Prospects of commodity exchange for Bangladesh
Thursday, 26 March 2009
Salahuddin A Khan and M Bakhtear U Talukdar in the first of a two-part article
DUE to lack of any market-based supervision and regulation mechanism; volatilities in the prices of essential commodities, whether produced domestically or imported from abroad, became the greatest challenges for the governments over the years. It also became one of the major political issues in the last national election of Bangladesh. Most often popular statements like blames on 'syndicates' overshadowed the pertinent issue - the market failure.
It is actually our market structure which enables major market players to enjoy oligopolistic advantage. In fact, absence of any reliable information and poor dissemination of the same always enabled some of the market participants to gain some oligopolistic and even on some occasion monopolistic control and monopolistic or oligopolistic (extra) profit. A carefully designed legal framework supported by necessary institutional support can bring some degree of competitiveness in the present market situation.
Systematic market information based trading mechanism along with wider participation in the markets need to be established in the country to minimise such oligopolistic cartels (or syndication arrangements). It is observed that, a well functioning commodity exchange along with appropriate regulatory framework and infrastructural facilities can attain this objective effectively. The government of Bangladesh made earlier the first step - the decision to establish commodity exchange in the country.
As we started our write up many months back, commodity prices in Bangladesh are notoriously volatile. Volatility in prices of different essentials like fuels, cereals, edible oil etc., created a massive stoke on different initiatives taken by various government agencies to check the adverse price movement. And the volatility has become a source of uncertainty affecting general people, government agencies, traders, importers and also financial institutions that provide financing to the commodity production, import or trading.
In the past, a spectrum of traditional methods such as buffer funds, buffer stocks, international commodity agreements, use of government trading agency (TCB) or para-military forces (BDR) were used to address the problem. Unfortunately, none of those mechanisms could provide any workable or sustainable solutions as these efforts failed to bring any structural change in the market system. Hence, we can look at the decision of the last caretaker government of Bangladesh to allow establishment of commodity exchange in this country can be an important step forward for the nation.
In general by commodities exchange we mean an exchange where various commodities and derivative products are traded. A commodity exchange, more precisely, is defined as an auction market where contracts on commodities are available for purchase or sale at an agreed price and for delivery on a specified date. Most commodity markets across the world trade on contracts based on agricultural products and other raw materials (like wheat, barley, sugar, maize, cotton, cocoa, coffee, milk products, pork bellies, oil, metals, etc.). These contracts can include spot prices, forwards, futures and in some cases, options on futures. Other sophisticated products may include interest rates, environmental instruments, swaps, or ocean freight contracts. These exchanges usually trade futures contracts on commodities, such as trading contracts to receive something, say corn, in a certain month. For example a farmer in Rajshahi having a mango plantation can sell a future contract on his mango, which will not be harvested for several months. This contract guarantees him the price he will be paid when he delivers; a fruit juicing company like Pran buys the contract now that guarantees the company that price will not go up when it is delivered. This protects the farmer from price drops and the buyer from price rises.
Thus, in the domestic market, pricing base can be established through contracts while traded in the exchange allows others interested to know in which direction the prices of such commodities are moving. The commodities exchange is new in Bangladesh but not new in the global context. So, the modalities and functionalities of these exchanges required to be understood by all, since we can expect such market mechanism to be present sooner than later.
First known commodity exchange (Bourse) for agricultural products was seen in Bruges in Belgium in 11th century where agricultural producers could settle their loans against output. However, the world's oldest established commodity exchange, the Chicago Board of Trade, was founded in 1848 by 82 Chicago merchants. The first of what was then called "to arrive" contracts were traded for flour, timothy seed and hay. "Forward" contracts on corn came into use in 1851 and gained popularity among merchants and food processors. Although in Buffalo New York some organised commodity trading for agricultural products had started much before it begun in Chicago.
In the backdrop of market failure or for the sake of bringing better trading environment for major commodities, different developed and developing countries started establishing commodity exchanges during the late eighties and nineties. In Asia alone, there are now 22 such commodity exchanges. In south Asian region, India, Pakistan and Nepal have already established commodity exchanges.
Commodities contracts are standardised contracts traded through regulated exchanges whereby an investor agrees to buy or to sell a fixed quantity of a certain commodity at a specified price for delivery in the future. In the commodities markets, the parties to a future trade thus can set and lock a price through entering into the contract. This purchase or sale of commodities must be made through a broker who must be a member of the exchange and the trade should be done under the terms and conditions of the exchanges. The customer's funds are placed with an independent clearing house (preferably a clearing company capable of meeting the financial exposure made through all contracts created under the exchange). This is required to keep funds separate and not being used for any purpose other than the settlement of the contract.
Participants of a commodities exchange are not free from risk. Especially in the case of futures contracts, inexperienced investors may face price risk as all futures prices respond to many factors. Such factors may include unexpected high inflation, general strikes (hartals), natural calamities, reports on economic forecasts, politics and even on rumours and many other internal and external matters. The factors which can influence commodities prices may occur any time. Therefore, profits from commodities trading can be high but price fluctuation risk takes away all the profits any time.
Furthermore, commodity futures trading involves leveraged position as contracting parties deposit only a part of the overall contract value as margin. This deposit or "margin" is in general maintained by the contract buyer upon the overall price of the underlying commodity in order to ensure safe and clear settlement of a contract. Because of this leverage, a small change in the underlying commodity price can cause a large change - (upward or downward) - in the value of a futures contract. In sum, the nature of futures trading is such that investors can realise potentially large and rapid profits or incur equally large and rapid losses.
The writers are faculty of the Department of Finance, Dhaka University
DUE to lack of any market-based supervision and regulation mechanism; volatilities in the prices of essential commodities, whether produced domestically or imported from abroad, became the greatest challenges for the governments over the years. It also became one of the major political issues in the last national election of Bangladesh. Most often popular statements like blames on 'syndicates' overshadowed the pertinent issue - the market failure.
It is actually our market structure which enables major market players to enjoy oligopolistic advantage. In fact, absence of any reliable information and poor dissemination of the same always enabled some of the market participants to gain some oligopolistic and even on some occasion monopolistic control and monopolistic or oligopolistic (extra) profit. A carefully designed legal framework supported by necessary institutional support can bring some degree of competitiveness in the present market situation.
Systematic market information based trading mechanism along with wider participation in the markets need to be established in the country to minimise such oligopolistic cartels (or syndication arrangements). It is observed that, a well functioning commodity exchange along with appropriate regulatory framework and infrastructural facilities can attain this objective effectively. The government of Bangladesh made earlier the first step - the decision to establish commodity exchange in the country.
As we started our write up many months back, commodity prices in Bangladesh are notoriously volatile. Volatility in prices of different essentials like fuels, cereals, edible oil etc., created a massive stoke on different initiatives taken by various government agencies to check the adverse price movement. And the volatility has become a source of uncertainty affecting general people, government agencies, traders, importers and also financial institutions that provide financing to the commodity production, import or trading.
In the past, a spectrum of traditional methods such as buffer funds, buffer stocks, international commodity agreements, use of government trading agency (TCB) or para-military forces (BDR) were used to address the problem. Unfortunately, none of those mechanisms could provide any workable or sustainable solutions as these efforts failed to bring any structural change in the market system. Hence, we can look at the decision of the last caretaker government of Bangladesh to allow establishment of commodity exchange in this country can be an important step forward for the nation.
In general by commodities exchange we mean an exchange where various commodities and derivative products are traded. A commodity exchange, more precisely, is defined as an auction market where contracts on commodities are available for purchase or sale at an agreed price and for delivery on a specified date. Most commodity markets across the world trade on contracts based on agricultural products and other raw materials (like wheat, barley, sugar, maize, cotton, cocoa, coffee, milk products, pork bellies, oil, metals, etc.). These contracts can include spot prices, forwards, futures and in some cases, options on futures. Other sophisticated products may include interest rates, environmental instruments, swaps, or ocean freight contracts. These exchanges usually trade futures contracts on commodities, such as trading contracts to receive something, say corn, in a certain month. For example a farmer in Rajshahi having a mango plantation can sell a future contract on his mango, which will not be harvested for several months. This contract guarantees him the price he will be paid when he delivers; a fruit juicing company like Pran buys the contract now that guarantees the company that price will not go up when it is delivered. This protects the farmer from price drops and the buyer from price rises.
Thus, in the domestic market, pricing base can be established through contracts while traded in the exchange allows others interested to know in which direction the prices of such commodities are moving. The commodities exchange is new in Bangladesh but not new in the global context. So, the modalities and functionalities of these exchanges required to be understood by all, since we can expect such market mechanism to be present sooner than later.
First known commodity exchange (Bourse) for agricultural products was seen in Bruges in Belgium in 11th century where agricultural producers could settle their loans against output. However, the world's oldest established commodity exchange, the Chicago Board of Trade, was founded in 1848 by 82 Chicago merchants. The first of what was then called "to arrive" contracts were traded for flour, timothy seed and hay. "Forward" contracts on corn came into use in 1851 and gained popularity among merchants and food processors. Although in Buffalo New York some organised commodity trading for agricultural products had started much before it begun in Chicago.
In the backdrop of market failure or for the sake of bringing better trading environment for major commodities, different developed and developing countries started establishing commodity exchanges during the late eighties and nineties. In Asia alone, there are now 22 such commodity exchanges. In south Asian region, India, Pakistan and Nepal have already established commodity exchanges.
Commodities contracts are standardised contracts traded through regulated exchanges whereby an investor agrees to buy or to sell a fixed quantity of a certain commodity at a specified price for delivery in the future. In the commodities markets, the parties to a future trade thus can set and lock a price through entering into the contract. This purchase or sale of commodities must be made through a broker who must be a member of the exchange and the trade should be done under the terms and conditions of the exchanges. The customer's funds are placed with an independent clearing house (preferably a clearing company capable of meeting the financial exposure made through all contracts created under the exchange). This is required to keep funds separate and not being used for any purpose other than the settlement of the contract.
Participants of a commodities exchange are not free from risk. Especially in the case of futures contracts, inexperienced investors may face price risk as all futures prices respond to many factors. Such factors may include unexpected high inflation, general strikes (hartals), natural calamities, reports on economic forecasts, politics and even on rumours and many other internal and external matters. The factors which can influence commodities prices may occur any time. Therefore, profits from commodities trading can be high but price fluctuation risk takes away all the profits any time.
Furthermore, commodity futures trading involves leveraged position as contracting parties deposit only a part of the overall contract value as margin. This deposit or "margin" is in general maintained by the contract buyer upon the overall price of the underlying commodity in order to ensure safe and clear settlement of a contract. Because of this leverage, a small change in the underlying commodity price can cause a large change - (upward or downward) - in the value of a futures contract. In sum, the nature of futures trading is such that investors can realise potentially large and rapid profits or incur equally large and rapid losses.
The writers are faculty of the Department of Finance, Dhaka University