A very significant announcement regarding our Capital Markets that was published by this paper last week may have escaped notice of many market watchers. After a lapse of 33 years, apparently, the Government has decided to allow "Hedge Trading" in cotton by the Karachi Cotton Association. If so, it will usher in monumental changes in our capital markets as presaged by the price of a brokerage seat at KCA, which is reported to have skyrocketed from PKR 300,000 to PKR 4 million. If the report is true, this long overdue policy initiative of the Government raises several fundamental questions that will need to be adequately addressed.
1. With great fanfare, over three years ago, the Government set up National Commodity Exchange Limited (NCEL), a Company with specific mandate to serve as the country's first Commodity Futures Exchange. Though legally registered, and with an M.D. and a Chairman ensconced in offices in Karachi, for all practical purposes this entity has remained moribund.
The reason is that in its eager zeal for capital market reforms, the Government had overlooked a minor detail...Pakistan has no enabling law for Futures Exchanges. I.e., our legislators first need to pass a "Commodity Futures Trading Act"...its draft only now being feverishly prepared by SECP...a classical example of putting one's cart before the horse!
2. If NCEL cannot become operational till legislation of a Commodity Futures Trading Act, then how will KCA begin "Hedge Trading"...another name for Futures trading...which implies that it will act as a Commodity Futures Exchange?
3. Though KCA was registered over 50 years ago and was pretty active for 25 years after partition, its current membership has no clue about the functioning of modern derivative markets (financial futures and options). Legal niceties aside, if, under their present state of abysmal ignorance, these cotton brokerages are let loose on our capital markets, the mayhem they are likely to cause will surely dwarf the current turmoil at KSE.
4. Lastly, it appears that prior to announcing its decision to allow hedge trading in cotton, the Government did not consult the Authority that will eventually regulate such a market, ie, SECP. Had it done so, it would have surely been informed that our financial markets regulator was still struggling with the Government's earlier NCEL faux pas, and could well do without further complications.
Prerequisites of futures exchanges: What is so esoteric about Futures Exchanges? Aren't they similar to ordinary stock exchanges like KSE? How is buying and selling futures contracts any different from buying and selling stocks at KSE?
For a pat answer, see what happened to KSE with its introduction of trading in 30 days Futures on a handful of hot stocks like OGDC, PTC, and PSO. Apparently, KSE management was unaware that margin requirements for Futures Contracts are quite different for the three distinct groups of market players...hedgers, arbitrageurs, and speculators. In developed capital markets, these vary from zero (for arbitrageurs) to as high as 50% (for speculators). By requiring a uniform 10% initial margin for futures contracts, and without daily mark-to-market mechanisms being in place, KSE was playing with fire. Add to this the wild leveraging potential of Badla financing available to speculators; it was a recipe for disaster that befell the market last month...and, as this piece goes to press, continues to manifest itself in daily volatility that makes KSE-100 Index jerk up and down by several hundred points a day.
An interesting aside before we proceed; if Futures trading is unlawful till Parliamentary approval of a Futures Trading Act, then under which enabling law is KSE trading stock futures? After all, the operational mechanics of futures contracts are independent of the nature of underlying assets...whether they are shares of PSO or warehouse receipts entitling holders to take delivery of cotton bales.
Be that as it may, let us review the basic features of futures markets and their peculiar prerequisites that SECP needs to resolve before trading commences.
DEFINITIONS: A. Product: A commodity needs to be clearly defined. For instance, if it is wheat, what are the standard grain size, acceptable colour, gluten content, weight and mode of delivery (50 kg in hessian bags);
B. ACCEPTABLE POINT OF DELIVERY: Warehouse at Lahore (?), contract size (250 bags?), allowable variation (+/- 2.5 %?)
C. STANDARDIZED CONTRACT MATURITY: 3rd Friday of contract month (?), and futures tenors (30, 60, 90, 180, and 360 days?)
D. CONTRACT MONTHS: These may be calendar quarters or may be months that coincide with sowing or harvesting seasons, and
E. MARGIN STANDARDS: As discussed above, what they will be for different types of investors.
EXCHANGE AND BROKER CERTIFICATION: Whether it is KCA or NCEL, or any other futures exchange that SECP licenses in future, it will need to ensure the professional competence of Exchange managements and component brokerages. Licensing of brokerages especially will have to be contingent upon their quality of staffing. Every brokerage house's market makers will have to take and pass exams to certifying their professional competence.
EDUCATION: Whereas, in developed capital markets, spot and futures prices of equities are mathematically consistent (Futures being Spot plus market interest for intervening period), anyone who has traded stock futures at KSE is aware that there is no logical relationship between them. Implied interest rates may vary from zero to 100%. But, even so, the Spot-Futures relationship is a relatively simpler one. When trading commodities, two other factors come into play, these are:
(I) CARRYING COSTS: In the case of commodities these include financing costs and storage costs. While the former may be identical (going rate of interest), the latter vary from commodity to commodity. For instance, wheat storage costs are quite different from those for cotton. And
(II) CONVENIENCE YIELD: It denotes the premium that an investor of consumable assets is willing to pay for the security of having the commodity in stock. For instance, when the investor is an Oil Refinery, its demand for 180 days future supply of crude oil will affect the price of 180 days futures contract for crude oil over and above its price determined by storage and interest costs.
Both the foregoing costs have to be analysed and estimated by polling market players and by soliciting assistance from other exchanges in neighbouring countries. To give a concrete example, let's look at price determination of futures contracts for a cotton spinning mill that uses 40,000 bales of cotton each year over the hypothetical one year period commencing March 2005.
The purpose of the foregoing illustration is simply to convey the message that both the writers (brokerages) of Futures Contracts and its users (commodity trading houses) will have to be proficient in mechanisms of this trade. It is somewhat more complicated than simple buying and selling of company shares at KSE...don't you think so?
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Month Year Spot ?Si Futures ?Fi
price....Si 90-days price.... Fi 90-days
(PKR / Maund) (PKR / Maund)
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Mar 2005 2,150 (0.0652) 2,240 (0.0056)
Apr 2005 2,250 (0.0110) 2,215 (0.0111)
May 2005 2,100 (0.0455) 2,141 (0.0331)
Jun 2005 2,150 0.0000 2,093 (0.0224)
Jul 2005 2,300 0.0222 2,190 0.0460
Aug 2005 2,325 0.1071 2,044 (0.0665)
Sep 2005 2,400 0.1163 2,094 0.0243
Oct 2005 2,510 0.0913 2,240 0.0698
Nov 2005 2,600 0.1183 2,265 0.0111
Dec 2005 2,450 0.0208 2,338 0.0325
Jan 2006 2,250 (0.1036) 2,446 0.0460
Feb 2006 2,315 (0.1096) 2,533 0.0355
Mar 2006 2,200 (0.1020) 2,386 (0.0582)
Apr 2006 2,150 (0.0444) 2,191 (0.0815)
May 2006 2,100 (0.0929) 2,254 0.0285
Standard Deviation
of Spot Price, sSi = 0.084
Standard Deviation
of Futures Price, sFi = 0.046
Correlation Coefficient
Spot / Futures ?sf = 0.487
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