can start a derivative exchange. Only we need to make a few additions and amendment to existing OTC market regulations.
For information, OTC market is the same as the stock market but not that much regulated as we describe earlier. We may call it 'unregulated stock market'.  The main objective of our OTC market is to facilitate Z-Category listed company to turn around or any public limited company can trade their share directly through OTC point. But we may not be able to trade in form of commodity future contracts because we must need exchange for commodity spot trading.
To start derivative market moulding our OTC market, we need to form a 'clearing company' to settle transaction. For your information, Clearing Members are the most prime concerns of any commodity exchange, as they give funds to settle all unsettled deals at the end of the day.
To come up with a commodity spot exchange, the preparation is really on large scale. Its outcomes also add value at macro level. The Agricultural Commodity Exchange adds significant value to agricultural value chain and eco system. Farmers are highly benefited from such a system as they can make fair bargain to get fair price for their produce.  We must need to integrate a few large-scale infrastructures to design the platform like exchange designated warehouse and logistic system all around the country which must be connected by a well-managed ICT system. To generate volume of trade, we must need warehouse receipts collateralisation under well-defined rules. After having prepared these we need to conduct country-wide awareness programme to form producer groups to let them participate at spot trading.
Now we may leave the matter to experts and policy-makers and hope that they would do the best to develop such a system in our country. But without the commodity spot market, the derivative exchange is another third market for stocks and bonds. Eventually that won't be our farmers' cup of tea.
The writer is presently working as Executive Director of Idol Group, Dhaka rahman.habib.investment.analyst@gmail.com