Insights into Editorial: A first step: On Multi Commodity Exchange
Context:
The government announced last year that it would take steps towards introducing new varieties of commodity derivatives in the market.
Recently, Finance minister launched the first options security with gold as the underlying asset for trading on Multi Commodity Exchange Ltd. This marks a very important evolution in trading of the yellow metal itself. Launching gold options is a step towards “formalising trade” in the yellow metal.
The gold options contract launched allows trading in 1kg gold. The move to allow options trading comes on the back of several other steps the government has taken to make gold trading more transparent.
Introduction
Gold Options is the first product for options trading that the regulator Securities and Exchange Board of India (Sebi) has allowed after 14 years of commencement of commodity exchanges in the country.
What is MCX?
Multi Commodity Exchange (MCX) as the name suggests is an exchange like BSE and NSE where commodities are traded.
- It is a platform for commodity traders that facilitate online trading, settlement and clearing of commodity futures transactions, thereby providing a platform for risk management (hedging).
- It was established in November 2003 under the regulatory framework of FMC (Forward Markets Commission).
- In 2016, the FMC was merged with SEBIand MCX as an exchange falls under the regulatory purview of SEBI.
What are Options?
Options are a type of derivative security. They are a derivative because the price of an option is intrinsically linked to the price of something else.
Options, like other financial derivatives, allow price risks to be transferred between market players in an efficient manner.
The Gold options product is unique and the first of its kind, giving buyers the right to buy or sell the underlying asset, but no obligation, at a specified price at the expiry.
What are the benefits of Gold Options?
The derivative instrument allows investors to enter into contracts to either buy or sell gold sometime in the future at a pre-determined price, thus allowing investors to hedge any volatility in the price of the metal, for a price.
- Options usually are cheaper than binding future agreements will help in the wider participation of investors in the realm of commodity speculation.
- Helps in formalising Gold trade.
- The introduction of a new financial instrument in India clears a path to building a vibrant market for commodities.
- The benefits of well-regulated commodity speculation are likely to outweigh the potential systemic risk from asset bubbles.
The commodity options would be taken up initially by hedgers, professionals and high net worth individuals. Retail investors will participate only if mini gold contracts are launched as the lot size is not manageable for retail as per the current specification.
What is required is avoiding some policy mistakes of the past
The business of anticipating prices in the future is left to professional speculators while their clients benefit from the prospect of stable prices. In the process, financial derivatives can facilitate the conduct of real economic activity in higher risk segments — including in agriculture and industrial activity.
Confusion over this has led to an unjustified hostility towards financial speculation, as well as some hasty policy measures. Almost a decade ago, a rapid increase in food prices pushed the government to impose a blanket ban on any speculation on agricultural products.
While it may have been relevant for the specific circumstances, the wide-ranging nature of the move slowed the development of a healthy market for commodity speculation. The government should now resist similar temptation and focus instead on real-time monitoring systems.
To improve market efficiency, the market regulator is also mulling the entry of mutual funds and portfolio management services into the business of investing in commodity derivatives.
Conclusion
The move to allow ‘options trading’ comes on the back of several other steps the government has taken, like Sovereign Gold bond scheme and Gold monetization scheme, to make gold trading more transparent.
Apart from the standardized derivatives approved by SEBI for trading in exchanges, a framework that promotes over-the-counter products will help improve the scope for risk mitigation. The debut of gold options should be seen as a step towards greater reforms.
