Five challenges that prevent greater adoption of derivatives trading by farmer producer companies (FPCs)

• by TVS Ravi Kumar, Mukesh Kumar and Rajnish Kumar
• Nov 24, 2023
• 5 min

The blog highlights the challenges faced by the FPCs in using derivatives markets like futures and options and what steps need to be taken to overcome these challenges.

Our previous blog highlighted the impressive benefits and potential returns for farmer producer companies (FPCs) that use various futures trading options. It also explained how the two major derivative markets, the National Commodities and Derivatives Exchange (NCDEX) and Multi-commodity Exchange (MCX), are already deeply involved with FPCs and help them increase profitability and manage risk.

FPCs and derivatives markets: Contrasting experiences from the field

In May 2022, Saharsa JEEViKA Mahila Producer Company entered into maize September futures for USD 306 per metric ton (MT) for 800 MTs of maize. It completed the transaction and earned a margin of 4% against a 0.5-1% margin it would have received in the spot market in May. The FPC had sufficient working capital to hold the produce till September and could continue its other business activities.

During the same period, FPC ABC of Begusarai and FPC XYZ of Muzaffarpur also wanted to sell their maize produce on the NCDEX platform. FPC ABC deposited its produce at the exchange-designated warehouse and waited to sell its products, as the platform had no buyers available. It did not get any buyers even after it waited 15 days, so it finally sold its products in the local market. This happened because the maize futures contract was still relatively illiquid. The exchange did not have enough buyers and sellers.

In contrast, FPC XYZ took a sell position when it deposited its maize at the warehouse. However, it failed quality control and was rejected. The FPC had to sell its maize in the local market, but it had to buy the same quantity on the exchange platform to leave its sell position. At the time of exit, the price had increased, which resulted in a loss for the FPC.

The above examples and MSC’s experience suggest that FPCs must address and mitigate key challenges to achieve widespread adoption. Let us discuss these challenges in detail.

1. Low awareness and technical knowledge of derivatives trading: FPC managers and board members should thoroughly understand the benefits and risks of derivatives trading. However, derivatives trading is complex and requires a sound understanding of its workings, each party’s expectations, and extensive documentation. NCDEX and SEBI conduct many programs to demystify derivatives trading for FPC management. However, more efforts are required. FPC-promoting institutions and nodal agencies, such as the Small Farmers Agri-business Consortium (SFAC) and National Rural Livelihoods Mission (NRLM), should make a concerted effort to scale up such awareness programs.

2. Inadequate working capital: Participation in the exchange platform requires significant working capital, as explained below:

a. Margin call and mark to market: Participants who want to engage in derivatives trading must deposit margin money, typically 10-12% of the total trade value. This amount remains blocked until the position is closed or settled with delivery. The other reason for the working capital requirement is the “mark to market” method to calculate the security’s fair value. Mark to Market (MTM) in a futures contract is the daily settlement of profit and losses that arise due to the change in the security’s market value until it is held.

The price movements of these contracts are monitored daily, and buyers and sellers pay or receive margins on their futures contracts, which the exchange executes. When the price of the futures drops, the exchange will withdraw the corresponding amount of money from the buyers’ margin account and deposit it in the sellers’ margin account to compensate for the price change. Similarly, when the futures contract price rises, the gains will be deposited into the buyer’s account, and the seller will lose this money in their account. So, FPCs must be ready to deposit money into their margin account to compensate for any price increases. This leads to additional working capital requirement from the FPC.

b. Capital for the duration of stock holding and logistics: The full delivery process of the material on the exchange takes at least 20 to 35 days. FPCs must crucially arrange sufficient working capital to buy materials and meet exchange and warehouse-level expenses. However, many FPCs lack the requisite working capital, which naturally discourages their participation in this ecosystem.

Only FPCs that meet these working capital requirements can engage in the derivatives markets. So, those with limited liquidity are excluded.

3. Stringent quality requirements: The exchange’s quality parameters are strict. FPCs risk rejection of produce at the exchange warehouse if their product does not meet the warehouse quality parameters. To prevent this, FPCs should develop internal capabilities to ensure high-quality procurement from its members and invest to educate members on quality parameters.

For example, JEEViKA FPCs have invested in training all their field team to use moisture meters. In fact, all the procurement teams and the Board of Directors (BoDs) have been given moisture meters during maize procurement. The FPCs also send advisories to farmers on simple post-harvest techniques, such as drying, storage, sorting, and grading, among others, to reduce issues of fungus and weevil-infested grains. Similarly, the FPCs conduct regular training for field teams and BoDs on measuring hector-liter.

4. High premium on options: The premium required to buy options contracts can be as high as 6-7% of the total trade value, higher than margins usually available in the spot market. The Securities and Exchange Board of India (SEBI) and some private sector players, such as Bayer Crop Science, have provided subsidies to encourage FPCs to participate. However, these subsidies are not permanent and available for a limited time. Policymakers play a role to subsidize the premium cost for FPCs to enable suitable price hedging. Suggestions have also emerged to replace the MSP (minimum support price) with put options for farmers. Philanthropic capital can also subsidize the premiums to buy options for qualified and well-functioning FPCs.

5. Liquidity of trades on the commodity exchanges: The futures market’s success is determined by liquidity—the frequency of trades in a specific commodity and the number of market participants trading in that commodity. FPCs or other market participants cannot enter or exit the market at will if the liquidity is low. Moreover, FPCs may also run the risk of market manipulation. Liquidity improvement will require government support to encourage derivatives trading across a slew of commodities and give confidence to market participants.

Conclusion

As highlighted in our previous blog, derivatives trading is an important tool for mature FPCs to de-risk themselves from price risks and ensure better market linkages. Systematic and structured capacity building of FPC management, subsidizing some transaction costs associated with trading, and consistent policy support could help increase the penetration of derivative trading among FPCs.