The Chittagong Stock Exchange (CSE) has decided to establish a commodity exchange in the country for which formal approval from the Bangladesh Securities and Exchange Commission is awaited. The legal framework is already in place. This will be a first for Bangladesh. But failed experiments can be costly.
Among physical goods, commodities occupy a special place. They are fungible and can be transported over long distances in bulk with relative ease. Commodities are widely used as food, building materials or raw materials. Cocoa, corn, wheat and oilseeds are some examples of agricultural commodities. In addition, there are metals (gold for example) and energy (gasoline for example) commodities. The demand for commodities is increasing worldwide driven by product innovations, new products, population increase and affluence.
Commodities have been traded for millennia. What is new is the introduction of derivatives in in the United States in the nineteenth century. Concerned about prices at the time of harvesting, wheat farmers in the Midwest started making forward sale for their growing produce. The first forward contract was transacted in 1851 in Chicago Board of Trade (CBOT), which came into being in 1848. The need to manage price risk led to the creation of forward contracts. A forward contract is an agreement to sell a commodity in the future. Initially, contract enforcement was a problem in forward contracts.
Gradually futures contracts evolved in 1865 in the same exchange. Futures contracts are standardised, and performance is guaranteed. This market allows producers, buyers, and processors of a commodity to better plan expenses and revenues by reducing exposure to price volatility. CBOT is now known as the Chicago Mercantile Exchange (CME) where many other types of commodities have been added and billions of dollars of futures trades are transacted. Later, options (another derivative) were added. What are derivatives and what is its utility?
As per Investopedia a derivative is a type of financial contract whose value is dependent on an underlying asset, group of assets, or benchmark. One needs to be skillful to become a trader because of the intricacies and risks involved. In line with the evolution of financial markets, commodities have also entered the realm of exchange traded derivatives for arbitrage, risk mitigation, and speculation. The motivations of arbitrageurs, hedgers, and speculators are different but nonetheless participate in the same arena.
A fourth category of market participants-investors-enter the market for gains as well as portfolio diversification.
Scholarly literature suggests most endeavours to set up commodity exchanges and commodity futures exchanges have failed. Lack of a conducive ecosystem is to blame.
It has been found that gold has little correlation with other asset classes. Although CSE’s belief that the time is ripe for a commodity exchange is not misplaced it is as well to remember that a commodity exchange serves different functions. One form, existing only in emerging countries, is a physical market where goods exchange hands on a cash (spot) basis.
As per UNCTAD a commodity exchange cannot be created in isolation. It depends on a strong set of supporting or complementary organisations, institutions and structures. In other words, an ecosystem has to surround the exchange for its sustenance.
At a minimum, we need good warehousing, grading and sorting capability, storage facilities, good road and rail network and transportation and collateral management companies (CMA). CMAs assist lending banks monitor pledged commodities. However, CSE will bypass the physical market exactly because of the shortcomings noted above.
But the news has raised eyebrows. Scholarly literature suggests most endeavours to set up commodity exchanges and commodity futures exchanges have failed. Lack of a conducive ecosystem is to blame. Additionally, the dire strait of our banking sector and the stock market does not make us optimistic about the quality of governance. For it to succeed the government has to patronize the initiative wholeheartedly. It is possible that some government policies will run counter to the objectives of the exchange.
Secondly, sound legal and regulatory framework has to be in place. People complain that in Bangladesh despite there being laws the problem lies in its implementation. Foreign investors complain about contract enforcement. Thirdly, the customs and practices prevalent in commercial activities in Bangladesh must align with the rules enforced by the proposed exchange. Fourthly, the volume of trading should generate enough revenues for the market to break-even.
* Raihan Amin is a former banker.
* Views expressed her are the author's own.